For every dollar that was ever put to work in the business, they generate 20 cts of operating income today. For this group, retained earnings + paid in capital is less than 5x operating income. The outright owner of these companies would be smiling ear to ear.
Retained earnings are the sum of all historic earnings that were not paid out as dividends but instead reinvested in the core business or used to pay off debt. Retained earnings are also known as earned surplus, accumulated earnings or unappropriated profit.
Now if the intrinsic value of a business is the present value of all future dividends, then retained earnings are a good thing if they are allocated in a way that will produce a much greater dividend stream in future. If earnings are retained but not put to good use, it is fair to say the business, to date has been terrible from an owners perspective.
Using retained earnings as a starting point, businesses can be grouped into five categories.
I) Businesses with little or no retained earnings because they have not been very profitable over their lifetime. Photochannel serves as an example.
II) Businesses with significant retained earnings but a dodgy balance sheet. Ingersoll Rand in H1 2009 serves as an example. One way to do this is to retain earnings, overpay for a business and subsequently write down the goodwill. Another way is to report nonexistent earnings. This means retained earnings are high but there is no actual capital to deploy.
III) Businesses with high retained earnings and a high cash balance. George Risk and Solitron serve as examples. These are profitable businesses that for some reason do not pay a lot of dividend.
IV) Businesses with relatively low retained earnings in relation to their operating income but high debt. Aircastle serves as an example. These are companies that have sold debt to raise capital to grow the business. The assets come cheap to the stock investor. Beware of leverage though.
V) Businesses with hardly any retained earnings, a strong balance sheet and good earnings. From an owners perspective, these have been a good business to own. One way to do this is pay out a lot of dividends while maintaing a strong balance sheet (Psychemedics). Another way is to allocate the retained earnings wisely and grow.
Retained earnings are a simple, intuitive number linking the balance sheet and the earnings statement. If you are looking for evidence that a business is profitable and well managed, retained earnings (including paid in capital) are a good place to start.
Any and all questions welcome as usual; remember, do not overpay!