Businesses exist to make money for their shareholders, but that doesn't mean that every dollar that a company makes goes directly to its owners. In many cases, businesses don't pay out their earnings - they retain them and reinvest them into the business. In his 2019 letter to shareholders of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), Warren Buffett (Trades, Portfolio) explained how investors can analyze a company's retained earnings, using Berkshire's own annual figures as an illustrative example.
Retained earnings: The unseen force
Paying all cash earned to shareholders is often not the best option for a business. If the company has a lot of growth potential - if it has developed a new product or has expanded into a new market - it may make more sense to reinvest that money back into the business so that more cash can be generated later. Earnings, when retained and redeployed correctly, are a source of compound interest - the more you retain, the more you gain. However, this benefit is often difficult to quantify using standard accounting methods. This is one reason why Buffett believes Berkshire's true strength is often underestimated by traditional valuation methods:
"In the non-controlled companies, in which we own marketable stocks, only the dividends that Berskhire receives are recorded in the operating earnings that we report. The retained earnings? They're working hard and creating much added value, but not in a way that gains directly into Berkshire's reported earnings. At almost all major companies other than Berkshire, investors would not find what we'll call this 'non-recognition of earnings' important. For us, however, it is a standout omission."
For instance, in 2019, Berkshire owned 18.7% of American Express (AXP). Berkshire received $261 million worth of dividends, but its ownership "entitled" it to an additional $998 million in retained earnings. Similarly, in 2019, Berkshire owned 5.7% of Apple (AAPL, Financial), which entitled it to a $773 million dividend. However, it was also "entitled" to $2.519 billion in retained earnings. In total, the top 10 largest companies in Berkshire's minority ownership portfolio generated $3.798 billion in dividends, but had an additional $8.332 billion in retained earnings.
It should go without saying that having a claim on retained earnings - as Berkshire does - does not mean this money will eventually trickle down to shareholders. If the leadership of a business like American Express or Apple mismangages its capital, it may squander money that could have been distributed to shareholders like Berkshire. But on the other hand, reinvested capital doesn't usually carry with it the taxes that are imposed on recipients of dividends.
And if the money is invested wisely, the compounding effect can more than offset the risk of capital loss. Buffett believes this compounding effect explains why stocks historically outperform bonds - although usually considered riskier as an investment, the average risk-adjusted return on corporate and government bonds has generally been lower than the risk-adjusted return on stocks.
All of this can help to explain why Buffett looks for "businesses that even an idiot can run, because sooner or later, one will." If you are invested in a business that is retaining a large percentage of its earnings, you need to make sure that the underlying model is solid enough to withstand the occasional bout of poor management.
Disclosure: No positions.
Read more here:
- Seth Klarman Explains Graham-Style Value Investing
- Warren Buffett's Best Friend
- Charlie Munger: The Best Investors View Stocks Like Their Own Businesses​
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