Introducing the key metrics series, we take a look at retained earnings to market value. I want to explain exactly what retained earnings are, what they can show us and why they can be telling of management. Then we'll analyze why Warren Buffett (Trades, Portfolio) likes to compare retained earnings growth to market value growth.
When seeking out potential investments we're obviously looking for profitable, successful companies. After all, making profits and delivering them to shareholders should be in the top tier of a company's priorities. But a concept that's often overlooked by investors is what the company does with its profits. The retained earnings to market value metric attempts to verify that management is using profits kept from shareholders to create value, and a decent amount of value at that.
What is the metric retained earnings to market value?
Let's first break this down into two parts.
Retained EarningsÂ – Simply the portion of net income, or profits, that is retained by the company rather than redistributed to shareholders as dividends. Essentially, a company can use profits in two ways:
- Pay back shareholders in the form of dividends, buybacks or debt reduction.
- Plow the excess money back into the business in order to expand, innovate and generate increased value.
In order to determine if management is properly putting its profits to good use, we measure the growth of retained earnings to market value.
Market ValueÂ – Technical definition is the price for which an asset would sell on the open market. In this instance we'll use market capitalization. To find market cap simply multiply the share price by total number of outstanding shares.
What does it reveal?
"Unrestricted earnings should be retained only where there is a reasonable prospectÂ – backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the futureÂ – that, for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors."Â – Warren Buffett Â (Trades,Â Portfolio)
Ideally, retained earnings should be used in some manner to increase profits and create more value for shareholders. In Buffett's eyes, if management cannot make good use of the money then it should be returned to him. In other words the shareholder is better off receiving dividends than having the company simply maintain status quo.
So he developed what we'll call the retained earnings to market value, or the $1, test. Just like his quote states, we want to see the business create $1 of market value for every $1 of retained earnings. If a company is able to pass this test then investors can rest easy knowing that management is capable of returning value with capital retained by the business. Put simply, you should require more than just profits. You need to know if your investment is capable of producing the returns you want, and this metric is a very telling figure if analyzed.
"You should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment."Â – Warren Buffett Â (Trades,Â Portfolio)
How to use retained earnings to market value
Let's go through a real-world example using Apple (AAPL, Financial). We'll use a five-year period in order to smooth out inconsistencies while still reflecting recent trends. First step is to calculate market value change for five years. You can use any site you want to find financial data, but personally I use GuruFocus because it usually has everything I need along with five to 10 years' worth of numbers. To do this we simply take the closing share price of 2015 ($110.30) and subtract the closing share price of 2011 ($54.47). Then we find retained earnings for five years. Retained earnings equals the sum of earnings per share from 2011 to 2015 ($31.61) minus the sum of dividends per share from 2011 to 2015 ($5.80). To get the retained earnings to market value, we simply divide market value change by total retained earnings:
- Market value change (five years) / total retained earnings (five years).
- ($110.30 - $54.47) / ($31.61 - $5.80) = $2.16.
So, for every $1 of retained earnings, amount kept from shareholders and reinvested, $2.16 of market value was created. This is exactly what investors want out of management.
Another way to use these numbers is by determining the return on retained earnings. Consider it an alternative method to test how well management uses its retained capital to generate value. To calculate we need to find the EPS change over five years from 2011 to 2015Â ($9.22 - $3.95) and then divide by total retained earnings for five years:
- EPS change (five years) / total retained earnings (five years).
- ($9.22 - $3.95) / ($31.61 - $5.80) = 0.204 = 20.4%.
A 20.4% return on retained earnings would be very respectable, but as an individual investor you would have to consider if you could have put that money to better use.