Key Metrics – Retained Earnings To Market Value by Chris Gilbert
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 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 their 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 the 2 parts.
Retained Earnings - Simply the portion of net income, or profits, that is retained by the company rather than distributed back to shareholders as dividends. Essentially, a company can use profits in 2 ways - 1) Pay back shareholders in the form of dividends, buybacks, or debt reduction or 2) 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 their profits to good use, we measure the growth of retained earnings to market value.
Market Value - Technical definition is the price 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 # of outstanding shares.
What Does It Reveal?
"Unrestricted earnings should be retained only where there is a reasonable prospect – backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future – 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."
-- Warren Buffett
Ideally, retained earnings should be used in some manner to increase profits and create more value for shareholders. In Warren 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 re-invested 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 re-investment."
-- Warren Buffett
How To Use Retained Earnings To Market Value
Let's go through a real-world example using Apple. We'll use a 5 year period in order to smooth out inconsistencies while still reflecting recent trends. First step is to calculate market value change for 5 years. You can use any site you want to find financial data, but personally I use Morningstar because they usually have everything I need along with 5-10 years worth of numbers. To do this we simply take the closing share price of 2015 ($105.26) and subtract the closing share price of 2011 ($57.86). Then we find retained earnings for 5 years. Retained earnings equals the sum of earnings per share from 2011-2015 ($31.61) minus the sum of dividends per share from 2011-2015 ($5.80). To get the retained earnings to market value we simply divide Market Value Change by Total Retained Earnings:
- Market Value Change (5 years) / Total Retained Earnings (5 years) =
- ($105.26 - $57.86) / ($31.61 - $5.80) = $1.84
So, for every $1 of retained earnings, amount kept from shareholders and reinvested, $1.84 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 their retained capital to generate value. To calculate we need to find the EPS change over 5 years from 2011-2015 ($9.22 - $3.95) and then divide by Total Retained Earnings for 5 years:
- EPS Change (5 years) / Total Retained Earnings (5 years) =
- ($9.22 - $3.95) / ($31.61 - $5.80) = 0.204 = 20.4%
20.4% return on retained earnings would be very respectable in my opinion, but as an individual investor you would have to consider if you could've put that money to better use.
About Chris Gilbert
I am a full-time pharmacist as well as an avid investor. I discovered the art of value investing by reading the works of Benjamin Graham. After that I began to drift towards Peter Lynch, Warren Buffett, and Charlie Munger. My investing philosophy now is simply to find great companies at a discount while using a common sense, value oriented strategy, and maintaining a long-term outlook. I am determined to educate the individual investor that investing is not hard, not time consuming, and not expensive. Through the use of value investing and the (Y)OURPORTFOLIO Spreadsheet, my goal is to help you obtain better results in a fraction of the time.
