Retained earnings to market value attempts to verify that management is using profits kept from shareholders to create value↓
Next up in the Key Metric series we have 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.
Let's first break this down into the 2 parts.
“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
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. 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. If the calculations overwhelm you, don't worry... I got you covered. The YourPortfolio Software calculates 3, 5, and 10yr values.
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%
A 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. The YourPortfolio Software also calculates return on retained earnings as well for 3, 5, and 10yr periods.