Saturday, 25 February 2012

Compounding and Retained Earnings

Warren Buffet is said to look at the compounding factor when deciding on investments, requiring a stock investment to show a high probability of compound growth in earnings of at least 10 per cent before making an investment decision.

Warren Buffett has on several occasions referred to the use by a company of its retained earnings as a test of company management.
  • He tells us that, if a company can earn more money on retained earnings than the shareholder can, the shareholder is better off (taxation aside) if the company retains profits and does not pay them out in dividends. 
  • If the shareholder can achieve a higher rate of return than the company, the shareholder would be better off if the company paid out all its profits in dividends (taxation situation again excluded) so that they could use the money themselves.

Put simply, 
  • if a company can retain earnings to grow shareholder wealth at better than the market rates available to shareholders, it should do so. 
  • If it can’t, it should pay the earnings to shareholders and let them do with them what they wish.

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