Saturday, 25 February 2012

Warren Buffett's Test for Retained Earnings


The test for Warren Buffett is whether company management can transform each dollar of earnings retained into no less than a dollar of market value. The period he implies that he uses is 5 years (on a rolling basis).

Using the retained earnings profitably is not enough for Warren Buffett. The retained earnings must increase earnings substantially. After all, just leaving the earnings in a savings account will increase earnings without any effort.

Warren Buffett has suggested to investors that they need to predict, after reasoned analysis, what rate of return a company will average over the near future. The rest is simple.

‘You should wish your earnings to be re-invested [by the company] 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.’


Mary Buffett and David Clark see Warren Buffett’s test from an additional perspective. They take the total value of the profits retained and use them to calculate the rate at which profits have increased by the use of that money.

Take for example, Canon Inc. Using figures available from Value Line, we can calculate that, in the period from 1993 to 2002, 
  • Alcoa earned a total of $9.56 per share. It paid a total of $ 1.55 to shareholders by way of dividends. 
  • This means it retained profits over that period amounting to $8.01.
  • In that period, earnings per share grew from .24 to 1.79. 
  • That is, all the profits retained by the company ($8.01 per share) resulted in the earnings per share rising 1.55 (1.79-.24). 
  • To show the return percentage, the calculation is

1.55 x 100 = 19.35

A return of 19.35% would be acceptable to most investors but, in the end, shareholders would have to consider whether, had they received all the profits by way of dividends, they could have put the money to better use.

It is this ability to use retained earnings of a company to increase earnings at a higher than market rate that attracts successful investors like Warren Buffett.
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