Wednesday, 28 March 2018

RETAINED EARNINGS: Warren's secret for getting super-rich


             Balance Sheet/Shareholders' Equity

     ($ in millions)

     Preferred Stock
     Common Stock
     Additional Paid in Capital
-> Retained Earnings  
    Treasury Stock---Common
    Other Equity
    Total Shareholders' Equity

At the end of the day, a company's net earnings can either be paid out as dividends or used to buy back the company's shares, or they can be retained to keep the business growing. When they are retained in the business, they are added to an account on the balance sheet, under shareholders' equity, called retained earnings.

If the earnings are retained and profitably put to use, they can greatly improve the long-term economic picture of the business. It was Warren's policy of retaining 100% of Berkshire's net earnings that helped drive its shareholders' equity from $19 a share in 1965 to $78,000 a share in 2007.

To find the yearly net earnings that are going to be added to the company's retained earnings pool, we take the company's after-tax net earnings and deduct the amount that the company paid out in dividends and the expenditures in buying back stock that it had during the year. In 2007 Coca-Cola had after-tax net earnings of $5.9 billion and paid out in dividends and stock buybacks $3.1 billion. This gave the company approximately $2.8 billion in earnings, which were added to the retained earnings pool.

Retained Earnings is an accumulated number, which means that each year's new retained earnings are added to the total of accumulated retained earnings from all prior years. Likewise, if the company loses money, the loss is subtracted from what the company has accumulated in the past. If the company loses more money than it has accumulated, the retained earnings number will show up as negative.

Out of all the numbers on a balance sheet that can help us determine whether the company has a durable competitive advantage, this is one of the most important. It is important in that if a company is not making additions to its retained earnings, it is not growing its net worth. If it not growing its net worth, it is unlikely to make any of us superrich over the long run.

Simply put, the rate of growth of a company's retained earnings is a good indicator whether or not it is benefiting from having a durable competitive advantage. Let's check out a few of Warren's favorite companies with a durable competitive advantage: Coca-Cola has been growing its retained earnings pool for the last five years at an annual rate of 7.9%, Wrigley at a very chewy 10.9%, Burlington Northern Santa Fe Railway at a smoking 15.6%, Anheuser-Busch at a foamy 6.4%, Wells Fargo at a very bankable 14.2%, and Warren's very own Berkshire Hathaway at an outstanding 23%.

Not all growth in retained earnings is due to an incremental increase in sales of existing products; some of it is due to the acquisitions of other businesses. When two companies merge, their retained earnings pools are joined, which creates an even larger pool. As an example, Procter & Gamble, in 2005, saw its retained earnings jump from $13 billion to $31 billion when it merged with The Gillette Co.

Even more interesting is the fact that both General Motors and Microsoft show negative retained earnings. 
  • General Motors shows a negative number because of the poor economics of the auto business, which causes the company to lose billions. 
  • Microsoft shows a negative number because it decided that its economic engine is so powerful that it doesn't need to retain the massive amount of capital it has collected over the years and has instead chosen to spend its accumulated retained earnings and more on stock buybacks and dividend payments to its shareholders.

One of the great secrets of Warren's success with Berkshire Hathaway is that he stopped its dividend payments the day that he took control of the company. This allowed 100% of the company's yearly net earnings to be added into the retained earnings pool. As opportunities showed up, he invested the company's retained earnings in businesses that earned even more money, and that money was all added back into the retained earnings pool and eventually invested in even more money-making operations. As time went on, Berkshire's growing pool of retained earnings increased its ability to make more and more money. From 1965 to 2007, Berkshire's expanding pool of retained earnings helped grow its pretax earnings from $4 a share in 1965 to $13,023 a share in 2007, which equates to an average annual growth rate of approximately 21%.

The theory is simple: the more earnings that a company retains, the faster it grows its retained earnings pool, which, in turn will increase the growth rate for future earnings. The catch is, of course, that it has to keep buying companies that have a durable competitive advantage. Which is exactly what Warren has done with Berkshire Hathaway. Berkshire is like a goose that not only keeps laying golden eggs, but each one of those golden eggs hatches another goose with the golden touch, and those golden geese lay even more golden eggs. Warren has discovered that if you keep this process going on long enough, eventually you get to start counting your net worth in terms of billions, instead of just millions.

No comments: