Retained Earnings and the Market Value of the Company

Does the value added by Retained Earnings increase the Market Value of the Company?

Warren Buffett believes that if you can purchase a company with a durable competitive advantage at the right price, the retained earnings of the business will continuously increase the underlying value of the business and the market will continuously ratchet up the price of the company's stock. The key lies in the company's ability to properly allocate capital and keep adding to the company's net worth.

A perfect example, of this is his own Berkshire Hathaway, which in 1983 had a book value of $975 a share and was trading at around $1,000 a share. Eighteen years later, in 2001, it has a book value of approximately $40,000 a share and is tradinga t approximately $68,000. This means that Berkshire's book value has increased approximately 4,002% and the price of its shares by 6,874%. Warren grew the company's net worth by using the company's retained earnings to purchase whole or partial interests of other businesses with durable competitive advantages. As the net worth of the company grew, so did the market's valuation of the company, thus the rise in the price of the stock.

This is not true with the price-competitive business. It can retain earnings for years and still never show a real increase in the value of the company's stock. In 1983, General Motors had a book value of $32.44 a share and was trading at approximately $34. In 2001, General Motors' book value stood at approximately $36 a share and the price of its shares at around $55. All General Motors has to show for those eighteen years in business is a 10% increase in its book value and a 52% increase int he price of its stock.

All you have to do is review a company's historical increase or decrease in the price of its shares and the historical increase or decerease in the company's per share book value. Use at least a 10 year spread. A company with a durable competitive advantage will have an increasing share price and an increasing book value.

Remember, the ultimate goal is to buy on of these businesses at a time that it is suffering from some bad news situation that has caused the shortsighted stock market to send its stock price down. You are looking for a RECENT downturn in the price of a company's stock, not for a company whose stock price has done nothing over 10 years.