The Mark of a Good Business: High Returns on Capital

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter


It is useful here to remember Buffett’s reminder that it is not necessarily a cause for celebration if a business grows its earnings year after year. The same thing happens to a savings account if you add more capital each year, which does not make a savings account a good investment. It’s the return on this additional capital that determines whether something is a good investment or not.

To illustrate, let’s look at Johnson & Johnson (JNJ). In 2000, JNJ had shareholders’ equity of $18.8 billion. At the end of 2009, its shareholders’ equity had grown to $50.6 billion. We can calculate that, since 2000, JNJ invested $31.8 billion back into the business.

During that same time, earnings grew $8.1 billion, from $4.8 billion in 2000 to $12.9 billion in 2009.

By dividing the additional earnings of $8.1 billion by the additional $31.8 billion in capital, we can see that JNJ earned a return of 25.5% on its investment, which is very good.

It is also useful to look at what percentage of its total net earnings JNJ reinvested back into the business. The reason is that this is suggestive of how much of its future earnings JNJ is likely to reinvest. By multiplying the rate of reinvestment by the return on that investment, we can then calculate an expected growth rate for earnings.

Since 2000 through 2009, JNJ earned a total net profit of $89.7 billion. Since we already know that JNJ reinvested $31.8 billion over that same time period, we can calculate that JNJ’s rate of reinvestment is 35.5%.

If JNJ can continue to earn 25.5% on equity and reinvest 35.5% of its earnings, earnings should grow at about 9% (.255 x .355).

Keep in mind that this does not include dividends or share repurchases. The latter would cause earnings per share to grow at a faster rate. Also, it does not include an analysis of where JNJ is selling in relation to its intrinsic value which could have a material impact on the expected total return. Finally, this type of analysis works best with a stable business that enjoys durable competitive advantages, such as JNJ.

Another example is Southwest Airlines which is a successful airline that operates in the highly competitive and capital intensive airline industry. Between 2000 and 2009, Southwest’s shareholders’ equity increased by $2 billion. Earnings were $140 million in 2009 compared to $625 million in 2000 and have generally bobbed around over that time period. The return on that additional $2 billion has been relatively poor.

Calculating the return on incremental equity over a long-period of time should prove a useful tool in your analysis of prospective investments. Coupled with the rate of reinvestment, it can also allow you to get an idea of how fast a company can be expected to grow its earnings.

http://gregspeicher.com/?p=1660

The Importance of Retained Earnings

The Importance of Retained Earnings
BY STOCK RESEARCH PRO • JUNE 9TH, 2009

Retained earnings, also known as “accumulated earnings” or “retained capital” refer to the portion of net income the company retains as opposed to distributing those funds to shareholders in the form of dividends. A company’s retained earnings are typically reinvested into its core business or used to pay down debt. A company’s retained earnings (or retained losses) are cumulative from year to year with losses and earnings offsetting and reported in the company’s Statement of Retained Earnings/ Losses.

Calculate Retained Earnings
The formula to calculate retained earnings can be written as:

Retained Earnings = Beginning Retained Earnings + Net Income – Dividends

The formula simply adds net income for the period (or subtracts a loss) from the beginning retained earnings and then deducts any dividends paid for the period.

Interpreting Retained Earnings

• Reinvestment of retained earnings can be an important source of financing for many companies. 
• Many creditors will closely monitor a company’s retained earnings statement because the company’s policy regarding dividend payments to its stockholders can have a direct impact on its ability to repay its debt.
• The importance of retained earnings to investors is in understanding the level to which the company reinvests its earnings to fund growth and expansion. If, however, the company reinvests retained earnings without demonstrating significant growth, investors would probably be better off if the company had issued a dividend.

The Statement of Retained Earnings
The Statement of Retained Earnings or Statement of Owner’s Equity is a basic financial statement issued by a company to outline the changes in the company’s retained earnings over the reporting period. Using net income for the period and other company financial statements, the statement reconciles the beginning and ending retained earnings for the reporting period. The statement of retained earnings uses information from the income statement and provides information to the balance sheet.


http://www.stockresearchpro.com/the-importance-of-retained-earnings

Bullbear Stock Investing Notes
http://myinvestingnotes.blogspot.com/

Retained Earnings or Reserves

Retention Rate Is Important Factor For Dividend Growth Companies

Investing in a company that simply increases it dividend will not ensure an investor that the investment will yield higher returns. One factor to evaluate is the earnings retention rate. Retention rate is the amount of earnings left over after accounting for the dividends paid to shareholders. If a company pays all earnings to shareholders, then the earnings retention would be zero. If a company pays out 70% of its earnings to shareholders, then the company's retention rate would equal 30%.

The table below shows the average retention and dividend growth rates over the past ten and five years for a number of companies we have recommended. As can be seen, since 1999 these companies, as a group, had an average retention rate of 17%, or more than four times the average of the S&P 500 for the same period. Their average dividend growth rates for the past five years were also far superior to the S&P 500 -- even taking into account the three companies in the group not paying dividends for the entire period.



http://disciplinedinvesting.blogspot.com/2009/05/retention-rate-is-important-factor-for.html

Buffett (1980): The true value is determined by the intrinsic value of the company and not the dividends.

Warren Buffett in his 1980 letter to the shareholders of Berkshire Hathaway:

"The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage."

The maestro made the above statements because in those days he felt that the prevailing accounting convention/standards were not in sync with a value based investment approach (Infact, they still aren't). In the paragraphs preceding the one mentioned above, he painstakingly explains that while accounting convention requires that a partial ownership (ownership of say 20%) in a business be reflected on the owner's books by way of dividend payments, in reality, they are worth much more to the owner and their true value is determined by the 20% of the intrinsic value of the company and not by 20% of the dividends that are reflected on its books. In the Indian context, imagine someone valuing a company like say M&M -if it had say a 20% stake in Tech Mahindra- based on the 20% of dividends that the latter pays out to M&M. This will be a rather incorrect way of valuing M&M, which in effect should be valued taking into account 20% of the intrinsic value of Tech Mahindra and not the dividends.

"The competitive nature of corporate acquisition activity almost guarantees the payment of a full - frequently more than full price when a company buys the entire ownership of another enterprise. But the auction nature of security markets often allows finely run companies the opportunity to purchase portions of their own businesses at a price under 50% of that needed to acquire the same earning power through the negotiated acquisition of another enterprise."

Buffett, as most of us might know, is a strong advocate of buyback, especially at a time when the stock is trading significantly lower than its intrinsic value and the above paragraph is just a testimony to this principle of his. Indeed, when stock prices are low, what better way to utilize capital than to enhance ownership in the company by way of buy back. The master further goes on to add that one can buy a portion of a business at a much lower price, provided there is auction happening. In other words, when there is a panic in the market and everyone is offloading shares, the chances of getting an attractive price is much higher. On the other hand, when there is a competition between two or more companies for buying another enterprise, the competitive forces will more likely than not keep the acquisition price higher, in most cases, higher than even the intrinsic value of the company.

http://www.equitymaster.com/detail.asp?date=7/12/2007&story=2

That a company earns a lot of money doesn't necessarily mean the stockholders will benefit.

That a company earns a lot of money doesn't necessarily mean the stockholders will benefit.  The next big question is:

• What does the company plan to do with this money? 

Basically, it has 4 choices.

1.  It can plow the money back into the business, in effect investing in itself.

• It uses this money to open more stores or build new factories and grow its earnings even faster than before. 
• In the long run, this is highly beneficial to the stockholders. 
• A fast growing company can take every dollar and make a 20% return on it. 
• That's far more than you and I could get by putting that dollar in the bank.

2.  Or it can waste the money.

• It can waste on corporate jets, teak-paneled offices, marble in the executive bathrooms, executive salaries that are double the going rate, or buying other companies and paying too much for them. 
• Such unnecessary purchases are bad for stockholders and can ruin what otherwise would be a very good investment.

3.  Or a company can buy back its own shares and take them off the market. 

• Why would any company want to do such a thing? 
• Because with fewer shares on the market, the remaining shares become more valuable. 
• Share buybacks can be very good for the stockholders, especially if the company is buying its own shares at a cheap price.

4.  Finally, the company can pay dividend. 

• A majority of companies do this. 
• Dividends are not entirely a positive thing - a company that pays one is giving up the chance to invest that money in itself. 
• Nevertheless, dividends are very beneficial to shareholders.

A dividend is a company's way of paying you to own the stock.  The money gets sent to you directly on a regular basis - it's the only one of the above 4 options in which the company's profits go directly into your pocket. 

• If you need income while you're holding on to the stock, the dividend does the trick. 
• Or you can use the dividend to buy more shares.

Dividend also have a psychological benefit. 

• In a bear market or a correction, no matter what happens to the price of the stock, you're still collecting the dividend. 
• This gives you an extra reason not to sell in a panic.

Millions of investors buy dividend-paying stocks and nothing else. 

• Compile a list of companies that have raised their dividends for many years in a row. 
• In Wall Stree, one company has been doing it for 50 years, and more than 300 have been doing it for 10. 

Shareholders' equity: the retained earnings portion is often the largest component.

Shareholders' Equity

 

What Does Shareholders' Equity Mean?

 

A firm's total assets minus its total liabilities. Equivalently, it is share capital plus retained earnings minus treasury shares. Shareholders' equity represents the amount by which a company is financed through common and preferred shares.

 

Also known as "share capital", "net worth" or "stockholders' equity".

Shareholders' equity comes from two main sources.

• The first and original source is the money that was originally invested in the company, along with any additional investments made thereafter.
• The second comes from retained earnings which the company is able to accumulate over time through its operations. In most cases, the retained earnings portion is the largest component.

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.

Sources of Shareholder Value

Sources of Shareholder Value

For the equity holder, the source of future cash flows is the earnings of firms.

Earnings create value for shareholders by the :

• Payment of cash dividends
• Repurchase of shares
• Retirement of debt
• Investment in securities, capital projects, or other firms.

If a firm repurchases its shares, it reduces the number of shares outstanding and thus increases future per-share earnings.

If a firm retires its debt, it reduces its interest expense and therefore increases the cash flow available to the shareholders.

Finally, earnings that are not used for dividends, share repurchases, or debt retirement are retained earnings. These may increase future cash flows to shareholders if they are invested productively in securities, capital projects, or other firms.

Which creates more value?

Cash dividends: Some argue that shareholders most value stocks' cash dividends. But this is not necessarily true. In fact, from a tax standpoint, share repurchases are superior to dividends. Cash dividends are taxed at the highest marginal tax rate to the investor; share repurchases, however, generate capital gains that can be realized at the shareholder's discretion and at a lower capital gains tax rate.

Share repurchases: Recently, there have been an increasing number of firms who engage in share repurchases. The shift from dividends to share repurchases is one factor that has raised the valuation of some equities.

Debt repayment: Others might argue that debt repayment lowers shareholder value because the interest saved on the debt retired generally is less than the rate of return earned on equity capital. They also might claim that by retiring debt, they lose the ability to deduct the interest paid as an expense. However, debt entails a fixed commitment that must be met in good or bad times and, as such, increases the volatility of earnings that go to the shareholder. Reducing debt therefore lowers the volatility of future earnings and may not diminish shareholder value.

Reinvestment of earnings: Many investors claim that this is the most important source of value, but this is not always the case. If retained earnings are reinvested profitably, value surely will be created. However, retained earnings may tempt managers to pursue other goals, such as overbidding to acquire other firms or spending on perquisites that do not increase the value to shareholders. Therefore, the market often views the buildup of cash reserves and marketable securities with suspicion and frequently discounts their value.

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Fear of misusing retained earnings

If the fear of misusing retained earnings is particularly strong, it is possible that the market will value the firm at less than the value of its reserves. Great investors, such as Benjamin Graham, made some of their most profitable trades by purchasing shares in such companies and then convincing management (sometimes tactfully, sometimes with a threat of takeover) to disgorge their liquid assets.

Why management would not employ assets in a way to maximise shareholder value, since managers often hold a large equity stake in the firm? The reason is that there may exist a conflict between the goal of the shareholders, and the goals of the management, which may include prestige, control of markets, and other objectives. Economists recognise the conflict between the goals of managers and shareholders as AGENCY COST, and these costs are inherent in every corporate structure where ownership is separated from management.

Payment of cash dividends or committed share repurchases often lowers management's temptation to pursue goals that do not maximise shareholder value.

In recent years, dividend yields have fallen to 1.5%, less than one-third of their historic average. The major reasons for this are the tax disadvantage of dividends and the increase in employee stock options, where capital gains and not dividends figure into option value. Nevertheless, dividends historically have served the function of showing investor that the firms' earnings were indeed real.

Recent concerns about aggressive accounting policies and the integrity of earnings following the Enron debacle may bring back this once-favoured way of delivering investor value.

Ref: Stocks for the Long Run, Jeremy Siegel