Evaluating Retained Earnings: What Gets Kept Counts

When sizing up a company's fundamentals, investors need to look at how much capital is kept from shareholders. Making profits for shareholders ought to be the main objective for a listed company, and, as such, investors tend to pay the most attention to reported profits. Sure, profits are important. But what the company does with that money is equally important.

Typically, portions of the profits are distributed to shareholders in the form of dividends. What is left over is called retained earnings or retained capital. Savvy investors should look closely at how a company puts retained capital to use and generates a return on it.

The Job of Retained Earnings

In broad terms, capital retained is used to maintain existing operations or to increase sales and profits by growing the business.

Life can be hard for some companies—such as those in manufacturing—that have to spend a large chunk of profits on new plants and equipment just to maintain existing operations. Decent returns for even the most patient investors can be elusive. For those forced to constantly repair and replace costly machinery, retained capital tends to be slim.

Some companies need large amounts of new capital just to keep running. Others, however, can use the capital to grow. When you invest in a company, you should make it your priority to know how much capital the company appears to need and whether management has a track record of providing shareholders with a good return on that capital.

Retained Earnings for Growth

If it has any chance of growing, a company must be able to retain earnings and invest them in business ventures that, in turn, can generate more earnings. In other words, a company that aims to grow must be able to put its money to work, just like any investor. Say you earn $10,000 each year and put it away in a cookie jar on top of your refrigerator. You will have $100,000 after 10 years. If you earn $10,000 and invest it in a stock earning 10% compounded annually, however, you will have $159,000 after 10 years.

Retained earnings should boost the company's value and, in turn, boost the value of the amount of money you invest into it. The trouble is that most companies use their retained earnings to maintain the status quo. If a company can use its retained earnings to produce above-average returns, it is better off keeping those earnings instead of paying them out to shareholders.

Determining the Return on Retained Earnings

Fortunately, for companies with at least several years of historical performance, there is a fairly simple way to gauge how well management employs retained capital. Simply compare the total amount of profit per share retained by a company over a given period of time against the change in profit per share over that same period of time.

For example, if Company A earns 25 cents a share in 2002 and $1.35 a share in 2012, then per-share earnings rose by $1.10. From 2002 through 2012, Company A earned a total of $7.50 per share. Of the $7.50, Company A paid out $2 in dividends, and therefore had a retained earnings of $5.50 a share. Since the company's earnings per share in 2012 is $1.35, we know the $5.50 in retained earnings produced $1.10 in additional income for 2012. Company A's management earned a return of 20% ($1.10 divided by $5.50) in 2012 on the $5.50 a share in retained earnings.

When evaluating the return on retained earnings, you need to determine whether it's worth it for a company to keep its profits. If a company reinvests retained capital and doesn't enjoy significant growth, investors would probably be better served if the board of directors declared a dividend.

Evaluating Retained Earnings by Market Value

Another way to evaluate the effectiveness of management in its use of retained capital is to measure how much market value has been added by the company's retention of capital. Suppose shares of Company A were trading at $10 in 2002, and in 2012 they traded at $20. Thus, $5.50 per share of retained capital produced $10 per share of increased market value. In other words, for every $1 retained by management, $1.82 ($10 divided by $5.50) of market value was created. Impressive market value gains mean that investors can trust management to extract value from capital retained by the business.

The Bottom Line

For stable companies with long operating histories, measuring the ability of management to employ retained capital profitably is relatively straightforward. Before buying, investors need to ask themselves not only whether a company can make profits, but whether management can be trusted to generate growth with those profits.