Why we (investors) need to know about retained earnings? Because it is the money of the shareholders. How? When we buy stocks of a company, we are actually buying a share in company’s ‘net profit’.
Technically speaking, net profit generated by the company are the ‘owner’s money’. Who are the owners of a publicly traded company? Its the shareholders. How shareholder can get hold of the net profit? In form of dividends.
But companies often do not pay 100% of their net profits as dividends to its shareholders. They retain a big chunk of net profit. These are called retained earnings.
We generally see cumulative retained earnings mentioned in the company’s balance sheet. Let’s get more clarity on retained earning’s…
What are Retained Earnings?
Retained earning is that portion of company’s net profit which has not been paid to shareholders as dividend.
Formula: Retained Earnings = Last Year Reserves + PAT – Dividend + Depreciation
It means, retained earnings has the following four components:
- Last Year Reserves: Every year the company makes profit and it retains a portion of it. This way, over a period of time, the retained earnings gets accumulated (called reserves). Continuously growing reserves is a sign of good fundamentals. Read more about fundamentally strong stocks.
- PAT: We also call it net profit. Retained earnings will grow YOY only if the company’s PAT is in positive. A continuously growing PAT is a clear sign that retained earnings of the company is also growing.
- Dividend: Out of the PAT generated by the company, a portion of it is paid to shareholders as dividends. The higher is the dividend payout ratio, lesser will be the retained earnings. Read more about dividend analysis of a stock.
- Depreciation: Why depreciation expense is added back in the retained earnings formula? Because this is a non-cash expense. The company actually has not spent this money. It has been indicated in the profit and loss account, as expense, as a rule (just for accounting purpose).
It is also important to note that retained earnings are not companies savings (or cash) stacked in bank accounts or lockers. Instead, it is that money that is ‘always at work’. How?
1. Utilisation of retained earnings
It is an obligation of the top management to use retained earnings in the most effective way. Why it is essential? Because retained earnings are recorded in companies balance sheet as “Shareholders Equity.”
Retained earnings are actually shareholders money. So, when a company’s management decides to retain profits, they must assure that this money is utilised well (in the interest of the shareholders).
1a. How to best utilise retained earnings?
As you can see in the above flow chart, retained earning ultimately settles as “cash” in the companies balance sheet.
There are no specific rules or guidelines regarding utilisation of retained earnings. But for sure, companies would not like to keep it as “cash or cash equivalent”.
In this case, which are the better alternatives to cash?
- Reduce Debt: Debt adds to the companies liability. The lower is the company’s liability, lower will be the expenses and risks associated with it. Hence company’s often use their retained earnings to pay-off their debts (specially long term debts).
- Buy Fixed Assets: A growing company must increase its profits. How to do it? By expansion and modernisation of its facility. The best way to do it is by buying new fixed assets (like land, building, machinery etc). Retained earnings can be used to buy new assets.
- Buy Investments: Like we buy investments for self, companies can also invest their retained earnings. Investments like bonds, deposits, mutual funds, stocks in secondary market, takeover of another company, real estate etc. The company will consider outside investment if reinvesting back into its own business is not as lucrative.
- Keep Liquid Cash: It is always better to maintain a minimum cash balance. How much cash needs to be kept, is dependent on the historic ‘collection vs consumption’ pattern of the company. A company which consumes faster than it collects-payments, needs to keep higher liquid cash for safety.
Traditionally, company’s have used their balance sheet reserves as indicated above. More popular utilisation of reserves is debt reduction and asset purchase (expansion/modernisation).
B. Check EPS and Share Price Growth. Why?
Why company’s retain profits? To improve shareholders returns.
Profits are basically shareholder’s money. By not paying these profits to shareholders in form of dividends, the company is saying (to shareholders) that I have a better plan.
Company is saying, “by reinvesting the profits back into the company, I can assure better returns in long term”. How?
By assuring faster market price appreciation of its shares.
Though such shareholders may not benefit in form of dividends, but they will benefit in form of price appreciation in long term. How? By the following 4 after-effects of ‘good utilisation’ of retained earnings.
Also see the above flow chart:
- Income Increase: A company which is utilising its retained earnings properly (by expanding and modernising its facility) will eventually increase its income.
- Net Profit Increase: Efficient utilisation of retained earning will make the company more efficient. It will spend less and earn more. Hence the company will make more profits.
- EPS Increase: Increase in net profits eventually leads to higher EPS. This should be the ultimate objective of a company. A continuously growing EPS is something which best influences the market price of its stocks. Read more about high EPS stocks.
- Market Price Increase: When EPS grows, market price will also grow at a similar pace. Here at this step, the shareholders actually benefit from retention of earnings over a period of time. Read more about highest return stocks here.
I personally think that, the above specified 4 steps are the best way to utilise retained earnings. The kind of price appreciation which is assured by such actions is phenomenal.
Not so Good Example:
Warren Buffett’s company Berkshire Hathaway pays almost zero dividends. It retains majority portion of its net profits. Let me show you how EPS and market price of Berkshire Hathaway has grown in last 5 years.
|Retained Earnings ($ Mn)||3,21,112||2,55,786||2,10,846||1,87,703||1,63,620||14.44%|
|Market Price ($)||3,06,000||2,97,600||2,44,121||1,97,800||2,26,000||6.25%|
In last 5 years, retained earnings has grown at a rate of 14.44% per annum. But in the same period, the market price of Berkshire Hathaway has grown by only 6.25% p.a.
As per the standards of Warren Buffett, the price appreciation should have been more than retained earnings growth.
In last 10 years, the market price of Berkshire has grown from $94,000 (Apr’08) to $324,921 (Apr’19). This is a growth rate of 13.2% p.a.
We have a company in India which paid (average in last 5 years) 48% of its profits as dividends, and balance 52% was retained. Which is this company? VIP Industries.
Let’s check how the EPS and market price of VIP has grow with respect to its “reserves growth”.
|Financials||Mar ’18||Mar ’17||Mar ’16||Mar ’15||Mar’14||5Y Growth|
|Market Price (Rs.)||316.80||196.90||105.00||93.20||104.50||24.83%|
In last 5 years, retained earnings has grown at a rate of 11.32% per annum. But in the same time period, EPS has grown by 15.23%, and the market price of VIP Industries has grown by 24.82% p.a.
Comparing EPS and price growth with retained earning growth is a good way to check the business fundamentals of a company.
When you will check more companies, you will find that even best of best companies will not pass this litmus test.
What is the litmus test? Last 5 years EPS and price growth must be same or better than retained earning growth.
I have checked this with TCS and Eicher Motors, they did not pass the test. I will request you to check for your stocks and post the results in the comment section below.
Having said that, it is also true that companies cannot convert retains earnings into EPS growth, within a short time horizons. Shareholders must give them more time (like 5+ years).