Calculating Return on Retained Earnings

Return on Retained Earnings

 

When researching companies as possible candidates for a long term portfolio prime importance must be placed on retained earnings. Essentially a company’s retained earnings are what is left over from net profit after paying out dividends.

These profits are employed by the company in order to grow the business. Therefore the higher the return on these profits the more the shareholders should benefit.

Picture two friends: Bob and Andy. Both are the same age, have the same health and are mostly the same in other comparisons. Currently Bob earns $100,000 per annum whereas Andy earns $50,000 per annum. For sake of argument both Bob and Andy have no chance of promotion but are so happy in their prospective jobs that they are not thinking of leaving them.

Now Bob earns a nice salary and he takes advantage of it: he likes to gamble online, he often has large dinner parties, drives a diesel guzzling monster and generally fritters most of his cash away on consumables with a short shelf live. Furthermore Bob rents a nice apartment in the business district and even employs a maid. Often his end of month cash balance is very close to nil.

Andy on the other hand is more cautious with his cash. He keeps a tight budget and enjoys life by attending free events, heading for walks or the beach with friends. Andy saves his left over cash at the end of the month in a savings account and deploys most of this cash in equities whenever a sharp downward correction shocks the market.

From this basic example we can see that although Bob earns more than Andy, we would be wise to invest in Andy if we were forced to invest in either Bob or Andy over the long term, as Andy has a higher return on his retained cash.

So it is with companies. Although you may have two similar companies one of those companies may have a higher return on retained earnings ( RoRE ) whereas it may be earning less than the other company.

The following table shows examples from the European and US markets based on a five year earnings period ( mostly from years ending December, 2006 – December, 2010 ):

 

Company ( Ticker ) Market Return on Retained Earnings
     
Petrofac ( PFC ) LSE 40.94%
Red Electricia ( REE ) IBEX 35 34.85%
British American Tobacco ( BATS ) LSE 31.35%
Reckitt Benckisser ( RB. ) LSE 28%
Abbott Laboratories ( ABT ) NYSE 26.64%
Astrazeneca ( AZN ) LSE 17.95%
Tesco ( TSCO ) LSE 15.01%
Johnson & Johnson ( JNJ ) NYSE 9.06%

 

 

To calculate the Return on Retained Earnings just follow the Tesco example below:

 

Year End EPS Dividend per Share
     
25-Feb 2006 20.30p 8.63p
24-Feb 2007 22.36p 9.64p
23-Feb 2008 27.37p 10.90p
28-Feb 2009 29.06p 11.96p
27-Feb 2010 31.82p 13.05p
     
Total 130.91p 54.18p

 

The earnings figures listed in the table above include exceptional items as we are concerned with longer term investing.

From the information above we calculate RoRE as follows:

1 ) We subtract the total dividends paid out from the total EPS earned as this calculates the retained earnings.

130.91p less 54.18p = 76.73p

2 ) We then subtract the 2006 EPS from the 2010 EPS.

31.82p less 20.30p = 11.52p

3) For our final step we divide the 11.52 by 76.73 and multiply the answer by 100.

11.52/76.73 = ( .1501 X 100 ) = 15.01%

Of course the RoRE calculation should not be used in isolation when making an investment decision. Other factors such as a reasonable multiple, low gearing, competitive position and a good free cash flow rate should enter the decision making process as well.

 

Long term investors would do well by reviewing their portfolio, calculating the RoRE on each of their holdings, as well as those in similar industries for comparative reasons, and thinking about the implications of the RoRE answers calculated.

 

Disclosure: Long TSCO and JNJ.

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