When reading through any financial statements, on annual reports, I always zoomed by the statement of earnings because frankly, I didn’t know what it was. Or what retained earnings were on the balance sheet.
Until recently, when I started reading through the Berkshire Hathaway Letters to Shareholders, it was then that I discovered the importance of retained earnings and what they meant. I want to share what I have learned on my discoveries so we could learn together.
Buffett includes an “Owners Manual” in each of his annual reports that you can find here. The owner’s manual doesn’t change much from year to year, and in the manual, there are many different principles, I am going to share principle #9 as it relates to retained earnings.
“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.”
To try to interpret what Buffett is saying. He means that over the long-term retained earnings must return at least $1 in market value to us the shareholders for each dollar that management retains.
Our goal in the post will be to determine:
- What a Statement of Retained Earnings are
- How to read a Statement of Earnings
- What Retained Earnings Are
- What Impact Retained Earnings Have on Shareholders
What is the Statement of Retained Earnings?
According to our friends at Investopedia:
“The statement of retained earnings (retained earnings statement) is a financial statement that outlines the changes in retained earnings for a company over a specified period. This statement reconciles the beginning and ending retained earnings for the period, using information such as net income from the other financial statements, and is used by analysts to understand how corporate profits are utilized.”
Each public company must prepare four financial statements. We are all familiar with the Big Three, Income Statement, Balance Sheet, and the Cash Flow Statement. We are going to explore the fourth requirement, the Statement of Retained Earnings.
Referred also to as the statement of owner’s equity, and it is prepared according to GAAP principles, yeah.
The statement of retained earnings can be either as a standalone document or included in the balance sheet or income statement. It includes items such as:
- Net income
- Retained earnings
The net income is listed to help show what amounts are set aside for dividend payments, plus any monies set aside for any losses that might have occurred. The statement covers the period listed, which will coincide with the balance sheet, for example.
The main goal of the statement of retained earnings is to layout the company’s plans for its capital allocation. The statement is the place to tell us how they plan to deploy the capital for growth, i.e., dividend payments, share repurchases, debt payments, etc.
The statement also shows how the retained earnings accumulated, shown on the balance sheet.
The statement of retained earnings can show us how the company intends to use their profits; we can see quite easily how they use their earnings to grow the business. As we will see, the statement reveals whether the company will reward us with dividends, share repurchases, or by retaining the earnings for future opportunities.
Think of the heat that Warren Buffett has received lately with the refusal to pay a dividend or lack of share repurchases. If you look at the statement of retained earnings for Berkshire, you can see all those intentions, more on this in a bit.
Let’s dive into retained earnings a bit more.
What are Retained Earnings?
Retained earnings are the difference of the net income from the bottom line of the income statement less any dividends paid to shareholders.
As we discussed earlier, the company can use retained earnings for any reinvestment that could help the company. Items such as the purchase of more equipment, building a new plant, buy more inventory, the list can go on and on.
When the big wigs at a company decide to retain the profits instead of paying them out as a dividend, they need to account for them on the balance sheet under shareholder’s equity. The reason for this disclosure is simple; retained earnings are monies that can and should be used to better shareholder value.
We, as investors, can use retained earnings as an opportunity to decide how wisely management deploys their capital, especially if it is not distributing to the shareholders.
When analyzing the financials of a company, we can determine if the company is allocating all of its money back into itself, but it doesn’t see high growth in financial metrics. Then maybe shareholders would be better served if those monies were paid out as a dividend instead.
The above statement is one of the leading reasons that Warren Buffett has been under so much fire for holding so much cash on the balance sheet of Berkshire Hathaway. The reasoning being that if he isn’t going to put that money to use by creating more value for the shareholders by buying more companies or investing in more businesses. Then shareholders would be better served with a dividend or buybacks.
His refusal to do either has lead to some criticism with his decisions. I would argue that he has earned the right to be cautious and to tread with care, especially in today’s frothy market. With the size and scope of Berkshire, finding a worthy investment is much trickier for you or me.
Another point I would make in his defense, one could argue that there is no better capital allocator in the history of investing and why you would question his decisions when he has done a fantastic job of allocating capital through the years is the better question.
How to Calculate Retained Earnings
Again, to drive it home. Retained earning is that portion of the profits of a business that have not been distributed to shareholders. Instead, it is held back to use for investments in working capital or fixed assets.
The formula to calculate retained earnings:
Beginning retained earnings
+ Net income, during the stated period
– Dividends paid out
= Ending retained earnings
That’s pretty simple, keep in mind that any changes in the income statement will reflect in the retained earnings.
Examples of a Statement of Retained Earnings
Let’s take a look at some actual statement of retained earnings. The first company we will take a look at is Berkshire Hathaway.
Notice several things, first that the ending balance is the total for retained earnings. Next, notice that there are no dividends paid out and that there are minimal deductions from the retained earnings from the previous quarter.
The above statement is from the latest 10q, and all the dollars listed are in millions unless otherwise stated.
You will notice that Berkshire’s statement of retained earnings is fairly simple because they are added each quarter without much in the way of distributed earnings to shareholders.
Looking at the statement of retained earnings is a quick way to investigate the capital allocation of any company. In Buffett’s case, it appears he is keeping some powder dry in case he comes across a fantastic investment.
Let’s take a peek at the income statement and balance sheet to reinforce further how the statement of retained earnings flows from the income statement into the balance sheet.
Notice the net earnings from the income statement and compare that to the statement of retained earnings, they are the same.
The balance sheet shows the shareholders’ equity equals our retained earnings from the statement of retained earnings.
The flow from each statement to each statement is fascinating and helps illustrate how each statement is connected. And the impact each line item can have on the total outlook of a company.
Let’s pull out another statement for a look. The next company we will take a look at will be Wells Fargo.
A few things I would like you to notice in this statement of retained earnings from Wells Fargo. First, notice they list common stock repurchased, which means share repurchases or buybacks to the tune of $20,663 million. So we can see that Wells Fargo decided to use part of their accumulated net earnings to give back to the shareholders in that way.
Next, notice that Wells has also paid out dividends both to common stockholders and preferred stockholders.
It is amazing to me to see how revealing the statement of retained earnings is in regards to capital allocation of any company that we are investigating.
We can see how Wells Fargo intends to give back to its shareholders via either dividends or buybacks.
One thing to keep in mind when analyzing companies is the intention behind the capital allocation. For example, Wells Fargo has requirements concerning its capital allocation. Because of how banks work, they are required by law to request approval to allocate their capital in different ways. Typically banks are going to pay dividends and use buybacks as ways to reward shareholders. Because of their restrictions, using their funds to purchase other banks or businesses is a little more complicated.
Whereas, Berkshire Hathaway has no such restrictions. Their capital allocation is completely at the discretion of Buffett and Munger, with their board’s approval, of course.
Let’s look at one more just for giggles. We will look at Johnson & Johnson’s statement of retained earnings from their latest 10-k.
The reason I wanted to look at Johnson & Johnson was to see inside a dividend aristocrat. They are best known for their growing dividends, as well as their financial stability because of the ability to continually grow that dividend.
And we can see that they are growing dividends from one year to the next in the above example, from 2017’s payment of $8943 to 2018’s payment of $9917.
But something that I found interesting was the use of share repurchases. Frankly, that is not an item I think of when investigating a dividend aristocrat, they are known for dividends, not buybacks.
Ok, now that we have an understanding of how to read the statement of retained earnings and where to find valuable information. Let’s take a look at a few ratios that can help us determine the effectiveness of retained earnings.
Retained Earnings Ratios
Now that we have examined what retained earnings are and how to read a statement of retained earnings, let’s look at some ratios, shall we?
First up is the retention ratio.
The retention ratio is the ratio of our company’s retained earnings to its net income. The ratio measures the percentage of our company’s profits that are reinvested in the company such as buying more assets, building a new plant, or buying more inventory, other than paying the earnings out as a dividend or share repurchase.
The formula is fairly simple, divide the company’s retained earnings by its net income minus the dividends.
Retention ratio = (net income – dividends) / net income
So let’s take the 10-k statements from Oshkosh Corp as an example. In this case, I am going to include share repurchases in our formula, as they have become almost as important as dividends in paying back the shareholders.
- Net income = $579.4
- Dividends = $75.5
- Share repurchases = $350.1
I am plugging the above numbers into our formula.
Retention ratio = ( 579.4 – (75.5 + 350.1)) / 579.4
Retention ratio = 26.5%
That indicates that Oshkosh Corp retained 26.5% of its earnings to either put back into the business or to grow the retained earnings for some other purpose.
The interesting trick about the above formula is that when using it on Johnson & Johnson, it shows that they are paying out almost all of their net earnings in either dividends or share repurchases. That could indicate that they are an older, more mature company, and they choose to return any excess cash to the shareholders instead of growing the retained earnings.
Keep in mind that younger companies may have a higher retention rate because instead of growing dividends, they would be interested in the growth of the business. As we see from Johnson & Johnson, larger, more mature companies will post lower retention ratios because they are already profitable and don’t need to reinvest in the company as heavily.
As an aside, the retention ratio is sometimes referred to as the plow back ratio.
Retained earnings / Total Assets Ratio
Next up is the retained earnings over total assets. Ideally, we are looking for a ratio of 1:1 or 100%. For most businesses, this is going to be impossible to achieve; a more realistic goal would be as close to 100% as we can get.
If we look at the latest balance sheet of Oshkosh Corp 2019, to keep it in the family. We can find the information we need there.
The retained earnings from the shareholder’s equity section are $2505, and the total assets from the top of the balance sheet equal $5566.3
To find our ratio, we divide each number by itself.
Retained earnings Total Assets = 2505 / 5566.3
Retained Earnings Total Assets = 45%
If we look at the previous years, 2018. We can run the same calculation.
Retained Earnings/Total Assets = 2007.9/5294.2
Retained Earnings/Total Assets = 37.92%
We can see that Oshkosh Corp has grown the ratio from year to year.
Interestingly, if you look at Berkshire Hathaway’s balance sheet, you see that for the last two years, they have run with percentages similar to Oshkosh Corps.
- 2018 = 41.19%
- 2017 = 36.4%
As you work through this ratio, remember that a higher number means that the company is less reliant on other forms of growth, such as taking on more debt to grow the business or pay out dividends.
Return on Retained Earnings
The return on retained earnings tells us how effectively the company uses profits from the previous years.
The ratio can relay to us whether the company is better investing in itself or paying back investors with a dividend or share repurchases.
The formula for return on retained earnings:
RORE = Net income / Retained Earnings from previous year
We can use the statement of retained earnings to find all of our information. Let’s look at Apple for this example, their 10-k 2019
Net income = $55,256
Retained Earnings 2018 = $107,147
RORE = 55256 / 107147
RORE = 0.51
The above answer tells us that Apple was able to generate $0.51 for every $1 of retained earnings the previous year. For giggles, I was looking at the previous year’s numbers.
- 2018 = 0.44
- 2017 = 0.37
As we can tell from this small sample size, Apple appears to be growing its return on its retained earnings. Using the RORE is a fun exercise to run when analyzing your company, and it is an item that I have added to my checklist.
Digging into the his fourth financial statement has been interesting; there is quite a bit of information to uncover when looking deeper into the statement of retained earnings.
You can determine quite a lot about management, their plans for growth, and how shareholder-friendly they are.
It is also interesting that there are several simple ratios we can use to compare our company to others to give us a better comparison of the effectiveness of a company using its funds to better the company.
Think about any business that we are trying to invest our money; we must determine not only how they make money if they make money, but also what do they do with their money.
I know that Buffett has come under a lot of criticism lately, but who can argue that he knows better how to allocate his capital? I certainly don’t.
Remember to include this statement of retained earnings in your analysis of any company and to try to use that info to help you find your story in regards to that company.
As always, I appreciate you taking the time to read this post, and I hope you find some value for you on your investing journey.
If you have any questions or I can be of any further help, please don’t hesitate to reach out.