The Nature and Use of Retained Earnings
January 9th 2008 15:00
Retained earnings are an obscure concept and value of which investors are seldom aware. Yet, Retained Earnings can be, and often are, of considerable magnitude. On the other hand, I have never heard a CEO reporting on the use of retained earnings.
What are Retained Earnings, though? After a company finds its Net Profit After Tax part of this is made into Dividends, often 60 per cent of it, and the remaining is made into Retained Earnings. The Dividend portion is then divided by the number of outstanding shares of the company and often expressed in cents per share.
The Retained Earnings are then charged to the Equity section of the Balance Sheet together with Reserves and Shareholder’s Funds.
The amount of Retained Earnings is established by the Board of Directors and in Annual General Meetings shareholders do not vote for it. Yet, it is clear that Retained Earnings, being equity, belong to the shareholder.
It’s an old story that managements like Retained Earnings because of the reasons above. Retained Earnings are often used to increase business empires with little regard for the need to attain satisfactory Returns on Equity.
But there should be a way to measure management’s use of Retained Earnings. In the book “The Warren Buffett Way” Robert Hagstrom suggests a method: for each dollar of Retained Earnings there should be a dollar increase in the capitalisation of the company after 10 years.
Otherwise, if Retained Earnings fails to return the Required Rate of Return of the company in question, they should be paid to the shareholder who would then look for a more profitable employment for them.
Such is the nature and use of Retained Earnings.
What are Retained Earnings, though? After a company finds its Net Profit After Tax part of this is made into Dividends, often 60 per cent of it, and the remaining is made into Retained Earnings. The Dividend portion is then divided by the number of outstanding shares of the company and often expressed in cents per share.
The Retained Earnings are then charged to the Equity section of the Balance Sheet together with Reserves and Shareholder’s Funds.
The amount of Retained Earnings is established by the Board of Directors and in Annual General Meetings shareholders do not vote for it. Yet, it is clear that Retained Earnings, being equity, belong to the shareholder.
It’s an old story that managements like Retained Earnings because of the reasons above. Retained Earnings are often used to increase business empires with little regard for the need to attain satisfactory Returns on Equity.
But there should be a way to measure management’s use of Retained Earnings. In the book “The Warren Buffett Way” Robert Hagstrom suggests a method: for each dollar of Retained Earnings there should be a dollar increase in the capitalisation of the company after 10 years.
Otherwise, if Retained Earnings fails to return the Required Rate of Return of the company in question, they should be paid to the shareholder who would then look for a more profitable employment for them.
Such is the nature and use of Retained Earnings.
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