# Retained Earnings: Effect on stock valuation?



## Dominover (28 August 2011)

Would anyone know any material whether it be books / articles / journals which explain how retained earnings affect stock valuation.

I'm specifically interested in knowing how the shareholders equity grows and anything related to that.   

It's a hard one to find though there may be a simple reference somewhere.  I've looked at 'The Theory of Investment Value' by John Bur Williams but it skips around any mention of how the retained earnings affect the company in any detail.

Thanks very much.
Dominover.


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## danbradster (28 August 2011)

I usually don't think much about retailed earnings.  I look at dividend payout ratio and the ROE instead.  Like if the dividend payout ratio is 40% that means 60% is retained for growth or debt reduction, if the retained earnings help to grow EPS sufficiently then it's good.

I don't look at total retailed earnings, just the current year's retained earnings.  Should I be considering the total too?


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## bellenuit (28 August 2011)

Dominover said:


> Would anyone know any material whether it be books / articles / journals which explain how retained earnings affect stock valuation.
> 
> I'm specifically interested in knowing how the shareholders equity grows and anything related to that.
> 
> ...




This is a fairly simplistic explanation and I'm sure someone will find faults with it.

There are a lot of factors that determine how people evaluate what a stock should be valued at. Earnings, growth prospects, economic outlook etc. However, *all things being equal*, if the only difference between end year 1 and end year 2 is that the company has increased its retained earnings by $X, then the stock valuation should increase by $X/N, where N is the number of shares issued.

The way I would explain it is as follows, again emphasising *all things being equal*. 

Retained earnings represents the profit left over after tax and dividends have been paid. 

The basic equation for representing the shareholders equity in the company is Equity = Assets - Liabilities (E = A - L). This is often called the Net Worth of the company. You can relate this to your own personal circumstances by valuing your own personal Net Worth, which is What You Own (your Assets) less What You Owe (your Liabilities). However, shares are valued using additional metrics to simply Net Worth. Two companies could have a similar net worth at a particular moment in time, but one could be in an industry that is in its infancy and has high growth potential and the other could be in an industry that is in decline. So one would place a higher value on the company in the growth industry.

So the value that analysts might place on a company is more like E + P where P is the premium being assessed for all the other metrics applicable to the company, such as some of those mentioned above: growth prospects, economic outlook etc. 

Now retained earnings increase the E side of the E=A-L equation from the end of one financial year to the next , so assuming there is no change in Liabilities (*all things being equal*) the only way the equation can still balance is by A increasing by the same amount as retained earnings. Thus the increase in the A side may just be the increase in the company's cash balance (if the company simply banks their year end profit) or may represent an increase in the value of other assets (if year end profits are used to purchase plant and equipment etc.).

So going back to how analysts value a company which is E + P, if P remains the same (*all things being equal* between one year and the next) and E has increased by the retained earnings, then the company valuation by the analysts if they use the same criterion, should also increase by the retained earnings in the year and the share price value is simply that divided by the number of shares issued.

One might ask: why would a company keep retained earnings rather than pay the profits out to shareholders as dividends? There are a few reasons. Young companies in growth industries require finance and retained earnings are a cheaper source of funds than borrowing from the bank or issuing additional shares (which dilutes ownership). So the shareholders in such companies will benefit more by the funds being utilised that way than by being paid out as dividends. However, established companies that are not in growth industries might deem it better to pay dividends to their shareholders than keep the retained earnings (as they have no need for additional capital). Another determining factor is the taxation system. Compared to Australia, established US companies (GE, IBM etc.) pay miserable dividends compared to established Australian companies (the banks, Telstra etc.). The reason is the end value to the respective shareholder. In the US, they do not have dividend imputation like here, so dividends are taxed at your marginal tax rate. However, capital gains are taxed at a lower tax rate (15% from memory). So rather than earnings being paid as dividends (and taxed at marginal rates) they are kept as retained earnings and thus increase the stock valuation as discussed above. So rather than paying a dividend that pays 5% of the net worth of the company say, shareholders are better of selling 5% of their stock in the company (which should instead be worth 5% more based on the above) due to the lower tax that will be applicable. Note that in both cases the value of their remaining stock remans the same (all things being equal). When paid as dividends, they still have the same number of shares, but the value of their stock is 5% less than otherwise. If retained, they have 5% less shares, but each are worth 5% more than otherwise). However, the taxation in the US favours the latter.


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## RandR (28 August 2011)

Dominover said:


> Would anyone know any material whether it be books / articles / journals which explain how retained earnings affect stock valuation.
> 
> I'm specifically interested in knowing how the shareholders equity grows and anything related to that.
> 
> ...




Roger Montgomery actually talks about this a fair bit in his book, Valuable. I would suggest it as a good starting guide to understand how to value retained earnings

The important measure for the success of retained earnings is ROE. 


EG 1  - If you have a company with a high consistent ROE, you want them to retain earnings, as they can achieve stronger returns on these earnings then is otherwise available to you. The perfect example of this is* BHP*. Where they consistently achieve returns on equity of 20% + Its much more beneficial for a shareholder for them to retain the earnings and further compound that at the significantly higher rate then you can in a bank account.

EG 2 - If you have a company with a consistently low ROE, (say less then 10%) you want them to payout as much of the earnings as possible to you. Because if the company has a ROE ratio in the single digits, any earnings they retain i will compound at a pitiful rate that you could possibly achieve just by holding cash. Any company that has a consistently low ROE and low pay out ratio, is a destroyer of wealth imo.

Consistently high ROE - You want lower payout ratio and more retained earnings. EG- a BHP.

Consistently low ROE - You want high payout ratio and little retained earnings. EG - a media stock like SWM.

This is of course not a broad rule to use against all companies, as there are exceptions (like a business with high roe that has little potential for growth).


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## skc (28 August 2011)

bellenuit said:


> So the value that analysts might place on a company is more like E + P where P is the premium being assessed for all the other metrics applicable to the company, such as some of those mentioned above: growth prospects, economic outlook etc.
> 
> Now retained earnings increase the E side of the E=A-L equation from the end of one financial year to the next , so assuming there is no change in Liabilities (*all things being equal*) the only way the equation can still balance is by A increasing by the same amount as retained earnings. Thus the increase in the A side may just be the increase in the company's cash balance (if the company simply banks their year end profit) or may represent an increase in the value of other assets (if year end profits are used to purchase plant and equipment etc.).
> 
> So going back to how analysts value a company which is E + P, if P remains the same (*all things being equal* between one year and the next) and E has increased by the retained earnings, then the company valuation by the analysts if they use the same criterion, should also increase by the retained earnings in the year and the share price value is simply that divided by the number of shares issued.




Agree with your take but the company valuation is probably better thoguht of as E x P with P being a premium multiple over book value. So the effect of retained earning is to increase company value by RE x P, all things being equal.


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## craft (28 August 2011)

What really matters in business valuation is what amount of new capital can be employed and what incremental return that capital will achieve. 

Retained earnings are not the only way companies finance themselves. They can also borrow, raise capital or utilise non-interest bearing cash flows from their business model.

Historical returns are not an ideal indicator of future returns on additional capital, especially after accounting standards act to distort the book equity figure and those distortions are compounded year after year. 

The Walter dividend Model does show that a company should retain and redeploy capital where it can get an incremental return on this capital higher the investors required return on capital. To show this it had to make the assumption that the company had no other sources of funding and that ROE never changed.

Adopting different assumptions other models (Miller and Modigliani Model  etc) argue than irrelevance of dividend policy to valuation.

My view is that so long as economically profitable opportunities to supply capital are offered first  to existing shareholders on a proportional basis in the form of rights issues and not to vested interests through institutional placements, then all profits should be payed out to the limit of the franking account. This view is based on the current Australian taxation rules

I find Retained Earnings * ROE totally useless and often misleading when valuing companies. It is rarely an accurate indication of how much capital can be employed and at what rate.  I think for a short cut indication SKC’s  RExP (if you are good at judging a suitable premium) is more practical than RE x ROE.


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## Dominover (28 August 2011)

Thanks for all the responses.  I didn't expect a reply so soon.  Some good explanations here but I probably haven't explained this very well.

What I'm basically trying to do is this:  *I'm trying to establish how I would value a business if they retained their earnings as opposed to one which does not*.  This would therefore depend on the effect of retaining the earnings (originally expressed as a percentage of ROE) on the Equity component of ROE itself.  Basically I'm looking for a quantitative approach to solving this. 

Roger Montgomery does provide some great explanations though a classic example of what I'm trying to understand can be found by a look at  Roger's tables 11.1 and 11.2.

The mathematical idea behind table 11.1 is simple.  If you have an ROE of 10% but your required return is 5% then you would multiply the shareholders equity by 2 because you would still hold the shares if that dollar value of the 10% return is only 5% of the total amount you invested.   This is only if all the earnings are paid out as dividends and not Reinvested.

Now lets move to his table 11.2.  If the company retains it's earnings the multiples used in his table are much higher than 2 (using the exact example above).  This would mean that you would pay much more for that company because you are expecting the dollar value of that company's return to increase with an increase in equity (which would result in some way or another from the reinvested earnings of which you didn't receive as a dividend). 

This would mean that there is *1 -* An Increase in Equity and *2 -* A corresponding increase in the return.  So at a minimum you are still going to get a 5% return on your invested funds but the company itself (in terms of market value) will increase with an increase in the equity base (remember, this is at a minimum), there are a whole range of factors which would push the market price higher.

It would be nice to solve Roger's table 11.2 formula but I'm more curious as to how those reinvested earnings contribute to the growth of a company and what kind of assumptions are commonly made in these circumstances?  

Maybe there's a key word I need to look at here or a specific concept I'm missing which would answer this.   I though John Burr Williams (The theory of investment value) would cover this but it still seems to move around that concept.  

Thanks again.  Any suggestions.


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## craft (28 August 2011)

Dominover said:


> Thanks for all the responses.  I didn't expect a reply so soon.  Some good explanations here but I probably haven't explained this very well.
> 
> What I'm basically trying to do is this:  *I'm trying to establish how I would value a business if they retained their earnings as opposed to one which does not*.  This would therefore depend on the effect of retaining the earnings (originally expressed as a percentage of ROE) on the Equity component of ROE itself.  Basically I'm looking for a quantitative approach to solving this.
> 
> ...




RM’s table 11.2 is just a re-jig of Walters’s dividend discount model where 100% of earnings are retained.  

With 100% retained earnings, Walters formula reduces to (ROE/RR)^2 x Equity.

RM’s 11.2 is (ROE/RR)^1.9. I think he claims to have modified it to add a margin of safety (hmmmm?). Where the ROE is less than the RR raising to the power of 1.9 instead of 2 gives you a higher valuation, so defeats the claim of a larger margin of safety. I believe he may have changed the table in latter editions and now raises by 2.1 when ROE is less than RR

The impact of dividend payout on valuations is disputed. Its only not disputed if you force the assumption that companies have no other method of funding themselves than Retained earnings.

I suggest you research The Walter dividend model and also the models  that argue the irrelevance of dividend policy and most importantly pay attention to the assumptions that underlie them. One additional important problem not included in the limiting assumptions of the Walter dividend model and effects other valuation methods based upon it, is that Raising ROE/RR to the power of 2 to value growth may be a handy shortcut  but it imposes an arbitrary time frame on growth that often bears no resemblance to the  competitive advantage period of the company being valued.

I will restate my position from the previous post because I think it does provide an answer to the relevance of retained earnings in robust valuation approaches. – but it might not be what you are looking for. 

What really matters in business valuation is what amount of new capital can be employed and what incremental return that capital will achieve.

My view is that so long as economically profitable opportunities to supply capital are offered first to existing shareholders on a proportional basis in the form of rights issues and not to vested interests through institutional placements, then all profits should be paid out to the limit of the franking account. This view is based on the current Australian taxation rules. [I should add to this that if Economic return available on retained earnings is less than cost of capital (shareholders required return) than all profit should be paid out regardless of tax situation] 


I find Retained Earnings * ROE totally useless and often misleading indicator of growth when valuing companies. It is rarely an accurate indication of how much capital can be employed and at what rate.


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## craft (28 August 2011)

Edit

Just checked RM table 11.2. His formula is ROE/RR ^ 1.8 not 1.9 as I had in the above post.  

Not sure what he changed to for when ROE is less than RR in latter additions. Probably stands to reason that it is ^2.2 not 2.1 as I had above.


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## Dominover (28 August 2011)

craft said:


> Edit
> 
> Just checked RM table 11.2. His formula is ROE/RR ^ 1.8 not 1.9 as I had in the above post.
> 
> Not sure what he changed to for when ROE is less than RR in latter additions. Probably stands to reason that it is ^2.2 not 2.1 as I had above.




Thanks very much for that.  It is to the power of 1.8 or 2.2 depending on where the RR sits in relation to the ROE (Greater or less than).   It was the underlying assumptions for this calculation and any other calc which implies a certain effect on the actual equity value when earnings are reinvested.    I'm certainly going to look into the Walter model you suggested, thanks very much for the help.   I think you've pretty much set me on the right path. 

Cheers.
Dominover


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## waimate01 (29 August 2011)

If all things are equal, then you should see the Book Value increase by at least the amount of retained earnings (otherwise where did they go?)

Likewise if all things are equal, you should see earnings next year increase by at least the amount of retained earnings times the recent ROE% (otherwise the 'its better for us to retain it' argument somewhat goes out the window). Or if you prefer to express it the other way around, the difference in earnings from year to year divided by the amount of equity retained gives you the ROE on what they kept, which should compare favourably to the overall ROE otherwise WTF.

Things are rarely equal, so don't expect rock solid relationships here. But they are useful trajectory checks.


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## craft (29 August 2011)

waimate01 said:


> If all things are equal, then you should see the Book Value increase by at least the amount of retained earnings (otherwise where did they go?)
> 
> Likewise if all things are equal, you should see earnings next year increase by at least the amount of retained earnings times the recent ROE% (otherwise the 'its better for us to retain it' argument somewhat goes out the window). Or if you prefer to express it the other way around, the difference in earnings from year to year divided by the amount of equity retained gives you the ROE on what they kept, which should compare favourably to the overall ROE otherwise WTF.
> 
> Things are rarely equal, so don't expect rock solid relationships here. But they are useful trajectory checks.







> Things are rarely equal




And that is the big point. The formula for valuing a company based on retained earnings and historical ROE (or forecasts extrapolated from recent history) is only any good if nothing changes, i.e. the future is a strict continuation of the past. Additionally if you introduce shortcuts like valuing growth by raising ROE/RR to a power then you are introducing an arbitrary time frame.

If the actual growth period is different to the implied growth period the valuation estimate will be wrong.

If current ROE is impacted by historical write downs or accounting goodwill the estimate will be wrong.

If the business is subject to revenue cycles the estimate will be wrong.

If the business margins are increasing or decreasing the estimate will be wrong.

If the company uses funding other than retained earnings the valuation will be wrong.

If the companies business model can utilise customer cash flow to fund its growth, estimates will be wrong.

If the company has the most logical Capital allocation policy (for Aus tax rules) of returning profits to the level of franking and re-raising funds where necessary the estimate will be wrong.

And on and on we could go.

It seems to me many who subscribe to this method of valuation are not buying the most undervalued companies. They are buying where the futre is most likely to be different to the past and hence they most disagree with the market price, but this discrepancy is more likely than not caused by an unrealistic estimate of what the underlying value really is, rather than the market being truly mispriced.  If you have to use up all your MOS compensating for a crap valuation method then you have nothing left for when the future business conditions do not meet your expectations.


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