I have been working on a new spreadsheet template that estimates management’s ability to allocate capital over the long-term. Here is a screenshot example using one of my favorite companies: AutoZone (AZO). I want to highlight one calculation, and then I’ll provide background and context on why this matters to investors. In the cell “S11″ (row 11, column S”), it shows that AutoZone has a Return on Retained Earnings of 14.25% between August 2005 to August 2019. That is a very good performance.
But before we get into the details of this spreadsheet, let’s provide some context.
Every year Warren Buffett writes a letter to the shareholders of Berkshire Hathaway. The company website has letters going back to 1977. Whereas most public company CEOs write a 1-page letter or 2-page letter, Buffett writes much longer detailed letters; last year in 2019, the shareholder letter was 19 pages long. For the first time in many years, he writes on the topic of retained earnings. The section titled “The Power of Retained Earnings” starts from the bottom of page 2 and runs through the end of page 5, comprising 1,156 words to thoroughly and patiently explain the power of retained earnings.
Buffett’s message is that many investors underappreciated the power of retained earnings prior to the publication of an obscure book in 1924 called Common Stocks as Long Term Investments by Edgar Lawrence Smith. But I wonder if even present-day investors underappreciate the power of retained earnings, despite the publication of Mr. Smith’s book and also Mr. Buffett’s letters to shareholders. Prior to the 2019 letter, Buffett also discussed retained earnings in 1978, 1979, 1980, 1981, 1982, 1983, 1984, 1985, and 1994. The topic of retained earnings deserved an annual mention in the years between 1978-1985, but there was a 9-year gap between 1985-1994 and a 15-year gap between 1994-2019. Since retained earnings is such an important topic, I want to discuss in further detail before getting back to the spreadsheet.
“It’s difficult to understand why retained earnings were unappreciated by investors before Smith’s book was published. After all, it was no secret that mind-boggling wealth had earlier been amassed by such titans as Carnegie, Rockefeller and Ford, all of whom had retained a huge portion of their business earnings to fund growth and produce ever-greater profits. Throughout America, also, there had long been small-time capitalists who became rich following the same playbook.”Warren Buffett, Berkshire Hathaway Letter to Shareholders, 2019
I think the mention of Carnegie, Rockefeller and Ford is signaling a message to shareholder. Understanding the power of retained earnings is no small topic of minimal importance; unlocking the power of retained earnings can produce mind-boggling wealth.
Where to Look For Retained Earnings
The retained earnings can appear in different places in a company annual report. Usually the Balance Sheet includes a “retained earnings” figure that is a cumulative balance of earnings over time. The “retained earnings” figure in the Balance Sheet is a bit hard to understand, because in some situations it can actually be reported as a negative number. Rather than a cumulative figure, the annual “retained earnings” can be calculated from the Net Income (aka “Earnings”) in the Income Statement, and the Dividend Payments which may be in the Income Statement and/or the Cash Flow Statement.
Here is an example looking for the “retained earnings” figures in the 2019 Annual Report from Omnicom (OMC), a global advertising agency.
The Balance Sheet lists “Retained Earnings” in 2019 of $7,806.3 Million. Although this is a cumulative sum of Net Income over time, I am not quite sure how to interpret this figure. However it is useful to note the common stock shares outstanding of 217.1 million in 2019. The shares outstanding figure fluctuates over the course of the year, since a company can issue new shares or repurchase outstanding shares. A weighted-average figure of shares outstanding is used to calculate earnings-per-share and dividends-per-share.
The Net Income in 2019 is $1,339.1 Million, and earnings per share (basic) is $6.09. An approximate calculation of earnings per share (basic) is $1,339.1 Million in earnings divided by 217.1 million shares outstanding => $6.19 which is close approximation to the reported EPS (basic) figure of $6.09.
The dividends in 2019 are $564.3 Million. An approximate calculation of dividends per share is $564.3 Million in dividends divided by 217.1 million shares outstanding => $2.60 which is equal to the reported dividends per share figure of $2.60.
Rather than looking up each number in the annual reports, I use a paid financial data service called GuruFocus, which provides up to 30 years of financial results via website (and Rest API, a format convenient for computer programmers). Here is the GuruFocus Financials Page for Omnicom.
Here is an example of the spreadsheet calculator for Return on Retained Earnings of Omnicom (OMC). In the cell “S11″ (row 11, column S”), it shows that Omnicom has a Return on Retained Earnings of 10.73% between December 2005 to December 2019. I want to point out some differences between Autozone (in Figure 1) and Omnicom (in Figure 6). Autozone does not pay a dividend, but has a very aggressive share buyback program (measured as a % of operating cash flow); Omnicom pays a very significant dividend, but has a much smaller share buyback program (as % of operating cash flow). Although both dividends and shareholder buybacks return capital to shareholders, each policy has a very different impact on future earnings growth.
Buffettology (Original), Chapter 42
I studied business in my undergraduate program at New York University (NYU), and yet I have to admit that I was confused by many aspects of retained earnings until I started studying Warren Buffett’s life. It wasn’t until I read Chapter 42 of the original edition of Buffettology (not the New Buffettology version), that I truly appreciated the importance of the long-term picture of retained earnings and growth in EPS. (Incidentally I had wonderful professors at NYU, so the slow learning was the fault of the students – not the teachers. I had a really great visiting professor from Australia named Greg Clinch who taught Introductory Accounting using an annual report from Intel Corp; and an excellent professor named Crocker Liu who taught Investment Principles by having each student write the equivalent of a Wall Street Equity Research Initiation report over the semester. I have mostly fond memories of studying at NYU, and I am grateful to have received a solid education.)
Mary Buffett’s original book “Buffettology” is substantially different than her later book called “The New Buffettology”. In particular, Chapter 42 of Buffettology is titled “How to Measurement Management’s Ability to Utilize Retained Earnings”.
“Warren believes that management should retain unrestricted earnings only if it can earn a higher rate of return on the unrestricted earnings than the shareholders could ear on the outside. […]
Our problem as investors is that it is hard to determine if the management of a company is doing a superior job of allocating its unrestricted earnings. This is because a company with exceptional economics in its core business can produce tons of excess cash and in the process cover up any mistakes that management makes in allocating capital. As noted, a tremendous business can be so strong that it can hide even inept management. […]
So that is the problem. How do we as investors measure a company and its management’s ability to profitably allocate unrestricted earnings?
What we do is take the per share earnings retained by a business for a certain period of time, then compare it to any increase in per share earnings that occurred during this same period.Buffettology by Mary Buffett and David Clark (Chapter 42)
In my own mind, there were 4 very interesting takeaways regarding this calculation.
- Takeaway #1: Positive Earnings. This calculation is not useful on companies with negative earnings (or negligible earnings), for example, a “growth” company.
- Takeaway #2: Steady Earnings. This calculation can vary significantly depending on the choice of starting year and ending year, due to the annual fluctuations of earnings. Therefore this calculation is best suited for companies with relatively steady earnings.
- Takeaway #3: Comparing Different Approaches. This calculation “normalizes” comparisons of companies with different dividend and share buyback policies.
- Takeaway #4: Nothing About Price. This calculation reports on management’s ability to allocate capital. However, it says little about the attractiveness of the current price of the stock.
Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.”Warren Buffett, Berkshire Hathaway Letter to Shareholders, 2008
Comparing AutoZone (AZO) and Omnicom (OMC)
Let’s examine each of these takeaways for Omnicom. Below is a table of the past 15 years of EPS and dividends for Omnicom (Dec 2005 to Dec 2019).
|Fiscal Year||EPS (Basic)||Dividends per Share||Retained Earnings|
Source: GuruFocus (https://www.gurufocus.com/financials/OMC)
- Takeaway #1: Positive Earnings. OMC’s earnings are positive in each of the years between 2005 and 2019. None of the years show a negative earnings figure. By comparison, many “growth” companies lose money for years amid strong growth in revenue and stock price.
- Takeaway #2: Steady Earnings. OMC’s earnings show a steady growth over the long term. The years of 2009 and 2010 show some slowdown due to the recession, but by 2011 the earnings continue the steady march upwards.
- Takeaway #3: Comparing Different Approaches. The long term growth in EPS is partially driven by OMC share buybacks. However OMC’s generous dividend policy (as % of EPS) means that management has a smaller base of retaining earnings to invest. So the long-term growth in OMC earnings should be measured against this smaller cumulative retained earnings base.
- Takeaway #4: Nothing About Price. The current price of the OMC stock, and its valuation, are not accounted for in the EPS and Dividends.
Now let’s examine each of these takeaways for AutoZone. Below is a table of the past 15 years of EPS and dividends for AutoZone (Aug 2005 to Aug 2019).
|Fiscal Year||EPS (Basic)||Dividends per Share||Retained Earnings|
Source: GuruFocus (https://www.gurufocus.com/financials/AZO)
- Takeaway #1: Positive Earnings. AZO’s earnings are positive in each of the years between 2005 and 2019. None of the years show a negative earnings figure. By comparison, many “growth” companies lose money for years amid strong growth in revenue and stock price.
- Takeaway #2: Steady Earnings. AZO’s earnings show a steady growth over the long term. Every year between 2005 to 2019 shows substantial positive year-over-year (YoY) growth in EPS. Said another way, not a single year showed less EPS than the prior year. Although this extreme level of consistency is not required for this calculation, a general earnings growth consistency provides a more uniform picture over time.
- Takeaway #3: Comparing Different Approaches. The long term growth in EPS is very strongly driven by AZO share buybacks. By contrast, AZO pays zero dividends, and retains all of the earnings. So the long-term growth in AZO earnings is measured against a higher cumulative retained earnings base.
- Takeaway #4: Nothing About Price. The current price of the AZO stock, and its valuation, are not accounted for in the EPS and Dividends.
Here is a table to compare the calculations on the spreadsheets for OMC and AZO. The biggest highlights are that while OMC provided investors a steady increasing dividend during the 15-year period, OMC use of retained earnings (10.73%) was not as effectively as AZO (14.28%); by contrast AZO provided zero dividend during the 15-year period, but were good stewards of retained earnings. Lastly the current PE valuation of OMC (8.67) is at a discount to AZO (17.26), but both earnings yields (OMC 11.53% and AZO 5.79%) are well above 10-year U.S. Treasury Bond yields of 0.67% (as of June 22, 2020).
|PE Ratio (TTM) as of 2020-06-26||8.67||17.26|
|Earnings Yield (inverse of PE Ratio)||11.53%||5.79%|
|Starting EPS in 2005 (FY Aug vs. Dec)||2.19||7.27|
|Ending EPS in 2019 (FY Aug vs. Dec)||6.09||64.78|
|Cumulative Dividends 2005-2019||20.64||0.00|
|Growth in EPS 2005-2019||3.90||57.51|
|Cumulative Retained Earnings 2005-2019||36.34||402.81|
|Return on Retained Earnings 2005-2019||10.73%||14.28%|
The Return on Retained Earnings calculation can vary depending on the starting and ending year chosen for the calculation. So the spreadsheets in Figure 1 and Figure 6 also includes a sensitivity table at the bottom that shows the different results depending on starting and ending year. To make the table easier to read, I added conditional formatting shading depending on 3 threshold values:
- Greater than 10%: Green Shading
- Between 0% and 10%: Yellow Shading
- Less than 0%: Red Shading
Price vs. Value
Investing is like a complex puzzle with many different factors to consider. Each investor needs to develop a personal philosophy about which factors are more important than others. I actually like both AutoZone (AZO) and Omnicom (OMC). The Return on Retained Earnings analysis suggests that AutoZone might be a slightly better business, while Omnicom might be selling for a slightly better price. Although I currently hold both stocks in my portfolio, the current (attractive) price of Omnicom factors heavily into my thinking at the moment.
On that note, I will leave you with a quote from Charlie Munger from Poor Charlie’s Almanac (Third Edition):
Munger’s Three Great Lessons of Investing:
1. “A great business at a fair price is superior to a fair business at a great price.”
2. “A great business at a fair price is superior to a fair business at a great price.”
3. “A great business at a fair price is superior to a fair business at a great price.”Charlie Munger, Poor Charlie’s Almanac (Third Edition)
Disclosure: I own shares in AutoZone (AZO) and Omnicom (OMC) as of publishing this article (June 2020). I have no intention of selling my positions in the near future. This article is not a recommendation. Investors should make their own determination of whether or not to buy or sell this stock based upon their specific investment goals, and in consultation with their financial advisor.