Each dollar of retained earnings is translated into at least one dollar of market

Hey guys,

Been reading the warrent buffet way book, however, I am not too sure if my understanding of the phrase below is 100% correct.

"Each dollar of retained earnings is translated into atleast one dollar of market value."

Retained earnings are the profits from the company right?

So if company X makes 100 million retained profit, they reinvested 100 million back into the company million, they would make another 100 million profit from it?

Therefore translating to at least one dollar of market value right?



Thanks heaps!!!

Hey KW,

Thanks so much for your reply.

I understand it fully now, "market value" rather than my confusion thinking it had to translate into profit value.

Confused myself with whatever money was retained, had to profit dollar for dollar.

Thanks so much, I love this forum, everyone is so helpful and nice... Wish I knew about this forum when i was 16!!!!!

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Originally Posted by baller18

I understand it fully now, "market value" rather than my confusion thinking it had to translate into profit value.

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Hi Baller18

KW's post is spot on. I am not sure this adds anything to KWs perfect description but in the interest of having a go:

Companies that wish to grow often retain profits as opposed to giving profits back to shareholders. This is so they can invest in new assets that will generate new profit streams.

If the new assets generate a return above what all other investors are looking for, then that should translate to greater than $1 in value created for every $1 retained. This is because the market (all other investors) will be willing to buy the shares at higher prices for the new and old cashflows combined and they will bid up the shares until the price reflects the return they are happy with!

If the new assets only generate exactly the return that investors require, then obviously only $1 of value is created for every $1 retained - a neutral result where no value is created or lost by the retained earnings.

finally, if the ratio of new profits to new capital (the retained earnings) is LOWER than the return all other investors in aggregate are happy with, then of course the value added will LESS than $1 for every $1 retained. In this case the company has actually destroyed value for shareholders and would have been better to have paid all the profits out to its owners rather than have invested the funds internally.

The return that these new investments are bench marked against is known as 'the hurdle rate' or 'the cost of capital' - This is the rate all investors in aggregate need to compensate them for the risk of the investment. It is also helpful to think of this hurdle rate as relative to investors 'opportunity costs'. This is because it is the returns the market can get in other investments with similar risk that determines what rate of return the market wants.

The risk that profits may be reinvested unwisely is one of the many reasons that good management is so important. As the people running your business (as a shareholder you are a joint owner of the business and should behave like one) they are the stewards of your capital! They need the judgement and skill to know when the investment opportunities they see are going to compensate the owners sufficiently. If it won't they need the humility to accept this and pay out the cash to shareholders rather than make a mistake.

Unfortunately there is an inherent conflict of interest between owners and managers in this sense.

It is often in the managers best interests to keep reinvesting and building a larger ship to justify more compensation and more kudos, even if its at the expense of shareholders because the investments are not beating the hurdle rate.

This is why many investors like see managers with significant shareholdings as it more closely aligns the interests.

It is really is a good idea to research corporate finance and get to know all this theory like the back of your hand. I would say how value is created and destroyed, and how this relates to the time value of money and compounding, are the most crucial aspects of investment theory that exist. Luckily its all quite intuitive when you get into it.

I hope this helps

Cheers

Wasn't Buffett into saying that reinvesting earnings and returning the same return on equity (ROE) creates added Market value

Simple case -

Equity 1000 and 20% ROE gives 200 earnings = say PE is 10 then share price is 2000

Assume earnings retained - equity now 1200 - 20% ROE would give earnings of 240 - PE stays at 10 gives shareprice of 2400

The 200 retained has added 400 market value - 1 buck retained giving 2 bucks return ...as you say baller "Each dollar of retained earnings is translated into at least one dollar of market value."

Mr Buffett had a very simplistic approach eh. Give the 200 back to shareholders and still make 20% ROE the shareprice stays at 2000.

SNOOPY has a whole thread on this approach somewhere with worked examples to get Buffet's intrinsic value of companies .... Would Warren buy etc

Great example of the maths Winner

My only criticism of all those Warren Buffett books is that it's not some proprietary Warren Buffett valuation approach. It is simply the maths behind all growth - good or bad.

But if it gets people across the theory, then its all good I guess.

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Originally Posted by winner69

Wasn't Buffett into saying that reinvesting earnings and returning the same return on equity (ROE) creates added Market value

Simple case -

Equity 1000 and 20% ROE gives 200 earnings = say PE is 10 then share price is 2000

Assume earnings retained - equity now 1200 - 20% ROE would give earnings of 240 - PE stays at 10 gives shareprice of 2400

The 200 retained has added 400 market value - 1 buck retained giving 2 bucks return ...as you say baller "Each dollar of retained earnings is translated into at least one dollar of market value."

Mr Buffett had a very simplistic approach eh. Give the 200 back to shareholders and still make 20% ROE the shareprice stays at 2000.

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Now you into these things baller - have you heard of the price book (PB)? Price is share price and B(ook) is the book value or equity.

So above company has a PB of 2 - it's market value is 2 times its equity. The difference between the two is 1000 - that is the market value added, good for shareholders eh.

Seeing they maintained the 20% ROE the PB has stayed at 2 but the market valued added has increased to 1200 - even better for shareholders eh.

Very simplistic eh

Your homework - would you prefer this company to pay out 100% of earnings in divies or to retain the lot and make 20% on it?

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Originally Posted by baller18

Hey guys,

Been reading the warrent buffet way book, however, I am not too sure if my understanding of the phrase below is 100% correct.

"Each dollar of retained earnings is translated into atleast one dollar of market value."

Retained earnings are the profits from the company right?

So if company X makes 100 million retained profit, they reinvested 100 million back into the company million, they would make another 100 million profit from it?

Therefore translating to at least one dollar of market value right?



Thanks heaps!!!

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Being the simpleton that I am.. If a dollar is retained .. it would immediately transfer into the NTA.. Thus the company would be worth one dollar more, divided by the number of shares... Not an addition of one dollar per share.. I think..

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Originally Posted by winner69

Now you into these things baller - have you heard of the price book (PB)? Price is share price and B(ook) is the book value or equity.

So above company has a PB of 2 - it's market value is 2 times its equity. The difference between the two is 1000 - that is the market value added, good for shareholders eh.

Seeing they maintained the 20% ROE the PB has stayed at 2 but the market valued added has increased to 1200 - even better for shareholders eh.

Very simplistic eh

Your homework - would you prefer this company to pay out 100% of earnings in divies or to retain the lot and make 20% on it?

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Thank you Sauce, Janner and winner! Thank you guys!!!

Yup I have heard price to book ratio winner.

I would prefer the company to retain the lot and make 20% on it, so therefore the SP which is the capital of invested in the company goes up by 20% as well, therefore, making another 20% on the capital I have invested in the company. But, if it was paid out in dividends to all the shareholders, my capital would not increase by 20%, because the 20% is shared about shareholders. Is this correct winner? Thank you so so much for the question!!!!

So in regards to PB, if the equity doest not increased to 1200 but 1100, giving it a 10% ROE but share price is at 2400 and gives it a PB of 2.18. Does this mean it’s overvalued?
Because ROE increased by 10% but share price increased by 20%, is this thinking right?