Retained Profits: A Vital Sign for Smart Share Investing

Share investors who invest in companies that put their profits towards development are often rewarded in the long term.

What a company does with its profits is important in assessing a business's potential to create wealth in the future. Reinvesting profits wisely results in increased profitability of the company in the long run which, if we are shareholders, is what we are interested in.

Let's begin with the story about the grasshopper, the ant and the company dividend cheque. 

Everyone knows the tale of the frivolous grasshopper who gobbled up everything today with no thought for tomorrow, and the frugal ant who deliberately put away some of today's assets to meet future needs.

As shareholders, some of us may live in the grasshopper hope that every cent of profit the company makes will be distributed to us in the form of a dividend payout, preferably fully franked so we don't have to pay tax on it.

Indeed, if you are investing in shares primarily for a regular income, the size and reliability of the annual dividend may be of prime importance to you. But is the distribution of all profits in the form of shareholder dividends a realistic expectation? Or even a good way to run a company?

What would you do if you were the CEO of a company? Would you share out every dollar of after tax profit between the shareholders? (This could be a personal question, as the shareholders might include yourself and your key executives as well as members of the public.)

Or would you distribute part of the profits and put some aside for the proverbial rainy day, or to pay for planned expansion, or just in case a great market growth or profit making opportunity came along?

If you were a retailer, you could have plans to widen your distribution by opening new stores, perhaps in a part of the country where you've never operated before.

If you were a drug company, you may wish to invest in research and development of a promising new cure, which could cost millions and make hundreds of millions.

And whatever business you are in, you may discover that one of your smaller competitors is having a cash flow problem and is ready to sell a cheap way to grow the business.

Whatever the reason, using your own company's money is usually a lot cheaper than borrowing from the bank or having to issue new shares to pay for your growth and diluting the ownership of the company.

Accountants call this process of holding back part of the profits retaining earnings, and these Retained Earnings or Retained Profits are one of the trademarks of a well-managed company

Why is profit retention important, and how does it benefit a company and its shareholders?

First of all, consider the positive effect on the company's dividends that results when the earnings of the retained profits are compounded over the years. Let's keep the numbers simple. Imagine you had $100 invested in a business that was earning 10% a year. In year one, you made a $10 profit, took $5 as a dividend and retained and reinvested the balance. At the end of year two, you have a profit of $10.50, distribute $5.25 and reinvest $5.25. By year 10, your business would be worth more than $160 in assets - asset growth of more than 60%. What would 60% growth in dividends mean to the shareholders of a company worth tens of millions of dollars?

Furthermore, the undistributed dividend on the company's books is not just earning higher returns, it also adds to the total asset value of the company, and of course the asset value of each share is a major element of the share price and this in turn will benefit the shareholders. Thus profit retention it can have a positive effect on both share value and share dividends.

"The ultimate value of a stock to Berkshire (Warren Buffet's holding company) depends on how the retained earnings are reinvested and what that reinvestment produces in future earnings."
Robert G. Hagstrom Jr.

As investors, we pay a lot of attention to a listed company's declared profits - which are often widely reported in the business press. That's as it should be, because a public company's main reason for being is (and should be) to generate a return on investment for its shareholders.

But what the company does with these profits is equally important in assessing a business's potential to create wealth in the future. Reinvesting profits wisely results in increased profitability of the company in the long run which, if we are shareholders, is what we are interested in.

After all, one of the main advantages of investing in shares rather than simply taking the safer route of compound fixed interest is that the value of the shares themselves has the potential to increase over time, providing the opportunity for genuine capital growth as well as earnings.

As a shareholder or potential shareholder, you can usually start to investigate a company's attitude to dividend distribution and judge how well it uses retained earnings simply by reading through the annual report.

Warren Buffet started his first investment company with less than $100 of his own capital, and now has a personal worth of over $50 billion. Widely respected as the world's most successful investor, Buffet is a great believer in using annual reports as a guide to choosing the companies he invests his money in - his filing cabinets are stuffed with them.

Every annual report tells a story, and unlike an advertising brochure, it has to be signed off by the company's accountants and lawyers, so you can usually trust the information in it.

The annual accounts in the Report will tell you exactly what the company earned, and what proportion of these profits were paid to shareholders and what proportion retained for the future.

There should also be a report covering the year's activities and plans for the future which will give you valuable clues as to how well the company has invested retained earnings in the past, and what they intend to do with them in the future.

The internet is a godsend here, because most large company websites carry download-able copies not only of this year's Annual Report, but also those of several previous years. In them, you will find the quality of a company's management decisions laid out like a book.

Investing on the stock exchange appears to be incredibly complicated, but Warren Buffet has become very rich by making it exceptionally simple. Instead of watching the company's share price and trying to predict which way it will jump, he focuses his attention on the management quality of the company issuing the share.

?When I buy a stock,? says Buffet, ?I think of it as buying a whole company, just as if it was a store across the street?. That means looking at the way its managers have done business in the past in order to get an idea of how successfully they've been able to generate positive outcomes over the long term, as well as their potential for significant future earnings.

One specific trademark of quality businesses is the ability to reinvest retained earnings so as to profit their shareholders in the future. So the proportion of profits that are not handed over to shareholders as dividends, and what is done with the retained funds, is just as important as the dividends themselves. Ask any ant.

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