During the earnings reporting season, the emphasis is often on which company smashed the previous period's results, like a horse race, because it is exciting, and investors have something to talk about. Half-year results are like being nine holes into a golf tournament- the eventual winner may have a lead, but it is too early to declare the victor.
Earnings also give us the dividends, but the part that is retained for future business growth is shunted off and forgotten about until the next season when we repeat it all over again for the full-year.
We may talk about return on equity or net profit margins, but what about the return that the company makes on its retained earnings? Theoretically, if the company can't figure out a way to give an adequate return by growing the business, more of the earnings should be delivered to shareholders, and let them go invest it for their required rate of return. Is the company getting a double-digit rate or is it throwing it into a money-hungry commodity business?
You can find out by a simple method. Go back over the past, let's say, 10 years, and calculate the total earnings per share generated, subtract the total dividends paid out during the period, and that will tell you the total amount of earnings the company kept to grow the business.
Using a great retained earnings return example, look at REA Group Limited (ASX: REA), the operator of realestate.com.au.
In 2003, EPS were -1.67 cents per share, yet by 2013 EPS were 83.29 cps. Summing up each year's EPS, we get a total 335.4 cps. Until 2009, the company didn't pay a dividend because it was channeling every last cent towards expanding the business, but after ten full years, shareholders had received a total 126 cps in dividends.
That means it kept 208.9 cps. We could argue that the money retained was the investment back into the company that created the higher future earnings, so what did we get? During the time earnings grew by 84.96 cps, the difference between -1.67 and 83.29.
We then see that 208.9 cps grew EPS by 84.96 cps for a return of 84.96/208.9 = 0.4067 or 40.67%. If you can't find another investment with such a return, then let it keep growing for you.
Using another example, what return on retained earnings did Australia and New Zealand Banking Group (ASX: ANZ) give shareholders?
Again, totaling all earnings per share of 2003-2013, it comes to 1,999.8 cents – almost $20. It paid out 1,380 cps as dividends, thus retaining 619.75 cps to plough back into the bank business. In 2003, EPS were 147.9 cps and 2013 EPS were 216.31 cps, for a difference of 68.41 cps. We could then argue that the 619.75 cps retained generated the extra 68.41 cps of EPS. That would be a return of 68.41/619.75 = 0.1103 or 11.03%.
Foolish takeaway
The 11.03% return on retained earnings is good for an average business growing steadily, but I would rather have the 40%+ return REA Group theoretically got. While we are looking at earnings and dividends during the reporting season, keep an eye on a management's ability to generate a decent rate of return on what they keep. Some companies have to put a lot of capital into keeping competitive for a small rate of return. You want solid companies that spin off money because of their premium business and management.
