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Stocks in DepthTwo Arrows

by WealthEffect Staff


Return on retained earnings (RORE) is a crucial component of stock-picking
  The simple math of the RORE  
  Why the RORE is so important  

Having discussed some in-depth issues concerning companies and managements, let's consider one of the key components in the decision to purchase a stock: the return on retained earnings, or RORE. This fairly intimidating term is actually self-explanatory — it is the return a company gets from the profits it reinvests in its business.

A company can do one of two things with the money it earns: it can pay it out immediately to shareholders as dividends or it can reinvest some, or all of the profits to grow those profits further. What portion of the earnings should be reinvested depends on the amount of additional profit a company can generate (the bang for the buck). If a company can earn 30 cents for every dollar it reinvests — a 30% RORE — it should retain all its earnings. If a company can only generate 5 cents for each dollar reinvested, it should pay out all its earnings in dividends and retain nothing.


Computing the RORE can be confusing, but it's not difficult. Start with the Value Line Investment Guide, available at most libraries or by subscription; from the index at the front, find the page for the company in which you're interested. Turn to this page and look on the right side, below the graph, where a number of categories are listed (beginning with "Sales per sh," short for sales per share). Focus on the 3rd and 4th categories: "Earnings per sh" (earnings per share) and "Div'ds Decl'd per share (dividends declared per share).

To determine the five-year RORE, take the most recent earnings per share and subtract the earnings per share from five years earlier — this represents the increase (return) over a five-year period. For Coca-Cola, the return was 58 cents per share (1.42 in '98 versus .84 in '93). Next, add the earnings for five years and deduct the dividends paid during those five years — this represents the amount reinvested (retained earnings) over the period. For Coke, the retained earnings were 3.73/share (6.06 in eps from 1993-1997* minus 2.33 in dividends paid).

The five-year return on retained earnings for Coke was 15.5% (.58 return on 3.73 retained earnings). Next, compute the ten-year RORE (if you crunch the numbers for Coke, you'll get a 20% return on retained earnings.)


The RORE is important for several reasons: it quantifies a company's success, it cuts through much of the confusion of GAAP accounting, and it's (relatively) simple to compute. Ideally, you want to find companies with a five- and ten-year RORE above 20%, and which reinvest most or all of their earnings — after all, the higher their returns, the more you want them to reinvest.

You should also hope that the five-year returns are actually higher than the ten-year returns, but should recognize that the normal case is for the returns to decline a bit over time as the company grows and the best opportunities are already taken. You want to focus your attention on companies with track records defined in decades and, in all cases, you need to be comfortable with the sustainability of their competitive advantages and the quality of their managements.

* The five-year period does not include 1998 because the return in one year is generated by the retained earnings of the prior year. If this explanation has become too detailed, ignore it — but don't ignore the RORE.

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