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Retained Earnings Critical Driver of Earnings Growth


InfraCap Insights:  Retained Earnings Critical Driver of Earnings Growth

New York - November 16, 2023 ~ Many market strategists have been very bearish on S&P 500 (“S&P”) earnings this year based on the fact that they thought that corporate margins were at cyclical peaks. What they missed is that almost all earnings growth comes from the reinvestment of retained earnings and depreciation. Without reinvestment, most businesses would have flat earnings and cash flow over long periods of time. In addition, Earnings would likely decline as the company’s assets and franchise deteriorate due to lack of investment.


The average earnings retention rate of the S&P 500 is approximately 70%. Most S&P companies target after-tax investment returns of over 12%. If a company retains 70% and invests those earnings at 12%, the company will grow earnings at 8.4% per year (70% times 12). The current dividend yield on the S&P is 1.5%, which would imply a total return of approximately 10% (8.4% earnings growth plus the 1.5% yield). The average return on the S&P since inception is 10.7% per year. In addition, any S&P company with significant depreciation would also have that cash flow to reinvest to maintain the return on its existing assets.


A typifying example of how retained earnings explain earnings growth is regulated utilities. Since a utility has a fixed regulated rate of return on net book value, its earnings growth is 100% explained by retained earnings. A utility that retains 50% of its earnings and has a 10% regulated rate of return will grow its earnings at exactly 5%. More mature companies may not have attractive investment opportunities and typically trade at lower earnings multiples as low as 10x or less. If the company retains 70% of its earnings and buys back stock at a 10x multiple it will still grow earnings at 7% (70% times the earnings yield of 10%). Since the company is only trading at 10x it will have a 3% dividend yield at a 30% retention rate and will still be able to deliver a 10% total return which is in line with the market as a whole. Consequently, even mature companies with limited attractive new investment opportunities can be attractive investments if purchased at modest earnings multiples.


We believe income investors should focus on companies with attractive dividend yields but also ensure that those companies have good coverage of dividends by book earnings, which provides dividend safety and sets the company up for good earnings and dividend growth through reinvesting in new businesses or buying back shares. Pipeline MLPs are a good example of an industry that 5 years ago had attractive dividend yields but limited retained earnings. This dynamic forced the companies to rely on the capital markets for growth. When energy prices declined, the capital markets were closed and many companies were forced to cut their distributions and reduce leverage.


Today, many pipeline MLPs have transformed themselves into attractive dividend growth vehicles as almost all of the companies have low leverage and high coverage of dividends/distributions with earnings and cash flow. These companies are utilizing retained earnings and cash flow for new investments and share repurchases resulting in steady earnings and dividend growth.


Investors should recognize that stocks in general are attractive long-term investments as the retention and reinvestment of earnings are likely to produce earnings growth over the long term in cases where management executes effectively on growth opportunities or repurchases shares. Earnings growth is likely to drive stock appreciation over the long term so investors should not focus too much on short-term fluctuations in stock prices and/or negative comments from market pundits.


 



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