When a company creates profits, it has a decision to make. It’s all between how much of the earnings they should pay back to shareholders as a dividend, and how much they should reinvest in the business. Keeping the earnings is known as retained earnings.

Many investors can be led astray by the deceitfulness of retained earnings because on the surface it sounds like a great idea.

Warren Buffett is a proponent of retained earnings, after all, his company Berkshire Hathaway retains all of its earnings. His argument is that the company can compound the retained earnings at a much higher rate than the investor can if it was instead paid out as a dividend.

In fact, the better a company is at this– evidenced by high efficiency ratios such as return on assets, return on equity, etc– the stronger the argument for retained earnings tends to become.

Many of the “growth stocks” of today, those that are popularized by the media that usually have high rates of earnings growth, don’t pay out a dividend and use the excuse of retained earnings quite frequently. It’s almost expected by growth investors that their companies won’t pay a dividend.

The logic is this. If a company can utilize earnings and return 20% on that money, meaning create 20% more profits for the company, then that’s a superior compounding rate than an investor can expect to get in the market. And it’s true, investors can’t expect 20% returns in the market most of the time.

So then investors should be in favor of retained earnings most of the time, right?

Not so fast.

There’s several reasons why I disagree. It’s not that I don’t agree with the base level logic. I do, I get it. But you have to look deeper than that, and really examine the implications. Look at all possible outcomes of when a company does this.

Let’s not just blindly follow successful investors like Buffett. After all, his company Berkshire implements this standard for their own company– but look at many of Buffett’s past and present investments. They tend to pay great dividends or have high levels of dividend growth, indicating a stock that retains less of its earnings.

The first and most easiest point to understand is the valuation effect. I mentioned earlier that many growth stocks tend to be the biggest perpetrator of retaining earnings. They also tend to carry high valuations.

For beginners, a high valuation means a stock is expensive. And the higher a valuation you pay for a stock, the less of a positive effect retains earnings has on your results. 

Bear with me, there’s some math involved.

Say you bought at stock at a P/E of 20. Let’s make the bold assumption that all stocks have an average P/E ratio over the years, so most stocks will tend to trade in a range close to that average (let’s use the median to filter out stocks that got extremely expensive and would push the average too high).

The median P/E historically has been 15.

If you think your stock doesn’t apply to the average or median P/E because you have a special snowflake, good luck to you. Thinking you can always find the exception to the rule is a terrible way to do investing, or even live life.

Yes, the P/E ratios move over time. But if you think again this won’t apply to you because you’re going to sell when the P/E is at a high range– essentially timing the market– start again at square 1. It’s been proven all over the place that you can’t time the market effectively.

Now, we don’t know where a price will go on any given day. It’s our wild variable, so let’s hold it constant.

Say you bought a stock at a P/E of 20. Hold the Price (numerator) constant. For that stock to trade at the historical median P/E of 15, a company would have to increase earnings by 33%.

[The math: multiply the P/E by 3/4 to change 20 to 15. We’re not changing P, so you have to multiply E by 4/3, or a growth of 33%]

Say someone else bought a stock at a P/E of 10. For that stock to trade at a P/E of 15, the company could lose 33% of their earnings for the same result as above.

[The math: multiply P/E by 3/2 to change 10 to 15. Multiply the E by 2/3 when P doesn’t change]

Yes I just made a strong case for the validity of the P/E ratio. But this applies heavily to retained earnings as well.

You can see that increasing the earnings by a certain amount will change the returns for an investor. If we are going to argue that a company will keep earnings to grow future earnings, you can see this has different implications for the investor depending on his P/E entry point.

The higher the P/E of a company, the more an investor depends on high earnings growth to get a good ROI.

Of course the investor could also achieve the same goal with an increasing price, but remember you don’t want to depend on that. Now you’re playing the timing game and the greater fool theory– that someone will buy at a more expensive price point than you– and it’s just not sustainable or realistic.

Notice that the lower the P/E, the less the investor leans on those earnings. The company could actually shrink their earnings and the investor would still come out even or maybe even ahead. You can see in this case that paying those earnings out in a dividend would be better for the investor than retaining them and plowing them into a shrinking business.

I really simplified this. But it’s just scratching the surface.

My biggest conclusions are coming up below.

Another simple logic argument made in favor of retained earnings is this. Well if a company has proven to have a high return on equity, they should reinvest more capital into the business.

What’s equity? It’s the number of assets above the liabilities number. So say we pump 100% of earnings into the business. We’re essentially increasing equity by this much. Using earnings to buy assets. So if a company has an ROE of 20% (they turn 20% of their equity into earnings), we’re essentially increasing earnings by 20%.

Average stock market returns are 7-11% depending on who you ask and what variables you include. Surely you won’t find returns in a different stock of 20% on average. So the 20% increase in earnings should be more reliable.

And that argument is right. Take the same valuation-type math analysis we did earlier. We hold Price constant because it can’t be predicted. So if you add 20% to the Earnings (denominator) of the P/E ratio… then to achieve the same P/E ratio you’d have to increase the price side by 20%.

Which equals a 20% ROI. Nice, right?

Here’s where it gets tricky. The

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