Return on Retained Earnings

Return on Retained Earnings (RORE) is a powerful, yet often overlooked, metric championed by legendary investor Warren Buffett. It measures how effectively a company's management is at turning the profits it keeps (reinvests) back into the business to generate even more profit. Think of it this way: when a company earns a profit, it has two main choices. It can either hand that money back to shareholders in the form of dividends, or it can keep the money and reinvest it to grow the business. This reinvested profit is called retained earnings. RORE calculates the return generated on only this reinvested capital. For a value investing practitioner, this is a crucial test of management’s skill. A high RORE indicates that management is making smart decisions and creating shareholder value, suggesting that every dollar kept by the company is working harder for you than if it had been paid out.

At its heart, RORE is a report card on a company's capital allocation decisions. As a shareholder, you are a part-owner of the business. The company's profits are your profits. If management decides to keep that profit instead of paying it to you, they'd better have a good reason! They are essentially telling you, “We can invest this dollar for you and earn a better return than you could on your own.” RORE allows you to check their work. It answers the critical question: For every dollar of profit the company keeps, how many cents of additional profit does it generate in the future? A company that can consistently generate a high return on its retained earnings is a compounding machine, turning small profits into a mountain of value over time. A company that can't is destroying value by hoarding cash it can't use effectively.

While there are a few ways to slice this, the most insightful method for long-term investors is the one Buffett uses, which looks at performance over several years. A single year can be misleading, so a 5 or 10-year period gives a much clearer picture of management's true ability.

The formula focuses on the growth in a company's earning power relative to the profits it has reinvested over a period. Formula: RORE = (Increase in Earnings Per Share over the Period) / (Total Retained Earnings Per Share over the Period) To get the “Total Retained Earnings Per Share,” you simply add up all the annual EPS figures for the period and subtract the total dividends paid per share over that same period.

Let's imagine we are analyzing Widget Wonders Inc. over a five-year period.

• Year 1 Data:
  • Earnings Per Share (EPS): $2.00
• Year 5 Data:
  • Earnings Per Share (EPS): $4.50
• Performance over the 5 Years:
  • Total EPS Earned: $15.00
  • Total Dividends Paid Per Share: $5.00

Now, let's plug these numbers into our formula:

1. Step 1: Calculate the Increase in EPS.
   • $4.50 (Year 5 EPS) - $2.00 (Year 1 EPS) = $2.50
2. Step 2: Calculate the Total Retained Earnings Per Share.
   • $15.00 (Total EPS) - $5.00 (Total Dividends) = $10.00
3. Step 3: Calculate the RORE.
   • $2.50 / $10.00 = 0.25 or 25%

The result? For every single dollar that Widget Wonders' management retained over the last five years, it successfully generated an additional 25 cents in annual earnings. That's an outstanding result.

A great RORE is a clear sign of a business with a powerful economic moat.

• Exceptional (>15%): A company consistently earning above 15% on its retained profits is a rare gem. It signals a strong competitive advantage, pricing power, and brilliant management.
• Mediocre (8-12%): A return in this range is acceptable but not spectacular. It's roughly what an investor might expect from a broad market index fund. It raises the question: why not just pay out more dividends and let investors manage their own money?
• Poor (<8%): A consistently low RORE is a major red flag. It suggests that management is either unskilled at reinvesting capital or is operating in a fiercely competitive industry with no durable advantages. In this case, retaining earnings actually destroys shareholder value relative to other opportunities.

Never judge a company by a single year's RORE. A one-off event, an accounting change, or a lucky break can distort the numbers. The true power of this metric is revealed over a long-term trend (5-10 years). A consistently high RORE demonstrates that the company's success is not a fluke but the result of a sustainable and profitable business model.

RORE shouldn't be the only metric you use, but it's a fantastic supplement to more common measures like Return on Equity (ROE) and Return on Invested Capital (ROIC). Here's the key difference: ROE and ROIC give you a snapshot of a company's profitability on its entire capital base. RORE, on the other hand, is more dynamic. It specifically measures the profitability of incremental capital—the new money being reinvested each year. Think of it like this: ROE tells you how good the chef's entire pot of stew tastes right now. RORE tells you how much better the stew gets every time the chef adds a new ingredient. For an investor looking to the future, the chef's skill with new ingredients is arguably the more important piece of information.