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Reinvestment is a board game that should be rewarding fun for all the corporate family, and shareholders must help to ensure the money is handled properly and effectively. Peter Webb checks the dice

When a company makes a profit it is down to the board, your board, to reinvest that money on your behalf or return it to shareholders. Keeping an eye on how effectively the board is doing this is a good idea. Otherwise, you could find that retained profits are generating little or no return for you and would be better off invested elsewhere.

The directors will always need to reinvest some of the profits to replace old equipment or to expand into new product categories or new markets. When earnings are announced, the board can define a dividend policy that not only achieves the objective of investing in the business but also gives a return to shareholders. Share buybacks can, indirectly, increase the value of your holding but a

more direct way is dividends and this is

the most common way to return ‘spare’ profits to shareholders.

In theory, management should be making a judgement on how much capital it needs to grow and protect the business and, after that, should return the remainder to shareholders. Ideally, ‘spare’ earnings should be used to give shareholders the best value. Earnings should only be retained if they can earn a higher rate of return than the shareholders could earn outside that business.

So how do you judge the effectiveness of management to produce a good return on your reinvested capital? You can help your judgement by examining what has happened to capital reinvested in the business in previous years. By analysing previous years’ earnings and how much has been retained for use in the business and how much has been returned to shareholders, you can roughly judge what that retained capital has produced in extra profits. More importantly, you can find out if that extra return is worthwhile.

Compare and contrast

In my example you can see I have chosen two different companies to examine what has happened to retained profits.

The first step is to examine the earnings per share (EPS) and dividends per share (DPS) over a reasonable period. The example lists EPS and DPS from 2000 to 2007. For the EPS I have used normalised earnings, which has removed the effect of ‘exceptional’ charges to the profit-and-loss account. The reason for this is to present a clearer picture of earnings to aid my calculation. Including exceptionals often distorts this method, though I suggest you always examine each case individually if you are serious about investing in a company.

Once I have this data, I then add up all the EPS and DPS for the time period. From this, I can work out the amount of profit per share retained by the company. I simply deduct dividends from the total EPS for the period to calculate how much profit has been retained. Taking the growth in EPS over the period, I can simply divide this by the amount of earnings retained to work out what the management has done with our money.

In the case of Tesco (TSCO), during the period under examination, the company had earnings of 107p per share, paid 42.9p in dividends and retained 57.9p for reinvestment in the business. Over this period EPS grew by 9.7p, which means, hypothetically, that it returned 16.7% on the earnings retained to reinvest in the business. In this case the money left in the business grew at an excellent rate.

For Sainsbury (SBRY) the situation is somewhat different over the period in question. EPS shrank over the period in question so all that extra retained capital has lost us money! In this case it would seem more appropriate to return capital to shareholders rather than continue to invest it in a business that is unable to use it effectively. Shareholders could have earned more on their capital elsewhere.

Useful pointer

Obviously, when companies don’t grow earnings, the money is better returned to shareholders, but there are a number of qualitative issues that need to be resolved to see if this is a good idea.

You tend to find that businesses that lack pricing power, face a competitive environment, or have capital-intensive businesses tend to make less effective use of retained earnings than a company that has good management and economics. Therefore using this calculation as a quality lever is a good idea. Companies that do a good job of making retained profits work over the long term are much more likely to make shareholders a lot of money than those that don’t. Also, the need for additional funding to grow the business can come from this retention rather than raising additional debt to finance expansion or maintenance of the business; so keep an eye on how much is retained.

Next time you look at a business, run this test to see how effectively management is putting your money to use.