Issue #14 - Perceiving the right operational costs

A company needs to decide how it should use its earnings. Actually, earnings are attributed to the owner of the company. The shareholder can choose to keep all the earnings with the company as additional investment or withdraw them for their investment elsewhere. Such decision should always be driven by return on investment (ROI). Say for example Company A earned RM1 per share in year 2006. At present the interest rate of a fixed deposit is 3.75%. This means if the shareholders withdraw all their earnings from Company A to invest in FD their ROI a year from now is RM0.0375 per share or 3.75%. Alternatively, shareholders can retained their earnings with Company A. But what is the ROI should they choose to reinvest with Company A? Shareholder should always be motivated by higher ROI.

Hence, the question to answer is how much is the ROI of retaining earnings with a company for shareholder?

Retained earnings (or unappropriated profit) can be found in the "consolidated statement of changes in equity" section of an annual report.

Retained Earnings = Net Earnings - Dividends

Retained Earnings per Share (REPS) = Retained Earnings / Weighted-average of Outstanding Shares

Below are retained earnings of SP Setia and I&P.

SP Setia
Years     EPS     Delta(EPS)   REPS    RORE
2005      0.324    0.039       0.125    27.64%
2004      0.285    0.058       0.140    44.97%
2003      0.227    0.002       0.129     1.21%
2002      0.225   -0.002       0.163   - 1.55%
2001      0.228   -0.014       0.157   - 7.17%
2000      0.242   -0.033       0.200   -13.94%
1999      0.275    0.038       0.238    19.77%
1998      0.237    N/A         0.194

Total REPS ('98-'04) = 1.220

Average RORE         = (0.324 - 0.237) / 1.220
                     = 7.15%


Island & Peninsular
Years     EPS     Delta(EPS)   REPS    RORE
2005      0.151   -0.173       0.070   - 95.95%
2004      0.324    0.187       0.180    286.94%
2003      0.137    0.023       0.065     55.33%
2002      0.114    0.001       0.042      9.00%
2001      0.113   -0.133       0.012   - 91.86%
2000      0.245   -0.177       0.144   - 51.10%
1999      0.423    N/A         0.322

Total REPS ('99-'04) = 0.770

Average RORE         = (0.151 - 0.423) / 0.770
                     = -24.58%


Fixed Deposit (using REPS of SP Setia)
Years     EPS     Delta(EPS)   REPS    RORE
2005      0.046   0.005        0.125   3.75%
2004      0.041   0.005        0.140   3.75%
2003      0.036   0.006        0.129   3.75%
2002      0.030   0.006        0.163   3.75%
2001      0.024   0.008        0.157   3.75%
2000      0.016   0.009        0.200   3.75%
1999      0.007   0.007        0.238   3.75%
1998      0.000   N/A          0.194

Total REPS ('98-'04) = 1.220

Average RORE         = (0.046 - 0.000) / 1.220
                     = 3.75%

Delta(EPS) represents the difference of EPS of current year with EPS of previous year.

RORE represents the return on retained earnings and is calculated here as ratio of Delta(EPS) to REPS of previous year.

Average RORE measures the additional earnings from 1998 to 2004 due total retained earnings invested. The higher the RORE the better. Price-competitive are unable to utilize their retained earnings in a manner that will cause a significant increase in future earnings due to high cost of maintaining their businesses. Their stock prices should have little appreciation.

An extract from "The New Buffettology":
The advantage of this test is that it gives you a fast method of determining whether it is a durable-competitive advantage business that lets its management utilize retained earnings to increase shareholders' riches or whether it's a price-competitive business that is stuck allocating its retained ernings to maintain its current business.