Sunday, May 21, 2006

Test of retained earnings

Capital allocation is an extremely important process. To put it bluntly, poor capital allocation would lead to decreased intrinsic value and superior capital allocation under above average business conditions would lead to increased intrinsic value. According to Warren buffet he expects every dollar retained to result in an increase in a dollare of market value in a 5 year rolling basis. More recently, other test of retained earnings have been developed to check if increases in retained earnings has led to increases in net income or owner earnings. For example, if the change in retained earnings in the last 10 years was $100 and the increase in net income over the last 10 years was $20, then it can be argued that the company's earnings increased $20 from the increase of a $100 in retained earnings , 20% that is. However in my opinion this is still and inadequate test. What i would like to find out is how capital expenditures would lead to an increase in earnings per share in franchise businesses with competitive advantages? Does anyone have any comments over this or suggestions? Do feel free to contact me and share your views!!1

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