Recently, I talked a little about the relationship between the so-called retained or undistributed profits in companies and the value of companies (ie, also the value of shares). In my experience, retained earnings can have a lot to say. Today about them, stock prices and even gold.
I came across the following two charts that focus on stock market valuations and gold. In the first case, it is specifically the ratio of the value of the American stock index SPX 500 to the profits retained in companies over the past seven years. In the second case, it is the ratio of the price of gold to these retained earnings. Gavekal Research writes about the images that stocks are now expensive from this point of view, the opposite should be true for gold, as its price is historically low for retained earnings:
Source: X
It is not my aim to criticize the authors of the chart for their work and approach. However, as I wrote, the topic of retained earnings may be worth paying attention to, and that is why I return to it in connection with the images. In my experience, retained earnings can sometimes be used as a valuation metric in a way that is misleading. Of course, the crux of the matter is what retained earnings are. Their name (in both Czech and English) could give the impression that it is cash that the company has earned and that is lying in its accounts ready to be distributed. If that were the case, then it would make sense to add this cash (net of the part of it needed to run the company) to the total value of the company. But retained earnings are something else.
Let’s say that a company has sales of 100 million dollars, all costs and taxes are 90 million, so the net profit will reach 10 million dollars. None of it will pay out to shareholders. Her own wealth will thus increase by these retained profits, which, however, on the side of assets – property, can finance a number of things. For example, the company’s receivables may have increased by 10 million, so its free cash flow is zero. The company could also use the profit to buy a new machine or increase inventory. Generally for expansion. He can also keep cash, but it is far from a rule.
