The Buffett Retention Test: A Value Investor's Tool for Evaluating Capital Allocation

The Value Investor
Aug 25
3 min read

Warren Buffett, the legendary investor and chairman of Berkshire Hathaway, is known not just for picking great companies, but for analyzing how well companies allocate their retained earnings. One of his favorite methods to evaluate this is the Buffett Retention Test.

This simple yet powerful tool helps investors determine whether a company is generating good returns on the profits it keeps, rather than returns being purely driven by external financing or market sentiment.

Origin of the Buffett Retention Test

The idea behind these formulas comes from Warren Buffett's annual letters to Berkshire Hathaway shareholders, particularly those from 1983, 1992, and 2003.

In his 1983 letter, Buffett wrote:

"Unrestricted earnings should be retained only where there is a reasonable prospect, backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future that for every dollar retained by the corporation, at least one dollar of market value will be created for owners."

In 1992, he explained the logic further:

"We test the wisdom of retaining earnings by assessing whether retention, over time, delivers at least proportional gains in per-share earnings."

And in 2003, he introduced the broader market-value perspective:

"The real test of performance is whether a company has increased per-share intrinsic value at a satisfactory rate and deployed retained earnings productively."

These insights underpin the two retention test methods:

The earnings-based approach, which compares EPS growth to retained earnings.
The market-based approach, which assesses the change in market cap and dividends relative to retained earnings.

Both aim to answer the central question: Has management turned retained profits into shareholder wealth?

What Is the Buffett Retention Test?

The Buffett Retention Test measures how effectively a company converts its retained earnings into shareholder value. There are two main ways to approach this, each offering a different lens on capital reinvestment efficiency.

Method 1: Earnings-Based Retention Test

This version focuses on how retained earnings translate into EPS growth.

Formula:

Return on Retained Earnings (RORE) = (EPS Growth Rate) / (Retention Ratio)

Where:

EPS Growth Rate = CAGR of Earnings Per Share over a period (usually 5 or 10 years)
Retention Ratio = 1 - Dividend Payout Ratio

Alternatively:

Retention Ratio = (Retained Earnings / Net Income)

Example:

5-year EPS CAGR = 12%
Dividend Payout Ratio = 40%
Retention Ratio = 60%

RORE = 12% / 0.60 = 20%

A 20% RORE means the company is earning 20 cents in EPS growth for every dollar of earnings it retains. That's an excellent use of retained capital.

Method 2: Market-Based Retention Test

This version ties retained earnings to actual shareholder returns by incorporating market value.

Formula:

Return on Retained Earnings = (Δ Market Cap + Dividends Paid) / Cumulative Retained Earnings

Example:

Market Cap in 2013: $50B
Market Cap in 2023: $120B
Dividends Paid over 10 years: $20B
Cumulative Retained Earnings: $40B

(120B - 50B + 20B) / 40B = 90B / 40B = 2.25 or 225%

This tells us that every $1 retained over that period generated $2.25 in value. Outstanding capital allocation.

Why It Matters

Buffett believes that capital allocation is the CEO's most important job. If a business can reinvest its profits at high rates of return, it can grow intrinsic value rapidly without needing external capital.

Poor use of retained earnings? That’s a red flag suggesting management is wasting shareholder capital.

When to Use It

The Buffett Retention Test is especially useful when:

Evaluating long-term compounders
Comparing high-retention companies
Assessing whether management deserves to retain profits
Back-testing capital allocation outcomes

It complements other value investing tools like return on equity (ROE), free cash flow, and intrinsic value calculations.

Final Thought

The Buffett Retention Test is a value investor's tool for evaluating capital allocation by management. It’s about clarity: are retained profits producing real value?

Next time you're analyzing a stock, ask not just how much profit it earns, but what it does with that profit. If a company passes the Buffett Retention Test in either form, it may just belong in your portfolio.