Retained earnings is the lifetime running total of every profit a company has ever made, minus every dividend it has ever paid out. It answers one question: over its whole life, how much profit has this company kept rather than handed to its owners?
The trap to avoid: retained earnings is not money sitting in the company. That is a different balance-sheet line, cash and cash equivalents, which counts what is actually available right now. Retained earnings is a historical tally, and the money itself was spent long ago on machines, buildings, inventory, and running the business. Picture a coffee shop that has kept $200,000 of profit over ten years, ploughing it into a second location and new espresso machines. Its retained earnings say $200,000, but its bank account might hold $15,000. One records what was kept over a lifetime, the other counts what is spendable today.
In Buffett's thinking, growing retained earnings is the engine of compounding. Profit kept this year enlarges the base, the bigger base earns more next year, and the cycle builds, provided the company earns high returns on what it keeps. A business whose retained earnings climb steadily for a decade while sustaining strong returns is a compounding machine.
Falling retained earnings deserve a closer look, but context decides. Losses or write-downs shrinking it are a genuine warning. Heavy dividends shrinking it are often perfectly healthy, since a mature company that cannot reinvest profitably should hand money back. The question is never whether they kept the profit, but whether what they keep earns a high return.