What are Retained Earnings

A business generates earnings which can be positive (profits) or negative (losses). While managing losses is a different ball game altogether, profits (or the positive earnings) give a lot of room to the business owner(s) or the company management to utilize the surplus money earned. The following options broadly cover all possibilities on how the surplus money can be utilized:

  • The income money can be distributed (fully or partially) among the business owners (shareholders) in the form of dividends
  • It can be invested to expand the existing business operations, like increasing the production capacity of the existing products, or hiring more sales representatives
  • It can be invested to launch a new product/variant, like a refrigerator maker foraying into producing air conditioners, or a chocolate cookie manufacturer launching orange- or pineapple-flavored variants
  • The money can be utilized for any possible merger, acquisition or partnership that leads to improved business prospects
  • It can also be used for share buybacks
  • The earnings can be used to repay any outstanding loan (debt) the business may have

The first option leads to the earnings money going out of the books and accounts of the business forever because dividend payments are irreversible. However, all the other options retain the earnings money for use within the business, and such investments and funding activities constitute the retained earnings (RE). By definition, retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments. It is also called earnings surplus, and represents the reserve money which is available to the company management for reinvesting back into the business. When expressed as a percentage of total earnings, it is also called Retention Ratio, and is equal to (1 - Dividend Payout Ratio).

While the last option of debt repayment also leads to the money going out, it still has an impact on the business accounts, like saving future interest payments, which qualifies it for inclusion in retained earnings.

BREAKING DOWN Retained Earnings

Companies record retained earnings under shareholders' equity on the balance sheet. The figure has now become a standard and is reported as a separate line item in the company’s balance sheet. For instance, Apple Inc.’s (AAPL) recent balance sheet shows that the company had retained earnings of $79.436 billion as of June 2018 quarter:

Similarly, the iPhone maker, whose fiscal year ends in September, had $98.33 billion as retained earnings as of September 2017:

The retained earnings are calculated by adding net income to (or subtracting  net losses from) the previous term’s retained earnings and then subtracting any net dividend(s) paid to the shareholders.

Mathematically,

Retained Earnings (RE)  = Beginning Period RE + Net Income (Loss) – Cash Dividends – Stock Dividends

The figure is calculated at the end of each accounting period (quarterly/annually). As the formula suggests, retained earnings are dependent on the corresponding figure of the previous term. The resultant number may either be positive or negative, depending upon the net income or loss generated by the company. Alternatively, the company paying large amount of dividends that net exceed the other figures can also lead to retained earnings going negative. Any item that impacts net income (or net loss) will impact the retained earnings. Such items include sales revenue, cost of goods sold (COGS), depreciation, and necessary operating expenses.

Management v/s Shareholders – To Retain or To Pay Out?

Whenever a company generates surplus income, a portion of the long term shareholders may expect some regular income in the form of dividends as a reward for putting their money in the company. Traders who look for short term gains may also prefer getting dividend payments that offer instant gains. Dividends are also preferred as many jurisdictions allow dividends as tax-free income, while gains on stocks are subject to taxes.

On the other hand, company management may believe that they can better utilize the money if it is retained within the company. Similarly, there may be shareholders who trust the management potential, and may prefer allowing them to retain the earnings in hopes of much higher returns (even with the taxes).

The decision to retain the earnings or to distribute it among the shareholders is usually left to the company management. However, it can be challenged by the shareholders through majority vote as they are the real owners of the company.

Management as well as shareholders may like the company to retain the earnings for several different reasons. Being better informed about the market and company’s business, the management may have a high growth project in sight which they may perceive as a candidate to generate substantial returns in the future. In the long run, such initiatives may lead to better returns for the company shareholders instead of that gained from dividend payouts. Paying off a high interest debt is also preferred by both management and shareholders, instead of dividends payment.

Most often, a balanced approach is taken by the company management. It involves paying out a nominal amount of dividend, and retaining a good portion of the earnings which offers a win-win.

Impact of Dividends on Retained Earnings

Dividends can be distributed in the form of cash or stock. Both forms of distribution reduce the retained earnings. Cash payment of dividend leads to a cash outflow and is recorded in the books and accounts as net reductions. As the company loses ownership of its liquid assets in the form of cash dividends, it reduces the company’s asset value in the balance sheet thereby impacting RE. On the other hand, though stock dividend does not lead to a cash outflow, the stock payment transfers a part of retained earnings to common stock. For instance, if a company pays one share as a dividend for each share held by the investors, the price per share will reduce to half because the number of shares will essentially double. Since the company has not created any real value simply by announcing a stock dividend, the per-share market price gets adjusted in accordance with the proportion of the stock dividend. While the increase in number of shares may not impact the company’s balance sheet because the market price automatically gets adjusted, it decreases the per share valuation which gets reflected in capital accounts thereby impacting the RE.

A growth focused company may not pay dividends at all or pay very small amounts, as it may prefer to use the retained earnings to finance activities like research and development , marketing, working capital requirements, capital expenditures, and acquisitions in order to achieve additional growth. Such companies have high RE over the years. A maturing company may not have many options or high return projects to use the surplus cash, and it may prefer handing out dividends. Such companies have low RE.

Interpreting Retained Earnings

The absolute figure of retained earnings during a particular quarter or year may not provide any meaningful insight, and its observation over a period of time (like over five years) may only indicate the trend about how much money a company is retaining. As an investor, one would like to infer much more – like, how much returns the retained earnings have generated, and if they were better than any alternate investments.

A way to assess how successful the company was in utilizing the retained money is to look at a key factor called “Retained Earnings To Market Value.” It is calculated over a period of time (usually couple of years) and assesses the change in stock price against the net earnings retained by the company.

For example, during the five year period between September 2012 and September 2017, Apple stock price rose from $95.30 to $154.12 per share. During the same five year period, the total earnings per share were $38.87, while the total dividend paid out by the company was $10 per share. These figures are arrived at by summing up earnings per share and dividend per share for each of the five years. These figures are available under the “Key Ratio” section of company’s reports. As available on the MorningStar portal, Apple had the following EPS and Dividend figures over the given time frame, and summing them up give the above mentioned values for total EPS and total dividend:

The difference between total EPS and total dividend gives the net earnings retained by the company: $38.87 - $10 = $28.87. That is, over the five year period, the company retained a total of $28.87 earnings per share. Over the same duration, its stock price rose by ($154.12 -$95.30 = $58.82) per share. Dividing this price rise per share by net earnings retained per share gives a factor of ($58.82/$28.87 = 2.037), which indicates that for each dollar of retained earnings, the company managed to create $2.037 worth of market value.

If the company had not retained this money, and instead taken an interest-bearing loan, the value generated would have been less owing to the outgoing interest payment. RE offers free capital to finance projects allowing for efficient value creation by profitable companies.

A look at similar calculation for another stock, Walmart Inc. (WMT), indicates that over the five year period between January 2013 and January 2018, its stock price rose from $69.95 to $106.6, and net earnings retained were $12.36 per share. The change in market value with respect to retained earnings comes to ($106.6 - $69.95)/$12.36 = 2.965, which indicates that Walmart generated almost triple the market value for each dollar of retained earnings.

However, readers should note that above calculations are indicative of the value created with respect to the use of retained earnings only, and it does not indicate the overall value created by the company. It is possible that in totality the Apple stock may have generated more returns than the Walmart stock during the period of study because Apple may have additionally made separate (non-RE) large-size investments resulting in more profits overall. On the other hand, Walmart may have a higher figure for Retained Earnings to Market Value factor but it may have struggled overall leading to comparatively lower overall returns.

The Bottom Line

A popular quote about retained earnings goes as:

"You should wish your earnings to be re-invested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of re-investment."

While the large diversified group of shareholders have little say in the decision and utilization of earnings retention, the company management has the best knowledge about the possible use of surplus money available to them. Among other factors, a thoughtful consideration can be given to the past performance and trends of how efficiently the retained earnings were utilized by the company while looking for dividend payouts or long term value investments.