Retained Earnings
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What are Retained Earnings?
In a nutshell, retained earnings are profits that are not distributed to shareholders. Thus, retained earnings increase when new profits are generated and decrease when dividends are paid. Alternatively, retained earnings are the remaining profits after dividends have been paid. The retained earnings are a form of self-financing. A company that is focused on growth prefers to use retained earnings for expansion activities instead of paying dividends. Additionally, retained earnings can be used to pay off some of the company's debt.
Normally, the company's management makes the decision whether to retain or distribute profits. However, the shareholders have the right to challenge the decision through a majority vote, since they are the owners of the business. Over time, however, retained earnings can lead to greater returns for shareholders than dividend payouts. In contrast, shareholders seeking short-term gains may prefer dividends. In most situations, it is common for the management to take a balanced approach.
A company's retained earnings are reported in equity on its balance sheet. The figure is also reported in the statement of retained earnings. Retained earnings are also referred to as the retention ratio (expressed as a percentage of total revenues) or profit surplus.
The Formula for Retained Earnings
Retained Earnings = BP + Net Income (or Loss) - C - S
where,
BP = Retained Earnings Beginning Period
C = Cash Dividends
S = Stock Dividends
For the calculation of retained earnings, the net profit is added to the previous period's retained earnings (or the net losses are subtracted). Afterward, dividends paid to shareholders are deducted. This figure is calculated at the end of each accounting period (monthly, quarterly, or annually).
Dividends and Retained Earnings
Dividends may be paid in cash or in the form of shares. In both cases, retained earnings are reduced. Dividend payments in cash result in a cash outflow that is reflected on the balance sheet as a net reduction. By paying cash dividends, the company lowers its asset value on its balance sheet, which affects its retained earnings.
Unlike cash dividends, stock dividends do not result in a cash outflow. Nevertheless, a portion of retained earnings is transferred to common stock. For example, if a company pays one share as a dividend for each share held by investors, the price per share is reduced by half as the number of shares is doubled. In view of the fact that announcing a stock dividend does not create real value for the company, the market price per share is adjusted in accordance with the proportion of the stock dividend that is distributed. Due to the automatic adjustment of the market price, the number of shares does not affect the company's balance sheet. However, the value of each share is reduced, which is reflected in the capital accounts and therefore impacts retained earnings as well.
Retained Earnings and Market Value
An analysis of retained earnings for a particular quarter or year does not provide any meaningful information. Investors are much more concerned with the returns that were generated by retained earnings. An evaluation of the ratio between retained earnings and market value is a useful tool for determining the success of an organization. It measures the relationship between the change in the share price and the change in a company's net retained earnings over a particular period of time. The ratio is used to determine whether the retention of earnings has increased the company's market value. Consequently, the retained capital should generate additional profits.
Example: Calculation of Retained Earnings to Market Value
The table illustrates the earnings per share and dividends of company Y over a period of time. The share price of the company increased from CHF 30 to CHF 100 between 2017 and 2020. The summed earnings per share were CHF 10.98 (2.87+2.98 +3.01 +2.12) and the summed dividends were CHF 2.84 (0.65+0.75+0.89+0.55).
The difference between the earnings per share summed over the years and the dividend summed over the years results in retained net earnings per share of CHF 8.14 (10.98 - 2.84). In the same period, the share price increased by CHF 70 per share. By dividing the share price increase per share by the retained net earnings per share, a factor of 8.59 is obtained (70/8.14). For every franc of retained earnings, company Y has created a market value of CHF 8.59. This value can now be compared with alternative investment opportunities. A good wealth manager can assist you in determining and evaluating retained earnings to market value ratios.
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