When a company makes a profit, it has two options. It can pay out the money to shareholders as a cash dividend. Or, it can keep the earnings to reinvest in the business.
The reinvestment could go toward any of a number of things that might help the business. It could be used to:
- Build new factories
- Increase stock levels
- Create larger cash reserves
- Lower long-term debt
- Hire more employees
- Research and develop new products
- Buy new equipment to increase production
The company could also choose to buy back its own shares. This could raise the company's market value.
Because there will be fewer shares outstanding, the company's per-share metrics, such as earnings per share and book value per share, could increase. This makes the company's stock look better to shareholders.
- When earnings are retained rather than paid out as dividends, they need to appear on the balance sheet.
- Retained earnings can be negative if the company experienced a loss.
- Warren Buffet recommended creating at least $1 in market value for every $1 in retained earnings on a five-year rolling basis.
How Do Retained Earnings Work?
When looking at a company before investing, you can use the retained earnings figure to learn about the business. It can show you how well management uses the money it isn't sending to shareholders.
If a company puts all of its earnings back into itself but doesn't show high growth, stockholders might be better served if the board of directors declared a dividend instead.
What Are Retained Losses?
Retained earnings can be a negative number. This happens if the company has had a loss or a series of losses that are more than its recent profits.
In this situation, the figure can also be referred to as an accumulated deficit.
What Is the Warren Buffett Test?
In 1983, Warren Buffet put out his first Owner's Manual for Berkshire Hathaway shareholders. In it, he laid out a test for managers about the wisdom of retaining earnings. His benchmark was whether they created at least $1 in market value for every $1 of retained earnings on a five-year rolling basis.
In the company's 2017 annual report, Buffett revised that test. He accounted for times when stock market values had dropped greatly during the previous five years. This had sometimes resulted in Berkshire's market-price premium to book value dropping and the company failing that test.
His new five-year test was whether:
- The company's book-value gain was higher than the S&P 500
- The stock sold at a premium to book, meaning that every $1 of retained earnings was always worth more than $1
If these tests were met, he felt that retaining earnings made sense.
Retained losses can result in negative shareholders' equity. This can be a serious sign of financial trouble for a company. At the very least, it might show that the company ought to lower its dividend.
What Is A Real Retained Earnings Example?
Retained earnings show up on a company's balance sheet. Along with some other financial measures, this can show whether management has been using the retained earnings well.
Apple Inc., which makes consumer electronics, computers, and other products, had retained earnings of $45.9 billion as of September 28, 2019. This was the end of its 2019 fiscal year.
It had almost twice that amount in shareholders' equity: $90.5 billion. Return on equity is a sign of how well a company's management is using company assets to make a profit.
Apple's return on equity was 61.1% as of September 28, 2019. That figure can be found by dividing Apple's net income of $55.3 billion by its shareholders' equity of $90.5 billion.
The company also announced dividends totaling $3.00 a share in that fiscal year. It used $14.1 billion in cash to pay dividends or dividend equivalents. The ability to do both showed that Apple was in a strong place financially and using its profits well.