Retained Earnings on the Balance Sheet
When a company generates a profit, management has one of two choices: They can either pay it out to shareholders as a cash dividend or retain the earnings and reinvest them in the business.
That reinvestment may be used to fund acquisitions, build new factories, increase inventory levels, establish larger cash reserves, reduce long-term debt, hire more employees, start a new division, research and develop new products, buy common stock in other businesses, purchase equipment to increase productivity, or a host of other potential uses.
When the executives decide that earnings should be retained, they have to account for them on the balance sheet under shareholder equity. This allows investors to see how much money has been put into the business over the years.
Once you learn to read the income statement, you can use the retained earnings figure to decide on how wisely management is deploying and investing the shareholders' money. If you notice a company is plowing all of its earnings back into itself and isn't experiencing exceptionally high growth, you can be sure that the stockholders would be better served if the board of directors declared a dividend instead.
Ultimately, the goal of any successful management is to create $1 in market value for every $1 of retained earnings. Any business that insisted upon keeping the profit that belonged to you, the owner, without ever sending funds to you in the form of a dividend or increasing your own wealth through higher capital gains is not going to have much utility.
Investing is about putting out money today for more money in the future. No rational person would continue to hold a stake in a corporation that never permitted any of the rewards to flow through to the stockholder.
Retained Earnings from Real Companies
Take a look at an example of retained earnings on the balance sheet:
- Microsoft has retained $18.9 billion in earnings over the years. It has over 2.5 times that amount in stockholder equity ($47.29 billion), no debt, and earned over 12.57 percent on its equity the previous year. Obviously, the company is using the shareholder's money very effectively. With a market cap of $314 billion, the software giant has done an amazing job.
- Lear Corporation is a company that creates automotive interiors and electrical components for everyone from General Motors to BWM. In 2001, the company had retained over $1 billion in earnings and had a negative tangible asset value of $1.67 billion! It had a return on equity of 2.16 percent, which, at the time, was less than a passbook savings account. The company was astronomically priced at 79.01 times earnings and had a market cap of $2.67 billion. In other words: Shareholders reinvested a billion dollars of their money back into the company and what did they receive in return? They owed $1.67 billion. That is a bad investment.
The Lear example deserves a closer look. You may be wondering how the company had a supposed book value of $23.77 per share, and yet the shareholders owed a billion and a half dollars.
If you look at Lear's balance sheet, you will notice it showed shareholder equity of $1.6 billion and tangible assets of $-1.665 billion. This doesn't look as horrible as it is until you discover $3.27 billion of the assets on the company's balance sheet consisted of goodwill. The shareholders' equity was being inflated by the goodwill figure - without it, the shareholders were left owing money to the company's creditors
It is immediately apparent that shareholders would have been better off had the company paid out its earnings as dividends. Unfortunately, the economics of the company were so bad had the profits been paid out, the business probably would have gone bankrupt.
The earnings were reinvested at a sub-par rate of return. At the time, an investor would have earned more on the earnings by putting them in a CD or money market fund than by reinvesting them into the business.