What are Retained Earnings?
Retained Earnings Are Important, But How They Are Used Is Critical
Retained earnings -- sometimes known as accumulated earnings, earnings surplus or unappropriated profit -- is that portion of net income or net profit (a figure most often taken from the income statement) that is not paid out as dividends, but are retained in the company. Retained earnings are often reinvested in the company for research and development purposes, investment in the physical plant, purchase of additional or better equipment or for retiring debt.
Accounting Treatment of Retained Earnings
Retained earnings are cumulative.
They represent past as well as present earnings of the firm that have been reinvested in the firm. The retained earnings account under the Shareholder's Equity section of the balance sheet shows the retained earnings since the inception of the company. Retained earnings are cumulative revenues from undistributed profits.
The Conflict Between Retained Earnings and Dividends
Here's a potential financial dilemma: For most investors, the most immediate concern when evaluating a company is how much money the company is making. Beyond that, investors want a payoff--either in dividends or in an increasing share price. Investors nearing retirement pay particular importance to a company's dividend stream. Other investors may be more attentive to share price.
But to some extent, these two wants are in conflict. A company that delivers outstanding dividends quarter after quarter may accomplish this by cutting back on the the kind of reinvestment in the company that allows it to grow.
But it can also happen that a company that never declares a dividend will turn off investors who may wonder if there's an underlying structural problem in the absence of dividends.
Which is More Important, Dividends or Retained Earnings?
Here are two examples that illustrate the problem:
Company A is a classic rust-belt manufacturer facing increased competition from lower-cost, emerging-market-based suppliers of similar industrial products.
Forced to cut prices in order to survive, the company's profit margins are slim. Profits are insufficient to support both dividend payments and the absolutely necessary kind of basic reinvestment in the physical plant necessary to keep the company running. As a necessary consequence, the company hasn't declared a dividend in years. In recent years, its share price has steadily declined
Company B is a multibillion-dollar high-tech conglomerate. It began as an online sales company, but has since expanded into computer storage, print and electronic media, even drone and automobile manufacturing. It successfully competes in another dozen important financial sectors. It has never paid a dividend and its reported profits have remained low because its rapid -- even unprecedented -- expansion has increased operating costs drastically quarter after quarter. It has never paid a dividend. Over a ten-year period its share price has increased by a factor of 20.
From these two examples, you can conclude that there's no "one size fits all" answer to the question "Which is more important, dividends or retained earnings?" because it's really a trick question: the correct answer is "profits."
Underlying Company A's failure to pay dividends is an absence of profitability.
Profits are limited and are spent simply to slow down the deterioration of the physical plant. Company B doesn't pay dividends for a couple of reasons, one of them being that it doesn't have to. Investors who follow the company know that it's a runaway success, which its soaring share price history confirms. Investors are quite willing to do without a dividend from a company whose stock price doubles every couple of years.
What Counts Most Is the Stock Price
It's a truism in accounting that a good way to evaluate a company and its use of retained earnings is to compare the profit per share the company historically retains over several accounting periods with the growth in profit per share over the same period. If the profits are growing, the profits retained are being put to good use. If profits per share aren't growing, that's a problem.
The bottom line when using retained earnings when evaluating a company may be simply this: is the company's share price consistently growing or has it remained stagnant? If the share price, as is the case with Company B, keeps growing, that's a nearly certain indication that the retained profits are being put to good use. Or, as in the case of Company B and some similar tech behemoths, there may not even be exceptional profits -- the company's real profits from operations are consistently plowed back into the growing cost of the expanding operational structures that both fuel and are a consequence of its rapid expansion. It isn't so much a matter of the percentage of retained profits or even the amount per share that counts as it is the company's overall effectiveness. What finally counts most is the share price.