What Are Retained Earnings?
Retained earnings are important, but how they're used is critical
You'll find retained earnings, sometimes known as accumulated earnings, earnings surplus or unappropriated profit, shown on a company's balance sheet under Shareholders' Equity. It represents the part of net income or net profit, which you'll see on the company's income statement, that is not paid out as dividends, but is retained in the company. Retained earnings are often reinvested in the company to use for projects such as research and development, investment in a new warehouse, purchase of additional or better equipment, or for paying off debt.
How Accountants Treat Retained Earnings
Retained earnings are treated as a cumulative number over the life of a company. In other words, the retained earnings account shown on a company's balance sheet records the earnings that have been retained since the inception of the company. Retained earnings are profits that have remained undistributed to shareholders.
The Conflict Between Retained Earnings and Dividends
Private companies can choose to do what they want with their retained profits, but publicly-held companies have a potential financial dilemma. For most investors, their immediate concern when evaluating a company is the amount of profit the company's making. Beyond that, investors want a payoff to reward them for their investment in the company, in the form of either in dividends or an increasing stock price. Investors nearing retirement tend to pay particular importance to a company's dividend payments because it means more potential retirement income to them.
Other investors may be more attentive to share price.
To some extent, these two desires conflict. A company that delivers outstanding dividends quarter after quarter may accomplish this sacrificing spending on the kind of reinvestment in the company that allows it to grow. But it can also happen that a mature, stable company that never declares a dividend can 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?
Following are two examples that illustrate this ongoing debate:
Company A is a classic manufacturer that faces increasing competition from lower-cost, emerging-market-based suppliers of similar industrial products. Forced to cut its prices to survive, the company's profit margins have become very slim. The firm's profits can't support both dividend payments and the critical, basic reinvestment in its physical plant that's needed to keep the company running. As a consequence, the company hasn't paid a dividend in years. Over the past few years, its share price has steadily declined.
Company B is a multibillion-dollar high-tech conglomerate. It began as an online sales company in a small niche but has since expanded into computer storage, print and electronic media, and even drone and automobile manufacturing. It also successfully competes in several other important financial sectors. It has never paid a dividend, and its reported profits have remained low because its rapid, even unprecedented, expansion has continually increased its operating costs quarter after quarter. Since it became publicly-held, the company has never paid a dividend.
Over a ten-year period, its share price has increased by a factor of 20.
From these two examples, it's evident that there's no "one size fits all" answer to the question "Which is more important, dividends or retained earnings?" because the real answer to this question is something different, namely, "profits."
Company A's failure to pay dividends is due to an absence of profitability. Its profits are limited and it can only afford to spend enough to slow down the deterioration of its production facilities. 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 because even if it doesn't currently turn a large profit, it has very good prospects of doing so in the future.
What Counts Most Is the Stock Price
A good way to evaluate a public company and its use of retained earnings is to compare its profit per share historically retained over several accounting periods with its growth in profit per share over the same period. If the profits are growing, the profits it's retained are being put to good, productive use. If profits per share aren't growing, that's a problem that requires further investigation.
When considering retained earnings activity and what it says about 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, and reflects all of this information, is the company's share price.