Candlestick Trading Blog

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Retained earnings are the sum of a company’s profits after stock dividends payments have been made to shareholders. When a company generates a profit, management has the option of doing one of two things:  They can pay the profit out as a cash dividend to shareholders or they can retain the earnings and reinvest them into the business.  The purpose of retained earnings is to either maintain existing operations or to increase profits by growing a business. This will depend on the money management of the company in that some may be forced to spend this type of earnings on maintenance of the company or equipment, or some may be able to use the capital to grow.

The total retained earnings must be accounted for on the balance sheet under Shareholder Equity for every company and is reported during the earnings season. The goal of executives is to create one dollar in market value for every one dollar in retained earnings.  The balance sheet reporting this information is what investors will use to track how much money has been invested back into the company over a period of time. This will tell you how wisely executives of that company are investing the shareholders’ money.  You can also look at the retained earnings statement that summarizes changes in earnings for a fiscal period, as well as the projected earnings estimates.

It is very important to understand this type of earnings as either asset purchases made by a company or liability reductions.  It is important to understand as well that these earnings are not surplus cash or cash left over from payment of dividends. When you invest in a company, you will want to understand how you will get the highest return on your shares or rather the highest return on investment. Retained earnings demonstrate what a company’s dividend stocks policy is in that the company will either reinvest profits or pay them out to shareholders.  If the company has any chance of growing, however, it must be able to retain earnings and invest them in business ventures that will generate more earnings.

The purpose of these earnings should be to enhance the company’s value thus increasing the amount of shares in a shareholders stock portfolio.  Unfortunately, most companies use these earnings to maintain the company, rather than grow the company. There are a couple of methods used to analyze the retained earnings of a company. You can compare the amount of capital retained during a period of time to the change in share price during that time, or you can compare the retained earnings per share to profit per share over a specific period of time. You also need to evaluate the effectiveness of the company’s management team by understanding how it uses retained capital which will show you how much market value has been added to the company’s retention of capital.  When you have inspiring market value gain it means that the investors will trust management to uncover value from capital retained by the business.

It is important to note that if a company accumulates earnings beyond reasonable needs of the business, it may be subject to an accumulated earnings tax.  This tax is in addition to the income tax of a corporation.  Some examples of accumulated retained earnings considered “reasonable” includes business needs such as expansion, product liability loss reserves, debt, working capital supplier or customer needs. Some examples of “unreasonable” business needs include the company providing funds for investments unrelated to the activities of the business, expenses for personal benefit of the shareholders, and to avoid tax on dividend distributions. In fact, the existence of a tax avoidance purpose will immediately trigger the accumulated earnings tax. Companies must be careful to avoid investing errors that would be deemed as “unreasonable.”

In conclusion, measuring the ability of management (with companies with a long history) to retain capital profitably is imperative to value stock investing. Investors must also look at how much capital is kept from shareholders in addition to how much profit is seen by shareholders. Retained earnings information is reported on the balance sheet. Once you understand how to read the balance sheet you will be steps closer to investing in stock!