More of this Feature • Lesson 3 Main • How to Get Copies • What is it? • Typical Balance Sheet • Current Assets • Receivables • Receivable Turns • Inventory • Inventory Turns • Inventory Example • Prepaid Expenses • Current Liabilities • Working Capital • WC Per Dollar of Sales • Negative Work. Cap • Current Ratio • Quick Ratio • Long Term Investment • Property, Plant, Equip. • Intangible Assets • Goodwill • Deferred Charges • Debt, Debt to Equity • Other Liabilities • Minority Interest • Shareholder Equity • Book Value • Com. & Pref. Shares • Cap. Surplus, Reserve • Treasury Stock • Retained Earnings • Formula & Calculations • Putting it all Together • Segment 2

Related Resources • Investing Lesson 1 • Investing Lesson 2 • Investing Lesson 3 • More Lessons

Retained Earnings

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.

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 make a decision on how wisely management is deploying and investing the shareholder's 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 stock holders would be better served if the board of directors declared a dividend.

Ultimately, the goal for any successful management is to create $1 in market value for every $1 of retained earnings.

Let's look at an example:

• Microsoft has retained $18.9 billion in earning over the years.  It has over 2.5 times that amount in stockholder equity ($47.29 billion), no debt, and earned over 12.57% on its equity last 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.  As of 2001, the company had retained over $1 billion in earnings and had a negative tangible asset value of $1.67 billion dollars!  It had a return on equity of 2.16%, which is less than a passbook savings account.  The company is astronomically priced at 79.01 times earnings and has a market cap of $2.67 billion.  In other words: Shareholders have reinvested a billion dollars of their money back into the company and what have they gotten?  They owe $1.67 billion.¹  That is a bad investment.

The Lear example deserves a closer look.  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 are so bad had the profits been paid out, the business probably would have gone bankrupt.  The earnings are reinvested at a sub par rate of return.  An investor would earn more on the earnings by putting them in a CD or Money Market fund then by reinvesting them into the business.

¹You may be wondering how the company has a supposed book value of $23.77 per share, and yet the shareholders owe a billion and a half dollars.  If you look at Lear's balance sheet, you will notice it shows 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 consist of goodwill.  The shareholders' equity is being inflated by the goodwill figure - without it, the shareholders are left owing money to the company's creditors. 

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