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What is Return on Retained Earnings?
What’s important to know about it?
In this article, I will break down the meaning of Return on Retained Earnings so you know all there is to know about it!
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Let me explain to you what Return on Retained Earnings is and why it’s important!
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What Is Return on Retained Earnings
Return on retained earnings, as the name suggests, is a profitability measure allowing you to determine how much a company’s profits are kept in the business for reinvestment.
Typically, the return on retained earnings is a measure of a company’s overall profitability.
A company’s retained earnings can be used for many purposes, such as funding the company’s growth, funding acquisitions, investing in research and development, launching new products, or others.
The company’s return on retained earnings will essentially show the company’s growth potential.
When a company’s return on retained earnings is high, it is a sign that the company should reinvest money back into the business.
When the return on retained earnings is low, it means that it should consider paying out a dividend to shareholders unless it can find projects that can generate an acceptable return to the business.
Keep reading as I will further break down the meaning of return on retained earnings and tell you how it works.
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How To Calculate Return on Retained Earnings
The way you can calculate the return on retained earnings is to use the following formula:
Return on Retained Earnings = (Recent EPS – EPS Beginning of Period) / (Cumulative EPS during Period – Cumulative Dividends Paid during Period)
As you can see, with the return on retained earnings formula, you can assess how well a company is doing during a given period.
You take the company’s current earnings-per-share and deduct the earnings-per-share at the start of the given period.
You then divide the result by the cumulative earnings-per-share less the cumulative dividends paid during the given period.
Companies that generate enough profits to fund their ongoing business operations are generally perceived as better than those that inject capital to stay steady.
Companies that are quickly expanding tend to have a higher return on retained earnings ratios as they use their retained earnings to fund their growth.
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Interpreting Return on Retained Earnings
The return on retained earnings is an important financial measure of a company’s overall profitability and performance.
Investors, financial analysts, and company managers will assess their return on retained earnings to see how well they are performing.
Typically, young and growing companies will usually have a high return on retained earnings as they will typically keep their retained earnings and reinvest the money back into their business.
Investors looking for companies with high growth potential will want to look for those that have a high return on retained earnings.
On the other hand, mature companies generating consistent returns will have a lower return on retained earnings and tend to pay out dividends to their shareholders.
In this case, a company with a lower return on retained earnings can benefit more by paying dividends to its shareholders keeping them happy, and attracting new shareholders to the company.
Having a high or low return on retained earnings is not necessarily a bad thing; it’s important to look at the company’s business and how it is doing compared to its competitors.
A company with a low ratio may no longer be growing as fast but is a highly profitable company able to pay dividends consistently.
A company with a high ratio may be growing very fast but is early in its lifecycle exposing investors to more risk.
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Return on Retained Earnings Limitations
When looking at a company’s return on retained earnings, it’s important that you analyze a company’s overall financial position to assess its growth potential.
One important limitation of this ratio is that it does not consider a company’s financial standing.
For example, a company may have invested a significant amount of money in purchasing revenue-generating assets allowing the company to generate profits long-term.
However, this investment will not be reflected in return on retained earnings ratio.
Another limitation is that a company’s one-time expense will also not be reflected in return on retained earnings.
For example, if a company has incurred a one-time expense for a cybersecurity incident or a lawsuit but the company’s operation is highly profitable, this may lead to a lower return on retained earnings.
However, this does not mean that the company does not have good growth potential.
When you are looking at this ratio, keep in mind these limitations and look at a company’s financial statements to better assess its financial position.
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Return on Retained Earnings Example
Let’s look at an example of return on retained earnings to better understand the concept.
Let’s assume the following for Company A:
- EPS Year 1: $1.25
- EPS Year 2: $1.35
- EPS Year 3: $1.50
- Annual Dividend Year 1: $0.05
- Annual Dividend Year 2: $0.06
- Annual Dividend Year 3: $0.07
Now, we need to take the recent EPS ($1.50) and the EPS at the beginning of the period ($1.25).
Then, we need to add up the cumulative EPS during the period ($1.25 + $1.35 + $1.50 = $4.10).
Then, we need to add up the annual dividends for the period ($0.05 + $0.06 + $0.07 = $0.18).
Now, we use our return on retained earnings formula to calculate the ratio: ($1.50 – $1.25) / ($4.10 – $0.18) = $0.25 / $3.92 = 6.38%.
This company’s return on retained earnings is relatively low compared to others in the same industry.
This company may be potentially a company that is no longer growing as fast, is potentially more mature, and may offer its shareholders a steady income.
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So there you have it folks!
What does return on retained earnings mean?
In a nutshell, return on retained earnings is a financial ratio allowing you to calculate how much return it is generating for its shareholders by reinvesting its profits back into the business.
The return on retained earnings is an important financial measure as it allows companies and investors to assess a company’s growth potential.
A high return on retained earnings means that the company can generate a higher return for its shareholders by reinvesting the money back into the business.
A low return on retained earnings means that a company should pay out dividends to its shareholders allowing it to attract new investors looking for an income and keeping its current shareholders happy.
You should assess the return on retained earnings in light of the nature of the company’s business, its competitors, and your risk tolerance.
An investor may prefer to have a lower return on retained earnings offered by blue-chip stocks compared to high returns offered by upcoming tech stocks that do not pay dividends.
Now that you know what the return on retained earnings is and how it works, good luck with your research!
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