Trying to make heads or tails of balance sheets, income reports, and cash flow statements is enough to make anyone’s head spin. Today’s we’re going to make it a little easier by focusing on one of the most important factors in your investment decisions: Retained earnings, how to calculate them, and how to leverage that knowledge for profit.
Whether you are trying to improve the profitability of your own company or you are trying to choose the best investments to make for your portfolio, we will help you understand, calculate, and intercept retained earnings figures.
After all, this one metric has been at the heart and soul of our own investment decisions. Using the information in this post, we have grown our investment returns at more than 15% per year since we started to apply these principles.
Alright, let’s do this!
What Are Retained Earnings?
The Textbook Definition
The textbook definition of retained earnings usually goes something like this:
“Retained earnings are the difference between beginning period retained earnings and ending period retained earnings plus profit, less cash and stock dividends.”
But let’s be honest, that doesn’t really help much does it?
So let’s push aside the gatekeeping jargon for a minute and look at a more practical definition:
“Retained earnings is all the money a company keeps for itself.”
If cash is spent on expenses it is not retained earnings.
If profit is spent on dividends it is not retained earnings.
If profits are distributed to owners it is not retained earnings.
Instead, retained earnings are kept within the company and reinvested.
The Warchest Analogy
Warren Buffest used to call the retained earnings of his company, Berkshire Hathaway, ‘the warchest’.
This is a reference to the days of old, when nations would stockpile their wealth in preparation for the next conflict.
That cash would be used to train more military or build more weapons.
In today’s, less warlord environment, the analogy can still help us understand retained earnings.
The money in your ‘warchest’ (your retained earnings) are best spent in two ways
- Maintaining or Improving your competitive advantage
- Reducing debt or expenses
Either way, the desired end result is the same:
You want each $1 that you retain to create more than $1 of retained earnings next year.
If your business can retain $100,000 this year (after you have paid all of your expenses, of course) you want to invest that $100,000 in ways that increase profits by the end of next year.
Maybe you pay off debt and lose less to interest payments.
Maybe you launch a new marketing campaign.
Maybe you use it to develop a new product.
Good businesses can turn each retained dollar into more than $1 the next year.
Retained Earnings: Meaning to Business and Investments
Sure that’s what retained earnings are, but do they mean for you, your business, or your portfolio?
Retained Earnings are the Best Engine of Growth
They are the leanest, most efficient, least risky means for you to grow your portfolio or business.
Why?
They are not loans. They are not leveraged. There is no interest charge and they give no outside entities influence over your decisions.
If your business is a healthy one, the more earnings you can retain, the more your earnings will grow. It is a virtuous cycle.
What Does It Mean For Investments?
If you are invested (or thinking of investing) in a company, take a look at their history of retained earnings.
If they have continuously turned each dollar of retained earnings into more than $1 of market value, you are looking at a wonderful business. They know how to invest in projects that are profitable.
If they haven’t, look elsewhere. This company wastes money on go-nowhere projects or management inefficiencies.
Understanding this can help you make better investment decisions.
Here’s a quick example:
Here are two tech companies: ABC and XYZ (fictional stock tickers, but based on actual numbers).
ABC
For the last five years, ABC has retained an average of $201 billion dollars per year. It’s market capitalization has risen from $541 billion to $2 trillion.
On average, each dollar ABC has retained has turned into $7 of market value.
XYZ
On the other hand, XYZ has managed to retain $241 billion over the last five years. It’s market capitalization has risen from $167 billion to $218 billion.
On average, each dollar XYZ retained has turned into 21 cents of market value.
Even though XYZ retained more absolute dollars, it could not find productive ways to reinvest the money.
ABC created more wealth by retaining less, but putting it to much better use.
Retained Earnings vs Net Profit (Which is better for your investment?)
Given the example above, you might now see the solution to an ongoing debate in the investment world:
Which is better: Profits or retained earnings?
Generally, when you hear people touting this or that investment, they are talking about Earnings per Share, or Revenues, or Operating Profits.
But now you see the problem with all of these viewpoints.
Sure, you can have a company that makes lots of money each year, but if they can’t figure out how to put that money to good use, you (the shareholder or part owner) suffer.
Imagine a company that makes $1 billion per year. Yay. Good for them.
But they can’t figure out how to spend it. So they hand it all out as dividends.
You might be happy to get a dividend check this year, sure. But next year? And the year after?
Other companies start to sail past you and your earnings stay flat.
Retained Earnings and Dividends
So which is better? Retained earnings or dividends.
The answer sort of depends on your situation.
If you need a predictable amount of cash coming in from your investments and you are not really concerned about the long-term health of your investment portfolio (meaning, you don’t care what happens to it after you die) then dividends are probably best for you.
Your earnings will be steady, but they will not easily compound.
If on the other hand, you do not need steady and predictable cash and you want your portfolio to march ever upward, then you want to focus on companies that make good use of retained earnings.
Over the long term, a good company that turns each dollar retained into more than one dollar of market value will beat any company that pays out most of its earnings as a dividend.
The key question to ask is this:
Which company will give me the most earnings five (or ten, or twenty, depending on your horizon) years from now?
You also want to consider this:
You pay tax today on dividends you receive today. But retained earnings grow tax deferred. You won’t pay a dime of tax on them until you cash out your position.
How A Company Can Use Its Retained Earnings
So how do companies use these retained earnings?
Remember the warchest analogy.
- Maintaining or improving competitive advantage
- Reducing debt
Some of these are obvious. Others, not so much.
What do I mean?
For my business to maintain its competitive advantage I need to make a set amount of investments each year (I have to keep advertising, securing talent, that sort of thing).
This is called the Red Queen Effect. You need to run very fast, just to stay standing still.
To improve my competitive advantage I need to make even more investments. (More advertising, developing new products). Everybody is running, but I need to find a way to run faster than them.
Maybe I can’t run faster. Maybe I have invested every dollar I can in my business and anything else would just be a waste.
I can still grow my market value.
How?
- I can buy back shares of my company. Now all the remaining shareholders earn more even if my profits have not grown.
- I can pay off debt so less of my profits go to interest payments. Each of my shareholders earn more, even if profits have not grown.
- Or I can invest in other companies and use my retained earnings to benefit from their retained earnings. I do this when I find a company that has more room to grow than me or can earn a higher return on capital than me.
The best example ever.
The greatest example of the power of retained earnings is of course Berkshire Hathaway.
Berkshire has never paid a dividend since Buffet took over. Instead they retain all profits.
Even though the original company was losing money and had no good way to invest those earnings in-house.
How did it grow so big?
By making good use of the three methods above.
When Berkshire had extra cash, it didn’t waste it by investing in more textile machines, it bought a candy company instead (See’s Candy) and an insurance company (Geico).
All Berkshire profits have to go into other investments, debt pay-down, or stock buybacks.
What Do Retained Earnings Mean for Your Business?
Sky’s the limit. Keep reinvesting in yourself until you can’t. Then reinvest in others.
This worked for Berkshire and it will work for you, too.
One of the best things about this model of retaining earnings is that it works for any business of any size. This is how we built our businesses from a side-hustle during our summer vacation into what it is today.
And we run our two businesses in less than two hours per day.
How? By reinvesting retained earnings. Now we have very little work that we need to do, but lots of other people are working for us. People at some of the biggest companies in the world.
Here’s a clear picture for you:
Last year, I made three times as much money from my retained earnings (requiring almost no work from me whatsoever) than I did from any effort I actually put into the business.
Retained earnings let your business grow without your constant input.
Related: see how we did it in our Business Guide and Investing Guide
What Do Retained Earnings Mean for Your Portfolio?
When you pick good companies (meaning, companies that can turn each dollar of retained earnings into at least one dollar of market value) you can estimate your portfolio growth fairly accurately.
I keep a spreadsheet with all the retained earnings of all my investees. I know that on average I have chosen businesses that turn each one dollar retained into three dollars of market value.
So over the long term, I have a pretty good idea what my portfolio will do.
Now there will be bumps and panics. But that doesn’t bother me at all.
As long as my investees are growing their retained earnings, and turning those retained earnings into at least one dollar of market value, I’m happy.
Those bumps and panics are just a chance to buy more shares at a better price.
How Can I be Misled by Retained Earnings?
You cannot look at just retained earnings in a vacuum. The price you pay, if too high, can wipe years or decades of retained earnings value.
If I have a company that retains $10 of earnings per share, but is trading at 90 times its earnings, I won’t benefit from any retained earnings unless this same company reaches that 90X multiple again in the future.
If that company (that I bought for $900/share) retains $100 over the next ten years, I might expect it to be worth $1000 per share.
BUT if, after a decade, it is trading at a 50X multiple, it will only be worth $500.
In that case, none of its retained earnings translated to market value and I have lost nearly half my investment… All because I paid too much for it in the beginning.
This is why so many investors urge to buy with a margin of safety in mind. Whether you focus on intrinsic value or some other metric, be sure that you are buying a good company at a good price!
How to Calculate Retained Earnings on a Balance Sheet
If you are looking at the balance sheet for another company that you are thinking of investing in, then this part is easy.
The work has been done for you. You simply need to look at the balance, usually toward the bottom. There should be a clearly marked entry for “Retained Earnings”.
If, on the other hand, you are trying to calculate the retained earnings for a company without a standardized balance sheet, things can be a little trickier.
To make it as easy as possible on yourself, try this method:
Take the beginning retained earnings balance (say, the retained earnings from the end 2020) and add to that number the net profit of the company.
Now subtract any dividends or cash disbursements that occurred in the current year.
The result is your retained earnings figure.
Retained Earnings Formulas
Retained Earnings = Beginning Value + Net Income (or Net Loss) – Cash Dividend
Retained Earnings Example
Last year my company made $750,000 in revenue. I had expenses of $50,000. I paid total dividends to my investors of $10,000. I ended last year with $500,000 in retained earnings.
What were my Retained Earnings for this year?
Net Income = 750,000 – 50,000 = $700000
Retained Earnings = $500,000 + $700,000 – $10,000 = $1,190,000.
Are Retained Earnings Assets?
No, not until they are invested. Retained Earnings are not assets by themselves, but you can and should use them to buy assets…
As long as you are reasonably sure that those assets will turn each dollar of retained earnings into at least one dollar of value.
Closing Thoughts
There you have it. I hope we’ve cleared up what retained earnings are and how to calculate them.
To dig deeper into how we use retained earnings in a 3MM-style business (that is a business that can be run in less than two hours per day) check out these other posts:
- Our Ultimate Guide to Building a Business
- Our Ultimate Productivity Guide
- Our Ultimate Guide to Investing
- Our Income Reports
We also publish unbiased reviews of business tools and software. To see some of our top review posts, Check out:
- Our reviews of the Best Online Course Creation Software
- Our reviews of the Best Books For Following the Three Month Millionaire Journey
- Our reviews of the Best Business Tools No One Ever Told Us About
- Our reviews of the Best Social Media Management Tools
