Investors can use the percentage of earnings retained to evaluate how effectively a company is producing share value using retained earnings compared to other potential investments that instead yield dividends.
When a corporation earns money, it can use that money in one of two ways:
It can issue the money out to shareholders in the form of dividends (see the next section).
It can keep the money as retained earnings with the intention to reinvest it into growing the value of the company.
Here’s what the percentage of earnings retained measure looks like:
Follow these steps to use this equation:
Find the net income and all dividends on the income statement.
Add up all the dividends paid out and then subtract that number from the net income.
Divide the answer from Step 2 by the net income to find the percentage of earnings retained.
The interpretation of the percentage of earnings retained can vary. If a company is new or anticipates growth, then odds are it’ll have a very high percentage of earnings retained because it’ll need those funds to invest in the growth.
If a company is stagnate and still has a very high percentage of earnings retained, it may be expecting problems. Small companies with growth potential that have a low percentage of earnings retained may also face trouble in the future or otherwise not meet their potential, thereby decreasing their value compared to their price.