There are a few different ways to arrive at the return on retained earnings. The simplest way to calculate the return on retained earnings formula is by using published information on earnings per share (EPS) over a period of your choosing, say five years.
The RORE equation would look like this:
Return on Retained Earnings % = (Most Recent EPS – First Period EPS) / (Cumulative EPS for Period – Cumulative Dividends Paid for Period)
To calculate, first find the sum of all earnings per share over the period you are evaluating and the sum of all dividends paid to shareholders during this time. Subtract the cumulative dividends paid from the cumulative EPS. This is your denominator for the next step.
Step two is to find the difference, or growth/loss over time, in EPS from the beginning to end of the period. Divide this answer by the answer in step one. This value is expressed as a percentage.
ABC, Inc. has paid a 1% dividend to common shareholders over the past five years and has steadily increasing earnings per share (EPS). Sally wants to evaluate ABC’s growth potential by looking at return on retained earnings. She adds up the previous five years of EPS ($1.00)
$1.30; $1.50; $1.70; and $2.00). Then, she adds up the annual dividend paid in those years ($0.01; $0.13; $0.15; $0.17; and $0.20). Sally uses the following formula to find ABC, Inc.’s return on retained earnings over the past five years.
RORE = ($2.00 – $1.00) / ($7.50 – $0.66) = $1.00 / $6.84 = 14.62%
Sally sees that the return on retained earnings is just under 15%. She compares that with other companies in the sector and sees that ABC, Inc. is generating a decent RORE and likes the continued growth prospects of the company.
Usage Explanations and Cautions
The usefulness of the return on retained earnings calculation is apparent for investors, as it can help distinguish growth opportunities and even reveal if a company is more stable and just kicking off high dividends to shareholders from its earnings. It is also important to the executive team to monitor the efficiency of the business. Lower returns on retained earnings could signal a need for process improvements or something else to generate more profit from the capital.
It is also helpful to use this knowledge to see how well the company’s retained earnings have contributed to any increase in the stock’s market price over time. Companies with a high RORE but an incongruent increase in market price may have other factors that need to be evaluated. So, it’s important to use the return on retained earnings as a complement to other financial analysis tools.