This is an ultimate guide on how to calculate Return on Retained Earnings Ratio (RORE) with in-depth analysis, interpretation, and example. You will learn how to use its formula to evaluate a firm’s profitability.
Definition - What is Return on Retained Earnings Ratio?
The return on retained earnings ratio (RORE) measures how effectively a company uses its profits from the previous years.
The ratio can inform investors whether the company is better off investing its profits back into the company, or paying its shareholders a dividend.
A high ratio suggests that the company should invest heavily in itself, while a low ratio means a company may benefit from paying a larger dividend.
It is not commonly used by investors to assess the attractiveness of an investment.
It is mostly used as a measure to aid a management company in decision making regarding dividend payouts.
The equation for RORE ratio is as follows:
Return on Retained Earnings = Net Income / Retained Earnings
You simply divide a company’s net income by its previous year’s retained earnings.
The ratio has powerful ramifications, and helps a company’s management company decide upon the most efficacious dividend payout strategy.
Suppose last year a company added $25 million to its retained earnings on its balance sheet, and this year its net income was $75 million.
Inputting the numbers into the above equation, we can compute the rate of return on retained earnings ratio to be 3.00.
Meaning, for $1 of retained earnings that the company generated the previous year, it produced $3 of net income this year.
Interpretation & Analysis
The high RORE of 3.00 could signify that the company produces significant value from its retained earnings.
So, the management team may conclude that the company is better off curtailing its dividend, and investing a large amount - if not all - of its net income back into the business.
However, if the company had a ratio of 0.75, the company would be generating less net income than the retained earnings it invested in the previous year.
So, the management team may find it a more effective method to instead pay a larger percentage of net income as a dividend, and a smaller percentage to retained earnings.
It is obviously not the end-all ratio which management uses to choose its dividend payout strategy, but when taken with other metrics, it can underscore the most effective and profitable strategies to take regarding a company’s dividend.
Cautions & Further Explanation
While the return on retained earnings ratio is an effective method for a management team to gauge the final performance of its retained earnings, it has its shortcomings.
For example, a company does not include Capex in the equation.
So, a company may have an unusually high RORE, but because the considerable amount of money the company spent on upgrading its machinery and equipment is not included in the RORE equation, RORE does not accurately reflect the company’s financial standing.
Additionally, RORE includes one-time expenses that are not usually part of the company’s income statement.
For example, if a company has a high legal expense one year because of an ongoing lawsuit, the company may have a significantly lower RORE for that year.
But that is not indicative of the operations of the business.
So, when calculating this ratio, you must analyze the company’s financial statements to ensure there are no anomalies present in the company that would knowingly alter the RORE.