Retained earnings represent the cumulative profits of the company or the profits that have not been paid out as cash dividends to shareholders. Retained earnings can be reinvested back into the company. However, there is an opportunity cost associated with retained earnings, especially if they are not used properly or remain idle, which can limit the company’s growth.
Discounted Cash Flow (DCF) Method
You can calculate the cost of retained earnings using the Discounted Cash Flow (DCF) method. Investors buying shares expect to receive two types of returns from those shares – dividends and capital gains. Companies pay dividends to investors quarterly in the form of cash dividends. Capital gains, which are the preferred return for most investors, consist of the difference between what investors pay for a share and the price at which they can sell it.
To calculate the cost of retained earnings, we can use the stock price, the dividends paid per share, and the capital gain known as the growth rate of dividends per share. The growth rate is equivalent to the average growth from year to year of the dividend amount.
These values can be entered into the following formula. This method is also known as the “retained earnings yield plus growth” method.
Cost of Retained Earnings = (Next Year’s Dividends / Stock Price) + Growth
For example, if your expected annual dividends are $1.08, the growth rate is 8%, and the stock cost is $30, the formula would be as follows:
Cost of Retained Earnings = ($1.08 / $30) + 0.08 = 0.116 or 11.6%
Note: By retaining earnings, companies deprive shareholders of cash dividends that could be paid from those funds. Shareholders could invest those earnings in the market, generating income for themselves.
Capital Asset Pricing Model (CAPM) Method
The Capital Asset Pricing Model (CAPM) can be used to calculate the cost of retained earnings. The CAPM financial model requires three pieces of information to determine the required return rate on a stock or the amount of earnings a stock must generate to justify its risks. The model requires the following formula:
- Current risk-free rate in the economy: the return you expect from an investment without risk. You can use the return on a 3-month U.S. Treasury bond.
- Market return: what you expect from the market as a whole. To determine this return, use the return of a market index like Wilshire 5000 or Standard and Poor’s 500.
- Stock Beta: this measure represents the stock’s risk, with a beta of 1.0 representing the market as a whole. A stock that is 10% riskier than the market would have a beta of 1.1, for example. Safer stocks would have a beta of less than 1.0. Many investment sites like Bloomberg calculate and report stock betas.
Use the formula for the required return as follows:
Required Return = Risk-Free Rate + Beta × (Market Return – Risk-Free Rate)
For example, if you have a risk-free return rate of 2%, a beta of 1.5, and an expected market return rate of 8%, the formula would be as follows:
Required Return = 0.02 + 1.5 × (0.08 – 0.02) = 0.11 or 11%
Thus, the cost of retained earnings in this example is 11%.
Note: Shareholders should monitor the company’s management team to ensure that retained earnings are being effectively utilized by the company. For example, if the company fails to reinvest its profits into modernizing its technology or equipment, it may fall behind its competitors.
Bonds Yield Plus Risk Premium Method
The cost of retained earnings can also be calculated using the Bonds Yield Plus Risk Premium method, which provides a “quick and simple” estimate. The calculation involves taking the interest rate on the company’s bonds and adding a risk premium. The risk premium typically ranges from 3% to 5%, based on an estimate of the company’s risk level.
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For example, if the interest rate on bonds is 6% and you set the risk premium at 4%, then add these two elements together to get an estimate of 10% for the cost of retained earnings.
Average of the Three Methods
When calculating the cost of retained earnings, any of the three methods mentioned above can provide an estimate. However, the most comprehensive approach is to calculate all three methods and use the average.
For example, the previous calculations gave answers of 11.6%, 11%, and 10%. The average of these numbers can be 10.86%. Thus, we now have a more comprehensive estimate of the cost of retained earnings by averaging the results from the calculations provided in the examples.
Frequently Asked Questions (FAQs)
How do you find the cost of retained earnings?
There are three methods to calculate the cost of retained earnings, including:
- The discounted cash flow (DCF) method uses the stock price, dividends paid, and the average growth rate of dividends.
- The capital asset pricing model (CAPM) uses the risk-free rate of return, market return, and the stock’s beta to determine the required rate of return on the stock necessary to justify its risks.
- The bond yield plus risk premium approach uses the interest rate on the company’s bonds and adds a risk premium, which can range from 3% to 5%, depending on the company’s risk level.
Why is the cost of retained earnings not zero?
The cost of retained earnings is not equal to zero because it represents the return that shareholders should expect on their investments. There is an opportunity cost where the earnings could be invested in the market instead of building the company’s earnings schedule.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Cornell Law School, Legal Information Institute. “Retained Earnings.”
Accounting Tools. “Cost of Retained Earnings.”
Santa Clara University. “Investing Retained Earnings.”
Source: https://www.thebalancemoney.com/calculation-of-the-cost-of-retained-earnings-393131
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