What it means
Each year a company decides how much of its profit to pay out as dividends and how much to keep. The money kept is called retained earnings, and management promises that reinvesting it will grow future profit.
RORE tests whether that promise came true. The calculation compares the growth in earnings per share (EPS) with the earnings per share that were retained.
If the company kept $3.00 per share and EPS rose by $0.45 the following year, then each retained dollar produced 15 cents of extra annual earnings. A higher figure suggests management is putting retained money to good use.
Investors use RORE to decide whether they would prefer dividends or reinvestment. If RORE is higher than the return the investor could earn elsewhere at similar risk, then retaining profit is a good deal.
If it is lower, shareholders might be better off receiving the cash. A single year of RORE can be misleading, because profits are affected by the economic cycle, one-off items and accounting changes.
For that reason, many analysts measure RORE over several years, comparing EPS growth with total retained earnings per share across the period. The longer view smooths out the noise.
RORE is related to, but not the same as, return on equity (ROE). ROE measures profit relative to all shareholders' equity, while RORE focuses on the incremental profit from the portion that was retained.
A company with a high ROE is not guaranteed a high RORE, particularly if the old business is stronger than the new projects. The nuance is that EPS growth can come from sources other than reinvestment, such as price rises, cost cuts or share buybacks.
Because of this, RORE is a rough indicator, and it should be paired with a look at where the growth actually came from.
In practice
Real-world examples.
Example
A fast-growing technology company pays no dividend and retains all of its $2.50 EPS. A year later EPS is $2.90. RORE is 0.40 / 2.50 = 16%, and the investors judge that reinvesting was worthwhile.
Example
A mature utility pays out most of its profit as dividends and retains only $0.50 per share. EPS grows by $0.03 the next year, a RORE of 6%. Shareholders accept this because the dividend is stable and the company has few high-return projects.
Example
A shareholder in a retailer notices that the company has kept $5.00 per share for three years, but EPS has barely moved. The three-year RORE is close to zero, and she writes to the board asking for a higher dividend.
Formula
Calculation
RORE = (EPS this year - EPS last year) / (EPS last year - dividends per share last year)
Suppose a company reported EPS of $4.00 last year and paid dividends of $1.00 per share, so it retained 4.00 - 1.00 = $3.00 per share. This year EPS rose to $4.45, an increase of 4.45 - 4.00 = $0.45. RORE = 0.45 / 3.00 = 0.15, or 15%. That means each retained dollar added 15 cents of annual earnings.Case study
Seen in the real world.
Oakfield Industries is an illustrative, fictional manufacturer that kept 80% of its profits to build new plants. Over four years, its EPS rose from $3.00 to $3.60, while it retained a total of $8.00 per share.
The four-year RORE was (3.60 - 3.00) / 8.00 = 0.60 / 8.00 = 7.5%. The board's cost of equity was 10%, so the retained money earned less than shareholders could expect elsewhere.
After reviewing the figures, the board cut the retention ratio to 50% and raised the dividend. The illustrative lesson is that retaining profit is only sensible when the business can earn more on it than shareholders could. Two years later, the lower retention ratio had returned about $1.08 more per share to investors each year, which is 30% of the $3.60 EPS, and the share price held steady. The directors also agreed to report RORE in the annual review so that future investment plans could be judged against actual results.
Watch out
Common mistakes.
- Reading one year of RORE as a long-term trend, when profits can swing for reasons unrelated to reinvestment.
- Assuming all EPS growth came from retained earnings, when price rises, cost cuts and buybacks may play a part.
- Confusing RORE with return on equity, which looks at all equity rather than the retained slice.
Questions
People also ask.
What is a good RORE?
One that is clearly above the shareholders' required return, otherwise they would be better off receiving dividends. Because the required return reflects the risk of the business, a stable utility and a young technology company will be judged against different benchmarks.
Can RORE be negative?
Yes, if EPS falls after earnings were retained, which suggests the reinvested money destroyed value or that conditions worsened. A negative result for a single year should be checked against the wider economy before blame is placed on management.
Why does a company with no dividends still have a RORE?
All of its earnings are retained, so the whole of EPS is the retained amount in the calculation.
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