Retained earnings are a part of stockholder's equity. Capital stock is the other component to stockholder's or shareholder's equity. Combined, retained earnings, which are profits a company uses to reinvest in the business, and capital stock, which is a financial accounting term that assigns a value other than market value to stocks, represent shareholder's equity.
Stockholder's equity, or the equity owned by shareholders, is found on a company's balance sheet, which is a a type of financial statement. When a company has a profitable period, it may reward investors with some of those earnings through dividends. Any profits that are not distributed to investors are retained earnings. Capital stock has a par value that is used for accounting purposes. This par value may be a fraction of where the stock trades in the public markets.
Shareholder's equity can be used to measure the financial health of a corporation. According to an article in Reuters, Kingsway Financial Services warned investors in March 2011 about an anticipated drop of $55 million in shareholder's equity in the fourth quarter of the same year. The expected decline was attributed to the condition of profits from operations in addition to certain expenses. The motives behind warning investors about the anticipated shortfall were not given, but a research report issued by San Diego State University suggests companies may do so to stave off lawsuits from disappointed investors.
When a company has excess profits, it may use a portion of the income to pay investors a quarterly or yearly dividend. Some of those profits may be retained so that a business can reinvest in some expansion effort or pursue a project, for instance. Profits may also be retained in order that the company may have a greater chance to increase the size of the dividend payout in future periods. Stockholder's equity is not decreased if dividends are paid in shares of stock instead of cash.
Berkshire Hathaway chairman Warren Buffett outlined his theory for retained earnings in a company manual. His theory suggests that a company should only hold onto profits when the result will explicitly benefit shareholders. He says that at least $1 should be created for shareholders in the market value of a company's stock for each $1 in profits that is kept as retained earnings. Mr. Buffett admitted that as the company grows, the need for retained earnings diminishes.