SHAREHOLDERS' EQUITY SECTION

Book Value of Equity

The Book Value of Equity is the amount received by the common shareholders of a
company if all of its balance sheet assets were to be hypothetically liquidated.

In comparison, the market value refers to how much the equity of a company is worth
according to the latest prices paid for each common share and the total number of shares
outstanding.

How to Calculate Book Value of Equity

The book value of equity, or “Shareholders’ Equity”, is the amount of cash remaining
once a company’s assets have been sold off and if existing liabilities were paid down
with the sale proceeds.

To calculate the book value of equity of a company, the first step is to collect the re-
quired balance sheet data from the company’s latest financial reports such as its 10-K or
10-Q.

As implied by the name, the “book” value of equity represents the value of a company’s
equity according to its books (i.e. the company’s financial statements, and in particular,
the balance sheet).

In theory, the book value of equity should represent the amount of value remaining for
common shareholders if all of the company’s assets were to be sold to pay off existing
debt obligations.

Book Value of Equity Formula

The formula for the book value of equity is equal to the difference between a company’s
total assets and total liabilities:
Book Value of Equity = Total Assets – Total Liabilities
For example, let’s suppose that a company has a total asset balance of $60mm and total
liabilities of $40mm. The book value of equity will be calculated by subtracting the
$40mm in liabilities from the $60mm in assets, or $20mm.

If the company were to be liquidated and subsequently paid off all of its liabilities, the
amount remaining for common shareholders would be worth $20mm.

Components of “Book Value of Equity” Line Item

Common Stock and Additional Paid-In Capital (APIC)
Next, we’ll walk through the main parts that make up the equity section on the balance
sheet.

The first line item is “Common Stock and Additional Paid-In Capital (APIC)”.

Common Stock: Common stock refers to equity capital issued in the past, recorded at
the par value of the shares (the value of a single common share as set by a corporation),
while the APIC section is related to the extra capital paid in excess of the par value of
common stock issued.

APIC: APIC increases when a company decides to issue more shares (e.g. secondary of-
fering) and declines when repurchasing shares (i.e. share buybacks).

Retained Earnings
On to the next line item, “Retained Earnings” refer to the portion of net income (i.e. the
bottom line) that is retained by the company, rather than issued in the form of dividends.

When companies generate positive net income, the management team has the discre-
tionary decision to either:

• Reinvest into the Operations of the Business

• Issue Common or Preferred Dividends to Equity Shareholders
For high-growth companies, it’s far more likely that earnings will be used to reinvest
into ongoing expansion plans.

But for low-growth companies with limited options for reinvestments, returning capital
to equity holders by issuing dividends could potentially be the better choice (versus in-
vesting in high-risk, uncertain projects).

If a company consistently performs well from a profitability standpoint and decides to

reinvest into its current growth, the retained earnings balance will increasingly accumu-
late over time.

To investors, retained earnings can be a useful proxy for the growth trajectory of the
company (and return of capital to shareholders).
Treasury Stock
Next, the “Treasury Stock” line item captures the value of repurchased shares that were
previously outstanding and available to be traded in the open market.

• Following a repurchase, such shares have effectively been retired and the number of
outstanding shares decreases.
• When a company distributes dividends, these shares are excluded.
• Repurchased shares are not factored in when calculating basic EPS or diluted EPS.

Treasury stock is expressed as a negative number because the repurchased shares reduce
the value of a company’s equity on the balance sheet.

Other Comprehensive Income (OCI)

Finally, the “Other Comprehensive Income (OCI)” line item can contain a wide variety
of income, expenses, or gains/losses that have not yet appeared on the income statement
(i.e. that are unrealized, not redeemed).

The line items frequently grouped into the OCI category stem from investments in secu-
rities, government bonds, foreign exchange hedges (FX), pensions, and other miscella-
neous items.

Book Value vs. Market Value of Equity

The book value of equity is a measure of historical value, whereas the market value re-
flects the prices that investors are currently willing to pay.

Typically, the market value almost always exceeds the book value of equity, barring un-
usual circumstances.

One common method to compare the book value of equity to the market value of equity
is the price-to-book ratio, otherwise known as the P/B ratio. For value investors, a lower
P/B ratio is frequently used to screen for undervalued potential investments.

While the market value accounts for investor sentiment regarding the growth and profit
potential of the company, the book value is a historical measure used for accounting pur-
poses (and for consistency and standardization across all companies)

The book value of equity is the net value of the total assets that common shareholders
would be entitled to get under a liquidation scenario.

But the market value of equity stems from the real, per-share prices paid in the market as
of the most recent trading date of a company’s equity.

Market Value < Book Value of Equity

Even though it is plausible for a company to trade at a market value below its book value, it is a
rather uncommon occurrence (and not necessarily indicative of a buying opportunity).

Remember that the markets are forward-looking and the market value is dependent on the outlook
of the company (and industry) by investors.

If a company’s market value of equity is lower than its book value of equity, the market is basically
saying that the company is not worth the value recorded on its books – which is unlikely to occur
without a legitimate cause for concern (e.g. internal problems, mismanagement, poor economic con-
ditions).

But in general, most companies expected to grow and produce higher profits in the future are going
to have a book value of equity less than their market capitalization.

The equity value recorded on the books is significantly understated from the market
value in most cases. For example, the book value of Apple’s shareholders’ equity is
worth around $64.3 billion as of its latest 10-Q filing in 2021.

However, Apple’s market value of equity is well over $2 trillion as of the current date.

Generally speaking, the more optimistic the prospects of the company are, the more the
book value of equity and market value of equity will deviate from one another.

From the opposite perspective, the less promising the future growth and profit opportuni-
ties seem, the more the book and market value of equity will converge.

Book Value of Equity Calculation Example

For our modeling exercise, we’ll be projecting the “Total Equity” line item for three
years with roll-forward schedules.

By explicitly breaking out the drivers for the components of equity, we can see which
specific factors impact the ending balance.

The ending equity calculation that we’re working towards consists of adding three
pieces:

1. Common Stock and APIC

2. Retained Earnings
3. Other Comprehensive Income (OCI)

The following assumptions will be used for “Common Stock & APIC”:

Common Stock and APIC, Beginning Balance (Year 0): $190mm

Stock-Based Compensation (SBC): $10mm Per Year

Since the issuance of compensation in the form of stock- based compensation increases
the account balance, we’ll add the SBC amount to the beginning balance.
Next, the beginning balance for the next period (Year 2) will be linked to the ending bal-
ance of the prior period (Year 1).

The process will be repeated for each year until the end of the forecast (Year 3), with the
assumption of an additional $10mm stock-based compensation consistent for each year.

From Year 1 to Year 3, the ending balance of the common stock and APIC account has
grown from $200mm to $220mm.

As for the “Retained Earnings” line item, there are three drivers that affect the beginning
balance:

1. Net Income: The accounting, after-tax profits generated by a company (“bottom

line”).

2. Common Dividends: Payments issued to common shareholders from retained earn-

ings.

3. Share Repurchases: Shares repurchased by the company either in a tender offer or

just in the open market – here, share repurchases (i.e. treasury stock) are modeled within
retained earnings for simplicity rather than explicitly creating a contra equity account.

The following operating assumptions will be used:

• Retained Earnings (Year 0): $100mm

• Net Income: $25mm Per Year
• Common Dividends: $5mm Per Year
• Share Repurchases: $2mm Per Year

While net income each period is an inflow to the retained earnings balance, common
dividends and share repurchases represent cash outflows.

As for “Other Comprehensive Income (OCI)”, we’ll simply apply the $6mm assumption
in Year 0 across the next two years.

Other Comprehensive Income (OCI): $6mm Per Year

In Year 1, the “Total Equity” amounts to $324mm, but this balance grows to $380mm by
the end of Year 3.

Retained Earnings

Retained Earnings measures the total accumulated profits kept by the company to date
since inception, which were not issued as dividends to shareholders.

The discretionary decision by management to not distribute payments to shareholders

can signal the need for capital reinvestment(s) to sustain existing growth or to fund ex-
pansion plans on the horizon.
How to Calculate Retained Earnings
The retained earnings of a company refer to the profits generated, and not issued out in
the form of dividends, since inception.

On the balance sheet, the relevant line item is recorded within the shareholders’ equity
section.

The formula is equal to the prior period balance plus net income – and from that figure,
the issuance of dividends to equity shareholders is subtracted.

In effect, the equation calculates the cumulative earnings of the company post-adjust-
ments for the distribution of any dividends to shareholders.

The prior period balance can be found on the beginning of period balance sheet, whereas
the net income is linked from the current period income statement.

Retained Earnings Formula

Retained Earnings = Prior Period Balance + Net Income – Dividends

How to Interpret Retained Earnings

Generally, a company with more retained earnings on its balance sheet is more prof-
itable.

Higher retained earnings mean increased net earnings and fewer distributions to share-
holders (and vice versa)

Company Lifecycle: One influential factor is the maturity of the company, as a low-
growth company with minimal opportunities for capital allocation is more likely to issue
dividends to shareholders. In other words, cash from operations is sufficient to fund rein-
vestment needs.

Growth Opportunities: For mature companies, the available opportunities to place cap-
ital for expansion and to drive growth become more limited (or the risk profile does not
meet the return hurdle). With that said, a high-growth company with minimal free cash
flow will conversely re- invest toward extending its growth trajectory (e.g. research &
development, capital expenditures).

Profit Margins: Another factor to consider is the profitability of a company, as for

growth oriented companies in hyper- competitive industries, most likely the market par-
ticipants probably could not afford to issue dividends to shareholders in the first place,
even if it wanted to compensate shareholders.

Dividend Policy: Next, another important consideration is the dividend policy of the
company. Given the formula stated earlier, the relationship between the two should be
rather intuitive – i.e. a company that issues dividends routinely is going to have lower re-
tention, all else being equal. Even if a company underperforms, the management teams
of publicly traded companies tend to be very reluctant to cut dividends out of fear of
sending out a negative message to the markets that could cause a significant drop in the
current share price.

Cyclicality: Furthermore, the cyclicality of the industry can also be a contributing fac-
tor, i.e. when a company operates in an industry that is very cyclical, the management
team reserves more earnings as a risk-averse measure in case of an impending downturn.

Causes of Negative Retained Earnings

If a company has consistently incurred substantial losses at the net income line item (i.e.
the “bottom line”), its retained earnings balance could eventually become negative,
which is recorded as an “accumulated deficit” on the books.

But while the first scenario is a cause for concern, a negative balance could also result
from an aggressive dividend payout – e.g. dividend recapitalization in LBOs.

As a broad generalization, if the retained earnings balance is gradually accumulating in

size, this demonstrates a track record of profitability (and a more optimistic outlook).

However, from a more cynical view, the growth in retained earnings could be interpreted
as management struggling to find profitable investments and project opportunities worth
pursuing.

Step 1. Income Statement Assumptions and Roll-Forward

Schedule
For our retained earnings modeling exercise, the following assumptions will be used for
our hypothetical company as of the last twelve months (LTM), or Year 0.

Income Statement Assumptions (Year 0)

• Retained Earnings – Beginning of Period: $200m

• Net Income: $50m
• Common Dividends: $10m

Upon combining the three line items, we arrive at the end-of- period balance – for in-
stance, Year 0’s ending balance is $240m.

Year 0 = $200m + $50m – $10m

Note how in our roll-forward schedule, net income has a positive impact on the end of
period balance (i.e. cash inflow) while common dividends have a negative effect (i.e.
cash outflow)

Step 2. Retained Earnings Projection Period

In the next step, we’ll forecast the metric for the next five years, with two operating
cases to pick from:

1. Upside Case: Consistent operating performance with profit margins in-line with his-
torical trends – therefore, the common dividend issuance program remains in place.

2. Downside Case: Poor operating performance with declining profitability – manage-

ment is forced to cut the dividend (and eventually put a complete end to the payouts in
later periods)

Upside Case – Forecast Assumptions

Net Income: Straight-Line (i.e. Held Constant)

Common Dividends: Straight-Line

Downside Case – Forecast Assumptions

Net Income: Reduction by $25m Per Year

Common Dividends: Payout Value Decline of $2m Per Year

In the “Upside Case”, the ending balance increases from $240m in Year 0 to $440m by
Year 5 – reflecting how management’s decision to retain a greater proportion of its net
income has a net positive impact on the retained earnings balance.

As for the “Downside Case”, the ending balance declined from $240minYear0to $95m
by the end of Year5–even with the company attempting to offset the steep losses by
gradually cutting off the dividend payments.

Additional Paid-In Capital (APIC)

Additional Paid-In Capital (APIC) represents the value received in excess of the par
value from issuances of preferred or common shares.
How to Calculate Additional Paid-In Capital (APIC)
Additional paid-in capital (APIC) represents the excess amount paid in total by investors
above the par value of a company’s shares.

Additional paid-in capital (APIC) is the amount that investors are willing to pay over the
par value of the company’s shares.

On the balance sheet, APIC is shown separately in the shareholders’ equity section be-
low common stock, with the par value stated near it as reference.

The par value of stock is normally set very low (e.g. $0.01), so the majority of the value
received from investors for a capital raise will be recorded in the additional paid-in capi-
tal (APIC) account, rather than the common stock account.

APIC is often used interchangeably with several terms, such as:

• Contributed Surplus
• Contributed Capital in Excess of Par
• Capital in Excess of Par Value
• Paid-In Capital in Excess of Stated Value

When a private company decides to go public in an initial public offering (IPO), its eq-
uity is offered to the public for the first time.

As part of the IPO process, the company must set an appropriate price per each share
within its charter – and that price is called the “par value” of the shares.

The paid-in capital metric equals the sum of the par value and APIC, meaning APIC is
intended to capture the “premium” paid by investors.

APIC Formula
Calculating the additional paid-in capital (APIC) is a two-step process:

1. The par value of the shares is subtracted from the issuance price at which the shares
were sold.
2. The excess of the sale price and par value is then multiplied by the number of shares
issued.

The APIC formula is as follows.

APIC = (Issuance Price – Par Value) × Common Shares Outstanding

For purposes of financial modeling, APIC is consolidated with the common stock line
item and then projected with a roll- forward schedule.

Ending APIC = Beginning APIC + Stock- Based Compensation (SBC) + Exercised

Stock Options

APIC and Stock Price Relationship

One common misconception is that the sale price on the date of issuance represents the
market value of the shares, i.e. the current share price of the company determined by the
secondary trading in the open markets.

APIC is instead based on the initial “offering price” of the shares on the date of issuance,
such as the date of the IPO or the secondary offering.

To reiterate, the APIC account can only increase if the issuer were to sell more shares to
investors, in which the issuance price exceeds the par value of the shares.

So movements in the company’s share price – whether upward or downward – have no

effect on the stated APIC amount on the balance sheet because these transactions do not
directly involve the issuer.

Additional Paid-In Capital Calculation Example

Suppose a private company recently went public via an IPO where its shares were issued
at a sale price of $5.00 each at a par value of $0.01 per share.

• Issuance Price = $5.00

• Par Value = $0.01

The excess of the issuance price over the stated par value is $4.99.

• Excess of Stated Par Value = $5.00 – $0.01 = $4.99

If the total number of common shares outstanding is assumed to be 10 million, how

much in APIC would be recorded on the balance sheet?

Upon multiplying the excess spread over the stated par value by the number of common
shares outstanding, we arrive at an additional paid-in capital (APIC) value of $49.9 mil-
lion.
• APIC = $4.99 × 10 million = $49.9 million

Treasury Stock

Treasury Stock represents shares that were issued and traded in the open markets but are
later reacquired by the company to decrease the number of shares in public circulation.

Treasury Stock Balance Sheet Accounting

On the shareholders’ equity section of the balance sheet, the “Treasury Stock” line item
refers to shares that were issued in the past but were later repurchased by the company in
a share buyback.

Following the repurchase, the formerly outstanding shares are no longer available to be
traded in the markets and the number of shares outstanding decreases – i.e. the reduced
number of shares publicly traded is referred to as a decline in the “float”.

Since the shares are no longer outstanding, there are three notable impacts:

• The repurchased shares are NOT included in the calculation of basic or diluted earn-
ings per share (EPS).
• The repurchased shares are NOT included in the distribution of dividends to equity
shareholders.
• The repurchased shares do NOT retain the voting rights previously given to the share-
holder.

Therefore, an increase in treasury stock via a share buyback program or a one-time buy-
back can cause the share price of a company to “artificially” increase.

The value attributable to each share has increased on paper, but the root cause is the de-
creased number of total shares, as opposed to “real” value creation for shareholders.

Share Buyback Rationale and Impact on Share Price

The rationale for share repurchases is often that management has determined its share
price is currently undervalued. Share repurchases – at least in theory – should also occur
when management believes its company’s shares are underpriced by the market.

If the company’s share price has fallen in recent periods and management proceeds with
a buyback, doing so can send out a positive signal to the market that the shares are po-
tentially undervalued.

In effect, the company’s excess cash sitting on its balance sheet is utilized to return some
capital to equity shareholders, rather than issuing a dividend.

If the shares are priced correctly, the repurchase should not have a material impact on
the share price – the actual share price impact comes down to how the market perceives
the repurchase itself.
Controlling-Stake Retention

One common reason behind a share repurchase is for existing shareholders to retain greater control
of the company.

By increasing the value of the shareholders’ interest in the company (and voting rights), the repur-
chase of shares helps fend off hostile takeover attempts.

If the equity ownership of a company is more concentrated, takeover attempts become far more
challenging (i.e. certain shareholders hold more voting power), so share buybacks can also be uti-
lized as a defensive tactic by management and existing investors.

Treasury Stock Contra-Equity Journal Entry

Why is Treasury Stock Negative?
Treasury stock is considered a contra-equity account.

Contra-equity accounts have a debit balance and reduce the total amount of equity
owned – i.e. an increase in treasury stock causes the shareholders’ equity value to
decline.

That said, treasury stock is shown as a negative value on the balance sheet and additional
repurchases cause the figure to decrease further. Wall Street Prep | www.wallstreetprep.com

On the cash flow statement, the share repurchase is reflected as a cash outflow (“use” of
cash).

After a repurchase, the journal entries are a debit to treasury stock and credit to the cash
account.

If the company were to resell the previously retired shares at a higher price than the orig-
inal price (i.e. when retired), the cash would be debited by the sale amount, treasury
stock would be credited by the original amount (i.e. same as prior), but the additional
paid in capital (APIC) account would be credited to ensure both sides balance.

If the board elects to retire the shares, the common stock and APIC would be debited,
while the treasury stock account would be credited.

Treasury Stock in Diluted Share Count Calculation

To calculate the fully diluted number of shares outstanding, the standard approach is the
treasury stock method (TSM).

Examples of Potentially Dilutive Securities

• Options
• Employee Stock Options
• Warrants
• Restricted Stock Units (RSUs)
Under the TSM, the options currently “in-the-money” (i.e. profitable to exercise as the
strike price is greater than the current share price) are assumed to be exercised by the
holders.

However, the more prevalent treatment in practice has been for all outstanding options –
regardless of if they are in or out of the money – to be included in the calculation.

The intuition is that all outstanding options, despite being unvested on the present date,
will eventually be in the money, so as a conservative measure, they should all be in-
cluded in the diluted share count.

The final assumption of the TSM approach is that the proceeds from the exercise of the
dilutive securities will immediately be used to repurchase shares at the current share
price – under the presumption that the company is incentivized to minimize the net im-
pact of dilution.

Retired vs. Non-Retired Treasury Stock

Treasury stock can either be in the form of:

• Retired Treasury Stock (or)

• Non-Retired Treasury Stock

Retired treasury stock – as implied by the name – is permanently retired and cannot be
re-instated on a later date.

In comparison, non-retired treasury stock is held by the company for the time being,
with the optionality to be re- issued at a later date if deemed appropriate.

For example, non-retired shares can be re-issued and ultimately return to being traded in
the open markets by:

• Dividends to Equity Shareholders

• Shares Issued Per Options Agreements (and Related Securities – e.g. Convertible
Debt)
• Stock-Based Compensation for Employees
• Capital Raising – i.e. Secondary Offerings, New Financing Round

Treasury Stock Cost Method vs. Par Value Method

In general, there are two methods of accounting for treasury stock:

1. Cost Method
2. Par Value Method

Under the cost method, the more common approach, the repurchase of shares is recorded
by debiting the treasury stock account by the cost of purchase.
Here, the cost method neglects the par value of the shares, as well as the amount re-
ceived from investors when the shares were originally issued.

By contrast, under the par value method, share buybacks are recorded by debiting the
treasury stock account by the shares’ total par value.

The cash account is credited for the amount paid to purchase the treasury stock.

In addition, the applicable additional paid-in capital (APIC) or the reverse (i.e. discount
on capital) must be offset by a credit or debit.

If the credit side is less than the debit side, APIC is credited to close the difference

If the credit side is greater than the debit side, APIC is debited instead.

Retention Ratio

The Retention Ratio is the portion of net earnings that are retained by a company rather
than being paid out as dividends to shareholders.

How to Calculate the Retention Ratio

The importance of the retention ratio is related to the fact that companies re-investing
their net income into their operations implies that there are growth opportunities worth
pursuing in their current pipelines.

For companies profitable at the net income line (i.e. “the bottom line”), there are two op-
tions available to the management team in terms of how to use the proceeds:

1. Re - Invest into Operations:Maintain possession of those earnings and on a later date,

use them to fund ongoing operations as well as discretionary growth plans

2. Compensate Equity Shareholders: Issue payments to preferred and/or common share-

holders in the form of dividends

If the former is chosen, the percentage of profits that the company opts to hold onto as
opposed to paying out as dividends increases – which is quantified by the retention ratio.
Since the earnings retention of the company is expressed in the form of a percentage,
this enables comparisons among peer companies in the same industry.

The inverse of the retention ratio is called the “dividend payout ratio”, which measures
the proportion of net income paid out as dividends to shareholders.
Retained Earnings on Balance Sheet

When the earnings of companies are credited to retained earnings instead of being issued out as div-
idends, the preserved amount flow into the “Retained Earnings ” line item on the balance sheet.

To forecast retained earnings, the process consists of taking the prior period balance of retained
earnings, adding the net income from the current period, and then subtracting any dividends issued
to shareholders.

Factors Affecting the Retention Ratio

Considering the retention ratio – also known as the “plowback ratio” – indicates the
amount of retained profits, the fact that a company would decide to keep its profits tends
to be a positive sign that management is confident regarding its future business growth
opportunities.

However, this interpretation is based on the assumption that management is rational and
makes corporate decisions with the “best interests” of its shareholders in mind.

As a general rule, the retention ratio is typically lower for mature, established companies
that have accumulated large cash reserves.

Often, such companies are referred to as “cash cows”, as they are characterized by large
market share in a mature, single- digit growth industry.

Consequently, these types of companies have minimal reinvestment needs and essen-
tially have developed into a steady turnkey business following years of strong growth to
become a market leader.

Here, the decision-making process is based on whether or not the projects in the current
pipeline could be undertaken in the present date – if not, it is often because the risks as-
sociated with the projects are not justified by the potential returns.

On the other hand, a high-growth company riding a positive trajectory in terms of market
expansion and new customer acquisitions would be comparatively far more likely to re-
tain earnings, as there are more likely to be worthwhile projects worth undertaking.

To expand further, growing companies require additional cash to fund upcoming invest-
ments in assets (i.e. capital expenditures) and other strategic operational investments
into:

• Sales & Marketing Spend (S&M)

• Advertising Campaigns
• Customer Service and Support
• Business Development Representatives

Nuances to Earnings Retention

There are exceptions to the rules generalizing that low growth companies have low re-
tention ratios (and vice versa).

For instance, a mature company might have a high retention ratio due to a business
model oriented around acquiring competitors or adjacent companies in the market (i.e.
growth through acquisitions/M&A).

Additionally, if a company operates in a capital-intensive industry (e.g. automobiles, oil

& gas) that requires large funds to maintain their current level of output, this industry
dynamic also would call for higher retention rates.

And along the same lines, companies with cyclical operating performance must preserve
more cash on hand to be able to withstand an economic downturn.

The final consideration is that the act of company retaining more of its earnings should
not always be interpreted as a positive indicator, as confirmation is required to ensure the
capital is being spent effectively and efficiently via metrics such as the:

• Return on Invested Capital (ROIC)

• Return on Assets (ROA)
• Return on Equity (ROE)

Therefore, the retention ratio should be used in conjunction with other metrics to assess
the actual financial health of a company.

Retention Ratio Formula

To calculate the retention ratio, the formula subtracts the common and preferred divi-
dends distributed from the net income of the current period and then divides the differ-
ence by the current period’s net income value.

Once dividends for the period have been paid out, the remaining profits are considered
retained earnings.

With that said, the numerator, in which dividends are deducted from net income, is sim-
ply the retained earnings account.
Retention Ratio = (Net Income – Dividends) / Net Income

For instance, let’s say a company has reported a net income of $100,000 in 2021 and
paid $40,000 of annual dividends. In our scenario, the retention ratio is 60%, which was
calculated using the following formula:
• Retention Ratio = ($100k Net Income – $40k Dividends Paid) ÷ $100k Net Income
• Retention Ratio = 60%

An alternative method to calculate the retention ratio is by subtracting the payout ratio
from one.
Retention Ratio = 1 – Payout Ratio

Continuing off on the prior example, we arrive at a retention ratio of 60% once again.

• Payout Ratio = $40k Dividends Paid ÷ $100k Net Income = 40%

• Retention Ratio = 1 – 40% Payout
• Ratio Retention Ratio = 60%

Conceptually, the formula should make sense given how the retention ratio is the oppo-
site of the payout ratio, which is the percentage of net earnings paid out to shareholders
as dividends.

Retention Ratio Example Calculation

For our simple modeling exercise, we’ll use the following assumptions for the historical
financials:

Year 0 Financials

• Net Income = $100m

• Dividends Distributed = $10m

Considering the retained earnings equation is net income minus the dividends distrib-
uted, the retained earnings for Year 0 come out to $90m.

• Retained Earnings (Year 0) = $100m Net Income – $10m Dividends Distributed =

$90m

Furthermore, the payout ratio is calculated by dividing the dividends distributed by the
net income.

• Payout Ratio (Year 0) = $10m Dividends Distributed ÷ 100m Net Income = 10%

As for the retention ratio, the equation is retained earnings divided by net income, as dis-
cussed earlier.

• Retention Ratio (Year 0) = $90m Retained Earnings ÷ $100m Net Income = 90%

The 90% retention ratio signifies that net of any dividends paid out to equity sharehold-
ers, 90% of the company’s net earnings are kept and accumulated on its balance sheet to
be spent on a later date.

Retention Ratio Projection

In the next section, we’ll practice forecasting retained earnings using the payout ratio,
which is directly linked to the retention ratio.

Public companies tend to publicly disclose their plans for dividends issuance programs –
whether it be a long-term plan or one-time special dividend. However, rather than also
explicitly announcing their retention plans, retention metrics have to be calculated using
the relationship between dividends and retained earnings.

To project the retained earnings balance in Year 1 and Year 2, we’ll be using two as-
sumptions:

Payout Ratio Assumptions

• Year 1: 25%
• Year 2: 40%

Given the increasing payout of dividends, we’d expect retained earnings to decline even
with the $10m year-over-year (YoY) increase in net income.

• Retained Earnings (Year 1): $83m

• Retained Earnings (Year 2): $72m

Confirming our statement from earlier, the inverse of the payout ratio is the retention ra-
tio, so we can see that the sum of the two ratios equals 100% in all three years in the
completed model output.

Plowback Ratio

The Plowback Ratio is the percentage of a company’s earnings retained and reinvested
into operations as opposed to being paid out as dividends to shareholders.

How to Calculate the Plowback Ratio

The plowback ratio, also known as the “retention ratio,” is the fraction of a company’s
net earnings that are retained to be reinvested into its operations.

Management’s decision to hold onto earnings could suggest that there are currently prof-
itable opportunities worth pursuing.

The inverse of the plowback ratio — the “dividend payout ratio” — is the proportion of
net income paid out in the form of dividends to compensate shareholders.

Considering that higher retention indicates more growth potential, a higher dividend
payout ratio should result in lower growth expectations, i.e. the two are inversely related.

If a company opted to pay out a large percentage of its earnings as dividends, no (or
minimal) growth should be expected out of the company.

The rationale behind a long-term dividend program is typically that growth opportunities
are limited and the company’s pipeline of potential projects has been exhausted; thus,
the best course of action to maximize shareholder wealth is to pay them directly via divi-
dends.

Plowback Ratio and Implied Growth Formula

In theory, greater retention of earnings and rates of reinvestment into profitable projects
should coincide with higher near-term growth rates (and vice versa).

A higher plowback ratio implies a higher growth rate, all else being equal.

As a result, a company’s growth rate (g) can be approximated by multiplying its return
on equity (ROE) by its plowback ratio.
Growth Formula

g = ROE × b

Where:
g = Growth Rate (%)
ROE = Return on Equity
b = Plowback Ratio

The plowback ratio, however, cannot be used as a standalone metric, as just because
earnings are retained does not mean it is being spent efficiently. The ratio should there-
fore be tracked alongside the following return ratios:

• Return on Invested Capital (ROIC)

• Return on Assets (ROA)
• Return on Equity (ROE)
Plowback Ratio and Company Lifecycle
If a company is profitable at the net income line — i.e. “the bottom line” — there are
two main options for management to spend those earnings:

1. Re-Invest: The net earnings can be kept and then be used to fund ongoing operations
(i.e. working capital needs), or discretionary growth plans (i.e. capital expenditures).

2. Dividends: The net earnings can be used to compensate shareholders; i.e., direct pay-
ments can be made to either preferred and/or common shareholders.

The retention ratio is generally lower for mature companies with established market
shares (and large cash reserves).

But for companies in high-growth sectors at risk of disruption and/or a large number of
competitors, constant reinvestments are typically necessary, which leads to lower reten-
tion.
Capital-Intensive / Cyclical Industries

Note that not all market-leading, established companies have low retention ratios.

For example, companies operating in capital-intensive industries such as automobiles, energy (oil &
gas), and industrials must constantly spend significant amounts of money just to maintain their cur-
rent output.

Capital-intensive industries are also often cyclical in performance, which further creates the need
for retaining more cash on hand (i.e. withstand a slowdown in demand or global recession).

Plowback Ratio Formula

One method to calculate the plowback ratio is to subtract common and preferred divi-
dends from net income, and then divide the difference by net income.

After dividends for the period have been paid out to shareholders, the residual profits are
called retained earnings, i.e. net income minus dividend distributions.
Plowback Ratio = Retained Earnings ÷ Net Income

Plowback Ratio Calculation Example

Suppose a company has reported a net income of $50 million and paid $10 million in
dividends for the year.

Plowback Ratio = ($50 million – $10 million) ÷ $50 million = 80%

In our illustrative scenario, the plowback ratio is 80%, i.e. the company paid out 20% as
dividends, and the remaining 80% was kept to be reinvested at a later date.

An alternative method to calculate the ratio is to subtract the dividend payout ratio from
one.
Plowback Ratio = 1 – Payout Ratio
Recall that the plowback ratio is the inverse of the payout ratio, so the formula should be
intuitive since the sum of the two ratios must equal one.

Using the same assumptions as in the prior example, we can calculate the plowback ratio
by subtracting 1 minus the 20% payout ratio.

• Payout Ratio = $10 million ÷ $50 million = 20%

We can then subtract the 20% payout ratio from 1 to calculate a plowback ratio of 80%,
which aligns with the previous calculation.

• Plowback Ratio = 1 – 20% = 80%

Plowback Ratio — Per Share Calculation

The plowback ratio can also be calculated using per-share figures, with the two inputs
consisting of:

1. Earnings Per Share (EPS)

2. Dividend Per Share (DPS)

Let’s assume that a company has reported an earnings per share (EPS) of $4.00 and paid
an annual dividend per share (DPS) of $1.00.

The company’s dividend payout ratio is equal to the earnings per share (EPS) divided by
the dividend per share (DPS).

• Payout Ratio = $1.00 ÷ $4.00 = 25%

Considering that 25% of the company’s net earnings were paid out as dividends, the
plowback ratio can be calculated by subtracting 25% from 1.

• Plowback Ratio = 1 – 25% = .75, or 75%

In conclusion, 75% of the company’s net earnings were kept for future reinvestments
while 25% was paid out to shareholders as dividends.

Book Value Per Share (BVPS)

Book Value Per Share (BVPS) refers to the per-share value of equity on an accrual ac-
counting basis that belongs to the common shareholders of a company.
How to Calculate Book Value Per Share
The book value per share (BVPS) shows a company’s net asset value (i.e. the total assets
minus the total liabilities) on a per- share basis, which makes comparisons among differ-
ent companies possible.

The book value of equity is defined as the value of a company’s assets as if all of its as-
sets were liquidated to pay off its liabilities. The amount of cash remaining once all out-
standing liabilities are paid off is captured by the book value of equity.

Often called shareholder’s equity, the “book value of equity” is an accrual accounting-
based profit measure.

As suggested by the name, the “book” value per share calculation begins with finding
the necessary balance sheet data from the latest financial report (e.g. 10-K, 10-Q).

Book Value Per Share Formula

The formula for BVPS involves taking the book value of equity and dividing that figure
by the weighted average of shares outstanding.

Book Value Per Share = (Shareholders’ Equity – Preferred Equity) / Weighted Average
of Common Shares Outstanding

If relevant, the value of preferred equity claims should also be subtracted out from the
numerator, the book value of equity.
For example, if a company has a total asset balance of $40mm and total liabilities of $25mm, then
the book value of equity is $15mm.

If we assume the company has preferred equity of $3mm and a weighted average share count of
4mm, the BVPS is $3.00 (calculated as $15mm less $3mm, divided by 4mm shares).

Book Value Per Share vs. Market Share Price

The difference between book value per share and the market share price is as follows.
Book Value Per Share (BVPS): The book value of equity per share reflects the equity
value recorded on the balance sheet. Unlike the market share price, the BVPS is a histor-
ical measure intended for purposes of accrual accounting.

Market Share Price: The market share price factors in existing investor sentiment re-
garding future growth and profits (and is forward-looking). In nearly all cases, the mar-
ket price is much greater than the book value of equity per share. The market share price
reflects the most recent prices that investors paid for each share.

Although infrequent, many value investors will see a book value of equity per share be-
low the market share price as a “buy” signal. But an important point to understand is that
these investors view this simply as a sign that the company is potentially undervalued,
not that the fundamentals of the company are necessarily strong.

In other words, the investors understand the company’s recent performance is under-
whelming, but the potential for a long- term turnaround and the rock-bottom price can
create a compelling margin of safety.

Nevertheless, most companies with expectations to grow and produce profits in the fu-
ture will have a book value of equity per share lower than their current publicly traded
market share price.

For companies seeking to increase their book value of equity per share (BVPS), prof-
itable reinvestments can lead to more cash.

In return, the accumulation of earnings could be used to reduce liabilities, which results
in a higher book value of equity (and BVPS).

Alternatively, another method to increase the BVPS is via share repurchases (i.e. buy-
backs) from existing shareholders.

Book Value Per Share (BVPS) Calculation Example

In our example scenario, the company we’ll be calculating the book value of equity per
share with the following financial data:

• Common Stock and APIC = $1bn

• Retained Earnings = $520mm
• Other Comprehensive Income (OCI) = $80mm
With those three assumptions given, we can calculate the book value of equity as $1.6bn.

The next assumption states that the weighted average of common shares outstanding is
1.4bn.

Using those two assumptions, we can calculate the Year 1 BVPS as $1.14.

• BVPS = $1.6bn / 1.4bn = $1.14

As for the next projection period, Year 2, we’ll simply extend each operating assumption
from Year 1, and thereby, the BVPS is going to be $1.14 once again.

The difference lies in the change in the market share price. We’ll assume the trading
price in Year 0 was $20.00, and in Year 2, that the market share price increases to
$26.00, which comes out to be a 30.0% year-over-year increase.

By multiplying the diluted share count of 1.4bn by the corresponding share price for the
year, we can calculate the market capitalization for each year.

• Year 1 = $28.0bn
• Year 2 = $36.4bn

Despite the increase in share price (and market capitalization), the book value of equity
per share remained unchanged.

Unless the company has updated certain assets and liabilities items on its balance sheet
to their (usually higher) fair market values (FMVs), the book value of equity will NOT
reflect the true picture.

Clear differences between the book value and market value of equity can take place,
which occurs more often than not for the vast majority of companies.

Accumulated Deficit

The Accumulated Deficit line item arises when a company’s cumulative profits to date
have become negative, which most often stems from either sustained accounting losses
or dividends.

How to Calculate Accumulated Deficit

An accumulated deficit occurs when a company has incurred more losses than profits
since its inception.
On the balance sheet, a company’s retained earnings line item — the cumulative earn-
ings carried over and not distributed to shareholders as dividends — serves virtually the
same purpose as the accumulated deficit.

Hence, the term “accumulated deficit” can be used interchangeably with “retained
loss.”

But for purposes of financial reporting, companies with a negative retained earnings bal-
ance will often opt to report it as an accumulated deficit.

Accumulated Deficit Formula

The formula for retained earnings equals the prior year’s retained earnings plus the cur-
rent period’s net income, less any dividends paid out to shareholders.

Retained Earnings / (Accumulated Deficit) = Prior Balance + Net Income – Dividends

How to Interpret Negative Retained Earnings

If a company’s retained earnings balance becomes negative, that could often be a cause
for concern. But negative retained earnings should be interpreted as a bad sign only if
the cause is mounting accounting losses.

In the worst-case scenario, the company has frequently sustained significant losses (i.e.
negative net income), resulting in a negative retained earnings balance.

But one consideration is where the company is currently at in its lifecycle. For instance,
growth-oriented startups and early- stage companies reinvesting heavily into themselves
to support future growth and scale will incur substantial capital expenditure (CapEx),
sales & marketing expenses, and research and development (R&D) expenses.

Other exceptions where negative retained earnings are not necessarily a negative sign in-
clude the payout of dividends, which contributes to lower (or even negative) retained
earnings.

In the case of dividends, the cause of the negative retained earnings is actually beneficial
to shareholders since more capital is distributed to shareholders (i.e. direct cash pay-
ments are received)

Tesla (TSLA) Accumulated Deficit Example

In Tesla’s 2021 10-K, we can see how their balance sheet’s retained earnings line is
stated as “Retained earnings (accumulated deficit)”.

When Tesla’s retained earnings balance was negative in FY-20, it was reported as an ac-
cumulated deficit.

Accumulated Deficit Calculation Example

In a financially stable company, if a company with a retained earnings balance of $10
million just generated $6 million in net income and paid $2 million in dividends, the re-
tained earnings for the current period is $14 million.

• Retained Earnings = $10 million + $6 million – $2 million = $14 million

Conversely, suppose a different company with a retained earnings balance of $2 million

just incurred a loss of $4 million in net income and paid no dividends.

In that case, the retained loss for the current period is negative $2 million.

• Accumulated Deficit = $2 million – $4 million = – $2 million

Other Comprehensive Income (OCI)

Other Comprehensive Income (OCI) refers to any revenues, expenses, and gains /
(losses) that not have yet been realized. These items, such as a company’s unrealized
gains on its investments, are not recognized on the income statement and do not impact
net income.

Other Comprehensive Income (OCI) Accounting

Other comprehensive income (OCI) is recorded on the shareholders’ equity section of
the balance sheet and consists of a company’s unrealized revenues, expenses, gains, and
losses.

While such items affect a company’s balance sheet, the effect is not captured on the in-
come statement (and has no impact on net income) per GAAP reporting standards.

Once the “paper” gain or loss is realized, it would then appear and affect the company’s
income statement and net income.

Further, since net income is unaffected by OCI, neither is the retained earnings account
on the balance sheet.

A “gain” would cause the OCI account to increase (credit), while a “loss” would cause
the OCI account to decrease (debit).

What is Included in Other Comprehensive Income (OCI)

The most common examples of items included in OCI are the following:

• Unrealized Gains and Losses from Financial Instruments, e.g. Bonds, Derivatives,
Hedges
• Foreign Exchange (FX) Currency Adjustments
• Unrealized Gains and Losses on Pension Plans, i.e. Employee Post-Retirement Plans
For instance, suppose a company has a portfolio of bonds and the value of those debt se-
curities has changed.

The difference would be recognized as either a gain or loss in the OCI line item of the
balance sheet.

Why? The gain or loss has not been realized yet, so there will be no income statement or
net income impact.

However, once the bond investment has been sold — i.e. the gain or loss has now been
“realized” — the difference would be recognized on the income statement in the non-op-
erating income / (expenses) section.

Other Comprehensive Income — Amazon Example

The screenshot below of Amazon’s balance sheet for the fiscal year ending 2021 shows
an example of OCI.

Rather than “Other Comprehensive Income (OCI)”, Amazon records the line item as
“Accumulated other comprehensive income (loss)”, which is also common as the two
terms are interchangeable.