Common stock and retained earnings are components of stockholders' equity. Investors evaluate both features to determine company strength or weakness. However, they aren't the same things. The primary differences pertain to accounting, legal aspects and the real world. Common stock equity defines the level of shareholder ownership, while retained earnings is a measure of the corporation's operating results, dividends paid and profits over time.
Common Stock Equity
Although most financial and investment theory relates to public companies whose shares are purchased by the general public and listed on a stock exchange, common stock is the foundation for the capital of all corporations, large and small. Common stock is just as vital to a one-person company whose owner owns 100 percent of the stock as it is to the world's largest public companies such as IBM, Apple and Microsoft. Stock prices measure the popularity of a company's ownership.
Retained Earnings Composition
Analyzing retained earnings, the other primary component of stockholders' equity, requires more investigation than simply viewing a common stock price. When comparing two similar corporations, you might see a large difference between their retained earnings balances. They might have averaged similar net profits over the past decade. However, you might find that one organization has regularly returned much of its annual profit as dividends to common stockholders, while the other has kept most of its profit, limiting dividends.
Common stock equity and retained earnings are often paired, such as when calculating a company's earnings per share ratio -- retained earnings divided by number of shares outstanding. However, common stock and retained earnings are very different entities, with different purposes. Stock is evidence of your physical ownership in a corporation. Retained earnings is simply a balance sheet account that measures organization performance since its beginning. There is little common ground in their relationship, and they have more differences than similarities.
Different, But Related
Although common stock equity and retained earnings are very different than each other, they are closely related from an investment perspective. The strength of common stock equity and stock prices is directly linked to the strength of a corporation's retained earnings and profitability. For every documented exception to this relationship -- such as Amazon, whose common stock remained popular even in the company's early money-losing years -- there are millions of examples of this relationship between equity and retained earnings.
An organization's dividend policy illustrates a major difference between owning stock and retained earnings. Although a corporation's board of directors can change its dividend policy from year to year, dividend payments still come from retained earnings. The shares of organizations that choose to pay large dividends, which reduce retained earnings, appeals to investors who prefer hefty annual cash returns on their stock. Conversely, investors looking for strong growth for their stocks might prefer restrictive dividend policies, which typically increase retained earnings balances.
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