Key Takeaways
- Portion of net income reinvested in business.
- Calculated as 1 minus dividend payout ratio.
- High ratio signals focus on growth and expansion.
- Low ratio indicates preference for shareholder dividends.
What is Retention Ratio?
The retention ratio, also known as the plowback ratio, measures the portion of a company’s net income that is reinvested in the business rather than paid out as dividends. It reflects how much earnings are kept to fund growth, research, and development instead of being distributed to shareholders.
This ratio complements metrics like dividend payout ratio and is essential when analyzing a firm’s dividend policy and growth potential. Understanding earnings and how they are allocated helps you assess a company’s financial strategy.
Key Characteristics
Here are the main features of the retention ratio:
- Calculation: It’s calculated as retained earnings divided by net income, or equivalently, 1 minus the dividend payout ratio.
- Range: Values range from 0% (all earnings paid as dividends) to 100% (no dividends, all earnings reinvested).
- Growth Indicator: High ratios suggest a focus on funding expansion or R&D, appealing to growth-oriented investors.
- Dividend Policy Insight: Low retention ratios often indicate a company prioritizes returning cash to shareholders, suitable for income-focused portfolios like those targeting dividend stocks.
- Financial Statements: Derived from net income on the income statement and dividends reported in cash flow or equity sections.
How It Works
The retention ratio shows what percentage of profits a company keeps to reinvest in operations, debt reduction, or new projects. It is a crucial factor for evaluating sustainable growth, as retained earnings provide internal funding without raising additional capital.
For example, a firm with a retention ratio of 70% reinvests most profits back into the business, which could support innovation or expansion. This contrasts with companies distributing most earnings as dividends, which might appeal to investors seeking steady income rather than growth.
Examples and Use Cases
Consider how the retention ratio applies in different industries and companies:
- Airlines: Delta typically balances reinvestment with dividends, reflecting capital-intensive operations requiring steady data analytics and strategic planning.
- Growth Stocks: Firms featured in the best growth stocks category often exhibit high retention ratios as they prioritize funding innovation and market expansion.
- Dividend ETFs: Funds focused on dividend ETFs usually include companies with lower retention ratios, favoring those that return more income to shareholders.
Important Considerations
While the retention ratio helps assess how earnings are allocated, it does not guarantee successful reinvestment outcomes. A high retention ratio may not translate into value creation if funds are poorly deployed.
Additionally, industry context matters: technology firms often have higher retention ratios due to ongoing R&D, whereas mature utility companies may maintain lower ratios to satisfy dividend-seeking investors. Always consider the retention ratio alongside other financial metrics and qualitative factors.
Final Words
A high retention ratio indicates a company prioritizes reinvestment for growth over immediate shareholder payouts. Review your portfolio to see how these reinvestment strategies align with your income and growth goals.
Frequently Asked Questions
Retention ratio measures the proportion of a company's net income that is kept for reinvestment in the business instead of being paid out as dividends to shareholders.
You calculate the retention ratio by dividing the retained earnings by net income, or by subtracting the dividend payout ratio from 1. The formula is (Net Income - Dividends Paid) / Net Income.
The retention ratio indicates how much profit a company reinvests for growth, which can signal future earnings potential. High ratios appeal to growth-focused investors, while low ratios suit those seeking dividend income.
A high retention ratio, typically above 70-90%, suggests the company is focusing on expansion, research and development, or reducing debt, aiming for long-term growth rather than immediate shareholder payouts.
Yes, they complement each other since the retention ratio equals 1 minus the dividend payout ratio. Together, they show how a company balances reinvesting earnings and distributing dividends.
Net income is found at the bottom of the income statement, dividends paid appear in the financing section of the cash flow statement, and retained earnings are listed under shareholders' equity on the balance sheet.
Not necessarily; a low retention ratio usually means the company prioritizes returning cash to shareholders through dividends, which can be attractive to income-focused investors, especially if growth opportunities are limited.
