Retention ratio (also known as plowback ratio) is the percentage of a company's earnings retained and reinvested by the company. Retention ratio is the opposite of payout ratio.
Equity shareholders invest in a company expecting payback in the form of dividends and capital gains. A company's board of directors takes its dividend policy decisions i.e. decisions about the extent and timings of dividend payments. If the company has surplus cash, the board may decide to pay a higher dividend resulting in lower retention rate. But if they believe more profitable investment opportunities are available and that the company may generate higher future earnings by availing those opportunities, the board may elect to pay less dividends or do not pay dividends at all, and instead invest the money in future projects, in which case the company will have higher retention ratio (and lower payout ratio).
Retention ratio is calculated by dividing earnings retained during the period by total earnings for the period. Earnings retained during a period equals total earnings for the period less total dividend payments during the period.
|Retention Ratio =||Earnings Retained||=||1 - total dividends||=||1 - dividends per share|
|Total Earnings||Total earnings||Earnings per share|
Retention ratio can also be calculated as 1 minus payout ratio.
Retention ratio = 1 – Payout Ratio
Higher retention ratio of a company suggests that it may generate higher growth in future periods resulting in higher share price and potential capital gain. A lower retention ratio means that the company's management is not so confident about future profitability and has elected to pay back cash to the investors.
Retention ratio and future growth potential are so much linked that future sustainable growth rate is calculated as a product of retention ratio and return on equity of the company.
Analyse the financial position and future outlook of Company A and Company in light of their retention ratio.
|Company A||Company B|
|EPS for last year||$3.2||$8.4|
|Dividends paid per share during last year||$2.8||$1.4|
|Net cash flows from investing activities||Positive||Negative|
Retention ratio for Company A = $2.8 ÷ $3.2 = 88%
Retention ratio for Company B = $1.4 ÷ $8.4 = 17%
Retention ratio of Company A suggests that the company is struggling to find any profitable opportunities. Lack of opportunities is leaving the company with no other option but to pay out cash to investors. The analysis is further supported by the fact that it operates in a very stable industry and that its net cash flows from investing activities during the period are positive.
The retention ratio, industry and the fact that Company B has net negative cash flows from investing activities tell that Company B has invested significantly in future projects.
Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork