Retention Ratio

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What is the 'Retention Ratio'

The retention ratio is the proportion of earnings kept back in the business as retained earnings. The retention ratio refers to the percentage of net income that is retained to grow the business, rather than being paid out as dividends. It is the opposite of the payout ratio, which measures the percentage of earnings paid out to shareholders as dividends.

The formula for the retention ratio is:

Retention Ratio = (Net Income - Dividends) / Net Income

On a per-share basis, the retention ratio can be expressed as 1 – (Dividends per share / EPS).

The retention ratio is also known as “plowback ratio.”

BREAKING DOWN 'Retention Ratio'

Companies that make a profit at the end of a fiscal period can do a number fo things with the profit they earned. They can pay it to shareholders as dividends, they can retain it to reinvest in the business for growth, or they can do both. The portion of profit that a company chooses to retain for its business operations can be measured with the retention ratio.

For example, on November 29, 2017, The Walt Disney Company declared a $0.84 semi-annual cash dividend per share to shareholders of record December, 11, to be paid January, 11. As of the fiscal year ended September 30, 2017, the company's EPS was $5.73. Its retention ratio is, therefore, 1 - ($0.84/$5.73) = 0.8534, or 85.34%.

The retention ratio is a converse concept to the dividend payout ratio. The dividend payout ratio evaluates the percentage of profits earned that a company pays out to its shareholders. It is calculated simply as dividends per share divided by earnings per share (EPS). Using the Disney example above, the payout ratio is $0.84/$5.73 = 14.66%. This is intuitive as you know that a company keeps any money that it doesn't pay out. Of its total net income of $8.98 billion, Disney will pay out 14.66% and retain 85.34%. The retention ratio is 100% for companies that do not pay dividends, and is zero for companies that pay out their entire net income as dividends. Since both ratios are connected, knowing one of the ratios can give you the other, as in the formula below:

Deriving the retention ratio from the payout ratio

The retention ratio is typically higher for growth companies that are experiencing rapid increases in revenues and profits. A growth company would prefer to plow earnings back into its business if it believes that it can reward its shareholders by increasing revenues and profits at a faster pace than shareholders could achieve by investing their dividend receipts.

Investors may be willing to forego dividends if a firm has great growth prospects, which is typically the case with companies in sectors such as technology and biotechnology. The retention rate for technology companies in a relatively early stage of development is generally 100%, as they seldom pay dividends. But in mature sectors such as utilities and telecommunications, where investors expect a reasonable dividend, the retention ratio is typically quite low because of the high dividend payout ratio.

The retention ratio may change from one year to the next, depending on the company’s earnings volatility and dividend payment policy. Many blue-chip companies have a policy of paying steadily increasing or, at least, stable dividends. Companies in defensive sectors such as pharmaceuticals and consumer staples are likely to have more stable payout and retention ratios than energy and commodity companies, whose earnings are more cyclical.

Dividend-paying stocks became all the rage in the low interest-rate environment that prevailed post-recession 2008-09. As an increasing number of companies – even those in sectors that had hitherto not paid dividends, such as gold producers – began paying dividends, their retention rates declined, as investors put more value on current income than on the promise of (higher) potential income down the road.