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Retaining Earnings: What It Is, How It Works, and Its Impact on Investors

Last updated 04/09/2024 by

Abi Bus

Edited by

Fact checked by

Summary:
The retention ratio, also known as the plowback ratio, is the percentage of a company’s earnings kept in the business as retained earnings for growth, rather than being distributed as dividends to shareholders. This article explains the concept of the retention ratio, its significance for investors, how to calculate it, and its real-world applications. Discover the key takeaways and limitations of this financial metric to make informed investment decisions.

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What is the retention ratio?

The retention ratio is a critical financial metric that reflects the portion of a company’s earnings retained in the business for future growth, as opposed to being paid out as dividends to shareholders. This ratio is also referred to as the plowback ratio. It stands in contrast to the payout ratio, which measures the percentage of profits distributed to shareholders as dividends.

Understanding the retention ratio

When a company generates profits at the end of a fiscal period, it has various options for utilizing these funds. Management can opt to distribute the profits to shareholders as dividends, retain them for reinvestment in the business, or employ a combination of both. The segment of profits that a company chooses to keep and not pay out as dividends is referred to as retained earnings.
Retained earnings can be likened to a savings account where accumulated profits are kept within the company instead of being distributed to shareholders. These profits can also be reinvested into the business to fuel growth.

How to calculate the retention ratio

The retention ratio can be calculated using two different formulas:
The first formula involves retained earnings from the balance sheet:
Retention ratio = Retained earnings / Net income
To apply this formula:
  1. Obtain the net income figure from the income statement.
  2. Divide the company’s retained earnings by the net income figure.
The alternative formula does not use retained earnings but instead subtracts dividends distributed from net income and divides the result by net income:
Retention ratio = (Net income – Dividends distributed) / Net income

Special considerations

The retention ratio is typically higher for growth-oriented companies experiencing rapid revenue and profit increases. Companies in such stages prioritize reinvesting earnings to achieve faster growth compared to what shareholders could attain by receiving dividends.
Investors may be willing to forgo dividends when a company exhibits high growth potential, which is common in sectors like technology and biotechnology.
In technology companies, especially those in the early stages of development, the retention rate is generally 100%, as they seldom pay dividends. In mature sectors like utilities and telecommunications, with expectations of reasonable dividends, the retention ratio tends to be low due to higher dividend payouts.
The retention ratio can fluctuate from year to year, depending on a company’s earnings volatility and dividend payment policy. Blue-chip companies often maintain a policy of steadily increasing or at least stable dividends. Companies in defensive sectors like pharmaceuticals and consumer staples typically exhibit more stable payout and retention ratios compared to energy and commodity companies, whose earnings are subject to greater cyclical variation.

Limitations of using the retention ratio

One limitation of the retention ratio is that companies with significant retained earnings may have a high ratio without necessarily reinvesting those funds effectively.
Furthermore, the retention ratio does not provide insight into how the retained earnings are invested or whether such investments are effective. It is advisable to combine the retention ratio with other financial metrics to assess how well a company deploys its retained earnings.
When analyzing the retention ratio, it’s crucial to compare results with other companies in the same industry and monitor the ratio over multiple quarters to identify any trends.

Real-world example

As an illustration, let’s consider the balance sheet of Meta (formerly Facebook), as reported in the company’s annual 10-K filing on January 31, 2019:
In the shareholders’ equity section, Meta’s retained earnings amounted to $41.981 billion (highlighted in green).
From the company’s income statement (not shown), it posted a profit or net income of $22.112 billion for the same period.
To calculate the retention ratio, we divide retained earnings by net income: $41.981 billion / $22.112 billion, which equals 1.89 or 189%.
The high retention ratio in this case results from the company’s accumulation of profit and lack of dividend payments. Meta had ample retained earnings to invest in its future. High retention ratios are often associated with technology companies.
This comprehensive understanding of the retention ratio can assist investors in evaluating a company’s financial strategy and growth potential.
WEIGH THE RISKS AND BENEFITS
Here is a list of the benefits and the drawbacks to consider.
Pros
  • Facilitates business growth: A high retention ratio enables companies to reinvest profits for expansion.
  • Enhances shareholder value: Effective reinvestment can lead to increased share prices and long-term gains.
  • Attracts investors: Growth potential can attract investors seeking capital appreciation.
Cons
  • Reduced immediate income for shareholders: High retention ratios mean fewer dividends for investors in the short term.
  • Risk of inefficiency: Companies with high retention ratios must ensure effective reinvestment to justify retaining profits.
  • Varies by industry: The impact of retention ratios differs across sectors, making it less universally applicable.

Frequently asked questions

What is the difference between the retention ratio and the payout ratio?

The retention ratio measures the proportion of earnings a company retains for reinvestment, while the payout ratio represents the portion of earnings paid out to shareholders as dividends.

Do all companies use retained earnings for growth?

No, not all companies use retained earnings for growth. Some may choose to pay out a significant portion as dividends, while others reinvest a substantial amount.

Is a high retention ratio always beneficial for investors?

A high retention ratio can be beneficial if the company effectively reinvests retained earnings for growth. However, if the reinvestment is inefficient or the company does not offer dividends, it may not be advantageous for investors.

What industries typically have high retention ratios?

Industries with high growth potential, such as technology and biotechnology, often have high retention ratios. Conversely, sectors with mature companies, like utilities and telecommunications, tend to have lower retention ratios.

Key takeaways

  • The retention ratio signifies the percentage of earnings retained by a company for reinvestment and growth, rather than being distributed as dividends.
  • The payout ratio, conversely, represents the proportion of profits paid out to shareholders as dividends.
  • Retained earnings denote the net income left over after dividend payments and are akin to a company’s savings account.
  • Investors use the retention ratio to gauge how effectively a company is reinvesting profits into its operations.
  • Growth-oriented companies tend to have higher retention ratios as they prioritize reinvesting profits for rapid expansion.

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