Retention ratio (also known as plowback ratio) is the percentage of a company's earnings that are retained and reinvested by the company. It equals 1 minus the dividend payout ratio.
Equity shareholders invest in a company expecting a return in the form of dividends and/or capital gains. A high dividend yield and high capital gains yield are mutually-exclusive. It is because a company can grow only if it reinvests most of its surplus cash in new projects. But this leads to a low dividend payout ratio and high retention ratio. A company's board of directors takes its dividend policy decisions i.e. decisions about the extent d timings of dividend payments considering it surplus cash balance and available investment opportunities. If the company has surplus cash i.e. cash which is more than the company's initial investment requirement for new projects, the board may decide to pay a higher dividend resulting in lower retention ratio.
Retention ratio can be computed by dividing increase in retained earnings during the period by net income for the period. Earnings retained during a period equals total earnings for the period less total dividend payments during the period.
|Retention Ratio =||Net Income - Dividends||=||1 - Total Dividends||=||1 - Dividends per Share (DPS)|
|Net Income||Net Income||Earnings per share (EPS)|
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 stock 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 highly-related 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 B 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. It has no 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.
On the other hand, Company has higher retention ratio, a growing industry and a net negative cash flows from investing activities which means it has invested significantly in future projects.