====== Retention Ratio ======
The Retention Ratio (also known as the Plowback Ratio) is a straightforward but powerful metric that shows what percentage of a company's [[net income]] is kept and reinvested back into the business. Think of it as a company's "savings rate." Instead of paying all its profits out to shareholders in the form of [[dividends]], the company "retains" a portion to fund future growth, pay down debt, or make acquisitions. This single number tells a fascinating story about a company's strategy and its management's confidence in its own future. A high retention ratio suggests a company is in growth mode, betting on itself to generate better returns than shareholders could get elsewhere. A low ratio often signals a mature, stable company with fewer high-growth projects, choosing instead to reward its investors with cash.
===== What Does the Retention Ratio Tell Us? =====
For a [[value investing]] enthusiast, the retention ratio is a starting point for a deeper investigation. It’s the flip side of the coin to the [[payout ratio]] (which measures the percentage of earnings paid out as dividends). If a company has a payout ratio of 40%, its retention ratio is 60%. Simple as that.
This ratio provides a window into the mind of a company's management. Are they:
  * **Ambitious Growers?** A young, dynamic company like a tech startup in its prime might have a 100% retention ratio. It needs every penny to fuel research, development, and expansion. It believes—and wants you to believe—that a dollar reinvested in the business today will be worth much more than a dollar in your pocket.
  * **Mature Cash Cows?** A well-established utility or consumer goods company might have a low retention ratio (e.g., 20%). It has limited opportunities for explosive growth and instead opts to reward its loyal shareholders with a steady stream of dividend income.
Understanding this ratio helps you align your investment goals with the company's operational strategy. If you're looking for growth, a high retention ratio might be attractive. If you're an income investor, you'll likely favor companies with a lower one.
===== The Formula and a Simple Example =====
Calculating the retention ratio is refreshingly simple. There are two common ways to do it.
==== The Formulas ====
You can either calculate it directly from the income statement and dividend information or by using the payout ratio.
  - **Method 1:** Retention Ratio = ([[Net Income]] - Total Dividends) / Net Income
  - **Method 2:** Retention Ratio = 1 - [[Payout Ratio]]
==== A Worked Example ====
Let's imagine a fictional company, "Durable Goods Inc."
In its last fiscal year, Durable Goods Inc. reported:
  * Net Income: $500 million
  * Total Dividends Paid: $150 million
Using Method 1, the calculation is:
  * ($500 million - $150 million) / $500 million
  * $350 million / $500 million = 0.70 or **70%**
This means Durable Goods Inc. reinvested 70% of its profits back into the company and paid out the remaining 30% to its shareholders.
===== The Value Investor's Perspective =====
A high retention ratio is not automatically good, and a low one is not automatically bad. The real magic—or tragedy—lies in what the company //does// with that retained cash.
==== The Key Question: How Well Is the Capital Reinvested? ====
This is the most important question a value investor can ask. Retaining earnings is only a good idea if the company can invest that capital at a high rate of return. A company that retains 80% of its earnings but only generates a paltry 2% return on that new capital is destroying shareholder value. You would have been better off receiving that cash as a dividend and investing it yourself.
Look at the retention ratio in conjunction with metrics like [[Return on Equity (ROE)]] or [[Return on Invested Capital (ROIC)]]. A high retention ratio paired with a high and stable ROIC is the hallmark of a fantastic compounding machine—a business that is skillfully turning retained profits into even greater future profits.
==== Warren Buffett on Retained Earnings ====
The legendary investor [[Warren Buffett]] has a simple test for this. He argues that a company's management has a duty to retain earnings only if they can create more than one dollar of market value for every dollar they keep. If a company retains $1 million in earnings, the market value of the company should, over time, increase by //at least// $1 million as a result. If it doesn't, management has failed its shareholders. This principle forces you to focus not on the act of retaining earnings itself, but on the //value created// by that act.
===== Pitfalls and Considerations =====
While useful, the retention ratio should never be viewed in a vacuum. Always consider the context:
  * **Empire Building:** Be wary of management teams that retain cash simply to grow the size of their corporate empire, even if the investments are unwise. A high retention ratio coupled with declining returns is a major red flag.
  * **Future Plans:** A company might temporarily have a high retention ratio because it's saving up for a large acquisition or a major capital project. This requires you to dig into the company's reports and investor presentations to understand management's intentions.
  * **Industry Norms:** Compare a company's retention ratio to its direct competitors. What is normal for the industry? A deviation from the norm isn't necessarily bad, but it does demand an explanation.
Ultimately, the retention ratio is a fantastic tool for framing your analysis. It helps you understand a company's capital allocation strategy, which is the very heart of long-term value creation.