How to Calculate the Retention Ratio

Generally, companies distribute a part of their profits among stockholders as dividends and retain the rest to invest back into the business. The ratio of retained earnings to net income is calculated using the retention ratio formula.

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But why is the retention ratio important? Well, it helps to indicate a company’s financial health and show how it’s reinvesting in growth opportunities. Investors calculate companies’ retention ratios to decide which stocks to invest in, with expectations of short- and long-term gains.

This article provides an in-depth look at the retention ratio, its interpretation, and how you can use it along with other metrics to select stocks wisely. Use these links to jump to specific topics:

• What is the retention ratio?
• Calculating the retention ratio
• Interpreting the retention ratio
• Practical retention ratio examples‍‍

‍What is the retention ratio?

The retention ratio is the ratio of a company’s retained earnings to its net income. The retention ratio is also known as the plowback ratio, earnings retention ratio, or net income retention ratio.

Companies periodically pay dividends to reward their existing stockholders and incentivize new ones. Company management decides the amount of dividend per share, and each shareholder periodically (quarterly, in some cases) receives the dividend amount multiplied by the number of shares they hold.

Alternatively, the company can retain its earnings and reinvest in growth-oriented activities, such as R&D, marketing, or technology upgrades.

Many companies adopt a mix of the two. They direct a proportion of their cash flow toward stockholders and retain some to fund growth operations.

Investors often complete a retention ratio analysis to speculate on how much  the company focuses on growth. A higher retention ratio means that the company is putting most of its net profit back into the business, which is a good sign for growth investors because a company’s growth pushes its stock prices higher. Investors who buy stocks of companies with a high retention ratio hope to earn big profits by selling the stocks when the share prices of the company increase.

Alternatively, investors who want to earn income through dividends might buy shares in companies with a lower retention ratio.

Calculating the retention ratio

There are two retention ratio formulas. The first one is simple and takes the net and retained revenue into consideration. The second formula considers the dividends distributed as well.

Before applying the formulas, though, it helps to know some variables.

• Retained earnings. The proportion of net income invested back into the company
• Net income. Total company profits after deducting allowances, taxes, and costs
• Dividends distributed. Total dividends distributed to shareholders

The value of these variables is generally found at the bottom of a company’s filed earning reports. You can use quarterly or annual values to calculate the retention ratio.

Primary method

The primary way of calculating the retention ratio is:

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Let’s look at an example for a better understanding.

Shoe-In Inc.—a fictional footwear business—had $1 million in net income in 2019. Back then, the company worked aggressively on paying off debts and expanding its product line. Management decided to retain all earnings for reinvestment.

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A 100% retention ratio tells investors that Shoe-In Inc. is reinvesting its entire profit. Growth investors who think that Shoe-In Inc. will become profitable in the future may consider buying its stocks.

In 2020, Shoe-In Inc. generated $5 million in net income and retained $4.2 million.

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An 84% retention ratio indicates that the company is still focused on growth and paying low dividends.

In 2021, Shoe-In Inc. generated $10 million in net income. Management decided to invest in new technology and distribute only $640,000 to stockholders, retaining a revenue of $9.36 million.

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Shoe-In Inc. has had a high retention ratio in the last three years, which is likely to continue in the future. Growth investors may want to buy and hold onto this company’s stock. Investors looking for short-term gains through dividends might avoid investing in this stock.

Secondary method

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Continuing the previous example, suppose that the management of Shoe-In Inc. decided to pay a quarterly dividend of $1 per share in 2020. If the company sold 200,000 shares and paid dividends quarterly, it paid a total of $800,000 to its stockholders ($200,000 x 4 = $800,000).

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In 2021, Shoe-In Inc. management decided to invest in new technology and reduce the quarterly dividend amount to $0.80 per share. With 200,000 stockholders paid quarterly, the company spent $640,000 in annual dividend payments.

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Both retention ratio formulas yield the same results. Depending on the data available, you can apply either.

Interpreting the retention ratio

You can use the retention ratio to speculate on a company’s financial health and its approach to growth. A high retention ratio—as typically seen with start-ups and growth companies—may indicate that the company is gearing up for fast growth. Investors who buy stocks in such companies believe that the value of their shareholdings will increase in the future and they will be able to sell their shares at a considerable profit.

Income stocks are shares of companies with low retention or plowback ratios, offering higher dividends per share. Generally, mature companies with huge profits have low retention ratios. The prices of such stocks grow at an average but steady rate, so some investors prefer them because of the low risk associated.

Bear in mind, though, that not all established companies have low retention ratios. For example, several of the largest S&P 500 companies pay zero dividends.

The retention ratio shouldn’t be used by itself. A high earnings retention ratio may not necessarily imply that a company is reinvesting 100% of its retained earnings into growth operations. Instead, it could just be hoarding money. A low retention ratio can also mean that the company cannot identify future growth opportunities and is instead distributing profits among shareholders.

Also, a high or low retention ratio doesn’t guarantee an increase or decrease in company stock prices in the future. Other factors, such as assets, debts, and liabilities, can also affect a company’s stock prices. Calculating a few financial ratios and metrics may not give a clear picture of a company’s financial health.

Analyzing financial metrics like shareholders’ equity, the reinvestment rate, dividend payout ratio, or return on equity over a period of time (along with retention ratio) can provide a more accurate analysis of stocks by helping you identify trends.

Practical retention ratio examples

Now, let’s calculate the retention ratio of two real-life companies using the two different retention ratio formulas.

The Home Depot

Below are screenshots of statements from The Home Depot’s annual report for 2018, 2019, and 2020.

HIGHLIGHT OF ANNUAL FINANCIAL PERFORMANCE

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The company reported net earnings of $12.866 billion in 2020. In the same year, the company paid $6.451 billion as dividends and $10 million as other expenses, retaining earnings of $6.405 billion in 2020. Note that we can obtain the retained earnings by subtracting the cumulative balance at the start of 2020 from the cumulative balance at the end of 2020 ($58,134 - $51,729M = $6,405M).

By applying values in the primary formula, the retention ratio comes out to be about 50%.

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The Home Depot is a well-established company with a profitable business model. A retention ratio of 50% can make The Home Depot appealing to investors interested in income generation or those with a low-risk appetite.

Electronic Arts

Here’s an example that demonstrates the second formula.

The third quarter of EA fiscal year 2021 ended on Dec. 31, 2020. EA reported a net income of $211 million for the three months. In Q3, EA paid a dividend of $0.17 per share, and the total number of shares outstanding in Q3 was 290 million. So, the total amount of dividends distributed in Q3 was $49.3 million.    

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Using the alternative formula, we obtain a retention ratio of 77%.

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EA stock prices have gone up by approximately a factor of 7 in the last decade (from $16.69 on March 1, 2012, to $128.15 on March 1, 2022). This boost in stock price and a retention ratio on the higher side makes EA stocks lucrative for bullish investors (i.e., investors hoping for EA stock prices to soar even higher).

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