Retention Ratio

The retention ratio, also called the plowback ratio, shows how much of each year's profit is reinvested in the company.

For example, a company with net income of 100 million that pays 40 million in dividends retains 60 million. Its retention ratio is 60%.

Retained profits add to shareholders' equity and fund investments such as new equipment, research, acquisitions or debt reduction. A high retention ratio is common for growing companies that have many attractive investment opportunities.

The retention ratio is a key ingredient in estimating how fast a company can grow without raising new capital. Multiplying the retention ratio by return on equity gives the sustainable growth rate. If a company retains 60% of its profits and earns an ROE of 12%, it can grow at about 7.2% a year using only its own profits, assuming its financial structure stays the same.

A high retention ratio is only valuable if the company invests the money well. Retaining profits and earning low returns on them can destroy value compared with paying them out to shareholders.