What a company keeps rather than pays out
The retention ratio is the share of profit a company reinvests instead of distributing as dividends. It is the mirror of the payout ratio, and the two always sum to 100%.
The formula
Worked example: $600,000 retained from $1,000,000 of profit
- Retention ratio: 60%
- Payout ratio: 40%, or $400,000 in dividends
Why the ratio predicts growth
Retained profit is the capital a company grows with when it does not borrow or issue shares. Multiply the retention ratio by the return on equity and you get the sustainable growth rate — the pace the business can expand at without changing its financing.
| Retention | Return on equity | Sustainable growth |
|---|---|---|
| 60% | 10% | 6.0% |
| 60% | 15% | 9.0% |
| 80% | 15% | 12.0% |
| 20% | 15% | 3.0% |
A company that pays out 80% of profit and claims 12% growth is either borrowing to fund it or overstating it. The retention ratio is the quickest way to test that claim.
High retention is not automatically good
Retaining profit only creates value if the company can reinvest it above its cost of capital. A mature utility earning 6% on new projects with a 9% cost of equity destroys value by retaining, and should pay out instead.
Growth companies with abundant high-return projects retain everything; mature ones with few should retain little. The right ratio depends on what the money can earn inside the business against what shareholders could earn outside it.
Buybacks blur the picture
A company that retains 60% and spends half of that on repurchasing its own shares has effectively paid out 70%, not 40%. The accounting retention ratio counts buybacks as retained, which overstates reinvestment in companies that favour them over dividends.
What this calculator leaves out
Whether the retained profit is cash. A company can retain 60% of accounting profit while its cash flow is negative, if the profit sits in receivables or inventory rather than in the bank.
Reading it alongside the dividend history
A retention ratio that rises because dividends were cut tells a different story from one that rises because profit grew faster than the payout. The ratio is identical; the direction of travel is not.
Look at the absolute dividend over five years. A stable or rising payment with a rising retention ratio is a company growing into its distribution. A falling payment with the same ratio is one retreating from it.
Retention and the tax position of shareholders
Retained profit is taxed once, at the company. Distributed profit is taxed again in the hands of the recipient. For a shareholder facing a high dividend tax rate, retention that raises the share price is often worth more after tax than the same amount paid out.
Companies with tax-sensitive shareholder bases tend to retain more and buy back rather than distribute, which is a financing choice rather than a signal about growth prospects.
Related calculators
- Payout ratio calculator — the same figure from the other side
- Sustainable growth rate — what this ratio implies for expansion
- Return on equity — the other input to that growth figure