Retention

Retention (also known as 'Retained Earnings') is the portion of a company's profit that is kept or “retained” within the business after all costs, taxes, and dividends have been paid. Think of it as a company's savings. Just as you might set aside a part of your paycheck for future investments or a rainy day instead of spending it all, a company saves a portion of its profits to reinvest in its own operations. This retained cash is the primary fuel for a company's future growth—it can be used to fund research and development, upgrade machinery, expand into new markets, or pay down debt. For a value investing practitioner, understanding how much a company retains and, more importantly, how well it uses those retained funds is a cornerstone of analyzing a business's long-term potential. It’s not just about what a company earns; it’s about what it does with those earnings.

At its heart, retention is all about compounding. When a company retains a dollar of profit and successfully reinvests it to generate, say, a 15% return, that dollar becomes $1.15. The next year, that $1.15 can be reinvested to grow further. This is the magic of compounding at the corporate level, and it’s what can turn a good company into a spectacular long-term investment. The legendary investor Warren Buffett built his fortune by identifying companies that were masters of this process. He looks for businesses that can retain a large portion of their earnings and reinvest them at high rates of return. A company that can do this consistently creates a powerful, self-fueling engine for wealth creation. Conversely, a company that retains earnings but fails to invest them wisely destroys shareholder value. Therefore, high retention is not automatically good; it’s only good if management can deploy that capital effectively.

To measure a company’s retention, investors use a simple metric called the Retention Ratio. It shows what percentage of Net Income is plowed back into the company. The formula is:

• Retention Ratio = Retained Earnings / Net Income

Since a company can only do two things with its profit—pay it out or retain it—the ratio can also be calculated by looking at what it pays out:

• Retention Ratio = 1 - Dividend Payout Ratio

For example, if a company has a Dividend Payout Ratio of 40% (meaning it pays out 40 cents of every dollar in profit as dividends), its Retention Ratio is 60% (1 - 0.40). This means it keeps 60 cents of every dollar to reinvest.

You can find the data needed to understand retention in a company's annual or quarterly reports.

• The Income Statement: This is where you'll find the company's Net Income for the period.
• The Statement of Retained Earnings: This statement (sometimes part of the “Statement of Changes in Equity”) directly shows the flow. It starts with the beginning retained earnings, adds the net income for the period, and subtracts the dividends paid to arrive at the ending retained earnings.
• The Balance Sheet: This shows Retained Earnings as a cumulative figure under “Shareholders' Equity.” It represents the sum of all profits the company has ever retained throughout its history. By comparing this number from one year to the next, you can see the change, which primarily reflects the earnings retained during that year.

For a value investor, the retention ratio is just the starting point. The real analysis lies in judging the quality of that retention.

The most important question is: What return will the company generate on the money it keeps? To answer this, savvy investors look at profitability metrics like Return on Invested Capital (ROIC) or Return on Equity (ROE). Imagine two companies, A and B, both retain 100% of their profits.

• Company A consistently generates an ROIC of 20%. Every dollar it retains and reinvests creates 20 cents of new profit each year. This is fantastic for shareholders.
• Company B struggles to find good projects and only earns an ROIC of 3%. Shareholders would likely be better off if Company B paid out the profit as a dividend, allowing them to reinvest it elsewhere for a better return.

Warren Buffett famously proposed a “one-dollar test”: For every dollar of earnings a company retains, does it create at least one dollar of additional market value for its owners? If not, management is failing to create value with the shareholders' capital.

When analyzing a company's retention policy, here’s what to look for:

• Green Flags (Signs of Value Creation)
  1. High retention paired with a history of high and stable ROIC or ROE.
  2. A management team that clearly communicates its capital allocation strategy.
  3. Growth in earnings that is logically connected to the amount of capital being retained and the returns it generates.
• Red Flags (Signs of Value Destruction)
  1. High retention but low or declining ROIC. This suggests management is throwing good money after bad, perhaps through ill-advised acquisitions (a phenomenon Buffett calls “diworsification”).
  2. A growing pile of cash on the balance sheet with no clear plan for its use. This cash earns a very low return and acts as a drag on overall profitability.
  3. Management retaining earnings simply to make the empire bigger, rather than more profitable.