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Find the retention rate of Zeta Limited, when:
Retention Rate = 1 − payout ratio = 1 – ($1 ÷ $2) = 1 – 0.50 = 0.50 = 50%
When companies offer dividends, they normally retain part of their earnings to meet future expenses. Retention rate measures the amount of earnings that a company keeps (retains) after they pay out dividends. Also known as the plowback ratio, the retention rate is calculated as annual earnings (after dividends are distributed) divided by total earnings for the year. In short, this ratio measures the part of total earnings that a company reinvests, rather than pays out to shareholders.
Investors are interested in learning a company’s retention ratio. A higher ratio means that more money is put back into the company. This might mean the company is poised for growth. Investors can also use the retention ratio to calculate the maximum sustainable growth rate of a company. This growth rate is determined by multiplying the company’s return on equity by the retention ratio. The return on equity can usually be found in the company’s annual report.
The higher a company’s retention rate, the higher its sustainable growth rate and share price are likely to be. However, the appropriateness of high or low values depends on the type of company being analyzed. The faster a company grows, the more desirable a higher plowback ratio would be. With slow-growing companies, investors often prefer a large payout ratio (higher dividends).
Retention rate = Earnings retained ÷ total earnings = 1 - minus payout ratio (expressed as a decimal)