What it means
Every dollar of profit faces the same fork: distribute it or reinvest it. Reinvesting is only the better choice when the return the business can earn on that dollar beats what shareholders could earn elsewhere at comparable risk.
The share of profit kept in the business is the retention ratio, which is simply one minus the dividend payout ratio. Multiplying the retention ratio by return on equity gives the sustainable growth rate, the pace at which a company can grow without new borrowing or new shares.
Young growth companies typically retain everything and pay nothing, while mature businesses with fewer opportunities hand cash back instead. A company that keeps reinvesting after its returns have fallen below its cost of capital is destroying value, however impressive the growth headline looks.
Investors meet the idea in a second and narrower sense: dividend and interest reinvestment. A holding that returns 7% a year compounds far faster when the income is reinvested than when it is spent, which is why total return figures assume reinvestment while price charts do not.
There is also reinvestment risk, which mainly troubles bondholders. When a bond matures or is repaid early, the money has to be put back to work at whatever rates prevail then, so if rates have fallen the investor's income drops even though nothing went wrong with the original bond.
In practice
Real-world examples.
Example
A regional grocery chain earns $15,000,000 and reinvests $12,000,000 of it in six new stores at about $2,000,000 each. The remaining $3,000,000 goes to shareholders, and the board judges the decision on whether the new stores return more than the group's 9% cost of capital.
Example
A private investor holds 4,000 shares paying an annual dividend of $1.20, giving $4,800 of income. With the shares trading at $40 and a reinvestment plan in place, that income buys $4,800 / $40 = 120 more shares, so next year's dividend is paid on 4,120 shares without any new money.
Example
A charity's $500,000 bond paying 6% matures, producing $30,000 a year of income it had been relying on. Replacement bonds of similar quality now yield 3.5%, so the reinvested capital generates $17,500, and the trustees have to cut $12,500 from the grants budget.
Formula
Calculation
Retention ratio = retained earnings / net income = 1 - dividend payout ratio
Sustainable growth rate = return on equity x retention ratio
A specialist manufacturer earns net income of $4,000,000 and pays dividends of $1,000,000, so it retains $3,000,000. The retention ratio is $3,000,000 / $4,000,000 = 75%, and the payout ratio is the remaining 25%.
Shareholders' equity at the start of the year was $25,000,000, so return on equity is $4,000,000 / $25,000,000 = 16%. The sustainable growth rate is therefore 16% x 75% = 12%.
That figure can be checked directly. Equity grows to $25,000,000 + $3,000,000 = $28,000,000, and earning the same 16% on it produces $28,000,000 x 16% = $4,480,000 of profit next year, which is exactly 12% more than $4,000,000.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Ferngate Tooling, an invented family owned engineering firm, had for years paid out its entire annual profit of about $2,000,000 to the four family shareholders. Its equipment was ageing, its lead times were slipping, and it was losing work to competitors with newer machines.
A new finance director laid out the arithmetic. Shareholders' equity was $10,000,000, so the business was earning a return on equity of 20%, and every dollar paid out was a dollar not compounding at that rate. The family agreed to retain 60% of profit, or $1,200,000 a year, giving a sustainable growth rate of 20% x 60% = 12%.
Five years later the fictional company's annual profit had grown from $2,000,000 to roughly $3,500,000, and the 40% payout was worth about $1,410,000. That was still less cash each year than the old arrangement, but the family owned a business worth substantially more, and the shareholders who wanted income had been bought out along the way at a price the retained profits had helped support.
Watch out
Common mistakes.
- Assuming reinvestment is always the responsible choice, when reinvesting at returns below the cost of capital destroys value more quietly than paying a dividend ever would.
- Confusing retained earnings with cash, since a company can have a large retained earnings balance and no money in the bank because the profits are already sitting in stock and equipment.
- Comparing investment returns using price charts alone, which understates the outcome for income paying assets because they exclude reinvested dividends.
Questions
People also ask.
What is the difference between reinvestment and retained earnings?
Retained earnings is the accounting balance of profits not yet distributed, while reinvestment is the act of actually putting that money to work in the business.
Does reinvesting dividends have tax consequences?
In most systems yes, a reinvested dividend is still taxed as income in the year it is declared, even though no cash reached the investor.
What is reinvestment risk?
It is the risk that money returned from an investment has to be redeployed at lower rates than the original holding earned, which is why callable bonds tend to be called when rates fall.
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