The part of net earnings that the company holds back with itself after distributing dividends to the shareholders is termed as retained earnings. And, the plow back ratio is a metric to indicate this portion kept with the company. It is also known as the retention ratio. The plow back ratio calculator helps in a quick calculation of the same.
A company retains earnings in the company for its routine needs as well as for upcoming projects which will eventually contribute to the growth of the company. This simply means that the company is paying lesser dividends today to pay more in the future by earning from the retention and reinvestment.
A company with high growth opportunities will retain more or a whole of earnings. While, companies that do not have growth opportunities, may not retain anything and payout the whole of their earnings as dividends to shareholders. These are the companies that have touched their maturity level or whose scope of growth is very limited or nil. So there can be extremes scenarios wherein either no dividends or entire earnings are distributed as dividends. However, mostly the situation falls in between these two scenarios.
The plow back ratio is in complete contrast to the payout ratio. The payout ratio determines the dividends paid out of the net income and the left out portion is therefore retained by the company.
Plow Back Ratio Formula
The Formula to calculate plow back ratio is as follows:
Plow back Ratio = (Net Income – Dividends) / Net Income
This difference of net income and dividend is the retention made by the company.
As said above, the plow back ratio is in complete contrast to the payout ratio, we can also calculate the plow back ratio by the following formula:
Plow back Ratio = 1 – Payout Ratio
The payout ratio is nothing but the dividend paid out per share from the earnings made per share. Therefore, we can also write the above formula as:
Plow back Ratio = 1 – (Dividend per Share / Earnings per Share)
Plow Back Ratio Calculator
How to Calculate using Plowback Ratio Calculator
The followings particulars are to be entered into the plow back ratio calculator.
Net income refers to the actual earnings of the company after allowing for business expenditures and taxes. A positive income determines that the income of the company is more than its expenditures or vice versa.
The formula for calculating it is:
Net Income = Gross Income – Business Expenditures
To know more about net income, you can refer to our article – Net Income
Part of the net income paid to shareholders for their investment in the company is dividends.
Example of Plow Back Ratio
For a better understanding of the concept, let us take an example.
Assume that a company Alpha has a net income of $5,000,000 and it distributes $1,250,000 as dividend among the shareholders. While another company Beta has net income of $5,105,000 and it distributes $510,500 as dividends. Hence, the retention ratio of both the Alpha and Beta is:
Plowback Ratio of Alpha = 3,000,000 / 5,000,000 = 0.60 or 60%
Plowback Ratio of Beta = 4,594,500 / 5,105,000 = 0.90 or 90%
(Net Income – Dividend)
Plow Back Ratio and Interpretation
A direct interpretation by saying that company Beta is retaining more, hence, it has a better retention ratio or company Alpha is paying more dividend, hence, it is better, is not correct. While making a comparison between the two, it is crucial to know whether both companies belong to the same industry or not. If the answer to this is yes, only then it is correct to make a comparison.
Assuming that both Alpha and Beta are from the same industry, the Beta will have a better retention ratio if the growth opportunities are higher in the industry. As retaining for further investment and growth is the more feasible solution rather than raising funds from outside. On the contrary, if the growth rate is lower, it is better to distribute more dividends and retain less. Therefore, Alpha is better in this case. Moreover, despite being in the same industry, the stage at which the company is makes a difference in the approach and evaluation. So after understanding and appreciating that stage, one can say whether higher payout or higher plow back ratio is a preferable one for the company.