Plowback ratio represents the earnings that a company retains after paying for the dividends to the shareholders. The ratio is commonly known as retention ratio and is the opposite of the payout ratio, which represents the dividend paid out as a percentage of earnings.
The Plowback ratio tells about the amount of profit that has been plowed back or retained in the business. A company mostly uses this amount for business development and expansion. Therefore, growing companies usually plow back profit. Businesses that are established and have reached maturity level do not solely focus on reinvesting profit to expand the operations, rather pay back investors in the form of dividends.
Retention ratio would be 100% for companies that do not pay dividends. On the other hand, it is zero for the companies that pay their entire net income as dividends.
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Formula Plowback Ratio
Plowback Ratio = (Net Income – Dividends)/ Net Income
On a per-share basis, Plowback or Retention Ratio is (1- Dividend per share)/ EPS (earnings per share).
A company’s choice of accounting methods directly affects the plowback and dividend payout ratios. For example, a depreciation method that a company chooses impact the earnings per share, and this, in turn, affects the payout ratio.
Understanding Plowback Ratio
A common understanding is that when a company pays a higher dividend, investors should assign it a higher valuation. However, what usually happens is just the opposite as companies who pay higher dividends get weaker valuations in the market. This is because, investors expect the company to reinvest the profit and maintain the same or higher ROE.
Investors often face a question that what is the use of getting a higher dividend if they can’t reinvest it and get the same return as the company’s ROE. Therefore, the better option is to enable the company to reinvest it back into the business, provided the return on equity is better.
|ABC Ltd||Amount||XYZ Ltd||Amount|
|Total Equity||$10,00,00,000||Total Equity||$10,00,00,000|
|Net Profits 2018-19||$4,40,00,000||Net Profits 2018-19||$4,40,00,000|
|Dividend Paid||$66,00,000||Dividend Paid||$44,00,000|
|Dividend Payout Ratio||15%||Dividend Ratio||10%|
|Plowback Ratio||85%||Plowback Ratio||90%|
Return on Equity = Net Profit/Total Equity. For both ABC Ltd and XYZ Ltd, the ROE is 44%.
However, the dividend rate and Plowback ratio of both are different. ABC Ltd pays 15% of the profits as dividends and retains 85%. XYZ Ltd pays 10% of the profit as dividend and retains the rest.
In the above example, XYZ retains higher profit, and this, in turn, creates more wealth for the shareholders. More wealth could be in the form of higher dividends in the future, or appreciation in the share price.
There is, however, one more thing. If two companies are equal in every respect, the choice of company for investment purposes also depends on the type of investor. An income-oriented investor, who gives more importance to dividends, would go for a company with a low retention ratio. Growth investors, on the other hand, would prefer a company that is reinvesting the money for further growth.
Interpretation of Retention Ratio
One way to interpret the plowback ratio is that the higher the ratio, the less dependent the company is on debt and equity financing. Retained earnings are always better than debt and equity financing because it does not include any interest payment or risk. Moreover, unlike with equity financing, the company doesn’t have to worry about the dividend payment and other ways to incentivize investors if it has retained earnings.
A high retention ratio could mean that the management feels there is a need for cash internally, and that it would generate a higher return than the cost of capital. However, if the company is holding back funds for unproductive purposes, then investors may end up with a negative return on the funds.
On the other hand, if the management decides to bring down the retention ratio all of a sudden, it could mean that the profitable avenues for business are decreasing.
We can say that a higher retention ratio would suggest high growth periods. On the other hand, a lower ratio could mean that a business is expecting rough times ahead. However, this is not always true.
How it Help Investors?
Investors, mostly growth investors, use this ratio to identify companies that divert more funds into the operations. Growth investors believe that such companies would see an appreciation in the stock price over the long-run, resulting in capital gains for them.
However, if a company expects a business downturn, then using this ratio to invest in stock could prove wrong. It is possible that the company in increasing the retention level to prepare for the downturn that it expects in the future. Moreover, a sharp drop in the retention ratio could also be if the company doesn’t see any profitable investment opportunities in the near future.
On the other hand, income investors who prefer cash dividends usually avoid companies with more retention ratio. Even for income investors, a plowback ratio of close to 0% (or a payout ratio of close to 100%) could be a warning sign. A 100% payout ratio means that the company is distributing all earnings as dividends and that it doesn’t have sufficient cash to fund the capital needs. Or, the company may not be able to sustain 100% dividend going ahead.
Trends in Different Industries
Usually, tech companies have 100% retention ratio. Apple, for example, had a retention ratio of 100% until 2011. However, since 2012, the company is paying a dividend, and its retention ratio now is in the range of 70 %to 75%. High retention has helped Apple to register massive growth in the past years.
Companies in the consumer staples and pharmaceuticals have a comparatively more stable dividend and retention ratio than the companies in the Energy sector. The energy sector usually has volatile earnings.
Advantage and Disadvantages
Following are the advantages of this ratio;
- It is easy and simple to understand and calculate.
- There is more than one formula to calculate this ratio.
- It along with the dividend payout ratio helps to understand the growth plans of a company.
One limitation of using retention ratio is that the cash flow per share does not equal to the earnings per share. The cash flow per share is the total cash flow for the year divided by total shares. For instance, EPS (earnings per share) for a company is $3, while the cash flow per share is $2. In this case, the company does not have enough cash to pay a full $3 as dividends.
Also, there are no criteria for a high or low retention ratio. An investor needs to analyze other factors as well to comprehend the growth plans of a company. We can say that the retention ratio is merely an indicator of the company’s possible intentions.1,2