Plowback ratio represents the earnings that a company retains after paying the dividends to the shareholders. The ratio 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 but rather pay back investors in the form of dividends. It is also known as the retention ratio.
The Plowback 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.
Formula Plowback Ratio
Plowback Ratio = (Net Income – Dividends) / Net Income
On a per-share basis, Plowback 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 impacts the earnings per share, which affects the payout ratio.
You can calculate the plowback ratio on the plowback ratio calculator
Understanding Plowback Ratio
A common understanding is that investors should assign a higher valuation when a company pays a higher dividend. 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 the question of 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, providing a better return on equity.
|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%|
There are two companies in the above example with identical equity bases and net profits. Return on Equity (ROE) is, therefore, the same for both companies.
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 a 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 Plowback ratio. Growth investors, on the other hand, would prefer a company that is reinvesting the money for further growth.
Interpretation of Plowback 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 they do not include interest payments or risks. 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 Plowback 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 plowback ratio all of a sudden, it could mean that the profitable avenues for business are decreasing.
We can say that a higher plowback ratio would suggest high growth periods. On the other hand, a lower ratio could mean that a business expects 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 their 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 increase the plowback level to prepare for the downturn that it expects in the future. Moreover, a sharp drop in the plowback 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 plowback ratios. A plowback ratio of close to 0% (or a payout ratio of close to 100%) could be a warning sign even for income investors. 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 a 100% dividend going ahead.
Trends in Different Industries
Usually, tech companies have a 100% Plowback ratio. Apple, for example, had a plowback ratio of 100% until 2011. However, since 2012, the company is paying a dividend, and its plowback ratio now is in the range of 70 %to 75%. High plowback 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 plowback 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 the plowback 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, a company’s EPS (earnings per share) 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 plowback ratio. An investor needs to analyze other factors as well to comprehend the growth plans of a company. We can say that the plowback ratio is merely an indicator of the company’s possible intentions.
Quiz on Plowback Ratio