Plowback Ratio

Plowback ratio also called a retention ratio, is the ratio of the remaining amount after the dividend is paid out and the net income of the company. A company which pays a 20 million USD dividend out of 100 million USD net income, has a plowback ratio of 0.8.

This ratio indicates the quantum of profit retained in a business instead of being paid out to the investors. It generally represents the portion of retained earnings, which could have been distributed in the form of dividends. For instance, a firm having a Plowback of, say, 1.5% indicates that significantly less or no dividend has been paid, and most of the profits have been retained for business expansion.

We note below that Amazon and Google have a Plowback of 100% (they retain 100% of profit for reinvestments), whereas Colgate's Plowback is 38.22% in 2016.

This ratio is the opposite of the Dividend Payout Ratio calculated as:

1 – (Annual Dividend Per Share / Earnings Per Share)

Let us assume Company 'A' reported earnings per share of $10 and decided to pay $2 in dividends. With the above ratio, the Dividend pay-out ratio is: $2 / $10 = 20%

This means Company 'A' distributed 20% of its income in dividends and re-invested the rest in the company, i.e., 80% of the money was ploughed back into the company. Thus,

Plowback formula = 1 – ($2 / $10) = 1- 0.20 = 0.80 = 80%

This formula indicates how much profit is getting re-invested towards the company's development instead of distributed as returns to the investors.

• Higher Plowback is usually followed by Fast-growing and dynamic businesses that believe in supportable economic conditions and persistent high-growth periods.
• Matured businesses generally adopt a lower level of plowback, indicating sufficient cash holdings and sustainable business growth opportunities.

The size of the plowback ratio will attract different types of customers/investors.

• Income-oriented investors would expect a lower plowback, as this suggests high dividend possibilities to the shareholders.
• Growth-oriented investors prefer a high plowback implying that the business/firm has profitable internal usage of its earnings. This, in turn, would push up the stock prices.

When the plowback ratio is close to 0%, there is a large possibility that the firm could not maintain the current level of dividend distributions, as it is distributing all returns back to the investors. Thus, sufficient cash is not available to support the capital requirements of the business.

One of the critical issues with the plowback is that earnings per share do not necessarily match the cash flow per share so that the amount of cash available to be paid out as dividends does not always match the number of earnings. This indicates that the board of directors may not always have the cash available to pay dividends that are indicated by the EPS figure.

• One should note that the choice of accounting methods can also have an impact on the Dividend Pay-out ratio and, thus, the Plow-back ratios as well. For instance, the depreciation methods followed by the firm can have an overall impact. A Straight Line Method (SLM) records more amount of depreciation as compared to the Reducing Balance Methods (RBM), which does have an overall impact on the Dividend ratios. An unusually low plowback over time can foreshadow a cut in dividends when the company encounters a need for cash.

Let us consider another example taking a comparison of 2 companies with the help of the plowback formula for better understanding:

Answer:

Plowback for Firm ‘A’ = = $3.0 / $3.5 = 85.71%

Plowback for Firm ‘B’ = $1.5 / $8.5 = 17.65%

The plowback of Company 'A' suggests that they have been struggling to find any profitable opportunities. The firm may not have many opportunities and thus will distribute a reasonable portion of its earnings as dividends. This could also be a temporary tactic to keep many shareholders satisfied and enhance stock prices for the immediate future.

Concerning Company' B', a lower Plowback and negative cash flows highlight the fact that they have been heavily investing in futuristic projects and perhaps may have retained sufficient earnings for future opportunities.

Let's look at a practical example to understand Plowback better –

source: ycharts

Until 2011, Apple didn't pay dividends to its investors, and its Plowback was 100%. Because they believed that if they reinvested the earnings, they would be able to generate better returns for the investors, which they did eventually. However, they started reducing their Plowback ratio in 2012. Apple has been maintaining a retention ratio in the 70-75% range in the past four years.

Global banks are big banks with a large market cap and stable growth rate.

• We note that most global banks have a very stable Plowback ratio policy.
• JPMorgan has a Plowback of 65.70%, whereas UBS Group has only 1.20%.

Most of Tech Companies are high-growth firms and prefer investing the profit generated in their products. Below are the tech companies with a Plowback ratio of 100%.

• One of the most significant advantages of this ratio is that the Plowback ratio is relatively easy to understand and decipher.
• There are multiple ways of calculating this ratio since many Plowback formulae can be used.
• The ratio can work in tandem with the dividend payout ratio to understand the company's future intentions.

• The firm's growth cannot be ascertained exclusively with this ratio but also the performance of the other sectors of the company, which is being analyzed. One must also keep in mind the growth rate of other sectors that are part of the company and Plowback the money accordingly.
• The higher the Plowback, the growth prospects of the businesses increase accordingly. This, in turn, can create an artificial increase in share prices. This can be an area of concern since the shareholders might want to control the shares and finances they have invested in the firm. Thus, a situation of panic can be created.

It is necessary to understand that investor expectations and capital requirements vary from one industry to another. Thus, comparing Plowback ratios will make sense when the same industry and/or companies are being made.

There is no fixed definition of 'high' or 'low' ratio, and other factors will have to be considered before analyzing the company's possible future opportunities. It is just an indicator of possible intentions made by the firm.

The Plowback ratio can change from one year to another, depending on the macroeconomic factors, firms' earnings, volatility, and dividend payment policy. Most established companies follow a policy of paying stable or increasing dividends.

Companies in the defense sectors, like pharmaceuticals and consumer staples, will generally have regular pay-out and Plowback ratios compared to the Energy sector, whose earnings tend to be cyclical.

This article has been a guide to the Plowback Ratio Ratio. Here we discuss the formula to calculate the Plowback ratio along with practical examples, advantages, and disadvantages. Below are the other financial analysis articles that you may like -

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