The plowback ratio, also known as the retention ratio, is a fundamental analysis metric that helps measure a business's earnings after the necessary dividends are distributed to stakeholders. The ratio indicates the amount of profit retained in the business instead of being paid out to investors.
A business growing rapidly will have a high plowback ratio since all the available funds will be reinvested in the growth of the business. A business growing at a slower pace should not ideally have a high plowback ratio as it means the business cannot deploy the funds productively, so it is better to pay back the cash to shareholders.
In this article, we will understand the plowback ratio definition, its formula, how to calculate it, its impact, and the advantages and disadvantages of the plowback ratio.
What is the plowback ratio?
Plowback ratio determines the percentage of the earnings of a business that are retained and reinvested in the business operations instead of being given away as dividends to various shareholders. This is why it is also referred to as retained earnings—it represents that quantum of profit that could have been distributed as dividends.
Most internet companies have a 100% plowback ratio. This is because they prioritise reinvesting their earnings into growth opportunities, such as expanding their user base, improving technology, and enhancing product offerings, rather than paying dividends to shareholders.
The opposite metric of the plowback ratio is the payout ratio, which measures the percentage of a company’s earnings paid out in the form of dividends.
What does the plowback ratio ratio tell you?
The plowback ratio reflects the amount of profit retained by a business instead of paying it to investors. If a business is young, it will likely have a high plowback ratio since it will be focused on growing its operations and require greater capital investment. On the other hand, more mature companies do not need as much re-investment in their businesses and hence can have more money to spare for distributing dividends.
A company that does not pay any dividends will have a 100% plowback ratio. In contrast, a company that gives away its entire profits as dividend income to its shareholders will have a zero plowback ratio.
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Formula for the plowback ratio
The formula of the plowback ratio is given as:
Plowback ratio = (Net income - Dividends)/ Net income
Another simple way of calculating the plowback ratio is to divide a business's retained earnings by its net income.
Plowback ratio = Retained Earnings ÷ Net Income
Where, retained earnings = Net Income - Dividends
The plowback ratio can also be calculated if you know the dividend payout ratio. This can be computed by using the formula:
Plowback ratio = 1 – Payout Ratio
Where,
Dividend payout ratio = Dividends ÷ Net income
How to calculate the plowback ratio?
Consider a company ‘ABC Ltd.’ that has reported a profit of Rs. 50 crore and has decided to pay Rs. 10 crore as dividends to its shareholders.
Plowback ratio of ABC = (Rs. 50 crore - Rs. 10 crore) ÷ Rs. 50 crore = 80%
In the above example, the company has a plowback ratio of 80%, which means it reinvested 80% of its profit into the business and the remaining 20% was distributed as dividends among shareholders.
Impact of plowback ratio
Different investors are drawn to different plowback ratios. Investors who want a higher dividend income or have invested in getting a dividend return periodically will opt for companies with a lower plowback ratio. Such companies will have a high dividend possibility for an investor.
On the other hand, investors who are more focused on growth will invest in businesses that have a higher plowback ratio, which indicates the money is being used by the business to grow and expand. This, in turn, will lead to an increase in the company's stock price, which will lead to higher gains for the investor in the future.
Advantages of plowback ratio
Here are some of the benefits of using the plowback ratio:
- The plowback ratio formula is straightforward in its calculation and easy to decipher and understand.
- As seen above, the plowback ratio can be calculated using various simple formulas. So, you could use other formulas if one piece of information is missing.
- Plowback ratio, when used with the dividend payout ratio, can provide a good picture of the company’s operations and future plans.
Disadvantages of the plowback ratio
Despite its advantages, the plowback ratio has a few limitations:
- The retention ratio is not enough to gauge the growth of a business. The performance of other companies within the sector must also be considered. It's essential to evaluate the growth rates of these companies and reinvest funds accordingly.
- As discussed above, a higher plowback ratio is indicative of the growth trajectory of a company. However, this could sometimes lead to an artificial rise in share prices. This could sound alarm bells for some shareholders who wish to manage their investments in the firm, potentially causing panic.
Key takeaways
- The plowback ratio indicates the profit the business has retained instead of being distributed to shareholders as dividends. It is known as a fundamental ratio for analysis, which measures the retained company earnings after dividends have been paid out.
- If the plowback or retention ratio of a company is high, it means the management is anticipating a period of high growth for the business and the economic and market conditions will also be conducive for the business. A lower plowback ratio is sometimes seen as a sign of uncertainty for the future growth of a business, or it can also mean that the company is satisfied with its current cash holdings.
- The plowback ratio is zero for companies that pay the entire net profit to their shareholders as dividends. Conversely, it is 100% in the case of companies that do not pay any dividends and re-invest all of their profit.
Conclusion
The plowback ratio of companies changes from year to year, as it relies on several macroeconomic factors like market conditions, interest rates, volatility, and the company’s dividend payout policy. Most of the established legacy companies have a policy of giving their shareholders either stable or increasing dividend payouts periodically.
However, it is important to note that investors' expectations and capital needs vary across industries. Hence, the plowback ratio is relevant only when companies belonging to the same industry or sector are compared. Additionally, there is no standard definition of a "high" or "low" ratio, and other factors must be taken into account when assessing a company's potential future opportunities. The plowback ratio merely indicates the firm's potential intentions. It is advisable to do proper fund analyses and performance tracking, and also look at expert recommendations to understand market trends before investing.
