What is the Plowback Ratio?

The plowback ratio is a fundamental analysis ratio that measures how much earnings are retained after dividends are paid out. It is most often referred to as the retention ratio. The opposite metric, measuring how much in dividends are paid out as a percentage of earnings, is known as the payout ratio.

The Formula For The Plowback Ratio Is

The plowback ratio is calculated by subtracting 1 from the quotient of the annual dividends per share and earnings per share (EPS). On the other hand, it can be calculated by determining the leftover funds upon calculating the dividend payout ratio.

Retention Ratio=Net Income  DividendsNet Income\text{Retention Ratio}=\frac{\text{Net Income } -\text{ Dividends}}{\text{Net Income}}Retention Ratio=Net IncomeNet Income  Dividends

On a per-share basis, the retention ratio can be expressed as:

1Dividends per ShareEPS1-\frac{\text{Dividends per Share}}{\text{EPS}}1EPSDividends per Share

For example, a company that reports $10 of EPS and $2 per share of dividends will have a dividend payout ratio of 20% and a plowback ratio of 80%.

What Does the Plowback Ratio Tell You?

The plowback ratio is an indicator of how much profit is retained in a business rather than paid out to investors. Younger businesses tend to have higher plowback ratios. These faster-growing companies are more focused on business development. More mature businesses are not as reliant on reinvesting profit to expand operations. The ratio is 100% for companies that do not pay dividends, and is zero for companies that pay out their entire net income as dividends. 

Key Takeaways

  • The plowback ratio is a fundamental analysis ratio that measures how much earnings are retained after dividends are paid out - it is an indicator of how much profit is retained in a business rather than paid out to investors.
  • Higher retention ratios indicate management’s belief of high growth periods and favorable business economic conditions. Lower plowback ratio computations indicate a wariness in future business growth opportunities or satisfaction in current cash holdings.
  • It is most often referred to as the retention rate or ratio.
  • The ratio is 100% for companies that do not pay dividends, and is zero for companies that pay out their entire net income as dividends. 

Use of the plowback ratio is most useful when comparing companies within the same industry. Different markets require different utilization of profits. For example, it is not uncommon for technology companies to have a plowback ratio of 1 (that is, 100%). This indicates that no dividends are issued, and all profits are retained for business growth.

The plowback ratio represents the portion of retained earnings that could potentially be dividends. Higher retention ratios indicate management’s belief of high growth periods and favorable business economic conditions. Lower plowback ratio computations indicate a wariness in future business growth opportunities or satisfaction in current cash holdings.

Investor Preference

The plowback ratio is a useful metric for determining what companies invest in. Investors preferring cash distributions avoid companies with high plowback ratios. However, companies with higher plowback ratios could have a greater chance of capital gains, achieved through appreciated stock prices during the growth of the organization. Investors see stable plowback ratio calculations as indicators of current stable decision-making that can help shape future expectations.

The ratio is typically higher for growth companies that are experiencing rapid increases in revenues and profits. A growth company would prefer to plow earnings back into its business if it believes that it can reward its shareholders by increasing revenues and profits at a faster pace than shareholders could achieve by investing their dividend receipts.

Impact From Management

Because management determines the dollar amount of dividends to issue, management directly impacts the plowback ratio. Alternatively, the calculation of the plowback ratio requires the use of EPS, which is influenced by a company’s choice of accounting method. Therefore, the plowback ratio is highly influenced by only a few variables within the organization.

Example of the Plowback Ratio

For example, on November 29, 2017, The Walt Disney Company declared a $0.84 semi-annual cash dividend per share to shareholders of record December, 11, to be paid January, 11th. As of the fiscal year ended September 30, 2017, the company's EPS was $5.73. Its plowback (retention) ratio is, therefore, 1 - ($0.84 / $5.73) = 0.8534, or 85.34%.

The retention ratio is a converse concept to the dividend payout ratio. The dividend payout ratio evaluates the percentage of profits earned that a company pays out to its shareholders. It is calculated simply as dividends per share divided by earnings per share (EPS). Using the Disney example above, the payout ratio is $0.84/$5.73 = 14.66%. This is intuitive as you know that a company keeps any money that it doesn't pay out. Of its total net income of $8.98 billion, Disney will pay out 14.66% and retain 85.34%.