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 sometimes referred to as the retention rate. The opposite metric, measuring how much in dividends are paid out as a percentage of earnings, is known as the payout ratio.
BREAKING DOWN Plowback Ratio
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.
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.
Plowback Ratio Formula
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. 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%.
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.
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.