What is 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 is an indicator of the quantum of profit retained in a business instead of being paid out to the investors. It generally represents the portion of retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company., which could have been distributed in the form of dividends. For instance, a firm having a Plowback of say 1.5% indicates that very less or no dividend has been paid, and most of the profits have been retained for business expansion.
We note from 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.
Plowback Ratio Formula
This ratio is the opposite of the Dividend Payout RatioDividend Payout RatioThe dividend payout ratio is the ratio between the total amount of dividends paid (preferred and normal dividend) to the company's net income. Formula = Dividends/Net Income 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 back in the company, i.e., 80% of the money was ploughed back in 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 development of the company instead of distributing them as returns to the investors.
- Higher Plowback is normally followed by Fast-growing and dynamic businesses that have a belief of supportable economic conditions and persistent high-growth periods.
- Matured businesses generally adopt a lower level of plowback, indicating sufficient levels of cash holdings and sustainable business growth opportunities.
The size of the plowback ratio will attract different types of customers/investors.
- Investors who are income-oriented would expect a lower plowback, as this suggests high dividend possibilities to the shareholders.
- Growth-oriented investors will 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 would be unable to 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 key issues with the plowback is that earnings per share do not necessarily match the cash flow per shareCash Flow Per ShareCash flow per share of the company shows the cash flow portion of the company, allocated against each of the common stock presents in the company. Cash flow per share = (operating cash flow – preferred dividends)/Weighted average number of shares. 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 methodsAccounting MethodsAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant 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)Straight Line Method (SLM)Straight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. 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:
|Company ‘A’||Company ‘B’|
|EPS for Previous Year||$3.5||$8.5|
|Dividends paid in the previous year per share||$3.0||$1.5|
|Net Cash Flow from Investment activities||Positive||Negative|
Plowback for Firm ‘A’ = [Dividend / EPS] = $3.0 / $3.5 = 85.71%
Plowback for Firm ‘B’ = $1.5 / $8.5 = 17.65%
The plowback of Company ‘A’ suggests that they have been struggling to find any profitable opportunities. Perhaps, the firm does not have many opportunities at the moment and thus will be distributing a reasonable portion of its earnings as dividends. This could also be a temporary tactic to keep a current lot of shareholders satisfied and enhance stock price for the immediate future.
With respect to Company’ B’, a lower Plowback and negative cash flowsNegative Cash FlowsNegative cash flow refers to the situation when cash spending of the company is more than cash generation in a particular period under consideration. This implies that the total cash inflow from the various activities under consideration is less than the total outflow during the same period. highlight the fact that they have been heavily investing in futuristic projects and perhaps may have retained sufficient earnings for future opportunities.
Apple – Plowback Ratio Analysis
Let’s look at a practical example to understand Plowback better –
|Dividends ($ bn)||2.49||10.56||11.13||11.56||12.15|
|Net Income ($bn)||41.73||37.04||39.51||53.39||45.69|
|Dividend Payout Ratio||6.0%||28.5%||28.2%||21.7%||26.6%|
Until 2011, Apple didn’t pay any dividend to its investors, and their 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 from 2012. Apple has been maintaining a retention ratioRetention RatioRetention ratio indicates the percentage of a company’s earnings which is not paid out as dividends but credited back as retained earnings. This ratio highlights how much of the profit is being retained as profits towards the development of the firm. in the 70-75% range in the past four years.
Stable Plowback Ratio of Global Banks
Global banks are big banks with a large market cap with a stable growth rate.
|S. No||Name||Plowback Ratio (Annual)|
|3||Bank of America||76.60%|
|5||Royal Bank of Canada||52.00%|
|7||The Toronto-Dominion Bank||56.80%|
|8||Mitsubishi UFJ Financial||68.70%|
|10||Bank of Nova Scotia||49.40%|
|14||Sumitomo Mitsui Financial||71.00%|
- We note that most global banks have a very stable Plowback ratio policy.
- JPMorgan has a Plowback of 65.70%, whereas that of UBS Group is only 1.20%.
Internet Companies – 100% Plowback
Most of the Tech Companies are high growth firms, and they prefer investing the profit generated in their products. Below are the tech companies with their Plowback ratio as 100%.
|S. No||Name||Plowback Ratio (Annual)|
- One of the biggest 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 future intentions of the company.
- The growth of the firm cannot be ascertained exclusively with the use of this ratio but also the performance of the other sectors of the company, which is being analyzed. One is also required to 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 their shares and finances they have invested in the firm. Thus, a situation of panic can be created.
It is necessary to understand the investor expectations and capital requirements vary from one industry to another. Thus, a comparison of 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 taken into consideration before analyzing the possible future opportunities of the company. 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 policyDividend Payment PolicyDividend policy is the policy that the company adopts for paying out the dividends to the company's shareholders, which includes the percentage of the amount at which the dividend is to be paid out to the stockholders and how frequent the company pays the dividend amount.. Most of the established companies follow a policy of paying stable or increasing dividends.
Companies in the defense sectors like pharmaceuticals and consumer staples will generally have stable pay-out and Plowback ratios in comparison to the Energy sector, whose earnings tend to be cyclical in nature.
Plowback Ratio Video
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 –