What is Plowback Ratio or Retention Ratio?
This ratio is an indicator of the quantum of profit retained in a business instead of being paid out to the investors. It is also referred as the Retention ratio or Plowback and generally represents the portion of retained earnings which could have been distributed in the form of dividends.
For instance, a firm having a plowback ratio 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 has a retention ratio of 100% (they retain 100% of profit for reinvestments), whereas, Colgate’s retention ratio is 38.22% in 2016.
Plowback Ratio Formula
This ratio is opposite of the Dividend Payout Ratio computed 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 plowback ratio formula, 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 ratio = 1 – ($2 / $10) = 1- 0.20 = 0.80 = 80%
This retention ratio indicates how much of profit is getting re-invested towards the development of the company instead of distributing them as returns to the investors.
- Higher retention ratios are normally followed by Fast-growing and dynamic businesses which have a belief of supportable economic conditions and persistent high-growth periods.
- Matured businesses generally adopt a lower level of plowback ratios indicating sufficient levels of cash holdings and sustainable business growth opportunities.
Impacts of Retention Ratio / Plowback Ratio
The size of the plowback ratio will attract different types of customers/investors.
- Investors which are income-oriented would expect a lower plowback ratio, as this suggests high dividend possibilities to the shareholders.
- Growth-oriented investors will prefer a high plowback ratio 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 ratio 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 amount of earnings. This indicates that the board of directors may not always have the cash available to pay dividends that is 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 ratio 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 plowback ratio 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|
|Industry Utilities Technology|
|Net Cash Flow from Investment activities Positive Negative|
Retention ratio for Firm ‘A’ = [Dividend / EPS] = $3.0 / $3.5 = 85.71%
Retention ratio for Firm ‘B’ = $1.5 / $8.5 = 17.65%
The plowback ratio of Company ‘A’ suggests that they have been struggling to find any profitable opportunities. Perhaps, the firm does not have many opportunities at the moment and thus will be distributing a reasonable portion of their earnings as dividends. This could also be a temporary tactic to keep a current lot of shareholders satisfied and enhance stock price for the immediate future.
With respect to Company ‘B’, a lower retention ratio and negative cash flows highlights the fact that they have been heavily investing in futuristic projects and perhaps may have retained sufficient earnings for future opportunities.
Apple – Retention Ratio Analysis
Let’s look at a practical example to understand retention ratio better –
|Dividends ($ 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 retention ratio was 100%. Because they believed that if they would reinvest the earnings, they would be able to generate better returns for the investors which they did eventually. However, they started reducing their retention ratio from 2012. Apple has been maintaining a retention ratio in the 70-75% range in the past four years.
Stable Retention Ratio of Global Banks
Global banks are big banks with a large market cap with stable growth rate. Below is the table that provides the retention ratio of these banks.
|S. No||Name||Retention 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 retention ratio policy.
- JPMorgan has a retention ratio of 65.70%, whereas, that of UBS Group is only 1.20%.
Internet Companies – 100% Retention Ratio
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 retention ratio as 100%.
|S. No||Name||Retention Ratio (Annual)|
Advantages of Plowback Ratio / Retention Ratio
- One of the biggest advantages of this ratio is that is a plowback ratio formula relatively easy to understand and decipher.
- There are multiple ways of computing this ratio since many plowback ratio formulae can be used.
- The ratio can work in tandem with the dividend payout ratio to understand the future intentions of the company.
Disadvantages of Plowback Ratio
- 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 which are part of the company and plowback the money accordingly.
- Higher the plowback ratio, 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, comparison of plowback ratios will make sense when 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 retention ratio can change from one year to another depending on the macroeconomic factors, firms’ earnings, volatility and dividend payment policy. 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 retention ratios in comparison to Energy sector whose earnings tend to be cyclical in nature.
This has been a guide to Plowback Ratio / Retention Ratio, its formulas along with practical examples and calculations. Below are the other financial analysis articles that you may like –
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