Plowback ratio
/What is the Plowback Ratio?
The plowback ratio measures the amount of earnings that have been retained after investor dividends have been paid out. It is used by investors to evaluate the ability of a business to pay dividends. If the plowback ratio is high, this has different implications, depending on the circumstances. When a business is growing at a rapid rate, there should be a high plowback ratio, since all possible funds are needed to pay for more working capital and fixed asset investments. When a business is growing at a slow rate, a high plowback ratio is counterproductive, since it implies that the business cannot use the funds, and would be better off returning the cash to investors. When the plowback ratio is close to 0%, there is a heightened risk that the company will not be able to sustain its current level of dividend distributions, since it is diverting essentially all earnings back to investors. This leaves no cash to support the ongoing capital needs of the business.
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Impact of the Plowback Ratio on Investors
The size of the plowback ratio will attract different types of investors. An income-oriented investor will want to see a low plowback ratio, since this implies that most earnings are being paid out to investors. A growth-oriented investor will be attracted to a high plowback ratio, since this implies that a business has profitable internal uses for its earnings, which will increase the stock price.
Formula for the Plowback Ratio
To calculate the plowback ratio, divide the annual aggregate dividends per share by the annual earnings per share, and subtract the result from 1. The plowback ratio calculation is as follows:
1 - (Annual aggregate dividends per share ÷ Annual earnings per share) = Plowback ratio
Example of the Plowback Ratio
If a business pays out $1.00 per share and its earnings per share in the same year were $1.50, then its plowback ratio would be:
1 - ($1.00 Dividends ÷ $1.50 Earnings per share) = 33%
Problems with the Plowback Ratio
There are several problems with the plowback ratio that tend to limit its use. These issues are as follows:
Ignores profit quality. The plowback ratio focuses only on the percentage of earnings retained, without considering the quality or sustainability of those earnings. High retention based on volatile or non-recurring profits can be misleading.
Overlooks investment efficiency. A high plowback ratio suggests significant reinvestment, but it doesn’t indicate how effectively those retained earnings are used. If management reinvests poorly, shareholder value might decline despite a high plowback ratio.
Does not match cash flow. A key problem is that earnings per share do not necessarily equate to 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 means that the board of directors may not always have the cash available to pay dividends that is indicated by the earnings per share figure. This can cause conflicts with shareholders who believe that they should be receiving more dividends.
No insight on growth prospects. While a higher plowback ratio implies a focus on growth, it doesn’t directly measure actual growth potential or the expected return on reinvested earnings. Industries with limited growth opportunities might retain earnings unnecessarily.
Inapplicable across industries. Different industries have distinct capital requirements and growth dynamics. A low plowback ratio might be appropriate for mature industries with steady dividends, while a high ratio suits high-growth sectors, making cross-industry comparisons unreliable.
Ignores debt financing. The plowback ratio doesn’t account for external financing methods, such as debt, which can also fuel growth. A low plowback ratio doesn’t necessarily imply limited growth if a company effectively uses debt.
Dividend policy distortion. Management might manipulate dividend policies to influence the plowback ratio, retaining earnings unnecessarily to project growth ambitions, which might not align with actual investment opportunities.
Conflicts with strategy. The board of directors may have expansion plans for the business that require the use of all available funds (if not more), leaving no cash or little cash available for payouts to investors. This can also result in conflicts with shareholders who believe they should be receiving dividends.
Short-term focus. The ratio is typically calculated annually, providing a short-term view that might not reflect long-term reinvestment strategies or evolving business conditions.
By recognizing these limitations, investors can use the plowback ratio more effectively alongside other financial metrics.
Terms Similar to the Plowback Ratio
The plowback ratio is also known as the retention rate.