How to Calculate Plowback Ratio?

Introduction

The intrinsic value of a stock is different from its price in the stock market. This is mainly because other factors may also determine the value of a stock. Investors value stocks based on what they will be worth in the future rather than the stocks’ current market price. Therefore, the intrinsic value of a stock will almost always be different from its current market value. Investors use many fundamental analysis techniques to measure the intrinsic value of a stock. These ratios require examining the related economic and financial factors of a company.

Fundamental analysis can be qualitative, although mostly it is quantitative. Qualitative fundamental analysis consists of analyzing the internal and external factors of a company. Qualitative analysis can assist investors in selecting different companies on which they can apply the quantitative measure. On the other hand, a quantitative analysis consists of analyzing different aspects of the performance of a company. At its basic, quantitative analysis consists of conducting a thorough analyzation of the financial statements of a company. However, it may also consist of conducting a ratio analysis of historical and forecasted financial information of a company.

One particular quantitative fundamental analysis ratio that is of use to both investors and companies is the plowback ratio of a company.

What is Plowback Ratio?

The Plowback ratio is the ratio of the total earnings retained of a company, after paying its dividends from its earnings, to its total earnings. It is also known as Retention ratio. The plowback ratio is the opposite of a (dividend) payout ratio. A payout ratio is a calculation of how much dividends companies pay from their earnings after a period. Both of these ratios are directly related to each other and can be very helpful to investors.

The plowback ratio can be used on its own or as a comparison tool. On its own, a high plowback ratio means that a company is holding most of its earnings and not paying any dividends to customers. Some companies have plowback ratios as high as 100% which means they don’t pay any dividends at all. On the other hand, a low plowback ratio means that a company is paying more dividends and retaining fewer earnings.

Companies must know how to calculate plowback ratio and how to find optimal plowback ratio to satisfy the needs of their shareholders. The retention of earnings for each company will differ according to the type and needs of a company. The more earnings companies can retain, the more they can invest in their operations and expand the company. However, a high retention ratio may not be acceptable for some shareholders. Therefore, companies need to know how to find optimal plowback ratio.

How to Calculate Plowback Ratio?

Companies or investors that want to know how to calculate plowback ratio can use the plowback ratio formula. The plowback ratio formula is simple to understand from its definition. As mentioned before, the plowback ratio is the ratio of the total retained earnings of a company to its total earnings. Therefore, the plowback ratio formula can be written as:

Plowback Ratio = (Net Earnings – Dividends) / Net Earnings

The net earnings in the above formula can be obtained from the Statement of Profit or Loss of a business and are also known as net income or net profit.

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As mentioned above, the plowback ratio is the opposite of a dividend payout ratio. Therefore, the plowback ratio can also be calculated using the dividend payout ratio of a company. The dividend payout ratio formula is as below:

Dividend Payout Ratio = Dividend Per Share / Earnings Per Share

Therefore, to calculate its plowback ratio using the dividend payout ratio, a company can use the following formula:

Plowback ratio = 1 – Dividend Payout Ratio

Or, we can rewrite the plowback ratio formula as follow:

Plowback ratio = 1 – Dividend Per Share / Earnings Per Share

Using any of the above formulas, a company or an investor can calculate the plowback ratio of the company for a particular period.

Example and Analysis

A company, ABC Co., made net profits of $10 million during their latest accounting period. Of the $10 million, they paid out dividends of $3 million to shareholders. To calculate the plowback ratio of ABC Co., the plowback ratio formula can be used as below:

Plowback Ratio = (Net Earnings – Dividends) / Net Earnings

Plowback Ratio = ($10 million – $3 million) / $10 million

Hence, plowback Ratio = 70%

This means that the company retained 70% of its earnings while it distributed the remaining 30% to its shareholders. The plowback ratio of ABC Co. can be considered as high. For growth investors, a 70% plowback ratio means that they will have a better chance of increasing their wealth through capital gains. On the other hand, a plowback ratio of 70% for dividend investors may be considered low as it means that they will get only a 30% payout ratio.

The 70% plowback ratio also means that the price of the shares of ABC Co. will increase in the market. This is because more retention is perceived as a growth signal by the market. This will probably result in a higher P/E ratio for ABC Co.

In the next period, if ABC Co. decides to pay higher dividends, perhaps 50%, it will satisfy the needs of dividend investors. However, it may disrupt the expectations of investors. A lower plowback ratio will also affect the price of the shares of ABC Co. This will probably result in a lower P/E ratio for the company.

How Plowback Ratio Help Investors?

There are different ways in which plowback ratio can help different types of investors. There are two types of returns that investors may expect from a company when they buy shares of the company. The first type of return comes in the form of dividends, which are periodic payments made from the earnings of the company to the investor. The second type of return is in the form of capital gain. Capital gains are created when the market value of the shares of a company exceed the amount initially paid by investors for the shares.

The plowback ratio can help investors determine whether an investment can give them profits in the form of dividends or capital gains. Different investors will have different requirements. Some investors want short-term returns and, thus, prefer dividend returns over long-term capital gains while others prefer capital gains.

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If the plowback ratio of a company is low, it means that the company will pay dividends and, thus, investing can be beneficial for investors who want dividend returns. If the plowback ratio is high, it means that the company retains its earnings and does not prefer to pay dividends. However, the more earnings the company retains, the more it can invest in future activities, thus, creating long-term returns for the shareholders. These returns are apparent in the form of a raise in the market value of shares and are considered capital gains.

Investors can also investigate any trends with the plowback ratio of a company. For example, if the plowback ratio of a company keeps increasing for some years, then it means that the company is retaining more earnings as compared to before. This can mean one of two things. Firstly, it can mean that the company is going through a growth phase and, therefore, needs to retain earnings to finance future needs. However, it may also mean that the company is facing a decline in performance and needs to retain more as security.

Plowback ratios can also provide other useful insights into a company to investors. For example, if a company constantly has a plowback ratio on either of both extreme ends (0% or 100%), then it could act as a warning signal to investors. Constant plowback ratios near to 0% could also mean that the company is not retaining enough earnings and, therefore, its future growth potential may be limited.

Example of Industry with High Plowback Ratio

Different industries will have different plowback ratios. Some industries are going to offer high plowback ratio due to their nature while some may offer a low plowback ratio. An example of an industry with high plowback ratio is the Technology industry, which includes technology companies.

The technology industry has a high plowback ratio due to its nature. This is mainly because the technology industry is subject to constant change and face the risk of obsolescence. Therefore, the companies within the industry have to adapt to any changes in technology. Furthermore, it means that these companies will need constant funds to finance their activities. The technology industry also has the greatest number of startups. For startups, keeping a high plowback ratio is critical.

Top 10 Companies with Higher Plowback Ratio

The top 10 companies with higher plowback ratios are as following:

S. NoCompany NamePlowback ratio
1Amazon.Com Inc.100%
2Facebook Inc.100%
3Berkshire Hath Hld100%
4Celgene Corp.100%
5Priceline Group100%
6Charter Communications100%
7Adobe Systems Inc.100%
8Netflix Inc.100%
9Paypal Holdings100%
10Electronic Arts Inc.100%

Factors Affecting the Plowback Ratio

Many factors affect the plowback ratio of a company. First of all, the type of industry that the company is operating in will impact its plowback ratio. Historically, technology industries are most likely to have a higher plowback ratio. In contrast, stable industries such as the utility industry may have lower plowback ratios.

The current lifecycle stage of a company will also affect its plowback ratio. Companies in the early stages of their lifecycle are more likely to have higher plowback ratios as compared to companies that have matured. For example, startups will have higher plowback ratios while more established companies will have a lower plowback ratio.

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The expectations of the shareholders of a particular company can also affect the plowback ratio of a company. If a company has historically had a high plowback ratio, its shareholders will likely expect a low dividend. Similarly, any investors in the market will also be aware that the company will not pay them high dividends.

Likewise, a company that is looking to invest in any future projects is also more likely to retain earnings for future use. For example, if there is a project that a company is willing to undertake in the next period, it will pay lower dividends to its shareholders and retain more. This is mainly because retained earnings cost the lowest as a type of finance.

Other factors affect the plowback ratio of a company. These may include liquidity reasons, legal rules, government regulations, taxation policies, trends in earnings, inflation, leverage, capital structure or ownership structure of the company.

Advantages and Disadvantages of Plowback Ratio

The main advantage of plowback ratio is that it is easy to understand for investors. If a firm increases its plowback ratio then it means that it pays lower dividends while decreasing plowback ratio means more dividends for shareholders. Based on this, investors can make decisions related to investing in a particular company.

Similarly, investors can easily understand how to calculate the plowback ratio of a company. There are different formulas to calculate the plowback ratio of a company. This makes the calculation of plowback ratio even more simple. Companies can also use different formulas and understand how to find optimal plowback ratio.

The ratio is also advantageous because it can be used by investors to forecast the growth plans of a company. If a company has a high plowback ratio, then it is likely going to invest the retained earnings in future projects. This can be particularly useful for investors who are looking for growth returns.

However, while it can be used to forecast the growth of a company, higher retained earnings do not mean the company will use them towards generating wealth for shareholders. If a company has inefficient management, then retained earnings may not be used for activities. This is something the ratio can’t detect or predict, which is a disadvantage.

The plowback ratio can also be used by companies to increase their P/E ratios and create favourable market conditions. As stated above, if a firm increases its plowback ratio, this will probably result in better P/E ratio. Therefore, companies can easily start retaining earnings to manipulate it.

Conclusion

Plowback ratio is a fundamental analysis ratio that can be used to determine the percentage of retained earnings of a company. The plowback ratio is highly useful for investors who want to make investments in a company. Similarly, it can also be beneficial for businesses. Usually, companies within the technology industry have higher or even 100% plowback ratios. Different factors affect the plowback ratio of a company which include the industry, shareholder expectations and plans of the company, among other factors.

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