Plowback Ratio

From CEOpedia | Management online

Plowback ratio (also known as redemption ratio) is determined as a proportion of the business's current earnings that are reinvested - not pay out as dividends to shareholders and not withdrawn to be used for personal consumption by owners [1] (expressed as a percentage). As a result, the plowback ratio is the opposite of the dividend payout ratio. According to Larry J. Kasper, the firm's current earnings have to be defined as ‘’ the maximum amount that could be paid as dividends without depleting its productive capacity. Thus it is net of the funds required to be reinvested to maintain the current level of productive capacity" [2].

Plowback ratio equation

Plowback ratio may be calculated using many different options as follows [3] [4]:

  • Retention (plowback) ratio = Addition to retained earnings / Net income
  • Retention (plowback) ratio = 1 - (Annual Dividend Per Share / Earnings Per Share)
  • Retention (plowback) ratio = Net Income - Dividends / Net Income
  • Retention (plowback) ratio = 1 − Dividend Payout Ratio

Importance of plowback ratio

There are many useful information which plowback ratio can show, not only related to investors and management [5] [6] [7]:

  • The higher the plowback ratio, the more of net income is reinvested in the business.
  • A decrease in the plowback ratio may mean that the proportions of a company's returns through capital appreciation have been accepted by the investors.
  • Plowback ratio may represent management's belief in business economic conditions.
  • Plowback ratio may be a clue for investors because it shows what a company invests in.
  • Plowback ratio may lead to a decrease in the company's market valuation.
  • High plowback ratio is usually observed in a dynamic businesses, which expect high-growth periods in the future.
  • Low plowback ratio is typical for old and well-established businesses, in which growth expectations can be predictable.

Examples of Plowback Ratio

  • The Plowback ratio is calculated by dividing the net income of a company by the total dividends paid to shareholders. For example, if a company earns $100,000 in net income and pays out $50,000 in dividends, the Plowback ratio is 0.50 (or 50%). This means that 50% of the company’s earnings are retained and reinvested in the business.
  • Another way to think of the Plowback ratio is as a measure of how much of a company’s earnings are plowed back into the business. For example, if a company earns $1,000 in profits and pays out $500 in dividends, it has a Plowback ratio of 0.50 (or 50%). This means that 50% of the company’s profits are used for reinvestment into the business.
  • An example of a company with a high Plowback ratio is Apple. In 2017, Apple earned $48.35 billion in profits and paid out $14.14 billion in dividends, resulting in a Plowback ratio of 0.71 (or 71%). This means that 71% of the company’s profits were reinvested back into the business.

Advantages of Plowback Ratio

The Plowback ratio is a measure of the proportion of current earnings that a business retains, instead of paying out as dividends or withdrawing for personal use. The advantages of this financial metric include:

  • Increased reinvestment into the business which can be used to finance expansion and growth, purchase new equipment, or fund research and development initiatives.
  • Reduced dependence on external financing, such as loans and bond sales, which can be expensive and come with attached strings.
  • Ability to retain higher profits, which can be used to reward shareholders through higher dividends or stock buybacks.
  • Reduced vulnerability to external economic forces, such as recessions and economic downturns, since the business has more of its own capital to rely on.

Limitations of Plowback Ratio

Plowback ratio is a useful tool for assessing a company's financial health and performance, but it has certain limitations. These include:

  • The plowback ratio does not take into account any additional factors that may influence the company's financial performance, such as market conditions or other external economic forces.
  • It is based solely on the company's current earnings and does not consider any projected earnings or potential profits.
  • Plowback ratio may be inaccurate if the company has made changes to its dividend policy or other financial strategies.
  • It does not take into account any debt payments the company may have, which could affect the amount of reinvested earnings.
  • It does not consider any non-monetary activities, such as research and development, that may be beneficial to the company's long-term growth.

Other approaches related to Plowback Ratio

Introduction: In addition to the Plowback Ratio, there are several other approaches that can be used to calculate the amount of earnings a business should reinvest.

  • Residual Dividend Model - This model takes into account the amount of dividends that are distributed to shareholders and the amount of retained earnings that is used to finance projects and investments. This approach assumes that the company should pay out dividends to shareholders up to the point where the shareholders are indifferent between receiving a dividend or reinvesting their money.
  • Discounted Cash Flow Model - This model uses future cash flows from a project or investment to calculate the present value of the cash flows. This approach assumes that the company should reinvest all of its earnings up to the point where the present value of the cash flows is equal to the amount of earnings.
  • Payback Period Model - This model takes into account the time period it takes for a project or investment to generate enough cash flows to cover the initial outlay. This approach assumes that the company should reinvest earnings up to the point where the payback period of the project or investment is less than a predetermined period of time.

Summary: The Plowback Ratio is just one of several approaches that can be used to calculate the amount of earnings a business should reinvest. Other approaches include the Residual Dividend Model, Discounted Cash Flow Model, and Payback Period Model. Each approach uses different criteria to determine the amount of reinvestment, such as dividends to shareholders, present value of cash flows, and payback period.

Footnotes

  1. ↑ Moss C. B. (2013) p.104
  2. ↑ Kasper L. J. (1997) p. 40
  3. ↑ Parrino R. (2018) p. 18-29
  4. ↑ Kasper L. J. (1997) p. 40-43
  5. ↑ Moss C. B. (2013) p.104
  6. ↑ Sarkis K. J. (2003) p. 188
  7. ↑ Kumar N. (2002) p. 62


Plowback Ratio — recommended articles
Ebitda ratio — Free cash flow yield — Degree of financial leverage — Yield on cost — Debt management ratio — Capital gearing — WACC — Total capital — Bird-in-the-hand theory

References

Author: Weronika Kaca

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