Plowback Ratio: Definition, Calculation Formula, Example

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. Investors can also investigate any trends with the plowback ratio of a company.

Net income after tax or NIAT represents all the company’s profits during a financial period after paying the due taxes. The net income is calculated by subtracting all the administrative, marketing, and other expenses and interest expense from the operating income of the business entity. The alternative formula does not use retained earnings but instead subtracts dividends distributed from net income and divides the result by net income.

Advisory services provided by Carbon Collective Investment LLC (“Carbon Collective”), an SEC-registered investment adviser. A high retention ratio may not always be indicative of financial health. To better understand the retention ratio, we must first understand the company that we are calculating the ratio for. Ted’s TV Company earned $100,000 of net income during the year and decided to distribute $20,000 of dividends to its shareholders. They rarely give dividends because they want to reinvest and continue to grow at a steady rate.

  1. The inverse of the plowback ratio — the “dividend payout ratio” — is the proportion of net income paid out in the form of dividends to compensate shareholders.
  2. You can use the retention ratio calculator below to quickly calculate how much of your company’s earnings have been or should be retained, by entering the required numbers.
  3. The plowback ratio is an indicator of how much profit is retained in a business rather than paid out to investors.
  4. Investors purchase stock in these companies under the expectation that the value of the stock will rise – rather than expecting a dividend return.
  5. It compares the total retained earnings for a period to the income for that period.
  6. If a firm increases its plowback ratio then it means that it pays lower dividends while decreasing plowback ratio means more dividends for shareholders.

Similarly, shareholders and prospective investors can compare companies within an industry by using the Plowback ratio. The lower Plowback ratios are not discouraged in the market as the investors consider dividend a better metric than the appreciation in the stock’s intrinsic value. The lower retention ratios might mean that the industry or company’s products have matured. Another reason for decreased retention might be representative of decreasing opportunities in the market. The basic interpretation of a company’s Plowback ratio is the percentage of total profit retained by the company for investment purposes.

There are different formulas to calculate the plowback ratio of a company. Companies can also use different formulas and understand how to find optimal 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. The expectations of the shareholders of a particular company can also affect the plowback ratio of a company.

What Is the Retention Ratio?

Plowback ratio is important as it represents the company’s strategy of reinvesting earnings to grow business. If the company does not reinvest its earning, the business will never become self-sufficient to support its operations and will always rely on creditors and shareholders for capital. The Plowback Ratio is the percentage of a company’s earnings retained and reinvested into operations as opposed to being paid out as dividends to shareholders. Use of the plowback ratio is most useful when comparing companies within the same industry. For example, it is not uncommon for technology companies to have a plowback ratio of 1 (that is, 100%).

Is plowback ratio the same as retention ratio?

These may include liquidity reasons, legal rules, government regulations, taxation policies, trends in earnings, inflation, leverage, capital structure or ownership structure of the company. 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 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. Higher retention rates are not always considered good for investors because this usually means the company doesn’t give as much dividends. It might mean that the stock is continually appreciating because of company growth however. This ratio helps illustrate the difference between a growth stock and an earnings stock.

Also, a company that is not using its retained earnings effectively has an increased likelihood of taking on additional debt or issuing new equity shares to finance growth. 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.

How Plowback Ratio Help Investors?

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. Mature businesses usually pay out most of the dividends to shareholders.

This enables analysts to evaluate changes in the company’s performance over a given time interval. In the example above, we can see that the retention ratio for Alice’s business is going down each year. This is because net income is rising each year and dividends are rising by a proportionally larger amount, leading plowback ratio formula to a downward trend in the ratio. Plowback ratio should be used for comparison in combination with other financial ratios like efficiency ratios, profitability ratios, return on net operating assets, and leverage ratios. There can be many other factors that affect the Plowback ratio negatively or positively.

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 retention ratio (also known as the net income retention ratio or plowback ratio) is the ratio of a company’s retained income to its net income.

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. The numerator of this equation calculates the earnings that were retained during the period since all the profits that are not distributed as dividends during the period are kept by the company. You could simplify the formula by rewriting it as earnings retained during the period divided by net income. The retention ratio represents all the amount kept by the company, but it does not represent how much will be plowed back to generate more income.


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