The plowback ratio, also known as the retention ratio, is a crucial metric in financial analysis that gauges how much earnings a company retains after distributing dividends. The opposite of this ratio, which measures the portion of earnings paid out as dividends, is known as the payout ratio.
How to Calculate the Plowback Ratio
The plowback ratio is computed using the formula:
( \text{Retention Ratio} = 1 - ( \frac{\text{Dividends Per Share}}{\text{EPS}} ) )
Alternatively, it can be expressed by calculating the remaining funds after determining the dividend payout ratio. For instance, a company with an Earnings Per Share (EPS) of $10 and dividends of $2 per share would have a dividend payout ratio of 20% and a plowback ratio of 80%.
The Significance of the Plowback Ratio
The plowback ratio illuminates how much profit a business retains for reinvestment as opposed to paying out to its investors. Typically, younger, fast-growing companies exhibit higher plowback ratios, reflecting a focus on expansion. In contrast, mature businesses, which are less dependent on reinvesting profits, tend to have lower ratios. Companies that do not pay dividends demonstrate a plowback ratio of 100%, while those that distribute all their net income as dividends have a plowback ratio of zero.
Key Takeaways
- A higher plowback ratio indicates management’s belief in strong future growth and favorable economic conditions for the business. Conversely, a lower ratio may imply caution regarding growth opportunities or contentment with the current financial state.
- This ratio is essential for evaluating how much profit is retained within a business rather than distributed to investors.
- Comparing plowback ratios is most valuable among companies within the same industry, as different sectors utilize profits differently.
Tech companies, for instance, often maintain a plowback ratio of around 100%, signifying that no dividends are paid out and all profits are channeled back into business growth. This indicates a strategic focus on expansion and leveraging opportunities for increased profit.
Investors and the Plowback Ratio
Investors use the plowback ratio to discern company priorities. Those seeking regular cash distributions favor companies with lower ratios. However, firms with higher plowback ratios may present more significant capital gains opportunities due to anticipated profit growth and stock price appreciation. Stable plowback ratios often signify consistent, prudent management decision-making.
Particularly for growth companies seeing rapid increases in revenues and profits, a higher plowback ratio means reinvesting earnings to potentially reward shareholders by accelerating revenue and profit growth more than dividend reinvestments might.
Management’s Role in Plowback Ratios
Since company management decides the portion of earnings to be paid out as dividends, they significantly influence the plowback ratio. This ratio also relies on EPS, which can be affected by the chosen accounting methods, making the calculation sensitive to specific in-house financial strategies.
t## Practical Example: The Walt Disney Company
As a practical example, consider The Walt Disney Company. On November 29, 2017, Disney declared a $0.84 semi-annual cash dividend per share. With an EPS of $5.73 for the fiscal year ending September 30, 2017, Disney’s plowback ratio is:
( 1 - \frac{0.84}{5.73} = 0.8534 ) or 85.34%.
This means Disney retains 85.34% of its earnings, while 14.66% of its earnings (the payout ratio) go to shareholders. With a net income of $8.98 billion, 14.66% is paid out as dividends, and the remaining 85.34% is retained for reinvestment.
Related Terms: Retention Ratio, Dividend Payout Ratio, Earnings Per Share, Retained Earnings.
References
- The Walt Disney Company. “The Walt Disney Company Announces Semi-Annual Cash Dividend of $0.84 per Share”.
- The Walt Disney Company. “Fiscal Year 2017 Annual Financial Report”, Page 24.
- The Walt Disney Company. “Fiscal Year 2017 Annual Financial Report”, Page 23.
