What it means
After a company earns a profit, its owners have a choice. They can pay it out as dividends, or they can retain it and use it to buy equipment, hire people, develop products or reduce debt.
The plowback ratio measures how much is retained. Fast-growing companies tend to have high ratios, sometimes close to 100%, because they have many opportunities to invest and prefer to avoid raising new capital.
Mature companies in stable industries often retain less and pay more in dividends, because they have fewer attractive projects. Neither approach is right in itself.
The ratio matters because retained profit is a cheap source of funds. Reinvesting avoids the cost and effort of borrowing or issuing new shares, but only creates value if the company can earn a good return on the money.
Shareholders should ask whether management would use the cash better than they could themselves. It is directly related to the dividend payout ratio, because the two add up to 100%.
If a company pays out 40% of its earnings, it retains 60%. The plowback ratio is also used to estimate growth, since a company that reinvests more and earns a high return on equity can grow faster.
Analysts use the ratio together with other measures. A very high ratio with a poor return on equity can signal that management is wasting shareholders' money, while a very low ratio in a growing company may suggest it is starving the business of investment to pay for dividends.
Note that the British spelling of the word is plough, though plowback is the standard term in finance. The figure should be calculated consistently, using net income after tax and the dividends declared for the same period.
In practice
Real-world examples
Example 1
A young technology company earns $2,000,000 and pays no dividend, so its plowback ratio is 100%. It uses the profit to hire engineers and open a new office. Investors accept the lack of dividends because the share price has been rising. The board reviews the policy each year as the business matures.
Example 2
A utility company earns $80,000,000 and pays $60,000,000 in dividends, giving a plowback ratio of 25%. Its customers and regulators expect steady service, and investors value the reliable income. The company funds major projects through bonds as well. Its steady cash flow makes lenders comfortable with that approach.
Example 3
A family-owned manufacturer is deciding how much profit to take out. It earns $900,000 and the owners withdraw $300,000, leaving a plowback ratio of 67%. They use the retained $600,000 to buy a new machine that increases capacity. The owners judge the decision by the extra profit the machine produces.
Think of it
Plowback ratio shows what percentage of profits get 'plowed back' into the business rather than paid out.
Formula
Calculation
Plowback ratio = (net income - dividends) / net income; sustainable growth rate = return on equity x plowback ratio
Suppose a company earns net income of $5,000,000 and pays dividends of $2,000,000. Plowback ratio = (5,000,000 - 2,000,000) / 5,000,000 = 3,000,000 / 5,000,000 = 0.60, or 60%. If its return on equity is 15%, the sustainable growth rate = 15% x 60% = 9%. That means the company could grow equity and earnings by about 9% a year using only retained profit, assuming returns stay the same.Case study
Seen in the real world
Brightfield Packaging is a fictional company created for this illustration. It earned $4,000,000 a year and paid out $3,200,000 in dividends, a plowback ratio of only 20%, while its return on equity was 14%.
A new chief executive argued that the company had good opportunities to automate its plants and should retain more. The board raised the plowback ratio to 60% by cutting the dividend to $1,600,000, and used the extra $1,600,000 for automation.
The illustrative result was that profit grew faster than before, as the sustainable growth rate rose from 14% x 20% = 2.8% to 14% x 60% = 8.4%. Some income-focused shareholders sold their shares, but growth-focused investors bought them, and the board explained the logic in its annual report. Two years later the lower dividend was widely accepted because earnings had risen.
Watch out
Common mistakes
- Assuming a high ratio is always good, when retained profit that earns poor returns destroys value for shareholders who could have invested it elsewhere.
- Confusing it with the payout ratio, when the two add up to 100% and describe opposite sides of the same decision.
- Using the sustainable growth formula as a forecast, when it assumes stable returns and no new funding.
Questions
People also ask
What is a good plowback ratio?
It depends on the industry and the company's opportunities, with growth businesses typically retaining more than mature ones, so compare a company with its peers and its own history.
Is the plowback ratio the same as the retention ratio?
Yes, the two terms describe the same measure.
Can the ratio be negative?
Yes, if a company pays out more in dividends than it earns, the ratio drops below zero because it is eating into past reserves, and that usually draws attention from analysts and lenders.
Watch