Every investor has a different perspective when it comes to making an investment. But one thing is constant that is considering the intrinsic value of stock than market value. Although, the day traders are not much interested in the growth potential of a stock. Instead, they invest their money on the market trend of a stock’s demand. Real investors always use different fundamental analyses to assess intrinsic value to understand a company’s true potential.
The intrinsic value is the value that represents the real worth of a stock based on different internal and external factors of a company. Various quantitative measures are employed to quantify the impact of external and internal factors. The quantitative analysis encompasses the financial statements of a business entity to draw meaningful information.
The Plowback ratio is a quantitative measure used by business management and investors as well. This article will talk about the Plowback ratio, its interpretation, uses, and why it matters for a company and investors.
What Is The Plow back Ratio?
Many business entities chose to pay their earnings to the shareholders in the form of dividends. They also retain a part of earnings for different internal uses. The retained part of the net income of every year combined with historic amounts retained every year is retained earnings.
Did you know Apple Inc. never paid dividends to their shareholders before 2010? They were reinvesting all the profits in different projects to grow their corporation. Similarly, many tech companies retained a big proportion of net income or all net income for reinvesting in growth projects.
From here, we can define Plowback ratio as,
Plowback ratio is the ratio of retained earnings (after dividend declaration and distribution) of every financial year to the net income after tax payments.
Plowback ratio is also often known as the retention ratio. The opposite of the Plowback ratio is the dividend payout ratio that shows the dividend rate from the total net income of a company.
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. Because retained earnings are also used for payment of loans, paying additional dividends, and reserves besides plowing back.
Understanding Plowback Ratio
Plowback ratio is important as it represents the company’s strategy of reinvesting earnings to grow business. A steady reinvestment policy is healthy for the company’s growth. 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.
Retention of the earnings allows the company to create a reserve fund that can be used when there is a new opportunity to grow business, acquire market share by new products and services, etc. The relationship of the Plowback ratio is direct with the retention ratio. The higher retained earning proportions signifies the greater value of the Plowback ratio.
Whereas a negative relationship exists between the payout ratio and Plowback ratio. The companies that distribute their all profits remain dependent on the shareholders and external stakeholders for raising capital. It also hurts the intrinsic value of the stock in the long term.
How To Calculate Plowback Ratio?
The calculation of the Plowback ratio is simple as dividends are subtracted from total net income, and the answer is divided by net income to get the Plowback ratio.
We can represent the formula of the Plowback ratio as,
The Plowback ratio can also be represented as,
Net Income After Tax
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.
Dividend Declared & Distributed
The primary interest of investors in a company is the dividend. Dividend declared and distributed is the amount from the company’s net income that is distributed among the company’s shareholders.
Retained Earnings
Retained earnings represent the part of net income after tax that is kept by the company for reinvestment.
The Plowback ratio of the company can also be calculated by another formula.
Plowback Ratio = 1 – (Dividend distributed per share/ Earning Per Share)
Interpretation Of Plowback Ratio
The basic interpretation of a company’s Plowback ratio is the percentage of total profit retained by the company for investment purposes. The Plowback ratios of growth companies are higher than those in conventional business. For instance, a tech company will have a higher Plowback ratio. Many investors are looking for a continuous return. The companies with higher Plowback ratios are not welcomed by such investors.
Mature businesses usually pay out most of the dividends to shareholders. New businesses also retain most part of their profits to grow business; therefore, such businesses also have higher Plowback ratios.
Therefore, it can not be said that a company with a high Plowback ratio is good or bad. Neither a statement can be given about lower Plowback ratio companies. Plowback ratio is a useful metric for comparing the companies in the same industry or at the same growth stage.
Let’s analyze by two companies, Apple Inc. and General Electric.
Apple Inc. is a technology company, and they did not pay any dividends to their customers until 2011. The retention ratio of the company was 100% by 2011. They believed in reinvesting the earnings to gain a better positioning and market share. The company started paying a dividend in 2012.
If we look at General Electric, it is a mature and established company for many years. The company is a manufacturing giant, and they pay their shareholders a dividend every financial year.
It is important to understand from the example of Apple that considering a stock as unattractive just because of the high Plowback ratio is not sound. The higher Plowback ratio usually depicts an increase in stock’s intrinsic value signifying how attractive investment is.
Factors That Affect Retention Ratio
We have already discussed some factors behind higher Plowback ratios. Let’s generalize why a company’s retention ratio might be higher or lower. The following factors affect the retention rates of a company.
The high Plowback ratio of a company might be due to the following factors:
- A company has growth opportunities, and the capital required to make financial investments might retain more net profit. The investments can be of a capital nature like plant, property, and equipment for increasing production.
- If there is an expected business combination like acquisition or merger, the companies will need more investment for acquiring other companies. Therefore, the retention ratio will be high, consequently representing a higher plowback ratio.
- A company might retain more income if there has been a lot of debt to be paid. It signifies a difficult financial situation for a business entity. In such a case, the plowback ratio will be higher.
- The earnings of a company are subject to double taxation. A company might decide to keep a high ratio of retained earnings because they consider dividends an inefficient way of distributing returns to investors.
- The high plowback ratio might be due to industry requirements. For instance, we discussed an example of the technology industry where plowback ratios are generally higher.
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.
There can be many other factors that affect the Plowback ratio negatively or positively. Some of the most common factors can be legal regulations, liquidity goals, taxation policies, earning trends, financial leverage, the company’s capital structure, inflation, etc.
Examples
Let’s take an example of a company Lukeman Co. The net income of the company for the year 2019 was reported to be $70,000. The declared dividends for the year were $35,000. What will be the Plowback ratio?
Plowback ratio = Net Income – Dividends distributed/ Net income
Plowback ratio = $(70,000- 35,000)/70,000
Plowback ratio = 0.5 or 50% of earnings are invested back.
Conclusion
There are many advantages and disadvantages of the Plowback ratio. The most significant advantage of the Plowback ratio goes to the business management as they can invest the earnings into growth opportunities. Conversely, the lower Plowback ratios are an attraction for the company’s shareholders –more dividends. Similarly, shareholders and prospective investors can compare companies within an industry by using the Plowback ratio.
The limitations faced in using Plowback ratio are that the higher or lower value is not determined if a company is good for investment. For instance, a company with a high Plowback ratio might be attractive for a growth investor, but the reason behind the high ratio might be a large amount of debt. Similarly, a low Plowback ratio might be representing the decreasing market of the company’s product.
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.
