Investors get their returns from a company in two ways. The first comes from dividends that a company distributes from its profits. However, that does not imply that the amount the company holds back from allocating as dividends doesn’t provide value. This amount falls under retained earnings and can help a company invest in future projects.
The more a company invests in projects and generates profits, the higher its share price will grow. This growth represents the second way an investor gets returns from investing in companies. Therefore, investors must consider these factors when choosing their investments. The plowback ratio may help investors in those decisions.
What is the Plowback Ratio?
The plowback ratio gauges the earnings retained after distributing dividends among shareholders. It compares the total retained earnings for a period to the income for that period. Thus, it helps investors understand the portion of profits that will go back into operations. Investors can also use the plowback ratio to calculate the payout ratio for a company or vice versa.
Usually, the plowback ratio for growth-based companies is the highest. These companies retain between 90%-100% of their earnings every period. Therefore, the dividend payout ratio for them is 0%-10%. On the other hand, stable companies may have a plowback ratio of 0% since they distribute all income among investors. Unlike most other financial ratios, the plowback ratio does not have an ideal or optimum range.
How to calculate the Plowback Ratio?
Investors can calculate the plowback ratio in various ways. In either case, the calculation will result in the same amount. The basic formula for the plowback ratio is as below.
Plowback ratio = (Net earnings – Dividends distributed) / Net earnings
The above formula helps calculate the plowback ratio directly. If investors don’t have access to the information above, they can also use the dividend payout ratio to measure this ratio. In that case, the plowback ratio formula will be as below.
Plowback ratio = 1 – Dividend payout ratio
Investors can also calculate the dividend payout ratio similar to the plowback ratio. However, the basic formula will deduct the retained earnings rather than the dividends distributed. Alternatively, investors can rearrange the above equation to calculate the dividend payout ratio.
Example
A company, Red Co., generated net earnings of $100,000 during a fiscal year. The company paid $60,000 of these earnings to its shareholders as dividends. On the other hand, Red Co. retained $40,000 to invest in future projects. The plowback ratio for Red Co. during the fiscal year would be as below.
Plowback ratio = (Net earnings – Dividends distributed) / Net earnings
Plowback ratio = ($100,000 – $60,000) / $100,000
Plowback ratio = 0.4 or 40%
The above plowback ratio implies that Red Co. retained 40% of its earnings for the fiscal year. On the other hand, it paid 60% of it as dividends during the same period.
Conclusion
The plowback ratio helps investors calculate the amount retained by companies from their net earnings during a period. This ratio is the opposite of the dividend payout ratio, which shows the earnings allocated as dividends. Nonetheless, this ratio can help investors understand how much returns they get from the invested company.
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