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Plowback Ratio in Finance: Definition & Formula

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, you will learn the definition and formula of the plowback ratio, also known as the retention ratio. We will work through some examples and discuss some reasons companies reinvest earnings versus paying dividends.

Plowback Ratio

As the name suggests, the plowback ratio, also known as the retention ratio, is the percentage of earnings that a company reinvests back into the company, usually by buying fixed assets like a plant, property, and equipment. The formula is:

1 - (dividends per share / earnings per share)

The ratio of (dividends per share / earnings per share) is often referred to as the dividend payout ratio.

So, you may see the plowback ratio's formula as:

1 - dividend payout ratio.

Examples

Let's work through some examples with two companies, Dividend Corp. and Growth Inc.

Dividend Corp

In the last fiscal year, Dividend Corp produced $10 in earnings per share and paid a dividend of $8 per share. Their dividend payout ratio was:

$8 / $10 = 80%

Their plowback ratio was:

1 - 80% = 20%

In plain English, this means Dividend Corp paid out 80% of their earnings from last year and kept 20% to make further investments in the company.

Growth Inc.

In the last fiscal year, Growth Inc. also generated $10 in earnings per share, but they needed $9 per share to grow their business. They paid a dividend of $1 per share with the remaining earnings. The company's dividend payout ratio was:

$1 / $10 = 10%

Their plowback ratio was:

1 - 10% = 90%.

Again, in plain English, this means Growth Inc. reinvested 90% of their earnings and paid out the remaining 10% as a dividend.

Factors that affect the plowback ratio

So, what factors motivate the company's management to either reinvest their earnings or to pay them out as a dividend?

A company with a high plowback ratio (like Growth Inc.) could be:

  • Growing and need the additional cash to finance investments - These investments are mostly in plants, property, and equipment. They can also be in marketing and promotion to 'capture' a larger customer base.
  • In acquisition mode - Companies looking to acquire other companies, especially in a fragmented market, may like to reinvest a larger portion of their earnings so they have cash on hand ('dry powder') to acquire when the opportunity presents itself.
  • Facing financial difficulties - If a company has taken on too much debt they may need to retain cash to pay down the debt or to shore up their balance sheet.
  • Wary of having their shareholders pay taxes twice - Dividends are 'double taxed.' This means that first, the company pays a tax on its earnings, and then the shareholder pays a tax when they receive the dividend. Company management may plowback their earnings because they deem dividends to be an 'inefficient' way of returning cash to their shareholders.
  • In an industry with high capital requirements - Certain industries, like oil and gas exploration and production, require massive amounts of money to be invested to just keep the same level of production. A company in that type of industry will have a higher plowback ratio just because of the nature of the industry.

A company with a low plowback ratio (like Dividend Corp.) could be:

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