What is a Plowback Ratio?
The opposite of the dividend payout ratio, a company's plowback ratio is calculated as follows:
Plowback ratio = 1 – (Annual Dividend Per Share / Earnings Per Share)
How Does a Plowback Ratio Work?
Let's assume Company XYZ reported earnings per share of $5 last year and paid $1 in dividends. Using the formula above, Company XYZ's dividend payout ratio is:
$1 / $5 = 20%
Company XYZ distributed 20% of its income in dividends and reinvested the rest back into the company.
In turn, that means that the company plowed the remaining 80% back into the company. Using the formula and the information above, we can show it this way:
Plowback ratio = 1 – ($1/$5) = 1 – 0.20 = 0.80 or 80%
Why Does a Plowback Ratio Matter?
Plowback ratios indicate how much profit is being reinvested in the company rather than paid out to investors. Some investors prefer the cash distributions associated with low plowback-ratio companies, while other investors prefer the capital gains expected from a company's reinvestment of earnings. Older, more mature companies generally have a lower plowback ratio than fast-growing companies, which are typically more focused on reinvesting cash in order to grow the business. Thus, the ratio is one way to identify growth companies.
Dividend payout ratios, and thus plowback ratios, are significantly influenced by a company's choices of accounting methods. For example, different depreciation methods affect a company's earnings per share, which affects the dividend payout ratio. An unusually low plowback ratio over time can foreshadow a cut in dividends when the company encounters a need for cash.
It is important to understand that capital needs and investor expectations vary from industry to industry, which is why comparison of plowback ratios is generally most meaningful among companies within the same industry, and the definition of a 'high' or 'low' ratio should be made within this context.
