The plowback ratio measures the amount of earnings that have been retained after investor dividends have been paid out. It is used by investors to evaluate the ability of a business to pay dividends. The plowback ratio calculation is:
1 - (Annual aggregate dividends per share ÷ Annual earnings per share)
For example, if a business pays out $1.00 per share and its earnings per share in the same year were $1.50, then its plowback ratio would be:
1 - ($1.00 Dividends ÷ $1.50 Earnings per share) = 33%
If the plowback ratio is high, this has different implications, depending on the circumstances. Possible scenarios are:
- High growth. When a business is growing at a rapid rate, there should be a high plowback ratio, since all possible funds are needed to pay for more working capital and fixed asset investments.
- Low growth. When a business is growing at a slow rate, a high plowback ratio is counterproductive, since it implies that the business cannot use the funds, and would be better off returning the cash to investors.
The size of the plowback ratio will attract different types of investors. An income-oriented investor will want to see a low plowback ratio, since this implies that most earnings are being paid out to investors. A growth-oriented investor will be attrached to a high plowback ratio, since this implies that a business has profitable internal uses for its earnings, which will increase the stock price.
When the plowback ratio is close to 0%, there is a heightened risk that the company will not be able to sustain its current level of dividend distributions, since it is diverting essentially all earnings back to investors. This leaves no cash to support the ongoing capital needs of the business.
A key problem with the plowback ratio is that earnings per share do not necessarily equate to cash flow per share, so that the amount of cash available to be paid out as dividends does not always match the amount of earnings. This means that the board of directors may not always have the cash available to pay dividends that is indicated by the earnings per share figure.
The plowback ratio is also known as the retention rate.