The big question for any investor is whether a company is worth putting money into. One of the measures for figuring this out is the retention ratio or plowback ratio. The higher the ratio, the more earnings the company retains rather than issuing them as dividends.
TL;DR (Too Long; Didn't Read)
To calculate the plowback ratio, divide the dividends per share by the earnings per share. Subtract the result from one and turn that figure into a percentage. The higher the number, the larger the retention ratio.
The Retention Ratio
Suppose a company wraps up the year and issues a $2-per-share dividend. The earnings per share are $4. The first step in calculating the plowback ratio is to divide earnings into dividends, giving you 1/2. If you subtract that from 1, you get 1/2; turn that into a percentage and you have a retention ratio of 50%.
If, on the other hand, you had the same dividend but earnings of $5 per share, you'd end up with a 60% plowback ratio. If all the earnings are issued as dividends, the ratio would be 1 minus 1, equalling zero. That company is not plowing any of its earnings back into operations.
Why Plowback Matters
Ratios help evaluate companies by taking size out of the picture. Whether a company declares $500 dividends and $2,000-a-share earnings or $5 dividends and $20 earnings, they'll have the same plowback ratio. That makes it easier to compare them.
- If a company is high growth, a high retention figure shows they're plowing back earnings into operations so that they can keep expanding.
- If a company's growth is sluggish, a high plowback ratio means they're simply hanging on to the money but not using it. Investors might prefer larger dividends.
- A retention ratio of zero or close to it shows the company's earnings are going overwhelmingly or entirely to dividends. The business may not be reserving enough money for its capital needs and probably won't be able to sustain its current dividends in future years.
Growth or Income?
A high or low plowback ratio isn't automatically good or bad. If everything else about two companies is equal, different investors will favor different plowback ratios.
An income-oriented investor might prefer a company with a low plowback ratio, showing the firm prioritizes dividends over growth. Other investors would sooner see a high ratio, showing the company is investing in growing its operations.
One drawback to using retention ratio as a measure is that the earnings per share don't match the cash flow per share, which is the net cash flow for the year divided by the number of shares. If the earnings are $2.50 per share but cash flow is only $1.50, the company doesn't have the cash on hand to pay $2.50 per share dividends. The plowback ratio doesn't reveal this.
Is Growth Sustainable?
A high plowback ratio shows the company is putting money into growth. Even so, it's possible the company is growing faster than it can support without borrowing more money or issuing more stock. Investors concerned about that can use the sustainable growth rate formula to get an answer.
First, figure the dividend payout ratio, which is total dividends divided by net income. Subtract this from 1 and then multiply it by the return on equity to get the sustainable growth rate.
For example, suppose you have a company with 20% dividend payout ratio and a 20% return on equity. One minus 20% equals 80%; multiply that by 20% to get 16%. That's the rate of growth the company can manage without needing extra money.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com