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Plowback Ratio- a Definition and Pros and Cons
The plowback ratio has been the subject of many controversies; shareholders want it to be as low as possible, whereas managers of the company want it to be very high: a perfect example of conflict of interest.
Plowback ratio is simply the percentage of gross, before tax, profits invested back into the company. There are two formulas for the plowback ratio. The formulas are the following:
Plowback ratio = Plowed back gross profits / total gross profits
Plowback ratio = Total Gross Profits – Payout ratio
Obviously, the total gross profits would be 1 (that’s 100 percent of the gross profits). In the second formula the Payout ratio is the exact opposite of the plowback ratio, the percentage of total gross profits paid out to shareholders/owners of the company (usually in the form of dividends).
There is a third, easy way to calculate the plowback ratio:
Plowback ratio = (Total Net Profit / Number of Total share)- (Dividend / Share)
The Dividend / Share paid out to shareholders is regularly published by publicly listed companies before its dividend payment period. This is always given in absolute numbers, not in percentages. For example: Company A announces that in December of the current year it will pay $10 / share.
Total Net Profits are always published in the annual reports of publicly listed companies. The total number of share almost never changes. Total number of share can change in to occasions, during share splitting and share mergers (100 share of $1 face value vs. 10 shares of $10 face value: this way the share capital of the company remains the same).
Investing into the company means that it increases the assets of the company. These assets usually a combination of asset types, however they constitute of three major asset types:
- current assets,
- long term assets, and
- investment assets.
Current assets are usually the smallest of the three asset types. They include liquid assets such as cash, current bank account, fixed deposits and bonds, and notes with a maturity of less then one year.
Long term assets include bonds with a maturity of 5-, and more years. Investments into shares are also common long term assets for plowed back gross profits. However, these share investments must be into companies that operate in another sector of the economy due to legal prohibition of insider trading by securities trading authorities of the country where the particular company is headquartered.
The third category of asset where withheld gross profits are usually invested can be further broken down to two major subcategories:
- Corporate development investments, and
- Financial investments within the company
Corporate investments are investments that grow and develop the company itself, and include such as setting up new divisions in new geographical areas, building new production facilities, or increasing R&D activities.
Financial investments within the company have two major categories:
- Decreasing liabilities of the company
- Shares, warrants, etc buyback.
When a company decreases liabilities, that is, its credits and debts, it pays back loan installments that are overdue, or are in advance. These include payments to purchases on credit, bank loans, and debt securities purchases, like buying back bonds issued by the company.
Share buybacks increase the percentage that the company “owns”. These own shares can later have a variety or uses, such as collateral and guarantees for future loans, shares swap during acquisitions, and managerial incentivisation (top managers receive free share as bonus in the event of exceptional performance by the particular managers).
Advantages of the Plowback Ratio
Probably the biggest advantage of the plowback ratio is that it is relatively easy to use and understand.
The fact that there are a number of ways to calculate the ratio gives it some sort of flexibility.
Disadvantages of the Plowback Ratio
Theoretically speaking, from the point of view of the shareholder, the higher the plowback ratio, higher the growth of the company is and therefore the value of the shares also rise. However, studies, and historical data show that it is not as clear cut as that. There are many such speculations as to why this is the case, two of the two most common reasoning is the time value of money and the phsycological aspects of investors like to control their finances as much as possible. For this reason, in terms of the shareholder, the usefulness of the plowback ratio is highly debatable.
There are different growth figures in different industries, so, as with all other ratios, you need to compare only companies that are within the same industries. There are sectors of the economy with high growth rates; in these sectors it expected of the company to plow back a relatively large portion of its profits. In industries with slow growth and high profitability (utilities companies) it is expected that only a small fraction of profit should be plowed back.