When a company makes net profits, a portion of the net profits is paid out to the shareholders in dividends.
This is usually referred to as paying some or all of your profits back to shareholders.
Paying out dividends to shareholders of a company will normally receive a portion of those dividends as cash income.
Ploughing back profits is the opposite of paying out dividends. When a company makes net profits, a portion of the net profits is paid out to the shareholders in dividends.
On the other hand, ploughing back profits involves investing its money into its operations rather than distributing it to the shareholders.
Example of Plough Back Ratio of X Ltd and Y Ltd
X Ltd Amount Y Ltd Amount Total Equity Rs.10,00,00,000Total EquityRs.10,00,00,000Net Profits 2017-18Rs.3,30,00,000Net Profits 2017-18Rs.3,30,00,000Dividend PaidRs.66,00,000Dividend PaidRs.33,00,000Dividend Ratio20%Dividend Ratio10%Plough Back Ratio80%Plough Back Ratio90%Market CapitalizationRs.52.80 Crore Market CapitalizationRs.85.80 Crore P/E Ratio16XP/E Ratio26X
In the above example, we can see that both companies X and Y have the same equity base, and we considered that they earned the same profit in the last financial year 2020-2021.
This means both X and Y have the same return on Equity (ROE).
Return on Equity(ROE) = Net Profit of Business / Total Equity of Business.
ROE of X = 3.30 Cr(Net Profit) / 10 Cr(Total Equity) = 33%
ROE of Y = 3.30 Cr(Net Profit) / 10 Cr(Total Equity) = 33%
We have seen both X and Y companies have the same ROE and similar net profits.
But they both differ in the way they pay out dividends.
For example, X pays out 20% of its profits as dividends and ploughs back 80% of profits. On the other hand, we see Y pays out just 10% of its profits as dividends and ploughs back 90% of its profits into its reserves.
What is significant is that X quotes at a P/E ratio of 16X while Y quotes at a P/E Ratio of 26X.
Why is there such a vast difference?
Because Y invests more profits to buy assets and grow as a company and make profit accordingly rather than giving money to shareholders.
To know more about investment in high dividend-paying companies - click here
Why Don't Many Traders Reward High Dividend Paying Companies?
Both companies have the same ROE in the above example, but the Y’s P/E ratio is much higher than X.
Why is it so? Some people like it if the company pays a high dividend, but many don't like dividend-paying companies.
The reason behind that is that when a company gives a high percentage of dividend to shareholders as X did, traders stop investing in that stock because they think that the company should invest the profit into their growth rather than giving high dividend shareholders.
Company Y gives only 10% of its shareholders and invests more of its profit into their growth. That's the reason the Y P/E ratio is 26X
Some people like that they should get the bonus money from the company, i.e., dividend, but these people are very less. The majority of long-term investors don't like dividend-paying companies.
So, Which Company Should you Invest in, X or Y?
X pays out 20% dividends compared to Y's 10% payout. Hence, if you are looking for dividend income, you would prefer investing in X.
But suppose you are a long-term investor who is willing to remain invested for at least ten years and does not mind volatility in the stock price.
Then you would prefer investing in Y because Y invests 90% of profits back into the business, and hence Y will have much more money to grow at a faster rate than X. Thus, your long-term expected return from Y is higher than that of X.
Advantage of Plough back Profits for Traders
Plough back profits is a term used in the corporate world. The number of net profits (or net profit available to shareholders) that a company reinvests back into the business, rather than paying out as dividends.
The reinvestment back into the business is generally done in two ways:
1) Increasing working capital by buying additional inventory and raw materials, paying off debt, and increasing short-term investments.
2) Investing in long-term assets such as new facilities, machinery, and equipment.
The advantage of ploughing back profits into the business, as opposed to paying out dividends to shareholders, is that it allows for the creation of long-term value for the company.
This ultimately helps the share price at some stage in the future.
Conclusion
So the plough back ratio can be beneficial for both short-term traders and long-term traders accordingly. If you are a short-term trader, you should invest in a high dividend-paying company, and if you are a long-term trader, you should invest in a no dividend-paying company or less dividend-paying company.
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