The plowback ratio is the percentage of earnings reinvested into the firm.  In other words, it is the amount of earnings the firm retains after it has issued dividends.

The size of the plowback ratio is important as the more money a firm retains the more growth a firm can sustain.  A new start-up company will (or should) have a higher plowback ratio as it is seeking to grow.  However, a company that is mature and a “cash cow” will have a lower plowback ratio as it has already passed its stages of large growth.

A new start-up company has many opportunities for new investments and with a solid business model those investments can have high returns.  On the other hand, a mature company will have less investment opportunities with high returns as it has already reached most of its potential.  For a mature company it is often a better idea to payout its earnings to investors so they can invest those earnings in investments with higher returns.

The plowback ratio is simply the inverse of the payout ratio (the percentage of earnings paid out to investors).

Plowback ratio = (earnings - payout)/earnings

The plowback ratio can be used to find the growth rate of a company (which is used in the dividend capitalization model) by multiplying it against the return on equity.

To be honest, no one knows when a bottom is in. Only time can tell.  I am sure you are wondering, “When should I invest then?!”  Well, there isn’t an easy answer; however, there are a few ways to help you choose.

Example:

The market is currently in a down trend. Suddenly one day it rebounds. The next day it rebounds again. What do you do? You can put 1/10 of your money to work in a few stocks. Now, if the market goes down you only have a 1% risk. (10% money at work with 10% stop loss.) If it goes up, you have great upside. You will also want to keep adding to your positions and adding new positions in your stock portfolio.

Another thing you could do is invest after a confirmed market rally. This will help cut losses and help capture gains. You can get the status of the market at investors.com.

Note: If anyone tells you they know when the market is at the bottom - they are flat-out liars. They might pull out their charts and tell you why it is a bottom or about history. Now, history helps us predict things such as in the market, but there never is a for sure in the market.

Many people do not understand risk management. Here is a simple guide you can refer to.

1.  Stop losses - You set them within your broker’s site to make sure a certain stock does not go below a certain price, usually by 8 - 10%.

2.  % of Money at work - If you only have half your money at work, you only have half the risk.

Example of how this works:

For argument’s sake, let’s say you have $100,000. If you were to invest 50% of that money, which would be $50,000, you would have cut your overall risk down to 50%.  That means if tomorrow every stock you had went bankrupt, you would still be left with $50,000 in the bank you did not invest with.  If you are an investor, you should be putting stops on each stock. Usually you will buy on pull backs and put your stop loss at 8% on each stock.

If you only have $50,000 of $100,000 invested, your risk is only 50% and if you put your stop losses at 10% your overall risk is only 5%. To some people this can give great comfort at night knowing they have a tremendous upside, but also have a low risk downside.

Playing around with these types of scenarios can give you different risks and rewards. If interested, I encourage you to see what investing 75% of your money with a 10% loss, etc. will do to your risk/reward. Risk management should always be apart of your stock game plan.

Do you know the answer to this question?  A lot of professionals on Wall Street would find it difficult to give you a complete answer.  Let’s start the thought process and see if we can arrive at an answer that is complete.  What influences the price of anything?  Supply and demand.  The smaller the supply of an item the higher the price it will have then if there was a greater supply of it in the market.  The greater a demand for an item the higher the price it will command in the market.  OK, that’s the simple stuff, now let us apply it to a share of common stock.

Before we continue let’s make sure we know what a share of common stock is.  A share of common stock is a claim on a company’s earnings and assets.  That doesn’t mean if you own a share of Kraft Foods Inc. (KFT) that you can walk into Kraft and demand that you get a box of their cheesiest macaroni.  Companies issue these claims so that they can raise capital.  Investors then buy them because they expect to have a claim on future earnings through dividend payments.  In theory when a company goes bankrupt and liquidates they should pay out to equity holders, stock holders, for their claim, but equity holders are the last ones paid in a Chapter 11, they are a residual claimant, and by the time it comes to pay them there’s usually nothing left to pay them with.

Imagine that all of the stock market exchanges closed tomorrow and would never reopen.  In this world you would never be able to sell your stock.  You would not want to buy the stock because you think at a later date someone will pay you more money for it, you can no longer sell it!.  So why own it?  You own the stock because of that claim on the company’s earnings, and the dividend payment; which is the company giving you your “share” of that claim on earnings.   Why then would you want to buy stock in a company that is not issuing dividend payments, or are issuing very low ones?  Because in the future you believe that they will issue payments, or if they already are, larger payments.  A company would begin to issue divdiend payments, or larger dividend payments because they are earning more, they are growing or becoming more efficient and thus more profitable.  This is why revenue growth and cost efficency is so important to a company, and why it should be very important to an investor investing in the company.

Let’s come back to the real world where stock exchanges do exist.  And let’s ask the question we started with again, “what influences the price of a stock?”  Supply and demand. We already got that part, but now that we know more we can expand that answer.  Supply influences the price of a stock because the smaller the supply of the outstanding shares of common stock, the greater the stock holder’s “share” of earnings will be, the greater their dividend payment.  There is a demand for common stock because of the claim on earnings that it entails and the dividend payment that comes with that claim.  When the dividend payment increases that is going to increase the demand for the stock.

Compacted answer: the smaller the amount of shares of common stock for the company in the market the greater its price than if there were more shares of the common stock  for the company in the market.  The larger the dividend payment the more expensive a share of common stock will be in the market.

The dividend capitalization model, also known as the dividend growth model, is used to find the cost of equity.  To understand why the dividend capitalization model makes sense and is useful you must understand what influences the price of a stock.  And you must believe that the most important factor that influences the price of a stock is the future dividends that it’ll pay.

The calculation for the dividend capitalization model is as follows:

Cost of Equity = (Dividends per Share (for next year)/Current Market Value of Stock) + Growth Rate of Dividends

Dividends per share are reported in the company’s financial statements, and future ones are always disclosed in news releases.  The current market value of the stock can easily be obtained from places such as google.com/finance or finance.yahoo.com.  However, the growth rate of the dividends is an assumption estimation that you must make when valuing the company.  You can look up in the company’s annual reports the dividends that have been paid year by year by the company up to this point and figure out the growth rate.  This is a good strategy, but keep in mind that past results are not always implications of future results.  Another method would be to look at what the company’s management is prediciting for future dividend payment; remember though that management is often optimistic in their forecasts.  There is no perfect method, that’s why telling the future isn’t easy, even if Miss Cleo claims on her commercials that it is.

The dividend capitalization model is not the only model used for calcuating cost of equity.  The capital asset pricing model, CAPM, is also widely used and often more popular.  Both, however, can be used and often are for discounted cash flow anyalsis, DCF.