3 - Investment Ratios Flashcards
What is the purpose of investment ratios?
Why should care be taken when using them?
Investment ratios summarise the value/expensiveness of shares.
They allow investors to compare shares to each other and make decisions about whether to invest or not.
Care should be taken comparing companies and drawing conclusions based on these ratios. Companies in different sectors or at different stages in their life (i.e. start-up vs mature company) will inevitably have different ratios.
What is Earnings Per Share?
How does it relate to the dividend?
Earnings per share is the profit made by the company divided by the number of shares.
The company decides how much of it’s profit to pay out as a dividend, usually it will pay some out and keep some to re-invest.
HOWEVER the dividend could be higher than EPS if they choose to pay out cash reserves, or the dividend could be zero if they want to focus on growing the company.
When do you use revenue in investment ratios?
Never!
We only care about the profits (i.e. earnings).
What is the dividend yield?
What does a high or low yield potentially mean?
If the dividend stays the same and the share price falls what will happen to the dividend yield?
This is the return/yield you’re receiving as a result of the dividend.
= Dividend / Share price
If you have a very high dividend yield it might be unsustainable.
If the div yield is very low the company is likely retaining it’s profits to invest in growth.
If the share price falls and dividends don’t change then the yield will rise.
What is dividend cover?
How do you calculate it?
Do you want it to be high or low?
Difference between young and mature companies?
Dividend cover is the number of times the company could pay out it’s dividend out of it’s profits/earnings.
Dividend cover = Earnings per share / Dividend per share
The higher the dividend cover the better, a low dividend cover means they are finding it hard to generate the profits to pay the dividends. If profits fell they might have to reduce dividends.
A young company which is growing may have a higher cover since they are paying out very little of their profits (dividends are much lower than earnings) whilst a mature company might have a lower ratio because it pays out everything it earns.
Price/Earnings Ratio
Calculation
What is it?
What does a high number mean?
P/E ratio = Price per share / Earnings Per Share
This is the amount you have to pay for £1 of earnings/profits.
A high number means you have to pay a lot for the earnings, but is not necessarily “good” or “bad”.
It could mean the share are “expensive”, but more likely there is another reason, for example it is high growth company. People are willing to pay a lot for the current level of earnings, because they think earnings in the future will grow much higher.
Price Earnings Ratio
What happens to the PE ratio if earnings rise at the company (assuming nothing else changes)?
What if the dividend is increased (assuming nothing else changes)?
What if the same price falls (assuming nothing else changes)?
If earnings rise at the company but nothing else changes then the PE ratio will fall. You are paying the same price per share but getting more earnings for each £1 you spend.
Dividends don’t affect the PE ratio! PE ratio ignores how much of the earnings are paid out as dividends, because in the long run it doesn’t matter.
If the share price falls, the PE ratio will also fall (you have to pay less to receive the same amount of earnings).
Net Asset Value
Calculation
How is it used?
When is it useful?
Net Asset Value is the value of all the assets of the company minus all the liabilities (ignore anything called capital accounts, reserve accounts or profit/loss accounts).
It is used to calculate NAV per share (Net Asset Value / # shares) which gives you an alternative valuation for the shares.
For some companies this may provide a meaningful way to value the company (e.g. a company investing in real estate is worth roughly the value of it’s properties). For others it will be irrelevant (e.g. service companies that generate profits but don’t own many assets.
It is also useful if a company is getting liquidated. Earnings/dividend measures are irrelevant, you just care about what’s left when you sell off the assets and pay off the debts.
What are the 2 main limitations of investment ratios?
- They are backwards looking (i.e. historical), ignore any judgement about what happens in the future
- They are dependent on accounting methodologies (accountants can make earnings or asset values higher or lower in a given year)
