6.) Assessment of Equity Performance

Question 1

Define bear markets, in relation to shares

Answer 1

A market in which share prices are falling, encouraging selling.

Question 2

Define bull markets, in relation to shares

Answer 2

A market in which share prices are rising, encouraging buying.

Question 3

Briefly describe why investors buy ordinary shares

Answer 3

Investors buy ordinary shares because they expect share prices to increase, resulting in:

Capital gains

An increase in the nominal value

Dividend payments due to increased earnings of the invested company

Question 4

Define how the rate of return on equities can be calculated

Answer 4

By calculating the yield, which expresses the return earned on the investment as a percentage of the amount of capital invested.

Yields are normally calculated on a gross basis, so that investors can assess them based on their own individual tax situation

Question 5

Briefly describe the pattern that that share prices tend to follow

Answer 5

Share prices tend to follow a regular cyclical pattern of bull markets (prices in a rising trend for a year or so) followed by bear markets (whereby prices start falling)

Question 6

Define what comprises the total return for equity investors

Answer 6

Any dividend paid plus growth in the value of their capital investment

Question 7

Define the Gross Dividend Yield

Answer 7

Aka the gross yield

The yield on an investment before the deduction of taxes and expenses. Gross yield is expressed in percentage terms.

It is calculated as the annual return on an investment prior to taxes and expenses divided by the current price of the investment.

Question 8

Define how Gross Dividend Yield is calculated

Answer 8

Gross Dividend Yield (%) = gross dividend paid in year divided by current market price of share X 100

Question 9

Briefly describe what the Gross Dividend Yield is based on, or made up of

Answer 9

The Gross Dividend Yield is based on all dividends paid by the company to an ordinary shareholder in respect of the preceding financial year.

It is therefore an historical measurement of the rate of return

When a company declares an interim dividend, it is usual to continue reporting dividend yield on the basis of the dividend for the previous year.

The dividend isn’t updated to reflect the current year’s interim amount

Question 10

Define why the value of dividend yields may vary, and how this may correlate with the size of the company issuing said dividend

Answer 10

Dividend yields may vary according to the investment risk.

The more profitable companies, when profits and dodo ends are expected to grow over time, tend to establish lower yields.

In contrast, high dividend yields are generally on low growth companies which don’t have good long-term prospects. High yields are nearly always associated with high risk

Question 11

Define the Earnings Yield, and how it is calculated

Answer 11

The Earnings Yield provides an indication of growth in earnings and therefore a likely growth in dividends. It is calculated as follows:

Earnings Yield (%) = Earnings per share (gross)/current market price of share X 100

E.g. Company A has an earnings per share of £0.79p and current market price of each share is £2.50

Earnings yield per share: 79/250 X 100 = 31.6%

Question 12

Define how the Earnings Yield is calculated

Answer 12

Earnings Yield (%) = Earnings per share (gross) divided by current market price of share X 100

E.g. Company A has an earnings per share of £0.79p and current market price of each share is £2.50

Earnings yield per share: 79/250 X 100 = 31.6%

Question 13

Define the abbreviation P/E Ratio

Answer 13

Price/Earnings Ratio

Question 14

Define the P/E Ratio (Price/Earnings Ratio), and how it is calculated

Answer 14

The P/E Ratio is calculated by the current market price of the share divided by the annual earnings per share, and is deemed to be an effective tool in analysing the performance of an equity on the basis of earnings (profit) rather than dividends.

It is very useful for comparing share prices of different companies who operate within the same sector as it gives the investor a like-for-like comparison of potential earnings. It is a way of measuring how highly investors value the earnings the company produces

E.g. Company C had earnings per share of £0.35p and the market price is £5.00p

The shares sell at 14.3 times earnings (or another way of saying it); the shares are on a multiple of 14.3

As with all performance assessment calculations, the P/E Ratio shouldn’t be used in isolation, particularly if the company’s earnings fluctuate from one year to the next

Question 15

Define what low or high P/E Ratios indicate, respectively

Answer 15

A low P/E ratio indicates a HIGH assessment of risk and/or LOW prospects for profit growth

A high P/E ratio indicates a LOW assessment of risk and/or HIGH prospects for growth in either profits or dividends

Question 16

Define dividend cover and how it is calculated

Answer 16

The dividend cover is calculated by the maximum profits of a company that are attributable to the ordinary shareholder divided by the total amount of the dividend cover actually paid to the ordinary shareholder. The profits attributable to the ordinary shareholders are profits after tax and preference share dividends

It simply states the number of times that the dividend could theoretically have been paid to the ordinary shareholders

E.g. Company D made £14,000 profits that are attributable to the ordinary shareholders and £8,000 was actually paid to the ordinary shareholder

14000/8000 = 1.75

Therefore, dividend cover is 1.75 times, I.e. dividends could be paid 1.75 times over

Question 17

Define the consequences of high dividend cover

Answer 17

Shareholders will be more reassured if dividend cover is high, as it means that they’re more likely to be able to continue to receive their dividends in the future.

High dividend cover is also an indication that the company is retaining earnings in the business.

However, too high dividend cover could suggest the company isn’t particularly good at cash management and may need to reinvest or distribute some of its retained profits.

Question 18

Define the industry norm/average for dividend cover

Answer 18

1.5 times, anything below this is deemed as too low

Question 19

Describe the importance of strong dividend cover

Answer 19

Dividend cover is an important measure of the safety of the dividend and the company’s ability to pay it in the future

The more strongly it is covered, the less chance the company will reduce it if profits fall.

However, if a company reports losses in a particular year, dividends can still be paid out of its retained profits, the company reserves.