Equity Investment Ratios Flashcards
What is the formula for calculating EPS (Earnings Per Share)?
Earnings (Net of tax) / No. of shares in issue
Number of shares in issue is different to the overall number of shares.
What is the formula for the P/E ratio (Price/Earnings ratio)?
Share Price / Earnings per Share
What does the P/E ratio tell us?
- The P/E ratio measures how highly investors value the earnings of a company.
- High P/E ratios can tell us that a company shares are in demand - high demand for shares pushes price up and so increases ratio over the earnings per share
- The P/E ratio gives us an indication of how the market views a companies earnings growth potential.
What are the drawbacks of the P/E ratio?
- Generally based on historic data (unless forecasts are used - though these come with their own drawbacks and are based on further assumptions).
- It is only ONE number and rather simplistic
- P/E ratios are limited to comparisons within the same sector/ and competitor companies
- P/E ratios should be compared to past levels and trends within an industry sector
The Price Earnings Growth ratio is an extension of the P/E ratio - what does this show?
- The PEG ratio shows the projected growth in earnings per share in relation to a company’s share price.
- A high PEG may indicate that the share is expensive
- A high PEG may indiciate that the share has limited growth potential
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What are the disadvantages of the Price Earnings Growth (PEG) ratio?
- It is based on forecasted data/ projections which come with their own assumptions
- It is a simplistic single figure
- It should only be used to compare companies in similar/ the same sectors
- It is mainly used with growth (fast growing EPS) companies
How is the Price Earnings Growth (PEG) ratio calculated?
- We first need to calculate the P/E ratio i.e. Price per share / EPS
- Then once we have the P/E ratio:
- PEG ratio = P/E ratio / earnings growth rate
- The PEG ratio is generally considered a more accurate metric than the P/E ratio. PEG ratios higher than 1 are generally considered unfavourable (overvalued).
Company A has a higher P/E ratio than Company B, what could this mean?
- Company A is valued more highly by the market than Company B
- Company A may be a takeover target or may have a temporary fall in profits -
- takeover = jump in share price
- fall in profits reduces EPS ratio per the share price
- Company B may be experiencing a temporary jump in profits or be looking to make a takeover bid of another company
Earnings per share - key points:
- This is the profit that could have been paid as an ordinary dividend, calculated after all expnses have been deducted.
- EPS is an absolut and specific figure where trend in EPS over time is useful for comparative performance.
- Can be distorted by accounting policy of where share issue/ buy backs have taken place.
- Diluted EPS assumes any options in issue that could convert to ordinary shares are converted.
(Net income - preference shares) / Number of ordinary shares in issue
Price-earnings ratio - key points and drawbacks:
- Gives an indcation of the market;s expectation of company earnings growth potential.
- It is the time, in years, it would take the current EPS to repay the share price.
- High P/E inicates greater ability to grow EPS than competitors.
- Using historic data is said to be “trailing” - using forecast data is “forward”.
It does have drawbacks:
- Generally only based on historic values/ forecast assumptions
- One number and relatively simplistic
- Can only be compared in same sector and similar companies
- Should be compared to past levels and trends within secotr
Price-earnings growth (extension of P/E ratio) - key points:
- Shows the projected growth in earnings per share in relation to a company’s share price. Ratio 1+ considered unfavourable (overvalued); lower than 1 generally considered unfavourable (undervalued).
- High PEG may indicate:
- Share is expensive
- Share has limited growth potential
- Disadvantages are similar to those associated with the PER:
- Mainly used in conjunction with growth companies
- Simplistic, single figure
- Used for same companies and sectors
To calculate, first need P/E ratio. Once P/E is calculaed, PEG is:
PEG ratio = P/E ratio / earnings growth rate
Dividend yield - key points:
- This gives us an indication of the dividend income return on a share.
- Method of comparing dividend with other investments, such as property rental income and bond yields.
- Indicated ability to grow dividends in future. Low yield indicated ability for high growth and vice-versa.
- Compares what an investor receives as a % of what they invest.
Dividend yield = dividend per share / Market price per share
Dividend cover - key points:
- Dividend cover is how many times a company could have paid out its dividends based on the profit for the year.
- Higher the dividend cover, the less likelt that dividends will reduce if profits fall.
- Cover between 1. and 2 often considered healthy.
Dividend cover = EPS / dividend per share
Net asset value (NAV) per share - key points:
- NAV per share, simply the net value of the company, divided by the number of shares.
- Statement of financial position is a list of the assets and liabilities of a company at its year-end.
- Total assets owned by the company and equity and liabilities (shareholders and creditors).
- Total assets always equal equity and liabilities.
NAV per share = Total assets attributable to ordinary share holders / number of ordinary shares in issue
A share would normally be expected to sell at a premium to its NAV.
Price-to-book ratio - key points:
- Indicates how much shareholders are paying for the net assets of the company. Calculated as:
- P to B ratio = share price / NAV per share
- If trading at a discount, this could indicate share is undervalued, or market sees it will remain a stagnant investment.
- If trading at premium, this indicates that the market views it has above average growth potential.
In practice, most companies trade at valuations well above NAV - this becomes much more relevant when dealing with investment trusts.
