Equity Investment Ratios Flashcards

1
Q

What is the formula for calculating EPS (Earnings Per Share)?

A

Earnings (Net of tax) / No. of shares in issue

Number of shares in issue is different to the overall number of shares.

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2
Q

What is the formula for the P/E ratio (Price/Earnings ratio)?

A

Share Price / Earnings per Share

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3
Q

What does the P/E ratio tell us?

A
  • 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.
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4
Q

What are the drawbacks of the P/E ratio?

A
  • 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
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5
Q

The Price Earnings Growth ratio is an extension of the P/E ratio - what does this show?

A
  • 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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6
Q

What are the disadvantages of the Price Earnings Growth (PEG) ratio?

A
  • 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
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7
Q

How is the Price Earnings Growth (PEG) ratio calculated?

A
  • 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).
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8
Q

Company A has a higher P/E ratio than Company B, what could this mean?

A
  • 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
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9
Q

Earnings per share - key points:

A
  • 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

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10
Q

Price-earnings ratio - key points and drawbacks:

A
  • 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
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11
Q

Price-earnings growth (extension of P/E ratio) - key points:

A
  • 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

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12
Q

Dividend yield - key points:

A
  • 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

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13
Q

Dividend cover - key points:

A
  • 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

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14
Q

Net asset value (NAV) per share - key points:

A
  • 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.

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15
Q

Price-to-book ratio - key points:

A
  • 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.

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16
Q

Formula for Gordon’s Growth Model?

What does it do/ show?

A

Share price = Dividend / (Return required - dividend growth)

  • Dividend - expected dividend one year from now
  • Return Required - required rate of return for an equity investor
  • Dividend growth - growth rate of dividends

The Gordon Growth Model (GGM) is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. The GGM assumes that dividends grow at a constant rate in perpetuity and solves for the present value of the infinite series of future dividends.

17
Q
A