Measures of Return on Investment and Risk

Question 1

What does dividend yield measure?

Answer 1

equity shareholder’s annual cash return on
investment

Question 2

If the dividend yield of Sainsburys is 1.56%, what does that mean?

Answer 2

Sainsbury’s shareholders receive 1.56% dividend for every
£1 invested (at current share price levels)

Question 3

What does the dividend yield tell us?

Answer 3

how much of the investment does the company return in cash

Question 4

High dividend yield means…

Answer 4

a higher portion of profits back to investors
through dividends.

Question 5

What does the dividend cover show us?

Answer 5

Shows number of times dividend is ‘covered’ by current profits

Question 6

What does the dividend cover indicate?

Answer 6

how likely it is that company will be able to
maintain dividends if profits fall; Measure of risk

Question 7

If Sainsburys dividend cover is 2.08, what does this mean?

Answer 7

Sainsburys current profits are over two times its current dividend.

Question 8

What does earnings per share (EPS) measure?

Answer 8

profitability, ability to pay dividends

Question 9

What does the profit in EPS represent??

Answer 9

profit available for distribution to equity shareholders

Question 10

If Sainsburys EPS is 5.8 pence/share, what does this mean?

Answer 10

Sainsbury generated profits of 5.8 pence per share.

Question 11

Basic vs Diluted EPS

Answer 11

-Basic EPS: takes account of all equity shares in issue
- Diluted EPS: takes account of shares that may result if there
are financial instruments which might be converted into shares
in the future because this conversion would ‘dilute’ the EPS

Question 12

What does return on equity indicate?

Answer 12

performance – how well managers
use funds invested by shareholders

Question 13

How do you know when ROE is good?

Answer 13

ROE should exceed cost of equity capital for the firm to be regarded as a success.

Question 14

What do you need to remove to calculate ROE from the perspective of
parent shareholder?

Answer 14

Minority interest

Question 15

What is a minority interest?

Answer 15

company ownership aside from the parent

Question 16

If Sainsburys ROE is 1.77%, what does this mean?

Answer 16

Sainsbury has generated a return of 1.77% on equity invested by controlling shareholders

Question 17

What does the price earnings ratio measure?

Answer 17

Compares amount invested in one share with earnings per share

Question 18

What does the price-earnings ratio represent?

Answer 18

the number of years of current earnings that investors are prepared to buy

Question 19

What is a common range for (P/E)?

Answer 19

10-25

Question 20

P/E is a reflection of what two main things?

Answer 20

Risk: low PE ratio more risk
Expected earnings growth potential: high PE, firm expected to grow

Question 21

What causes variations in PE?

Answer 21

• Overall level of stock market
• Industry

Question 22

If Sainsburys PE is 36.1, what does this mean?

Answer 22

Sainsbury’s investors need 36 years to recoup their investment at current earnings levels

Question 23

What is the market to book ratio?

Answer 23

Relationship between stock market value of shareholder equity and accounting value of shareholder equity.

Question 24

What does the market to book ratio indicate?

Answer 24

whether a company is under- or overvalued… or whether market expectations of the company are high or
low.

Question 25

If Sainsburys has a market to book ratio of 0.64, what does this mean?

Answer 25

Sainsbury investors are paying £0.64 for every £1 of net assets (book equity value)

Question 26

What is interest cover?

Answer 26

Finance cost net of finance income; how many times does the profit for the period ‘cover’ the interest that has to paid;

Question 27

What does interest cover indicate?

Answer 27

how much of a cushion is there once the interest is paid

Question 28

If Sainsburys has an interest cover of 1.78, what does this mean?

Answer 28

Sainsbury’s current operating profit can cover current interest expense 1.78 times.

Question 29

What is gearing/leverage?

Answer 29

the relationship between fixed interest capital (e.g. loans, debentures, preference shares) and the amount of equity capital (i.e. shares).

Question 30

Highly geared/leveraged firm =

Answer 30

a firm with a lot of debt

Question 31

How is equity calculated?

Answer 31

Equity = share capital + share premium account + reserves + retained profits

Question 32

How is debt calculated?

Answer 32

Debt = preference shares + loans + bonds + other non-current borrowings

Question 33

Where is the debt-equity ratio used most?

Answer 33

Financial press

Question 34

If Sainsburys has a debt equity ratio of 111%, what does this mean?

Answer 34

Sainsbury debt is 111% of its equity.

Question 35

What does debt-equity ratio tell us?

Answer 35

the proportion of corporate debt to equity. Typically, higher proportions of debt make the company more risky

Question 36

Where is the gearing ratio used most?

Answer 36

Accounting

Question 37

How is debt expressed in a gearing ratio?

Answer 37

As a fraction of the total capital

Question 38

If Sainsburys has a gearing ratio of 53%, what does this mean?

Answer 38

Sainsbury debt makes up 53% of total capital.

Question 39

What does a higher gearing ratio tell us?

Answer 39

Gearing ratio tells us the relative proportion of corporate debt to equity. Typically, higher proportions of debt make the company more risky

Question 40

Is high gearing a good thing?

Answer 40

Though it increases profit available for distribution as dividends and it is deductible for tax purposes, if there is MORE debt there is MORE financial risk and MORE volatility so not good

Question 41

What are the implications of gearing?

Answer 41

High risk high reward. Increase in profit (before charging interest) in high geared company will result in a proportionately greater increase in the profit compared with the low geared company- but the REVERSE occurs BAD times.

Question 42

What are indicators of good investments (better future expectations)?

Answer 42

-High P/E -High MTB

Question 43

What are indicators of low risk?

Answer 43

-High P/E -High interest cover -Low gearing ratios