Ratio Analysis Flashcards
1
Q
What is a dividend yield? (7)
A
- Tells investors the dividend income return of a share
- Ratio compares what an investor receives (net) as a percentage of what they have invested (market price)
- Expressing yield as a percentage allows comparison of investing in a particular share with other shares or types of investments
- Div yield = div per share/market price per share*100
- Low yields indicate a high growth company or an overvalued share
- High yields indicate a low growth company and an undervalued share
- Yields are always inversely related to prices
2
Q
What is dividend cover? (6)
A
- Looks at how many time a company could have paid out its dividends based on profit for the year
- Important measure of the safety of a dividend
- More times it could’ve been paid, the stronger the dividend cover
- Less likely that dividends need to be reduced if profits fall
- Company can pay divididends greater than a years earnings (gives a dividend cover less than 1) by drawing on profits within the P/L reserve in the balance sheet - this is called uncovered dividend
- Dividend cover = earnings per share/dividends per share
3
Q
What is a payout ratio? (4)
A
- Measures the sustainability of a company’s dividend policy
- Payout ratio = dividend per share/earnings per share
- What percentage of the yearly earnings are needed to pay this years dividends - lower the percentage the better
- Dividend cover - higher the percentage the better
4
Q
What is absolute valuation? (2)
A
- Based on discounting techniques
- Used to estimate the value of equity as the present value of future equity returns to the investor
5
Q
What is relative valuation? (2)
A
- Estimates the value of equity as some measures of earnings power (e.g. profit) by an appropriate multiple
- Other earnings power includes sales, net assets (book value) or cash flows
6
Q
What is earnings per share? (3)
A
- Measures the profit available to ordinary shareholders e.g. profit that could have been paid as an ordinary dividend
- Profit is calculated after all other expenses and appropriates have been made
- EPS = profit available to ordinary shareholders/number of ordinary shares
7
Q
What is diluted EPS? (6)
A
- Worst case scenario calculation
- Assumes potentially dilutive securities (that could convert into ordinary shares)
- EPS is re calculated using the new, higher number of share and any revenue generated from process
- If diluted EPS is lower, must be displayed in addition to EPS
- Dilutive securities include; directors share options, warrants, convertible debt securities
- Diluted EPS acts as a warning to existing ordinary shareholders
8
Q
Evaluate EPS as a valuation technique (7)
A
- An absolute measure
- Not useful for inter company comparison
- Better used to analyse trends in EPS over time and used as an indicator of growth
- Dividend payouts are dependent on the availability of cash flows to meet them
- EPS is based on profit not cash which may be distorted by accounting standards - one of purchases and write offs
- Not indicative of a firms ability to meet or maintain current dividend yields
- EPS may rise due to a fall in number of shares - (buyback)
9
Q
Summarise the price/earnings ratio (7)
A
- Also known as earnings multiple - measures how highly investors value the company as a multiple of its earnings (profit)
- PE ratio = Market price per share/EPS OR market cap/profits available to ordinary shareholders
- PE ratios are expressed as multiples e.g. 35/6.83 = 5.1x
- High PE ratio relative to the sector average = investors expect the company to achieve above performance and growth
- Low PE ratio relative to the sector = investors expect the company to achieve below average future growth earnings
- Some investors will seek out value stocks that may have been attributed a low P/E - may be undervalued
- Some high P/E stocks may be overvalued and give rise to market correction
- P/E can be problematic for companies that experiences cyclical earnings cycles - stable prices but P/E calculations at different points in the cycle will give variable results
- P/E cannot be looked at in isolation
10
Q
What is EV/EBITDA? (6)
A
- P/E measures are based on accounting profit - includes items derived from estimates or judgements e.g. depreciation and amortisation
- EV/EBITDA uses earnings before interest, tax, depreciation and amortisation - exludes the main two items that can be inconsistently calculated or manipulated by accountants
- More comparable measure of the earnings available - compares market value of capital form all providers with a measure of profit available to them
- How investors value a company as a multiple earnings
- EV/EBITDA = EV/EBITDA
- EV = enterprise value = market value of debt + market value of equity
11
Q
What is price to book ratio? (4)
A
- Book value of net assets is likely to be more stable than earnings
- Less likely to be negative
- If book value is used in place of EPS in PE calculation, then this is price to book ratio
- A higher p/b ratio means the market believes the company is likely to use its assets to increase value
12
Q
What is price to sales ratio? (4)
A
- Can be used to create an alternative market multiple - sales are not negative and less subject to market distortion
- Sales do not necessarily create profit and cash
- Sales are generated by the use of both equity and debt, not equity alone
- More appropriate alternative is EV/S where enterprise value is the value of the entire entity (market value of debt + market value of equity)
13
Q
What is price to cash flow ratio? (2)
A
- Cash is unaffected by accounting policies and treatment but can still be negative
- Different definitions of cash flow can be used to get around this - operating cash flow, free cash flow
14
Q
What is residual income valuation model? (5)
A
- Alternative for the discounted cash flow method
- Valuation based on multiples in determining a company’s value
- Creates the company’s value from the book value of assets of a company and the present value of the future ‘residual income’
- Residual income is income achieved above the expected return of equity
- This approach works well for shares with negative earnings, cash flows and that do not pay out dividends e.g. Apple
15
Q
What is gearing? (7)
A
- Quantifies the proportion of capital that is debt financed and that which is provided by shareholders
- If a company is financed soled by equities, no interest is paid out before dividends - dividends are discretionary to the performance of the company
- If a company had debt finance then interest is paid before dividends - these payments are fixed, even in poor trading years interest has to be paid out and this will impact dividends
- Highly geared companies will have a greater return in good years and a greater loss is down years
- Gearing creates risk for ordinary shareholders
- If gearing is low, company has capacity to borrow
- Financial gearing = Debt/capital employed
- Capital employed = Debt + Equity
16
Q
What is a liquidity ratio? (6)
A
- Ability to pay is known as liquidity
- Assessed using current and quick ratios
- Current: puts current assets over current liabilities. Shows whether assets that covert in a year can cover liabilities in the same period. Current ratio = current assets/current liabilities
- Quick ratio/acid test: excludes inventory ‘stock’ from current assets as this is the least liquid current asset. Quick ratio gives a tighter measure of a company’s ability to meet sudden cash call. Quick ratio = current assets - stock/current liabilities
- A current or quick ratio > 1 indicates that the company has sufficient assets to cover short term liabilities
- A current or quick ratio < 1 will need to raise new finance
17
Q
What is operational gearing? (6)
A
- Looks at the sensitivity of profits to sales revenue
- Percentage change in trading profits that result from one percent change in sales revenue
- The value of operational gearing depends on the relationship between fixed costs, variable costs and profit
- Operational gearing = (sales revenue - variable costs)/trading profits
- Companies with the highest gearing will see profits increase disproportionately as sales increase
- More geared = more volatile
18
Q
What is return on capital employed (ROCE)? (6)
A
- Measure of profitability relative to size
- Compares profit with the assets available to generate profit (capital employed)
- Gives indication of how well a company is generating profits from its asset base
- ROCE = PBIT/capital employed * 100
- Capital employed = share capital + reserves + long term borrowing
- ROCE is based on profit before interest and tax (trading profit) - by using PBIT there is no distortion from changes in finance structure / tax planning
19
Q
What is operating profit margin and how is it calculated? (5)
A
- Looks at how efficient a company is at turning sales into profit once all costs are considered
- Operating profit margin = operating profit/sales
- Expressed as a percentage
- Higher the percentage the more efficient the company is
- Different sectors have different averages for profit margins - manufacturing 8-10%, retail has lower margins
20
Q
What is asset turnover and how is it calculated? (1)
A
- Asset turnover = total revenue/total assets
21
Q
What is the impact of corporate actions on major accounting ratios? (4)
A
- Rights issue - company issues shares for rights issue, raisins more capital. Increase in capital leads to a fall in ROE and ROE. Increased number of shares could reduce EPS. Key feature of rights issues is the reduced in financial gearing
- Share buy back - company uses capital to buy back shares from secondary market, this increases ROE and ROCE and gearing. EPS increases
- Scrip/bonus - company does not raise new capital with scrip/bonus issue, no impact on ROE, ROCE or gearing. Increased number of shares diluted the EPS
- Stock split - no impact on ROE or ROCE or gearing. EPS will be diluted
