Topic 7 - Analyse, interpret and compare ratio-analysis Flashcards
Earnings/Dividends Per Share
- Measures profitability of company as in £ per share
- Shows how much investor has made from each share
- Meaningful comparisons across years & competitors
- Strong cash flows enable ability to finance future operations and means to pay dividends. Therefore ability to grow EPS consistently drives up demand.
- EPS = Earnings divided by Number of Shares
- Earnings = All profits after tax, expenses, interest etc
What is the Price / Earnings Ratio?
How is it calculated?
Expression of number of years of earnings and measures how investors value a company and ability to increase revenue.
Can be calculated:
- Historic P/E Ratio from last reported annual earnings
- Potential P/E Ratio based on forecasted earnings
P/E = Share Price divided by EPS
I.e P/E of 25 means 25 years to recoup initial investment.
Must only ever be compared with similar companies
What does a high or low Price to Earnings Ratio Indicate?
What could be some reasons for the Price to Earnings Ratio being too high?
High P/E Ratio could indicate overvalued share or that investors expecting growth.
Low P/E could mean share is undervalued and bargain or that market hasn’t taken into account an future growth event such as restructuring. Could also mean market has low expectations and may not be a good bet.
Ideal is a stable low P/E Ratio as years required to recopu share price via cash earnings will be fewer.
Unusually high/low P/E ratio compared to competitors can be found by comparing current with average over last 5 years. Known as Price/Earnings Growth.
Reasons for Higher P/E Ratio apart from being overpriced:
- Better quality of earnings
- Market perception of EPS growth
- Subjection to merger and acquisition or fall in profits
What is the Price to Earnings Growth (PEG) Ratio?
How is it calculated?
P/E Ratio can be misleading. PEG ratio finds balance between Price, EPS and company’s expected growth.
- PEG Ratio of 1 = fair balance between cost and growth.
- PEG Ratio of 0-1 means it offers higher growth potential
- Negative PEG Ratio may but not always mean reduction in earnings
PEG = (Price divided by earnings) divided by Annual EPS Growth
What is EBITDA - Earnings Before Interest, Tax, Depreciation and amortisation and what is it used for?
Accounting ratio that allows for EPS and P/E Ratio of companies to be ignored to certain extent.
Used as a real-cash measure to compare similar companies more fairly because different firms have different grearing, tax laws and depreciation assumptions. Investor can see how much cash a company actually has and compare this to to others.
What is Return On Capital Employed (ROCE)?
What can ROCE be used for?
To compare operating performance of company, especially profitability & how well its assets and activities are generating income and shareholder value.
Capital employed includes equity and debt. Returns generated in terms of % of capital can be used to:
- Compare the returns generated to the cost of borrowing;
- Establish trends across accounting periods; and
- Make comparisons with other companies.
How is the ROCE Calculated?
ROCE = (Profit from Operations + interest recievable + other income (A.K.A PBIT) / divided by capital employed) x 100
Exam Note
The PFO and CE will be given to you. You will need to consider any relevant IR or OI to be included in the calculation.
(Profit from Operations + interest recievable + other income is also known as Profit before Interest and Tax (PBIT))
- CE = Total asets - current liabilities + Bank overdrafts*
- CE = Shareholder funds + Loan Capital + Bank Overdraft*
What circumstances can cause problems with using ROCE?
Relatively easy view of profitability but like alll accounting ratios it can be manipulated or cause misleading analysis.
- Company raises new finance at end of accounting period, increases capital employed but profit isn’t yet realised.
- Acquires subsidiary at end of period, CE increased but no post-acquisition profits as profit and loss kept separate.
- Company revalues fixed assets. Increases CE & due to depreciation charge increasing it reduces profit.
What is Asset Turnover and Profit Margin?
How are they calculated?
Breaks down ROCE into two further formulas. Can further interrogate the quality of the underlying revenue.
Must be interpreted and given meaning by comparing results with similar companies in sector.
Asset turnover
Relationship between sales and capital employed. I.e how efficiently company is generating sales by looking at how well assets and activities are working.
Asset Turnover = Sales divided by Capital Employed
Profit margin
Profit per £ worth of sales, taking account all associated costs
Profit Margin = PBIT divided by Sales
What is the Quick Ratio / Acid Test?
How is it calculated?
Company’s Cash liquidity to ensure it has cash flow to pay for liabilities as they fall due (within 1 year)
Current Assets - Inventory divided by Current Liabilities
If inventory is included this is the ‘Working Capital Radio’
Ideally higher than 1, otherwise on face value company is insolvent or illiquid but comparison to industry is key measure
