Week 9 - Tutorial 8

Question 1

Question A:
You are given the following information about two companies.
You are required to fill in the missing items for Beermouth plc.
Comment on the dividend yield of Alemouth plc.

                                         Alemouth plc  Beermouth plc Share Capital (20p shares)  £1,600,000       £2,000,000 Retained earnings               £3,200,000      £18,000,000
                                          £4,800,000    £20,000,000 Net profit after tax for year £3,520,000       £1,200,000 Dividends for year               £3,200,000         £800,000 Number of shares                 8,000,000       10,000,000 Market price of shares            £4.40                   £1.80 Market capitalization        £35,200,000     £18,000,000 EPS                                           £0.44                   £0.12 Dividend per share                 £0.40                  £0.08 P/E ratio                                       10                          - Dividend times cover             1.1 times                     - Dividend yield                          9.09%                      - Net assets per share               £0.60                       -

Answer 1

Missing items for Beermouth plc.

P/E ratio = Market value per share/Earnings per share
= (£1.80/£0.12) = 15
Dividend times cover = EPS/Dividend per share
= (£0.12/£0.08) = 1.5 times
Dividend yield = (Dividend per share/Share price) x100
= (£0.08/£1.80) = 4.44%
Net assets per share = Total equity/Number of shares
= (£20,000,000/10,000,000) = £2

The dividend yield of Alemouth plc is very high, which is associated with a low P/E ratio (10), a low dividend cover (1.1 times) and pessimism about future prospects.

Question 2

Question B:
You are given the following information about two companies, partly extracted from their most recent statement of financial position and income statement, and partly taken from the financial press.
You are required to fill in the missing items for Drinkmouth plc.

                                     Cidermouth plc Drinkmouth plc Share Capital (20p shares) £4,000,000     £1,200,000 Retained earnings              £14,000,000    £2,400,000
                                        £18,000,000     £3,600,000 Net profit after tax for year £3,400,000     £1,800,000 Dividends for year              £2,000,000       £900,000 Number of shares               20,000,000      6,000,000 Market price of shares            £3.40                     - Market capitalization         £68,000,000  £45,000,000 EPS                                            £0.17                 £0.30 Dividend per share                  £0.10                      - P/E ratio                                      20                      25 Dividend times cover           1.7 times                    - Dividend yield                          2.9%                    2.0% Net assets per share              £0.90                      -

Answer 2

Missing items for Drinkmouth plc.

Market price of shares = Market capitalisation/Number of shares
= (£45,000,000/ 6,000,000) = £7.5
Dividend per share = Dividends for year/Number of shares
= (£900,000/6,000,000) = £0.15
Dividend times cover = EPS/Dividend per share
= (£0.30/£0.15) = 2 times
Net assets per share = Total equity/Number of shares
= (£3,600,000/6,000,000) = £0.60

Question 3

Question C:
You are given the following information about Swin Gin plc

       Year 1 Year 2 Year 3 Year 4 Year 5* Year 6 Year 7 EPS £0.50 £0.55  £0.62  £0.01   £1.20   £0.83  £0.90 Share Price £6.00 £7.70 £9.92 £6.00  £7.20  £12.45  £15.30 (after publication of results for year)

*In year 5 the company sold its head office building in London making a profit that amounted to 45p a share.

You are required to calculate the P/E ratio for each year. How can you explain these changes in P/E? Why might the P/E ratio be abnormally high or low in a
particular year?

Answer 3

Swin Gin plc

       Year 1  Year 2  Year 3  Year 4  Year 5*  Year 6 Year 7 EPS  £0.50   £0.55    £0.62    £0.01    £1.20    £0.83  £0.90 Share Price £6.00  £7.70     £9.92    £6.00   £7.20   £12.45  £15.30 P/E        12       14          16         600       6           15        17

P/E ratio =
Market value per share (share price)/Earnings per share

• In years 1 to 3, as EPS has increased there have been
increasing P/E ratios. The market has reacted positively to the increases in profits and expected the business to continue to prosper.

• In year 4, there is an exceptionally low EPS. The market expected this to be temporary, so prices did
not fall by as much as EPS. As a result, the P/E ratio is
abnormally high.

• In year 5 we see a sizable increase in EPS fuelled by exceptional sale items. Again, this was expected to be temporary, so prices did not increase by as much as EPS. As a result the P/E is abnormally low.
• In years 6 and 7 as the confidence in the company grows, as shown by the increasing share prices, there is a corresponding increase in the P/E ratios.

Question 4

Question D:

Assess the usefulness of P/E ratios, and explain why they might be misleading.

Answer 4

• The P/E ratio measures how investors value shares of a company relative to it’s earnings
• A high P/E ratio suggests optimism whilst a low P/E ratio suggests lack of confidence by the market
• High P/E ratios are associated with high expectations about the rate of growth of earnings
• Sometimes P/E ratios may be abnormally high and therefore meaningless
• Unusual P/E ratios are often due to unusual earnings figures (for example, due to exceptional items) and in the interpretation of P/E ratios attention must be paid to this