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Financial Statement Analysis for Equityby Binam Ghimire

Learning Objectives

1. Investment Ratios2. Book Value Vs Market Value of a Business3. Risk & Beta 4. Risk Vs Return making Investment Decisions

Introduction

In the last session we made the point that the needs of shareholders and creditors are somewhat different

As a result investors (existing and potential) and interested in a different set of ratios

In this session we will examine Investment Ratios which assist investors to evaluate their investment

Investment Ratios

Here are the Investment ratios we will consider. What do they show and how are they calculated ? Earnings per Share Earnings Yield Dividend per Share Dividend Yield Dividend Cover Dividend Payout Ratio Price Earnings Ratio, (PE Ratio)

Example

Calculate the Investment Ratios for the following company:

Number of Ordinary Shares 3,000,000Market Value per Share £ 3.50Earnings attributable to ordinary shareholders£1,000,000Total Ordinary Share Dividend £ 300,000

Earnings per Share

Earnings attributable to ordinary shareholdersNumber of Ordinary Shares

 e.g. £1,000,000 = £0.33p per share

3,000,000 sharesWhere: Earnings attributable to ordinary shareholders = Profit after tax less Preference Share Dividends

because that part of the profit is not available to the ordinary shareholders

Earnings YieldEPS x 100%

Market or Nominal Value of Shares  e.g. £0.33p x 100 = 9.43% £ 3.50Note: Market value provides the more meaningful ratio

Dividend per Share

Total Ordinary Share DividendNumber of Ordinary Shares

  e.g. £300,000 = 0.10 p per share

3,000,000 shares

Dividend Yield

DPS x 100%Market or Nominal Value of Shares

  e.g. £ 0. 10 p x 100 = 2.86% £ 3.50Note:Market value provides the more meaningful ratio

Dividend CoverEPSDPS

  e.g. 33 p = 3.3 times 10 p

Dividend Payout Ratio

Ordinary Share dividend x 100Earnings attributed to Ordinary Shareholders e.g. 300,000 x 100 = 30% 1,000,000

Price Earnings Ratio, (PE Ratio) Market price per Share

EPS  e.g. £3.50 = 10.6

£0.33 p

Example Investment Ratios

Number of Ordinary Shares 3,000,000Market Value per Share £ 3.50Earnings attributable to ordinary shareholders£1,000,000Total Ordinary Share Dividend £ 300,000

Earnings per Share/Earnings Yield 33 p9.43% Dividend per Share 10p

2.86% Retention 23 p Dividend Cover 3.3 times Dividend Payout Ratio 30% Price Earnings Ratio, (PE Ratio) 10.6

Earnings per Share (EPS)

EPS = the amount of earnings per share. In our example each share earns 33p

shareholders will wish to see that the company is earnings more each year

a company must be able to generate earnings in order to declare dividends and to re-invest in the business so that it can grow

Earnings Yield

the yield is the % return EPS is 33p which equates to a return of 9.43% on

a share that cost £3.50 to buy But EPS is one thing, shareholders may not

receive the Earnings they may be retained for future investment, which is not a bad thing, but the shareholders will also wish to assess the actual dividend they receive.

Dividend per Share (DPS) DPS = the dividend paid per share, in our case 10

p per share shareholders will wish to see this rise and it is not

uncommon to see companies pay a slightly bigger dividends each year regardless of the trend in earnings !

you should also consider the shareholders tax position - not every shareholder wants more income ! Therefore companies tend to adopt an improving but consistent dividend policy

Dividend Yield

the yield is the % return DPS is 10p which equates to a return of 2.86% on

a share that cost £3.50 to buy As a shareholder how would you feel about a

return of 2.86%. You may get more from a bank at no risk (???),

with shares you could lose everything!

Dividend Cover

dividend cover is the number of times that the dividend could be paid out of current profits

it helps to assess the ability of the company to maintain such a dividend in the future, in our case profits could decline 3.3 times and the dividend could still be paid

it also examines the dividend policy. A high cover indicates that a high proportion of profits are being retained. In our example the company earned 33p per share and paid a dividend of 10 p per share meaning that they have retained 23 p per share

as a shareholder you will need to be convinced that the company will use the retentions wisely for your future prosperity

Dividend Payout Ratio

closely linked to the dividend cover it calculates the % of earnings attributable to

shareholders that are distributed in dividends in our case, 30%, therefore 70% is retained shareholders and the market would need

convincing about the use of these funds

Price Earnings Ratio, (PE Ratio)

the most important ratio for calculating the value of a share Our example shows that a share costing £3.50 earns 33p

giving a PE Ratio of 10.6 You could say that it would take 10.6 years of earnings to pay

for the share (at that price and level of earnings) If a similar company may have the following PE Ratio:

£ 1.75 = 5.3 £ 0.33 p

this would only take 5 years earnings to cover the cost of the share, which makes you wonder why people are willing to buy our shares at £3.50 when they only have the same earnings pr share as a similar company whose shares cost £1.75. Clearly the market must expect our company to have bigger earnings in the future. Whether they do or not is another matter.

Book Value and Market Value

In previous sessions we have considered the Book Value and Market Value of a company

If the Book Value of this company is £5,000,000 how does that compare to the Market Value

Book Value £ 5,000,000

Market Value £ 10,500,000Number of Ordinary Shares x Market Value per Share

3,000,000 x £ 3.50

The excess may well be due to market expectations over Future Earnings not reflected in the Balance Sheet (Book Value), hence a PE Ratio of 10.6 in comparison to similar companies of 5.3

Summary

Investment Ratios provide shareholders with vital information

However shareholders should also recognise the volatility of stock markets and in this respect they are advised to diversify in order to spread their risk

Diversifying across:Different sectors/industriesDifferent Beta’s (levels of Risk)

Beta

Beta is a measure of risk (used in CAPM). The volatility of the market (e.g. Stock Exchange)

as a whole is measured and given a score/Beta of 1, i.e. the market as a whole has a = 1

The volatility of each share, e.g. BP, Tesco etc are then measured and compared to the Market volatility,

If BP was:twice as volatile as the market it would have a

Beta of 2if it was half as volatile it would have a Beta of

0.5. Beta is therefore a relative measure of Market Risk,

i.e. it measures the sensitivity of an individual security relative to (in comparison) movements in the market.

Shares with: (>1) are known as Aggressive shares as they are more

volatile than the market (<1) are known as Defensive shares as they are less

volatile than the market.

On average:  aggressive shares (>1)

perform better than the market in a Bull Market (i.e. when market is rising),

worse than the market in a Bear Market (i.e. when the market is falling)

 defensive shares (<1) perform worse than the market in a Bull Market (i.e.

when market is rising), better than the market in a Bear Market (i.e. when the

market is falling)