The Brand Financial Training team explore investment ratios, which are important to help investors decide in which companies to buy shares.
Investment ratios are also important for anyone studying for the CII investment exams, namely R02 Investment Principles and Risk, J10 Discretionary investment management, and AF4 Investment planning, where they are tested often.
The most common ratios appearing in these exams are earnings per share (EPS), price earnings ratio (PE ratio) dividend yield and dividend cover; in this article we look at a working example of how to work these out.
Our working example concerns a PLC called Bright Training; they have profits (available for ordinary shareholders) of £100,000. They have issued 150,000 ordinary shares. Their current share price is 490p and the recent dividend paid was 12p.
The EPS figure is important and must be published in a company’s account enabling an investor to see the trend in a company’s profitability. It shows the amount of profit that is attributable to each issued share.
The EPS for Bright Training therefore is worked out as: profits attributable to ordinary shareholders divided by the number of ordinary shares in issue so £100,000/150,000 equals an EPS of 66p. If a company issues new shares this figure will reduce and if a company bought back their own shares this figure would increase (assuming profits remained the same).
Investors use this figure to compare growth over time and it’s also used to calculate the PE ratio which we look at next.
A company’s PE ratio can be viewed as how the market views the potential for future growth in earnings.
The P/E ratio for Bright Training is worked out as the share price divided by EPS which is 490/66 giving a PE ratio of 7.42. A simple way of looking at this figure is that it calculates the number of years the company would need to generate enough value to cover the cost of the share at the current market price, or another way of looking at it is that investors are prepared to pay £7.42 for every £1 of profits.
PE ratios do need to be used with some caution and should only be used to compare companies in the same sector. A share with a lower PE ratio is generally regarded as being less expensive than a share that has a higher PE ratio; however shares can be under-priced or over-priced for various reasons and so should be used as part of a bigger picture of analysis using other factors such as dividend history, business strategy and whether the share fits in with the objectives of the investor.
Dividend yield measures the annual value of dividends as a percentage return on the current share price.
Dividend yield for Bright Training is worked out as the dividend per share divided by the current share price multiplied by 100 to get a percentage. The dividend is 12p and the current share price is £4.90 so 12/490 x 100 gives a dividend yield of 2.45%. An investor can now use this information to compare a 2.45% return with the returns that could be achieved on other investments.
Dividend cover measures how many times the dividend could be paid out of the available current earnings. This can give an investor an indication as to the margin of safety the company has in paying the dividend.
On an individual share basis, the dividend cover for Bright Training is the EPS divided by the dividend per share which is 66p/12p giving dividend cover of 5.5.
Where a dividend cover ratio is more than 1, this indicates that the earnings being generated by the company are enough to pay shareholders the dividends. As a general rule of thumb a dividend cover ratio of above 2 is thought of as a healthy sign.
These ratios can be useful in helping someone decide whether to invest in a particular company but investors should remember that often the information data being used is historical so can’t necessarily be the most accurate guide for future performance.
Anyone sitting the CII investment exams should ensure they know how to calculate these most commonly tested ratios.
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