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AcF100 - Financial Statement Analysis > Week 23 - Measures of Return on Investment and Risk > Flashcards

Week 23 - Measures of Return on Investment and Risk Flashcards

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1
Q

What is the formula for dividend yield?

A

Dividend yield = (Annual Equity Dividend/ Current Market Value of Equity Shares) x100

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2
Q

Measures of Return on Investment and Risk

A
  • Dividend Yield
  • Dividend Cover
  • Earnings per Share
  • Return on Equity (ROE)
  • Price-Earnings Ratio
  • Market-to-Book Ratio
  • Interest Cover
  • The Debt-Equity Ratio
  • The Gearing Ratio

This group of ratios is primarily intended
for equity shareholders.
Although managers will monitor them too.

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3
Q

What does dividend yield assess?

A

It assesses equity shareholders’ annual cash return on their investment.

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4
Q

What is the typical range for dividend yield?

A

Usually between 2% and 5%, depending on the company and market.

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5
Q

Why might dividend yield be misleading when comparing investments?

A

Because different firms carry different investment risks, so higher yields may come with greater risk.

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6
Q

Why might dividend yield be more important to some shareholders than others?

A

Some shareholders prefer immediate income, while others may focus more on capital gains.

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7
Q

Dividend yield
E.g. J Sainsbury plc 2020
* Dividend for the period = interim dividend for current year £73m + final recommended dividend £0m = £73m

Calculation of Market Value (MV):
* Share price at balance sheet date (FAME): £2.11
* Number of Shares: 2,217 million (Note 25)
* Market Value = (2,217m shares x £2.11) = £4,677.87m

A

73 mil/ 4,677.87mil x100 = 1.56%

  • Interpretation
  • Sainsbury’s shareholders receive 1.56% dividend for every £1 invested (at current share price levels)
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8
Q

What does a higher dividend yield indicate?

A

The company returns a larger portion of profits to investors as dividends.

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9
Q

If Morrison has a higher dividend yield than Tesco, who is doing better?

A

It depends on investor preferences. Morrison gives more in cash returns, but this isn’t always better overall.

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10
Q

What are three possible reasons for Morrison’s higher dividend yield?

A

A high-dividend policy to attract investors

Excess cash reserves with no immediate need

Lack of profitable investment opportunities

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11
Q

Why might a high dividend yield not always be a good sign?

A

It could mean the firm lacks growth opportunities or is not reinvesting in its own business.

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12
Q

What is the formula for dividend cover?

A

Dividend Cover = Profit for the Year/ Annual Equity Dividend

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13
Q

What does dividend cover indicate?

A

How many times a company’s current profits can cover its dividend payments.

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14
Q

Why is dividend cover important for investors?

A

It shows the stability and safety of dividends—higher cover means less risk of a dividend cut if profits drop.

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15
Q

What does a dividend cover of 2x mean?

A

The company’s profits are twice as large as its dividend payments, suggesting dividend sustainability.

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16
Q

What does a low dividend cover (e.g., <1.5x) suggest?

A

Greater risk of future dividend cuts—profits may not be strong enough to sustain current dividends.

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17
Q

Dividend cover
E.g. J Sainsbury plc 2020
* Profit(Loss) for the year from Income Statement: £152m
* Dividend for the period = interim dividend £73m + final recommended dividend £0m = £73m

A

152mil/ 73mil = 2.08

  • Interpretation
  • Sainsburys current profits are over two times its current dividend.
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18
Q

What does a higher dividend cover indicate about a company?

A

It suggests that the company’s profits can comfortably cover its dividends, reducing the risk of dividend cuts even if profits decline.

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19
Q

What might explain why Morrison has a higher dividend cover?

A

Morrison might prioritize maintaining a high dividend cover, ensuring that it can continue paying consistent dividends.

Alternatively, Morrison might be holding back cash from dividends to reinvest in other profitable opportunities, keeping the payout low but still providing a safe margin.

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20
Q

Why do some investors value a higher dividend cover?

A

Investors seeking consistent income from dividends may prefer a higher dividend cover because it implies less risk of a dividend cut in tough times.

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21
Q

What does Earnings Per Share (EPS) represent?

A

EPS is a key measure of a company’s profitability and its ability to pay dividends, calculated as the profit for the year divided by the weighted average number of shares in issue

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22
Q

Why is Earnings Per Share (EPS) important for investors?

A

EPS helps investors gauge how much profit is attributable to each shareholder and is a common metric for assessing a company’s performance and future dividend potential.

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23
Q

What is the formula for calculating Earnings Per Share (EPS)?

A

EPS = Profit for the Year/ Weighted Average Number of Shares in Issue

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24
Q

What does the weighted average number of shares account for in EPS calculation?

A

The weighted average number of shares accounts for the number of shares in issue over time, adjusting for any changes in the number of shares during the period.

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25
What is the significance of Earnings per Share (EPS) according to IFRS?
IFRS requires listed firms to disclose Earnings per Share (EPS) in their financial statements, as it is a key indicator of a company's profitability and performance.
26
What does Basic EPS represent?
Basic EPS takes into account all equity shares in issue during the period, providing a straightforward measure of earnings per share for equity shareholders.
27
What is Diluted EPS, and why is it important?
Diluted EPS considers potential dilution from financial instruments (e.g., convertible bonds, options) that may convert into shares in the future, lowering the earnings per share. It helps show a more conservative estimate of a company's profitability.
28
Why do firms disclose both Basic EPS and Diluted EPS?
Disclosing both helps investors understand the potential impact of future share dilution on earnings, giving a clearer picture of future profitability and shareholder value.
29
What is Return on Equity (ROE), and why is it important?
ROE is a key performance indicator that measures how well managers use funds invested by shareholders. It is calculated by dividing Profit for the Year by Equity and multiplying by 100. ROE reflects the company’s profitability relative to shareholders’ equity.
30
What does a high ROE indicate about a company?
A high ROE suggests that the company is effectively using shareholder funds to generate profits, indicating strong performance. In the long run, ROE should exceed the cost of equity capital for the company to be regarded as successful.
31
Why is the cost of equity important when evaluating ROE?
The cost of equity represents the rate of return investors expect on their investments, and for a company to be considered successful, its ROE should exceed this cost, demonstrating that the company is providing returns that justify the risk for shareholders.
32
Why should minority interest be removed when calculating ROE?
Minority interest should be excluded from both the numerator (profit) and the denominator (equity) to calculate ROE from the parent shareholder's perspective, ensuring the calculation reflects only the performance related to the parent company's equity.
33
What is minority interest?
Minority interest refers to the ownership in a company held by non-controlling shareholders—i.e., shareholders who do not own a majority of the company's stock. It represents the portion of equity in a subsidiary not owned by the parent company.
34
Where is minority interest reported on the financial statements?
Minority interest is reported on the balance sheet and reflects the claim on assets that belongs to the non-controlling shareholders of a subsidiary.
35
Return on Equity (ROE) Example: J Sainsbury plc 2020 * Profit(loss) after tax for ordinary equity holders: £129m * Total equity before perpetual securities: = £7,277
129mil/ 7,277mil x100 = 1.77% * Interpretation * Sainsbury has generated a return of 1.77% on equity invested by controlling shareholders
36
Who is doing better based on Return on Equity (ROE)?
Morrison has a slightly higher ROE, indicating it generates more profit per unit of shareholder equity than Tesco, which is generally favorable for equity holders.
37
What might explain Morrison's higher ROE compared to Tesco?
Possible reasons include: Greater efficiency in generating profit from assets. Higher debt financing, which increases ROE by reducing the base of equity (i.e., profits are spread over fewer equity holders).
38
What does a high ROE indicate about a company?
A high Return on Equity (ROE) indicates that a company is effectively generating profits from its shareholders' equity, suggesting strong financial performance—provided it’s not solely due to excessive leverage.
39
What is Return on Equity (ROE) in DuPont analysis?
ROE measures shareholder return and is decomposed into operating performance (ROCE) and financial leverage (Equity Multiplier).
40
What does ROE equal in the DuPont formula?
ROE = Net Profit Margin × Asset Turnover × Equity Multiplier
41
What is Return on Capital Employed (ROCE)?
ROCE = Net Profit Margin × Asset Turnover — it reflects operating performance. MAYBE? from ChatGPT
42
What is the Equity Multiplier (also called the Financial Leverage Multiplier)?
Capital Employed ÷ Equity — it shows how much debt is used to finance assets.
43
What does a high equity multiplier indicate?
Greater use of debt financing; more leverage.
44
What does an equity multiplier of 2 mean?
The company is financed 50% by equity and 50% by debt.
45
What does an equity multiplier less than 2 imply?
The company has more equity than debt.
46
Which company has the highest Return on Equity (ROE) in 2020?
Morrison (7.66%), suggesting stronger profitability for equity holders.
47
Which company has the highest Dividend Yield in 2020?
Morrison (4.80%), indicating a higher cash return to shareholders.
48
Which company has the highest Dividend Cover in 2020?
Sainsbury’s (2.08 times), implying the most sustainable dividends.
49
Which company is likely the better investment based on ROE and dividend yield?
Morrison — due to the highest ROE and highest dividend yield.
50
Which company is the riskiest investment in terms of dividend sustainability?
Tesco — it has the lowest dividend cover (1.09), meaning it may struggle to maintain dividend payments.
51
What does the Price-Earnings (P/E) ratio measure?
It compares the current market price of a share to its earnings per share (EPS), showing how many years of earnings investors are willing to pay for.
52
What is the formula of Price-Earnings (P/E) ratio?
P/E Ratio = Current Market Price per Share/ Earnings per Share
53
What is the typical range of Price-Earnings (P/E) ratio?
Often between 10 and 25, but varies widely across and within industries.
54
What does a high P/E ratio indicate?
It suggests that investors expect high earnings growth in the future, or that the stock may be overvalued due to high investor confidence.
55
What does a low P/E ratio indicate?
It suggests low expected earnings growth or that the stock may be undervalued.
56
What other factors influence the P/E ratio besides company performance?
The overall level of the stock market and the industry in which the company operates.
57
Price-earnings (P/E) ratio E.g. J Sainsbury plc 2020 * Share price at balance sheet date (FAME): £2.11 * Basic Earnings per Share: 5.8p
211p/share / 5.8p/share = 36.1 * Interpretation * Sainsbury’s investors need 36 years to recoup their investment at current earnings levels
58
If Tesco has a higher P/E ratio than its peers, what does that suggest?
It suggests investors are more optimistic about Tesco’s future earnings or that Tesco may be overvalued.
59
What are two possible explanations for Tesco’s higher P/E ratio?
Tesco is making promising investments likely to boost future profits. Tesco may be overvalued due to irrational market behavior.
60
What does Tesla’s high P/E ratio suggest about investor expectations?
Investors expect strong future performance and perceive Tesla as relatively low-risk.
61
Which company has the lowest P/E ratio and what does that imply?
Hyundai (P/E = 3.26), suggesting low investor confidence and perceived higher risk.
62
Based on P/E ratios, which company might be overvalued and which might be undervalued?
Tesla may be overvalued; Hyundai may be undervalued—depending on future value creation strategies.
63
What is the formula for the Market-to-Book (MTB) ratio?
Market capitalisation of shares (market value) / Equity (book value)
64
What does the Market-to-Book ratio measure?
It measures the relationship between the market value and the accounting (book) value of shareholder equity.
65
What does a high Market-to-Book (MTB) ratio suggest?
It may indicate that a company is overvalued or that the market has high expectations for its future performance.
66
What does a low Market-to-Book (MTB) ratio suggest?
It may suggest the company is undervalued or that the market has low expectations for future performance.
67
What is a limitation of using the Market-to-Book ratio?
Book values are based on historical accounting data, which may not reflect the current economic value of assets or the company’s potential.
68
Market to book ratio (MTB) E.g. J Sainsbury plc 2020 * Share price at balance sheet date (FAME): £2.11 * Number of shares (Note 25): 2,217m * MV: £2.11 x 2,217m = £4,677.87m * Book Value – Equity section of Balance sheet (before perpetual securities): £7,277m
4,677.87mil/ 7,277mil = 0.64 * Interpretation * Sainsbury investors are paying £0.64 for every £1 of net assets (book equity value)
69
What could explain Tesco's higher MTB ratio?
Investors may believe Tesco has stronger future value creation potential. Tesco may be overvalued, meaning its market valuation is not aligned with its accounting fundamentals.
70
What does Interest Cover measure?
It measures how many times a company’s operating profit can cover its net interest expenses; it's a key indicator of debt-servicing ability.
71
Formula for Interest Cover
Interest Cover = Operating Profit (before interest and tax)/ Net Finance Cost = X times
72
What are finance costs?
Finance costs refer to interest expenses incurred by the company on borrowed funds.
73
Why is Interest Cover important?
It shows how much of a cushion a company has to meet its interest obligations—higher values suggest lower risk of default.
74
What does a low Interest Cover ratio suggest?
It may indicate financial distress or risk, as the company might struggle to meet interest payments from its profits.
75
Interest cover E.g. J Sainsbury plc 2020 * Operating Profit: £650m * Interest Expense: £366m (use net finance costs)
650mil/ (398mil-32mil) = 1.78 * Interpretation * Sainsbury’s current operating profit can cover current interest expense 1.78 times.
76
Who is doing better based on Interest Cover?
Morrison is doing better, with a higher interest cover, indicating it's less likely to default on interest payments and is therefore less risky.
77
What might explain Morrison’s higher Interest Cover?
Either Morrison is more efficient at generating profit, or it carries less debt and thus has lower interest expenses.
78
What is gearing (or leverage)?
Gearing refers to the relationship between fixed-interest capital (e.g. loans, debentures, preference shares) and equity capital (shares). It indicates how much of a firm’s capital comes from debt.
79
What does it mean if a firm is highly geared?
It means the firm has a high level of debt relative to equity (typically, debt > equity), increasing its financial risk.
80
Why do shareholders care about gearing?
Because high gearing increases financial risk. If a firm has too much debt, it may struggle to meet its obligations, putting shareholder returns at risk.
81
What is included in the calculation of equity?
Equity = Share capital + Share premium account + Reserves + Retained profits
82
What is included in the calculation of debt?
Debt = Preference shares + Loans + Bonds + Other non-current borrowings
83
Why are preference shares usually considered debt?
Because they require fixed interest payments that must be made before dividends are paid to ordinary shareholders.
84
How should convertible bonds and exotic instruments be classified?
They have both equity and debt components, so valuation must consider each component separately based on terms of conversion and repayment.
85
What is the formula for the Debt-Equity Ratio?
Debt-Equity Ratio = (Debt capital / Equity capital) × 100 = X%
86
What does the Debt-Equity Ratio indicate?
It shows the proportion of debt used to finance the company relative to equity, reflecting financial risk and leverage.
87
Why is the Debt-Equity Ratio important to investors and analysts?
Because it indicates the company’s reliance on debt versus shareholder funding; a high ratio suggests higher financial risk.
88
Where is the Debt-Equity Ratio commonly reported?
It is widely used and reported in the financial press and investment analysis.

AcF100 - Financial Statement Analysis (9 decks)

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