Week 5b - Financial Ratios: Uses and Limitations Flashcards
(49 cards)
State the Earnings Per Share (EPS) ratio
Earnings per share = Earnings available to ordinary shareholders/Number of ordinary shares in issue
What is the most frequently quoted measure of company performance?
Earnings Per Share (EPS)
What is one of the limitations of EPS?
- The percentage change from year to year should be monitored (trend analysis)
- However, this strong focus on annual earnings may cause short-termism
Calculate the Earnings Per Share (EPS) ratio using the following information and comment on the trend
2007
Profit for the period = £7,000
Number of shares = £30,000
2006
Profit for the period = £6,200
Number of shares = £25,000
Earnings per share = Earnings available to ordinary shareholders/Number of ordinary shares in issue
The earnings per share is:
2007
7,000/30,000 = £0.233
2006
6,200/25,000 = £0.25
• EPS has fallen from £0.25 per share to £0.23 per share
List the stock market ratios
Earnings per share (EPS) Price/earnings ratio (P/E) Dividend per share Dividend yield Dividend cover Dividend payout ratio
State the formula for the Price/earnings ratio (P/E)
Price/earnings ratio (P/E) = Market value per share (share price)/Earnings per share
What can the Price/earnings ratio (P/E) be interpreted as?
The number of years for which the currently reported profit is represented by the current share price
What does the PE ratio reflect?
The market’s confidence in future prospects of the company
What does a high PE ratio indicate?
The market believes that the current level of earnings may be sustained for a longer period
Why is the industry average PE ratio useful?
Can be used as a benchmark
Calculate the Price/earnings ratio (P/E) using the following information and comment on the trend
2007
Profit for the period = £7,000
Number of shares = £30,000
2006
Profit for the period = £6,200
Number of shares = £25,000
The share price at the end of 2007 was £2.01, and at the end of 2006 was £1.74
2007
2.01/0.233 = 8.6 times
2006
1.74/0.25 = 7 times
- The P/E ratio has increased from 7 to 8.6.
- Market confidence has increased
State the formula for the dividend yield ratio
Dividend yield = (Dividend per share/Share price)*100
What does the dividend yield ratio indicate?
The relationship between what the investors can expect to receive from the shares and the amount which is invested in the shares
State the benefits from share ownership
- Dividends
- Growth in share price
Calculate the dividend yield using the following information and comment on any trends
Dividend per share was £0.033 during 2007 and
£0.032 during 2006
Market price per share was 2.01 on 31
December 2007 and 1.74 on 31 December 2006
The dividend yield is:
2007
(0.033/2.01) x 100 = 1.64%
2006 (0.032/1.74) x 100 = 1.84%
- The dividend yield has fallen from 1.84% to 1.64%
- Relative to the risk free rate of interest this dividend
yield is low; however, the share price is rising suggesting that the bulk of the return being made by
equity holders, is capital gains
State the formula for the dividend cover ratio
Dividend cover = Earnings available/ Dividend paid
What does the dividend cover ratio show?
The number of times the dividend is covered by the year’s profits
What does a high dividend cover indicate?
- The higher the dividend cover, the ‘safer’ the dividend
* A higher dividend cover may also mean that the company is keeping new wealth to itself
Why is dividend strategy important for a company?
- Dividends carry a signal to the market of the strength and stability of the company
- Many companies like to keep to a ‘target’ dividend cover (with minor fluctuations)
Calculate the Dividend Cover and comment on your result
Dividends paid in 2007 were £1,000,000
Dividends paid in 2006 were £800,000
Profit for the period (2006) = £6,200
Profit for the period (2007) = £7,000
The dividend cover is:
2007
£7,000/£1,000 = 7 times
2006
£6,200/£800 = 7.75 times
Thus, the dividend cover is strong
In 2006 profits covered dividends 7.75 times, falling to 7 times in 2007
Even at the lower 2007 level, profits would have to fall by 85% before the current dividend distribution would be affected
What exactly is the dividend payout ratio?
The Dividend Payout ratio is the inverse of Dividend
Cover
Give the formula for the dividend payout ratio
Dividend Payout Ratio = Dividend paid/Earnings available
What does the dividend payout ratio indicate?
The proportion of funds that is being distributed each year and therefore highlights the proportion that is being retained for growth
Calculate the Dividend Payout Ratio and comment on any trends
Dividends paid in 2007 were £1,000,000
Dividends paid in 2006 were £800,000
Profit for the period (2006) = £6,200
Profit for the period (2007) = £7,000
The dividend payout ratio is:
2007
£1,000/£7,000 x100 = 14.28%
2006
£800/£6,200 x100 = 12.9%
- The dividend payout ratio has increased from 12.9% to 14.28%
- A greater proportion of the profits that are available for distribution, have been distributed in 2007