Week 6 - Accounting Information and Share Prices Flashcards by Conor Brolly

When buying shares listed on the stock exchange, market share price changes as a result of what factors?

Demand and supply:

Where demand is high the share price increases
Where demand is low the share price decreases
Fluctuations in share prices due to rumours

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Does the purchase and sale of shares affect the entries in the company’s statement of financial
position?

Purchase and sale of shares in the secondary market only changes share ownership and does not affect entries in the company’s statement of financial position

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What is the primary market?

Securities are sold to investors
Money that is raised goes to issuing firm
First share issue is called an Initial Public Offering (IPO)
Second Share issue is called a seasoned offering

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What is the secondary market?

Investors trade securities with each other
Money that is raised goes to seller of securities
Share prices

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Give the formula for the monetary return of share

Dividend income + Capital gains = Total monetary return

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Give the formula for percentage monetary return of a share

Percentage Return = Dividend Yield + Capital Gains Yield

Dividend Yield = Divt+1/Pt
Capital Gains Yield = (Pt+1 - Pt)/Pt
Therefore,
Percentage Return = (Divt+1 + Pt+1 - Pt)/Pt

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Percentage Return: Example

Calculate the percentage return given the following information:

Divt+1 = £1.85
Pt+1 = £40.33
Pt = £37

Percentage Return = (Divt+1 + Pt+1 - Pt)/Pt

= (1.85 + 40.33 - 37)/37 = 0.14 = 14%

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Percentage Return: Challenge

Calculate the percentage return given the following information:

Divt+1 = £2.00
Pt+1 = £35
Pt = £25

Percentage Return = (Divt+1 + Pt+1 - Pt)/Pt

= (2 + 35 - 25)/25 = 0.48 = 48%

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What is the FTSE 100?

• The “FOOTSIE” FTSE100

Financial Times Index
The index is calculated by taking the average share prices of the 100 largest companies on the LSE
The index is ‘weighted’ by market capitalisation of each stock in the index so that the largest companies have most influence on the index

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What is the FTSE All Share?

The index for all listed companies

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Is inclusion in the FTSE a good or bad thing for a company?

Inclusion in the index can affect a company’s share price

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What factors influence share price?

• The company itself
- Its plans
- Rumours of good news or bad news
- Rumours of takeovers
- Expectations of growth for the company
- Solvency and profitability
- Quality of management
• General economy
• Other companies in the same industry

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Question 1 – Share Price
Which of the following can influence a company’s
share price?
A. Other companies in the same sector reporting
poor results
B. Scandal and gossip
C. A financial journalist offering share price tips to
readers
D. All of the above

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What are the two different types of risk associated with shares?

Systematic Risk (non-diversifiable risk)
Unsystematic Risk (diversifiable risk)

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What is Systematic Risk?

Risk associated with the market generally

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What is Unsystematic Risk?

Risk associated with the specific company

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What is a balanced portfolio?

Holding a variety of shares to spread unsystematic risks

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How do investors pursue capital gains when buying and selling shares?

Investors buy shares when cheap and aim to sell them

when their price increases (i.e. buy low and sell high)

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What accounting information, when disclosed by a company, may influence its share price?

• The following may influence share price when a company discloses them:

Profit
Dividends
Net asset value
Cash flow

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Accounting Information and Share Prices

• The following may influence share price when a company discloses them:

Profit
Dividends
Net asset value
Cash flow

What might this information indicate about a share?

Each of these can be related to the share price, which gives an indication of whether a share is ‘expensive’ or ‘cheap’ in relation to that information

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What is Earnings Per Share (EPS)?

Calculated as Total Profit/Number of Shares

- Shows how much profit there is for each share

What relationship does the price–earnings ratio show?

Shows the relationship between share price and the latest profit figures

How can the P/E ratio be calculated?

Can be calculated using the Earnings Per Share and market price of one share

Price/Earnings = Share price/Earnings per share

What is the average P/E ratio of most companies?

Most companies have a P/E ratio of between 5 and 20

What does a high P/E ratio suggest about a company?

• A high P/E ratio suggests high expectations of growth in earnings - Investor confidence in the existing management team - Or, lack of confidence, but an anticipation of a takeover bid • A high P/E ratio may signify that the previous year’s earnings were unusually low, and better results are expected

What causes unusual P/E ratios?

Unusual earnings

Cronky Voddy plc plc Number of ordinary shares 1 million 1 million Current share price £2.00 £3.20 Market capitalization £2 million £3.2 million Total profits after taxation attributable to ord. shareholders £200,000 £160,000 Calculate the PE and EPS ratios for Cronky plc and Voddy plc

Market capitalization = Number of ordinary shares x Current share price P/E ratio = Market capitalization/Total profits after tax P/E ratio = Current share price/EPS EPS = Total profits after tax/No. of ordinary shares Cronky plc P/E = 10 EPS = £0.20 Voddy plc P/E = 20 EPS = £0.16

Question 2 – The P/E Ratio The following information is available for companies A, B, C and D: A B C D Current share price £2.50 £3.00 £1.50 £1.75 Total profits after tax £200,000 £225,000 £150,000 £250,000 Number of ordinary shares 1,000,000 1,250,000 750,000 500,000 Earnings Per Share ? ? ? ? i. Calculate Earnings Per Share (Total Profits/Number of Shares) ii. Calculate Price/Earnings Ratios iii. Which company has the lowest price/earnings ratio?

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What does the PEG ratio stand for?

Price/Earnings to Growth ratio

Give the formula for the PEG ratio

PEG = P/E ratio/Growth in EPS

What does the PEG ratio take into account?

The price/earnings to growth (PEG) ratio takes the | company's earnings growth into account

What does a low PEG ratio indicate?

A low PEG ratio may indicate that the company’s | share is undervalued

Question 3 – PEG Ratio The PE ratio of Company ABC’s stock is 20 The analysts estimate that the annual growth rate of earnings per share (EPS) is 30% What is the company’s price/earnings to growth (PEG) ratio? PEG = P/E ratio/Growth in EPS

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What are dividends?

The amount of cash paid out to shareholders by the company

What does the dividend yield show?

How much cash the shareholders get back compared to the price of the share

Give the formula for dividend yield

Dividend yield = Dividend per share/Share price

What does a high dividend yield mean?

The share price is low relative to dividends

What does a low dividend yield mean?

The share price is high relative to dividends

State how dividend yield and P/E ratio are closely related

A low dividend yield goes hand in hand with a high P/E ratio

Question 4 – Dividend Yield The following information is available for companies A, B, C and D: A B C D Current share price £2.50 £3.00 £1.50 £1.75 Total ordinary dividends £100,000 £100,000 £50,000 £40,000 Number of ordinary shares 1,000,000 1,250,000 750,000 500,000 Dividend Per Share ? ? ? ? i. Calculate Dividends Per Share (Total Dividends/Number of Shares) ii. Calculate Dividend Yields iii. Which company has the lowest dividend yield?

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What is dividend cover a measure of?

•How likely is it that a company’s dividend will be maintained and increased? - Dividends not covered by profits may be insecure

Give the formula for dividend cover

Dividend cover = Earnings per share/Dividends per share

``` Cronky plc Total profits after taxation attributable to ordinary shareholders = £200,000 Total ordinary dividends = £100,000 EPS = £0.20 Dividend per share = £0.10 ``` ``` Voddy plc Total profits after taxation attributable to ordinary shareholders = £160,000 Total ordinary dividends = £100,000 EPS = £0.16 Dividend per share = £0.10 ``` Calculate the dividend cover for Cronky plc and Voddy plc

Dividend cover = Total profits/Total ordinary dividends Dividend cover = EPS/Dividend per share Cronky plc Dividend cover = 200,000/100,000 = 2 Dividend cover = £0.20/£0.10 = 2 Voddy plc Dividend cover = 160,000/100,000 = 1.6 Dividend cover = £0.16/£0.10 = 1.6

Question 5 – Dividend Cover The following information is available for companies A, B, C and D: A B C D Number of ordinary shares 1,000,000 1,250,000 750,000 500,000 Current share price £2.50 £3.00 £1.50 £1.75 Total profits after tax £200,000 £225,000 £150,000 £250,000 Total ordinary dividends £100,000 £100,000 £50,000 £40,000 i) Calculate the Dividend Cover for each company ii) Which company has the highest dividend cover?

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What is net asset value?

•Net asset values - This is the book value of equity of the company Book Value of Equity = Share capital + retained earnings + reserves

Using net asset value what can we then calculate?

Price/Book ratio

State the formula for the Price/Book ratio

Price/Book = Share price/Book value per share

Why is the market value of a company often higher than the book value of net assets?

Two main reasons: - Share prices are mainly influenced by expectations of future profits and dividends and expectations that the share price will rise - The statement of financial position values may be understated

Question 6 – Price/Book Ratio The following information is available for companies A, B, C and D: A B C D Current share price £2.50 £3.00 £1.50 £1.75 Book Value Per Share £2.00 £1.50 £1.85 £1.20 i) Calculate Price/Book ratios ii) Which company has the highest P/B ratio?

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Which is a better indicator of company performance: cash flow or profit?

Cash flow

Why is Cash flow a better indicator of company performance than profit?

• Investors pay attention to: - Positive cash flow from operations (does the company generate cash from its normal operations?) - Negative cash flow from investing (is the company investing in more non-current assets and buying other businesses?) - Which financing method is used to finance expansion (how any expansion has been financed and whether the company has been increasing or reducing borrowings?)

What are some other predictors of performance?

• Many financial ratios can be used • Importance of analysing trend • Company’s turnover figure and its market capitalisation relationship - Where a company’s market capitalisation is higher than its turnover, the shares are overpriced • Earnings before interest, tax, depreciation and amortisation (EBITDA) - Market capitalisation should be three times EBITDA? • Past performance is not necessarily a predictor of future performance