1 Financial Statement Analysis for Equity by Binam Ghimire

Learning Objectives 1.Investment Ratios 2.Book Value Vs Market Value of a Business 3.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 3,000,000 Market Value per Share£ 3.50 Earnings attributable to ordinary shareholders£1,000,000 Total Ordinary Share Dividend £ 300,000

Earnings per Share Earnings attributable to ordinary shareholders Number of Ordinary Shares e.g. £1,000,000 = £0.33p per share 3,000,000 shares Where:  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 Yield EPS x 100% Market or Nominal Value of Shares e.g. £0.33p x 100 = 9.43% £ 3.50 Note: Market value provides the more meaningful ratio

Dividend per Share Total Ordinary Share Dividend Number 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. £ p x 100 = 2.86% £ 3.50 Note: Market value provides the more meaningful ratio

Dividend Cover EPS DPS e.g. 33 p = 3.3 times 10 p

Dividend Payout Ratio Ordinary Share dividend x 100 Earnings 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 3,000,000 Market Value per Share£ 3.50 Earnings attributable to ordinary shareholders£1,000,000 Total Ordinary Share Dividend £ 300,000 Earnings per Share/Earnings Yield33 p9.43%  Dividend per Share10p2.86%  Retention23 p  Dividend Cover3.3 times  Dividend Payout Ratio30%  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£ 10,500,000 Number 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/industries  Different 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 2  if 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)