Learning Objective
5.4.4 Understand the purpose of the following investors’ ratios: earnings per share (EPS); earnings before interest, tax, depreciation, and amortisation (EBITDA); earnings before interest and tax (EBIT); historic and prospective price earnings ratios (PERs); dividend yields; dividend cover;
price to book
In the following section we will consider some of the ratios that are used to assess potential investments.
4.4.1 Earnings per Share (EPS)
Earnings per share is a measure of the profitability of a company that is expressed in an amount per share in order that meaningful comparisons can be made from year to year and with other companies.
The quality of a company’s earnings stream and its ability to grow its EPS in a consistent manner are probably the most important factors affecting the price of a company’s shares, not least because earnings provide the ability to finance future operations and the means to pay dividends to shareholders.
There are three principal measures we need to consider:
• Earnings per share (EPS).
• Earnings before interest and tax (EBIT).
• Earnings before interest, tax, depreciation and amortisation (EBITDA).
EPS
The earnings per share ratio measures the profit available to ordinary shareholders and is taken as the profit after all other expenses and payments have been made by the company. It is calculated as follows:
EPS = (Net income – Preference dividends) Number of ordinary shares in issue The resulting figure is known as basic EPS.
EBIT
Earnings per share can also be calculated before the impact of interest payments and taxation. EBIT is, therefore, operating income or operating profit.
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EBITDA
Earnings can also be analysed before making any financial, taxation and accounting charges through an EPS measure known as EBITDA. EBITDA provides a way for company earnings to be compared internationally, as the earnings picture is not clouded by differences in accounting standards worldwide.
4.4.2 Price Earnings Ratio (PE Ratio)
The PE ratio measures how highly investors value a company in its ability to grow its income stream.
It is calculated by dividing the market price by the EPS as follows:
PE ratio = Share price EPS
A company with a high PE ratio relative to its sector average reflects investors’ expectations that the company will achieve above-average growth. By contrast, a low PE ratio indicates that investors expect the company to achieve below-average growth in its future earnings.
Example
XYZ plc is operating in a sector where the average prospective PE ratio is currently eight times.
If XYZ’s earnings per share are expected to be $0.30, the implied value of an XYZ plc share is:
PER x expected EPS = 8 x $0.30 = $2.40.
Although PE ratios differ significantly between markets and industries, there could be several reasons why a company has a higher PE ratio than its industry peers, apart from its shares simply being overpriced. These may include:
• A greater perceived ability to grow its EPS more rapidly than its competitors.
• Producing higher-quality or more reliable earnings than its peers.
• Being a potential takeover target.
• Experiencing a temporary fall in profits.
One way of establishing whether a company’s PER is justified is to divide it by a realistic estimate of the company’s average earnings growth rate for the next five years. A number of less than one indicates that the shares are potentially attractive. This is sometimes referred to as the PEG ratio – price earnings to growth rate.
It is also important to establish how a PER has been calculated to ensure that appropriate comparisons can be made. The main two encountered are:
• historical PE ratios – which are based on the last reported annual earnings;
• prospective PE ratios – which are based on forecasted earnings.
4.4.3 Dividend Yields and Cover
One major reason for buying shares is the dividend paid on the shares, and investors will want to have a measure that allows them to compare the dividend paid on one company’s shares with that of another’s, or with alternative investments such as bonds and cash deposits.
Dividend yields give investors an indication of the expected return on a share so that it can be compared to other shares and other investments.
Dividend yields are calculated by dividing the net dividend by the share price as follows:
Dividend yield = Net dividend per share x 100 = x%
Share price
So, if the dividend per share is $0.05 and the share price is $2.50, then the yield is $0.05/$2.50, which is 2%.
Some companies have a higher than average dividend yield, often showing one of the following characteristics:
• A mature company with limited growth potential, perhaps because the government regulates its selling prices. Examples are utilities such as water or electricity companies.
• Companies with a low share price, perhaps because the company is, or is expected to be, relatively unsuccessful.
In contrast, some companies might have dividend yields that are relatively low. This is generally when the share price is high, because the company is viewed by investors as having high growth prospects and a large proportion of the profit being generated by the company is being ploughed back into the business, rather than paid out as dividends.
As well as looking at the dividend yield, investors will also consider the ability of the company to continue paying such a level of dividend. They do this by calculating dividend cover, which looks at how many times a company could have paid out its dividend based on the profit for the year.
Dividend cover = EPS Net dividend per share
A dividend cover of less than one would indicate that the company is using prior-year earnings to pay the dividend and lead an investor to question its ability to continue to do so. A high dividend cover would indicate that the company is not distributing its profits, maybe because it is using these to finance expansion.
The higher the dividend cover, the less likely it is that a company will have to reduce dividends if profits fall.
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