Reading: 29.1, 29.5, 29.7
INTRODUCTION: APPRAISAL OF COMPANY FINANCIAL STATEMENTS
● It is important to appreciate at the outset that accounting ratios and percentages have a number of
limitations
○ One of these stems from the aggregate nature of information in published financial
statements. Companies are not required to disclose all the items that enter into the
computation of profit or values of assets and liabilities in the statement of financial
position. As a result, the information needed to compute some ratios may not be
available. This necessitates the use of surrogate data in the calculation of some ratios.
○ Furthermore, comparisons of ratios over time and between companies can be misleading
when economic conditions change and/or where the companies concerned are operating
in substantially different industries. Ratios must therefore always be interpreted in the
light of the prevailing economic climate and the particular circumstances of the company
or companies concerned. The limitations of ratio analysis are discussed in the context of
each ratio and are summarized at the end of the chapter
MEASURES OF RETURN ON INVESTMENT AND RISK
Dividend Yield
● The same principle can be used to calculate the dividend yield on preference shares and the
interest yield on debentures and loan stock
● The dividend yield is said to measure the equity shareholder’s annual cash return on investment,
and may be compared with what could be obtained by investing in some other company.
However, such comparisons can be misleading, for two main reasons.
○ First, companies have different risk characteristics. A comparison of the dividend yields
of, for example, a steel company and a large retailer such as Tesco plc would be
misleading because the former is a riskier investment than the latter.
○ Second, companies have different dividend policies, in that some distribute a greater
proportion of their annual profit than others. Put slightly differently, the annual dividend
is only part of an investor’s total return, in that the investor will also expect to make a
capital gain in the form of an increase in the market price of shares. This partly results
from companies retaining a proportion of their annual profits for growth.
● The dividend yield is often between 2 and 5 per cent, but varies between companies for the
reasons outlined above.
Dividend Cover
, ● The dividend cover ratio indicates how likely it is that the company will be able to maintain
future dividends on equity shares at their current level if profits were to fall in future years. It is
thus a measure of risk.
● The amount by which the dividend cover exceeds unity represents what might be called ‘the
margin of safety’. Thus, a company with a high dividend cover would be more likely to be able to
maintain the current level of equity dividends than a company with a low dividend cover.
Earnings Per Share (EPS)
● EPS provides a useful means of evaluating performance (where performance is defined from the
shareholders’ point of view as relating to the profit available for distribution as dividends).
● The trend in EPS over time indicates growth or otherwise in the profit attributable to each equity
share. Inter-firm comparisons of EPS are not advisable
Price to Earnings Ratio (P/E Ratio)
● The P/E ratio is often between 10 and 25 but varies considerably between different industries and
companies in the same industry.
● Where an investment is risky, investors will want to get their money back relatively quickly,
whereas if an investment is comparatively safe, a longer payback period will be acceptable.
○ Thus, companies in risky industries such as mining and construction tend to have a low
P/E ratio, whereas companies in relatively safe industries such as food manufacturers,
and those which are diversified tend to have a high P/E ratio.
● If investors think that a company’s earnings are going to decline, the P/E ratio will tend to be
lower than the average for the industry.
● Conversely, if profits are expected to rise, the P/E ratio will tend to be higher, both of which
occur because of decreases and increases in the share price, respectively.
● The P/E ratio is therefore also a reflection of the expected earnings growth potential of a
company. This also means that sometimes industries which one would expect to have a high P/E
ratio, since they are relatively safe, in fact have a low P/E ratio because the earnings are expected
to decline (and vice versa).
● It appears that the P/E ratio is sometimes also used in practice to identify shares that are over or
underpriced.
○ A share is said to be overpriced if its P/E ratio is higher than the norm for the industry or
other similar companies, and underpriced if the P/E ratio is lower than the norm for the
industry or other similar companies.
INTRODUCTION: APPRAISAL OF COMPANY FINANCIAL STATEMENTS
● It is important to appreciate at the outset that accounting ratios and percentages have a number of
limitations
○ One of these stems from the aggregate nature of information in published financial
statements. Companies are not required to disclose all the items that enter into the
computation of profit or values of assets and liabilities in the statement of financial
position. As a result, the information needed to compute some ratios may not be
available. This necessitates the use of surrogate data in the calculation of some ratios.
○ Furthermore, comparisons of ratios over time and between companies can be misleading
when economic conditions change and/or where the companies concerned are operating
in substantially different industries. Ratios must therefore always be interpreted in the
light of the prevailing economic climate and the particular circumstances of the company
or companies concerned. The limitations of ratio analysis are discussed in the context of
each ratio and are summarized at the end of the chapter
MEASURES OF RETURN ON INVESTMENT AND RISK
Dividend Yield
● The same principle can be used to calculate the dividend yield on preference shares and the
interest yield on debentures and loan stock
● The dividend yield is said to measure the equity shareholder’s annual cash return on investment,
and may be compared with what could be obtained by investing in some other company.
However, such comparisons can be misleading, for two main reasons.
○ First, companies have different risk characteristics. A comparison of the dividend yields
of, for example, a steel company and a large retailer such as Tesco plc would be
misleading because the former is a riskier investment than the latter.
○ Second, companies have different dividend policies, in that some distribute a greater
proportion of their annual profit than others. Put slightly differently, the annual dividend
is only part of an investor’s total return, in that the investor will also expect to make a
capital gain in the form of an increase in the market price of shares. This partly results
from companies retaining a proportion of their annual profits for growth.
● The dividend yield is often between 2 and 5 per cent, but varies between companies for the
reasons outlined above.
Dividend Cover
, ● The dividend cover ratio indicates how likely it is that the company will be able to maintain
future dividends on equity shares at their current level if profits were to fall in future years. It is
thus a measure of risk.
● The amount by which the dividend cover exceeds unity represents what might be called ‘the
margin of safety’. Thus, a company with a high dividend cover would be more likely to be able to
maintain the current level of equity dividends than a company with a low dividend cover.
Earnings Per Share (EPS)
● EPS provides a useful means of evaluating performance (where performance is defined from the
shareholders’ point of view as relating to the profit available for distribution as dividends).
● The trend in EPS over time indicates growth or otherwise in the profit attributable to each equity
share. Inter-firm comparisons of EPS are not advisable
Price to Earnings Ratio (P/E Ratio)
● The P/E ratio is often between 10 and 25 but varies considerably between different industries and
companies in the same industry.
● Where an investment is risky, investors will want to get their money back relatively quickly,
whereas if an investment is comparatively safe, a longer payback period will be acceptable.
○ Thus, companies in risky industries such as mining and construction tend to have a low
P/E ratio, whereas companies in relatively safe industries such as food manufacturers,
and those which are diversified tend to have a high P/E ratio.
● If investors think that a company’s earnings are going to decline, the P/E ratio will tend to be
lower than the average for the industry.
● Conversely, if profits are expected to rise, the P/E ratio will tend to be higher, both of which
occur because of decreases and increases in the share price, respectively.
● The P/E ratio is therefore also a reflection of the expected earnings growth potential of a
company. This also means that sometimes industries which one would expect to have a high P/E
ratio, since they are relatively safe, in fact have a low P/E ratio because the earnings are expected
to decline (and vice versa).
● It appears that the P/E ratio is sometimes also used in practice to identify shares that are over or
underpriced.
○ A share is said to be overpriced if its P/E ratio is higher than the norm for the industry or
other similar companies, and underpriced if the P/E ratio is lower than the norm for the
industry or other similar companies.
