11

Investor ratios

This chapter reviews:

• Share values, earnings per share and the price to earnings ratio
• Dividends per share, dividend cover and the pay-out ratio
• Earnings and dividend yields
• Market to book ratio

Introduction

The value of public companies is determined by the stock market. The value of companies not publicly quoted will be greatly influenced by the same market. In this chapter, therefore, we will look at the main stock-market-related ratios.

These are:

• share values (nominal, book and market)
• earnings per share (EPS)
• dividends per share (DPS)
• dividend cover and the pay-out ratio
• earnings yield
• dividend yield
• price to earnings ratio (P/E)
• market to book ratio.

When people talk about the value of a company they mean its market capitalisation or the combined value of the common stock. We have already looked at the position that common shares occupy in the balance sheet and have seen where they stand in the queue for participation in profits. Both these issues are important for an understanding of this chapter.

Figure 11.1 shows the balance sheet for the Example Co. plc. The top right-hand box shows owners’ funds totalling $360m. Various accounting rules have been applied over many years in arriving at this value, e.g. how much depreciation has been charged to the profit and loss account?

A more pragmatic approach to determine the value of owners’ funds is to take the total assets figure of $800m and deduct from it the total liabilities figure of $440m (200 + 240). This approach gives us the same answer in our example but it emphasises the importance of the asset values in determining shareholders’ funds. The authentic value for owners’ funds is derived simply by taking the total value of all assets in today’s terms and deducting all third party liabilities.

While all asset values can be queried, and one or two liabilities, the main areas where difficulties can be expected are:

• fixed assets
• inventories
• certain liabilities.

Fixed assets

How realistic are the values? We are primarily interested in value-in-use, but there are occasions when break-up value is important.

Inventories

These very often present difficulty in determining the appropriate value. When we place a value on inventory we are making a judgement about future trading conditions. We are assuming that the value shown will be realised.

Certain liabilities

There may be liabilities or potential liabilities which have not been provided for, e.g. pension liabilities that are not fully funded.

Share values

In Chapter 2, three types of share value were mentioned in passing. We now look at these in detail using figures from the Example Co. plc (Figure 11.2).

There are 32 million issued common shares, for each of which there is a:

• nominal (par) value of $2.50
• book (asset) value of $11.25
• market value of $22.50.

Let us now look at each of these in turn.

Nominal (par or face) value

The nominal value is largely a notional low figure arbitrarily placed on a company’s stock. It serves to determine the value of ‘issued common stock’, i.e. in the Example Co. plc the number of issued shares is 32 million. The par value is $2.50 to give a value of $80m. If new shares are issued, they will hold this same nominal value even though the issue price will probably be much above it, close to the current market price. If new shares are issued at a price of, say, $17.50, there is a surplus of $15.00 over the nominal value. This surplus is called the ‘share premium’ and it forms part of the capital reserves. Many companies today have shares of ‘no par value’ for simplicity. They simply put it in the books at their original sale price.

Book value (asset value, or asset backing)

This value is arrived at by dividing the number of issued shares – 32 million – into the owners’ funds of $360m. The book value of all the shares is $360m. Therefore each share has a book value of $11.25. We discussed earlier the need to validate the value of $360m. For instance, if an examination of the inventories produced a more prudent valuation of $20m less than the balance sheet value ($108m), this write-down would reduce the owners’ funds from $360m to $340m. The book value would fall from $11.25 to $10.625 per share.

Market value $22.50

This is the price quoted on a stock market for a public company or an estimated price for a non-quoted company. The stock market price will constantly change in response to actual or anticipated results. Media commentary and overall market sentiment will also impact on the share price. The main objective of company management is usually to maintain the best share price possible under any set of conditions.

Market value can be expressed per share (usually referred to as share price) or for the company as a whole (usually referred to as market capitalisation).

These different values will be used to derive the various ratios explored in the rest of the chapter.

Earnings per share (EPS)

‘Earnings per share’ is one of the most widely quoted statistics when there is a discussion of a company’s performance or share value.

Figure 11.3 shows how this ratio is calculated. Remember that the common shareholder comes last in the queue for participating in profit. The profit used in the calculation is the figure after all other claimants have been satisfied. The most common prior charges in the profit and loss account are interest and tax.

Therefore it is the earnings after tax (EAT) figure that is divided by the number of common shares to calculate the value of earnings per share. This figure tells us what profit has been earned by the common shareholder for every share held.

It serves no purpose to compare the earnings per share in one company with that in another because a company can elect to have a large number of shares of low denomination or a smaller number of a higher denomination. A company can also decide to increase or reduce the number of shares on issue. This decision will automatically alter the earnings per share. We cannot say, therefore, that a company with an earnings per share value of 50¢ is any better than one with a value of 40¢.

While the absolute amount of earnings per share tells nothing about a company’s performance, the growth in EPS over time is a very important statistic. Indeed, many chairpersons stress it as a prime target in annual reports. Furthermore, growth in earnings per share has a significant influence on the market price of the share.

Growth in EPS tells us more about a company’s progress than growth in absolute profits. Growth in profits can result from a great many things. However, following a share issue, if the percentage increase in profit is less than the percentage increase in the number of shares, earnings per share will fall even with higher profits.

Stability of EPS is often more important than growth and potential volatility in EPS. Investors look closely at the quality of earnings. They dislike the erratic performance of companies with widely fluctuating profits. A high-quality rating is given to earnings that are showing steady, non-volatile growth.

Dividends per share (DPS)

Figure 11.4 shows how to calculate this value. Only a proportion of the earnings accruing to the shareholders is paid out to them in cash. The remainder is retained to consolidate and expand the business.

It is a well-established rule that dividends are paid only out of profits, not from any other source. However, the earnings need not necessarily fall into the same year as the dividends. Therefore situations can arise when dividends exceed earnings. In such cases, dividends are being paid from earnings that have been retained in the business from previous years.

The total return to the shareholder over any given time consists of the dividend received plus the growth in the share price. While for some investors growth is most important, many shareholders and potential investors – both private individuals and institutions such as pension funds which need income for their day-to-day affairs – pay very close attention to dividends. They look at the absolute dividend per share and for a history of stable but growing payments.

Therefore companies dislike intensely having to reduce the dividend because this will drive away investors with possibly serious effects on share price. A company in a difficult year will often decide that it must pay a dividend in excess of earnings rather than cut the pay-out. Of course, this policy can be followed only for a short time and when there is reason to believe that earnings will recover to a figure greater than the dividends. It should also be noted that it is illegal for a company to pay a dividend unless there are sufficient distributable reserves.

Dividend cover and the pay-out ratio

These two ratios are mirror images of one another and give the same information. Both express the relationship between a company’s earnings and the cash paid out in dividends. Figure 11.5 shows the calculations. For the first ratio divide EPS by DPS. For the second reverse the numbers.

Companies adopt dividend policies to suit their business needs. These will reflect the sectors in which they operate and the specific strategies they adopt. Fast-growing companies have a great need for cash and they pay out little. On the other hand stable low-growth companies usually pay out a higher percentage of earnings.

Public utility companies, for example, usually follow high stable pay-out policies. These companies attract investors for whom income is the most important consideration. As a contrasting example, some technology-based companies have never paid a dividend, even though they have made large profits over many years. These companies attract investors who look for capital growth.

The importance of the dividend cover is the indication it gives of the future stability and growth of the dividend:

• A high cover (low pay-out ratio) suggests that the dividend is fairly safe, because it can be maintained in the face of any expected downturn in profit.
• A high cover also indicates a high retention policy, which suggests that the company is aiming for high growth.

It is worthwhile considering the implication of the pay-out ratio. The pay-out ratio shown in Figure 11.5 of 40% tells us that 60% of available profit is retained and hopefully invested back into the business. If companies retain more profits than they distribute, more than 50% of equity returns should come from capital growth, not dividends. However, capital growth depends on the share price.

Most share prices show significant fluctuations around a central trend line. Therefore, the actual capital gain delivered to a particular investor is heavily dependent on the timing of the investment and its later conversion back into cash.

Earnings and dividend yield ratios

The yield on a share expresses the return it provides in terms of earnings or dividends as a percentage of the current share price. Both measures are important for both the investor and the company.

Figure 11.6 shows calculations for the Example Co. plc.

The earnings yield shows the relationship that EPS bears to the share price. For instance, if the EPS is $1.50 and the share price is $10.00 the earnings yield is 15%. If the share price moved up to $15.00 the corresponding yield would be 10%. As the share price increases the yield falls. Paradoxically, a low yield indicates a share that is in much demand by investors. We will see in the next section its link to the price to earnings ratio.

From the company’s point of view, the ratio indicates the return the company must provide to attract investors. If a company falls out of favour in the market-place the share price falls and the company is faced with a higher yield. It follows that a company with a poor image has to pay a high return to attract capital.

For the investor, yield calculations allow comparisons to be made between the return on shares and other types of investment, such as government stocks (gilts) or commercial property.

Managers of large investment funds constantly balance their portfolios between these different investment outlets. In doing so, they take account of the relative yields which change daily, together with the stability and capital growth expected in each area.

Whereas the earnings yield specifies the total return, the dividend yield is more important for investors dependent on income from the shares. It allows them to compare the cash flow that they will receive from investing a fixed sum in different stocks or other investment outlets. As mentioned earlier, public utility companies tend to have high dividend pay-out ratios and therefore have high dividend yields which are popular with certain pension fund managers.

Price to earnings ratio (P/E)

The price to earnings ratio or ‘multiple’ is a widely quoted parameter of share value. Figure 11.7 shows the method of calculation. The share price is divided by the EPS figure. The answer is the multiple of last year’s earnings that the market is prepared to pay for a share today.

While the calculation of the ratio is based on figures from the past, its value is determined by investors whose focus is on the future. They are primarily interested in the prospects for earnings growth. To estimate this they will look to the industrial sector, the company’s products, its management and its financial stability and growth history.

The company has no direct control over the P/E ratio. It may influence it in the short term through good public relations. In the long term, however, it must deliver a good return to equity shareholders to secure a continued high rating.

The advantages of a high price to earnings ratio value are considerable:

• The wealth of the company’s owners is increased in proportion.
• New funds can be raised at a favourable price.
• The possibility of a successful hostile takeover bid is much reduced.
• Most importantly, the company has the means to make acquisitions on favourable terms by using its ‘paper’ (shares), as opposed to cash.

The long-term historical average P/E ratio for all companies across all sectors is around 15. However, as this is an average there are naturally extremes with some high-growth technology-based companies achieving P/E ratios over 100. This is largely based on wild expectations of future growth. At the same time, these are often new businesses, and their earnings are relatively low, which helps to achieve such a high ratio.

Market to book ratio

The market to book ratio gives the final, and perhaps the most thorough, assessment by the stock market of a company’s overall status. It summarises the investors’ view of the company overall, its management, its profits, its liquidity, and future prospects.

Figure 11.8 shows the calculation. The ratio relates the total market capitalisation of the company to the shareholders’ funds. To express it in another way, it compares the value in the stock market with the shareholders’ investment in the company.

The answer will be less than, greater than or equal to unity. It is the investors’ perception of the performance of the company in terms of profits, balance sheet strength or liquidity and growth that determines this ratio.

A value of less than unity means that the shareholders’ investment has diminished in value; it has wasted away. The investing community have given a ‘thumbs down’ signal to the company. They do not anticipate that future profits will be sufficient to justify the current owners’ investment in the company.

On the other hand, when this value is well in excess of unity, it means that the investment has been multiplied by the market/book factor. A high ratio does not simply mean that the worth of the company has increased over time by means of its retained earnings. The multiplier acts in addition to this. Each $1 of original investment, plus each $1 of retained earnings is multiplied by a factor equal to the market to book ratio.

Two important questions must be kept in mind when considering this ratio:

• Do the shareholders’ funds reflect a realistic value for the assets?
• Is the market rating going through an exceptionally high or low phase?

In normal circumstances we would expect a value of between 2 and 3 times for this ratio. The US and the UK have historically experienced ‘bull’ markets with much higher multiples. This can be accounted for by:

• extraordinary exuberance in the market at certain times;
• the understatement of owners’ equity as a result of goodwill write-downs.

Recessions or ‘bear’ markets will reduce these multiples considerably.

The absolute minimum that management must achieve for this ratio is 1.0. Good companies should produce a factor of 2.0 or more.