27 Investor ratios

Need to know

Key investor ratios used to assess profitability and security include the following:

• 1Earnings per share (EPS)
• 2Price/Earnings ratio (P/E)
• 3Dividend cover
• 4Dividend yield
• 5Total shareholder return (TSR).

1 Earnings per share (EPS)

Calculated as:

$\frac{\text{Net profit after preference dividends}}{\text{Average number of shares in issue}}$

EPS is the profit generated for each share in issue. Earnings refers to the residual (net) profit, i.e. after payment of all expenses and taxes, and also preference dividends (see Chapter 29 Equity finance).

The ratio is reported as a ‘pence per share’ number, e.g. an EPS of 10p means that each share has earned a profit allocation of 10p.

EPS is commonly referred to as basic EPS

Advantage of EPS measure

Simple to calculate, yet a powerful way of breaking down a company’s profit into a meaningful metric that shareholders can understand.

EPS provides a measure of tracking growth in profits of a company over time. Assuming no change in the number of shares in issue, a year-on-year (YoY) increase in the EPS figure indicates that profits per share are growing, i.e. the company is generating increasing returns for investors. Conversely, a falling EPS highlights a decline in the company’s growth.

Although past performance can never be a guarantee of future performance, a company with a solid track record of EPS growth may be attractive to investors looking to get some degree of ‘certainty’ of future returns.

Disadvantage of EPS measure

The major limitation of EPS data is that it cannot (and should not) be used to compare performance between companies. This is because EPS ignores differences in capital structure between companies, as the example below demonstrates.

Example

Company A and company B have identical net profits of £10,000. Each company also has 10,000 shares in issue. However:

• ■Company A issued shares at £1 nominal value (issued capital £10,000).
• ■Company B issued shares at 10p nominal capital (issued capital £1,000).

In the example above, both companies would report identical EPS of £1. However, it can be seen that company B achieved this level of profit using (only) £1,000 of capital whereas company A required £10,000 of capital. While the EPS of each company is identical, the return on equity invested by shareholders (see Chapter 23 Profitability performance measures) from company B is 10 times higher than company A. Put another way, a shareholder of company A invested £1 to earn £1, whereas a shareholder of company B invested only 10p to get an identical return. Other things being equal, company B is clearly a better investment.

2 Price/Earnings (P/E) ratio

Calculated as:

$\frac{\text{Market price }pershare}{\text{Earnings }pershare}$

The ratio is reported as a number, e.g. 20.

The Price/Earnings (P/E) ratio is the most widely published investor ratio. It shows the price (cost) of buying a share in comparison to the annual return generated. A company with a P/E of 20 means that £20 invested today generates an annual return of £1 (based on historic earnings).

P/E is calculated and published live daily for listed companies based on current price data which can be obtained from the (relevant) stock market.

Earnings data is based on annual historic published earnings. For companies that report their results six monthly (UK) or quarterly (US), historic earnings are annualised by summing the most recent two (half year) or four (quarter year) periods reported.

The P/E ratio, which is based on historic earnings data, is referred to more precisely as trailing P/E.

Advantage of P/E measure

Unlike the EPS ratio, the P/E ratio is directly comparable between companies in the same sector.

P/E is often used to establish whether a company is fairly valued relative to other companies in the sector, or the sector more generally. A company’s P/E can be interpreted in a number of ways, to assess the prospects of the company and to provide an indicator of whether the share price is expensive or cheap relative to comparable companies.

* relative to other companies or the sector in general

Disadvantage of P/E measure

Interpreting what the number actually means is the key drawback of P/E. A high or low P/E can have more than one possible explanation (see table above). In addition, while P/E is a good measure of relative value, it does not tell a shareholder whether the shares are correctly valued. The price of any share is determined by numerous factors, including a collective perception of risk and growth by investors. However, this does not necessarily mean that the collective perception is correct. Using the P/E (or any single metric) as a valuation tool in isolation is therefore considered risky.

3 Dividend cover

Calculated as:

$\frac{\text{Net profit (}after\text{ preference dividend)}}{\text{Annual dividend paid}}$

Like EPS, dividend cover is reported as a number, e.g. 4. This is the number of times earnings exceed (or cover) the dividend paid.

Advantage of dividend cover measure

Dividend cover is simple to calculate and easy to understand. It gives an indication of the company’s resilience, of being able to continue paying dividends in the face of earnings volatility.

Example

A dividend cover of 4 indicates that the company could pay 4× the dividend actually paid. Looked at another way, this implies that profits could in future fall by 75% (i.e. a decline of £75,000) before the company would be unable to pay a similar level of dividend (from annual profits) to that paid in the current financial year.

Companies having high dividend cover (typically a number above 4) are considered to be more resilient (less risky) because they have significant profit ‘headroom’, i.e. they should be able to maintain dividend payout levels even if they suffered a significant, temporary decline in profits in one or more future years.

A dividend cover of less than 1 in a year indicates that a company has made insufficient profits to pay the dividend in that year and has therefore had to rely on accumulated reserves from earlier years to fund the dividend.

Disadvantage of dividend cover measure

Unlike P/E ratios, which can be compared between companies, dividend cover comparisons can only be made between companies that choose to make dividend payments. Some companies have a stated policy of not paying dividends. For example, Frasers Group plc (formerly Sports Direct plc) did not declare dividends in any year from 2010 to 2020.

It is important to note that there is no legal requirement for directors to pay dividends even when the company has the profits to do so. Dividends are paid at the discretion of directors. Equity shareholders have no right to receive dividends and cannot force the directors to pay them (see Chapter 29 Equity finance) even when they have an expectation of stable or steadily growing dividends.

Dividend payments are typically insensitive to earnings volatility in any single year. Even where a company has made insufficient profits to cover dividend in a year (i.e. it has a dividend cover of less than 1, as explained above), it is not prevented from paying that dividend, provided it has sufficient revenue reserves built up from earlier years (see Chapter 15 Capital and reserves).

While a strategy of paying out dividends from past profits cannot be used indefinitely, it is a tactic typically deployed by directors to signal confidence in the company’s prospects and therefore maintain investor support for the company.

Directors may be prevented in exceptional circumstances from paying dividends. The Prudential Regulation Authority (PRA), part of the Bank of England, stopped banks paying out billions of pounds to pension funds and private shareholders during 2020, to ensure stability of the banking system in the face of an economic downturn brought about by the Covid-19 pandemic. Banks including HSBC, Lloyds, NatWest, Santander and Barclays bowed to pressure and ceased dividend payments. These restrictions were lifted in July 2021.

4 Dividend yield

Calculated as:

$\frac{\text{Annual dividend per share}}{\text{Market price per share}}$

This ratio is reported as a percentage, e.g. 10%.

Dividends are typically declared twice annually by companies, as interim and final dividends. The annual dividend should therefore comprise both interim and annual amounts.

Advantage of dividend yield measure

The ratio can be compared between investments to identify companies that are paying the highest dividend returns.

Disadvantage of dividend yield measure

Dividend yields, like P/E, are open to interpretation.

A high dividend yield may indicate a good investment opportunity, e.g. due to the share being undervalued. Alternatively, the share price may reflect expectations about (poor) future performance, i.e. that dividend payouts cannot be sustained.

Conversely, a low dividend yield relative to the sector may indicate that shares are overpriced. Alternatively, it may reflect a company decision to reinvest a higher proportion of earnings to generate higher returns over the long term.

As share price can be subject to volatility, dividend yield too can suffer significant fluctuation.

There is no right level of dividend yield. A high dividend yield does not necessarily translate into a high dividend payout.

Investors looking for a steady dividend stream may find dividend cover a more useful measure than dividend yield.

5 Total shareholder return (TSR %)

A common criticism of investor ratios is that they rely on information extracted from the financial statements. To take one example, calculating the P/E ratio requires a number for earnings. This figure can only be obtained from published financial statements. The financial statements, which are prepared by directors, typically include accounting judgements and may reflect different accounting policies adopted by directors where accounting standards permit choice (see Chapter 19 Accounting and financial reporting standards). Because judgement and choice exist in accounting, it is argued that ratios are open to manipulation and therefore cannot be relied on as an objective basis for comparing company performance.

Total shareholder return (TSR %) overcomes these criticism as it is based only on market-based information.

TSR is reported as a percentage (e.g. 20%) and is calculated as follows:

$\text{TSR (\%)}=\frac{\text{share price (today) + dividend/share }-\text{ share price (last year)}}{\text{share price (last year)}}$

Essentially, the ratio uses market information (rather than accounting information) to measure management’s success in creating value for investors.

The metric in effect measures annual capital growth and income return. The year-on-year growth in share price (share price today − share price one year earlier) measures the capital growth that has accrued to shareholders over one year. The dividend per share measures the income that the investment has generated for shareholders in cash terms over that year.

The ‘total’ return to shareholders for the year comprises the combined sum total of income plus capital return since the previous year. By measuring this as a percentage return on invested capital, it is possible to compare performance between companies.

TSR is arguably a more objective measure of performance because the share price reflects the market’s view of the worth of a business. It is not reliant on accounting information that may be subject to judgement (or manipulation).

TSR is used to compare performance between companies and can also be used as assess investment return against benchmark investment opportunities. For example, the UK’s long-term interest rate is approximately 3%. During most of 2020, the UK interest rate (Bank of England base rate) was at 0.1%. A company TSR of, say 6%, can be assessed in terms of risk and reward against these (or other) benchmark levels of return.

In practice

Investor ratios can provide investors with valuable information on the profitability and security of investments. However, ratios are open to interpretation and no single ratio should be reviewed in isolation.

Investor ratios may be subject to significant fluctuation over time, for example, as a result of share price volatility. It is argued that using published historic financial information limits the usefulness of ratios as historic data only provides trailing indicators rather than forward guidance.

Nice to know

Price Earnings Growth (PEG) ratio

While the P/E ratio is the widest-used metric to compare companies, it is a metric based on historic earnings data, as explained above. In practice, Price Earnings Growth (PEG) is considered to provide a fuller picture of a share’s valuation and attractiveness and may address some of the drawbacks of using the P/E in isolation.

PEG (or Future PEG) measures the relationship between P/E and a company’s expected growth.

PEG requires an estimate of future earnings growth and is calculated as:

$\frac{\text{Price/Earnings}}{\text{Future annual growth rate in EPS}}$

A PEG of 1 is considered the base, i.e. that the shares are fairly valued. High P/E companies are generally expected to have higher growth rates.

A PEG ratio below 1 would generally be considered attractive because it indicates the company is undervalued as higher growth is expected in future years. A PEG ratio above 1 would indicate an overvaluation.

PEGs are often compared between companies to provide investment rankings.

Example

• ■Company A with a P/E ratio of 15 and expected to grow at 7.5% would have a PEG of 2.
• ■Company B with a P/E of 15 and expected to grow at 20% would have a PEG of 0.75.

Considered in isolation, company A has a high P/E ratio and high PEG and looks expensive. Company B, while it has the same P/E, it has a lower PEG and therefore may be a better investment opportunity.

The main disadvantage of PEG is the necessity to estimate future earnings. This is often based on past earnings, which itself is an unreliable predictor of future earnings.

Diluted EPS

Companies may have raised finance, for example, through convertible bonds (see Chapter 30 Debt finance), i.e. debt that can be converted into equity in the future. If this conversion to equity were to happen, the number of shares in issue would increase, and this would in effect ‘dilute’ the earnings available to each shareholder.

Share options, which are a form of benefit given by a company to an employee (to buy a share in the company at a discount or at a stated fixed price) can have a similar dilutive effect.

Diluted EPS is typically presented together with the basic EPS figure (explained earlier) to show the effect of any future possible dilution.

Optional detail

Price/Earnings and the dividend cover measure are based on historic earnings data. It is argued, however, that investors really want to know about future earnings. This desire for relevance rather than reliability of data has led to the development of ‘forward’ P/E and dividend cover ratios. Forward ratios originated in the US and have been popular for a few decades.

Calculating a forward ratio for P/E uses forecast rather than historic earnings information. Forecast earnings are typically estimated by analysts and may not be as reliable as audited (historic) earnings data. However, advanced data analytics programming tools are increasingly being deployed to arguably produce more accurate, evidence-based (i.e. data-driven) forecasts.

Forward dividend yield can also be calculated and is based on estimated future dividends. These can be forecast with greater certainty where companies have a published dividend policy.

It is argued that basing decisions on forward ratios (rather than historic, audited information) may simply bring additional complexity and (some might say) even more uncertainty to already difficult investment decisions.

Further, widely reported academic research has shown that the risk of using estimates is that they are more often than not overoptimistic and therefore wrong!

Reflect and embed your understanding

• 1Consider a company that has a P/E ratio above its sector average. How would you interpret this metric, i.e. does it make this company a good investment?
• 2Explain what the TSR ratio measures and why it might be considered to be a good metric for measuring performance between companies?
• 3What are the limitations of using ratios to draw conclusions on company performance?
• 4Reflect on which investor ratios, if any, you would consider relevant when considering investing in a company.
• 5Why should directors of listed companies pay attention to investor ratios?

For the authors’ reflections on these questions, please go to financebook.co.uk

Where to spot in company accounts

Shares of privately owned corporations not traded have no readily available market value for the stock. Unlike listed companies, private companies are not required to report EPS numbers.

EPS for listed companies will be disclosed below the profit and loss account, with the calculation of EPS included in the notes to the accounts.

Dividends to equity holders are detailed in the statements of changes in equity (Appendix p. 447). Details of dividends per share are typically disclosed separately in a note to the financial statements

Extracts from Greggs plc 2020 financial statements Appendix pp. 445, 481

Consolidate and apply

To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 422.

Watch out for in practice

• →When comparing ratios, consider the impact of differences in accounting policies, financing structures (debt versus equity) and different accounting year ends. No two businesses will be identical.
• →Investor ratios such as P/E make use of real-time (as well as historic) information so can be subject to extreme volatility. Trends over time and relative to the sector can be more informative.
• →Loss-making companies will have negative (or zero) ratios for P/E. This makes interpretation more difficult. Again, trend data may be more informative to determine whether a company is an attractive investment.
• →Always read the ‘small print’ in the annual report. The annual report highlights key risks that might seriously jeopardise future performance (e.g. product quality issues, over-reliance on customers or suppliers, lawsuits, corporate governance concerns, etc.) yet these are typically overlooked in favour of focusing on historic financial statements.
• →Never underestimate the importance of how the management team is perceived by investors. A departure/new appointment can have a dramatic effect on the ratios of a business.