Shareholder ratios
| by Philip Dunn 30 Nov 2006 Diploma in Financial Management Relevant to Module A |
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Interpreting financial statements usually includes comparison – that of one company with another or the same company over a period of years to examine performance and trend. Other comparisons may include those on an interim basis with published industry average figures.
From an investor perspective two major concepts feature in any analysis:
- risk
- shareholder interest.
Before we consider risk in the form of medium and long term solvency ratios we need to look at the various forms of long term finance and highlight their priority to distribution of profit. Refer to Table 1 below.
TABLE 1
Source of finance Priority in relation to profit
Secured loan stock debentures Interest must be paid regardless of the level of profit
Unsecured loan stock Interest must be paid regardless of profit
Preference share capital If a company makes a profit, preference shareholders have priority to dividend over ordinary shareholders
Ordinary share Dividend is paid after debentures capital interest and fixed preference dividend
The same order of priority of these sources of finance apply to claims in the case of liquidation.
Measurement of risk considers the financial risk incurred by borrowing. As we can see in Table 1 a company must pay interest on debentures regardless of profit levels. In good times, a company achieving a good level of Residual Income (RI) or Economic Value Added (EVA) would generate enhanced Shareholder Value Added (SVA).
Conversely in less profitable periods, a company may fail to generate earnings at a rate sufficient to cover loan interest and thus any shortfall would adversely affect the equity holders.
Before we consider performance from a shareholder perspective, we need to examine the concept ‘gearing’. Gearing or leverage is a widely used concept in accounting. It can be defined and calculated in several ways. It is said that the extent to which a company is financed by loan capital is gearing.
The most common form or definition is that of total gearing and is expressed as a % thus:
Loan capital plus preference share capital x 100
Total long term capital
Total long term capital is defined as:
Loan capital + preference share capital + ordinary share capital and reserves.
The measure shows the relationship of fixed interest finance to total finance. Some analysts would include short term debt in the calculation where short term loans, particularly overdrafts, are being used continuously by the business and thus form part of long term financing. There is no dividing line between what is considered to be a low or high geared company. Gearing or leverage can have a direct effect on the distribution of profit and hence shareholder return. Consider the following example of two companies with differing capital structures but the same levels of profit:
£m £m
Capital structure:
Debentures 10% 10.00 2.00
Ordinary share capital and reserves 5.00 13.00
15.00 15.00
Year 1 Profits before interest £2.5m
High Geared Low Geared
10% debenture interest 1.00 0.20
Ordinary shares balance 1.50 2.30
£2.50 £2.50
Year 2 Profits before interest £5.00m
High Geared Low Geared
10% debenture interest 1.00 0.20
Ordinary shares balance 4.00 4.80
£5.00 £5.00
It can be noted that a doubling in profit has an effect of almost tripling the return to equity holders in the high geared company. If however profits fell below £1m in the high geared company there would be no return for the equity holders. Thus an investment in ordinary shares in such a company is more speculative than in a company with much lower gearing. It was stressed earlier that interest on loan stock must be paid regardless of the level of profit. Interest cover is expressed as:
Profit before interest and tax = Number of times
Interest paid
This ratio represents the number of times that interest could be paid out of profit before interest and tax.
RETURN FOR INVESTORS
Equity holders hope for ‘added value’ from their investment through income from dividends and growth from capital gain.
Through an analysis of financial statements we can provide shareholders with a guide to appraise their dividend position.
Ratios covering return for investors include:
Earnings:
- Return on equity
- Earnings per share
- Price earnings ratio.
Dividends:
- Dividend per share
- Dividend cover
- Dividend yield.
RETURN ON EQUITY
This ratio is of particular significance to equity holders (ordinary shareholders). It is expressed as a % thus:
Profit after tax and preference dividends x 100
Ordinary Share Capital + Reserves
EARNINGS PER SHARE (EPS)
FRS 14 requires that EPS is shown as a footnote to the profit and loss account of a quoted company.
FRS 14 defines EPS thus:
‘Basic earnings per share should be calculated by dividing the net profit or loss for the period attributable to ordinary shareholders by the weighted average number of shares outstanding during the period.’
It is expressed thus:
Attributable equity profit for period
Number of equity shares ranking for dividend
The trend of EPS is a better indicator of progress than the trend in profit.
PRICE EARNINGS RATIO (P/E RATIO)
This is considered by many to be the most important investment ratio, and is expressed as:
Market price per share = Number of times
Earnings per share
It represents the number of years it would take to recoup the investment out of attributable equity profit, for example: the payback period.
A low P/E (suggesting a short payback period) is not necessarily good, nor a high one bad, since market expectations must be taken into account. A high P/E is viewed as an indicator that market expectations are that company profits will rise and that the business has significant growth prospects. The converse applies to a low P/E ratio.
On the other hand an exceptionally high P/E might suggest the company is on the margins of being overvalued, and a low P/E the reverse. P/E ratios vary between industrial sectors, depending on market expectations for the future of each particular industry.
DIVIDEND PER SHARE
This ratio is expressed as:
Ordinary dividend
Number of ordinary shares in issue ranking for dividend
The ratio tells equity holders the amount of dividend distributed per share. It will be influenced by the profitability of the company, its capital structure and dividend policy.
Some companies at some stages of their development choose to distribute a large percentage of post tax profits. Others – especially those experiencing fast growth – will want to plough as much as possible back into their business.
DIVIDEND YIELD
This is the percentage rate of return by investing in shares at current market price. It is expressed as:
Dividend per share x 100
Market price per share
As with P/E ratios, the dividend yield figure brings market expectations (as expressed in current share price) into the equation. A high yield could be taken as an indication that the market sees some risk involved in the investment.
DIVIDEND COVER
This is determined by dividing profit available to equity holders by the dividend for the year.
It is expressed as:
Earnings after tax and preference dividends = Number of times
Ordinary dividend
This is an indication of dividend policy – whether profits tend to be distributed or reinvested.
CASE STUDY
The summarised accounts of Dunn Publishing plc for years X1 and X2 showed:
Profit and loss account
X1 X2
£m £m
Turnover 980.00 1,170.00
Operating profit 35.00 43.20
Interest payable 3.96 3.96
Profit on ordinary activities
before tax 31.04 39.24
Tax on profit on ordinary
activities 9.31 11.77
Profit after tax 21.73 27.47
Dividends: preference 0.16 0.16
ordinary 4.60 5.83
Profit after tax and dividend 16.97 21.48
Balance sheet
X1 X2
£m £m
Tangible assets 15.84 26.47
Net current assets 108.34 119.19
Total assets less current
liabilities 124.18 145.66
Creditors falling due after one year
10% debentures 39.60 39.60
84.58 106.66
Share capital and reserves
X1 X2
£m £m
Ordinary shares (£0.25 each) 19.80 19.80
8% preference shares (£1 each) 2.00 2.00
Profit and loss account 62.78 84.26
84.58 106.06
Current market price per share for X1 is £1.50 and for X2 is £1.75.
Ordinary shares in issue
£19.8m = 79.2m
£0.25
Let us consider the performance indicators outlined above.
Risk
- Gearing / leverage
Long term capital plus preference share capital x 100/1
Total capital
Year X1 Year X2
£39.6m + 2m x 100 £39.6m + 2m x 100
£39.6m + 84.58 £39.6m + 106.06
= 33.50% = 28.56%
The gearing has fallen because there is less reliance on fixed interest capital than before, influenced by increased retention of profit.
Shareholders interest
- Return on equity
Profit after tax and preference dividend x 100/1
Ordinary share capital + reserves
Year X1 Year X2
£21.57m x 100 £27.31m x 100
£82.58m £104.06m
= 26.12% = 26.24%
There has been a marginal increase in return on equity due to the increase in profitability.
- Earnings per share (EPS)
Profit attributable to ordinary shareholders
Number of shares in issue
Year X1 Year X2
£21.57m £27.31m
79.2m 79.2m
= 27.23 pence = 34.48 pence
EPS has increased by 26.6% due to the improved level of profit attributable to ordinary shareholders whilst the number of shares in issue has remained constant.
- Price earnings ratio
Market price per share
Earnings per share
Year X1
£1.50 = 5.5
27.23p
This ratio implies that if EPS is maintained at its current level, it will take 5.5 years to pay back the cost of investing.
Year X2
£1.75 = 5.1
34.48p
This ratio implies that if EPS is maintained at its current level, it will take 5.1 years to pay back the cost of investing.
- Dividend per share
Ordinary dividend
Number of shares in issue
Year X1 Year X2
£4.60m £5.83m
79.2m 79.2m
= 5.81 pence = 7.36 pence
Reflects the increased profitability and continued dividend policy.
- Dividend yield
Dividend per share
Market price
Year X1 Year X2
£0.0581 x 100 £0.0736 x 100
£1.50 £1.75
= 3.87% = 4.21%
There is a marginal increase here due to the increase in dividend per share being in greater proportion than the increase in the share price.
- Dividend cover
Earnings after tax and preference dividend
Ordinary dividend
Year X1 Year X2
£21.57m £27.31m
£4.6m £5.83m
= 4.69 = 4.68
The dividend cover has remained constant over the two-year period.