Investment ratios - Accounting - Pearson A-Level

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Welcome to Investment Ratios: Decoding Shareholder Value!

Hello future accountants! This chapter is where Corporate Accounting truly meets the real world of finance. We are moving beyond just calculating profit and loss; we are learning how investors—the people who actually buy the company—judge whether a business is successful and worth investing in.

Don't worry if ratios seem complicated! We will break them down into simple pieces. By the end of this chapter, you will be able to speak the language of the stock market and understand exactly why a share price goes up or down.

Section 1: The Investor's Perspective – Why Investment Ratios Matter

Investment ratios are specific calculations that focus on the relationship between a company’s financial performance (its profit) and the value of its shares in the market (the share price). These ratios answer crucial questions for two groups:

Existing Shareholders: Am I getting a good return on my investment? Is the company's dividend secure?
Potential Investors: Is this share price fair? Is this company set up for future growth?

The Foundation: Understanding Earnings

Before we calculate ratios, we need to clarify what 'profit' we are using. For ordinary shareholders, we use the profit remaining after all mandatory deductions have been made.

Profit available to Ordinary Shareholders = Net Profit After Tax minus Preference Dividends.

(Prerequisite check: Preference Dividends are fixed dividends paid to holders of preference shares, and they must be paid before any profit can be distributed to ordinary shareholders.)

Key Takeaway: Investment ratios measure profitability and risk specifically from the viewpoint of the person owning the company's stock.

Section 2: Measuring Profitability Per Share

These ratios are arguably the most important, as they tell us exactly how much 'ownership' value is attached to a single share.

1. Earnings Per Share (EPS)

The Earnings Per Share (EPS) is the single most basic and critical measure of a company’s profitability for an investor. It tells you how much profit the company generated for each ordinary share outstanding.

The EPS Formula

The EPS is expressed in currency units (e.g., $ per share or pence per share).

$$ \text{EPS} = \frac{\text{Profit (Earnings) available to Ordinary Shareholders}}{\text{Number of Issued Ordinary Shares}} $$

Interpreting EPS

A high EPS is generally good: It means the company is earning more profit relative to the number of shares issued.
EPS is essential for comparison, especially when tracking the growth of the company over several years (time series analysis).

Common Mistake to Avoid: Always remember to deduct Preference Dividends from Net Profit After Tax before calculating the numerator (the top part of the fraction).

2. Price/Earnings Ratio (P/E Ratio)

The P/E Ratio (or P/E Multiple) connects the company's actual performance (EPS) with the market's perception of the company (Share Price). It answers: How much are investors willing to pay today for $ \$1 $ of the company's current earnings?

The P/E Ratio Formula

The P/E Ratio is expressed as a number (a multiple), not a percentage.

$$ \text{P/E Ratio} = \frac{\text{Market Price per Ordinary Share}}{\text{Earnings Per Share (EPS)}} $$

Interpreting the P/E Ratio

Analogy: The Rental Property

Imagine you buy a rental property for $ \$200,000 $ that generates $ \$20,000 $ profit (net rent) per year. Your P/E (Price divided by Earnings) is $ 10 $. This means it takes 10 years of earnings to pay back your initial investment.

High P/E Ratio (e.g., 25+): This usually means the market expects high future growth. Investors are willing to pay a premium now because they believe the company's earnings will increase significantly later. Shares with high P/E ratios are often considered growth stocks.
Low P/E Ratio (e.g., below 10): This might suggest the share is undervalued (a bargain!) or, more cautiously, that the market predicts the company’s future earnings will fall, or that the industry is considered risky. These are often called value stocks.

Quick Review: EPS is the profit reality; P/E is the market expectation.

Section 3: Measuring Return to Shareholders (Dividends)

While EPS shows how much the company *could* pay, dividends show how much the company *is* paying out in cash to its shareholders. Investors who rely on regular cash payments (like retirees) focus heavily on these ratios.

3. Dividend Per Share (DPS)

The Dividend Per Share (DPS) is simply the amount of cash dividend paid out for each ordinary share held.

The DPS Formula

$$ \text{DPS} = \frac{\text{Total Ordinary Dividends Paid}}{\text{Number of Issued Ordinary Shares}} $$

(Note: This calculation is often straightforward as the DPS is usually announced directly by the company, but you must know how to calculate it from totals.)

4. Dividend Yield

The Dividend Yield measures the dividend as a percentage of the current share price. It shows the immediate cash return (the yield) on the investment.

The Dividend Yield Formula

$$ \text{Dividend Yield} = \frac{\text{Dividend Per Share (DPS)}}{\text{Market Price per Ordinary Share}} \times 100 $$

Interpreting Dividend Yield

High Yield: Attractive to 'income investors' who want regular cash flow.
Low Yield: Suggests the company is retaining most of its profit for reinvestment (good for growth stocks), or that the share price is very high relative to the dividend paid.

Did you know? A company can choose to pay no dividend at all if it needs the cash to fund aggressive expansion. This would result in a Dividend Yield of 0%.

5. Dividend Cover (Dividend Pledging)

The Dividend Cover ratio is crucial for assessing the security of the dividend payment. It measures how many times the company's earnings can cover the ordinary dividend paid.

The Dividend Cover Formula

You can calculate this in two ways, both giving the same result:

$$ \text{Dividend Cover} = \frac{\text{Profit (Earnings) available to Ordinary Shareholders}}{\text{Total Ordinary Dividends Paid}} $$

$$ \text{Dividend Cover} = \frac{\text{Earnings Per Share (EPS)}}{\text{Dividend Per Share (DPS)}} $$

Interpreting Dividend Cover

High Cover (e.g., 3x or 4x): This is excellent. It means the dividend is very safe. Even if profits drop by half, the company could still easily afford the current dividend payment.
Low Cover (e.g., 1.2x): This is risky. If profits decrease even slightly, the company might be forced to cut the dividend, which almost always results in a drop in the share price.

Encouragement: Don't worry if this seems tricky at first. Remember that high cover = high security. It's like having a big safety net!

Key Takeaway: Dividend ratios measure the immediate cash return and the sustainability of that return.

Section 4: Comprehensive Analysis and Limitations

The best analysts never look at ratios in isolation. They must be compared and judged together.

Putting the Ratios Together

Imagine Company A has a P/E Ratio of 30 and Company B has a P/E Ratio of 8. Which is better? You need more context!

If Company A (P/E 30) is a high-tech startup, the high P/E is normal—investors expect massive growth. Its Dividend Yield will likely be low (0-1%) because it retains cash for reinvestment.
If Company B (P/E 8) is a utility company, the low P/E is normal. Its Dividend Yield will likely be high (4-6%) because it generates steady cash flow and pays it out to shareholders.

A solid investment analysis involves:

Trend Analysis (Time Series): Comparing the company’s ratios this year to its ratios over the past 5 years. Is EPS growing? Is Dividend Cover improving?
Industry Comparison: Benchmarking the company’s ratios against its closest competitors. (Is our P/E ratio higher or lower than the industry average?)

Limitations of Investment Ratios

Ratios provide a powerful snapshot, but they cannot tell the whole story. As students of accounting, you must recognise their limits:

Market Price Fluctuations: The P/E and Dividend Yield use the market share price, which can change hourly due to investor sentiment, rumours, or general economic panic—not just company performance.
Historical Data: Ratios use historical financial data (last year’s profit). Investors are interested in the future, which the ratios do not directly predict.
Accounting Policies: Different companies use different inventory valuation methods (e.g., FIFO vs. AVCO) which can distort profit figures and, consequently, the EPS and P/E ratios.

Quick Review Box: The Investment Ratio Toolkit

Ratio	What it Measures	Ideal Scenario
EPS	Profit earned per share	High and consistently growing
P/E Ratio	Market's valuation premium/discount	Varies by industry (High for Growth, Low for Value)
Dividend Yield	Cash return on investment cost	Attractive to income investors
Dividend Cover	Security/sustainability of the dividend	High (e.g., 2.5x or more)

Remember, understanding Investment Ratios is about determining if the market price of a share is justified by the company's underlying performance and future prospects. Keep practicing those interpretations!