Investment Ratios (Cambridge International A-Level Business)

The meaning and importance of return to investors

• A financial return is the **money made or lost on an investment **over a period of time

• Shareholders - and potential shareholders - look for** financial returns** on investments in the form of

  • Increased share price
  • Increased dividends

• A series of ratios can be used to determine whether an initial or ongoing investment in a company is worthwhile

  • Poor investment performance can cause shareholder discontent, which may lead to changes to the board of directors at the AGM

The main investment ratios

• Financial advisors and the media are also interested in these ratios, as they can be used to report on business performance

Dividend yield

• The dividend yield ratio shows how much a company pays out in dividends each year relative to its share price

• It is used to compare investments in a company

  • With other investments, such as bank interest rates and dividend yields of other investments
  • Over time to analyse long-term performance of investments

• Dividend yield is calculated using the formula

$\mathrm{Dividend} \mathrm{yield}=\frac{\mathrm{Dividend} \mathrm{per} \mathrm{share}}{\mathrm{Market} \mathrm{price} \mathrm{per} \mathrm{share}}\times100$

Worked Example Cymball Industries Plc issued shareholders a dividend per share of $0.87 in December 2023. Its share price at this time was $17.40

Calculate the dividend yield achieved by investors in Cymball Industries Plc in December 2023.

(2)

Step 1: Divide the dividend per share by the market price per share

= \ 0.87 \div $ 17.40

= 0.05$****(1)**

** Step 2: Multiply the outcome by 100 and express as a percentage **

$= 0.05 \times 100

= 5.00 %$** (1)

• Dividend yield is determined by the level of dividend issued by a company and the current market price of shares in the company

  • In general terms, the higher the dividend yield, the better

    • If the share price increases, dividend yield will fall
    • Despite this, investors may be keen to invest, as the rising share price indicates positive company performance
    • If the issued dividend increases, the dividend yield will rise

  • However, a high dividend yield can occur as a result of a fall in the share price as a result of poor business performance

    • In these circumstances, an investment may be less attractive

Dividend cover

• Dividend cover is a measure of how well profits cover the dividend paid to shareholders

  • The ratio shows how easy it is for a company to continue to pay out its current dividend, given the profit it has generated
  • The outcome of the ratio refers to the number of times profit covers the total value of dividends issued

• The ratio can be used to assess the current and future sustainability of the dividends paid out by a company

  • A high ratio suggests that a company can maintain its current dividend payments

    • Shareholders may retain their shares as they are likely to continue to receive the dividend to which they have become accustomed

  • A low ratio may suggest that future dividend payments are unlikely to be paid at their current level

    • Shareholders may choose to divest their shares and switch to more stable investments

  • In general, a dividend cover of 2 is viewed as good, as this indicates that a company has the capacity to pay its dividends twice over

• A high ratio does not guarantee a sustained dividend

  • Companies can choose to retain profits rather than issue a dividend to shareholders

• Dividend cover is calculated using the formula

$\mathrm{Dividend} \mathrm{cover}=\frac{\mathrm{Profit} \mathrm{for} \mathrm{the} \mathrm{year}}{\mathrm{Annual} \mathrm{dividend}}$

Worked Example Cymball Industries Plc issued its shareholders a total dividend of $915,500 in December 2023. Its profit for the year was $5.9 million.

Calculate Cymball Industries Plc's dividend cover in December 2023.

(2)

Step 1: Divide profit for the year by the annual dividend

= $ 5.9 million / $ 915 , 500 > > = 6.44****(1)**

** Step 2: Express the outcome as a ratio **

• In December 2023, Cymball Industries Plc's dividend yield was 6.44 : 1.
• This means it could cover its dividends with profits 6.44 times.** (1)

Price/earnings ratio

• The price/earnings ratio is a measure of confidence investors have in a company's ability to generate future returns

  • It compares the earning made per share during a specific time period to the current share price
  • Investors use this ratio to determine how many years it would take to buy one company share with the earnings (profit) generated per share

• Generally, the higher the price/earnings ratio, the better

  • A high ratio suggests that investors are confident enough to invest for a long period of time

  • Comparisons between the price/earnings ratio should focus on those in the same industry, as investors are likely to have different levels of confidence in diverse industries

    • E.g. Confidence in the growth of AI-based businesses is likely to be considerably higher amongst investors than in the construction industry

• Price/earnings ratio is calculated using the formula

$\mathrm{Price}/\mathrm{Earnings} \mathrm{ratio}=\frac{\mathrm{Market} \mathrm{price} \mathrm{per} \mathrm{share}}{\mathrm{Earnings} \mathrm{per} \mathrm{share}}$

• If the earnings per share is not given, it is calculated using the formula

$\mathrm{Earnings} \mathrm{per} \mathrm{share}=\frac{\mathrm{Profit} \mathrm{for} \mathrm{the} \mathrm{year}}{\mathrm{Number} \mathrm{of} \mathrm{issued} \mathrm{shares}}$

Worked Example Cymball Industries Plc reported profit for the year of $5.9 million in December 2023 and issued a dividend of $0.87 for each of its 1,052,300 shares. Its share price ended the year at $13.66.

Calculate Cymball Industries Plc's dividend cover in December 2023.

(2)

Step 1: Calculate earnings per share

$\mathrm{Earnings} \mathrm{per} \mathrm{share}=\frac{\mathrm{Profit} \mathrm{for} \mathrm{the} \mathrm{year}}{\mathrm{Number} \mathrm{of} \mathrm{issued} \mathrm{shares}}$

= \frac{ \ 5.9 million}{1 , 052 , 300 shares}

= $ 5.61$ (1)

Step 2: Divide the market share price by earnings per share

= \frac{\ 13.66}{$ 5.61}

= 2.43$ (1)

Methods of improving investor return

• In general, investor returns can be improved by increasing business profits

  • Higher profits allow companies to distribute greater dividends, increasing the dividend yield and dividend cover
  • The share price of a business is likely to increase if its profits grow, leading to a higher price/earnings ratio

• However, care should be taken to interpret the reasons for improvements in investment ratios

  • The dividend yield can increase if a company experiences a fall in its share price

    • A falling share price often indicates lower shareholder confidence, so this is unlikely to be welcomed

  • Dividend cover can rise if a company pays a lower dividend to shareholders

    • This may be as a result of a company using retained profits as a source of finance to fund growth
    • For short-term investors, however, this is also unlikely to be welcomed