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Investment Valuation Ratios - Coggle Diagram
Investment Valuation Ratios
Investment valuation ratios compare relevant data that will estimate the attractiveness of a potential or existing investment
Investors assess the performance of a company's shares by looking at how ratios compare from one company to another
Dividend payout ratio
This ratio measures the earnings attributable to equity shareholders that are paid out in the form of dividends
A higher ratio indicates that the company is sharing more of its earnings with its equity shareholders
A lower payout ratio indicates that the company is using more of its earnings to retain in the company to reinvest and grow further
DPR = Equity Dividends Paid / Profit x 100
Dividend yield
Indicates how much a company pays out in dividends each year relative to the equity share price
Normally only profitable companies pay out dividends
A stable dividend yield can be a sign of a stable and safer company
This refers to dividends paid in the year which are normally last years final dividend and the current years interim dividend payment
Dividend yield = Dividends per share / market price per equity share * 100
Earnings per share
The residual profit attributable to each equity shareholder
Residual profit means the profit for the period after charging interest and other finance charges, corporate tax, preference dividends and any transfers to other component of equity
A basic measure of a company's performance from an equity shareholders point of view, calculated as profit attributable to each equity share
EPS = profit attributable to equity shareholders / weighted average number of equity shares during the period
IAS 33 prescribes how quoted companies should calculate their EPS figures
These figures should be published at the base of a P&L by all quoted companies
Interpretation
The higher the EPS, the more attractive the shares will be to potential investors and higher the stock market value, an appreciating EPS trend indicates the growth of a company. Investors can also look at the estimates of future EPS to get an idea of the profits they will earn in future years
A high EPS indicates a company in good health with enough profits to pay dividends to the equity shareholders or to plough back into the company for future prospects and long term growth. A company with a reported loss gives a negative EPS which is usually reported as not applicable
EPS is measure of the management performance, it shows how effectively the available capital and opportunities have been fully utilised in the reporting period
It sets an upper limit for dividends which some consider to be an important determinant of share price, although users should be aware that dividends are sometimes financed from distributable profits from previous years
EPS changes when the level of profit increases or decreases
EPS will be altered or diluted when there is a new share issue giving rise to the calculation of basic EPS and diluted EPS E
Basical EPS is profit attributable to equity shareholders for a period divided into the weighted average number of outstanding equity shares for that same period
Diluted EPS is the adjusted attributable profit for a period divided into the outstanding equity shares and adjusted to include all potential dilution
A diluted EPS assumes that all the convertible securities such as convertible preferred shares, convertible debt, equity options and warrants will be exercised
Dilute EPS is generally less than basic EPS
**Diluted EPS = adjusted profit attributable to equity shareholders for a period / weighted average number of outstanding equity shares + diluted shares
Limitations
EPS does not represent actual income to the shareholder
Companies have the option to buy back their shares, in this case the number of shares outstanding decreases, increasing the EPS without an actual increase in the profit
Companies can make EPS look better without profit actually improving
EPS does not consider the debt element of the company, it may not be an ideal comparison of two companies where one company has debt and the other company does not
EPS trend analysis shows the growth of a company in recent years, however it may not be meaningful to compare EPS of different companies. The figures are dependent on the number of shares and their nominal value, that each company has in issue. Different companies are also likely to have different accounting policies
Price/earnings ratio
The P/E ratio measures the current market price of the share relative to its EPS
PE Ratio = market price / EPS
This ratio indicates the relationship between the market value of equity share capital and the profit for the year
The P/E ratio valuation method is a simple and commonly used method of valuation, this approach uses the PE rato of a similar quotes company to value shares in unquoted companies
Value of a share = EPS x suitable industry P/E ratio
The P/E ratio should be from the same industry with similar
Company risk
Finance risk
Growth rate
If using a quoted company's P/E to value an unquoted company, a substantial discount (around 25%) is often applied to reflect the lower marketability of unquoted shares
Interpretation
The P/E ratio gives a stock market view of the quality of the underlying earnings, generally a high P/E ratio indicates that investors anticipate higher earnings and higher growth in the future
The average market P/E ratio has often been stated at 20-25 times earnings
A loss making company does not have a P/E ratio
A company with a high P/E ratio can indicate that the equity shares are being overvalued. If a company has a high P/E, investors are paying a higher price for shares compared to its earnings
A company with a low P/E may indicate undervalued shares. This can make a company with a low P/E a good value investment with potential opportunity to be profitable, but it can also simply indicate that investors are not confident about the company's future prospects
The P/E ratio shows the number of years it would take for the company to pay back the amount an investor paid for the share. In other words, the number of multiples over one years earnings an investor is willing to pay for a share
Limitations
The P/E ratio is applied to earnings based on accounting policies which are more subjective than cash flows. A company can inflate their earnings to make them look betetr
The P/E ratio simply assumes that the market is valuing earnings and ignores many important variables in an equity share's worth: dividends, earnings grwoth, risk and so on
The P/E ratio is actually a backward looking indicator providing little help where economic conditions have changed signifciantly
Does not consider debt, companies with high debt levels are higher risk investment and the market price of an equity share is not always a good indicator of fair value
The P/E ratio is a useful valuation method used by investors but it should never be used as the sole reason for investing in a company
Relative value measures
Relative value is a method of determining an asset's value that takes into account the value of similar assets of competing companies in the same indsutry
Based on an approach that investors are not just interested in the absolute figures on the financial statementt but also in the valuation of the asset in relation to its peers
The investors measures share value in relation to a comparable share of another company
Steps in relative value analysis
Identify comparable companies. Revenue and market capitalisation are the widely used parameters
Calculate price multiples such as P/E ratio, equity share price to sales revenue and equity share price to operting cash flow
Compare these ratios with those of peers and the industry average. This will help in understanding whether the security is overvalued or undervalued