There are a number of ratios used by analysts to measure the performance of an entity over a period of time. Each ratio has its own use and importance for analysts, potential & current investors, and for other users of the financial statements. This article explains investor ratios and their types along with examples and illustrations.
What Do Investor Ratios Mean?
Investor ratios are the ratios that investors use to evaluate the potential of a company to generate a return on investment. Basically, the ratios let investors know the financial health of a company and help them make suitable investment decisions.
I have used the word “suitable” instead of good because investors are of different types. Some investors look for short-term profits while others prefer growth over the longer term. That being said, each type of investor would be interested in different investor ratios to analyze the performance of a company.
Explanation
Before investing in any company, an investor would want to know whether the company is worth their investment and if they could get their desired outcome. To find out, there are investor ratios that can help the investor analyze the performance of the company.
These ratios are of keen importance and knowing how to interpret investor ratios can mean the difference between investing in a good organization and investing in a bad organization!
When a company makes a profit, it has TWO options. Either to distribute the profit to shareholders or reinvest it to expand the company. If the company gives dividends (distributes the profits), the investors receive money and can use the money but if the company retains the profit, the investors don’t receive money due to the retention, the share price of the company could increase and the investors would make money in the long run…
To find out which organization could be a good fit for an investor, investor ratios are used by analysts. If an investor is looking for short-term profits, then it’s good to invest in a company that gives excessive dividends. But if the objective of an investor is to grow their capital over time, then it’s probably a good idea to invest in a company that retains and reinvests profits instead of issuing dividends.
TYPES OF INVESTOR RATIOS
There are 5 types of investor ratios and each shows a different perspective of the company to an investor. These ratios are:
- Earnings Per Share (EPS)
- Dividend Per Share (DPS)
- Dividend Yield
- Dividend Cover
- Price-to-Earnings Ratio (PE)
1. EARNINGS PER SHARE (EPS)
The Earnings per share ratio is used to find out how much each share of the company earns. It is a general investor ratio and is used by all types of investors regardless of their investment behavior. There are no advanced calculations involved in calculating EPS and can be simply calculated by dividing the total profit for the period by the total number of outstanding shares in the company.
Outstanding shares = shares currently held by all shareholders of the company including institutional investors and shares owned by the company’s officers and insiders.
For example, if a company makes a $1m profit and its total shares are 20,000, the Earnings per Share will be; = $50 (1,000,000/20,000). That means each share of the company has earned $50.
2. DIVIDEND PER SHARE
A type of investor ratio that calculates the sum of declared dividends issued by a company for every ordinary share outstanding. The ratio is specifically important for investors who are looking to invest in companies that pay excessive dividends. The dividend cover is a self-explanatory ratio and is clearly of interest to short-term investors. It is calculated using the following formula.
Annual Dividends Paid/Weighted Average number of Ordinary Shares
Where Annual dividends = Dividends paid in the period including interim dividends but excluding special dividends and weighted average number of shares = number of shares of a company calculated after adjusting for changes in the share capital over a reporting period.
For example, if a company has issued dividends worth $250,000 in a period and its total outstanding ordinary shares are 1m, the DPS can be calculated by;
= 0.25 (250,000/1,000,000)
3. DIVIDEND COVER
Dividend cover is a measure of the proportion of profit available for distribution to shareholders and the proportion that the company pays. Basically, the ratio is used to measure how much of the profit the company retains and how much it pays to shareholders. It can be used by all types of investors to analyze the financial behavior of a company.
Dividend Cover is calculated by using the formula: Earnings per share/dividend per share.
4. DIVIDEND YIELD
Dividend Yield is an investor ratio that tells us the percentage of the company’s share price that it pays out to shareholders as dividends. It is yet another important ratio, especially for dividend-oriented investors. The dividend yield is calculated as:
Dividend Paid on a share/Share price of the company
- The dividend paid on a share is taken as the previous year’s dividend
- Ex-div share price is used (meaning that the most recent dividend, that is expected to be paid in the current period, is excluded from the share price)
Solution:
Formula= dividend paid/ex-div share price*100
Putting values,
2.35/35*100
Dividend Yield = 6.71%
5. PRICE-TO-EARNINGS RATIO
The Price-to-Earnings ratio or P/E ratio measures the x times of earnings per share that an investor is ready to pay for the share of a company. It is calculated by dividing the share price of the company by the EPS of the same. For example, if the share price of a company is $20 and its EPS is $1, the price-to-Earnings ratio will be 20 ($20/$1). That means an investor is ready to pay 20 times more than what the share generates to buy the share.
INTERPRETATION OF INVESTOR RATIOS
Each investor ratio shows a different dimension of a company and likewise, each group of investors has a different definition of good and bad. An excessive dividend per share may seem like investing in a goldmine for short-term investors but it wouldn’t intrigue an investor who wants to grow over the long term.
Generally, there are some guidelines to follow and questions to ask that will help you understand how the interpretation works.
- Think about what the ratio means and when would it generally be considered good.
- What would the ratio mean for different groups of investors?
- Is there any benchmark available against which the ratio should be compared?
- Are the TWO companies that we are comparing operating in the same industry and/or of the same size?
That being said, now let’s look at each of the ratios in isolation and interpret it for different investor groups.
Earnings per Share: Generally, the higher the ratio the better. However, the ratio should be compared to benchmarks like the previous record of the same company, the EPS of competitors, or the industry average.
Dividend per Share: Dividends are lucrative for short-term investors but growth investors will be reluctant to invest in companies that pay out increased dividends. Therefore, we should consider the behavior of the investor before concluding positives merely because the ratio is on an uptrend. Even for short-term investors, the ratio should be compared to competitors and the industry average to gain a broader insight.
Dividend Cover: Let’s say a company’s dividend cover is 2. That would mean the company retains 50% of profits and payout 50% to shareholders. Think about it; What type of investor would be interested in the company’s shares? Someone who wants to grow over time as well as receive dividends each year!
If an investor is purely investing for short-term profit, they will prefer companies with lower dividend cover whereas a growth investor will be interested in a higher dividend cover ratio.
Dividend Yield: High dividend yield means the company pays a high percentage of profit on investments which is a good thing. However, the ratio should be compared to the previous record of the company and its competitors & industry average. In addition, the ratio should also be compared to EPS to see if the company has actually made profits in the year and not just maintained or improved dividend yield out of its reserves.
Price-to-Earnings: Generally, a low P/E ratio is considered good. Having a lower P/E ratio means the company’s share price is attractive for its profits. The P/E of a company should be compared to the P/E of competitors and the industry average. It is noteworthy to mention here that companies with a high P/E ratio shouldn’t be just disregarded due to expensive share prices. It could also mean that the companies are highly valued by investors for reasons like stability, societal impact, etc…
In conclusion, investor ratios are a powerful tool for evaluating a company’s financial health and performance. By understanding and analyzing these ratios, investors can make informed decisions about whether to invest in a company or not. It’s important to keep in mind that these ratios should be considered in the context of the industry and the company’s overall financial situation.
