Measuring Financial Well-Being (1/2)
In this lesson, you’re expected to learn about some special-use ratios that investors typically use.
A company’s finances are closely watched by the people who give that company money. Thus, many of the best ratios and financial calculations have been developed and are used by people with a financial stake in the success of one or more companies.
The information used by many of these specialists is now the gold standard for personal investing, corporate management and business analysts who want to know how well their company is performing for external stakeholders.
Some of these calculations are special-use ratios, meaning that they’re intended for companies in particular industries, and some of them also serve as measures of a company’s asset management and financial well being.
Investor ratios often relate to profitability in earnings, efficient use of capital and effective asset management.
In addition, because a company’s manager are obliged to maximize the wealth of shareholders, executive pay is often tied to the performance of the company.
Return on equity is the measure of a company’s profitability as a percentage of the shareholders’ funds. The equation is similar to return on capital employed, which we saw earlier.
It instead compares the profit that belongs to the ordinary shareholders with the book value of their investment in the business. Therefore, it’s an important tool for shareholders.
Return on Equity = Earnings after tax and preference dividends / Shareholders’ funds
When you own a company, the amount of money the company makes is the amount of money you earn.
In contrast, when you own a share in a company, you still own a part of the company but you have to split the amount of money the company makes with everyone else who owns the remaining shares.
EPS = Net profit less preference dividends / Average ordinary shares in issue
The earnings per share doesn’t give any indication of the quality of a company’s earnings.
Two companies with the same EPS may generate their earnings using different amounts of capital, making one more efficient than the other.
This is a useful ratio to calculate and something in which investors are particularly interested. Their primary concern is to get as much return as possible from the investment and this return is measured by the amount of dividend each investor receives.
In most cases, the company is more likely to pay a different amount of dividend each year but one thing that shareholders don’t want to see is their dividend per share decreasing.
Investors who want to estimate whether a share is over- or underpriced use the price to earnings ratio.
When estimating the P/E ratio, investors tend to look towards the future. The company hopes to continue making earnings over the course of several years, and the market price usually reflects that, being many times higher than the earnings of the company.
– A high P/E compared to other companies in the same industry means that investors anticipate high growth.
– A low ratio indicates anticipation of low growth or even negative growth.
Earnings yield is a measure of the potential return that shareholders can expect to receive in exchange for purchasing a share in an organization. Investors want to see earnings yield increase but they do recognize that the earnings yield is only a potential figure.
In reality, few companies pay out all their profits as dividends and many firms tend to retain some profits to reinvest into the company.
For investors concerned with the amount of income they generate from the dividends or shares they own, calculating the dividend yield is critical because it tells them how much income they’ll generate in the form of dividends for the price they pay on each share.
Comparing the dividend yield of different companies can help tell you whether you’re getting a competitive level of dividend-based income for the price.
Keep in mind that the amount of dividends issued each year can change so the dividend yield can be an unreliable measure.
What is Book Value?
Book Value is the amount that a company paid for its assets and is likely to be higher than the amount it can actually get during liquidation, which is known as market value or fair value.