Financial ratios.

Understanding Dividend yield & Earnings yield.

DIVIDEND YIELD.

Hi there,

Dividend yield is another ratio that’s connected with dividend payments. The yield ratio is particularly useful for investors who are looking to cash in on the dividends paid by a company.

Dividend yield and dividend pay out ratios are different. If dividend payout ratio was the percentage of profit that was paid out as dividends, dividend yield ratio shows how much divided you received for the money you spend on your investment. Yield is a measure to calculate the percentage of return on an investment. With dividend yield, it becomes easier for you to compare between companies that pay high dividends.

The formula for calculating the Dividend Yield is by taking the annual dividend per share and divide by the stock’s price. So, the equation is-

  • Annual dividend per share / the stock’s price.

For example: Two companies- A and B pay an annual dividend of Rs 15 per share. The share price of company A is Rs 100 and the price of company B is 150. Which stock gives better return?

  • Company A , because it gives an yield of 15% for every Rs 100 invested in it whereas company B gives an yield of just 10% ( 15/150)

The Dividend Yield Trap

We talked about dividend yield ‘s positive factors.  However, Dividend yield can lead you into a trap if you’re not careful.

The trap is the denominator figure. The dividend payout is divided by the share’s price. Since the share price keeps changing, the ratio will keep changing accordingly. So, if there is a sudden fall in a stock’s price, the dividend yield ratio will show a higher figure. That’s one pint to be careful.

EARNINGS YIELD.

As I said before, yield is a measure to calculate the percentage of return on an investment. Earnings yield is another ratio that’s similar to dividend yield. Earnings yield ratio shows how much earnings you received for the money you spend on your investment.

This ratio becomes useful where the dividend payments are low.

Earnings yield is calculated as follows:

  • Earnings per share / market price per share or E/P

That means, earnings yield is the exact opposite of P/E ratio. The convenience of earnings yield is that since it measures the return you received for the money you spend on your investment, it’s makes it easier for you to compare the company’s return against alternative investment options such as bonds or fixed deposits. So, practically it’s more useful than a P/E.

The only problem for E/P is that ‘earnings’ are not properly defined.

Benjamin Graham, the father of value investing, has recommended investors to buy a stock that has a P/E ratio equal or lower than the sum of the earnings yield plus the growth rate. That is , an investor should buy a share only id it’s P/E is less than the earnings yield + growth rate.

  • P/E Ratio < Earnings Yield + Growth Rate

For example, let’s say you want to invest in shares of a company that has 7% earnings yield and was growing at 7%.  You check he balance sheet and find that the company’s fundamentals are good. Considering the history of the company, quality of the management and order book for the future, you expected the company to accelerate it’s growth from now on. In this case, if you could buy the shares at a price-to-earnings ratio of 14 or less, you would have a reasonable chance for very satisfactory returns (7% earnings yield + 7% growth rate = 14 P/E ratio maximum).

However, it would be very difficult to get such investing opportunities where the P/E equals the earnings yield plus growth rate. It’s a very conservative filter. I am sure that 95% of the stocks you scan would get rejected on this basis alone. (And, that’s why it’s such a safe measure to valuate investments)

Bye for now…

…. have a nice time !!

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Understanding Dividend pay out & retention

DIVIDEND PAYOUT & RETENTION RATIOS

Hi there,

In this article, We look at two ratios that are connected with dividend payments. They are 1. the dividend payout ratio and 2. the retention ratio.

The dividend payout ratio measures the portion of profits that’s distributed as dividends. The Dividend Payout Ratio is calculated by dividing the annual dividends per share by the Earnings Per Share. So the formula is:

  • Dividends Per Share / EPS or

Alternatively, you can divide the dividend by net income to arrive at the same figure.

For example, If the company’s earnings per share is Rs 3 and it pays Rs 1 as dividend, the dividend payout ratio is 33%. That is, (Rs 1/ Rs 3) x 100

The next question is whether this 33% s good or bad. You may have to analyse the dividend history and the dividends declared by its peers to form an opinion.

Generally companies that pay higher dividends are large cap or so called ‘mature companies’ that doesn’t have big expansion plans anymore. A company that has massive expansion plans retains the profits with them and will not pay out much dividends.

RETENTION RATIO

Retention ratio is the exact opposite of dividend payout ratio. Retention ratio becomes important to spot growth companies.

The retention ratio shows how much is kept by the company from the profits made.  It is assumed in analysis that whatever amount the company retains, will be reinvested for growth in the company. So, it follows that, a company that retains a large portion of its income, is planning to expand its business. Generally, high retention ratios are seen in young and growing companies.

So, the formula for retention ratio is

  • Net income – dividends / Net income.

Alternatively you can deduct the dividend pay out ratio from 100 to get the retention ratio. A high retention ratio is a sign that the company is in a massive expansion mode.

A company that looks to sustain growth without any external financing would resort to increase the retention ratio.

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Understanding price to book ratio

PRICE TO BOOK RATIO

Hi there,

before I begin my discussion on Price to book, a quick recap of some important terms. Book value’ is a concept we discussed at earlier stages.The Book Value is simply the company’s assets minus its liabilities. That is the actual worth of the company. But if you want to acquire that company, you need to buy every single share at the current market price and that value (ie market price per share x total shares) is called market capitalization.

i hope you remember those two terms – book value and market capitalization or market value.

PRICE TO BOOK RATIO

Price to book ratio is computed as follows -

Market capitalization / Book value OR

Market price per share / Book value per share.

Market price of the share and book values for any listed company are available straight from financial web sites. So there is no need to compute it.So let’s try to understand the ratio and it’s significance.

The P/B  gives you an idea of what the market is willing to pay for a share of company’s book value.The higher the P/B the more the market is willing to pay for the company’s book assets.  Some investors read a high P/B as an overpriced stock.

P/B ratios should be used with caution. A low price to book ratio can mean the following-

  1. That the stock is selling at a discount to its book value.  That gives you a perfect buying opportunity.
  2. Something is fundamentally wrong with the company.
  3. That the book value of assets is over stated in the company’s balance sheet

MORE ON P/B

  • Since market price is compared with book values, a distortion in the book value of assets of the company affects this ratio. For example, a company might have acquired land 10 years back. The value shown in the balance sheet would be the price paid at the time of acquisition, 10 years back. Naturally, the asset price would have shot up several Crores, but the same will not be reflected in the balance sheet. The price to book ratio of this company may look expensive, but in reality , it may be an undervalued stock.
  • Companies like software firms, which rely on intellectual property may have very high price to book ratios. They are not capital intensive and hence invest little in solid assets. Their assets are the intellectuals they have and hence P/B are not suitable for valuing such stocks.
  • Assets heavy companies like infrastructure, financial institutions, banks, manufacturing companies can be better valued with this ratio.
  • The ROE and P/B are inter connected. A company with a higher ROE will have a higher P/B and vice versa.

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Understanding price to sales ratio

Hi there ,

We learned about P/E ratio in our earlier article. P/E ratio is useful for evaluating companies with adequate earnings. But in some cases, especially in the case of promising start up companies, earnings of the company may not be anything much to talk about. The reason could be high amounts spent for further expansion. In such cases, instead of P/E , P/S would be used. That is, we try to figure out what the market is willing to pay for a share of company’s sales. The higher the P/S the more the market is willing to pay for the company’s sales generated.

HOW IS IT CALCULATED?

Price to sales ratio relates market value of the company to it’s annual sales. You calculate the P/S by dividing the market cap of the stock by the total revenues of the company.

You can also calculate the P/S by dividing the current stock price by the sales per share.

P/S = Market Cap / Revenues

P/S is an alternative method to look at companies where P/E doesn’t work. For example – Price to sales are useful to value retailing companies.

ADVANTAGES AND DISADVANTAGES

  • Earnings is basically an accountant’s estimate of the profits made by a company. earnings can differ according to the accounting method used and the assumptions that has gone into computing it. So, a shrewd accountant can very easily manipulate the earnings figure of a company to please the share holders. But, sales figures are not subject to such high manipulation.
  • The flip side is that, eventually, any company should come up with profits. A business may have higher sales but a lower profit margin than a competitor, indicating that it’s not operating efficiently. what’s the benefit if a company generates crores and crores of sales but ultimately falls short when it comes to earning  profits? Ultimately , earnings is what drives the stock price up.
  • So, P/S is a tool that should be used very carefully in certain special circumstances. For example – we need to take a decision between two similar retailing companies. Both the companies are identical in all respects- EPS, Debt (borrowings) etc. You can use P/S to evaluate which company generates more volume of sales with the borrowed money. so, if leverage ( technical jargon for borrowings) is similar across companies , P/S may become useful for the investor to make decisions.
  • P/S can also be used to spot high growth companies of tomorrow which may not be reflected with P/E analysis. Companies with high potential for growth generally have low earnings due to heavy investments made in the initial years.If you assume that the future of the company is bright, P/S may be the measure you need to confirm that.

CONTRADICTION BETWEEN P/E AND P/S

    Generally, P/E of a company and P/S move in the same direction. There could be situations where P/E of a company contradicts with the P/S ratio. For example , If a company has a low P/E but a high P/S, it can be a signal that there were some one-time gains.

    That’s about price to sales ratio ..

    bye for now !

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