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### Meeting 4 - Valuation Market Ratios (Financial Reporting and Analysis)

1. Valuation Market Ratios Meeting 4
2. Valuation Market Ratios A. Earning per share /EPS B. Dividend per share / DPS C. Dividend Pay-out ratio D. Dividend yield E. Price to Earning ratio F. Market to Book value Ratio
3. Where do dividends appear on the financial statements? • The dividends declared and paid by a corporation will be reported as a use of cash in the financing section of the statement of cash flows. Dividends are also reported on the statement of changes in stockholders' equity. • Dividends on common stock are not reported on the income statement since they are not expenses. Dividends on preferred stock are not expenses, but will be deducted from net income in order to report the earnings available for common stock on the income statement. • Since the balance sheet reports only the ending account balances at an instant of time, the Cash and Retained Earnings amounts reflect the balances after past dividends and other transactions.
4. Earning per share /EPS: formula Net income – Dividends on preferred stock Average Outstanding Shares or Net income (profit) Number of Shares • Is the portion of a company's profit allocated to each outstanding share of common stock. • Earnings per share serves as an indicator of a company's profitability.
5. EPS: example • For example, assume that a company has a net income of \$25 million • If the company pays out \$1 million in preferred dividends and has 10 million shares for half of the year and 15 million shares for the other half, the EPS would be \$1.92 (24/12.5) • First, the \$1 million is deducted from the net income to get \$24 million, then a weighted average is taken to find the number of shares outstanding • (0.5 x 10M+ 0.5 x 15M = 12.5M)
6. EPS: limitations • An important aspect of EPS that's often ignored is the capital that is required to generate the earnings (net income) in the calculation. • Two companies could generate the same EPS number, but one could do so with less equity (investment) - that company would be more efficient at using its capital to generate income and, all other things being equal, would be a "better" company. • Investors also need to be aware of earnings manipulation that will affect the quality of the earnings number. • It is important not to rely on any one financial measure, but to use it in conjunction with statement analysis and other measures.
7. Companies Can’t Fake Dividends • Some investors prefer dividend-paying stocks because dividends are real and trackable. A company’s reported net income or earnings per share (EPS) is largely a product of accounting, and may have little or nothing to do with a company’s actual financial health. As a result, devious executives and skilled accountants can make even a terrible company look healthy through the lens of earnings and reported income. • Dividends are different. Dividends either appear in shareholders’ accounts or they don’t – and if they don’t, there are no accounting tricks that explain it. Dividends don’t necessarily have to be paid out of income, but paying dividends creates a paper trail of cash that is much harder to manipulate. • This is not to say that a company’s dividends are an accurate representation of a company’s financial health or liquidity. Companies can, and have, paid dividends with borrowed money or sources of funds other than operating cash flow.
8. Dividend per share / DPS Sum of dividends over a period (1 year) – Special, one time dividends Shares outstanding for the period or Sum of dividends Number of Shares • DPS is important because the number one goal of a company is to return value to its shareholders. • Investors receive value through dividend payments and the price of the stock itself, which is equal to a company's total expected future dividend payments. • Therefore, a company's profits, and the amount it pays out in dividends, drives shareholder value.
9. DPS: example • For example, ABC company paid a total of \$237,000 in dividends over the last year of which there was a special one-time dividend totaling \$59,250. ABC has two million shares outstanding, so its DPS is (\$237,000-\$59,250)/2,000,000 = \$0.09 per share. Having a growing DPS can be a sign that the company's management believes that the growth can be sustained.
10. EPS/DPS difference • Earnings per share and dividends per share differ from each other. The EPS calculates how profitable a company is by measuring the net income for each outstanding share of the company. • The DPS, on the other hand, calculates the portion of the company's earnings that is paid out to each preferred shareholder.
11. Dividend Pay-out ratio: formula Yearly Dividends per share (DPS) Earnings per share (EPS) • or Dividends Net income • The dividend payout ratio provides an indication of how much money a company is returning to shareholders, versus how much money it is keeping on hand to reinvest in growth, pay off debt or add to cash reserves.
12. Dividend Pay-out ratio: explanation • A number of considerations go into interpreting the dividend payout ratio, most importantly the company's level of maturity. • A new, growth-oriented company that aims to expand, develop new products and move into new markets would be expected to reinvest most or all of its earnings and could be forgiven for having a low or even zero payout ratio. • The payout ratio is also useful for assessing a dividend's sustainability. Companies are extremely reluctant to cut dividends, since it can drive the stock price down and reflect poorly on the management's abilities. If a company's payout ratio is over 100%, it is returning more money to shareholders than it is earning and will probably be forced to lower the dividend or stop paying it altogether. • Dividend payouts vary widely by industry, and like most ratios, they are most useful to compare within a given industry.
13. Payout Ratios Above 100% Are a Red Flag • Dividends are supposed to be a mechanism by which companies share their financial success with the shareholders. While dividends do not, strictly speaking, have to come from earnings it is not sustainable for a company to pay out more than it earns. • Accordingly, it is important for investors to monitor a company’s payout ratio. The payout ratio is simply the ratio of dividends in a specified period (typically the last twelve months) divided by the company’s reported earnings over the same period. For simplicity’s sake, most dividend payout ratios use the per-share dividend as the numerator and the earnings per share (EPS) as the denominator. • If a company has \$1 per share in earnings and pays a \$0.70 per share dividend, the payout ratio is 70%. Likewise, if the dividend were \$0.10 the payout ratio would be 10%. • If the same company paid a dividend of \$1.20 per share, the payout ratio would be 120% and investors would do well to ask how that company could hope to continue a dividend in excess of its earnings. Companies do try to maintain consistent (or rising) dividends, even in industries where year-to-year financial performance can vary. Consequently, not all companies with a dividend payout ratio above 100% are paying an unsustainable dividend, but no company can indefinitely pay out more in dividends than it earns.
14. Dividend Aristocrats: Exclusive Club • Investors will find many websites that try to use catchy titles to draw attention to particularly attractive dividend-paying stocks. One title worth looking out for is “dividend aristocrat”. Standard & Poors (“S&P”) defines a dividend aristocrat as a company that has increased its dividend for 25 straight years, excluding special dividends. • http://www.dividend.com/how-to-invest/10-big-tech-stocks-that- pay-a-dividend/ • http://www.dividend.com/dividend-stocks/25-year-dividend- increasing-stocks.php • http://www.nasdaq.com/dividend-stocks/ • http://www.dividend.com/dividend-education/the-biggest-dividend- stock-disasters-of-all-time/
15. Dividend yield: formula Dividends per share (DPS) Price per share • indicates how much a company pays out in dividends each year relative to its share price. • Dividend yield is a way to measure how much cash flow you are getting for each dollar invested in an equity position.
16. Dividend yield: example • Suppose company ABC’s stock is trading at \$20 and pays annual dividends of \$1 per share to its shareholders. • Also suppose that company XYZ’s stock is trading at \$40 and also pays annual dividends of \$1 per share. This means that company ABC’s dividend yield is 5% (1 / 20 = 0.05), while XYZ’s dividend yield is only 2.5% (1 / 40 = 0.025). • Assuming all other factors are equivalent, then, an investor looking to use his or her portfolio to supplement his or her income would likely prefer ABC's stock over that of XYZ, as it has double the dividend yield.
17. Effective Yield Is Based on Your Adjusted Cost Basis • One of the underappreciated ways to evaluate dividends is in the context of the investor’s own historical cost basis in the stock. “Effective yield” is a concept with multiple definitions in investing, but one definition includes evaluating dividend yield on the basis of an investor’s own cost basis. This analysis helps to cover the deficiency of information offered by current yield. • Consider the following – a stock currently trades at \$50 and pays a \$2 dividend, meaning that the stock has a current yield of 4%. But if an investor bought that stock years before (and the stock price has increased since then), it’s not an accurate reflection of the yield on the investment. If the investor bought the stock at \$35, the current yield on that cost basis (what we’re calling the effective yield here), is actually 5.7% (\$2 divided by \$35).
18. Current Yield Is Based on Different Calculations • Current yield is a relatively common concept in dividend investing. The current yield is simply the dividends paid per share divided by the price per share. If a company pays a \$1 per share dividend and the stock price is \$100, the current yield is 1%. • Yet not all sources calculate and report current yield the same way. While most sites report yield on the basis of four times the most recently paid or declared dividend, some pay on the basis of the dividends paid over the past 12 months. • Consider the following to see the difference – if the company in the prior example announced that it was increasing its dividend by 15% (to \$1.15 per share), some sites would report the yield as 1.2% (1.115% rounded up), while some would continue to report 1% until the first payment at the higher rate, at which point the yield would move up to 1.04% (three quarters of the old \$0.25/qtr dividend + one quarter of the new \$0.2875 dividend).
19. Price to Earning ratio P/E: formula Price per share Earnings per share (EPS) • ratio for valuing a company that measures its current share price relative to its per-share earnings • In essence, the price-earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company’s earnings. This is why the P/E is sometimes referred to as the multiple because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay \$20 for \$1 of current earnings.
20. Price to Earning ratio: explanation • A high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. A low P/E can indicate either that a company may currently be undervalued or that the company is doing exceptionally well relative to its past trends. • The price-earnings ratio can also be seen as a means of standardizing the value of one dollar of earnings throughout the stock market. In theory, by taking the median of P/E ratios over a period of several years, one could formulate something of a standardized P/E ratio, which could then be seen as a benchmark and used to indicate whether or not a stock is worth buying.
21. Price to Earning ratio: example • Suppose that a company is currently trading at \$43 a share and its earnings over the last 12 months were \$1.95 per share. • The P/E ratio for the stock could then be calculated as 43/1.95, or 22.05.
22. P/E limitations • One primary limitation of using P/E ratios emerges when comparing P/E ratios of different companies. Valuations and growth rates of companies may often vary wildly between sectors due both to the differing ways companies earn money and to the differing timelines during which companies earn that money. As such, one should only use P/E as a comparative tool when considering companies within the same sector, as this kind of comparison is the only kind that will yield productive insight. Comparing the P/E ratios of a telecommunications company and an energy company, for example, may lead one to believe that one is clearly the superior investment, but this is not a reliable assumption. • An individual company’s P/E ratio is much more meaningful when taken alongside P/E ratios of other companies within the same sector. For example, an energy company may have a high P/E ratio, but this may reflect a trend within the sector rather than one merely within the individual company. An individual company’s high P/E ratio, for example, would be less cause for concern when the entire sector has high P/E ratios.
23. P/E limitations • Moreover, because a company’s debt can affect both the prices of shares and the company’s earnings, leverage can skew P/E ratios as well. For example, suppose there are two similar companies that differ primarily in the amount of debt they take on. The one with more debt will likely have a lower P/E value than the one with less debt. However, if business is good, the one with more debt stands to see higher earnings because of the risks it has taken. • Another important limitation of price-earnings ratios is one that lies within the formula for calculating P/E itself. Accurate and unbiased presentations of P/E ratios rely on accurate inputs of the market value of shares and of accurate earnings per share estimates. While the market determines the value of shares and, as such, that information is available from a wide variety of reliable sources, this is less so for earnings, which are often reported by companies themselves and thus are more easily manipulated. Since earnings are an important input in calculating P/E, adjusting them can affect P/E as well.
24. P/E: things to remember • Generally a high P/E ratio means that investors are anticipating higher growth in the future. • The average market P/E ratio is 20-25 times earnings. • The P/E ratio can use estimated earnings to get the forward looking P/E ratio. • Companies that are losing money do not have a P/E ratio.
25. Market to Book value Ratio: formula • Market to Book Financial Ratio = Market Value ÷ Book Value • Book Value: • Security analysts and investors look at the market to book ratio as one indication of worth. The book value is not quite the same thing as the company's liquidation value — what stockholders might recover in the event of a bankruptcy — but it comes a lot closer than market value to assessing the worst case value of the company.
26. • Price = the market capitalization (total value) of the company • Earnings = amount of earnings (profits) that the company earned in the most previous year • Shares = the total # of shares outstanding (ex: if a company is worth \$1B and each share is worth \$100, then there are 1B/100 = 10M shares outstanding) • P/E is price divided by earnings -- it tells you how pricey the stock is, compared to how much the company makes • EPS is earnings divided by shares -- it tells you how profitable the company is on a per-share basis
27. Good Dividend Stocks Have More Than Just Good Yields • DARS Dividend.com rating system • Successful dividend stock investing is more than just selecting those stocks with the most impressive yields. Dividend.com has created a system called DARS™ to reflect and evaluate these other critical factors. • Relative Strength – Relative strength is a well-established technical analysis concept that argues that strong stocks tend to continue outperforming, while weak stocks tend to continue underperforming. In DARS™, relative strength assesses where a stock is relative to its 50-day and 200-day moving averages to assess whether it is in an uptrend or not. • Overall Yield Attractiveness – This is a subjective measure that evaluates both the size of a company’s dividend yield and its sustainability. Very high dividend yields tend to be quite unsustainable and the stocks tend to have above-average risks, while stocks with very low dividend yields are generally not worthwhile for long-term dividend investors. • Dividend Reliability – While there are numerous examples of reliable dividend payers that hit hard times, the reality is that the best predictor of a company’s ability to continue paying dividends is the number of years it has done so. Accordingly, the DARS™ Dividend Reliability rating reflects not only the number of years that the company has paid dividends, but a subjective evaluation of how likely it is that current payout levels can continue. • Dividend Uptrend – The DARS™ Dividend Uptrend factor reflects the company’s history of increasing its dividend, as well as a subjective evaluation as to the likelihood of future payout increases. • Earnings Growth – Dividends are ultimately dependent upon income and income growth. Accordingly, DARS™ tracks a company’s a company’s projected earnings growth to ascertain and rate its ability and likelihood to continue paying (and/or raising) its dividend.
28. Investors’ ratios  Dividend payout ratio Dividends announced for the year X 100 Earnings for the year available for dividends (profits after tax)  Dividend cover ratio Profit after tax = ? times Dividends announced for the year
29. Earnings per share (EPS)  Shows how much of a period’s net profit has been earned by each ordinary share outstanding (basic EPS) or by shares outstanding plus all potential shares (diluted EPS)  Potential shares are equity instruments issued that can be converted into ordinary shares at the option of the holder of the instrument  IAS 33 Earnings per Share requires that listed companies disclose both basic and diluted EPS on the face of the statement of profit or loss
30. Earnings per Share (IAS 33)  Basic EPS Earnings available to ordinary shareholders Weighted ordinary shares in issue  Diluted EPS  adjust the net profit available and the weighted average shares outstanding for the effect of all dilutive potential ordinary shares
31. Computing Basic and Diluted EPS ratios (an example) Assume company XYZ had at 31 December 2010:  An issued capital of 1,000,000 ordinary shares of 50p each nominal value;  Post-tax earnings for the year of £1,150,000;  An average market price per share of £4; and  Share options in existence 500,000 shares issuable in 2011 at £3.25 per share.  Compute the basic and diluted EPS ratios.
32. Solution: Per Share Earnings Shares Net profit for 2010 £1,150,000 W/A shares (2010) 1,000,000 Basic EPS (£1,150,000 / 1,000,000) 1.15 Number of shares under option 500,000 Number that would have been issued at fair value (500,000 x £3.25) / £4 _________ (406,250) Diluted EPS 1.05 £1,150,000 £1,093,750
33. Price/earnings ratio Price/Earnings = Market price per share EPS EPS is used as input to a market ratio, the price/earnings or P/E ratio: •Reflects how the market (market price) judges the company’s performance (growth expectations) •It is an inverted rate of return ratio •Also called the Earnings Multiple
34. Dividend yield ratio Dividend Yield = Dividend per share Market price per share The dividend yield ratio reflects the relationship between the dividends per share paid to shareholders and the current market price of a share: Both P/E and dividend yield ratios of listed companies are published daily by major financial newspapers
35. Investors’ ratios  Earnings yield Earnings Per Share Market Price per Share  Asset Cover Total Net Assets Ordinary Shares (“par “ value)
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