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Financial Statement Analysis

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Financial Statement Analysis-FIN621
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Lesson-37
PROFITABILITY RATIOS
(C)
Analysis by common stockholders:
Common Stockholders are the investors whose objective is to determine whether investment is
sound, how the business performed and what has are future expectations. Their interest is to
watch Return on their investment (ROI).
i)
Return on Common Stockholder's equity =
Net income applicable to common stock x 100 =20 x100=16% or 10.4%
Common stockholder's equity
125 (excluding other income)
It is another summary measure of overall firm performance is return on equity. Return on equity
(ROE) compares net profit after taxes (minus preferred stock dividends, if any) to the equity that
shareholders have invested in the firm.
The ratio tells us the earning power on shareholders ` book value investment and is frequently
used in comparing two or more firms in an industry. A high return on equity often reflects the firm's
acceptance of strong investment opportunities and effective expensive management.However, if the
firm has chosen to employ a level of debt that is high by industry standards, a high ROE might simply
be the result of assuming excessive financial risk.
With all of the profitability ratios discussed, comparing one company to similar companies and
industry standards is extremely valuable. Only by comparisons are we able to judge whether the
profitability of a particular company is good or bad, and why? Absolute figures provide some insight,
but it is relative performance that is most revealing.
If there are two types of Shareholders, the net income applicable to common stock = net
income ­ preferred dividend requirement; and common Stockholders' equity = total stockholders'
equity ­ preferred stock equity at issue price ­ dividend arrears, if any.
The shareholders would like to see if this rate is higher than rate of interest paid to long-
term creditors or rate of dividend paid to preferred stockholders? If return on equity falls below the rate
of interest, it is unfavorable from the viewpoint of common stockholders.
ii) Earning per share of common stock =Net income applicable to common shareholders
Number of common shares outstanding
= 20
=Rs.16 or 13 = Rs.10.4 (excluding other income)
1.25 (each share of Rs.100)
1.25
Decline in EPS is generally followed by decline in market value of common shares
though not necessarily to the same extent or percentage. EPS is applied to common stock. Preferred
shares have fixed dividends.
Before we move on, you should note that there are three types of EPS numbers:
Trailing EPS ­ last year's numbers and the only actual EPS
Current EPS ­ this year's numbers, which are still projections
Forward EPS ­ future numbers, which are obviously projections
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Financial Statement Analysis-FIN621
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iv)
Price-earning ratio (P/E) = Market price/share
Earning/share
Companies with record of rapid growth have P/E
ratio of 20 to 1 or even higher.
What does P/E tell you? The P/E gives you an idea of what the market is willing to pay for the
company's earnings. The higher the P/E the more the market is willing to pay for the company's
earnings. Some investors read a high P/E as an overpriced stock and that may be the case, however it
can also indicate the market has high hopes for this stock's future and has bid up the price.
Conversely, a low P/E may indicate a "vote of no confidence" by the market or it could mean this is a
sleeper that the market has overlooked. Known as value stocks, many investors made their fortunes
spotting these "diamonds in the rough" before the rest of the market discovered their true worth.
What is the "right" P/E? There is no correct answer to this question, because part of the answer depends
on your willingness to pay for earnings. The more you are willing to pay, which means you believe the
company has good long term prospects over and above its current position, the higher the "right" P/E is
for that particular stock in your decision-making process. Another investor may not see the same value
and think your "right" P/E is all wrong.
iv)
Dividend Yield
Some stockholders invest primarily to receive regular cash income in the form of dividends.
Others do so to secure capital gains through rising market price of common stock.
Dividend yield = Dividend per share x 100) %
Market price per share
Dividend Yield is anticipated annual dividend divided by the market price of the stock.
Date
Market price
EPS
P/E
Dividend
Dividend
per share
ratio
per share
yield
----
---------------
------- ------
------------ -----------
31.12.93
160
20.25
8
5
3.1
31.12.94
132
13.2
10
4.8
3.6
The dividend yield on a company stock is the company's annual dividend payments divided by its
market cap, or the dividend per share divided by the price per share. It's often expressed as a percentage.
Preferred share dividend yield
Since payment of the dividend is stipulated by the prospectus, owners of preferred shares calculate
multiple yields to reflect the different possible outcomes over the life of the security. Be aware that
these yields will be different from the company's point of view. The company will continue to call their
security (e.g.) a 6%--- when the stated dividend is 6% of the issue price of the share.
·
Current yield is the $Dividend / Pfd share current price.
·
Since the share may be purchased at a lower (higher) cost than its final redemption value,
holding it to maturity will result in a capital gain (loss). The annualized rate of gain is calculated using
the Present value of a dollar calculation. ('PV' is the current stock price. 'FV' is the redemption value. 'n'
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Financial Statement Analysis-FIN621
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is the number of years to redemption. Solve for the interest rate 'r'.) The yield to maturity is the sum of
this annualized gain (loss) and the current yield.
Common share dividend yield
Unlike preferred stock, there is no stipulated dividend for common stock. Instead, dividends paid to
holders of common stock are set by management, usually in relation to the company's earnings. There is
no guarantee that future dividends will match past dividends or even be paid at all. Due to the difficulty
in accurately forecasting future dividends, the most commonly-cited figure for dividend yield is the
current yield which is calculated using the following formula:
Current dividend yield = most recent full -year dividend
Current share price
For example, take a company which paid dividends totaling $1 last year and whose shares currently sell
for $20. Its dividend yield would be calculated as follows
= $1/$20
=0.05
=5%
Rather than use last year's dividend, some try to estimate what the next year's dividend will be and use
this as the basis of a future dividend yield. It should be noted that estimates of future dividend yields are
by definition uncertain
Dividend Pay out Ratio:
Annual cash dividends divided by annual earnings: or alternatively, dividends per share divided by
earning per share. The ratio indicates the percentage of a company's earnings that is paid out to
shareholders in cash.
Understanding Dividend Payout Ratio
The Dividend Payout Ratio (DPR) is one of those numbers. It almost seems like a measurement
invented because it looked like it was important, but nobody can really agree on why.
The DPR (it usually doesn't even warrant a capitalized abbreviation) measures what a company's pays
out to investors in the form of dividends.
You calculate the DPR by dividing the annual dividends per share by the Earnings Per Share.
DPR = Dividends per Share / EPS
For example, if a company paid out $1 per share in annual dividends and had $3 in EPS, the DPR would
be 33%. ($1 / $3 = 33%)
The real question is whether 33% is good or bad and that is subject to interpretation.
Growing companies will typically retain more profits to fund growth and pay lower or no dividends.
Companies that pay higher dividends may be in mature industries where there is little room for growth
and paying higher dividends is the best use of profits (utilities used to fall into this group, although in
recent years many of them have been diversifying).
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Financial Statement Analysis-FIN621
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Either way, you must view the whole DPR issue in the context of the company and its industry. By
itself, it tells you very little.
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