Profitability Ratios

Market Prospect Ratios Earnings Per Share Price Eanings P/E Ratio Dividend Payout Ratio Dividend Yield Earnings Per Share Explanation -Earning per share, also called net income per share, is a market prospect ratio that measures the amount of net income earned per share of stock outstanding. In other words, this is the amount of money each share of stock would receive if all of the profits were distributed to the outstanding shares at the end of the year. Earnings per share is also a calculation that shows how profitable a company is on a shareholder basis. So a larger company’s profits per share can be compared to smaller company’s profits per share. Obviously, this calculation is heavily influenced on how many shares are outstanding. Thus, a larger company will have to split its earning amongst many more shares of stock compared to a smaller company. Formula Analysis -Earning per share is the same as any profitability or market prospect ratio. Higher earnings per share is always better than a lower ratio because this means the company is more profitable and the company has more profits to distribute to its shareholders. Although many investors don’t pay much attention to the EPS, a higher earnings per share ratio often makes the stock price of a company rise. Since so many things can manipulate this ratio, investors tend to look at it but don’t let it influence their decisions drastically. www.myaccountingcourse.com/financial-ratios/earnings-per-share - page 24 Price Earnings P/E Ratio Explanation -The price earnings ratio, often called the P/E ratio or price to earnings ratio, is a market prospect ratio that calculates the market value of a stock relative to its earnings by comparing the market price per share by the earnings per share. In other words, the price earnings ratio shows what the market is willing to pay for a stock based on its current earnings. Companies with higher future earnings are usually expected to issue higher dividends or have appreciating stock in the future. Obviously, fair market value of a stock is based on more than just predicted future earnings. Investor speculation and demand also help increase a share’s price over time. Investors often use this ratio to evaluate what a stock’s fair market value should be by predicting future earnings per share. Formula Analysis -The price to earnings ratio indicates the expected price of a share based on its earnings. As a company’s earnings per share being to rise, so does their market value per share. A company with a high P/E ratio usually indicated positive future performance and investors are willing to pay more for this company’s shares. A company with a lower ratio, on the other hand, is usually an indication of poor current and future performance. This could prove to be a poor investment. In general a higher ratio means that investors anticipate higher performance and growth in the future. It also means that companies with losses have poor PE ratios. An important thing to remember is that this ratio is only useful in comparing like companies in the same industry. Since this ratio is based on the earnings per share calculation, management can easily manipulate it with specific accounting techniques. Dividend Payout Ratio Explanation -The dividend payout ratio measures the percentage of net income that is distributed to shareholders in the form of dividends during the year. In other words, this ratio shows the portion of profits the company decides to keep to fund operations and the portion of profits that is given to its shareholders. Investors are particularly interested in the dividend payout ratio because they want to know if companies are paying out a reasonable portion of net income to investors. For instance, most start up companies and tech companies rarely give dividends at all. In fact, Apple, a company formed in the 1970s, just gave its first dividend to shareholders in 2012. Conversely, some companies want to spur investors’ interest so much that they are willing to pay out unreasonably high dividend percentages. Inventors can see that these dividend rates can’t be sustained very long because the company will eventually need money for its operations. Formula Analysis -Since investors want to see a steady stream of sustainable dividends from a company, the dividend payout ratio analysis is important. A consistent trend in this ratio is usually more important than a high or low ratio. Since it is for companies to declare dividends and increase their ratio for one year, a single high ratio does not mean that much. Investors are mainly concerned with sustainable trends. For instance, investors can assume that a company that has a payout ratio of 20 percent for the last ten years will continue giving 20 percent of its profit to the shareholders. Conversely, a company that has a downward trend of payouts is alarming to investors. For example, if a company’s ratio has fallen a percentage each year for the last five years might indicate that the company can no longer afford to pay such high dividends. This could be an indication of poor operating performance. Dividend Yield Explanation -The dividend yield is a financial ratio that measures the amount of cash dividends distributed to common shareholders relative to the market value per share. The dividend yield is used by investors to show how their investment in stock is generating either cash flows in the form of dividends or increases in asset value by stock appreciation. Investors invest their money in stocks to earn a return either by dividends or stock appreciation. Some companies choose to pay dividends on a regular basis to spur investors’ interest. These shares are often called income stocks. Other companies choose not to issue dividends and instead reinvest this money in the business. These shares are often called growth stocks. Investors can use the dividend yield formula to help analyze their return on investment in stocks. Formula Analysis -Investors use the dividend yield formula to compute the cash flow they are getting from their investment in stocks. In other words, investors want to know how much dividends they are getting for every dollar that the stock is worth. A company with a high dividend yield pays its investors a large dividend compared to the fair market value of the stock. This means the investors are getting highly compensated for their investments compared with lower dividend yielding stocks. A high or low dividend yield is relative to the industry of the company. As I mentioned above, tech companies rarely give dividends at all. So even a small dividend might produce a high dividend yield ratio for the tech industry. Generally, investors want to see a yield as high as possible.