Investment Ratios (Cambridge (CIE) A Level Business)

The Meaning & Importance of Return to Investors

• A financial return is the money made or lost on an investment over a period of time
  

• Shareholders - and potential shareholders - look for financial returns on investments in the form of

  • Increased share price

  • Increased dividends
    

• A series of ratios can be used to determine whether an initial or ongoing investment in a company is worthwhile
  

  • Poor investment performance can cause shareholder discontent, which may lead to changes to the board of directors at the AGM
    

The main Investment Ratios 

• Financial advisors and the media are also interested in these ratios, as they can be used to report on business performance

Dividend Yield

• The dividend yield ratio shows how much a company pays out in dividends each year relative to its share price
  
  

• It is used to compare investments in a company

  • With other investments, such as bank interest rates and dividend yields of other investments

  • Over time to analyse long-term performance of investments
    

• Dividend yield is calculated using the formula

• Dividend yield is determined by the level of dividend issued by a company and the current market price of shares in the company

  • In general terms, the higher the dividend yield, the better

    • If the share price increases, the dividend yield will fall

      • Despite this, investors may be keen to invest as the rising share price indicates positive company performance 
        

    • If the issued dividend increases, the dividend yield will rise

  • However, a high dividend yield can occur as a result of a fall in the share price as a result of poor business performance

    • In these circumstances, an investment may be less attractive

Dividend Cover

• Dividend cover is a measure of how well profits cover the dividend paid to shareholders 

  • The ratio shows how easy it is for a company to continue to pay out its current dividend, given the profit it has generated

  • The outcome of the ratio refers to the number of times profit covers the total value of dividends issued
    
    

• The ratio can be used to assess the current and future sustainability of the dividends paid out by a company

  • A high ratio suggests that a company can maintain its current dividend payments

    • Shareholders may retain their shares as they are likely to continue to receive the dividend to which they have become accustomed
      
      

  • A low ratio may suggest that future dividend payments are unlikely to be paid at their current level

    • Shareholders may choose to divest their shares and switch to more stable investments
      
      

  • In general, a dividend cover of 2 is viewed as good, as this indicates that a company has the capacity to pay its dividends twice over
    
    

• A high ratio does not guarantee a sustained dividend

  • Companies can choose to retain profits rather than issue a dividend to shareholders
    
    

• Dividend cover is calculated using the formula

Price/Earnings Ratio

• The price/earnings ratio is a measure of confidence investors have in a company's ability to generate future returns

  • It compares the earning made per share during a specific time period to the current share price

  • Investors use this ratio to determine how many years it would take to buy one company share with the earnings (profit) generated per share
    

• Generally, the higher the price/earnings ratio, the better

  • A high ratio suggests that investors are confident enough to invest for a long period of time

  • Comparisons between the price/earnings ratio should focus on those in the same industry, as investors are likely to have different levels of confidence in diverse industries

    • E.g. Confidence in the growth of AI-based businesses is likely to be considerably higher amongst investors than in the construction industry
      

• Price/earnings ratio is calculated using the formula

• If the earnings per share is not given, it is calculated using the formula

Methods of Improving Investor Return

• In general, investor returns can be improved by increasing business profits

  • Higher profits allow companies to distribute greater dividends, increasing the dividend yield and dividend cover

  • The share price of a business is likely to increase if its profits grow, leading to a higher price/earnings ratio
    
    

• However, care should be taken to interpret the reasons for improvements in investment ratios

  • The dividend yield can increase if a company experiences a fall in its share price

    • A falling share price often indicates lower shareholder confidence, so this is unlikely to be welcomed

  • Dividend cover can rise if a company pays a lower dividend to shareholders

    • This may be as a result of a company using retained profits as a source of finance to fund growth

    • For short-term investors, however, this is also unlikely to be welcomed