12.5: Market Ratios- Analysis of Financial Returns to Investors
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Investors frequently consider whether to invest or divest in shares of a corporation. There are various ratios that help them make this decision. These are called market ratios, because the stock market plays an important role in allocating financial resources to corporations that offer their shares to the public.
Earnings-per-Share (EPS)
Measures of efficiency can focus on shareholder returns on a per-share basis. That is, the amount of net income earned in a year can be divided by the number of common shares outstanding to establish how much return has been earned for each outstanding share. This earnings-per-share (EPS) value is calculated as:
EPS is quoted in financial markets and is disclosed on the income statement of publicly-traded companies. If there are preferred shareholders, they have first rights to distribution of dividends. Therefore, when calculating EPS, preferred shareholders' claims on net income are deducted from net income to calculate the amount available for common shareholders:
BDCC has no preferred shares and thus no preferred share dividends. Recall that 100,000 common shares are outstanding at the end of 2019, 2020, and 2021. For BDCC, EPS calculations for the three years are:
| (000s) | |||||||
| 2021 | 2020 | 2019 | |||||
| Net income | (a) | $ | 116 | $ | 117 | $ | 112 |
| Number of common shares outstanding | (b) | 100 | 100 | 100 | |||
| Earnings per share | (a/b) | $ | 1.16 | $ | 1.17 | $ | 1.12 |
Big Dog's EPS has remained relatively constant over the three-year period because both net income and number of outstanding shares have remained fairly stable. Increasing sales levels and the resulting positive effects on net income, combined with unchanged common shares issued, has generally accounted for the slight increase from 2019 to 2020.
Price-earnings (P/E) Ratio
A price at which a common share trades on a stock market is perhaps the most important measure of a company's financial performance. The market price of one share reflects the opinions of investors about a company's future value compared to alternative investments.
The earnings performance of common shares is often expressed as a price-earnings (P/E) ratio. Price-earnings (P/E) ratio It is calculated as:
This ratio is used as an indicator of the market's expectation of a company's future performance. Assume Company A has a current market value of $15 per share and an EPS of $1 per share. It will have a P/E ratio of 15. If Company B has a market value of $4 per share and an EPS of $0.50 per share, it will have a P/E ratio of 8. This means that the stock market expects Company A to earn relatively more in the future than Company B. For every $1 of net income generated by Company A, investors are willing to invest $15. In comparison, for every $1 of net income generated by Company B, investors are willing to pay only $8. Investors perceive shares of Company A as more valuable because the company is expected to earn greater returns in the future than is Company B.
Assume that BDCC's average market price per common share was $4 in 2019, $5 in 2020, and $6 in 2021. Its P/E ratio would be calculated as:
| (000s) | |||||||
| 2021 | 2020 | 2019 | |||||
| Market price per common share | (a) | $ | 6.00 | $ | 5.00 | $ | 4.00 |
| Earnings per share (see above) | (b) | $ | 1.16 | $ | 1.17 | $ | 1.12 |
| Price-earnings ratio | (a/b) | 5.17 | 4.27 | 3.57 | |||
BDCC's P/E ratio has increased each year. Although industry and competitor's P/E ratio comparisons would be important to compare, BDCC's increasingly positive ratio also indicates that investors are "bullish" on BDCC. That is, the stock market indicates that it expects BDCC to be increasingly profitable in the coming years. Despite a relatively constant EPS ratio from 2019 to 2021, investors are willing to pay more and more for the company's common shares. This must be because future financial prospects are anticipated to be better than in the past three years.
Dividend Yield
Some investors' primary objective is to maximize dividend revenue from share investments, rather than realize an increasing market price of the shares. This type of investor is interested in information about the earnings available for distribution to shareholders and the actual amount of cash paid out as dividends rather than the market price of the shares.
The dividend yield ratio is a means to determine this. It is calculated as:
This ratio indicates how large a return in the form of dividends can be expected from an investment in a company's shares. The relevant information for BDCC over the last three years is shown in the financial statements, as follows:
| (000s – except per share values) | |||||||
| 2021 | 2020 | 2019 | |||||
| Dividends declared | (a) | $ | 80 | $ | 70 | $ | 60 |
| Outstanding common shares | (b) | 100 | 100 | 100 | |||
| Dividends per share | (a/b) | $ | 0.80 | $ | 0.70 | $ | 0.60 |
The dividend yield ratio is therefore:
| 2021 | 2020 | 2019 | |||||
| Dividends per share | (a) | $ | 0.80 | $ | 0.70 | $ | 0.60 |
| Market price per share (given) | (b) | $ | 6.00 | $ | 5.00 | $ | 4.00 |
| Dividend yield ratio | (a/b) | 0.13:1 | 0.14:1 | 0.15:1 | |||
The company's dividend yield ratio decreased from 2019 to 2021. In 2019, investors received $0.15 for every $1 invested in shares. By 2021, this had decreased to $0.13 for every $1 invested. Though the decline is slight, the trend may concern investors who seek steady cash returns. Also notice that total dividends declared increased from 2019 to 2021 even though net income did not substantially increase, and despite the company's poor liquidity position noted in an earlier analysis. Investors might ask why such high levels of dividends are being paid given this situation.