Investment Ratios (CIE A Level Business)

• 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

• 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

• 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

• 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