The meaning and importance of return to investors

Investment ratios help assess how well a business rewards its shareholders. These ratios are especially useful for current owners and people considering buying shares, as they show the potential financial benefits from owning part of a company.

Shareholders can gain returns in two main ways: through dividends, which are payments made from profits, and through capital gains if the share price increases. Companies usually pay dividends each year unless profits are very low or the business is making losses.

The dividend yield ratio

The dividend yield ratio shows the return a shareholder gets from dividends as a percentage of the current share price. It helps compare the income from shares with other investments, like savings accounts.

$\text{Dividend yield ratio}=\frac{\text{dividend per share}}{\text{market share price}}\times 100$

Where:

• Dividend per share = Total annual dividends divided by the total number of issued shares
• Market share price = Current price of one share (£)

Factors affecting the dividend yield ratio

• Rising share price - If the share price increases but the dividend stays the same, the yield decreases.
• Increasing dividends - If directors raise dividends without changing the share price, the yield rises.
• Comparisons for investors - Shareholders compare this yield with bank interest rates or yields from other companies, and with the company's past performance or industry averages.
• Attracting new investors - A high yield can draw in potential shareholders, but only if the share price is not expected to drop.
• Directors' decisions - Directors might use reserves to pay dividends during tough times to keep shareholders happy, or cut dividends to retain more profits for growth.
• Potential risks - A high yield might result from a recent drop in share price due to worries about the company's future, which could make it a poor investment.

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Worked example - Calculating the dividend yield ratio

A company pays total annual dividends of £100,000 and has 500,000 issued shares. The current market share price is £2.00. Calculate the dividend yield ratio.

Step 1: Identify the values

• Total annual dividends = £100,000
• Total number of issued shares = 500,000
• Market share price = £2.00

Step 2: Calculate dividend per share

Dividend per share = £100,000 ÷ 500,000 = £0.20

Step 3: Apply the dividend yield ratio formula

$\text{Dividend yield ratio}=\frac{\pounds 0.20}{\pounds 2.00}\times 100=10\%$

The dividend cover ratio

The dividend cover ratio measures how many times a company's profits after tax and interest can cover its dividends to ordinary shareholders. A higher ratio suggests the business can easily afford its dividends and has money left for reinvesting in growth.

$\text{Dividend cover ratio}=\frac{\text{profit for the year}}{\text{annual dividends}}$

Where:

• Profit for the year = Profits after tax and interest (£)
• Annual dividends = Total dividends paid to shareholders (£)

Factors affecting the dividend cover ratio

• Increasing dividends - If directors raise dividends without higher profits, the ratio falls.
• Investor concerns - A low ratio might worry potential investors about whether dividends can continue, as it shows little profit is being kept for future needs.
• Low retention of profits - A low ratio indicates directors are not saving much for expansion, which could limit the company's growth potential.

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Worked example - Calculating the dividend cover ratio

A company reports a profit for the year of £500,000 and pays annual dividends of £100,000. Calculate the dividend cover ratio.

Step 1: Identify the values

• Profit for the year = £500,000
• Annual dividends = £100,000

Step 2: Apply the dividend cover ratio formula

$\text{Dividend cover ratio}=\frac{\pounds \mathrm{500,000}}{\pounds \mathrm{100,000}}=5$

Step 3: Interpretation

This means the dividends could be paid five times over from the year's profits, leaving room for reinvestment.

The price/earnings ratio

The price/earnings ratio (P/E ratio) indicates how confident investors are in a company's future earnings. A high ratio shows expectations of strong growth, while a low ratio suggests less optimism.

$\text{P/E ratio}=\frac{\text{market share price}}{\text{earnings per share}}$

Where:

• Market share price = Current price of one share (£)
• Earnings per share = Profit for the year divided by the number of shares issued (£)

Factors affecting the price/earnings ratio

• Investor confidence - A high P/E means investors expect better earnings growth than in companies with low P/E ratios; a ratio of 1 shows very low confidence.
• Alternative views - It can show how much investors pay for each £1 of current earnings, or how many years it would take to recover the investment at current earnings levels.
• Comparisons - Only compare P/E ratios within the same industry, as optimism varies by sector (e.g., technology firms often have higher ratios than utilities).

Worked example - Calculating the price/earnings ratio

A company has a profit for the year of £400,000 and 800,000 shares issued. The market share price is £5.00. Calculate the P/E ratio.

Step 1: Identify the values

• Profit for the year = £400,000
• Number of shares issued = 800,000
• Market share price = £5.00

Step 2: Calculate earnings per share

Earnings per share = £400,000 ÷ 800,000 = £0.50

Step 3: Apply the P/E ratio formula

$\text{P/E ratio}=\frac{\pounds 5.00}{\pounds 0.50}=10$

Methods of improving investor returns

The best way to boost returns for investors is by increasing the company's profits, which can lead to higher dividends and a rising share price. This benefits shareholders through better income and capital gains.

Short-term trade-offs in improving returns

• Investing for growth - Profits might need to be used to buy new assets, which could mean cutting dividends temporarily to build up retained earnings.
• Reducing gearing - Lower dividends increase internal funds, helping to pay off debts and strengthen the business's finances.
• Long-term benefits - While this reduces immediate returns, successful expansion should raise future profits, leading to higher dividends and share prices over time.