The current business dynamic has increased the complexity involved with business decisions pertaining to investments. This requires them to study the organization and look at the financials so that they can have an idea about the organization’s position.
There are certain key factors that investors need to account for before they can make their decision regarding the investment, and if it is a good idea to invest in the given company or not. This is where investor ratios come in.
Investor Ratios are used by investors, as well as by organizations. Credit rating agencies also use them since they reflect on how well the company is performing.
Lenders and banks might also look at investor ratios to determine how well the company is operating and their ability to pay back the company’s investors (or lenders). Therefore, these ratios are important, and hence, they are also declared in the Notes to the Financial Statements.
Definition of Investor Ratios
Investor Ratios are defined as financial ratios that investors use to gauge the company’s ability to generate a positive and profitable return for the investors. When deciding about an investment, shareholders draw comparisons between different companies to determine the suitable investment for them, depending on their lookout.
The main factor that comes into play with investors making these decisions is the risk appetite of the given investor. Therefore, investor ratios are used to calculate the company’s functioning and how these factors come into play to generate a positive return for the company.
The investor ratios used are extremely resourceful in gauging the company’s financial health and providing them the ability to extend returns to the investors for the relevant risks involved in the assessment.
There are several different kinds of investor ratios that investors use. The details and explanation of these ratios is provided in the next section.
Types of Investor Ratios
Investor Ratios are of several different types, and all of them depict different aspects of the organization’s financial health. Some of the most commonly used investor ratios are as follows:
1) Earnings Per Share (EPS)
EPS is defined as a financial ratio that calculates the company’s earnings (in currency terms) on a per-share basis. In other words, it calculates the earnings generated per every share issued in the company.
This particular ratio shows the ability of the company, as well as the underlying strength, to generate profit. Investors mostly use this ratio to interpret the company’s performance compared to other potential investment options they have.
Generally, a company with a higher EPS is considered a better performing company than a company with a lower EPS.
EPS is calculated using the following formula:
Earnings per Share = Total Earnings of the company (Net Income after tax and dividends) / Number of shares outstanding
2) Price/Earnings Ratio (P/E Ratio)
P/E Ratio can be defined as the financial ratio that depicts the cost associated with owning a share in the company in comparison to the financial earnings of the company.
In technical terminology, PE Ratio draws a comparison between the share price of the company and the Earnings Per Share (EPS) of the company.
PE Ratio is commonly used as an indication of the value of the company that is placed in the market. Therefore, it is a reflection regarding assessing both risks and rewards in purchasing the company’s share in the market.
PE Ratio is calculated using the following formula:
PE Ratio = Share Price / Earnings per Share
3) Dividend Cover
Dividend Cover is another important investor ratio, which is used to determine the number of times a company can pay out dividends to its shareholders by comparing the company’s net income to the dividend that is paid.
This is simply a depiction of the ability of the company to pay out its dividends from the attributable profit to the shareholders.
Generally, higher dividend covers are considered to be better from the shareholders’ perspective since it depicts a lower risk profile that the investors will not receive dividends in the future.
Dividend Cover is calculated using the following formula:
Dividend Cover = Net Income of the organization / Dividends Declared (and paid)
Alternatively, dividend cover can also be calculated by drawing a comparison between earnings per share (EPS) and dividend per ordinary share. The dividend is calculated using the following formula:
Dividend Cover = Earnings per Share / Dividend per Ordinary Share
Dividend Cover, therefore, reflects the number of times that a dividend can be declared from the given earnings. However, it must also be noted that this ratio cannot be used in isolation because it might give skewed results.
For example, a company that has declared a lesser dividend for that particular year will have a higher dividend cover than companies with a lower dividend rate. Hence, this ratio should be used when the organizations in context have similar dividend payout rates.
4) Dividend Yield
A dividend Yield is defined as a financial ratio that mainly provides a direct measure of the return on investments in the company’s shares.
This is done by comparing the dividend per share with the market price of the share. It also shows the relationship between the dividend and the market price of the company’s share.
Dividend Yield is considered one of the most important factors that are commonly used by different investors when deciding on purchasing or selling shares in the capital market.
Investors mostly use dividend Yield to gauge the relative benefits of different investment opportunities present in the capital market.
Dividend Yield is calculated using the following formula:
Dividend Yield = Dividend per share / Share price
Generally, investors opt for investment options that have higher dividend yields. This is primarily because of the fact that it shows the underlying potential to get higher returns for companies in the longer run.
Importance of Investor Ratios
From the perspective of investors, investor ratios hold tantamount importance. The importance of investor ratios are as follows:
- Firstly, investor ratios help to align the expectations between the investor, and the organization. Despite the fact that investor ratios are trailing ratios, yet it helps investor to get an idea of what to expect in terms of returns of their investments.
- Investor ratios help investors to draw a comparison with other companies: Investors have multiple options to choose from when investing. In this aspect, comparing investment ratios across different companies help investors to gauge the relative performance and efficiency of different organizations they are choosing to invest in. Since investor ratios are relative, they can be compared across different organizations in order to get an accurate picture. For example, in isolation, earnings might not solely be compared because different organizations have different capacities depending on which they generate returns. However, metrics like EPS help investors to compare earnings on a per share basis, and this helps them to draw more valid comparisons.
- From an internal perspective, organizations also benefit from investor ratios. They are able to benchmark their targets with other organizations, and strive towards achieving those targets. For example, increasing EPS every year might be a target they can internally set for themselves to achieve.