9.4 Investor Ratios & Limitations of Financial Ratio Analysis

Stock Market Ratios and Investor Analysis

For publicly listed companies, shareholders and potential investors utilize a specific set of ratios that incorporate the market value (share price) of the business. These ratios evaluate the returns specifically accruing to ordinary shareholders.

Summary of Core Investor Ratios

Earnings Per Share (EPS)

EPS is perhaps the most widely cited financial metric. It calculates the amount of profit generated for each ordinary share in issue.

Formula: EPS = Profit Attributable to Ordinary Shareholders / Weighted Average Number of Ordinary Shares

Note: Profit attributable to ordinary shareholders is Profit After Tax minus Preference Dividends.

Interpretation: EPS is a fundamental indicator of profitability on a per-share basis. An increasing trend in EPS over time is viewed highly positively by the market and generally leads to an increase in the share price. However, absolute EPS figures cannot be easily compared between different companies because the number of shares issued is arbitrary.

Price/Earnings (P/E) Ratio

The P/E ratio links the earnings generated by the company (EPS) to the value the market places on the company (share price).

Formula: P/E Ratio = Market Price per Share / EPS

Interpretation: The P/E ratio represents how many years of current earnings it would take to recover the share price. A high P/E ratio (e.g., 25) indicates strong market confidence; investors expect significant future earnings growth and are willing to pay a premium now. A low P/E ratio (e.g., 5) might indicate a mature, slow-growing industry, or it could signal that the market lacks confidence in the company's future prospects.

Dividend Yield

The dividend yield measures the real cash return an investor receives relative to the current market price of the share.

Formula: Dividend Yield = (Dividend per Share / Market Price per Share) × 100%

Interpretation: This ratio allows investors to compare the cash return from buying shares with other investments, such as bank interest rates or bond yields. Utility companies often have high dividend yields, appealing to income-seeking investors. Tech companies often have low or zero dividend yields, preferring to reinvest profits for capital growth.

Dividend Cover

This ratio measures the safety or sustainability of the dividend payment.

Formula: Dividend Cover = Profit Attributable to Ordinary Shareholders / Total Ordinary Dividends (Alternatively: EPS / Dividend per Share)

Interpretation: A dividend cover of 2.0 times means the company earned twice as much profit as it paid out in dividends. High cover suggests the dividend is secure and can be maintained even if profits fall. A cover near or below 1.0 indicates the company is paying out nearly all its earnings, leaving no retained earnings for future growth, and putting future dividends at risk.

Limitations of Financial Ratio Analysis

While ratio analysis is an indispensable tool, interpreting these ratios blindly without understanding their limitations can lead to disastrously incorrect conclusions. An analyst must approach ratios with skepticism and recognize the following constraints:

1. Historical Nature

Financial statements are a reflection of the past. The statement of financial position represents a single snapshot at the year-end date, which may not be representative of the rest of the year (due to seasonal trading). Ratios based on historical data do not guarantee future performance.

2. Variation in Accounting Policies

Companies have discretion over the accounting policies they adopt within the bounds of accounting standards (IFRS). For instance, two identical companies might report different profit figures if one uses straight-line depreciation and the other uses reducing balance. This policy choice distorts profitability and asset turnover ratios, making cross-sectional comparison difficult.

3. Inflation

During periods of high inflation, historical cost accounting distorts ratios. Non-current assets are stated at out-of-date historical prices, whereas current revenues reflect inflated current prices. This mathematical mismatch artificially inflates ROCE, making performance look better than reality.

4. Window Dressing

Management may engage in "window dressing"—legal but manipulative actions taken just before the year-end to artificially improve the appearance of the financial statements. For example, a company might delay paying suppliers until after year-end to preserve cash and artificially boost the current ratio.

5. Lack of Standard Benchmarks

There is no universal "correct" ratio. An ideal current ratio in the retail industry might be disastrous in the manufacturing sector. Meaningful interpretation relies heavily on comparing against appropriate industry averages, which can be difficult to obtain for conglomerates operating in multiple sectors.

6. Ignoring Qualitative Factors

Perhaps the most significant limitation is that financial ratios are strictly quantitative. They completely ignore vital qualitative, non-financial factors that dictate long-term success. A company might have excellent ratios today, but if it has poor management, a demotivated workforce, a declining market share, or poor ESG (Environmental, Social, Governance) practices, its long-term survival is doubtful.

Conclusion

Ratio analysis should act as a diagnostic tool. It identifies areas of concern and highlights questions that need to be asked. It should be the starting point of an investigation into a company's performance, not the final answer.