Question

Ah, the investor. EPS, P/E, Dividend Yield,and Dividend Payout are very popular measures and most financial websites will prominently display them if you look up a stock on their site. Discuss the importance of these ratios to the individual investor.

Answer 1

Financial ratios play a vital role in the analysis of the financial statements and the operations of an entity.The importance of some of the vital ratios for an individual investor is given as follows :-

Earnings per share as a metric is extremely important to measure company’s profitability. In fact, in the entire subject of fundamental analysis, EPS is the only metric that isolates net income to find out what the shareholders are gaining by investing in the company. Positive EPS also indicates that the company is creating value for its investors. As a layman, we understand that a company is in the market to do business & make profits and the investors invest in companies to be a part of company’s profitability. A consistently growing EPS means that the investor is getting a share of company’s growing profits consistently. In contrast, a consistently falling EPS or negative EPS indicates financial trouble, low profitability or consistent losses, & eroding investor value.

Price-to-earnings (PE) ratio is one of the most widely used financial ratios in the world in equity parlance. Usually, investors love to check the PE multiple of the stock while analysing it before making an investment.PE ratio helps an investor to calculate the price multiple that he might be willing to pay for a company’s earnings and is calculated by current market price of the share divided by the earning per share (EPS). There are two types of PE multiples, namely, a Forward PE and a Trailing PE. The forward PE ratio is a widely accepted ratio in valuation because it is based on future earnings of the company and is generally calculated by the current market price of the share divided by estimated future earnings per share of that company. On the other hand, Trailing PE is based on the past earnings, and it is generally calculated by current market price of the stock divided by EPS over the previous 12 months. Since, it takes past earnings of the company into consideration, the future earnings prospects of the company might not be evaluated properly.

Dividend yield is important for investors because everyone likes to get paid some of the profit when a company is doing well. And dividends have been an important part of total returns on investments over time.The ability of a company to consistently pay a dividend can be seen as indicating the company has been making money and expects to continue to do so. Hence, this ratio helps to get an understanding about the company's ability to pay return towards the investments of its investors in the form of dividend.

Dividend Payout Ratio defined is simply the dividend rate of a company divided by the earnings.So, thinking about it very simply, if a company pays out, say, Rs 2/share and has Rs 5/share of earnings, two divided by five is 0.4, or 40%. That's your payout ratio.The reason I find the payout ratio to be even more powerful than the dividend yield is that dividend yield is partially to mostly--depending on the situation--a valuation statistic. If the stock price is high or low, it's going to correlate to a low or high yield, all else being equal. The payout ratio goes a little bit further. There is a big, strong correlation between high payout ratios and high dividend yields; but the payout ratio is also going to give you a sense of perspective that the company is or is not devoting a significant share of its earnings to the dividend, and it provides you with a framework for evaluating whether or not that dividend is safe and likely continue to grow.