a) Price-earnings ratio

The price earnings (P/E) ratio is regarded by many as the most important yardstick for assessing the relative worth of a share. It is calculated as:

Market price of share EPS = Total market value of equity Total earnings

The P/E ratio is a measure of the relationship between the market value of a company’s shares and the earnings from those shares. It is an important ratio because it relates two key variables for investors, the market price of a share and its earnings capacity.

Stock market appraisal the value of the P/E ratio reflects the market’s appraisal of the share’s future prospects. In other words, if one company has a higher P/E ratio than another it is because investors either expect its earnings to increase faster than the others, or they consider that it is a less risky company or in a more secure industry.

Influence of market efficiency the level of the ratio will change directly in response to changes in the share price and may vary widely during the course of the year as events alter investors’ perceptions. The extent and timing of changes will depend on the efficiency of the market; the stronger the level of efficiency, the more the market will be able to anticipate events.

Comparisons Earnings potential is strongly related to the sector in which the business operates, and therefore P/E comparisons are only valid in respect of companies in the same market sectors. They can be used in this case since all the companies are publicly quoted food retailers.

Price earnings ratios of companies being compared Using the information given in the table, the P/E ratio for B is 13.0. This means that it would take thirteen years for the earnings from the share to equal the price paid for it. The ratio for C is 21.1, the higher ratio meaning that the time taken for the earnings to equal the price of the share is 21.1 years. The reason for the higher level is that investors expect earnings from C to rise at a faster rate than those from B. The P/E ratio gives no indication of itself as to why earnings are expected to increase at different rates, although possibilities include superior management quality or more aggressive investment plans.

A has a current share price of 63 kobo and a P/E ratio of 14.2. Earnings for last year were therefore 4.437 kobo per share (63/14.2). At its high point for the year when the share price was 112, the P/E ratio was 25.2, while at its low point, the P/E ratio was 12.2. The figures also demonstrate that C has the lowest level of volatility, B the highest. This appears to reinforce the point made above that investors are confident about C‟s prospects (hence the P/E ratio has not altered much over the year) but are rather less sure about B‟s future.

b) Dividend cover

The dividend cover is the number of times that the actual dividend could be paid out of current profits. It indicates the proportion of distributable profits for the year that is being retained by the company and the level of risk that the company will not be able to maintain the same dividend payments in future years, should earnings fall.

Calculation of dividend cover In this case, the ratio must be approached by means of the dividend yield and the P/E ratio: P E = Market share price Earnings

Div yield = Dividend paid Market share price

P/E × Div yield = Dividend paid Earnings since the market share price cancels out

This is the inverse of the dividend cover, and therefore:

Dividend cover = 1÷ (P/E × div yield)

a. P/E Div yield P/E × div yield Dividend cover b. 21.1 2.3% 0.4853 2.06 times c. 13.0 2.1% 0.2730 3.66 times

Comparisons As, with the P/E ratio, comparisons with other companies in the same sector are a lot more valuable than comparisons with companies in different sectors, as the ‘typical rate’ for different business sectors will vary widely.

Dividend covers of companies being compared the lower level of dividend cover for C means that the company has paid out nearly half of its earning in the form of dividends, while B has only paid out less than one third. This suggests that B has retained a higher proportion of profits for reinvestment within the business. If earnings are very volatile, the figures could suggest that C might have problems in continuing to payout dividends at this level in the future.

However as indicated above, the market appears confident about C future, and rates C rather lower despite B retaining more funds for future expansion.