A share represents ownership of part of a company. A shareholder has two main reasons for buying shares in a company:
- Capital Gain. Shareholders hope that the market value of the share will increase over time, so if they choose to sell at a later date they will make a capital gain. However, investing in shares is not so different to gambling. Shares can increase, but also decrease, so it is quite possible to make a capital loss!
- Dividend. A dividend is payable to shareholders out of the after-tax profits of the company. The level of dividend is decided by the board of directors, but normally reflects the success of the business. The higher the profit levels, the higher the dividend. It is quite common for a firm to pay an interim dividend halfway through the financial year.
The company itself can only sell a share once, which forms the initial capital of the business. If a shareholder wants to later sell their shares they can only do this by finding another investor to take their place. Stock markets facilitate this trade in 'second hand' shares, e.g. Wall Street in USA, the London Stock Exchange and Frankfurt in Germany.
Shares in companies are only available for incorporated firms - private limited companies or plc's. They are not available for sole traders or partnerships, so the ratios have no meaning for these firms. Remember, also, that it is the shares of qualifying plc's that are sold on the main markets of a Stock Exchange, not those of limited firms. These have to be bought and sold by private arrangements.
Shareholders are the owners of a firm, and they may also be directors and/or employees. They look at a set of accounts in a different way to other stakeholders. They are still interested in profit and financial performance, but they are also interested in the dividend paid, the dividend history, and the future prospects for dividends. There are several shareholder ratios that can be calculated, but only two ratios are required for the IB programme:
Earnings per share (EPS)
Unlike most stakeholders, shareholders are interested in net profit after tax and interest, because this is the sum of money available for distribution.
By dividing the profits that are potentially available for distribution (net profit after interest and tax) as dividend by the number of shares, we get a figure of earnings per share. This can be used as a measure of the company's profit performance over time. It also shows the maximum potential for paying out a dividend to shareholders and how much each share has earned for its owner.
In reality, it would be unusual for a firm to distribute all the profit after tax, as this would mean there would be no funds to reinvest back into the business. It would not be in the long-term interest of the shareholders to pay out all profit as dividend as this would restrict the ability of the company to grow in the future.
The EPS ratio can only really be increased by increasing the level of profits made. It is only useful when compared with previous years, although the higher the figure the better for shareholders in the short-term.
This ratio shows the percentage yield of the dividends in relation to the current market price an investor would have to pay for each share.
If the dividends per share is announced as $0.25 and the current market price of the share is
$5, then the dividend yield is:
This 5% can be compared with other similar companies (inter-firm comparison) or with previous yields (historical comparison).
The face value of a share is fixed - usually £1, but the market value of a share fluctuates in real time according to the demand for, and supply of, that share. The value is shown on a daily basis in the stock exchange listings. The higher the ratio the better, but since the dividend is fixed for the financial year once it is announced, any increase in the dividend yield, normally means that the market price of the share has reduced. Clearly shareholders will compare the dividend yield with no-risk investment opportunities such as banking the money.
As dividend yield is based partly on the market price of shares, anything that affects this price will affect the ratio. A higher value for the ratio can be achieved by the directors agreeing to distribute a higher proportion of profit after tax.
Dividends are important to shareholders. This can lead to a short-term approach by the Directors trying to keep the shareholders happy. There may be pressure to give high dividends today, possibly at the expense of high profits in the future as many shareholders (investors) are looking for good short-term returns.
Improving the shareholder ratios
This really means increasing dividends. This should come as a result of increased profits, but may be an action taken just to please shareholders.
A fall in share price, not necessarily as a consequence of anything the firm has done, will improve the dividend yield. Look at the performance of banks over recent years.