Understanding Business Accounting For Dummies, 2nd Edition (108 page)

Annual bonuses are paid in shares. On award, the Executive can elect to defer receipt of the shares for a further two years, which is encouraged, with additional matching share awards.

Longer-term bonus based on a combination of relative total shareholder return, and the achievement of stretching EPS growth targets and specific corporate objectives. Longer-term bonuses are paid in shares, which must be held for a further four years. Executive Directors are encouraged to hold shares for longer than four years with additional matching share awards. Further details are provided below.

Share options are granted to Executive Directors at market value and can only be exercised if EPS growth exceeds Retail Price Index (RPI) plus 9 per cent over any three years from grant.

Executive Directors are required to build and hold a shareholding with a value at least equal to their basic salary; full participation in the Executive Incentive scheme is conditional upon meeting this target.

Price/earnings (P/E) ratio

The
price/earnings (P/E) ratio
is another ratio that's of particular interest to investors in public businesses. The P/E ratio gives you an idea of how much you're paying in the current price for the shares for each pound of earnings, or net income being earned by the business. Remember that earnings prop up the market value of shares, not the book value of the shares that's reported in the balance sheet. (Read on for the book value per share discussion.)

The P/E ratio is, in one sense, a reality check on just how high the current market price is in relation to the underlying profit that the business is earning. Extraordinarily high P/E ratios are justified only when investors think that the company's EPS has a lot of upside potential in the future.

The P/E ratio is calculated as follows:

Current market price of stock ÷ most recent trailing 12 months diluted EPS* = P/E ratio


If the business has a simple capital structure and does not report a diluted EPS, its basic EPS is used for calculating its P/E ratio. (See the earlier section ‘Earnings per share, basic and diluted'.)

Assume that the stock shares of a public business with a £3.65 diluted EPS are selling at £54.75 in the stock market.
Note:
From here forward, we will use the briefer term EPS in reference to P/E ratios; we assume you understand that it refers to diluted EPS for businesses with complex capital structures and to basic EPS for businesses with simple capital structures.

The actual share price bounces around day to day and is subject to change on short notice. To illustrate the P/E ratio, we use this price, which is the closing price on the latest trading day in the stock market. This market price means that investors trading in the stock think that the shares are worth 15 times diluted EPS (£54.75 market price ÷ £3.65 diluted EPS = 15). This value may be below the broad market average that values shares at, say, 20 times EPS. The outlook for future growth in its EPS is probably not too good.

Dividend yield

The
dividend yield
tells investors how much
cash flow income
they're receiving on their investment. (The dividend
is the cash flow income part of investment return; the other part is the gain or loss in the market value of the investment over the year.)

Suppose that a stock of a public company that is selling for £60 paid £1.20 cash dividends per share over the last year. You calculate dividend yield as follows:

£1.20 annual cash dividend per share ÷ £60 current market price of stock = 2% dividend yield


You use dividend yield to compare how your stock investment is doing to how it would be doing if you'd put that money in corporate or Treasury bonds, gilt edged stock (UK government borrowings) or other debt securities that pay interest. The average interest rate of high-grade debt securities has recently been three to four times the dividend yields on most public companies; in theory, market price appreciation of the shares over time makes up for that gap. Of course, shareholders take the risk that the market value will not increase enough to make their total return on investment rate higher than a benchmark interest rate. (At the time of writing this yield gap, as it is known, has shrunk to nothing and is causing an agonizing reappraisal of the value of equities in relation to debt, as an investment medium.)

Assume that long-term government gilt edged stock are currently paying 6 per cent annual interest, which is 4 per cent higher than the business's 2 per cent dividend yield in the example just discussed. If this business's shares don't increase in value by at least 4 per cent over the year, its investors would have been better off investing in the debt securities instead. (Of course, they wouldn't have had all the perks of a share investment, like those heartfelt letters from the chairman and those glossy financial reports.) The market price of publicly traded debt securities can fall or rise, so things get a little tricky in this sort of investment analysis.