Investment ratios — common mistakes

In an exam, when analysing dividend yield, always consider the trade-off between dividend income and potential capital growth. A company with a low yield isn't necessarily a poor investment if it is successfully reinvesting profits to increase its future value and share price.

Avoid stating that a high P/E ratio is simply 'good' or a low one is 'bad'. A high P/E ratio represents high expectations, which also means high risk if the company fails to deliver the expected growth. Analysis must always be in context.

Distinguish shareholders (yield, P/E) from directors (ROCE, liquidity) — match ratio to the stakeholder in the question.

Not necessarily. While a high yield provides good income, it can also be a red flag. It might result from a falling share price (indicating poor performance) or an unsustainable payout policy. Investors seeking capital growth may prefer a company with a lower yield that reinvests more profit for future expansion, which could lead to a higher share price.

A P/E ratio is calculated using 'Earnings per share'. If a company is making a loss, its earnings are negative. In this case, the P/E ratio is not a meaningful metric and is usually stated as 'N/A' (not applicable). Investors would then need to use other metrics to value the company, such as its assets or future sales potential.

Shareholders have different investment objectives. An institutional investor like a pension fund or a retiree may prioritise a reliable, high dividend for income. They would favour a high dividend yield with strong dividend cover. In contrast, a younger investor might prefer the company to pay low or no dividends and reinvest the profits to fuel growth, aiming for long-term capital gains through a rising share price.