Investment ratios

The dividend yield is the dividend per share expressed as a percentage of the market price per share (1). It shows the income return an investor earns on the current cost of the share (1) — for example, a $0.20 dividend on a $5.00 share is a 4% yield.

Dividend cover of 2.5 means the company's profit for the year is 2.5 times the dividend it paid. This tells an investor that the dividend is comfortably covered by profit, so it looks safe and sustainable: even if profit fell somewhat, the company could still afford the dividend. It also shows that profit is left over to reinvest for future growth. A cover below 1, by contrast, would mean the firm was paying out more than it earned — an unsustainable dividend.

A higher P/E ratio means the market is willing to pay more per $1 of the company's current earnings. The main reason is usually greater confidence in future growth: if investors expect the company's earnings to rise quickly — perhaps because it has strong new products, a fast-growing market or a respected management team — they will pay a higher price now relative to today's earnings.

A higher P/E can also reflect lower perceived risk: a stable, well-established company may command a higher P/E than a riskier rival because its earnings are seen as more dependable.

Therefore a higher P/E than a competitor usually signals that the market expects stronger and/or safer future earnings — though it could also mean the share is currently overvalued, so the figure should be interpreted with care.

A public limited company can improve shareholder returns in several ways. First, it can increase its profit through better marketing, tighter cost control or successful new products. Higher profit allows a larger dividend and/or supports a higher share price, and is the most fundamental and sustainable route because it raises the resources from which all returns flow.

Second, it can increase the dividend by paying out a larger share of profit. This directly raises the dividend yield, rewarding income-seeking investors immediately. However, it lowers dividend cover — making the dividend less safe — and leaves less profit to reinvest, which can harm future growth.

Third, it can retain and reinvest profit to grow future earnings. If reinvestment funds profitable expansion, future earnings and the share price rise, rewarding growth investors through capital gains and lifting the P/E ratio. The cost is lower dividends now, which may disappoint income investors.

Finally, it can improve overall performance and communicate its strategy clearly, raising investor confidence and supporting the share price; some firms also use share buybacks to raise earnings per share.

Therefore the company has several levers, but each involves a trade-off between income today and growth tomorrow. The most effective approach depends on the type of investor the company wants to keep or attract.

Increasing the dividend would raise the dividend yield, giving shareholders a higher income return now. Whether the company should do it depends on its investors, its prospects and its need to reinvest.

The case for increasing the dividend. A larger dividend directly rewards income-seeking investors (such as pension funds or retirees) and can attract more of them, supporting demand for the shares. It signals confidence — a board that raises the dividend is telling the market it expects profits to hold up — which can lift the share price. For a mature, profitable company with limited high-return reinvestment opportunities, returning cash to shareholders may be the best use of profit, since reinvesting in low-return projects would waste it.

The case against increasing the dividend. A large rise reduces dividend cover, making the dividend less safe: if profit later falls, the company may have to cut it, which damages confidence and the share price more than never raising it would have. It also leaves less profit to reinvest in new products, expansion or technology, which could weaken future earnings and the share price — disappointing growth investors, who prefer reinvestment. Paying out cash also reduces the firm's financial flexibility to cope with a downturn or fund opportunities.

Judgement (criterion). Whether the company should increase its dividend depends on its growth opportunities and the type of investor it wants to satisfy. If it is a mature firm with few profitable reinvestment options and mainly income investors, a higher dividend is sensible — provided cover stays comfortably above 1 so the dividend remains sustainable. If it has strong growth opportunities and growth-oriented shareholders, the money is better reinvested, because the resulting rise in the share price would reward shareholders more than extra dividends. On balance, the company should increase the dividend only if it can do so sustainably (keeping reasonable cover) and only to the extent that it does not starve genuinely profitable reinvestment — a moderate, sustainable rise is usually wiser than a large one driven simply by short-term shareholder pressure.

Investment ratios — the dividend yield, dividend cover and price/earnings ratio — give an investor a quick, numerical picture of the return a company offers. But how far an investor should rely on them depends on their limitations and on what other information is available.

The case for relying on investment ratios. The ratios directly address what an investor wants to know. The dividend yield shows the income return on the share's price, the dividend cover shows whether that income is safe and sustainable, and the P/E ratio shows how the market values the company's earnings and its growth prospects. They allow easy comparison — over time and against competitors — so an investor can quickly screen companies and match them to their own goals (income or growth). For an investor with limited time and access only to published accounts, the ratios are an efficient, objective starting point.

The case against relying on them. The ratios have real weaknesses. They are based on past (or current) data, whereas an investment is about the future — a strong yield today can collapse if profits fall. They can mislead: a rising dividend yield may simply reflect a falling share price (a warning, not a reward), and a high P/E may signal overvaluation rather than genuine growth. Ratios also ignore qualitative factors that drive future performance — the quality of management, the strength of the brand, the competitive and economic environment, and the company's strategy. They depend on the accuracy and comparability of the published accounts (different accounting policies make cross-company comparison unreliable), and a single ratio in isolation can be deceptive.

Weighing it up (criterion). How far an investor should rely on the ratios depends on the investor's goal, their access to other information, and the reliability of the accounts. An investor screening many companies for income can lean heavily on yield and cover; an investor making a large, long-term commitment should treat the ratios as only one input, because future performance turns on factors the ratios cannot capture.

Judgement. An investor should rely on investment ratios to a limited extent — as a valuable first filter and a way to compare returns, but not as the sole basis for buying shares. The deciding criterion is that the ratios describe the past and the present, while a share purchase is a bet on the future: they tell the investor what the return has been and how the market currently values the company, not whether that will continue. The most defensible position is to use the ratios alongside an assessment of management, market conditions, the company's strategy and the wider economy — so the ratios should inform, not replace, the investment decision.