Wealth Maximization vs Profit Maximization

Profit Maximization vs. Wealth Maximization

The objective of the firm is to maximize its value to its shareholders. Value is represented by the market price of the company’s common stock, which, in turn, is a reflection of the firm’s investment, financing, and dividend decisions.

The idea of wealth maximization involves increasing the Earning per share of the shareholders and to maximize the net present worth.
Wealth is equal to the the difference between gross present worth of some decision or course of action and the investment required to achieve the expected benefits.

Gross present worth involves the capitalised value of the expected benefits.This value is discounted a some rate,this rate depends on the certainty or uncertainty factor of the expected benefits.

The Wealth Maximization approach is concerned with the amount of cash flow generated by a course of action rather than the profits.

Any course of action that has Net Present Value above zero or in other words,creates wealth should be selected.

Frequently, maximization of profits is regarded as the proper objective of the firm, but it is not as inclusive a goal as that of maximizing shareholder wealth. For one thing, total profits are not as important as earnings per share. A firm could always raise total profits by issuing stock and using the proceeds to invest in Treasury bills. Even maximization of earnings per share, however, is not a fully appropriate objective, partly because it does not specify the timing or duration of expected returns. Is the investment project that will produce $100,000 return 5 years from now more valuable than the project that will produce annual returns of $15,000 in each of the next 5 years? An answer to this question depends upon the time value of money to the firm and to investors at the margin. Few existing stockholders would think favorably of a project that promised its first return in 100 years. We must take into account the time pattern of returns in our analysis.

Another shortcoming of the objective of maximizing earnings per share is that it does not consider the risk or uncertainty of the prospective earnings stream. Some investment projects are far more risky than others. As a result, the prospective stream of earnings per share would be more uncertain if these projects were undertaken. In addition, a company will be more or less risky depending upon the amount of debt in relation to equity in its capital structure. This risk is known as financial risk; and it, too, contributes to the uncertainty of the prospective stream of earnings per share. Two companies may have the same expected future earnings per share, but if the earnings stream of one is subject to considerably more uncertainty than the earnings stream of the other, the market price per share of its stock may be less.

For the reasons above, an objective of maximizing earnings per share may not be the same as maximizing market price per share. The market price of a firm’s stock represents the focal judgment of all market participants as to what the value is of the particular firm. It takes into account present and prospective future earnings per share, the timing, duration, and risk of these earnings, and any other factors that bear upon the market price of stock. The market price serves as a performance index or report card of the firm’s progress; it indicates how well management is doing in behalf of its stockholders.

Dividend Payout Ratio (DPR)

Dividend Payout Ratio

Definition:

The dividend payout ratio measures the percentage of a company's net income that is returned to shareholders in the form of dividends. (In the United Kingdom, this concept of Dividend Payout is referred to as Dividend Cover)

It is used as a tool in Analysis of Financial Statements. The payout ratio provides an idea of how well earnings support the dividend payments. More mature companies tend to have a higher payout ratio. When applied correctly, dividend payout ratios can be a powerful analytical tool.

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Calculation of dividend payout ratio:

DPR=

Dividend Per Share

Earnings Per Share

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For example, if XYZ company paid out $2 per share in annual dividends and had $4 in EPS, the DPR would be 50%. ($2 / $4 = 50%)

Growing companies will typically retain more profits to fund growth and pay lower or no dividends. So the Dividend Payout Ratio will be lower as the company expect that retaining the earnings, the return to shareholders can be maximised. Dividend payout ratios provide valuable insight into a company's dividend policy and can also reveal whether those payments appear "safe" or are in jeopardy of possibly being reduced. In the example of XYZ above, a ratio of 50% means that shareholders are only receiving 50 cents for every dollar the company is earning. In this case, the company is generating ample profits to support this relatively modest payment. In fact, if management considered it in the best interests of the company, it could probably afford to raise its dividend payment significantly.
Companies that pay higher dividends may be in mature industries where there is little room for growth and investment, so paying higher dividends is the best use of profits in such cases. An excessively high payout ratio suggests that the company might be paying out more than it can comfortably afford. Not only does this leave just a small percentage of profits to plow back into the business, but it also leaves the firm highly susceptible to a decline in future dividend payments. In some cases, a company will even pay out more than it earns, thus yielding a dividend payout ratio in excess of 100%. Such extremely high payouts are rarely sustainable and should warn investors that a dividend cut may be on the horizon. Because the act of reducing dividends is usually interpreted as a sign of weakness, when a dividend cut announcement is made, it also usually triggers a decline in the share price. Even if management finds a way to maintain an extremely high dividend payout ratio for an extended period of time, this strategy usually results in either a dwindling cash position or a rising debt load.

Dividend payout ratios can be impacted by a number of factors. For example, different accounting methods yield different earnings per share figures, which in turn influence the ratio. Furthermore, businesses in different growth stages can be expected to have different dividend policies. Young, fast-growing companies are typically focused on reinvesting earnings in order to grow the business. As such, they generally sport low (or even zero) dividend payout ratios. At the same time, larger, more-established companies can usually afford to return a larger percentage of earnings to stockholders.

Note: It can be misleading to compare the ratios of companies operating in different industries.

The Price Earning ratio or the PE ratio is the term commonly used to assess the fairness of the stock price.
PE ratio is defined as the ratio of market price to earning per share (EPS).

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PE ratio = Market price of the share

Earning per share (EPS)

For example, if a company is currently trading at $40 a share and earnings over the last 12 months were $2 per share, the P/E ratio for the stock would be 20 (=$40/$2).

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EPS in turn = Profit After Tax (EAT)

Number of shares in the share capital

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The common sense would dictate that lower Prie/Earning ratio means that the price is undervalued and higher Price/Earning ratio means that the price is overvalued. Unfortunately, it is not so simple that you would be sitting on the stock market and earning money by buying low Price/Earning ratio stocks and selling high Price/Earning ratio stocks.
In absolute terms there is no 'right' PE. One cannot say that PE of a stock of say 10 or 15 is good or bad.

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower Price/Earnings. However, the Price/Earning ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical Price/Earning Ratio. The P/E looks at the relationship between the stock price and the company’s earnings. The P/E is the most popular metric of stock analysis, although it is far from the only one you should consider.It would not be useful for investors using the Price / Earning ratio as a basis for their investment to compare the P/E of a technology company (higher Price/Earning) to a utility company (lower Price/Earning) as each industry has much different growth prospects. The P/E gives you an idea of what the market is willing to pay for the company’s earnings. The higher the P/E the more the market is willing to pay for the company’s earnings. Some investors read a high P/E as an overpriced stock and that may be the case, however it can also indicate the market has high hopes for this stock’s future and has bid up the price.

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What is the Right P/E?

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There is no correct answer to this question, because the answer depends on your willingness to pay for earnings. For an investor the stock of a company having PE of 20 is rightly priced the other investor may consider it highly priced due to higher price earning ratio. The more you are willing to pay, which means you believe the company has good long term prospects over and above its current position, the higher the Right Price/Earning is for that particular stock in your decision-making process. Another investor may not see the same value and took your Right P/E as wrong. The positive P/E shows that in how many years you will be able to get back your investment in form of profits. A PE of 10 indicate that you will be able to get back your investment in form of profits in 10 years assuming the price and EPS constant over the time. The negative Price/Earning Ratio shows that the company is suffering losses.

Earnings Per Share (EPS)

EPS is the portion of a company's profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company's profitability.

EPS is Calculated as:

EPS=

Net Income available for common stock holders

Outstanding Number of Shares

In the EPS calculation, it is more accurate to use a weighted average number of shares outstanding over the reporting term, because the number of shares outstanding can change over time. However, data sources sometimes simplify the calculation by using the number of shares outstanding at the end of the period.

Diluted Earnings Per Share expands on basic EPS by including the shares of convertibles or warrants outstanding in the outstanding shares number.

EPS is considered to be the single most important variable in determining a share's price. It is also a major component of the price-to-earnings valuation ratio. For example, assume that a company has a net income of $250 million. If the company pays out $10 million in preferred dividends and has 100 million shares for half of the year and 150 million shares for the other half, the Earnings Per Share would be $1.92 (240/125). First, the $10 million is deducted from the net income to get $240 million, then a weighted average is taken to find the number of shares outstanding (0.5 x 100M+ 0.5 x 150M = 125M).

An important aspect of Earnings Per Share (EPS) that's often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could generate the same EPS number, but one could do so with less equity (investment) : that company would be more efficient at using its capital to generate income and, all other things being equal, would be a "better" company. Investors also need to be aware of earnings manipulation that will affect the quality of the earnings number.

EPS : Where to use this financial ratio?

Companies A and B both earn $100, but company A has 10 shares outstanding, while company B has 50 shares outstanding. Which company’s stock do you want to own?
It makes more sense to look at earnings per share (EPS) for use as a comparison tool. You calculate earnings per share by taking the net earnings and divide by the outstanding shares.

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EPS = Net Earnings / Outstanding Shares

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Using our example above, Company A had earnings of $100 and 10 shares outstanding, which equals an EPS of 10 ($100 / 10 = 10). Company B had earnings of $100 and 50 shares outstanding, which equals an Earnings Per Share (EPS) of 2 ($100 / 50 = 2).
So, you should go buy Company A with an EPS of 10, right? Maybe, but not just on the basis of its EPS (Earnings Per Share).

The EPS is helpful in comparing one company to another, assuming they are in the same industry, but it doesn’t tell you whether it’s a good stock to buy or what the market thinks of it. For that information, we need to look at some other ratios, which will we discuss in other articles.