You have just won $2 million in lottery! Congrats! Realizing how fortunate you are, you have spent some of this money on a new car, a new condominium and a trip around the world. You have now returned back from your trip and would like to take the remaining $500,000 in the shares of one publicly traded Canadian company. You seek advice on which company to invest from one of your friends, who is a computer programmer. She tells you to invest in a new software company that just went public (the company’s shares begun trading on the stock exchange). The new technology company develops new online games and receives fees from players along with advertising revenue. This company has not had many sales yet, but expects to in the future due to the popularity of its product. Its price-earnings ratio is 80 times earnings, its return on common shareholder’s equity is 2.0% and its return on assets is 1.8%. (you may need to refresh your understanding of the underlined terms). Your uncle, on the other hand, suggests that you purchase shares in a large bank that has consistently paid dividends for over 100 years and has increased its dividends every year for the past 45 years.
This bank has a price-earnings ratio of 11 times earnings, but unlike the software company, it has a dividend yield of 3.0%. The bank’s net income has barely risen over the past two years but its return on common shareholders’ equity is 10.2%, while its return on assets is 2.7%.
Instructions
1. Research and find the meaning of the bolded and underlined terms. Include this in your response.
2. Why would the price-earnings ratio be higher for the software company? (3 marks)
3. Why would the bank have dividend yield and the software company would not? (3 marks)
4. Why would the software company have lower returns on both assets and equity? (3 marks)
5. Why would a bank have such a large difference between its return on common shareholders’ equity and return on assets? (3 marks)
6. Which company would you invest in? Explain your reasoning. (5 marks)