You have just won $2 million in a lottery. Realizing how fortunate you are, you have invested some of this money in a car, a house, some low-risk, interest-bearing guaranteed investment certificates, and some highly diversified mutual funds. You would like to take $100,000 of the remaining money and invest that amount in the shares of one publicly traded Canadian company. You seek advice on which company to invest in from one of your friends, who is a computer programmer.
She tells you to invest in a new soft ware company that just went public. It develops new on-line games and receives fees from players along with advertising revenue. This company has not had very many sales yet, but expects to in the future due to the popularity of its products. Its price earnings ratio is 80 times earnings, its return on common shareholders' equity is 2.0%, and its return on assets is 1.8%. 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 dividend every year for the last 45 years. This bank has a price earnings ratio of 11 times earnings but unlike the soft ware company, it has a dividend yield of 3.0%. The bank's profit has barely risen over the last two years but its return on common shareholders' equity is 10.2% while its return on assets is 2.7%.
Instructions
(a) Why would the price earnings ratio be higher for the software company?
(b) Why would the bank have a dividend yield and the soft ware company would not?
(c) Why would the soft ware company have lower returns on both assets and equity?
(d) Why would a bank have such a large difference between its return on common shareholders' equity and its return on assets?
(e) Which company would you invest in?