Common Stock Basics

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Chapter 8

• Common Stock Basics

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CHAPTER 8 OVERVIEW

• 8.1 Buying Part of a Business
• 8.2 Measuring Profitability
• 8.3 Firm Size Measures
• 8.4 Valuation Indicators
• 8.5 Growth Indicators
• 8.6 Financial Statement Analysis
• 8.7 Problems With Accounting Information

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KEY TERMSCommon Stock Basics

• Stock market investment
• Stock market speculation
• Net income
• Earnings per share
• Basic earnings per share
• Fully diluted earnings per share
• Profit margins
• Return on stockholders equity
• Stockholders equity

• Return on assets
• Total asset turnover
• Leverage
• Market cap
• Firm size by sales
• Firm size by revenue
• Net worth
• Book value per share
• Total assets

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BUYING PART OF A BUSINESSBusiness Valuation

• During 20th century, common stocks
• averaged 12-14 per year.
• vastly outperformed bond and money market
  instruments.
• even after taxes and inflation, showed positive
  returns.
• With debt securities, interest paid is less than
  expected return to issuing company.
• If the rate of interest offered gt the the
  expected return on the investment? In the long
  run, the company would go broke.
• Since the rate of interest offered lt the the
  expected return on the investment ? Provide
  required profit margin.
• Common stocks represent part ownership in
  corporation, proportional to shares owned.
• Investor owns 1 of the total number of
  outstanding shares? owns 1 of the company? buy
  part of a real business
• Prospects for stock performance are closely tied
  to real economic prospects of underlying business.

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INVESTMENT vs. SPECULATION

• Stock Market Investment process of buying and
  holding stock for dividend income and long-term
  capital appreciation
• The shares of companies with (good or poor)
  economic prospects.
• Investors seek to profit by sharing in normal and
  predictable good fortune of companies.
• Success depends on careful examination of
  essential economic characteristics

• Stock Market Speculation purchase or sale of
  securities on the expectation of short-term
  trading profits form share price fluctuations
  tied to temporary good fortune
• Speculators seek to profit on a short-term or
  fundamental change in the economic prospects
  facing a company
• Success depends on hard-to-predict changes in
  basic economic forces, investor psychology, and
  luck

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MEASURING PROFITABILITYAbsolute Measures

• Most useful measure of business quality
  consistently high profits
• high and growing stream of profits relative to
  amount of capital used
• best businesses self-financingprofits fund
  future investment needs
• Net income generated
• also called earnings per share
• difference between revenues and expenses, often
  after tax basis

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Earnings Per Share

• Basic EPS net income divided by number of
  outstanding shares
• Fully Diluted EPS net income divided by
  outstanding shares, including possible conversion
  of stock options
• Caveats
• net income growth with simple increase in scale
  of operations
• EPS artificially affected by number of
  outstanding sharesarbitrarily set by vote
• EX A 21 stock split ?the number of shares
  outstanding doubles? share price and earnings per
  share fall by one-half.
• Stock split? neither enhance nor detract from the
  economic appeal of a company

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MEASURING PROFITABILITYRelative Measures

• Profit Margin return earned per dollar of sales
  also called return on sales
• Profit margins are high ? the company is
  operating at a high level of efficiency
• Accounting rate of Return on Stockholders Equity
  (ROE) net income divided by the book value of
  stockholders equity
• book value of total assets minus total
  liabilities
• can be influenced strongly by stock buybacks or
  corporate restructuring
• How? GAAP (generally accepted accounting
  principles) the book value of stockholders
  equity the amount of money committed to the
  company by stockholders paid-in capital
  retained earnings amount paid for share
  repurchases
• Return on Assets (ROA) net income divided by the
  book value of total assets

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Return on Equity

• Popular indicator despite limitations
• Reflects companys use of operating and financial
  leverage
• Simple product of three common accounting ratios

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RETURN ON EQUITY Implications

• Profit Margin holding capital requirements
  constant, profit margin useful indicator of
  managerial efficiency
• Rich profit margins dont guarantee high returns
  on stockholder equity capital requirements?
• Significant capital expenditures are needed
  before sales revenue are generated
• Total Asset Turnover sales revenue divided by
  book value of total assets measures firm
  efficiency in investment independent of profit
  margins
• Leverage total assets divided by stockholders
  equity
• Reflects extent to which debt and preferred stock
  are used
• Amplifies firm profit rates over business cycle
• Economic booms? leverage increases firms profit
  rate
• Economic contractions, recession ? leverage
  decreases firms profit rate

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What is a typical ROE?

• Post WWII, ROE has fallen between 8-16 per year.
• To prosper and grow, firms need consistent 12
  ROE per year.
• Beware when evaluating companies with high ROE
  but moderate profit margins and low ROA

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QUICK QUIZ

• Holding all else equal, ROE will fall with a rise
  in

a. the book value of stockholders
equity b. profit margin c. sales d. leverage
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Firm Size Measures

• From investors perspective, is firm size
  important?
• Large companies with market cap gt 5 billion are
  less risky
• Liquid market for shares
• Large size may limit future growth opportunities
• EX
• Invest 10,000 in MSFT at the time it first went
  public? after 15 years it grows to 5 million ?
  5001 payoff
• Next 15 years keep 5001 payoff ? impossible
  because with its current market cap in excess of
  500 billion, it would imply a market cap of more
  than 250 trillion, which is 10 times the current
  market cap of all companies traded on all global
  equity markets.
• Financial economists argue that total market
  capitalization of common stock (market cap) is
  best available indicator of future profits.
• Market cap discounted net present value of all
  future profits (value of firm)

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FIRM SIZEAccounting Indicators

• Sales Gross Receipts Revenue

• Net Worth sum of common and preferred
  stockholders equity
• Book Value Per Share common shareholders equity
  divided by number of shares outstanding
• Total Assets stockholders equity plus total
  liabilities

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KEY TERMSStock Valuation Financial Analysis

• Price/Earnings (P/E) Ratio
• Earnings Yield
• Price/Book Ratio
• Dividend Yield
• Total Return
• Balance Sheet

• Income Statement
• Cash-flow Statement
• Historical Cost
• Current Cost
• Replacement Cost
• Intangible Assets

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Valuation Indicators

• Not all stocks carry same degree of risk.
• What is a reasonable price? Relative economic
  value?
• Valuation yardsticks
• P/E ratio stock price/earnings per share
• P/E 201 ? investors buying at the current
  market price is paying 20 for 1 in earnings per
  share (How about P/E 301?)
• E/P ratio earnings yieldearnings per
  share/price compared to Treasuries
• P/E 201 ? E/P 1/20 5 ? P/E of 201 is
  paid ? earnings yield on the investment is 5
  (How about P/E 301?)
• P/B ratio stock price/accounting net worth (on
  per share basis)
• Accounting net worth accounting book value
  total assets total liabilities
• P/B usually gt1 According to GAAP accounting book
  value numbers often neglect to include intangible
  assets such as valuable brand names
• Dividend yield dividend income as percentage of
  price paid
• Current market price 40, dividend 1 per
  year ? Dividend yield 1/40 2.5 per year.
• Total return sum of dividend income plus capital
  appreciationdividends can offset market losses

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Are Stock Prices Too High?As of January, 2000

• P/E ratios for DJIA stocks at high end of
  range201
• Earnings yield at low end of range
• P/B on DJIA ratios quite high
• Dividend yields at record low as of Jan. 2000
• Stock valuation program models flashing warning
  signals

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Growth Indicators

• Sales growth
• Building revenues
• Building loyal customer basedotcoms
• EPS (earnings-per-share) growth
• Dividend growth
• Book value growth

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FINANCIAL STATEMENTSBalance Sheets

• Balance Sheet snapshot information about
  company well-being at a specific time
• Total assets always equal total liabilities plus
  stockholders equity
• Current assetscash, cash equivalents, and
  inventories
• Increase in accounts receivable can be item for
  concern

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FINANCIAL STATEMENTS Income Statements

• Income Statements Ongoing view of dynamic change
• Net Revenues gross revenues less returns,
  discounts, allowances
• Operating Net Income difference between net
  revenues and operating costs and expenses
• Net after-tax income divided by number of shares
  is EPS (stock options alsofully diluted EPS)

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FINANCIAL STATEMENTSCash-Flow Statements

• Show changes in companys cash position and gives
  clear view of health of companys ongoing
  operations
• Sources of Income net cashoperating, financing,
  and investing activities
• Operating Cash Flow net income plus noncash
  chargesdepreciation and amortization
• Financing Activities purchase/sale of company
  stocks or bonds
• Investing Activities additions to plant and
  equipment, changes in short-term investments,
  mergers, acquisitions

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Problems With Accounting Information

• Historical focus problem
• Historical Cost actual cash outlay
• Current Costs amount that must be paid under
  prevailing market conditions
• Replacement Costs cost of duplicating productive
  capability by using current technologies

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PROBLEMOverlooking Intangible Assets

• Intangible Assets valuable holdings that have no
  physical form
• gap between book values per share and stock
  prices physical assets account for about 15 of
  total assets
• high tech firms feature even wider gap
• traditional methods fail to capture rapid growth
• difficulty identifying and measuring value of
• brands
• distribution networks
• advertising
• RD expenditures