Chapter 8 Common Stock Basics


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Chapter 8 Common Stock Basics

  1. 1. Chapter 8 Common Stock Basics
  2. 2. CHAPTER 8 OVERVIEW <ul><li>8.1 Buying Part of a Business </li></ul><ul><li>8.2 Measuring Profitability </li></ul><ul><li>8.3 Firm Size Measures </li></ul><ul><li>8.4 Valuation Indicators </li></ul><ul><li>8.5 Growth Indicators </li></ul><ul><li>8.6 Financial Statement Analysis </li></ul><ul><li>8.7 Problems With Accounting Information </li></ul>
  3. 3. KEY TERMS Common Stock Basics <ul><li>Stock market investment </li></ul><ul><li>Stock market speculation </li></ul><ul><li>Net income </li></ul><ul><li>Earnings per share </li></ul><ul><li>Basic earnings per share </li></ul><ul><li>Fully diluted earnings per share </li></ul><ul><li>Profit margins </li></ul><ul><li>Return on stockholders’ equity </li></ul><ul><li>Stockholders’ equity </li></ul><ul><li>Return on assets </li></ul><ul><li>Total asset turnover </li></ul><ul><li>Leverage </li></ul><ul><li>Market cap </li></ul><ul><li>Firm size by sales </li></ul><ul><li>Firm size by revenue </li></ul><ul><li>Net worth </li></ul><ul><li>Book value per share </li></ul><ul><li>Total assets </li></ul>
  4. 4. BUYING PART OF A BUSINESS Business Valuation <ul><li>During 20th century, common stocks </li></ul><ul><ul><li>averaged 12-14% per year. </li></ul></ul><ul><ul><li>vastly outperformed bond and money market instruments. </li></ul></ul><ul><ul><li>even after taxes and inflation, showed positive returns. </li></ul></ul><ul><li>With debt securities, interest paid is less than expected return to issuing company. </li></ul><ul><ul><li>If the rate of interest offered > the the expected return on the investment  In the long run, the company would go broke. </li></ul></ul><ul><ul><li>Since the rate of interest offered < the the expected return on the investment  Provide required profit margin. </li></ul></ul><ul><li>Common stocks represent part ownership in corporation, proportional to shares owned. </li></ul><ul><ul><li>Investor owns 1% of the total number of outstanding shares  owns 1% of the company  buy part of a real business </li></ul></ul><ul><li>Prospects for stock performance are closely tied to real economic prospects of underlying business. </li></ul>
  5. 5. INVESTMENT vs. SPECULATION <ul><li>Stock Market Investment: process of buying and holding stock for dividend income and long-term capital appreciation </li></ul><ul><ul><li>The shares of companies with (good or poor) economic prospects. </li></ul></ul><ul><ul><li>Investors seek to profit by sharing in normal and predictable good fortune of companies. </li></ul></ul><ul><li>Success depends on careful examination of essential economic characteristics </li></ul><ul><li>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 </li></ul><ul><ul><li>Speculators seek to profit on a short-term or fundamental change in the economic prospects facing a company </li></ul></ul><ul><li>Success depends on hard-to-predict changes in basic economic forces, investor psychology, and luck </li></ul>
  6. 6. MEASURING PROFITABILITY Absolute Measures <ul><li>Most useful measure of business quality: consistently high profits </li></ul><ul><ul><li>high and growing stream of profits relative to amount of capital used </li></ul></ul><ul><ul><li>best businesses self-financing — profits fund future investment needs </li></ul></ul><ul><li>Net income generated </li></ul><ul><ul><li>also called earnings per share </li></ul></ul><ul><ul><li>difference between revenues and expenses, often after tax basis </li></ul></ul>
  7. 7. Earnings Per Share <ul><li>Basic EPS: net income divided by number of outstanding shares </li></ul><ul><li>Fully Diluted EPS: net income divided by outstanding shares, including possible conversion of stock options </li></ul><ul><li>Caveats: </li></ul><ul><ul><li>net income growth with simple increase in scale of operations </li></ul></ul><ul><ul><li>EPS artificially affected by number of outstanding shares — arbitrarily set by vote </li></ul></ul><ul><ul><ul><li>EX: A 2:1 stock split  the number of shares outstanding doubles  share price and earnings per share fall by one-half. </li></ul></ul></ul><ul><ul><ul><li>Stock split  neither enhance nor detract from the economic appeal of a company </li></ul></ul></ul>
  8. 8. MEASURING PROFITABILITY Relative Measures <ul><li>Profit Margin: return earned per dollar of sales; also called return on sales </li></ul><ul><ul><li>Profit margins are high  the company is operating at a high level of efficiency </li></ul></ul><ul><li>Accounting rate of Return on Stockholder’s Equity (ROE): net income divided by the book value of stockholders’ equity </li></ul><ul><ul><li>book value of total assets minus total liabilities </li></ul></ul><ul><ul><li>can be influenced strongly by stock buybacks or corporate restructuring </li></ul></ul><ul><ul><ul><li>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 </li></ul></ul></ul><ul><li>Return on Assets (ROA): net income divided by the book value of total assets </li></ul>
  9. 9. Return on Equity <ul><li>Popular indicator despite limitations </li></ul><ul><li>Reflects company’s use of operating and financial leverage </li></ul><ul><li>Simple product of three common accounting ratios: </li></ul>
  10. 10. RETURN ON EQUITY Implications <ul><li>Profit Margin: holding capital requirements constant, profit margin = useful indicator of managerial efficiency </li></ul><ul><ul><li>Rich profit margins don’t guarantee high returns on stockholder equity: capital requirements? </li></ul></ul><ul><ul><ul><li>Significant capital expenditures are needed before sales revenue are generated </li></ul></ul></ul><ul><li>Total Asset Turnover: sales revenue divided by book value of total assets; measures firm efficiency in investment independent of profit margins </li></ul><ul><li>Leverage: total assets divided by stockholders’ equity </li></ul><ul><ul><li>Reflects extent to which debt and preferred stock are used </li></ul></ul><ul><ul><li>Amplifies firm profit rates over business cycle </li></ul></ul><ul><ul><ul><li>Economic booms  leverage increases firm’s profit rate </li></ul></ul></ul><ul><ul><ul><li>Economic contractions, recession  leverage decreases firm’s profit rate </li></ul></ul></ul>
  11. 11. What is a typical ROE? <ul><li>Post WWII, ROE has fallen between 8-16% per year. </li></ul><ul><li>To prosper and grow, firms need consistent 12% ROE per year. </li></ul><ul><li>Beware when evaluating companies with high ROE but moderate profit margins and low ROA </li></ul>
  12. 12. QUICK QUIZ <ul><li>Holding all else equal, ROE will fall with a rise in: </li></ul>a. the book value of stockholders’ equity b. profit margin c. sales d. leverage
  13. 13. Firm Size Measures <ul><li>From investor’s perspective, is firm size important? </li></ul><ul><ul><li>Large companies with market cap > $5 billion are less risky </li></ul></ul><ul><ul><li>Liquid market for shares </li></ul></ul><ul><ul><li>Large size may limit future growth opportunities </li></ul></ul><ul><ul><ul><li>EX: </li></ul></ul></ul><ul><ul><ul><li>Invest $10,000 in MSFT at the time it first went public  after 15 years it grows to $5 million  500:1 payoff </li></ul></ul></ul><ul><ul><ul><li>Next 15 years keep 500:1 payoff  impossible; because with it’s 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. </li></ul></ul></ul><ul><li>Financial economists argue that total market capitalization of common stock (market cap) is best available indicator of future profits. </li></ul><ul><li>Market cap = discounted net present value of all future profits (value of firm) </li></ul>
  14. 14. FIRM SIZE Accounting Indicators <ul><li>Sales = Gross Receipts = Revenue </li></ul><ul><li>Net Worth: sum of common and preferred stockholders’ equity </li></ul><ul><li>Book Value Per Share: common shareholders’ equity divided by number of shares outstanding </li></ul><ul><li>Total Assets: stockholders’ equity plus total liabilities </li></ul>
  15. 15. KEY TERMS Stock Valuation & Financial Analysis <ul><li>Price/Earnings (P/E) Ratio </li></ul><ul><li>Earnings Yield </li></ul><ul><li>Price/Book Ratio </li></ul><ul><li>Dividend Yield </li></ul><ul><li>Total Return </li></ul><ul><li>Balance Sheet </li></ul><ul><li>Income Statement </li></ul><ul><li>Cash-flow Statement </li></ul><ul><li>Historical Cost </li></ul><ul><li>Current Cost </li></ul><ul><li>Replacement Cost </li></ul><ul><li>Intangible Assets </li></ul>
  16. 16. Valuation Indicators <ul><li>Not all stocks carry same degree of risk. </li></ul><ul><li>What is a reasonable price? Relative economic value? </li></ul><ul><li>Valuation yardsticks: </li></ul><ul><ul><li>P/E ratio: stock price/earnings per share </li></ul></ul><ul><ul><ul><li>P/E = 20:1  investors buying at the current market price is paying $20 for $1 in earnings per share (How about P/E = 30:1?) </li></ul></ul></ul><ul><ul><li>E/P ratio: earnings yield — earnings per share/price compared to Treasuries </li></ul></ul><ul><ul><ul><li>P/E = 20:1  E/P = 1/20 = 5%  P/E of 20:1 is paid  earnings yield on the investment is 5% (How about P/E = 30:1?) </li></ul></ul></ul><ul><ul><li>P/B ratio: stock price/accounting net worth (on per share basis) </li></ul></ul><ul><ul><ul><li>Accounting net worth = accounting book value = total assets – total liabilities </li></ul></ul></ul><ul><ul><ul><li>P/B usually >1: According to GAAP accounting book value numbers often neglect to include intangible assets such as valuable brand names </li></ul></ul></ul><ul><ul><li>Dividend yield: dividend income as percentage of price paid </li></ul></ul><ul><ul><ul><li>Current market price = $40, dividend = $1 per year  Dividend yield = $1/$40 = 2.5% per year. </li></ul></ul></ul><ul><ul><li>Total return: sum of dividend income plus capital appreciation — dividends can offset market losses </li></ul></ul>
  17. 17. Are Stock Prices Too High? As of January, 2000 <ul><li>P/E ratios for DJIA stocks at high end of range — 20:1 </li></ul><ul><li>Earnings yield at low end of range </li></ul><ul><li>P/B on DJIA ratios quite high </li></ul><ul><li>Dividend yields at record low as of Jan. 2000 </li></ul><ul><li>Stock valuation program models flashing warning signals </li></ul>
  18. 18. Growth Indicators <ul><li>Sales growth </li></ul><ul><ul><li>Building revenues </li></ul></ul><ul><ul><li>Building loyal customer base—dotcoms </li></ul></ul><ul><li>EPS (earnings-per-share) growth </li></ul><ul><li>Dividend growth </li></ul><ul><li>Book value growth </li></ul>
  19. 19. FINANCIAL STATEMENTS Balance Sheets <ul><li>Balance Sheet: “snapshot” information about company well-being at a specific time </li></ul><ul><ul><li>Total assets always equal total liabilities plus stockholders’ equity </li></ul></ul><ul><ul><li>Current assets — cash, cash equivalents, and inventories </li></ul></ul><ul><ul><li>Increase in accounts receivable can be item for concern </li></ul></ul>
  20. 20. FINANCIAL STATEMENTS Income Statements <ul><li>Income Statements: Ongoing view of dynamic change </li></ul><ul><ul><li>Net Revenues: gross revenues less returns, discounts, allowances </li></ul></ul><ul><ul><li>Operating Net Income: difference between net revenues and operating costs and expenses </li></ul></ul><ul><ul><li>Net after-tax income divided by number of shares is EPS (stock options also — fully diluted EPS) </li></ul></ul>
  21. 21. FINANCIAL STATEMENTS Cash-Flow Statements <ul><li>Show changes in company’s cash position and gives clear view of health of company’s ongoing operations </li></ul><ul><ul><li>Sources of Income: net cash — operating, financing, and investing activities </li></ul></ul><ul><ul><li>Operating Cash Flow: net income plus noncash charges — depreciation and amortization </li></ul></ul><ul><ul><li>Financing Activities: purchase/sale of company stocks or bonds </li></ul></ul><ul><ul><li>Investing Activities: additions to plant and equipment, changes in short-term investments, mergers, acquisitions </li></ul></ul>
  22. 22. Problems With Accounting Information <ul><li>Historical focus problem </li></ul><ul><ul><li>Historical Cost: actual cash outlay </li></ul></ul><ul><ul><li>Current Costs: amount that must be paid under prevailing market conditions </li></ul></ul><ul><ul><li>Replacement Costs: cost of duplicating productive capability by using current technologies </li></ul></ul>
  23. 23. PROBLEM Overlooking Intangible Assets <ul><li>Intangible Assets: valuable holdings that have no physical form </li></ul><ul><ul><li>gap between book values per share and stock prices: physical assets account for about 15% of total assets </li></ul></ul><ul><ul><li>high tech firms feature even wider gap </li></ul></ul><ul><ul><li>traditional methods fail to capture rapid growth </li></ul></ul><ul><ul><li>difficulty identifying and measuring value of: </li></ul></ul><ul><ul><ul><li>brands </li></ul></ul></ul><ul><ul><ul><li>distribution networks </li></ul></ul></ul><ul><ul><ul><li>advertising </li></ul></ul></ul><ul><ul><ul><li>R&D expenditures </li></ul></ul></ul>