Chapter 8 Common Stock BasicsPresentation Transcript
Chapter 8 Common Stock Basics
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
KEY TERMS Common Stock Basics
Stock market investment
Stock market speculation
Earnings per share
Basic earnings per share
Fully diluted earnings per share
Return on stockholders’ equity
Return on assets
Total asset turnover
Firm size by sales
Firm size by revenue
Book value per share
BUYING PART OF A BUSINESS Business 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 > the the expected return on the investment In the long run, the company would go broke.
Since the rate of interest offered < 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.
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
MEASURING PROFITABILITY Absolute 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-financing — profits fund future investment needs
Net income generated
also called earnings per share
difference between revenues and expenses, often after tax basis
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
net income growth with simple increase in scale of operations
EPS artificially affected by number of outstanding shares — arbitrarily set by vote
EX: A 2:1 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
MEASURING PROFITABILITY Relative 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 Stockholder’s 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
Return on Equity
Popular indicator despite limitations
Reflects company’s use of operating and financial leverage
Simple product of three common accounting ratios:
RETURN ON EQUITY Implications
Profit Margin: holding capital requirements constant, profit margin = useful indicator of managerial efficiency
Rich profit margins don’t 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
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
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
Firm Size Measures
From investor’s perspective, is firm size important?
Large companies with market cap > $5 billion are less risky
Liquid market for shares
Large size may limit future growth opportunities
Invest $10,000 in MSFT at the time it first went public after 15 years it grows to $5 million 500:1 payoff
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.
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)
FIRM SIZE Accounting 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
KEY TERMS Stock Valuation & Financial Analysis
Price/Earnings (P/E) Ratio
Not all stocks carry same degree of risk.
What is a reasonable price? Relative economic value?
P/E ratio: stock price/earnings per share
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?)
E/P ratio: earnings yield — earnings per share/price compared to Treasuries
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?)
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 >1: 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 appreciation — dividends can offset market losses
Are Stock Prices Too High? As of January, 2000
P/E ratios for DJIA stocks at high end of range — 20:1
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
Building loyal customer base—dotcoms
EPS (earnings-per-share) growth
Book value growth
FINANCIAL STATEMENTS Balance Sheets
Balance Sheet: “snapshot” information about company well-being at a specific time
Total assets always equal total liabilities plus stockholders’ equity
Current assets — cash, cash equivalents, and inventories
Increase in accounts receivable can be item for concern
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 also — fully diluted EPS)
FINANCIAL STATEMENTS Cash-Flow Statements
Show changes in company’s cash position and gives clear view of health of company’s ongoing operations
Sources of Income: net cash — operating, financing, and investing activities
Operating Cash Flow: net income plus noncash charges — depreciation 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
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
PROBLEM Overlooking 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