Chapter 8 Common Stock Basics
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Chapter 8 Common Stock Basics

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    Chapter 8 Common Stock Basics Chapter 8 Common Stock Basics Presentation 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
      • 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
    • 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
      • Caveats:
        • 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
        • Amplifies firm profit rates over business cycle
          • Economic booms  leverage increases firm’s profit rate
          • Economic contractions, recession  leverage decreases firm’s profit rate
    • 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
    • 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
    • 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
          • EX:
          • 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
      • Earnings Yield
      • Price/Book Ratio
      • Dividend Yield
      • Total Return
      • Balance Sheet
      • Income Statement
      • Cash-flow Statement
      • Historical Cost
      • Current Cost
      • Replacement Cost
      • Intangible Assets
    • 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 = 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
    • Growth Indicators
      • Sales growth
        • Building revenues
        • Building loyal customer base—dotcoms
      • EPS (earnings-per-share) growth
      • Dividend 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
        • high tech firms feature even wider gap
        • traditional methods fail to capture rapid growth
        • difficulty identifying and measuring value of:
          • brands
          • distribution networks
          • advertising
          • R&D expenditures