Chapter 8

Common Stock Basics

CHAPTER 8 OVERVIEW
8.1 8.2 8.3 8.4 8.5 8.6 8.7 Buying Part of a Business Measuring Profitability Firm Size Measures Valuation Indicators Growth Indicators Financial Statement Analysis Problems With Accounting Information

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. Common stocks represent part ownership in corporation, proportional to shares owned. Prospects for stock performance are closely tied to real economic prospects of underlying business.

INVESTMENT vs. SPECULATION

Stock Market Investment: Stock Market Speculation:

process of buying and holding stock for dividend income and long-term capital appreciation
Success depends on careful

purchase or sale of securities on the expectation of shortterm trading profits form share price fluctuations tied to temporary good fortune
Success depends on hard-to-

examination of essential economic characteristics

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-financingprofits 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

Earnings Per Share

Backward looking:

Last years Earnings / number of shares

A better measure (?):

Forward looking:

Use analyst expected earnings per share / number of shares

Earnings Per Share: An Example

Get data from www.smartmoney.com
MSFT Stock Historical EPS

Jan 04-Dec 04 EPS

EPS = 0.34 + 0.28 + 0.32 + 0.35 = $1.29

Future EPS:

FY 05: $1.29 FY 06: $1.42

MEASURING PROFITABILITY
Relative Measures
Profit Margin: return earned per dollar of sales; also

called return on sales

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

Return on Assets (ROA): net income divided by the

book value of total assets

Dupont Analysis & Return on Equity

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

Net Income ROE = Equity Net Income Sales Total Assets Sales Total Assets Equity Profit Margin Total Asset Turnover Leverage

Dupont Analysis & Return on Equity: An Example

Look up MSFT Data
Get data from www.smartmoney.com

Net Income ROE = Equity Profit Margin Total Asset Turnover Leverage 28.9% 0.50 1.00 14.5%

Dupont Analysis & Return on Equity: An Example

Compare MSFT and ORCL

ROE ROE ROE

Profit Margin Total Asset Turnover Leverage ORCL 26.0% 0.60 1.02 15.6%
ORCL MSFT

28.9% 0.50 1.00 14.5%

RETURN ON EQUITY Implications

1.

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?

2.

Total Asset Turnover: sales revenue divided by book value of total assets; measures firm efficiency in investment independent of profit margins

3.

Leverage: total assets divided by stockholders equity

Reflects extent to which debt and preferred stock are used Amplifies firm profit rates over business cycle

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. b. c. d.

the book value of stockholders equity profit margin sales leverage

Firm Size Measures

From investors 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

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

Valuation Indicators

Valuation yardsticks: www.smartmoney.com

P/E ratio: stock price/earnings per share

Historical and Future Expected Earnings per share

E/P ratio: earnings yieldearnings per share/price compared to Treasuries P/B ratio: stock price/accounting net worth Dividend yield: dividend income as percentage of price paid Total return: sum of dividend income plus capital appreciationdividends can offset market losses

Growth Indicators
Sales growth

Building revenues

Building loyal customer basedotcoms

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 assetscash, 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 alsofully diluted EPS)

FINANCIAL STATEMENTS
Cash-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 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 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 (Coca-Cola) Distribution networks (Walmart) Customer Lock-in (MSFT) R&D expenditures (IBM)

KEY TERMS
Common Stock Basics
Stock market investment
Stock market speculation Net income

Return on assets
Total asset turnover Leverage

Earnings per share

Basic earnings per share Fully diluted earnings per

Market cap
Firm size by sales Firm size by revenue

share
Profit margins Return on stockholders equity Stockholders equity

Net worth
Book value per share Total assets

KEY TERMS
Stock Valuation & Financial Analysis

Price/Earnings (P/E) Ratio Earnings Yield

Income Statement Cash-flow Statement

Price/Book Ratio
Dividend Yield Total Return Balance Sheet

Historical Cost
Current Cost Replacement Cost Intangible Assets