Chapter 8 Common Stock Basics

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Chapter 8 Common Stock Common Stock Basics Basics
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Transcript of Chapter 8 Common Stock Basics

Page 1: Chapter 8 Common Stock Basics

Chapter 8

Common Stock Common Stock BasicsBasics

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CHAPTER 8 OVERVIEW

8.18.1 Buying Part of a BusinessBuying Part of a Business8.28.2 Measuring ProfitabilityMeasuring Profitability8.38.3 Firm Size MeasuresFirm Size Measures8.48.4 Valuation IndicatorsValuation Indicators8.58.5 Growth IndicatorsGrowth Indicators8.68.6 Financial Statement AnalysisFinancial Statement Analysis8.78.7 Problems With Accounting InformationProblems With Accounting Information

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KEY TERMSCommon Stock Basics

Stock market investmentStock market investment Stock market speculationStock market speculation Net incomeNet income Earnings per shareEarnings per share Basic earnings per shareBasic earnings per share Fully diluted earnings per shareFully diluted earnings per share Profit marginsProfit margins Return on stockholders’ equityReturn on stockholders’ equity Stockholders’ equityStockholders’ equity

Return on assetsReturn on assets Total asset turnoverTotal asset turnover LeverageLeverage Market capMarket cap Firm size by salesFirm size by sales Firm size by revenueFirm size by revenue Net worthNet worth Book value per shareBook value per share Total assetsTotal assets

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BUYING PART OF A BUSINESSBusiness Valuation

During 20th century, common stocksDuring 20th century, common stocks averaged 12-14% per year.averaged 12-14% per year. vastly outperformed bond and money market instruments.vastly outperformed bond and money market instruments. even after taxes and inflation, showed positive returns.even after taxes and inflation, showed positive returns.

With debt securities, interest paid is less than expected return to issuing company.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 investmentIf the rate of interest offered > the the expected return on the investment In In

the long run, the company would go broke.the long run, the company would go broke. Since the rate of interest offered < the the expected return on the investment Since the rate of interest offered < the the expected return on the investment

Provide required profit margin. Provide required profit margin. Common stocks represent part ownership in corporation, proportional to shares owned.Common stocks represent part ownership in corporation, proportional to shares owned.

Investor owns 1% of the total number of outstanding sharesInvestor owns 1% of the total number of outstanding shares owns 1% of the owns 1% of the companycompany buy part of a real business buy part of a real business

Prospects for stock performance are closely tied to real economic prospects of Prospects for stock performance are closely tied to real economic prospects of underlying business.underlying business.

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INVESTMENT vs. SPECULATION

Stock Market Investment:Stock Market Investment: process process of buying and holding stock for of buying and holding stock for dividend income and long-term dividend income and long-term capital appreciationcapital appreciation

The shares of companies with The shares of companies with (good or poor) economic (good or poor) economic prospects.prospects.

Investors seek to profit by Investors seek to profit by sharing in normal and sharing in normal and predictable good fortune of predictable good fortune of companies. companies.

Success depends on careful Success depends on careful examination of essential economic examination of essential economic characteristicscharacteristics

Stock Market SpeculationStock Market Speculation: : purchase or sale of securities on purchase or sale of securities on the expectation of short-term the expectation of short-term trading profits form share price trading profits form share price fluctuations tied to temporary fluctuations tied to temporary good fortunegood fortune

Speculators seek to profit on a Speculators seek to profit on a short-term or fundamental short-term or fundamental change in the economic change in the economic prospects facing a companyprospects facing a company

Success depends on hard-to-Success depends on hard-to-predict changes in basic economic predict changes in basic economic forces, investor psychology, and forces, investor psychology, and luckluck

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MEASURING PROFITABILITYAbsolute Measures

Most useful measure of business quality: consistently Most useful measure of business quality: consistently high profitshigh profits high and growing stream of profits relative to amount of high and growing stream of profits relative to amount of

capital usedcapital used best businesses self-financingbest businesses self-financing——profits fund future profits fund future

investment needsinvestment needs

Net income generatedNet income generated also called earnings per sharealso called earnings per share difference between revenues and expenses, often after tax difference between revenues and expenses, often after tax

basisbasis

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Earnings Per Share

Basic EPS:Basic EPS: net income divided by number of outstanding shares net income divided by number of outstanding shares

Fully Diluted EPS:Fully Diluted EPS: net income divided by outstanding shares, including net income divided by outstanding shares, including possible conversion of stock optionspossible conversion of stock options

Caveats:Caveats: net income growth with simple increase in scale of operationsnet income growth with simple increase in scale of operations EPS artificially affected by number of outstanding sharesEPS artificially affected by number of outstanding shares——arbitrarily set arbitrarily set

by voteby vote EX: A 2:1 stock split EX: A 2:1 stock split the number of shares outstanding doublesthe number of shares outstanding doubles

share price and earnings per share fall by one-half. share price and earnings per share fall by one-half. Stock splitStock split neither enhance nor detract from the economic appeal neither enhance nor detract from the economic appeal

of a companyof a company

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MEASURING PROFITABILITYRelative Measures

Profit Margin:Profit Margin: return earned per dollar of sales; also called return on sales return earned per dollar of sales; also called return on sales Profit margins are high Profit margins are high the company is operating at a high level of the company is operating at a high level of

efficiencyefficiency Accounting rate of Return on Stockholder’s Equity (ROE):Accounting rate of Return on Stockholder’s Equity (ROE): net income divided net income divided

by the book value of stockholders’ equityby the book value of stockholders’ equity book value of total assets minus total liabilitiesbook value of total assets minus total liabilities can be influenced strongly by stock buybacks or corporate restructuringcan be influenced strongly by stock buybacks or corporate restructuring

How? GAAP (generally accepted accounting principles): the book value of How? GAAP (generally accepted accounting principles): the book value of stockholders’ equity = the amount of money committed to the company by stockholders’ equity = the amount of money committed to the company by stockholders = paid-in capital + retained earnings – amount paid for share stockholders = paid-in capital + retained earnings – amount paid for share repurchasesrepurchases

Return on Assets (ROA):Return on Assets (ROA): net income divided by the book value of total assets net income divided by the book value of total assets

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Return on Equity

Popular indicator despite limitationsPopular indicator despite limitations Reflects company’s use of operating and financial leverageReflects company’s use of operating and financial leverage Simple product of three common accounting ratios:Simple product of three common accounting ratios:

ROE = Net IncomeEquity

Net IncomeSales

SalesTotal Assets

Total AssetsEquity

Profit Margin Total Asset Turnover Leverage

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RETURN ON EQUITY Implications

1.1. Profit Margin:Profit Margin: holding capital requirements constant, profit margin = useful holding capital requirements constant, profit margin = useful indicator of managerial efficiencyindicator of managerial efficiency Rich profit margins don’t guarantee high returns on stockholder equity: Rich profit margins don’t guarantee high returns on stockholder equity:

capital requirements?capital requirements? Significant capital expenditures are needed before sales revenue are Significant capital expenditures are needed before sales revenue are

generated generated

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

3.3. Leverage:Leverage: total assets divided by stockholders’ equity total assets divided by stockholders’ equity Reflects extent to which debt and preferred stock are usedReflects extent to which debt and preferred stock are used Amplifies firm profit rates over business cycleAmplifies firm profit rates over business cycle

Economic boomsEconomic booms leverage increases firm’s profit rate leverage increases firm’s profit rate Economic contractions, recession Economic contractions, recession leverage decreases firm’s profit rate leverage decreases firm’s profit rate

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What is a typical ROE?

Post WWII, ROE has fallen between Post WWII, ROE has fallen between 8-16% per year.8-16% per year.

To prosper and grow, firms need To prosper and grow, firms need consistent 12% ROE per year.consistent 12% ROE per year.

Beware when evaluating companies Beware when evaluating companies with high ROE but moderate profit with high ROE but moderate profit margins and low ROAmargins and low ROA

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QUICK QUIZ

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

a.a. the book value of stockholders’ equitythe book value of stockholders’ equityb.b. profit marginprofit marginc.c. salessalesd.d. leverageleverage

ROE = Net IncomeEquity

Net IncomeSales

SalesTotal Assets

Total AssetsEquity

Profit Margin Total Asset Turnover Leverage

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Firm Size Measures From investor’s perspective, is firm size important?From investor’s perspective, is firm size important?

Large companies with market cap > $5 billion are less riskyLarge companies with market cap > $5 billion are less risky Liquid market for sharesLiquid market for shares Large size may limit future growth opportunitiesLarge size may limit future growth opportunities

EX: EX: Invest $10,000 in MSFT at the time it first went publicInvest $10,000 in MSFT at the time it first went public after 15 years it after 15 years it

grows to $5 million grows to $5 million 500:1 payoff 500:1 payoff Next 15 years keep 500:1 payoff Next 15 years keep 500:1 payoff impossible; because with it’s current impossible; because with it’s current

market cap in excess of $500 billion, it would imply a market cap of more 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 than $250 trillion, which is 10 times the current market cap of all companies traded on all global equity markets.companies traded on all global equity markets.

Financial economists argue that total market capitalization of common stock (market Financial economists argue that total market capitalization of common stock (market cap) is best available indicator of future profits.cap) is best available indicator of future profits.

Market cap = discounted net present value of all future profits (value of firm)Market cap = discounted net present value of all future profits (value of firm)

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FIRM SIZEAccounting Indicators

Sales = Gross Receipts = RevenueSales = Gross Receipts = Revenue

Net Worth:Net Worth: sum of common and preferred sum of common and preferred stockholders’ equitystockholders’ equity

Book Value Per Share:Book Value Per Share: common shareholders’ equity common shareholders’ equity divided by number of shares outstandingdivided by number of shares outstanding

Total Assets:Total Assets: stockholders’ equity plus total liabilities stockholders’ equity plus total liabilities

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KEY TERMSStock Valuation & Financial Analysis

Price/Earnings (P/E) RatioPrice/Earnings (P/E) Ratio

Earnings YieldEarnings Yield

Price/Book RatioPrice/Book Ratio

Dividend YieldDividend Yield

Total ReturnTotal Return

Balance SheetBalance Sheet

Income StatementIncome Statement

Cash-flow StatementCash-flow Statement

Historical CostHistorical Cost

Current CostCurrent Cost

Replacement CostReplacement Cost

Intangible AssetsIntangible Assets

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Valuation Indicators Not all stocks carry same degree of risk.Not all stocks carry same degree of risk. What is a reasonable price? Relative economic value?What is a reasonable price? Relative economic value? Valuation yardsticks:Valuation yardsticks:

P/E ratio:P/E ratio: stock price/earnings per share stock price/earnings per share P/E = 20:1 P/E = 20:1 investors buying at the current market price is paying $20 for $1 in earnings per investors buying at the current market price is paying $20 for $1 in earnings per

share (How about P/E = 30:1?)share (How about P/E = 30:1?) E/P ratio:E/P ratio: earnings yield earnings yield——earnings per share/price compared to Treasuriesearnings per share/price compared to Treasuries

P/E = 20:1 P/E = 20:1 E/P = 1/20 = 5% E/P = 1/20 = 5% P/E of 20:1 is paid P/E of 20:1 is paid earnings yield on the investment is 5% earnings yield on the investment is 5% (How about P/E = 30:1?) (How about P/E = 30:1?)

P/B ratio:P/B ratio: stock price/accounting net worth (on per share basis) stock price/accounting net worth (on per share basis) Accounting net worth = accounting book value = total assets – total liabilitiesAccounting net worth = accounting book value = total assets – total liabilities P/B usually >1: According to GAAP accounting book value numbers often neglect to include P/B usually >1: According to GAAP accounting book value numbers often neglect to include

intangible assets such as valuable brand namesintangible assets such as valuable brand names Dividend yield:Dividend yield: dividend income as percentage of price paid dividend income as percentage of price paid

Current market price = $40, dividend = $1 per year Current market price = $40, dividend = $1 per year Dividend yield = $1/$40 = 2.5% per year. Dividend yield = $1/$40 = 2.5% per year. Total return:Total return: sum of dividend income plus capital appreciation sum of dividend income plus capital appreciation——dividends can offset market dividends can offset market

losseslosses

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Are Stock Prices Too High?As of January, 2000

P/E ratios for DJIA stocks at high end of rangeP/E ratios for DJIA stocks at high end of range——20:120:1

Earnings yield at low end of rangeEarnings yield at low end of range

P/B on DJIA ratios quite high P/B on DJIA ratios quite high

Dividend yields at record low as of Jan. 2000Dividend yields at record low as of Jan. 2000

Stock valuation program models flashing warning Stock valuation program models flashing warning signalssignals

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Growth Indicators

Sales growthSales growth Building revenuesBuilding revenues

Building loyal customer base—dotcomsBuilding loyal customer base—dotcoms

EPS (earnings-per-share) growthEPS (earnings-per-share) growth

Dividend growthDividend growth

Book value growthBook value growth

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FINANCIAL STATEMENTSBalance Sheets

Balance Sheet:Balance Sheet: “snapshot” information about “snapshot” information about company well-being at a specific timecompany well-being at a specific time Total assets always equal total liabilities plus Total assets always equal total liabilities plus

stockholders’ equitystockholders’ equity

Current assetsCurrent assets——cash, cash equivalents, and cash, cash equivalents, and inventoriesinventories

Increase in accounts receivable can be item for Increase in accounts receivable can be item for concernconcern

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FINANCIAL STATEMENTS Income Statements

Income Statements:Income Statements: Ongoing view of dynamic Ongoing view of dynamic changechange Net Revenues:Net Revenues: gross revenues less returns, gross revenues less returns,

discounts, allowancesdiscounts, allowances Operating Net Income:Operating Net Income: difference between net difference between net

revenues and operating costs and expensesrevenues and operating costs and expenses Net after-tax income divided by number of shares Net after-tax income divided by number of shares

is EPS (stock options alsois EPS (stock options also——fully diluted EPS)fully diluted EPS)

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FINANCIAL STATEMENTSCash-Flow Statements

Show changes in company’s cash position and gives Show changes in company’s cash position and gives clear view of health of company’s ongoing operationsclear view of health of company’s ongoing operations Sources of Income:Sources of Income: net cash net cash——operating, financing, and operating, financing, and

investing activitiesinvesting activities Operating Cash Flow:Operating Cash Flow: net income plus noncash charges net income plus noncash charges——

depreciation and amortizationdepreciation and amortization Financing Activities:Financing Activities: purchase/sale of company stocks or purchase/sale of company stocks or

bondsbonds Investing Activities:Investing Activities: additions to plant and equipment, additions to plant and equipment,

changes in short-term investments, mergers, acquisitionschanges in short-term investments, mergers, acquisitions

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Problems With Accounting Information

Historical focus problemHistorical focus problem Historical Cost:Historical Cost: actual cash outlay actual cash outlay Current Costs:Current Costs: amount that must amount that must

be paid under prevailing market be paid under prevailing market conditionsconditions

Replacement Costs:Replacement Costs: cost of cost of duplicating productive capability duplicating productive capability by using current technologiesby using current technologies

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PROBLEMOverlooking Intangible Assets

Intangible Assets:Intangible Assets: valuable holdings that have no physical form valuable holdings that have no physical form gap between book values per share and stock prices: physical gap between book values per share and stock prices: physical

assets account for about 15% of total assetsassets account for about 15% of total assets high tech firms feature even wider gaphigh tech firms feature even wider gap traditional methods fail to capture rapid growthtraditional methods fail to capture rapid growth difficulty identifying and measuring value of:difficulty identifying and measuring value of:

brandsbrands distribution networksdistribution networks advertisingadvertising R&D expendituresR&D expenditures