1 Chapter 8 Common Stock Basics. 2 Opening Chapter Statement This chapter looks at common stock valuation within the context of the firm’s economic fundamentals

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Chapter 8

Common Stock Basics

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Opening Chapter Statement

• This chapter looks at common stock valuation within the context of the firm’s economic fundamentals. – In the short run, stock prices change in

mysterious ways. – In the long run, stock prices rise only with

basic improvement in the firm’s earnings capacity.

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Buying Part of a BusinessBusiness Valuation

• In the U.S., common stocks have vastly outperformed all other types of financial assets during the 20th century.– Post WWII Common Stock average annual rates of return:

• 12 – 14%

– Bond and Money Market Instrument returns averaged closer to:

• 5 - 6%

• After taxes and inflation, bonds and money market instruments are losing propositions– Municipals might be the exception on some cases

• Stocks are big winners.

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• Long-term investors in common stock fair better than long-term investors in bonds.– A company issues debt at a rate of interest that is less

than the expected rate of return on the investment.– Since the long-run rate of return on common stocks is 12-

14% per year, the long-term average rate of return on investment also falls in the range between 12-14% per year.

– If a 6% interest rate is paid on long-term corporate bonds, the company’s expected profit margin on borrowed funds is in the range of 6 –8%, or 12-14% minus 6%.

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• Unlike corporate bonds, which represent debt, common stocks represent part ownership in a corporation

• Ownership is in direct proportion to the relative amount of shares owned– Ownership of 1% of the total o/s shares = 1%

ownership of the corporation

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• In the long run:– the prospects for profiting from stock market investing

are tied directly to the real economic prospects of the underlying business.

• If an investor buys and holds stock in an attractive business with large and rapidly growing profits:– Long-term investment success will follow

• If an investor buys and holds shares in a company with poor economic prospects:– Sub-par investment returns will follow.

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• If someone seeks to “time the market” (quickly profit from the hard-to-predict swings in volatile stock prices) through quick in-and-out-trading activity:– The higher transaction costs and taxes tied to such

speculation guarantee sub-par long-term results.

• In the short-run, speculators “sometimes” profit from the impossible-to-predict short-run twists and turns in the market.

• In the long-run, investors profit when they buy and hold shares in “attractive” businesses.

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Buying Part of a BusinessInvestment versus Speculation

• Stock market investment – is the process of buying and holding stock for dividend income and long-term capital appreciation

• Investors seek to profit by sharing in the normal and predictable good fortune of companies with inherently attractive economic prospects.– Success depends on:

• Careful examination of the economic characteristics of the business in which one is investing

• Is it a good business?• Actual success of the business company profitability

– Capital Appreciation – Growing Stream of Dividend Income

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• Stock market speculation – is the purchase or sale of securities on the expectation of capturing short-term trading profits from share price fluctuations tied to temporary good fortune of a given company– Success depends on:

• Hard-to-predict changes in basic economic conditions

• Investor psychology

• Luck

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• This course focuses on the “investment process”– In the long-run, stock market investors can do

no better than the companies in which they invest.

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• If share ownership is maintained in highly profitable companies that grow:– A growing stream of dividend income and

capital appreciation can be anticipated

• If shares are bought in companies with inferior rates of profitability and poor growth prospects:– Poor investor returns are ensured

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• The first criteria defining an attractive investment must be a superior rate of profitability.

• A rapidly growing company with poor profits in a bad business is a poor investment choice.

• Investors must detect corporate profitability• The most important question:

• Is this a good business?

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Measuring ProfitabilityAbsolute Measures

• The most useful indicator of business quality is a consistently high level of profitability

• A good business returns consistently high profits relative to the amount of capital used.

• A high and growing stream of business profits over time would not require additional capital resources.

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• The Best Businesses are self-financing• Sufficient profits are generated to fund all

investment needs

• Very few “good” businesses require substantial capital investment prior to the receipt of significant revenues and cash-flow income.

• Mediocre businesses commonly require significant up-front capital investment.

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• Business Profit Measures:• Net Profit: difference between revenues and

expenses often expressed after taxes.• Basic Earnings per Share (EPS): net income

divided by the number of shares outstanding– Look for growth in EPS over time

• Fundamental important determinant of future share prices• Must allow for Stock Splits

– EPS is not comparable between different organizations• Different number of shares o/s, etc.• Only compare EPS over time for the same organization

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• Fully Diluted Earnings per Share: net income divided by the number of shares outstanding, after consideration for the possible conversion of stock options

• High tech industries – Management and employees stock options

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• Net Income is a useful indicator of profit-generating ability, but has limitations:– Will grow with the simple increase in the scale

of the operations

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Measuring ProfitabilityRelative Measures

• Relative Measures are: Between-Firm comparisons• Profit Margin – profit earned per dollar of sales

– Accounting net income as a percentage of sales revenue– Rate of return on sales– Shows the amount of profit earned per dollar of sales– Useful indicator of managerial efficiency in responding to

rapidly growing demand and / or effective measures of cost containment

• When profit margins are high:– The company is operating at a high level of efficiency and/or– Competitive pressure is modest

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• Business profit rates are also measured by the accounting Rate of Return on Stockholders’ Equity (ROE): Net income divided by the book value of stockholders’ equity.– How profitable a company is in terms of each dollar

invested by shareholders– Shows the rate of profit earned on funds committed to the

enterprise by its owners, the stockholders.– Limitations:

• Historical (lower) Book values can inflate ROE• Can be influenced by share buybacks and other types of corporate

restructuring

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• Stockholders’ equity: Total assets minus total liabilities.– Book value of stockholders’ equity: is the

amount of money committed to the the enterprise by stockholders.

– Sum of paid-in capital and retained earnings, minus any amount paid for share repurchases

• Return on Assets: Net income divided by the book value of total assets

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• Financial Statements do not reflect the hard-to-measure extent of “future” liabilities – i.e. tobacco industry

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Measuring ProfitabilityElements of ROE

ROE =Net Income

Equity

Net Income

Sales

Sales

Total Assets

Total Assets

Equity

Profit Margin Total Asset Turnover Leverage

•Many investors regard ROE as the best indicator of corporate Profitability.

•ROE can be described as the product of three common accountingRatios:

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• Profit Margin: net income / sales (previously discussed)– High Profit margins don’t guarantee a high rate of return on

stockholders’ equity (ROE)

• Must consider the magnitude of capital requirements for a firm or industry.

• Significant capital expenditures may be required before meaningful sales revenues can be generated– Heavy equipment manufacturing– Cable TV– Motion Picture Production

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• Total Asset Turnover: Sales revenue divided by the book value of total assets– When total asset turnover is high, the firm makes its

investments work hard in the sense of generating sales volume– High rates of total asset turnover can allow efficient firms to

earn attractive rates of return on stockholders’ equity despite modest profit margins

• Grocery• Apparel Retailing• Wal Mart• Home Depot

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• Leverage: the ratio of book value of total assets divided by stockholders’ equity– Reflects the extent to which debt and preferred stock

are used in addition to common stock financing

– During economic booms/expansions – leverage can dramatically increase the firm’s profit rate

– During economic recessions or contractions – leverage can dramatically decrease realized rates of return or lead to huge losses

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Measuring ProfitabilityWhat is Typical ROE?

• For a typical year during the post-World War II period, the average ROE tends to fall in a range between 12% and 14%.

• In general, firms must produce at least an ROE of 12% per year to grow and prosper– Below this level:

• Sources of financing tend to dry up and the firm withers and dies

– Above this level: • New debt and equity financing is easy to obtain• Growth by new and established competitors is rapid

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• When ROE is at or above 12% per year:– Generally sufficient to compensate investors for the

risk involved with a typical business enterprise

• When ROE consistently falls far below 12% per year:– Profit rates are generally insufficient to compensate

investors for the risks undertaken.

• However: when business risk is somewhat lower than average a somewhat below-average profit rate is adequate.

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• How is it possible to know if business profit rates in any given circumstance are sufficient to compensate investors for the risks undertaken?– Shareholders and bondholders inform

management of their risk/return assessment of the firm’s performance on a daily basis.

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• If performance is below the minimum required:– Bond and stock prices will fall.

– For privately held companies:• bank financing will be hard to obtain

• If performance is good:– Bond and stock prices will rise

– For privately held companies:• bank financing will be easy to obtain

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Firm Size MeasuresMarket Capitalization

• Market Cap: Market Value of the firm– # of shares of stock outstanding times the

market price of the stock• In financial theory: discounted net present value of

all future profits

• Best indicator of future profits.

• Synonymous with the value of the firm.

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Firm Size MeasuresAccounting Indicators

• Sales: Gross Receipts• Revenue: Sales• Net Worth: Sum of common plus preferred

stockholders’ equity.– Measures the total amount committed to the enterprise

by equity investors

• Book Value per Share: Common shareholders’ equity divided by the number of shares outstanding– Measures the contribution of common stockholders

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Firm Size MeasuresAccounting Indicators

• Total Assets: Stockholders’ equity plus total liabilities– The Right side of the balance sheet =

• Stockholders’ Equity plus Total Liabilities

– The Left side of the balance sheet = • Total Assets

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Firm Size MeasuresDoes Size Matter?

• Does Size Matter? Yes!• Large-cap stocks less risky than mid-cap or small-cap

stocks– Large liquid market for shares– Long history of earnings and dividend growth– Stood the test of time– May operate in a variety of domestic and global markets– Typically involved in different lines of business -

diversification• Citigroup - Virtual financial supermarket: Credit Cards, Investment

Banking, Brokerage (Salomon Smith Barney), Travelers Insurance, Financial Planning, operate in 40 countries

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Firm Size MeasuresDoes Size Matter?

• However!

• Large size:– Limits opportunities for above-average future

growth • Start-up companies typically have the largest

growth in their early years and can’t repeat indefinitely

– i.e. Microsoft

– Elephants don’t run like jackrabbits

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Valuation IndicatorsP/E Ratio

• Based on lofty expectations for future earnings growth– Stock prices may be bid up– Stock prices crumble, if growth does not

materialize

• Based on pessimistic consensus concerning a company’s economic prospects:– Stock prices may linger at meager valuations

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• The overall stock market is not always priced the same.

• At times:– A cheery consensus regarding favorable future earnings

growth and moderate inflation causes investors to:• bid up stock prices.

• At other times:– A gloomy consensus (expected onset of an economic

recession or an unexpected upward spike in interest rates) causes investors to:

• dump stocks, and prices in general fall sharply

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• Stock analysts and investors use various valuation measures to arrive at what they think is a reasonable price for a given stock or for stocks in general.– Just as you wouldn’t pay $100,000 for a

Chrysler minivan, – Neither would a knowledgeable investor pay

$100 for a share of stock that has an economic value closer to $15 or $20 per share.

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• Perhaps the most common valuation yardstick used to measure relative value is the -

• Price Earnings (P/E) Ratio: Stock price divided by earnings per share– P/E of 20:1 – means that an investor is buying at the current

market price is paying $20 for $1 in earnings per share– When a P/E ratio of 20:1 is paid, the earnings yield, or E/P

ratio, is 5% (1/20)– Why would an investor settle for an earnings yield on on an

investment of only 5% in a market environment in which risk-free short-term Treasury bills might also pay roughly 5%?

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• High P/E ratios only make sense when:– High future earnings growth anticipated– Investor Confidence

• DJIA P/E Ratios usually fall between 10:1 and 20:1

• Stock prices are regarded as: – high when P/Es are greater than 20:1 and – cheap when P/Es are less than 10.1.

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Valuation IndicatorsP/B Ratio and Dividend Yield

• Many investors judge whether a stock is expensive on the basis of its current market price relative to the accounting book value per share.

• Price/Book (P/B) Ratio: Stock price divided by accounting net worth (total assets minus total liabilities) or equity

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• Accounting book values are historical values – as mandated by GAAP

• Neglect important intangibles:– Valuable brand names– Copyrights– Patents

• Therefore, stock prices exceed book values and typically average more than 1:1– DJIA P/B typical Range – 1.5:1 to 2:1– Prices below this range are considered cheap– Prices above this range are considered high

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• Dividend yield is a third popular measure of relative valuation.

• Dividend yield: Dividend Income expressed as a percentage of the amount paid for a stock.– Dividend / Stock price

– If, the stock is selling for $40 per share, with a 25 cent quarterly dividend $1 dividend per year:

• Dividend Yield = ($1 / $40) or 2.5%

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• Dividends play an important role in determining an investor’s total return

• Total Return: Sum of dividend income plus capital appreciation.

• Over the long term – dividend income can represent between 1/3 to ½ of the total return earned on common stocks

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• Since 1950, DJIA companies have paid an average 4% dividend and provided capital appreciation of roughly 8% per year. (.04 / .12 = .333 or 1/3)

• A riskier stock that paid no dividends would have to grow by 12% per year, or 50% faster than the 8% growth typical of the average DJIA stock, to provide a competitive long-term rate of return.

• High dividends serve as a protective cushion when the overall market declines.

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Valuation IndicatorsAre Stock Prices Too High?

• As per Table 8.4, page 309– P/E and P/B ratios for the DJIA rose to historic

highs during the late 1990s– Dividend yield plummeted to historic lows.

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• Are (were) stock prices too high?

• Stock market valuation models have been flashing warning signals since the end of 1996 when Federal Reserve Board Chairman Alan Greenspan first waned of “irrational exuberance”.

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• The market’s assumptions about risk and long-term earnings growth, were unusually optimistic.– Market prices have since made some downward

correction.

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Growth IndicatorsSales Growth

• The most valuable overall indicator of change or “top-line” growth in a firm’s business prospects is revenue growth or sales growth.– Generating Sales (building revenue) is the first step in

establishing a valuable business.

– Without sales, cost-cutting and operating efficiency are irrelevant.

– However, rapid sales growth doesn’t insure long-term success.

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Growth IndicatorsEPS Growth

• When an investor purchases a share of stock, part ownership of the corporation is established.– From the investor’s standpoint, it’s what

happens to the value of that part ownership that is most important.

– The rate of EPS growth is a vital determinant of the value of the firm.

• EPS can be distorted by one-time write-offs.

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Growth IndicatorsEPS Growth

• If long-term investors identify and hold companies with above-average EPS growth, such investors can anticipate above-average long-term rates of return.

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Growth IndicatorsDividend and Book Value Growth

• A large and growing stream of dividend income is one of the most powerful benefits of common stock ownership.– Dividend growth data can be overstated

following dividend interruptions or initiations.

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Growth IndicatorsDividend and Book Value Growth

• The rate of change in accounting book value per share over time is another useful indicator of corporate growth.

• Book-value growth generated internally stems from a rapid buildup in retained earnings– Investors must be cautious when book-value growth

merely stems from accounting adjustments or other external factors.

– Favorable when book-value growth is accompanied by rapid sales growth.

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Financial Statement AnalysisBalance Sheet

• Balance Sheet: “Snapshot” information about company financial well-being at a specific point in time.– Can be obtained from the company’s annual

report (usually on web site) or 10k report to the SEC (Edgar).

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• Rapid declines in cash or short-term investments of a firm might suggest– problems with collections or– accrual accounting problems with the

estimation of operating expenses

• Rapid increase in “older” accounts receivables might be cause for concern for– Collection problems

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• Rapid buildup in finished goods inventory might suggest softening product demand.

• Capital Structure or use of financial leverage can be determined:– Amount of accounts payable, accrued

compensation,other payables, and Long term debt (bonds) used to finance assets vs.

– Funds raised from stock issuance and retained earnings.

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Financial Statement AnalysisIncome & Cash-Flow Statements

• Income Statement: Ongoing view of dynamic change. Provides a vital measure of ongoing performance.– “Video”– Depicts the rate of change occurring in a

company’s operating performance.– Shows Operating Net Income

• Difference between net revenues and operating costs and expenses

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• Net after-tax income is divided by the number of shares outstanding to arrive at basic earnings per share.– Can be misleading when a large number of stock

options to top executives and employees are outstanding (diluted EPS)

• Accrual accounting errors or bias sometimes reduces the income statement value as a measure of economic performance.

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• Cash-Flow Statement: Change in the company’s cash position.– Provides an interesting perspective on change

in the company’s economic position.

• Cash Flow has 3 primary sources:– Operating Activities– Financing Activities– Investing Activities

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• “Operating” Cash Flow:– Change in company liquidity as captured by changes in

asset and liability accounts (balance sheet) and net income plus non-cash charges of depreciation / amortization (income statement).

• Cash Flow provided by or used for “Financing Activities” include transactions involving:– Purchase and/or sale of the company’s own stocks and

bonds.

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• Cash flows provided by or used for “Investing Activities” include:– Additions to plant and equipment

– Changes in short-term investments

– Mergers and acquisitions

• Together, the Income Statement and the Cash-Flow Statement give investors a clear view of the health of the company’s ongoing operations.

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Problems with Accounting InformationHistorical Focus Problem

• Balance Sheet data provide a historical record of the firm’s “past” investments and the decisions made to finance those investments.

• Income Statement information gives insight concerning the “present” flow of revenues and costs, as measured using GAAP.

• The reliance on historical rather than forward-looking perspectives can create problems for investors.

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• Current costs are typically much more relevant.

• Current Cost: is the amount that must be paid under prevailing market conditions.– Influenced by:

• Market Conditions - measured by the number of buyers and sellers

• The present state of technology• Inflation, etc.

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• For assets purchases recently:– historical cost and current cost are typically the same.

• For assets purchases several years ago:– historical cost and current cost are different.

• Since WWII, inflation has been an obvious source of large differences between current and historical costs throughout most of the world.– With an inflation rate of roughly 5% per year, prices

double in less than 15 years and triple in roughly 22 years.

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• Traditional accounting methods and the IRS rely heavily on the historical cost concept because it: – can be applied consistently across firms

– is easily verifiable

• Investors must be able to adjust historical accounting information to account for undervalued or overvalued assets on the firm’s balance sheet.

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• Historical costs:– Provide a measure of the market value of an

asset at the time of purchase.

• Current costs:– Are a measure of the market value of an asset at

the present time.

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• Regarding the U.S. savings and loan (S&L) industry debacle during the late 1980s:– On an historical cost basis:

• almost all thrifts appeared to have solid assets to back up liabilities

– On a current cost basis:• many S&Ls proved insolvent • assets had a current market value below the current

value of liabilities.

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• Current costs don’t always exceed historical costs:– Computers and many types of electronic

equipment cost much less today than they did just a few years ago.

• In many high-tech industries, the rapid advance of technology has overcome the general rate of inflation.– Current costs are falling

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• Current costs for computers and electronic equipment are determined by what is referred to as Replacement Costs: the costs of duplicating productive capability by using current technology.– The value of used personal computers tends to fall by

25-30% per year.

– When investors value such assets, the appropriate measure is the much lower replacement costs – not the historical cost.

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• Economic worth as determined by “profit-generating capability”, rather than “accounting value”– Is always the most vital consideration when

determining the investment value of specific assets.

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Problems with Accounting InformationThe Problem of Overlooking Intangible Assets

• Many of the most valuable assets owned by some corporations are its Intangible Assets: Valuable holdings that have no physical form.– Company reputation– Brand names– Patents– Copyrights

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• Investors have clearly decided that historical accounting book value and earnings information have little role to play in assessing the investment merit of individual issues.

• Problems involved with identifying and measuring intangible assets make setting clear and appropriate accounting standards difficult.

• The existence of intangible assets is measured by “future” economic benefits– Not by any costs that might have been incurred at some

point in the past.

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• Anything that is commonly bought and sold has future economic benefit.

• For the Coca-Cola Company, the Coca-Cola brand name is clearly its most valuable asset.– Coca-Cola’s flawless brand-name reputation explains

the company’s sterling profits and why the company sells at a P/B ratio of 14.9:1

– The book value of zero for the Coca-Cola brand name seems a little low!

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• Accounting balance sheet information and income and cash-flow statements – Offer only a distorted view of true economic

performance for many companies

• Investors should become adept at carefully analyzing and adjusting traditional accounting statements for important: – “off balance sheet” and

– “off income statement” information.

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Answers to Selected End of Chapter 8 Questions

and Suggested Study

• Study the following end-of-chapter questions:

• 1. (a)• 2. (b)• 3. (d)• 6. (b)• 9. (c)• 12. (c)

• 13. (a)• 14. (c)• 15. (c)• 16. (a)• 18. (d)

• Read the Chapter • Read the Chapter

“Summary” • Review the Power Point

Presentation

Documents

1 Chapter 8 Common Stock Basics. 2 Opening Chapter Statement This chapter looks at common stock valuation within the context of the firm’s economic fundamentals