©Cambridge Business Publishers, 2013 FINANCIAL STATEMENT ANALYSIS & VALUATION Third Edition Peter D. Mary LeaGregory A.Xiao-Jun EastonMcAnallySommersZhang

©Cambridge Business Publishers, 2013

FINANCIAL STATEMENT ANALYSIS & VALUATION

Third Edition

Peter D. Mary Lea Gregory A. Xiao-JunEaston McAnally Sommers Zhang


Module 8: Module 8:

Equity Equity Recognition Recognition and Owner and Owner FinancingFinancing


Stockholders’ EquityStockholders’ EquityTotal stockholders’ equity is divided into Total stockholders’ equity is divided into two components:two components:

1.1. Contributed capitalContributed capital - proceeds received by the issuing company from original stock issuances, net of the amounts paid to repurchase shares of the issuer’s stock from its investors.

2.2. Earned capitalEarned capital - Retained earnings and accumulated other comprehensive income (AOCI).

In addition, many companies report an equity In addition, many companies report an equity account called account called noncontrolling interestnoncontrolling interest, which , which reflects the equity of minority shareholders.reflects the equity of minority shareholders.


Components of Paid-in-Components of Paid-in-CapitalCapital


P&G’s Stockholders’ EquityP&G’s Stockholders’ Equity


Types of StockTypes of Stock

There are two classes of stock:There are two classes of stock:1.1. Preferred Stock Preferred Stock

2.2. Common StockCommon Stock Preferred stock preferences:Preferred stock preferences:

1.1. Dividend preferenceDividend preference – preferred – preferred shareholders receive dividends on their shareholders receive dividends on their shares before common shareholders do. shares before common shareholders do.

2.2. Liquidation preferenceLiquidation preference –preferred –preferred shareholders receive payment in full shareholders receive payment in full before common shareholders in before common shareholders in liquidation.liquidation.


Preferred Stock PrivilegesPreferred Stock Privileges

1.1. Conversion privilegesConversion privileges – a – a conversion privilege allows conversion privilege allows preferred stockholders to convert preferred stockholders to convert their shares into common shares at their shares into common shares at a predetermined conversion ratio. a predetermined conversion ratio.

2.2. Participation featureParticipation feature – allows – allows preferred shareholders to share preferred shareholders to share ratably with common stockholders ratably with common stockholders in dividends.in dividends.


Fortune Brands’ Fortune Brands’ Convertible Preferred StockConvertible Preferred Stock


Fortune Brands’ Fortune Brands’ Convertible Preferred StockConvertible Preferred Stock

Holders of convertible preferred are entitled to $2.67 Holders of convertible preferred are entitled to $2.67 dividends per share.dividends per share.

Each share of convertible preferred stock is entitled to Each share of convertible preferred stock is entitled to 3/10 of a vote per share.3/10 of a vote per share.

Holders of convertible preferred have a preference in Holders of convertible preferred have a preference in liquidation over common shareholders amounting to liquidation over common shareholders amounting to $30.50.$30.50.

Each share of convertible preferred is convertible into Each share of convertible preferred is convertible into 6.601 shares of common stock. 6.601 shares of common stock.

Fortune Brands has an option to redeem each share at a Fortune Brands has an option to redeem each share at a price of $30.50; upon redemption, the preferred price of $30.50; upon redemption, the preferred shareholder will receive that cash amount and will shareholder will receive that cash amount and will surrender that share to the company.surrender that share to the company.


P&G’s P&G’s PreferrPreferr

ed ed StockStock


Aon’s Common StockAon’s Common Stock

Par value of $1 per share. Par value of $1 per share. Aon has authorized the issuance of 750 million shares.Aon has authorized the issuance of 750 million shares. To date, Aon’s management has issued (sold) 385.9 To date, Aon’s management has issued (sold) 385.9

million shares of stock.million shares of stock. Aon has repurchased 53.6 million shares from its Aon has repurchased 53.6 million shares from its

shareholders.shareholders. The number of outstanding shares is equal to the The number of outstanding shares is equal to the

issued shares less treasury shares. There were 332.3 issued shares less treasury shares. There were 332.3 million (385.9 million – 53.6 million) shares million (385.9 million – 53.6 million) shares outstanding at the end of 2010.outstanding at the end of 2010.


P&G’s Common StockP&G’s Common Stock


Sale of Stock IllustratedSale of Stock Illustrated

1.1. Cash increases by $4,300,000 (100,000 shares @ $43 Cash increases by $4,300,000 (100,000 shares @ $43 per share)per share)

2.2. Common stock increases by the par value of shares Common stock increases by the par value of shares sold (100,000 shares @ $1 par value = $100,000)sold (100,000 shares @ $1 par value = $100,000)

3.3. Additional paid-in capital increases by the $4,200,000 Additional paid-in capital increases by the $4,200,000 difference between the issue proceeds and par value difference between the issue proceeds and par value ($4,300,000 - $100,000)($4,300,000 - $100,000)

To illustrate, assume that AON issues 100,000 shares of its $1 par value common stock at a market price of $43 cash per share:


Repurchase of Stock Repurchase of Stock IllustratedIllustrated

To illustrate, assume that 3,000 common shares of AON previously issued for $43 are repurchased for $40:


Repurchase of Stock Repurchase of Stock IllustratedIllustrated

Now assume that these 3,000 shares are subsequently resold for $42 cash per share::


Aon’s Treasury Stock Aon’s Treasury Stock Section Section

ofof 2010 Balance Sheet2010 Balance Sheet


Accounting for Stock Accounting for Stock OptionsOptions


Aon’s Aon’s Stock Stock Option Option PrograProgra

mm


Cisco’s Stock Option Cisco’s Stock Option ExpenseExpense


Accounting for Restricted Accounting for Restricted StockStock


Accounting for Dividends: Accounting for Dividends: Cash DividendsCash Dividends

Aon declares and pays a cash dividend of $10 million:


Preferred and Common Preferred and Common DividendsDividends

Assume that a company has 15,000 shares of Assume that a company has 15,000 shares of $50 par value, 8% preferred stock $50 par value, 8% preferred stock outstanding and 50,000 shares of $5 par outstanding and 50,000 shares of $5 par value common stock outstanding.value common stock outstanding.

During its first three years in business, the During its first three years in business, the company declares $20,000 dividends in the company declares $20,000 dividends in the first year, $260,000 of dividends in the first year, $260,000 of dividends in the second year, and $60,000 of dividends in the second year, and $60,000 of dividends in the third year. third year.

If the preferred stock is cumulative, the total If the preferred stock is cumulative, the total amount of dividends paid to each class of amount of dividends paid to each class of stock in each of the three years follows:stock in each of the three years follows:


Preferred and Common Preferred and Common Dividends Dividends (c(continuedontinued))


Accounting for Dividends: Accounting for Dividends: Stock DividendsStock Dividends


Small Stock Dividends Small Stock Dividends IllustratedIllustrated

Assume that a company has 1 million shares of Assume that a company has 1 million shares of $5 par common stock outstanding. It then $5 par common stock outstanding. It then declares a small stock dividend of 15% of the declares a small stock dividend of 15% of the outstanding shares when the market price of the outstanding shares when the market price of the stock is $30 per share. This small stock dividend stock is $30 per share. This small stock dividend has the following financial statement effects:has the following financial statement effects:


Large Stock Dividends Large Stock Dividends IllustratedIllustrated

To illustrate the effect of a large stock To illustrate the effect of a large stock dividend, assume that the company now dividend, assume that the company now declares a large stock dividend of 70% of the declares a large stock dividend of 70% of the outstanding shares when the market price of outstanding shares when the market price of the stock is $30 per share ($5 par value). the stock is $30 per share ($5 par value). The large stock dividend will have the The large stock dividend will have the following effects on the balance sheet:following effects on the balance sheet:


Stock Splits in the Form of Stock Splits in the Form of a a

Stock Dividend – John Stock Dividend – John DeereDeere


Aon’s Accumulated Aon’s Accumulated Other Comprehensive Other Comprehensive

IncomeIncome


Foreign Currency Translation Foreign Currency Translation Effects on the Balance SheetEffects on the Balance Sheet


Noncontrolling InterestNoncontrolling Interest Noncontrolling interest represents the equity of Noncontrolling interest represents the equity of

noncontrolling (minority) shareholders who only noncontrolling (minority) shareholders who only have a claim on the net assets of one or more of the have a claim on the net assets of one or more of the subsidiaries in the consolidated entity.subsidiaries in the consolidated entity.

If the company acquires less than 100% of the If the company acquires less than 100% of the subsidiary, it must include 100% of the subsidiary’s subsidiary, it must include 100% of the subsidiary’s assets, liabilities, revenues and expenses in its assets, liabilities, revenues and expenses in its consolidated balance sheet and income statement, consolidated balance sheet and income statement, but now there are two groups of shareholders that but now there are two groups of shareholders that have a claim on the net assets and earnings of the have a claim on the net assets and earnings of the subsidiary company:subsidiary company: The parent company, and The parent company, and The noncontrolling shareholders (those shareholders The noncontrolling shareholders (those shareholders

who continue to own shares of the subsidiary who continue to own shares of the subsidiary company).company).


Noncontrolling Interest: Noncontrolling Interest: Income StatementIncome Statement


Noncontrolling Interest: Noncontrolling Interest: Balance SheetBalance Sheet


Analysis and Interpretation Analysis and Interpretation of Noncontrolling Interestof Noncontrolling Interest

The return on equity (ROE) computation The return on equity (ROE) computation is usually performed from the perspective is usually performed from the perspective of the parent company’s shareholders. of the parent company’s shareholders.

Consequently, Consequently, the numerator is usually the net income the numerator is usually the net income

attributable to the parent company attributable to the parent company shareholders and shareholders and

the denominator includes only the equity of the denominator includes only the equity of the parent company’s shareholders the parent company’s shareholders (excluding noncontrolling interest equity).(excluding noncontrolling interest equity).


Equity Carve OutsEquity Carve Outs

Corporate divestitures have become Corporate divestitures have become increasingly common as companies seek increasingly common as companies seek to increase shareholder value through to increase shareholder value through partial or total divestiture of operating partial or total divestiture of operating units. units.

In general, these equity carve outs are In general, these equity carve outs are motivated by the notion that motivated by the notion that consolidated financial statements often consolidated financial statements often obscure the performance of individual obscure the performance of individual business units, thus complicating their business units, thus complicating their evaluation by market analysts. evaluation by market analysts.


Equity Carve Outs: Conoco’s Equity Carve Outs: Conoco’s Sell-OffSell-Off

Conoco received $4.6 billion in cash, which it reported as a component of cash flows from investing activities in its statement of cash flows.

The Syncrude joint venture was reported on Conoco’s balance sheet at $1.75 billion on the date of sale.

Conoco’s gain on sale equaled the proceeds ($4.6 billion) less the carrying amount of the business sold ($1.75 billion), or $2.85 billion which Conoco rounds to $2.9 billion in the footnote referenced above.

Conoco subtracts the gain on sale in computing net cash flows from operating activities to remove the gain from net income; cash proceeds are reported as a cash inflow in the investing section.


Equity Carve Outs: Equity Carve Outs: Altria’s Spin-Off of KraftAltria’s Spin-Off of Kraft


Equity Carve Outs: Equity Carve Outs: Altria’s Spin-Off of KraftAltria’s Spin-Off of Kraft


Equity Carve Outs: Equity Carve Outs: BMY’s Split-off of Mead BMY’s Split-off of Mead

JohnsonJohnson

The Treasury Stock account on Bristol-Myers’ balance sheet The Treasury Stock account on Bristol-Myers’ balance sheet increased (became more negative) by $6.9 billion (269 million increased (became more negative) by $6.9 billion (269 million shares x $25.70 per share), which reduced equity by $6.9 billion. shares x $25.70 per share), which reduced equity by $6.9 billion.

This reduction was offset, however, by the recognition of a gain This reduction was offset, however, by the recognition of a gain on the exchange amounting to $7.2 billion after tax. on the exchange amounting to $7.2 billion after tax.

This split-off was affected by a tender offer with Bristol-Myers This split-off was affected by a tender offer with Bristol-Myers shareholders. Consequently, it is a non pro rata exchange and is, shareholders. Consequently, it is a non pro rata exchange and is, therefore, valued at market value with a resulting gain. therefore, valued at market value with a resulting gain.

The net effect on equity is minimal, but the income statement The net effect on equity is minimal, but the income statement reports a substantial gain for that year.reports a substantial gain for that year.


Xilinx’s Convertible Xilinx’s Convertible SecuritiesSecurities


Xerox’s Convertible Xerox’s Convertible Preferred StockPreferred Stock


Global AccountingGlobal Accounting

Under IFRS, accounting for equity is Under IFRS, accounting for equity is similar to that under U.S. GAAP. Following similar to that under U.S. GAAP. Following are a few terminology differences:are a few terminology differences:


Global AccountingGlobal Accounting

U.S. GAAP has a more narrow definition of U.S. GAAP has a more narrow definition of liabilities than IFRS. Therefore, more items are liabilities than IFRS. Therefore, more items are classified as liabilities under IFRS.classified as liabilities under IFRS. For example, some preferred shares are deemed For example, some preferred shares are deemed

liabilities under IFRS and equity under GAAP.liabilities under IFRS and equity under GAAP. Treasury stock transactions are sometimes Treasury stock transactions are sometimes

difficult to identify under IFRS because difficult to identify under IFRS because companies are not required to report a separate companies are not required to report a separate line item for treasury shares on the balance line item for treasury shares on the balance sheet. Instead treasury share transactions sheet. Instead treasury share transactions reduce share capital and share premium.reduce share capital and share premium.


End Module 8End Module 8

Documents

©Cambridge Business Publishers, 2013 FINANCIAL STATEMENT ANALYSIS & VALUATION Third Edition Peter D. Mary LeaGregory A.Xiao-Jun EastonMcAnallySommersZhang