302922 Flashcards
An increase in the market price of a company’s common stock will immediately affect its:
earnings per share.
debt-to-equity ratio.
dividend yield.
dividend payout ratio.
dividend yield.
An increase in the market price of a company’s common stock will immediately affect its dividend yield (dividends per common share ÷ market price per common share).
The market price will not affect the debt-to-equity ratio, earnings per share, or dividend payout ratio because all these ratios use financial statement items obtained from the income statement, balance sheet, or statement of cash flows. The market price does not appear in any of those sources.
Common Stock
Common stock is ownership interest that is subordinate to all other classes of stock (and to all creditors) of the issuing corporation in participation rights and in dividend and liquidation preferences (i.e., holders of common stock are paid after debt and preferred stock obligations have been met). Common stock is also known as residual ownership interest and usually carries voting rights (at stockholders’ meetings), although some classes of common stock may be nonvoting. Common stock is often called common shares.
Debt-to-Equity Ratio
The debt-to-equity ratio is a leverage ratio that measures the relationships between total debt (current and long-term liabilities) to total equity. In other words, debt is expressed as a percentage of total equity or capitalization. When reviewing the results of this ratio, it is important to carefully identify how the two elements have been defined.
Debt can be defined as total debt, only long-term debt, total debt excluding deferred income taxes, total debt including redeemable preferred stock, etc.
Equity can be defined as total capital including or excluding preferred stock and total debt, stockholders’ equity, etc.
The computation is Debt ÷ Equity. Obviously, different definitions of debt and equity will change the results of this computation.
Issues to be aware of when analyzing this ratio:
- Since accounting principles require the use of historical costs rather than current value, the equity represented in the balance sheet can be quite different than the market value of assets less liabilities. This problem can be eliminated by restating the assets to market value. Since this information often is not available, another alternative is to use the total of the market value of the outstanding stock in place of the balance sheet stockholders’ equity; however, since stock prices can fluctuate between overvaluation and undervaluation, the use of average stock prices over the period of a year can help to eliminate market price error.
- Some analysts prefer to include preferred stock with total debt since preferred stock holds a preferential position in relation to common stock; however, failure to meet the dividend requirements of preferred stock will not have the same dire effect on the organization as failure to meet interest payments on debt. Therefore, other analysts prefer to include preferred stock with equity.
- Many analysts prefer to use ending balances to calculate this ratio since the measurement of the risk at a moment in time is desired. Transactions that occur at the end of a period can have dramatic effects on this ratio.
This ratio measures the risk contained in the capital structure of an organization. The higher the debt, the higher the risk to outside creditors that interest and principal payments will not be made on a timely basis during a period of declining earnings. One of the limitations of this ratio is that the availability of cash flows needed to meet the interest and principal repayment requirements is not measured. For example, if a long-term debt issue is repaid, the debt-to-equity ratio will improve; however, the cash available to make interest payments and principal repayments may not change significantly or could even be less than before the repayment. Since the organization’s profitability is the most reliable source of cash for interest and principal repayments, the analyst must look beyond the calculation of the debt to equity to fully understand the risk of the organization.
Dividend Yield
Dividend yield is a valuation ratio that measures the return to stockholders based on current market price per common share. It reflects the overall effect of risk and return.
The computation is Dividend per share ÷ Market price per share.
Limitations on use of this ratio—timing mismatch between numerator and denominator.
Dividends
Dividends are the distributions of cash, other corporate assets or property, or the corporation’s own stock to stockholders in proportion to the number of outstanding shares held. Accounting for dividends represents a debit to retained earnings and the establishment of a liability at the date of declaration. Dividends must meet the preferences of preferred stock first and then may be extended to common stock.
There are two types of dividends:
- Common, such as cash, stock (treasury or newly issued shares), and property
- Special, such as scrip and liquidating
Four dates are relevant to dividends: date of declaration, record, ex-dividend, and distribution (payment).
Date of declaration is the date whereby the dividend amount is decided by the board of directors for those shareholders owning stock on the date of record (usually 1 month later) and to be paid on the date of distribution. Ex-dividend date is a date prior to the date of record (see ex-dividend date).
Earnings per Share (EPS)
Earnings per share (EPS) is, generally, the allocation of a pro rata share of income to each share of common stock (EPS is not computed on preferred stock). It is a comparison of net income of an enterprise with the average number of common shares outstanding during the year.
The Financial Accounting Standards Board (FASB) has established this definition in FASB ASC 260-10-45. The required reporting for public companies is basic EPS and diluted EPS.
The standard is required for all interim and annual reports ending after September 15, 2009.
FASB ASC 260-10 applies to all entities that have issued common stock or potential common stock that trades in a public market. Potential common stock consists of other securities and contractual arrangements that may result in the issuance of common stock in the future, such as options, warrants, convertible securities, and contingent stock agreements.
Corporations with simple capital structures are required to report only basic earnings per share. Corporations with complex capital structures are required to report basic earnings per share and diluted earnings per share.
A simple capital structure is one that consists of capital stock and includes no potential for dilution via conversions, exercise of options, or other arrangements. A complex capital structure would include convertible bonds or preferred stock, outstanding options or warrants, and any contractual arrangement that would include the issuance of new shares.
Basic EPS measures the performance of an entity over the reporting period based on its outstanding common stock. The calculation is to divide the income attributable to common stock by the weighted-average number of common shares outstanding.
Diluted EPS measures the performance of an entity over the reporting period based on its outstanding common stock while giving effect to all dilutive potential shares that were outstanding. The calculation includes income attributable to common stock plus adjustments resulting from the issuance of dilutive potential common shares. This adjusted income figure is divided by the weighted-average number of common shares outstanding increased by the dilutive potential common shares.
Return on Net Worth
Return on net worth is a profitability ratio which measures the return on owners’ (common) equity. It measures the return that accrues to the owners (stockholders) after interest is paid to creditors. It measures the residual return to owners on their investment in the enterprise.
The computation is:
- Net income available to common ÷ Average common equity, or
- (Net income − Preferred dividends) ÷ Average common equity
Transformation of other ratios will also give the return on common:
- Return on common = Return on total assets ÷ (1 − Debt ratio)
There are limitations on use of this ratio.
Examples: Accrual income involves estimates and does not reflect actual cash returns. Book value of common stock reflects historical, not current, value.
2160.01
2163.02
Price-earnings ratio
The price-earnings (P/E) ratio indicates the relationship of common stock to net earnings. The market price is the investors’ perception of the future; therefore, this ratio combines the performance measure of the past (earnings per share) to perceptions of the future.
Price-earnings ratio = Price market of stock / Earnings per share
The earnings per share (EPS) computation is subject to arbitrary assumptions and accrual income. EPS is not the only factor affecting market prices.
A high P/E ratio is a possible indication of a growth company and/or of a low-risk organization.
Calculation using data from the Sample Company for 20X2 (section 2160.01):
Price-earnings ratio = Price market of stock
Earnings per share
= $17.00
$3.00
= 5.67
2163.03
Dividend yield
The dividend yield ratio shows the return to the stockholder based on the current market price of the stock.
Dividend yield = Dividend per common share / Market price per common share
Dividend payments to stockholders are subject to many variables. The relationship between dividends paid and market prices is a reciprocal one.
This ratio is calculated using the current market price; however, most of the shareholders did not purchase their shares at the current price, thus making their personal yield different than the calculated yield.
Calculation using data from the Sample Company for 20X2 (section 2160.01):
Dividend yield = Dividend per common share
Market price per common share
= $10,000 ÷ 20,000 shares
$17.00 per share
= 2.9%
2163.04
Payout ratio to common shareholders
The payout ratio to common shareholders measures the portion of net income to common shareholders that is paid out in dividends.
Payout ratio to common shareholders = Common dividends / (Net income – Preferred dividends)
Income does not necessarily measure cash available for dividend payment. Payments are heavily influenced by management policy, the nature of the industry, and the stage of development of the particular firm. All of these items diminish comparability between companies.
Organizations that have high growth rates generally have low payout ratios since most earnings are kept as retained earnings with the funds being reinvested in the company instead of providing cash dividends. A firm that has consistently paid a dividend and suddenly lowers its dividend payout often is signaling a lack of available cash and the existence of liquidity or solvency problems.
Calculation using data from the Sample Company for 20X2 (section 2160.01):
Payout ratio to common = Common dividends
shareholders Net income – Preferred dividends
= $10,000
$75,000 – $15,000
= 16.67%
2164.03
Debt-to-equity
The debt-to-equity ratio compares the book value of a company’s liabilities to the book value of its shareholder equity.
Debt to equity = Total liabilities / Total equity
This measure also assesses risk, but in a slightly different manner by reflecting total liabilities as a percent of total equity.
Debt is considered riskier because of its required payments for interest and principal by creditors. When it comes to equity, shareholders cannot demand payment from the company.
Calculation using data from the Sample Company for 20X2 (section 2160.01):
Debt to equity = Total liabilities
Total equity
= $650,000
$400,000
= 163%
