Often stock is split to lower the price per share so it is more accessible to investors. The stock split is not taxable.

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1 Reading: Chapter 8 Chapter 8. Stock: Introduction 1. Rights of stockholders 2. Cash dividends 3. Stock dividends 4. The stock split 5. Stock repurchases and liquidations 6. Preferred stock 7. Analysis of financial statements 8. Securities selection, and the Internet 9. Analysis of cash flow 1. Corporations and Rights of Stockholders Stock is a security representing ownership in a corporation. A corporationis an economic unit chartered by a state. Under state laws, a certificate of incorporationis issued to the corporation. The corporation also receives a charterthat specifies the relation with the state. Bylawsare established to specify the relationship with stockholders, including such issues as voting rights. Rights of Stockholders The stockholders elect a board of directors that selects the corporation s management. Traditional method of voting: Each share gives the stockholder the right to vote for one individual for EACH seat on board of directors. Cumulative voting: Each stockholder can cast all his or her votes for one candidate for the corporation s board of directors. Preemptive rights: The right of current some stockholders to maintain their proportionate ownership in the corporation Dividends Cash dividends Firms have two options with the profits they make: Distribute to stockholders as dividends Retain the profits for firm use. Different types of dividends: Cash dividends: e.g.: $0.50 per share Stock dividends: e.g.: 0.1 extra share of stock for every stock one owns 2.1. Different Dividend Policies Regular dividend: e.g.: quarterly dividend distribution Extra dividend: e.g.: an extra bonus dividend at the end of the year in addition to regular dividends Irregular dividend: e.g. no set dividend payment. Dividends are paid when the management makes such a decision

2 2.2. Payout Ratio & Retention Ratio Payout ratio = Dividends / Earnings Retention ratio= 1 - Payout ratio = 1-(Dividends/Earnings) Example: Firm XYZ s earnings are $2 million for the year. The management decides to distribute $0.5 million of the earnings as cash dividends and retain the rest. What is the payout ratio? What is the retention ratio? Answer: Payout ratio = 0.5 million / 2 million =25% Retention ratio = 1 Payout ratio = 1-25%=75% 2.3. Distribution of Dividends Dates are very important for dividend distribution because stock prices may be affected. Declaration date: The day the firm management declares a dividend and establishes date of record and date of distribution. Ex-dividend date: Two trading days prior to the date of record. If a stock is purchased after the ex-dividend date, the purchaser does not receive the dividend while the seller retains the dividend payment. Date of record: The day on which an investor must own shares in order to receive the dividend payment. Distribution date: The date on which a dividend is paid to stockholders on the date of record Dividend Reinvestment Plans Dividend reinvestment plans (DRIP) are plans that permit stockholders to have cash dividends reinvested in stock instead of receiving cash. Method 1: Often additional shares are purchased in the secondary market. New shares are not issued. Brokerage firms often offer this service. Method 2. Company sells shares from its own reserve. Advantages of DRIP Save of commissions. Often plans are automatic a form of forced saving. Tax implications: Treated as cash dividends received and subject to federal tax. 3. The Stock Dividend A stock dividend is a dividend paid in the form of stock. A stock dividend Does not affect proportionate ownership, total assets, total liability, and total equity A stock dividend is a form of recapitalization, which is an alternation in a firm s sources of finance. The overall balance sheet does not change, but funds are moved among individual categories on a balance sheet When a stock dividend is distributed, the stockowner has more shares, but the share price will drop. As such, the total value (number of shares * share price) is unchanged. The old shares thus are being diluted. Example: A 10% stock dividend causes a $20 stock price to fall to $18.18 $20/(1+10%)=$18.18 The stock dividend is not taxable. 4. The Stock Split A stock split increases the number of shares in a company and decreases the price per share. It is a form of recapitalization just like stock dividend. Does not affect proportionate ownership, total assets, total liability, and total equity Often stock is split to lower the price per share so it is more accessible to investors. The stock split is not taxable

3 5. Stock Repurchases & Liquidations Corporations with cash may reduce the number of existing shares through buy-back programs as an alternative to distributing dividends. The decision to sell rests with the stockholder. Repurchased shares are generally held in the firm s treasury for future use. The decrease in outstanding shares may: Increase earnings per share, and/or Increase the price of the stock. Tax implications: If one sells the stocks back to the company under a repurchase plan, the money received are realized capital gains, As such it is subject to capital gains taxation. Corporate Liquidations Corporate liquidations are rare. Company: Ceases operations; Pays off its liabilities, and Distributes its remaining assets to stockholders. Stockholders do not have the option of refusing to sell Preferred Stock Preferred stock is an equity instrument that usually pays a fixed dividend that is not guaranteed but receives preference over common stock dividends. Dividends paid from firm s earnings. If the firm does not have enough earnings to pay preferred stock dividends, the dividend is said to be in arrears. Typically arrearage needs to be paid in the future before any dividends are paid to common stock holders. This type of preferred stock is called cumulative preferred stock. Non-cumulative preferred stock erases the arrearage. Preferred stocks act somewhat like bonds Both make fixed payments. Both use the same valuation model. Bonds are debt, but preferred stocks are equity. Virtually all bonds have a maturity date; preferred stocks may be perpetual. From the issuing company's perspective bonds are riskier than preferred stocks. Bonds interest payment legally binding Preferred stocks dividends not legally binding From the investor's perspective preferred stock is riskier than bonds for the same reason Analysis of Financial Statements The Balance Sheet shows Assets = Liability + Equity. Thus it has information on Assets Liabilities Equity The Income Statement is used to determine a firm s income by looking at its Revenues Expenses On can find companies consolidated balance sheet and income statement online. Yahoo Finance -> company s tick symbol -> 10-K report through Edgar online -> 10-K report contains these financial statements. 17 Financial Ratios Financial Ratios may be the most frequently used tool to analyze a company. We will use the numbers in the Hershey statements for our financial ratio analyses. 18 3

4 7.1.Liquidity Ratios Liquidity is the ease with which assets may be quickly converted into cash without the firm s incurring loss. Higher liquidity ratios are good for creditors who are concerned with being paid. Three methods of measuring liquidity: Current Ratio = Total current assets / Total current liabilities The Quick Ratio = (Total current assets - Inventories) / Total Current liabilities The Components of Current Assets: To rank current assets with regard to their degree of liquidity and to determine the proportion of each asset in relation to total current assets Current Ratio Current Ratio = Total current assets / Total current liabilities E.g. Hershey Current Ratio for 2008= $1,345.0 / $1,270.2 = 1.06 For most industries, it is desirable to have more current assets than current liability, i.e. the current ratio should be greater than The Quick Ratio The Quick Ratio = (Total current assets - Inventories) / Total Current liabilities E.g. Hershey s Quick Ratio = ($1, ) / $1,270.2 = 0.59 The Quick Ratio is also called the Acid Test Ratio. The quick ratio takes into consideration that various types of current assets have various degrees of liquidity. For example, cash is a lot more liquid than inventory. The Quick Ratio is a more precise measure of liquidity than the current ratio. Higher Quick Ratio -> better liquidity 7.2. Activity Ratios Activity ratios indicate at what rate the firm is turning its inventory and accounts receivable into cash. The more rapidly the firms turns over its inventory and receivable, the better position the firm is in to pay its liabilities as they become due. A high receivable turnover is a good sign the firm can pay its liabilities, but may also indicate that the firm is offering large discounts, which could result in lower profits. Four activity ratios Inventory turnover = Sales / average inventory Average collection period = Accounts receivable / sales per day Receivable turnover = Sales / accounts receivable Fixed assets turnover = Sales / fixed assets Inventory turnover Inventory turnover = Sales / average inventory It measures the speed with which inventory is sold. For average inventory we use the average throughout the year. Often we can use the average of two years. Average inventory for 2008 and 2007 was ($592.5+$600.2)/2= $596.1 Inventory turnover = $ / $596.1 = 8.6 This indicates that inventory turns over 8.6 times each year, or about once every 6 weeks Average Collection Period Average collection period is the number of days required to collect accounts receivable. It is also called Days Sales Outstanding. Average collection period = Accounts receivable / sales per day Average collection period = $445.2 / ($5,132.8 / 360) = 31.2 Note often 360 days are used instead of 365. This indicates that the firm takes 31 days to convert its receivables into money

5 Receivables Turnover Receivable turnover is another way of viewing the average collection period. Receivable turnover = Annual sales / accounts receivable The larger the ratio, the more rapidly the firm turns its credit sales into cash. Hershey example Receivable turnover = $5,132.8 / $445.2 = 11.5 Indicating that receivables are paid off on the average of every 1 month (12 months/11.5). This is the same information given with the average collection period information on previous slide Fixed Asset Turnover Fixed assets are the firms plant and equipment. Fixed asset turnover = Sales / fixed assets This ratio indicates the amount of plant and equipment that were used to generate the firm s sales. Fixed assets turnover = $5,132.8 / $1,458.9 = 3.52 Hershey generated $3.52 in sales for every $1 invested in plants and equipment Total Assets Turnover Total Assets Turnover = Annual sales / Total assets This ratio considers the firms sales relative to all of the assets. Total assets turnover = $5,132.8/$3,634.7=1.4 This means that Hershey generated $1.4 of sales for every dollar of total assets invested Profitability Ratios The amount of profit a firm earns is particularly important for investors. Profitability measures are measures of performance that indicate the amount the firm is earning relative to some base, such as sales, assets, or equity. There are six commonly used profitability ratios: 1. Gross profit margin = (Revenues Cost of goods sold)/sales 2. Operating profit margin = Operating earnings / Sales 3. Net profit margin = Earnings after taxes / Sales 4. Return on assets = Earnings after taxes / Total assets 5. Return on equity = Earnings after taxes / Equity 6. Return on common equity = (Earnings after taxes Preferred stock dividends) / (Equity Preferred stock) Gross Profit Margin Gross profit margin = (Sales Cost of goods sold)/sales Gross profit margin for 2008 = ($5, ,375.1) / $5,132.8 = 34.2% This means the firm earned $0.342 on every dollar of sales before considering administrative expenses, depreciation, and financing costs. The gross profit margin measure is sensitive only to changes in the cost of goods sold Operating Profit Margin Operating profit margin is the percentage earned on sales before adjusting for nonrecurring items, interest, and taxes, but after adjusting all operating expenses. Operating profit margin = Operating earnings / Sales Operating profit margin in 2008= $589.9 / $5,132.8 = 11.5% This means Hershey earned about $0.115 on every dollar of sales before considering interest expenses and income taxes. Changes in advertising or depreciation affect this measure, but does not affect the gross profit margin measure

6 Net Profit Margin Net profit margin is the ratio of earnings after interest and taxes to sales. Net profit margin = Earnings after taxes / sales Net profit margin in 2008 = $311.3/ $5,132.8 = 6.1% This means Hershey earned $0.061 on every one dollar of sales after taxes and interest are subtracted. Net profit margin adds the impact of financing expenses and taxes on profitability. A change in income tax rates affects net profit but not operating profits Return on Assets Return on assets is the ratio of earnings to total assets. It measures the return on the firm s resources (i.e., assets). Return on assets = Earnings after taxes / total assets Return on assets in 2008 = $311.3/ $3,634.7= 8.6% This means Hershey earned $0.086 on every dollar of assets in This measure gives an overall measure of the firm s performance. However it does not tell how well the management is performing for the stockholders. For that purpose the return on equity measure is better Return on Equity Equity is the sum of stock, additional paid-in capital (if any), and retained earnings (if any). Return on equity measures the amount that the firm is earning on the stockholders investment. Return on equity = Earnings after taxes / Equity Return on equity for 2008 = $311.3 / $318.1 = 97.9% This means that Hershey earned $0.979 on every dollar of equity Return on Common Equity If the company has preferred stocks in addition to common stocks, many common stock investors may be concerned not with the return on the firm s total equity but with the return on common stock. If that is the case then the return on common equity is a useful measure. Return on common equity = (Earnings after taxes Preferred stock dividends) / (Equity Preferred stock) Return on common equity in 2008 = ($ ) / ($ ) = 97.9% Note in this case Hershey does not have any preferred stock so that number is zero Leverage (Capitalization) Ratios Financial leverage means the use of borrowed funds to acquire assets. Firms use financial leverage to magnify the return on stockholders investments. The use of financial leverage may be measured by two commonly-used capitalization ratios: Debt to equity ratio = Debt / Equity Debt to total assets ratio = Debt / Total assets Capitalization ratios give an indication of risk. Firms that have high capitalization ratios are considered to involve greater risk. On the other hand, financial theory suggests that there is an optimal combination of debt and equity financing that maximizes the value of a firm Debt-to-Equity Ratio Debt to equity ratio = Debt / Equity Debt to equity ratio in 2008 = $3,284.8 / $318.1 = 10.3 This means for Hershey, there was $10.3 debt for every $1 of stock

7 7.4.2.Debt-to-Total Assets Ratio Debt-to-total assets ratio = Debt / Total assets Debt-to-total assets ratio in 2008 = $3,284.8 / $3,634.7 = 90.4% This means that debt was used to finance 90.4% of the firm s assets Coverage Ratios Coverage ratios measure the firm s ability to service its debt. These ratios indicate how much the firm is earning relative to what is owed. The most important coverage ratio is the timesinterest-earned ratio: Times-interest-earned = Earnings before interest and taxes / Annual interest expense Times-Interest-Earned Ratio Times-interest-earned = Earnings before interest and taxes / Annual interest expense Times-interest-earned for 2008 = $589.9 / $97.9 = 6.03 This means Hershey has operating income of $6.03 for every $1 of interest expense. A decline in the times-interest-earned ratio indicates declining income relative to debt. It serves as an early warning of a deteriorating financial position and the increased probability of default on interest payment. The times-interest-earned ratio can be computed for each type of debt issue to reflect senior debt vs. subordinated debt Times-dividend-earned + Earnings per preferred share Times-dividend-earned=Earnings after tax / Dividends on preferred stock Earnings per preferred share = Earnings after tax / Number of preferred shares outstanding For both of these ratios, the larger they are, the safer the dividend payments. Hershey does not have preferred stocks so these two ratios do not apply Specialized Ratios Specialized ratios have been developed for certain industries. E.g., Pharmaceutical companies: R&D expense relative to sales. Occupancy ratio for commercial properties. Ratios of firms within an industry Tend to have similar numerical values Differences in numerical values are reasons for further analysis 8. Security Selection and the Internet One should realize that one ratio by itself can be misleading. One should either (1) Compare individual ratios for a firm over a period of time to establish norms for the firm or (2) Compare the individual firm s ratios to an industry average. However in many cases it is difficult to define what an industry is. Caution needs to be exercised. Analysts need to be aware of the weaknesses of financial ratios so adjustments can be made in either construction of ratios or interpretation of results

8 How Are These Ratios Useful? Financial ratios help investors understand a company s financial position. However they themselves do not answer the question of whether a particular stock should be bought or not. Most of these financial ratio information are on the Internet. The purpose of this chapter is for you to know these ratios exist, and to understand what they mean when you see them. Stockholders are concerned with Return on equity, Ability of the firm to maintain its dividend Earnings growth. An investor can use ratio criteria, such as return on equity >=15%, as a first cut. 9. Analysis of Cash Flow Financial ratio analysis put most of the emphasis on a firm s balance sheet and income statement. However, because net earnings may be affected by nonrecurring items or need not to represent cash, many analysts place more emphasis on cash flow. The argument is that the cash flow generated by a firm s operations is a better indication of its profitability and value. Thus instead of isolating income, these analysts determine the capacity of the firm to generate cash and use this information for their valuation of the firm Statement of Cash Flows Statement of cash flows is an accounting statement that enumerates a firm s cash inflows and cash outflows. Textbook page 291 : A statement of cash flows for Hershey Food Corporations for 2006, 2007, and The statement has three sections: (1) Operating activities, (2) Investment activities, and (3) Financing activities Each of the three sections enumerates the inflow and outflow of cash. An analysis of the statement of cash flows aims to determine changes in firm s cash position with an emphasis on the firm s ability to generate cash Cash Inflows and Outflows Cash inflows are: A decrease in an asset (Selling asset yields cash) An increase in a liability (Borrowing money yields cash) An increase in equity Cash outflows are: An increase in an asset (Using cash to buy asset) A decrease in a liability (Using cash to pay off debt) A decrease in equity Cash Flows Basically, cash inflows and outflows tell us where the firm generated cash and how the funds were used. In the case of Hershey, one can learn: Hershey experienced an increase in cash from operations, which was used to buy plant and equipment, and pay cash dividends. These outflows exceeded the cash inflows from operations. The net effect was to reduce the firm s cash position. Note the definition of cash flow can be different depending on the context. Using Cash Flow for Stock Valuation One can compute cash flow per share for stock valuation purpose. This number is then used in a way similar to the P/E ratio. One can also use cash flow as a substitute for earnings and dividends in the dividend-growth model. With this method estimated future cash flows are discounted back to present The present value of future cash flows is used to valuate the stock, just like the present value of all dividends can be used to valuate the stock

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