I'm Larry Walfur, this is principlesofaccounting.com, chapter 15.
In this module we will continue with our discussion of earnings per share and
other key indicators.
The previous module looks specifically at earnings per share.
Now we're going to see how earnings per share can be used in other
performance indicators, beginning with the price/earnings ratio.
Which is simply the market price of a company's stock
per share divided by the earnings per share.
Companies will have significant differences in their price/earnings ratio.
Other investors might be willing to pay a high multiple for
a company with a bright future, or maybe a low multiple for a company that's had
a good history of earnings but maybe the future doesn't look so bright.
Generally you try to find good value which is, when you're buying stocks,
which is looking for a low price/earnings ratios,
but that's not always the case because again you need to consider
the past as well as the future prospects for a company.
So value [INAUDIBLE] earnings is a bit tricky in that regard.
Sometimes people will look at a peg ratio,
which is the price earnings ratio divided by the company's growth rates.
A lower peg rate ratio numbers may help to identify more attractive investments .
These are generalizations every situation is unique of course.
If a company is growing at 20% per year
versus a company that's growing at 10% per year, obviously all of the things being
equal you would rather buy the investment that has the higher growth rate.
So this is a calculation that integrates the P/E
ratio with the company's growth rate.
Another ratio that should be looked at is the book value per share.
This is the common equity divided by the common shares outstanding
at the balance sheet date.
Book value is not the same as market value or fair value.
Book value is based upon amounts reported in the balance sheet.
Many assets many be carried at historical cost and certainly there
are certain things that may not appear on the balance sheet at all.
Or certain things that appear on the balance sheet that may not be readily
convertible to value such as certain intangibles a brand name or
something of that nature.
For a corporation with only one class of stock, we'll say common stock outstanding,
the book value per share calculations is not too difficult.
It's the total stockholder's equity divided by the shares outstanding at
the end of the period.
For example, here's a company with a book value of $24 per share.
It's 12 million in equity divided by 500,000 shares.
Here's their Stockholder's Equity.
Here's the $12,000,000 of total equity divided by the 500,000
shares issued in outstanding to give us that book value per share.
When we introduced preferred stock into the calculation of book value per share
we get a bit more complex scenario.
We need to determine how much of the total stock holder's equity is available to
the preferred shares.
And how much remains of the residual amount that's available to
the common equity.
The amount attributable to the preferred stock is generally considered to be
the call price of the preferred stock plus any amounts that are due for
current and prior periods dividend.
So lets assume that Meurer's Corporation has the following equity structure.
We've got preferred stock $100 par value callable at 110.
6% cumulative, 300,000 shares authorized, 100,000 shares issued and outstanding.
So although the par value is $10,000,000, the call price is $11,000,000,
a 110% of the par value.
So to get rid of those guys would take $11,000,000 plus we would also
need to pay the dividends.
The annual dividend is 6% of par or
$6 a share on a hundred thousand shares is $600,000.
The notes to the financial statements from Mueller corporation suggested that last
year's dividend did not been paid,
the current year's dividend did not been paid on the preferred stock.
They owe $600,000 for two years so we've got the eleven million dollar call price.
Another $1200000 of dividends,
theoretically it would take $12200000 to liquidate the preferred
shareholders if we dispersed that amount of the $36200000 total equity.
Dispersing $12200000 would leave $2400000 residual equity for the common shares.
And we would divide that by the 600,000 common shares to
come up with $40 book value per share in this particular case.
The calculations are shown in the textbook.
The dividend rate, it's the annual cash divided by the market price per share.
Some companies do not pay dividends.
They choose to reinvest in new money making ventures.
Or they may not be making money at all, in which case,
they can't pay dividends necessarily.
But dividend paying companies are often evaluated and
valued based on their dividend paying right.
And certainly, there's a certain class of investors who are very interested in that
annual dividend or periodic dividend.
If a company pays $1 per share each year of dividends and
the stock is selling for $20 a share, we would say it has a 5% yield.
The dividend pay out rate compares the annual cash dividends to the earnings
per share.
It evaluates whether a company's capable of sustaining its dividend rate.
For example, the company earn $3, per share,
payed out $1 in dividends on $3 in earnings, it's pay out rate would be .333.
On the other hand if earnings were only 50 cents per share but
the company continued to pay out its dollar, its pay out rate would be 2.
So, when you would see that particular company you'd say, well
there's some issue with the ability of the company to continue to pay that dividend.
The dividend safety is in question If the payout ratio is two,
you're paying out twice as much as you're earning.
That's unsustainable over a long term basis.
Return on assets is net income plus interest expense divided by average
assets.
The ratio of the calculation of the ratio varies by analyst.
You may see a little bit different twist on this in other textbooks.
It assesses how effectively assets are being utilized to generate profits.
Notice that it excludes financing costs and focuses on operating income,
hence we're adding back the interest cost to the net income.
It's often used to compare profitability and efficiency for
companies in similar industries.
Return on equity is the net income minus the prefered dividends
divided by the average common equity, somewhat akin to that book
value calculation we looked at with prefered stock.
It's used to compare the effectiveness of capital utilization by different firms,
however, it does not evaluate risk.
A firm with a high return on equity may rely heavily on debt financing.
The debt exposes the business to significant risk.
So you're not always interested in a high return on equity if you're getting there
at the extent of risking the business by being highly leveraged.
Return on equity can be compared to the rate of interest on borrowed funds to
assess how effective a company is in utilizing borrowed funds.
Or how effective they are in utilizing their leverage if
the return on equity exceeds the cost of borrowed funds or
the interest rate associated with borrowed funds.
You can generally conclude for
that period of time that they're using the borrowed funds effectively.
On the other hand, if the return on equity is less than the cost of borrowed funds,
then actually that debt's helping dig a hole.
We're not covering the cost of the borrowed funds operationally and
it suggests we're not being effective in utilizing borrowed funds.