OCW041: Reporting and Analyzing Equity

Reporting Stockholders’ Equity

Equity (beginning of year) + net income − dividends +/− gain/loss from changes to the number of shares outstanding = Equity (end of year).

Learning Objectives

Explain how a company would report changes in stockholder’s equity

Key Takeaways

Key Points

  • The book value of equity will change relative to changes in the firm’s assets ( liabilities, depreciation, new issue, and stock repurchase).
  • The book value of equity will change as there are changes in the firm’s assets. This includes changes to liabilities, depreciation, new issue, and stock repurchase.
  • The market value of shares in the stock market does not correspond to the equity per share calculated in the accounting statements.

Key Terms

  • share repurchase: Stock repurchase (or share buyback) is the reacquisition by a company of its own stock. In some countries, including the U.S. and the UK, a corporation can repurchase its own stock by distributing cash to existing shareholders in exchange for a fraction of the company’s outstanding equity; that is, cash is exchanged for a reduction in the number of shares outstanding. The company either retires the repurchased shares or keeps them as treasury stock, available for re-issuance.

Reporting Stockholders ‘ Equity

In financial accounting, owner’s equity consists of an entity’s net assets. Net assets are the difference between the total assets of the entity, and all its liabilities. Equity appears on the balance sheet of financial position, one of the four primary financial statements. “”

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Balance Sheet: Shareholders’ equity in a balance sheet.

A statement of shareholder ‘s equity provides investors with information regarding the transactions that affected the stockholder’s equity accounts during the period.

The book value of equity will change in the case of the following events:

  • Changes in the firm’s assets relative to its liabilities. For example, a profitable firm may receive more cash for its products than the cost at which it produced the goods, and so in the act of making a profit, it increases its assets.
  • Depreciation. For example, equity will decrease when machinery depreciates. Depreciation is registered as a decline in the value of the asset, and as a decrease in shareholders’ equity on the liabilities side of the firm’s balance sheet.
  • Issue of new equity in which the firm obtains new capital and increases the total shareholders’ equity.
  • Share repurchases, in which a firm gives back money to its investors, reducing its financial assets, and the liability of shareholders’ equity. For practical purposes (except for its tax consequences), share repurchasing is similar to a dividend payment, as both consist of the firm giving money back to investors. Rather than giving money to all shareholders immediately in the form of a dividend payment, a share repurchase reduces the number of shares, thereby increasing the percent of future income and distributions garnered by each remaining share.

The market value of shares in the stock market does not correspond to the equity per share calculated in the accounting statements. Stock valuations, which are often much higher, are based on other considerations related to the business’s operating cash flow, profits, and future prospects. Some factors are derived from the accounting statements.

Equity (beginning of year) + net income − dividends +/− gain/loss from changes to the number of shares outstanding = Equity (end of year).

Dirty Surplus Accounting

Dirty surplus accounting involves the inclusion of other comprehensive income or unusual items in net income, which will consequently flow into retained earnings. These items can skew net income and provide information that could be misleading. A prime example of dirty surplus accounting is the inclusion of unrealized gains or losses on treasury stocks, or securities they are holding for sale.

The main problem with dirty surplus accounting is that unusual items that affect shareholders equity can be easily hidden. Employee stock options are a good example of expenses that may not explicitly show up on the income statement. ESOs can, in actuality, cost shareholders a large sum; therefore, it is important for investors to realize the magnitude of these costs in order to correctly value a firm’s equity.

Earnings per Share

Earnings per share (EPS) is the amount of a company’s earnings per each outstanding share of a company’s stock.

Learning Objectives

Explain how a company would calculate their earnings per share

Key Takeaways

Key Points

  • Companies’ income statements must report EPS for each of the major categories of the income statement: continuing operations, discontinued operations, extraordinary items, and net income.
  • The EPS formula does not include preferred dividends for categories outside of continued operations and net income.
  • EPS (basic formula) = Profit / Weighted Average Common shares. EPS (net income formula) = Net income / Average Common shares. EPS (continuing operations formula) = Income from continuing operations / Weighted Average Common shares.
  • Diluted Earnings Per Share (diluted EPS) is a company’s earnings per share (EPS) calculated using fully diluted shares outstanding (i.e. including the impact of stock option grants and convertible bonds).

Key Terms

  • discontinued operations: A discontinued operation is a component of an enterprise that has either been disposed of, or is classified as “held for sale”, and also represents a separate major line of business or geographical area of operations; and is part of a single, co-ordinated plan to dispose of this separate major line of business or geographical area of operations; or is a subsidiary acquired exclusively with a view to resale.

Earnings Per Share

Earnings per share (EPS) is the amount of earnings per each outstanding share of a company’s stock. In the United States, the Financial Accounting Standards Board (FASB) requires that companies’ income statements report EPS for each of the major categories of the income statement: continuing operations, discontinued operations, extraordinary items, and net income.

The EPS formula does not include preferred dividends for categories outside of continued operations and net income. Earnings per share for continuing operations and net income are more complicated; any preferred dividends are removed from net income before calculating EPS. This is because preferred stock rights have precedence over common stock. If preferred dividends total $100,000, then that money is not available to distribute to each share of common stock.

Earnings Per Share (Basic Formula): “”

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Earnings Per Share: Basic formula

Earnings Per Share (Net Income Formula): “”

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Earnings Per Share: Net income formula

Earnings Per Share (Continuing Operations Formula): “”

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Earnings Per Share: Continuing operations formula

Only preferred dividends actually declared in the current year are subtracted. The exception is when preferred shares are cumulative, in which case annual dividends are deducted regardless of whether they have been declared or not. Dividends in arrears are not relevant when calculating EPS.

Diluted Earnings Per Share (diluted EPS) is a company’s earnings per share (EPS) calculated using fully diluted outstanding shares (i.e. including the impact of stock option grants and convertible bonds). Diluted EPS indicates a “worst case” scenario, one in which everyone who could have received stock without purchasing it directly for the full market value did so.

To find diluted EPS, basic EPS is first calculated for each of the categories on the income statement. Then each of the dilutive securities are ranked based on their effects, from most dilutive to least dilutive and antidilutive. Then the basic EPS number is diluted one by one by applying each, skipping any instruments that have an antidilutive effect.

Calculations of diluted EPS vary. Morningstar reports diluted EPS “Earnings/Share $” (net income minus preferred stock dividends divided by the weighted average of common stock shares outstanding over the past year). This is adjusted for dilutive shares. Some data sources may simplify this calculation by using the number of shares outstanding at the end of a reporting period.

Dividend Yield Ratio

The dividend-price ratio is a company’s annual dividend payments divided by market capitalization, or dividend per share divided by the price per share.

Learning Objectives

Explain how a company would use the dividend yield ratio

Key Takeaways

Key Points

  • Dividend yield is used to calculate the earning on investment (shares) considering only the returns in the form of total dividends declared by the company during the year. Its reciprocal is the Price/Dividend ratio.
  • Preferred share dividend yield is the dividend payments on preferred shares are set out in the prospectus.
  • Unlike preferred stock, there is no stipulated dividend for common stock. Instead, dividends paid to holders of common stock are set by management, usually with regard to the company’s earnings.
  • Historically, a higher dividend yield has been considered to be desirable among many investors. A high dividend yield may be evidence that a stock is under priced or that the company has fallen on hard times, and future dividends will not be as high as previous ones.

Key Terms

  • preferred share: Preferred stock (also called “preferred shares,” “preference shares,” or simply “preferreds”) is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (i.e., higher ranking) to common stock but subordinate to bonds in terms of claim (or rights to their share of the assets of the company). Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are stated in a “Certificate of Designation. “

The dividend yield or the dividend-price ratio of a share is the company’s total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share. It is often expressed as a percentage.

Dividend yield is used to calculate the earning on investment (shares) considering only the returns in the form of total dividends declared by the company during the year. Its reciprocal is the Price/Dividend ratio.

Preferred share dividend yield is the dividend payments on preferred shares, which are set out in the prospectus. The name of the preferred share will typically include its yield at par. For example, a 6% preferred share. However, the dividend may, under some circumstances, be passed or reduced. The yield is the ratio of the annual dividend to the current market price, which will vary.

Unlike preferred stock, there is no stipulated dividend for common stock. Instead, dividends paid to holders of common stock are set by management, usually with regard to the company’s earnings. There is no guarantee that future dividends will match past dividends or even be paid at all. The historic yield is calculated using the following formula:

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Current dividend yield: Current dividend yield = Most recent Full-Year Dividend / Current Share Price

For example, take a company which paid dividends totaling 1 per share last year and whose shares currently sell for $20. Its dividend yield would be calculated as follows: 1/20 = 0.05 = 5%.

The yield for the S&P 500 is reported this way. U.S. newspaper and Web listings of common stocks apply a somewhat different calculation. They report the latest quarterly dividend multiplied by 4 divided by the current price. Others try to estimate the next year’s dividend and use it to derive a prospective dividend yield. Such a scheme is used for the calculation of the FTSE UK Dividend+ Index. Estimates of future dividend yields are by definition uncertain.

Historically, a higher dividend yield has been considered to be desirable among many investors. A high dividend yield can be considered to be evidence that a stock is under priced or that the company has fallen on hard times and future dividends will not be as high as previous ones. Similarly, a low dividend yield can be considered evidence that the stock is overpriced or that future dividends might be higher. Some investors may find a higher dividend yield attractive, for instance, as an aid to marketing a fund to retail investors, or maybe because they cannot get their hands on the capital, which may be tied up in a trust arrangement. In contrast, some investors may find a higher dividend yield unattractive, perhaps because it increases their tax bill.


Source: Accounting