15 — Other Key Indicators in Financial Analysis

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.

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