Certain types of analysis particularly concern investors. While this chapter is not
intended as a comprehensive guide to investment analysis, it will introduce certain
types of analysis useful to the investor. In addition to the analysis covered in
this chapter, an investor would also be interested in the liquidity, debt, and profitability
ratios covered in prior chapters.
Leverage and Its Effects on Earnings
The use of debt, called financial leverage, has a significant impact on earnings. The
existence of fixed operating costs, called operating leverage, also affects earnings.
The higher the percentage of fixed operating costs, the greater the variation in income asa result of a variation in sales (revenue).
This book does not compute a ratio for operating leverage because it cannot be readily computed from published financial statements. This book does compute financial leverage because it is readily computed from published financial statements.
The expense of debt financing is interest, a fixed charge dependent on the amount of
financial principal and the rate of interest. Interest is a contractual obligation created by the borrowing agreement. In contrast to dividends, interest must be paid regardless of whether the firm is in a highly profitable period. An advantage of interest over dividends is its tax deductibility. Because the interest is subtracted to calculate taxable income, income tax expense is reduced.
DEFINITION OF FINANCIAL LEVERAGE AND
The use of financing with a fixed charge (such as interest) is termed financial leverage.
Financial leverage is successful if the firm earns more on the borrowed funds than it
pays to use them. It is not successful if the firm earns less on the borrowed funds than it pays to use them. Using financial leverage results in a fixed financing charge that can materially affect the earnings available to the common shareholders.
Exhibit 9-1 illustrates financial leverage and its magnification effects. In this illustration,
earnings before interest and tax for Dowell Company are $1,000,000. Further, the
firm has an interest expense of $200,000 and a tax rate of 40%. The statement illustrates
the effect of leverage on the return to the common stockholder. At earnings before interest and tax (EBIT) of $1,000,000, the net income is $480,000. If EBIT increases by 10% to $1,100,000, as in the exhibit, the net income rises by 12.5%. This magnification is caused by the fixed nature of interest expense. While earnings available to pay interest rise, interest remains the same, thus leaving more for the residual owners. Note that since the tax rate remains the same, earnings before tax change at the same rate as earnings after tax. Hence, this analysis could be made with either profit figure.
If financial leverage is used, a rise in EBIT will cause an even greater rise in net
income, and a decrease in EBIT will cause an even greater decrease in net income.
Looking again at the statement for Dowell Company in Exhibit 9-1, when EBIT
declined 20%, net income dropped from $480,000 to $360,000—a decline of $120,000, or 25%, based on the original $480,000. The use of financial leverage, termed trading on the equity, is only successful if the rate of earnings on borrowed funds exceeds the fixed charges.
COMPUTING THE DEGREE OF FINANCIAL LEVERAGE
Note that the degree of financial leverage represents a particular base level of income. The degree of financial leverage may differ for other levels of income or fixed charges.
The degree of financial leverage formula will not work precisely when the income statement includes any of the following items:
1. Noncontrolling interest
2. Equity income
3. Nonrecurring items
a. Discontinued operations
b. Extraordinary items
When any of these items are included, they should be eliminated from the numerator and denominator. The all-inclusive formula follows:
This formula results in the ratio by which earnings before interest, tax, noncontrolling interest, equity income, and nonrecurring items will change in relation to a change in earnings before tax, noncontrolling interest, equity income, and nonrecurring items. In other words, it eliminates the noncontrolling interest, equity income, and nonrecurring items from the degree of financial leverage.
Exhibit 9-2 shows the degree of financial leverage for Nike for 2009 and 2008. The degree of financial leverage is 1.02 for 2009 and 1.02 for 2008. This is a very low degree of financial leverage.
Therefore, the financial leverage at the end of 2009 indicates that as earnings before interest changes, net income will change by 1.02 times that amount. If earnings before interest increases, the financial leverage will be favorable. If earnings before interest decreases, the financial leverage will be unfavorable.
In periods of relatively low or declining interest rates, financial leverage looks more favorable than in periods of high or increasing interest rates. (Note: Essentially, Nike has minor financial leverage in 2009 and 2008.)
SUMMARY OF FINANCIAL LEVERAGE
Two things are important in looking at financial leverage as part of financial analysis. First, how high is the degree of financial leverage? This is a type of risk (or opportunity) measurement from the viewpoint of the stockholder. The higher the degree of financial leverage, the greater the multiplication factor. Second, does the financial leverage work for or against the owners?
Earnings per Common Share
Earnings per share—the amount of income earned on a share of common stock during an accounting period—applies only to common stock and to corporate income statements. Nonpublic companies, because of cost-benefit considerations, do not have to report earnings per share. Because earnings per share receives much attention from the financial community, investors, and potential investors, it
will be described in some detail. Fortunately, we do not need to compute earnings per share. A company is required to present it at the bottom of the income statement. Per share amounts for discontinued operations and extraordinary items must be presented on the face of the income statement or in the notes to the financial statements.
Earnings per share for recurring items is the most significant for primary analysis.
Computing earnings per share initially involves net income, preferred stock dividends declared and accumulated, and the weighted average number of shares outstanding, as follows:
Since earnings pertain to an entire period, they should be related to the common shares outstanding during the period. Thus, the denominator of the equation is the weighted average number of common shares outstanding.
The price/earnings (P/E) ratio expresses the relationship between the market price of a share of common stock and that stock’s current earnings per share. Compute the P/E ratio as follows:
Using diluted earnings per share results in a higher price/earnings ratio, a conservative computation of the ratio. Ideally, the P/E ratio should be computed using diluted earnings per share for continuing earnings per share. This gives an indication of what is being paid for a dollar of recurring earnings.
P/E ratios are available from many sources, such as The Wall Street Journal and Standard & Poor’s Industry Surveys. Exhibit 9-4 shows the P/E ratio for Nike for 2009 and 2008. The P/E ratio was 18.83 at the end of 2009 and 18.28 at the end of 2008. This indicates that the stock has been selling for about 19 times earnings. You can get a perspective on this ratio by comparing it with competitors ratio, average P/E ratio for the industry, and an average for all of the stocks on an exchange, such as the New York Stock Exchange. These averages will vary greatly over several years.
Investors view the P/E ratio as a gauge of future earning power of the firm. Companies with highgrowth opportunities generally have high P/E ratios; firms with low-growth tend to have lower P/E ratios. However, investors may be wrong in their estimates of growth potential. One fundamental of investing is to be wiser than the market. An example would be buying a stock that has a relatively low P/E ratio when the prospects for the company are much better than reflected in the P/E ratio.
P/E ratios do not have any meaning when a firm has abnormally low profits in relation to the asset base or when a firm has losses. The P/E ratio in these cases would be abnormally high or negative.
Percentage of Earnings Retained
The percentage of earnings retained is better for trend analysis if nonrecurring items are removed.
This indicates what is being retained of recurring earnings. Determine dividends from the statement of cash flows.
A problem occurs because the percentage of earnings retained implies that earnings represent a cash pool for paying dividends. Under accrual accounting, earnings do not represent a cash pool.
Operating cash flow compared with cash dividends gives a better indication of the cash from operations and the dividends paid. Chapter 10 introduces this ratio.
Many firms have a policy on the percentage of earnings that they want retained—for example, between 60% and 75%. In general, new firms, growing firms, and firms perceived as growth firms will have a relatively high percentage of earnings retained. Many new firms, growing firms, and firms perceived as growing firms do not pay dividends.
In the Almanac of Business and Industrial Financial Ratios, the percentage of earnings retained is called the ratio of retained earnings to net income. The phrase retained earnings as used in the ratio in the Almanac is a misnomer. Retained earnings in this ratio does not mean accumulated profits but rather that portion of income retained in a single year. Hence, this ratio has two different names.
Earnings per share are diluted in the formula because this is the most conservative viewpoint.
Ideally, diluted earnings per share should not include nonrecurring items since directors normally look at recurring earnings to develop a stable dividend policy.
The dividend payout ratio has a similar problem as the percentage of earnings retained. Investors may assume that dividend payout implies that earnings per share represent cash. Under accrual accounting, earnings per share do not represent a cash pool.
Most firms hesitate to decrease dividends since this tends to have adverse effects on the market price of the company’s stock. No rule of thumb exists for a correct payout ratio. Some stockholders prefer high dividends; others prefer to have the firm reinvest the earnings in hopes of higher capital gains. In the latter case, the payout ratio would be a relatively smaller percentage.
Exhibit 9-6 presents Nike’s 2009 and 2008 dividend payout ratios, which increased from 23.40% in 2008 to 32.34% in 2009. These are conservative payout ratios. Often, to attract the type of stockholder who looks favorably on a low dividend payout ratio, a company must have a good return on common equity. The dividend payout has been fairly consistent but did turn up in 2009 [2001 (22.22%); 2002 (19.51%); 2003 (19.49%); 2004 (21.08%); 2005 (21.21%); 2006 (22.35%); 2007 (24.23%)]; 2008 (23.40%); 2009 (32.34%).
Industry averages of dividend payout ratios are available in Standard & Poor’s Industry Surveys.
Although no correct payout exists, even within an industry, the outlook for the industry often makes the bulk of the ratios in a particular industry similar.
In general, new firms, growing firms, and firms perceived as growth firms have a relatively low dividend payout. Nike would be considered a growing firm.
For this ratio, multiply the fourth quarter dividend declared by 4. This indicates the current dividend rate. Exhibit 9-7 shows the dividend yield for Nike for 2009 and 2008. The dividend yield has been relatively low but did increase materially in 2009. Investors were likely satisfied with the dividend
yield for Nike.
Since total earnings from securities include both dividends and price appreciation, no rule of thumb exists for dividend yield. The yield depends on the firm’s dividend policy and the market price. If the firm successfully invests the money not distributed as dividends, the price should rise. If the firm holds the dividends at low amounts to allow for reinvestment of profits, the dividend yield is likely to be low. A low dividend yield satisfies many investors if the company has a record of aboveaverage
return on common equity. Investors that want current income prefer a high dividend yield.
Book Value per Share
A figure frequently published in annual reports is book value per share, which indicates the amount of stockholders’ equity that relates to each share of outstanding common stock. The formula for book value per share follows:
Book Value per Share ¼ Total Shareholders’ Equity Preferred Stock Equity
Number of Common Shares Outstanding Preferred stock equity should be stated at liquidation price, if other than book, because the preferred stockholders would be paid this value in the event of liquidation. Liquidation value is sometimes difficult to locate in an annual report. If this value cannot be found, the book figure that relates to preferred stock may be used in place of liquidation value. Exhibit 9-8 shows the book value per
share for Nike for 2009 and 2008. The book value increased from $15.93 in 2008 to $17.91 in 2009
The market price of the securities usually does not approximate the book value. These historical dollars reflect past unrecovered cost of the assets. The market value of the stock, however, reflects the potential of the firm as seen by the investor. For example, land will be valued at cost, and this asset value will be reflected in the book value. If the asset were purchased several years ago and is now worth substantially more, however, the market value of the stock may recognize this potential.
Book value is of limited use to the investment analyst since it is based on the book numbers.
When market value is below book value, investors view the company as lacking potential. A market value above book value indicates that investors view the company as having enough potential to be worth more than the book numbers. Note that Nike was selling materially above book value (Market 2009, $57.05).
When investors are pessimistic about the prospects for stocks, the stocks sell below book value.
On the other hand, when investors are optimistic about stock prospects, the stocks sell above book value. There have been times when the majority of stocks sold below book value. There have also been times when the majority of stocks sold at a multiple of five or six times book value.
Stock Options (Stock-Based Compensation)
Corporations frequently provide stock options (or other stock-based compensation) for employees and officers of the company. Setting aside shares for options (or other stock-based compensation) is very popular in the United States.
A basic understanding of stock option accounting (or other stock-based compensation) is needed in order to assess the disclosure of a company.
In December 2004, the FASB issued SFAS No. 123, revised (R), which is a revision of SFAS No.123, ‘‘Accounting for Stock-Based Compensation.’’ Prior to SFAS No. 123 (R), a company could elect to present the effect of stock-based compensation expense in the body of the income statement or in the notes. Under SFAS No. 123 (R), the effect of stock-based compensation must be presented in the income statement (disclosure detail can be in the notes).
The Securities and Exchange Commission accepted SFAS No. 123 (R), except for the compliance dates. In April 2005, the Commission issued revised compliance dates. The Commission rule allows companies to implement SFAS No. 123 (R) at the beginning of their fiscal year, instead of the next reporting period, which begins after June 15, 2005 (or December 15, 2005 for small-business issuers).
SFAS No. 123 (R) resulted in greater international comparability in the accounting for sharebased transactions. In February 2004, the IASB issued a reporting standard that requires all entities to recognize an expense for all employee services received in share-based payment transactions, using a fair-value-based method that is similar in most respects to the fair-value–based method established in SFAS No. 123 (R).
Two terms that are particularly important to understanding SFAS No. 123 (R) are grant date and vested. The grant date is the date at which an employer and an employee reach a mutual understanding of the key terms and conditions of a share-based payment award. The employer becomes contingently obligated on the grant date to issue equity instruments or transfer assets to an employee who renders the requisite service.1 A share-based payment award becomes vested at the date that the
employee’s right to receive or retain shares, other instruments, or cash under the award is no longer contingent on satisfaction of either a service condition or a performance condition.2 Key provisions of SFAS No. 123 (R) are as follows:
1. It requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award.
2. The option expense will be recognized over the period during which an employee is required to provide service in exchange for the award (usually the vesting period).
3. A public entity will initially measure the cost of employee services received in exchange for an award of liability instruments based on its current fair value.
4. The notes to financial statements of both public and nonpublic entities will disclose information to assist users of financial information to understand the nature of share-based payment transactions and the effects of these transactions on the financial statements. Warren E. Buffett, one of the world’s richest persons and likely the world’s most famous investor, had been critical of firms that do not recognize option expense in the body of the income statement. His view was that option expense needed to be considered when evaluating the performance of a company.
When stock prices decline, is there a value to holding stock options? A decline in stock prices could make the existing stock options worthless. But many companies rewrite the options with a lower price when the stock declines. Thus, for the holders of the options, it becomes a situation of ‘‘tails I win, heads I win.’’ Buffett tells the following story relating to stock options:
A gorgeous woman slinks up to a CEO at a party and through moist lips purrs, ‘‘I’ll do anything—anything— you want. Just tell me what you would like.’’ With no hesitation, he replies, ‘‘Reprice my options.’’3
In July 2003, Microsoft Corporation announced that it would stop issuing stock options to employees and instead give them restricted stock. This was a defining event in the popularity of restricted stock
and the reduction in stock option plans.
With restricted stock, employees cannot sell their shares until a certain amount of time passes, and
employees may have to forfeit their shares if they leave before vesting. Often, a portion of the shares
vest each year for three, four, or five years. For some restricted stock, an employee forfeits the shares
if certain financial targets are not met. With restricted stock, the expense is booked by companies in a manner similar to the new requirement for expensing options.
Some employees prefer restricted stock over options because they receive actual shares of stock.
Usually, the employee receives dividends. This may occur before the stock has vested.
Traditionally, restricted stock was only awarded to top executives, possibly along with options. In anticipation of a standard requiring expensing of options, firms started to issue restricted stock to a broad group of employees instead of options, sometimes in conjunction with options.
For Nike, as shown in Exhibit 9-9, restricted stock was included in the total stock-based compensation expense
Stock Appreciation Rights
Some firms grant key employees stock appreciation rights instead of stock options or in addition to stock options. Stock appreciation rights give the employee the right to receive compensation in cash or stock (or a combination of these) at some future date, based on the difference between the market price of the stock at the date of exercise over a preestablished price.
The accounting for stock appreciation rights directs that the compensation expense recognized each period be based on the difference between the quoted market value at the end of each period and the option price. This compensation expense is then reduced by previously recognized compensation expense on the stock appreciation right. For example, assume that the option price is $10.00 and the market value is $15.00 at the end of the first period of the stock appreciation right. Compensation
expense would be recognized at $5.00 ($15.00 $10.00) per share included in the plan. If 100,000 shares are in the plan, then the expense to be charged to the income statement would be $500,000 ($5.00 100,000 shares). If the market value is $12.00 at the end of the second period of the stock appreciation right, expenses are reduced by $3.00 per share. This is because the total compensation expense for the two years is $2.00 ($12.00 $10.00). Since $5.00 of expense was recognized in the first year, $3.00 of negative compensation is considered in the second year in order to total $2.00 of expense. With 100,000 shares, the reduction to expenses in the second year would be $300,000 ($3.00 100,000 shares). Thus, stock appreciation rights can have a material influence on income, dictated by changing stock prices.
A company with outstanding stock appreciation rights describes them in a note to the financial statements. If the number of shares is known, a possible future influence on income can be computed, based on assumptions made regarding future market prices. For example, if the note discloses that the firm has 50,000 shares of stock appreciation rights outstanding, and the stock market price was $10.00 at the end of the year, the analyst can assume a market price at the end of next year and compute the compensation expense for next year. With these facts and an assumed market price of $15.00 at the end of next year, the compensation expense for next year can be computed to be $250,000 [($15.00 $10.00) 50,000 shares]. This potential charge to earnings should be considered as the stock is evaluated as a potential investment.
Stock appreciation rights tied to the future market price of the stock can represent a material potential drain on the company. Even a relatively small number of stock appreciation rights outstanding could be material. This should be considered by existing and potential stockholders. Some firms have placed limits on the potential appreciation in order to control the cost of appreciation rights.
The General Electric Company 2001 annual report indicated that ‘‘at year-end 2001, there were 131 thousand stock appreciation rights outstanding at an average exercise price of $7.68.’’ The General Electric Company stock price during 2001 ranged from a low of $28.25 to a high of $52.90.
Apparently, stock appreciation rights were not outstanding as of May 31, 2009 for Nike.