Table of Contents:
Book Value per Share
Another per share amount that analysts frequently calculate from accounting information is the book value per share. The term "book value" is synonymous with the amount at which an item is reported on the balance sheet. For example, in the context of property, plant, and equipment, recall that it means the reported amount for a particular asset. However, in the context of the analysts' "book value per share" number, it refers to the amount of reported stockholders' equity for each share of common stock.
Importantly, book value is not the same thing as market value or fair value (but, analysts sometimes compare market price to book value); book value is based on reported amounts within the balance sheet. Many items included in the balance sheet are based on historical costs which can be well below fair value. On the other hand, do not automatically conclude that a company is worth more than its book value, as some balance sheets include significant intangibles that cannot be easily converted to cash if liquidation becomes necessary. Like EPS, P/E, EBIT, and so forth, be careful about evaluating a company based solely on a single calculated value. These values are but single yarns of information, and it takes more than just a few yarns to make a complete tapestry.
Calculating Book Value per Share
For a corporation with only common stock, book value per share is easy to calculate: total stockholders' equity divided by common shares outstanding at the end of the accounting period. To illustrate, assume that Fuller Corporation has the following stockholders' equity, which results in a $24 book value per share ($12,000,000/500,000 shares):
The above is simple. However, a company with preferred stock must allocate total equity between the common and preferred shares. The amount of equity attributable to preferred shares is generally considered to be the call price (i.e., redemption or liquidation price) plus any dividends that are due. The remaining amount of "common" equity (total equity minus equity attributable to preferred stock) is divided by the number of common shares to calculate book value per common share:
Book Value Per Share = "Common" Equity/Common Shares Outstanding
Assume that Muller Corporation has the following stockholders' equity:
Mike Kreinhop is a financial analyst for an investment fund, and is evaluating the merits of Muller Corporation. Pursuant to this task, he has diligently combed through the notes to the financial statements and found that the preferred dividends were not paid in the current or prior year. He notes that the annual dividend is $600,000 (6% X $10,000,000) and the preferred stock is cumulative in nature. Although Muller has sufficient retained earnings to support a dividend, it is presently cash constrained due to reinvestment of all free cash flow in a new building and expansion of inventory. Kreinhop correctly prepared the following book value per share calculation:
Dividend Rates and Payout Ratios
Many companies do not pay dividends. Perhaps you own stock in such a company. One explanation is that the company is not making any money. Hopefully, the better explanation is that the company needs the cash it is generating from operations to reinvest in expanding a successful concept. Many successful companies and stockholders prefer this course of action, anticipating that they will realize better after-tax increases in wealth as a result (remember from the prior chapter the problem of double-taxation of dividends). On the other hand, some profitable and mature businesses can easily manage their growth and still have plenty of cash left to pay a reasonable dividend to shareholders. Many investors seek out dividend paying stocks. After all, who doesn't like to get an occasional check in the mail, even if it is taxable?
In evaluating the dividends of a company, analysts calculate the dividend rate (also known as yield). This number is the annual dividend divided by the stock price:
Dividend Rate = Annual Cash Dividend/Market Price Per Share
Simply, if Pustejovsky Company pays dividends of $1 per share each year, and its stock is selling at $20 per share, it is yielding 5% ($1/$20).
Analysts may be interested in evaluating whether a company is capable of sustaining its dividends and will compare the dividends to the earnings:
Dividend Payout Ratio = Annual Cash Dividend/Earnings Per Share
If Pustejovsky earned $3 per share, its payout ratio is .333 ($1/$3), and this is seemingly in line. On the other hand, if the earnings were only $0.50, giving rise to a dividend payout ratio of 2 ($1/$0.50), one would begin to question the "safety" of the dividend.
Return on Equity
Earnings per share and book value per share calculations zeroed in on the interest of the common shareholder. Analysts do the same thing in considering the return on equity ratio:
Return on Equity Ratio
(Net Income - Preferred Dividends)/Average Common Equity
The "ROE" evaluates income for the common shareholder in relation to the amount of invested common shareholder equity. This number enables comparison of the effectiveness of capital utilization by different firms. What it does not do is evaluate risk. Sometimes, firms with the best ROE also took the greatest gambles. For example, a high ROE firm may rely heavily on debt to finance the business (instead of equity), thereby exposing the business to greater risk of failure when things don't work out.
Analysts sometimes compare return on assets (ROA) to Return on Equity (ROE). They may also compare ROE to the rate of interest on borrowed funds. This can help them in assessing how effective the firm is in utilizing borrowed funds ("leverage"). Obviously, undertaking debt involves risk. The only reason to do so is based on the belief that the utilization of borrowed funds will produce positive net returns that more than offset the underlying cost of the debt.