Course Title: Financial Statement Analysis Course Code: MGT-537 Course Instructor: Dr. Hafiz Muhammad Ishaq Total Lectures: 32

Previous Lecture Summary Analysis for the Investor Definition of Financial Leverage, Computation of Financial Leverage, Earnings per common share, Practical Exercises

Analysis for the Investor Today's Lecture Topics Analysis for the Investor Price/Earnings ratio, Percentage of Retained earnings, Dividend Payout Practical Exercises

Earnings Per Share and Capital Structure The amount of income earned on a share of common stock during an accounting period applied only to common stock and to income statements. Complex capital structure contains potentially dilutive securities: Options, rights, warrants Convertible debt Convertible preferred equity Contingent shares

Options A call option gives the holder the right, but not the obligation, to purchase 100 shares of a particular underlying stock at a specified strike price on the option's expiration date. For Example; let's say you purchase a call option on shares of Intel (INTC) with a strike price of $40 and an expiration date of April 16th. This option would give you the right to purchase 100 shares of Intel at a price of $40 on April 16th (the right to do this, of course, will only be valuable if Intel is trading above $40 per share at that point in time). 

Rights New stock (share) issue offered to existing stockholders shareholding, for a specified period and at a specified price. Its objective is to afford them the opportunity to maintain their percentage of ownership of the firm. See also scrip issue. Also called rights offering. Contingent Shares Shares of stock that are only issued under certain circumstances. A predetermined set of events must occur before the shares would be issued to investors. Fox example, ACME Corporation issues contingent shares only if the company's profits remain above $1M

Warrants Warrants are securities that give the holder the right, but not the obligation, to buy a certain number of securities (usually the issuer's common stock) at a certain price before a certain time. Warrants are not the same as call options or stock purchase rights. Occasionally, companies offer warrants for direct sale or give them to employees as incentive, but the vast majority of warrants are "attached" to newly issued bonds or preferred stock.

Example of Warrants For example, if Company ABC issues bonds with warrants attached, each bondholder might get a $1,000 face-value bond and the right to purchase 100 shares of Company ABC stock at $20 per share over the next five years. Warrants usually permit the holder to purchase common stock of the issuer, but sometimes they allow the purchaser to buy the stock or bonds of another entity (such as a subsidiary or even a third party).

Price/Earnings Ratio Measures the relationship between the market price of a share of common stock and that stock’s current earnings per share Use of diluted earnings per share gives more conservative price/earnings ratio

Price/Earnings Ratio (cont’d) Compare with Industry competitors Industry average Exchange (e.g., NYSE) average Interpretation High-growth-potential firms have higher P/E ratios P/E ratio is a function of the market

Percentage of Earnings Retained Reflects the proportion of current earnings retained for internal growth Trend analysis is improved by exclusion of nonrecurring items Higher percentage typically found in New firms Growing firms and firms perceived as growth firms

Dividend Payout Measures the portion of current earnings per common share being paid out in dividends A stable dividend policy is developed by consideration of recurring earnings Lower payout typically found in New firms Growing firms and firms perceived as growth firms

Dividend Yield Indicates the relationship between the dividends per common share and the market price per common share The yield is a function of The firm’s dividend policy Market price

Practical Exercise The following information was in the annual report of Rover Company 2003 2002 2001 Earnings per share $1.12 $1.20 $1.27 Cash dividend per share (Common) $.90 $.85 $.82 Market price per share $12.80 $14.00 $16.30 Total common dividends $21,700,000 $19,500,000 $18,360,000 Shares outstanding end of year 24,280,000 3,100,000 22,500,000 Total assets $1,280,100,000 $1,267,200,000 $1,260,400,000 Total liabilities $ 800,400,000 $ 808,500,000 $ 799,200,000 Nonredeemable Preferred stock $ 15,300,000 $ 15,300,000 $ 15,300,000 Preferred dividends $ 910,000 $ 910,000 $ 910,000 Net income $ 31,200,000 $ 30,600,000 $ 29,800,000

Practical Exercise (Cont’d) Required: Based on these data, Compute the following ratios for 2003, 2002,and 2001 1.Percentage of earnings retained 2.Price/earnings ratio 3.Dividend Payout 4.Dividend yield b. Discuss your findings from the viewpoint of a potential investor.

Practical Exercise The following data relate to Edger Company: 2003 2002 2001 Earnings per share $2.3 $3.40 $4.54 Dividends per share (common) $1.90 $1.90 $1.90 Market price end of year $41.25 $35.00 $29.00 Net Income $9,100,000 $13,300,000 $16,500,000 Total cash dividends $6,080,000 $ 5,900,000 $ 6,050,000 Order backlog at Year end $5,490,800,000 $4,150,200,000 $3,700,100,000 Net contracts awarded $2,650,700,000 $1,800,450,000 $3,700,100,000 Note: The stock was selling at 120.5%, 108.0% and 105.0% of book value in 2003, 2002 and 2001, respectively.

Practical Exercise (Cont’d) Required: Compute the following for 2003,2002,2001: Percentage of earnings retained Price/earnings ratio Dividend payout Dividend yield 2. Comment on your results from (a) Include in your discussion the data on backlog and new contracts awarded.

The percentage of earnings retained materially declined The percentage of earnings retained materially declined. The related ratio, dividend payout, materially increased. The price earnings ratio materially increased, which is difficult to explain, considering the decline in earnings and the other ratios computed. The dividend yield has declined each year, while the book value per share increased each year. The increase in market price and the increase in price earnings ratio appear to be explained by the increase in order backlog at year‑end and the increase in net contracts awarded.

Practical Exercise Smith and Jones Inc, is primarily engaged in the worldwide production, processing, distribution, and marketing of food products. The following information is extracted from its 2003 annual report: 2003 2002 Earnings per share $1.08 $ 1.14 Cash dividends per common share $ .80 $ .76 Marketing price per common share $12.94 $15.19 Common shares outstanding 25,380,000 25,316,000 Total assets $1,264,086,000 $1,173,924,000 Total liabilities $ 823,758,000 $ 742,499,000 Nonredeemable preferred stock $ 16,600,000 $ 16,600,000 Preferred dividends $ 4,567,000 $ 930,000 Net Income $ 32,094,000 $ 31,049,000

Practical Exercise (Cont’d) Required: Based on these data, compute the following for 2003 and 2002: Percentage of earnings retained Price/earnings ratio Dividend payout Dividend yield Discuss your findings from the view point of a potential investor.

Having the percentage of earnings retained decline provides mixed feelings. It implies that more is going to shareholders, but at the same time, earnings retained for growth have diminished. The rise in the dividend payout ratio supports this position. The price/earnings ratio has declined as a result of the drop in price. This decline indicates lower shareholder expectations but might also indicate a good time to buy. Dividend yield is up, caused by the rise in dividends and more so by the drop in price. Overall the signals are mixed. There is not enough information to determine if this is a good security.

Analysis for the Investor Lecture Summary Analysis for the Investor Definition of Financial Leverage, Computation of Financial Leverage, Earnings per common share, Practical Exercise