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

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

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

4. 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

5. 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). 

6. 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

7. 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.

8. 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).

9. 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

10. 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

11. 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

12. 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

13. 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

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

15. 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.

18. Practical Exercise The following data relate to Edger Company:
Earnings per share $ $ $4.54
Dividends per share (common) $ $ $1.90
Market price end of year $ $ $29.00
Net Income $9,100, $13,300, $16,500,000
Total cash dividends $6,080, $ 5,900, $ 6,050,000
Order backlog at
Year end $5,490,800, $4,150,200, $3,700,100,000
Net contracts awarded $2,650,700, $1,800,450, $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.

19. 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.

22. 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.

23. 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:
Earnings per share $1.08 $ 1.14
Cash dividends per common share $ .80 $ .76
Marketing price per common share $ $15.19
Common shares outstanding ,380, ,316,000
Total assets $1,264,086,000 $1,173,924,000
Total liabilities $ 823,758,000 $ 742,499,000
Nonredeemable
preferred stock $ ,600,000 $ ,600,000
Preferred dividends $ ,567,000 $ ,000
Net Income $ ,094,000 $ ,049,000

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

28. 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.

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