Friday, February 29, 2008

Shareholders' Equity

The balance sheet is basically an elaborated display of a simple equation.

Assets - Liabiilities = Shareholders' Equity or simply Equity

What this means is that whatever assets that a company owns, subtracting whatever the company owes, gives you what's left for shareholders. This is also known as the book value of the company.

Shareholders' Equity is usually at the bottom right of the balance sheet (Assets on the left side, Liabilities on the top right) and is usually broken down into the following sub components:

Common stock
Paid in capital
Retained Earnings
Preferred stock
Treasury stock
Others: there are actually a lot more complicated stuff but I will just lump it under others and we will talk about that on another day.

Common stock and paid in capital are usually thought of as the original capital of the company. Common stock is the no. of outstanding shares multiplied by its par value which is usually some arbitrary no. like $1 and paid in capital is usually the proceeds received during IPO or subsequent secondary equity financing.

Retained earnings would be the impt sub-segment to know. Needless to say, retained earnings comes from net profit (from the P&L statement). So what this means is that retained earnings should be as big as possible. If you see a company that has an original capital of say $1mn but retained earnings is like $80mn or some big no. then you know this co. has created tons of value for shareholders. And conversely, if paid in capital is bigger than retained earnings, either this firm is still very young, or it has continously raised new money from shareholders ie old shareholders keep getting their stake diluted and the business model's sustainability is questionable

Preferred stock is basically a stock pays dividend forever and is usually not a big sub-segment. Thus it pays to find out why a co. might have a huge preferred stock capital.

Treasury stock is a negative entry (ie the $ amt here is negative not positive) in shareholders' equity and it arises only when a company does share buybacks. This is a good sign bcos it signifies that the company has its shareholders in mind and is using share buyback as a way to return capital to its shareholders.

3 comments:

musicwhiz said...

Hi 8percentpa,

Most share buybacks are done with the intention of using the treasury shares for ESOP, which is a way to motivate staff. Share options are accounted for as an liability now, I think, which means that they are no more off-balance sheet. But please correct me if I am wrong on this.

Equity can also be classed into 2 major categories of capital reserves and revenue reserves. Capital reserves include share premium account (defunct since the concept of par value has been abolished), asset revaluation reserve, hedging reserve and foreign currency revaluation reserve. These CANNOT be distributed as dividends and are simply adjustments for unrealized transactions within the Balance Sheet or Profit and Loss account.

For revenue reserves, these include retained earnings, general reserves, dividend reserve and profit after tax. These can be distributed as dividends to shareholders of the company.

I feel it is important for a shareholder to take note of unusually large items within capital reserves which may have an exceptional impact on the Profit and Loss statement. Examples are gain on fair value of biological assets or derivative financial instruments which may flow into equity as a capital reserve. The shareholder has to be aware that this reserve can be written down or written off should the initial conditions for recognition not be present any longer, or if there is impairment in assets such as biological assets (forests for example) or property values.

Regards,
Musicwhiz

8percentpa said...

Hi Musicwhiz

Thanks for the very detailed note on various components on shareholders equity. It definitely pays to scruntinize the balance sheet more thoroughly.

I guess we will have a lot of time for that as we enter US-led recession and stocks continue to fall. It will be interesting to see how many investment blogs will be left at the end of the day. Hehe!

Nigel said...

Hi 8%pa,

Just wanted to say thanks for your ongoing series on financial statement analysis. I'm a newbie to Value Investing, and your series provides clearly explained info, esp since I have absolutely no accounting/financial/economic background. Keep it up!