My book, “Choose Stocks Wisely,” is all about the importance of the balance sheet equity (described as Stockholders’ Equity on the balance sheet) toward properly evaluating the quality and worth of a share of common stock. When you buy a share of common stock in a company, you are buying a share of the equity. So, analyzing the balance sheet equity of a company before investing money into that company is not only logical but also essential.
In this post, I want to discuss briefly how a company’s quarterly income statement impacts the equity value of a common share of stock. The income statement measures the company’s recent activity related to producing a corporate profit. Income is added to the balance sheet equity at the close of each successive quarter. Income is a term interchangeable with profit and with earnings. When income is spread over the number of common stock shares outstanding on the marketplace (i.e. net income/# of common shares outstanding), the result is referred to as “earnings per share.”
If a company has balance sheet equity per share of $10 (found by taking Stockholders’ Equity/# of common shares outstanding) just before a quarterly income report that reveals the company produced $2 of earnings per share (eps) for the quarter, then after the report, the balance sheet equity per share would be $12 ($10 + $2 = $12). If the quarterly income statement showed a net loss of $2 per share, the equity would be diminished to $8 per share ($10 – $2 = $8).
Based on everything I’ve observed over my investing tenure, the stock market is preoccupied today with a company’s quarterly income report and the resultant earnings per share to the virtual exclusion of examining the balance sheet equity. Earnings are very important to where equity goes next, as I’ve attempted to explain above. However, a quarterly income statement cannot be viewed properly if isolated from a context of the balance sheet equity. A stock’s worth today is impacted not only by today’s income statement and income statements yet to come, but also by all prior income reports. This is because each and every earnings report changes the balance sheet equity.
Past earnings are a known amount and are responsible for contributing to the amount of equity (or shareholder wealth) that is revealed on a company’s current balance sheet. Again, when you buy a share of stock, you buy a share of company equity. Well, what is the company’s equity position “when” you buy a stock, without regard to future revisions to that equity position due to future earnings? After all, you are buying in the present, not in the future.
My simple point is that if one is going to buy a share of common stock, also known as a share of equity, the analysis has got to start with the balance sheet. It provides the only context for properly evaluating the potential effect of future income statements on the value of the share of equity acquired.
This post is an over-simplification in that a company’s balance sheet equity amount today can be changed by more than just future income reports. For example, a company can issue more common stock on the market. That would be a financing activity, not an income activity, and would increase the balance sheet equity. Another example would be a company paying a dividend. Here a company is paying out part of its prior earnings. This will reduce the amount of balance sheet equity, yet not be considered an income activity to be included on the income report. Thus, there are company events other than income events that can change balance sheet equity. However, the central event to real equity or wealth improvement is that of income generated by the company. This post is intended to put the income event, as captured by the Income Statement, in its proper context, namely the corporate Balance Sheet.
The Statement of Stockholder Equity gives important (shocking) information. The increase in stockholder equity is often much less that net income less dividends. Repurchase of common stock, usually at prices much greater than book or intrinsic value, can often amount to more than half of net income; exercised stock options (at a price less that market) is another. These transactions usually benefit management to the detriment of stockholders.
James, thanks for that very relevant and true comment. My post was intended to give a rudimentary sketch of the relationship between the Income Statement and Balance Sheet equity. The big three financials are the Balance Sheet, Income Statement and Statement of Cash Flows. Another less-known statement, which you refer to, the Statement of Stockholders’ Equity, is intended to give further explanation of how equity has changed from one balance sheet to the next. Indeed, and unfortunately I might add, too many companies are managed in a manner that does not use company profits to build the wealth (equity position) of the external stockholders but rather to line the pockets of the inside managers who work for the shareholders (owners). With regard to plowing profits into management stock options and the repurchase of company shares, my mind goes to one particular company (I’ll not mention here) that reveals, through its financials, corporate profits being displaced from shareholders to managers in a big way for some time. Your comment is “spot on.” The only way to observe the essence of your point is to become familiar with the corporate financials. The balance sheet “is” the company on paper and the other statements are intended to complement one’s comprehension of the balance sheet. Thanks again for the helpful comment, James.
Dr. Allen,
I can appreciate that you don’t want to name the company, but can you tell us if it passed the liquidity and solvency tests from your book. And what else should the investor be looking for to avoid such companies.Thank you. Also, thanks for a very enlightening book.
William,
Thanks for the excellent comment. As you suspect, I will avoid revealing the particular company I had in mind. Indeed, at the time I’m writing this, the latest balance sheet I can access shows that it miserably fails both the liquidity and solvency tests, hands-down. So, the balance sheet reveals problems not noted in the “glowing” quarterly earnings reports that are causing investors to be driving the stock price way up. The profits have indeed been great. With profits soaring, one would expect that equity should be soaring too unless the company is paying out dividends greater than profits generated, and/or amounts beyond profits generated are being plowed into buying back stock (treasury shares or simply retiring the shares), etc. Where do you go to see what’s been happening to a company’s profits given its profits are rising but its equity is falling?
The Statement of Cash Flows is revealing and a great report to examine to find answers. It is broken down into Cash Flows from Operations, Cash Flows from Investing, and Cash Flows from Financing. In the case I’m thinking of, the cash being generated by operations (earnings activity) is significant as can be seen in the Operating section of the statement. However,the Financing section shows that the company has been regularly buying back its own stock to a tune that exceeds the cash its generating from operations. That same financing section shows that the company has not returned any money to shareholders in the form of dividends. So, buying back stock at a pace greater than the pace of profitability largely explains why company equity has declined while profits have been growing.
The Statement of Cash Flows shows what a company’s checkbook looks like for the past period(s) and it can be very revealing. It can tell you a lot about the quality of the earnings and what is being done with the money generated by the company.
Thanks again,
Paul