8 Equity Recognition and Owner Financing

MODULE 8
Equity Recognition
and
Owner Financing
© Cambridge Business Publishers, 2021

Learning Objective 1
LO1
Examine stock as a
financing source and
explain its various features.
© Cambridge Business Publishers, 2021 2

J&J’s Stockholders’ Equity

J&J’s Contributed Capital Accounts
 Preferred stock
 J&J is authorized to issue up to 2,000,000 preferred shares
 To date has not issued any — the balance is $0
 Common stock
 Par value – Par value (as stated in its charter) is $1 per share
 Authorized shares – Can issue up to 4,320,000,000 shares
without further approval from shareholders
 Issued shares – Has sold (issued) 3,119,843,000 shares at $1
par value to date. Thus, the common stock account has a
balance of $3,120 million

J&J’s Earned Capital Accounts
 Accumulated Other Comprehensive Income (AOCI)
 The cumulative changes to stockholders’ equity other than
from transactions with owners and transactions reflected in
net income. This account can be positive or negative.
 Retained earnings
 The cumulative net income recorded since J&J’s inception
less all the dividends J&J has ever paid to shareholders
 Treasury stock
 The cumulative amount J&J spent for stock repurchases less
the amounts received for subsequent resale of the shares
 At fiscal year-end 2018, the company held 457,519,000
shares for which it paid $34,362 million, net of resales
Book Value per Share
 A measure commonly used by analysts and the financial press is

book value per share.
 This is the equity (net book value) of the company that is
available to common shareholders and is defined as:
 J&J’s book value per share at fiscal 2018 year end is:
 J&J’s market price per share at fiscal 2018 year end was $129.05
and the company’s market to book ratio was 5.75.

Statement of Stockholders’ Equity
The statement of stockholders’ equity reconciles the beginning
and ending balances of the stockholders’ equity accounts. It
highlights the following:
 How net income and dividends impact retained earnings
 Cash raised from new shares issued
 Cash used to repurchase shares in the open market
 Changes in key balance sheet accounts not recorded in net income
or not arising from transactions with shareholders (AOCI)

Preferred Stock
 Preferred Stock is a multi-use security with a number of

desirable features
 In addition to usual dividend and liquidation preferences,
preferred stock has two other common features
 Yield Preferred stock can be structured to provide investors with a
dividend yield similar to an interest rate on a bond
 Conversion privileges Preferred stock often includes a feature that
allows investors to convert their preferred shares into common shares
at a pre-determined number of common shares per preferred share

Corning’s Convertible Preferred Stock
 Corning’s convertible preferred stock

1. Pays an annual dividend of 4.25% of par value, or $97.75 million
($2,300 million × 4.25%)
2. Includes a conversion option that allows the preferred shareholders to
exchange one preferred share for 50,000 common shares
J&J’s Common Stock (1)
J&J has one class of common stock with the following attributes
 A par value of $1.00 per share
 This is an arbitrary amount set when the company was formed
 Par value has no relation to, or impact on, the stock’s market value
 Par is used only to allocate proceeds from stock issuances between
common stock and additional paid-in capital
 Total authorized shares of 4,320,000,000
 The company cannot issue (sell) more shares than have been authorized
 If more shares are needed, stockholders must vote to increase the
number of authorized shares
 To date, JNJ has issued 3,119,843,000 shares of common.
 This is a cumulative amount – total sold to date
 Year-over-year changes in the number of issued shares represent the
number of shares of stock issued in the current year
J&J’s Common Stock (2)
 To date, JNJ has repurchased 457,119,000 shares from its

stockholders at a cumulative, net cost of $34,362 million
 These shares are currently held in the company’s treasury, hence the
name treasury stock
 Treasury shares neither have voting rights nor do they receive dividends
 Number of outstanding shares is equal to the issued shares less
treasury shares
 As of fiscal 2018 year end, there were 2,662,324,000 outstanding,
calculated as 3,119,843,000 − 457,519,000
 J&J’s market capitalization equals the number of outstanding
common shares multiplied by the market price per share.
 As of December 31, 2018, JNJ’s market cap was $343.6 billion
(2,662,324,000 shares outstanding × $129.05 per share)

Analyst Adjustments 8.1 (1)
Noncontrolling
interest is the
portion of the
subsidiary’s
stock
NOT owned by
the company
 Noncontrolling interest arises when the company controls a

subsidiary but does not own all of the subsidiary’s stock
 The noncontrolling interest account increases:
 With any additional investment made by the noncontrolling shareholders
 By the noncontrolling shareholders’ share of the subsidiary’s net income
 The account decreases
 By any dividends paid to the noncontrolling shareholders
 With share of net losses of the subsidiary
 General Mills’ balance sheet reports noncontrolling interest
Equity attributable to the

company shareholders
Total consolidated equity
 Which measure of equity do we use for a business analysis?

The answer depends on the focus of our analysis.
ROE Leverage ratios Market to book ratio
$7,054.5 $7,367.7 $7,054.5

LO2
Analyze stock issuances
and repurchases.

Stock Issuance
 Companies issue stock to obtain cash for use in their

business or to acquire another company
 If issued for cash, stock issuances increase cash by the issue
proceeds
 Stockholders’ equity increases by the same amount via
contributed capital
 If the stock has a par value, the common stock account
increases by the number of shares sold multiplied by par
value
 The additional paid-in capital account increases by the
remainder

Stock Issuance Financial Effects
 Assume that JNJ issues

 1,000 shares of common stock
 With $1.00 par value
 For $100 per share (the assumed market price)
 This stock issuance has the following financial statement effects
 Common stock (at par) increases by $1,000 and the APIC

account increases by $99,000

Stock Repurchase Financial Effects
 Assume that
 J&J repurchases 200 common shares
 J&J pays $90 cash per share
 The repurchase has the following financial statement effects
 Cash and contributed capital both decrease by $90 × 200 shares

 Treasury stock is a contra-equity account, it reduces equity

Reselling Treasury Stock
 Assume that
 The 200 shares of treasury stock are subsequently resold
 J&J receives $95 cash per share for the sale
 This resale of treasury stock has the following financial statement
effects
 Treasury stock is reduced for the cost of the shares ($90 × 2000)
 The difference is added to APIC – it represents additional
contributions from shareholders
Treasury Stock
Disclosures and Interpretation
 The treasury stock section of J&Js balance sheet reports:
 As of 2018 year end, J&J had repurchased 457,518,000 shares

for $34,362 M, an average repurchase price of $75.10 / share
 These shares, while legally owned by Johnson & Johnson, have
no voting rights and receive no dividends
 Treasury shares can be resold if J&J needs to raise capital for
operating or investing activities including mergers and
acquisitions

Treasury Stock Retirement
 Sometimes, companies “retire” treasury stock. In that event,
 The treasury stock account is reduced by the cost of the retired shares
 Common stock is reduced for the par value of the retired shares
 APIC account is reduced for the difference between cost and par
 Retained earnings is reduce for any remaining difference
 Consider Microsoft’s statement
of stockholders’ equity:

 Stock buybacks have increased dramatically over the past several

years
 Many balance sheets report large levels of treasury stock
 When a treasury stock balance is extreme, the equity balance can
become very small, yielding inflated ROE
 In more extreme cases, stock repurchases can cause a negative
equity balance and a negative ROE, which is uninterpretable
 Three ways to adjust for small or negative equity
1) Use metrics less sensitive to low or negative equity: ROA and RNOA
2) Compute ROE after adding back treasury stock, as illustrated above
3) Substitute market value of equity for book value
 For example, AbbVie in 2018

LO3
Interpret stock-based
compensation including
restricted stock and options.

Stock-Based Compensation
Companies use a range of stock-based compensation plans to:

 Create incentives for employees to think and act like shareholders
 The amount of the stock award is often tied to corporate performance
targets including sales, income, and stock price
 Stock-based compensation plans motivate employees to work hard and
make decisions that improve company performance
 Encourage employee retention and longevity
 Employees earn the right to own or purchase shares over time
 This waiting time is called the vesting period
 During the vesting period, employees have greater incentive to stay with
the company
Types of
Stock-Based Compensation Plans

Analysis of
Stock-Based Compensation Plans
 Two analysis issues relate to stock-based compensation plans:

1. Expense Recognition When shares or options are awarded
to employees, companies recognize compensation expense
2. Potential Dilution
 Dilution relates to the number of common shares outstanding that
have a claim against the company’s earnings or net assets
 Mindful of potential dilution, companies often repurchase shares in
advance to use for stock-based compensation plans
 For example, J&J reports the following:

Accounting for Stock-Based
Compensation
 Regardless of the type of stock-based compensation plan,

there are common accounting steps
 When the award is granted to employees, the company estimates the
fair value of the award
 The fair value of the award is recorded as an expense in the income
statement, ratably over the vesting period
 When the shares are issued, common stock and additional paid-in
capital increase in the same manner as for cash-based stock issuances

Reporting Stock-Based Compensation
 Stock-based compensation expense is included on the income

statement but rarely reported as a separate line item
 However, we can determine the amount of the expense from
the statement of cash flows

Is Stock-Based Compensation
a Cash Expense?
 The stock-based compensation add-back might lead some to

conclude that this form of compensation is cash free
 However, a real cash cost occurs when the company buys new
treasury shares in the open market to offset the dilution created
by the share award to the employees
 To accurately evaluate and forecast operating cash flow, analysts
must either:
 Include stock-based compensation expense – adding it back to calculate
non-GAAP measures is not correct
 Recognize the related treasury-stock purchase as an operating cash
outflow

Footnote Disclosures
for Stock-Based Compensation (1)
Footnotes describe two facets of stock-based compensation:
1. Plan Activity
 Number of shares granted to employees during the year
 Number of shares issued during the year to satisfy vested awards
 Any shares forfeited—when employees leave the company or fail to
exercise options within the specified time period

Footnote Disclosures
for Stock-Based Compensation (2)
2. Fair Value and Expense
 Fair value of the stock-based compensation awards
 How fair value is determined
 Restricted stock awards are valued using the share price on the date of
the award
 Stock option plans are valued using option pricing models (Black-
Scholes model and the bilateral model)
 The expense on the income statement
 Value of the shares issued to employees over and above the price the
employee paid for shares (this difference is called the intrinsic value)
 J&J reported the following fair values for 2018 stock-based awards:

LO4
Analyze cash dividends
and stock splits.

Dividend Payout and Yield
 Dividend Payout Measures the proportion of the company’s

earnings paid out as dividends
 Dividend Yield Measures the relation between dividends and

current market value of the company’s stock
 For J&J in 2018:

Cash Dividends Financial Effects
 Cash dividends reduce both cash and retained earnings by the

amount of the cash dividends paid
 To illustrate, assume that J&J declares and pays cash dividends
of $10 million
 The transaction is captured as follows:
 Dividend payments do not affect net income They directly

reduce retained earnings and bypass the income statement

Cumulative Dividends in Arrears
 Dividends on preferred stock have priority over those on

common stock, including unpaid prior years’ preferred dividends
(called dividends in arrears) when preferred stock is cumulative
 15,000 shares of $50 par, 8% preferred stock = $60,000 dividend

Stock Split
 A stock split involves the issuance of additional common

shares to existing stockholders
 Stock splits are usually prompted by the company’s desire to
reduce its stock price to improve marketability of the shares
 A stock split is not a monetary transaction and, as such, there
are no financial statement effects
 Companies must disclose the number of shares outstanding
for all periods presented in the financial statements
 Additionally, companies must reduce the par value of the
stock proportionally and historical financial statements
presented in the current 10-K must be adjusted likewise

Stock Dividend
 Companies can also declare a stock dividend where shares of

stock are distributed to shareholders instead of cash
 To account for a stock dividend, the company reduces retained
earnings (just as for cash dividends) and increases contributed
capital accounts
 Cash and the stock’s par value per share are both unaffected
by a stock dividend
 Many companies declare a stock dividend, rather than a stock
split, to avoid the reduction of the par value that is required in
a stock split
 This event is typically described as a stock split effected in the
form of a stock dividend

LO5
Interpret accumulated other
comprehensive income
and its components.

Components of AOCI (1)
 Foreign currency translation adjustments
 Foreign subsidiaries maintain their financial statements in foreign
currencies
 Statements are translated into $US before the subsidiaries’ financial
statements are included in the company’s 10-.
 The strengthening and weakening of the $US vis-à-vis foreign currencies
results in decreases and increases in the $US-value of subsidiaries’ assets
and liabilities
 These unrealized gains or losses in the $US value of foreign subsidiaries’
assets and liabilities are included in AOCI
 Employee benefit plans

 Unrealized gains and losses on some pension investments and pension
liabilities are reported in AOCI.

Components of AOCI (2)
 Gains and losses on marketable securities

 Investments in certain types of marketable securities are reported at
fair value on the asset side of the balance sheet
 If the fair value of DEBT securities differs from cost, the unrealized
gains or losses are included in AOCI
 Unrealized gains or losses on available-for-sale EQUITY securities are
not included in AOCI, they are recorded in net income
 Gains and losses on derivatives and hedges

 Unrealized gains and losses on certain financial securities (derivatives)
used to hedge exposures to interest rate, foreign exchange rate, and
commodity price risks are included in AOCI

J&J’s AOCI
 Following is the reconciliation of beginning and ending

balances in AOCI for Johnson & Johnson for two fiscal years

Comprehensive Income
 During the year, market values on the AOCI items inevitably
change and so do the unrealized gains and losses in AOCI
 Remember, changes in unrealized gains and losses do not flow
to the income statement as they are not part of net income
 Instead, those changes are aggregated and labeled other
comprehensive income (OCI).
 The following graphic depicts the relation between net
income and retained earnings and between comprehensive
income and AOCI

J&J’s Statement of
Comprehensive Income

LO6
Analyze convertible securities
and their financial effects.

Convertible Securities
 When common stock is issued, the company receives

proceeds equal to the market price of the stock multiplied by
the number of shares sold
 Companies can increase the cash proceeds by including
provisions in the preferred stock and bonds agreements that
make the securities more desirable
 One such provision is a conversion option that allows the
holder of those securities to convert them into common stock
at a preset price
 If the company performs well the preferred stockholder can
exchange their securities for common stock at a pre-agreed
exchange ratio benefit from the company’s upside potential

Convertible Securities Disclosures
and Interpretation
Tesla reported convertible bonds in 2018:
 After December 15, 2021, bondholders can exchange each

$1,000 bond for 3.0534 shares of Tesla common stock
 Until then, the bondholders earn 2.375% interest
 Conversion is advantageous to bondholders if Tesla’s stock
exceeds the $327.50 conversion price ($1,000/3.0534)
 On December 31, 2018, Tesla common stock was valued at
$332.80, making conversion attractive, but unavailable because
the conversion feature kicks in on December 15, 2021
Convertible Securities Financial Effects
 Assume that on December 31, 2021, Tesla bondholders convert

$600 million (of the total $977.5 million bond issue) into
common stock
 Tesla issues 1,832,040 shares of common stock with a par value
of $0.001 per share ($600 million/$1,000) × 3.0534 shares
 The financial statement effects are as follows:

LO7
Interpret earnings per share.

Basic and Diluted EPS
 A common metric reported in the financial press is earnings

per share (EPS)
 Companies report two EPS statistics: Basic and Diluted
 We cannot compare the EPS of different companies

 The number of shares outstanding is not proportional to income
 Management controls the number of common shares outstanding
 There is no relation between firm size and shares outstanding

J&J’s EPS
 JNJ reports the following basic and diluted EPS in 2018
 The diluted EPS denominator presumes the most-extreme case:

at the beginning of the year, all option holders exercise and all
convertible debt holders convert
 JNJ uses the treasury-stock method to determine the dilutive effect of
stock options
 Assumes that all options are exercised (139.0 million shares) and that the
company uses the proceeds to repurchase shares on the open market at the
current stock price (92.5 million shares).
 The 46.5 million share increase is 139.0 million – 92.5 million).
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MODULE 8

© Cambridge Business Publishers, 2021

© Cambridge Business Publishers, 2021 2

© Cambridge Business Publishers, 2021 3

© Cambridge Business Publishers, 2021 4

 A measure commonly used by analysts and the financial press is

© Cambridge Business Publishers, 2021 6

© Cambridge Business Publishers, 2021 7

 Preferred Stock is a multi-use security with a number of

© Cambridge Business Publishers, 2021 8

 Corning’s convertible preferred stock

 To date, JNJ has repurchased 457,119,000 shares from its

© Cambridge Business Publishers, 2021 11

 Noncontrolling interest arises when the company controls a

 General Mills’ balance sheet reports noncontrolling interest

Equity attributable to the

Total consolidated equity

 Which measure of equity do we use for a business analysis?

© Cambridge Business Publishers, 2021 13

© Cambridge Business Publishers, 2021 14

 Companies issue stock to obtain cash for use in their

© Cambridge Business Publishers, 2021 15

 Assume that JNJ issues

 Common stock (at par) increases by $1,000 and the APIC

© Cambridge Business Publishers, 2021 16

 Cash and contributed capital both decrease by $90 × 200 shares

© Cambridge Business Publishers, 2021 17

 The treasury stock section of J&Js balance sheet reports:

 As of 2018 year end, J&J had repurchased 457,518,000 shares

© Cambridge Business Publishers, 2021 19

© Cambridge Business Publishers, 2021 20

 Stock buybacks have increased dramatically over the past several

© Cambridge Business Publishers, 2021 22

© Cambridge Business Publishers, 2021 23

Companies use a range of stock-based compensation plans to:

© Cambridge Business Publishers, 2021 25

 Two analysis issues relate to stock-based compensation plans:

© Cambridge Business Publishers, 2021 26

 Regardless of the type of stock-based compensation plan,

© Cambridge Business Publishers, 2021 27

 Stock-based compensation expense is included on the income

© Cambridge Business Publishers, 2021 28

 The stock-based compensation add-back might lead some to

© Cambridge Business Publishers, 2021 29

© Cambridge Business Publishers, 2021 30

© Cambridge Business Publishers, 2021 31

© Cambridge Business Publishers, 2021 32

 Dividend Payout Measures the proportion of the company’s

 Dividend Yield Measures the relation between dividends and

 For J&J in 2018:

© Cambridge Business Publishers, 2021 33

 Cash dividends reduce both cash and retained earnings by the

 Dividend payments do not affect net income They directly

© Cambridge Business Publishers, 2021 34

 Dividends on preferred stock have priority over those on

© Cambridge Business Publishers, 2021 35

 A stock split involves the issuance of additional common

© Cambridge Business Publishers, 2021 36

 Companies can also declare a stock dividend where shares of

© Cambridge Business Publishers, 2021 37

© Cambridge Business Publishers, 2021 38

 Employee benefit plans

© Cambridge Business Publishers, 2021 39

 Gains and losses on marketable securities