Introductory Corporate Finance: Financial Statement Analysis - Statement of Stockholders' Equity

What This Is

The Statement of Stockholders' Equity (SSE) is a financial statement that presents the changes in a company's equity over a specific period. It's essential in corporate finance as it helps investors and analysts understand a company's financial performance, capital structure, and dividend policy. For example, consider Tesla, Inc. (TSLA), which reported a net income of $5.5 billion in 2020. The SSE would show the increase in retained earnings, which is a key component of equity.

Key Formulas & Models

• Retained Earnings (RE) = Net Income (NI) + Beginning Retained Earnings (BRE) - Dividends (D): RE is the change in equity due to net income and dividends.
  • BRE: beginning retained earnings at the start of the period
  • D: dividends paid to shareholders
• Dividend Payout Ratio (DPR) = Dividends (D) / Net Income (NI): DPR measures the proportion of net income distributed as dividends.
• Dividend Yield (DY) = Annual Dividend (AD) / Market Price (MP): DY is the ratio of annual dividend to market price, indicating the expected return on investment.
• Book Value Per Share (BVPS) = Total Equity (TE) / Number of Outstanding Shares (NOS): BVPS is the book value of equity per share, calculated by dividing total equity by the number of outstanding shares.
• Market Value Per Share (MVPS) = Market Capitalization (MC) / Number of Outstanding Shares (NOS): MVPS is the market value of equity per share, calculated by dividing market capitalization by the number of outstanding shares.
• Return on Equity (ROE) = Net Income (NI) / Total Equity (TE): ROE measures the return on equity, indicating how efficiently a company generates profits from its equity.
• Sustainable Growth Rate (SGR) = Retention Ratio (RR) × Return on Equity (ROE): SGR is the long-term growth rate of a company, calculated by multiplying the retention ratio by the return on equity.

Step-by-Step Calculation

1. Calculate the change in retained earnings: RE = NI + BRE - D
2. Calculate the dividend payout ratio: DPR = D / NI
3. Calculate the dividend yield: DY = AD / MP
4. Calculate the book value per share: BVPS = TE / NOS
5. Calculate the market value per share: MVPS = MC / NOS
6. Calculate the return on equity: ROE = NI / TE

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
  • Correction: Use market value for WACC, as it reflects the market's perception of a company's value.
• Mistake: Ignoring flotation costs when calculating WACC.
  • Correction: Include flotation costs in the WACC calculation to accurately reflect the cost of capital.
• Mistake: Confusing sunk cost with opportunity cost.
  • Correction: Recognize that sunk costs are irreversible and should not be considered in future decisions, while opportunity costs reflect the value of alternative choices.

Exam / CFA Tips

• Be aware of the difference between M&M Proposition I (no taxes) and M&M Proposition II (with taxes).
• Understand the distinction between IRR and NPV ranking.
• Recognize that dividend irrelevance theory suggests that dividend policy does not affect a company's value, but bird-in-hand theory suggests that dividend payments can affect a company's value.

Quick Practice Problem

A company has EBIT of $10M, interest $2M, and tax 25%. Calculate the degree of financial leverage (DFL).

Answer: DFL = (EBIT + Interest) / EBIT = ($10M + $2M) / $10M = 2

Explanation: DFL measures the sensitivity of EBIT to changes in sales.

Last-Minute Cram Sheet

1. Retained Earnings (RE) = Net Income (NI) + BRE - D
2. Dividend Payout Ratio (DPR) = D / NI
3. Dividend Yield (DY) = AD / MP
4. Book Value Per Share (BVPS) = TE / NOS
5. Market Value Per Share (MVPS) = MC / NOS
6. Return on Equity (ROE) = NI / TE
7. Sustainable Growth Rate (SGR) = RR × ROE
8. Weighted Average Cost of Capital (WACC) = wd × rd(1-T) + wps × rps + we × re
9. Degree of Financial Leverage (DFL) = (EBIT + Interest) / EBIT
10. In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.