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Type of Securities Investment Strategies Fundamental Analysis Technical Analysis
Understanding Financial Statements Income Statement Analysis Balance Sheet Analysis Cash Flow Analysis Shareholders' Equity Analysis Ratios and Definitions


Shareholders’ Equity Analysis

- Are the stockholders really
    owners?

 - Do you know where your
    equity dollars are?

 - How comprehensive income
    can affect stock values


 - Watch out for your Dividends
 
 - Stock splits, dividends
    and reverse splits

 - Spin-offs, tracking stocks
    and determining new cost
    basis

 - Stock rights give board of
    directors more power then
    they are entitled to  

 

 

 


How comprehensive income can affect stock values

Comprehensive income items are non-owner transactions charged directly to shareholders’ equity. Academics can make arguments either way as to the appropriateness of charging shareholders’ equity versus the income statement. The accounting profession, nonetheless, usurped the shareholders’ rights by allowing the following types of non-owner transactions to be charged directly to equity:   

·        Foreign currency translation adjustments

·        Minimum pension liability adjustments

·        Unrealized gains or losses on marketable securities

·        Unrealized gains or losses on derivative instruments

This is more then a “geography” discussion as to where on the financial statements certain items should be classified. Many times, comprehensive income adjustments become hidden expenses; for some companies, the amounts are enormous.

Here, for example, is another poignant illustration supplementing the text: Boeing, for the year ending December 31, 2002, reported net income before accounting changes of $2.3 billion, down from $2.8 billion in 2001. (Not bad for a company whose customers and main markets were devastated after 9/11.)  In 2002 they also had a $1.8 billion asset impairment charge, primarily from their space and communication segment, relating to a new accounting regulation on handling goodwill and acquired intangibles. The write-down basically resulted from projected cash flows from their acquisitions, which did not cover the goodwill and other intangible assets that were recorded on their balance sheet. In effect, the future business prospects of their acquisitions did not justify the price paid for them. This resulted in Boeing reporting $492 million net earnings for the year, with the Company proclaiming that they had a “solid performance in dynamic markets from Boeing’s balanced portfolio of aerospace businesses.”

Then, when reviewing the equity section of the financial statements, one finds that equity was reduced by a staggering $3.1 billion for the year, or a 29% reduction in equity from the prior year. Most of it originated from a $3.6 billion (net) pension adjustment, or $5.7 billion before taxes. Keep in mind that the focus of this book is the stockholder. While the company’s operations did have a solid performance, the equity owners took a bath; first, on the $1.8 billion P&L asset write-down, then on the $3.6 billion equity pension adjustment.  This is why I call comprehensive income adjustments hidden expenses. Dividends aside, the stockholders started the year with $10.8 billion in equity and ended the year with $7.7 billion in equity. It took approximately 86 years to build up that equity, only to lose 29% of it in one year! That said, Boeing is still a world class organization and is usually a good buy on price dips.

The question now is: what is the bottom line? 

I’ve always had the conviction that all transactions should “run through” the current year’s P&L. Charging equity directly or restating past results tends to disguise the reality of a situation. 

Investors must focus on net income, as well as comprehensive income, when measuring stock values. If book value is reduced, it ultimately will reduce the value of one’s stock.

 

 

 

 

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