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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

 - 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

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



Do you know where your equity dollars are?

Investors must realize that as “owners” they have the last claim on the assets of a company. The bankers, note holders, suppliers and other creditors usually have claims on the most liquid and valuable assets of a company.

Except for the most pristine credit quality companies, the share-holders’ equity dollars are invested in those assets that are the most subjective in value and the hardest to sell. If a company has any bank debt, usually the lenders have liens on most of the valuable assets as collateral for their loans.

Being the last claim on assets, the shareholders’ dollars are invested in the intangible assets like prepaid expenses, capitalized internal-use software, and goodwill. The equity dollars are also used to fund the past due receivables that fall out of the bank’s borrowing base or the inventories and facilities in foreign countries that won’t be financed by US lenders. If a company’s equity is invested in physical assets, they are usually the ones that are hardest to turn into cash. 

Please don’t misinterpret the previous concept. It’s not that the equity assets have no value; it just takes more work and a longer lead-time to realize their value. For example, if you own stock in a leasing company, the banks and insurance companies usually would have a lien on the lease payment streams, leaving the equity holders to fund such assets as the un-guaranteed residuals, the past due and written-off leases, uncollected late charges, and securitization servicing rights. These assets have value, but it takes time to convert them into cash. This is one of the reasons that in bankruptcies, the equity holders get wiped out. It’s because the creditors lose patience and sell out at any cost, leaving nothing for the equity holders. The Japanese understand this concept very well and slow down the liquidation process, so where possible, the equity holders also realize their values.

Here are two examples at the opposite end of the spectrum:

·        Microsoft is a simple example to understand, as to where shareholders’ equity is invested, primarily because they have so much cash. As of 12/31/06 they had shareholders’ equity of $37 billion of which $29 billion was invested in cash and investments. The majority of their equity is protected in secure liquid assets.  

·        At the opposite end of the spectrum is Sumitomo Mitsui Banking Corporation (“SMBC”); not because it’s a foreign company, but due to its more sophisticated financial structure. (My example is dated but it illustrates the point.)

SMBC is a Japanese money center bank, in size similar to JP Morgan Chase (before they acquired Bank One). Their March 31, 2002 year-end annual report reported their total assets at $766 billion and stockholders’ equity at $24 billion.

The main issue with SMBC is that out of $24 billion of equity, approximately $26 billion is tied up in problem assets that are classified as bankrupt, quasi-bankrupt, or doubtful assets. Additionally, they had another $18 billion invested in substandard loans. Most of SMBC’s equity was used to fund its credit-impaired loans. This is why it is important to understand where a company’s equity really is.

SMBC was a typical turn-around type stock play. The hope was that the government would not force one of its best financial institutions out of business, and that eventually the real estate market in Japan would appreciate enough to allow the mortgages to be paid off.  

The turnaround scenario at SMBC was proven correct; at $10.00 per share the stock is up over 5 fold from a few years earlier. Microsoft, in the meantime, paid a healthy $3.00 per share special dividend in 2006, but, nonetheless, its share price was basically flat during the same period. It’s a text book risk/reward situation.

It’s important for investors to know what they are buying, the risk involved, and to understand where and how the equity of a company is being deployed.





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