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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




Stock splits, dividends and reverse splits

Technically, stock splits, stock dividends, and reverse stock splits have no monetary effect on one’s investment. They just change the number of shares owned, resulting in a proportionate change in the share price, with no overall change in the total value of the investment. There are no tax consequences for non-cash stock reallocations. The nuances of each are discussed below:

Stock splits

Stock splits are an increase in the number of total shares outstanding of a company, with a proportional decrease in the share price and dividend of the company. Stock splits have no effect on the overall market capitalization of the company. The individual shareholders receive more shares, but their percentage ownership is the same, as is their overall cost basis, dividend, and original purchase dates. Usually, companies have 2 for 1, or 3 for 2 splits, but other combinations can also be used.

The investment strategy of buying a stock when a split has been announced and selling when the split occurs is no longer in favor. Companies split their stock for various reasons, such as:

·        Maintaining a price that is attractive to the average investor

·        Increasing the company’s outstanding floating shares

·        Broadening the company’s investor base

Stock splits are usually indicative of a forward moving company that is growing and improving shareholder value.  

Accounting treatment: “Memo” accounting entries are made with stock splits that increase the authorized and outstanding shares of the organization. Also, the company’s par value per share is proportionately adjusted, as well as all the historical stock charts.

Newspaper treatment: Some newspapers identify those stocks that had a split during the prior 52 weeks by having an “S” next to the company’s name. They also restate all prior share price statistics to reflect the stock split.

Stock dividends

Stock dividends are theoretically similar to a stock split, in that the number of shares outstanding increase, with a proportional decrease in the share price. The scale of a stock dividend is much smaller, usually between 1% and 25% of the outstanding shares; above that is considered a stock split. As with a stock split, the shareholders receive more shares, but their percentage ownership is the same, as is their total cost basis and original purchase dates. The original dividend rate may or may not be reduced; every transaction is different. 

While most of the stock charts and newspapers automatically make the proportionate changes for small stock dividends, some may not note it on the charts, because of spacing issues. In effect, one often receives more shares, with the same dividend rate. Additionally, management’s intent in paying a non-cash dividend is to show shareholders and the investing community, that the organization is growing in value, and is rewarding its shareholders. A cash dividend may not be available to the shareholders, but remuneration is still intended.

Accounting treatment: Stock dividends are accounted for as a non-cash dividend. As such, the accounting records are adjusted by debiting retained earnings for the fair market value of the dividend and crediting common stock at par value, with the difference being credited to additional paid in capital. This has zero impact on shareholders’ equity, but reduces the retained earnings of the company, for the value of the dividend.

Tax treatment: Generally, stock dividends, as well as stock splits, are non-taxable. There are a few exceptions, such as: if the company gives one an option for cash or stock, that option may make the transaction taxable, irrespective of the owner’s choice. Additionally, if the shareholders are not treated the same, and receive disproportionate distributions or different amounts, types, classes or terms, the distribution may be taxable. If shareholders receive any inequitable treatment, the transaction may be taxable. If common shareholders receive certain preferred stock, the transaction may be taxable. With unusual distributions, always consult with the company or the IRS, as to the tax consequences, before filing the annual 1040 tax return. 

Stock dividends are a good way for management to show investors that the company recognizes their ownership position, and is working at increasing the value of their investment.

Reverse stock splits

A reverse stock split is the opposite of a regular stock split.

Usually the company has had a “series of eroding fundamentals; it is a last ditch effort to keep the stock listed on exchanges as a marginable security.” It’s a natural process in reflecting the declining value of an enterprise. Usually, dividends have already been discontinued. Most stocks need to trade above $1 per share to maintain their listing on the stock exchanges and trade at or above $5 per share to be marginable. Shareholder approval is not needed for reverse stock splits. I believe, in most cases, these stocks continue to decline until they ultimately go out of business.

There are, however, cases where a stock previously bottomed-out, and now fundamentals are improving, and the institutional investors and analysts are recommending that the company reverse split their shares, to increase its stock price, thus making it eligible for institutional purchase. Reverse splits also reduces trading costs. These are the types of turnaround companies that speculative investors should look for.

Lab Corp of America is a good example. Their product is a healthcare necessity in today’s world. Emergency room doctors cannot be certain that a critically ill patient is having a heart attack until a series of blood work is done over a prolonged period of time. Blood testing is essential in the healthcare industry.

Back in the mid-to-late 1990’s Lab Corp had a series of mishaps, combined with changing governmental billing procedures at the doctor level, which took time to implement. This resulted in a company that was obviously improving, but was not yet recognized by Wall Street. They first had a 10 for 1 reverse split in 2000, followed by two 2 for 1 splits in 2001 and 2002. This was obviously a success story.

Lab Corp’s example may also be the footprint that some of the post-bubble technology companies can use, to correct the distortion between their stock price and their fundamentals. This can be a valuable and potentially profitable case study for investors.




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