Oct 7, 2013


Managerial Finance
Treasury Stock
When analyzing a balance sheet, you're apt to run across an entry under Shareholder Equity called "Treasury Stock".  This refers to the shares a company has issued and somehow reacquired either through share repurchase programs or donations.
Companies sometimes buy back their shares for a variety of reasons.  In most cases, it is a sign management believes the stock is undervalued.  Depending upon its objectives, a company can either retire the shares it purchases, or hold them with the intention of reselling them to raise cash when the stock price rises.
When a corporation purchases its own stock, the cash on hand is reduced.  This lowers the total shareholder equity.  In order for investors to know the reduced cash and equity was a result of share repurchases and not debt or losses, management puts the cost of the reacquired stock under "Treasury Stock" in order to clarify.  This is why you will often see a negative number besides the treasury stock entry.  (You may be wondering why the current market price of the company's treasury stock isn't listed as an asset (since the shares can be sold at any time to raise cash).  There is a debate about this in the accounting world.  The premise is that all unissued stock can also be sold for cash yet it isn't listed as an assets - treasury stock should be treated the same way.)
Many states limit the amount of treasury stock a corporation can own at any given time since it is way of taking resources out of the business by the owners / shareholders, which in turn, may jeopardize the legal rights of the creditors.
In the accounting sense, Goodwill can be thought of as a "premium" for buying a business.  When one company buys another, the amount they pay is called the purchase price.  Accountants take the purchase price and subtract it by a company's book value.  The difference is called Goodwill. 
When a company buys another company, they can use one of two accounting methods:

pooling of interest or purchase.  When the pooling of interest method is used, the balance sheets of the two businesses are combined and no goodwill is created.  When the purchase method is used, the acquiring company will put the premium they paid for the other company on their balance sheet under the "Goodwill" category.  Accounting rules require the goodwill be amortized over the course of 40 years.
What does that mean?  Let's use McDonald and Wendy's as an example since most people are familiar with them.
         Earnings: $1,977,300,000
         Shares Outstanding: 1.29 Billion
         (You don't need McDonald other information for this example)
         Book Value: $1,082,424,000
         Book Value per Share: $10.3482
         Shares Outstanding: 104.6 Million
         Earnings: $169,648,000
Say McDonald decided to buy all of Wendy's stock using the purchase method.  Wendy's has a book value of $10.3482 per share, yet is trading at $32 per share.  If McDonald's were to pay the current market price, they would spend a total of $3,347,200,000 (104.6 million shares x $36 per share).  To keep this example simple, we are going to assume the shareholders of Wendy's approved the merger for cash.  McDonald would mail a check to the Wendy's shareholders, paying them $32 for each share they owned.
Since the book value of Wendy's is only $1,082,424,000, and McDonald paid $3,347,200,000, McDonald paid a premium of $2,264,776,000.  This is going to go onto their balance sheet as Goodwill.  It is required to be amortized against earnings for up to 40 years.  This means that each year, 1/40 of the goodwill amount must be subtracted from McDonald' earnings so that by the 40th year, there is no goodwill left on the balance sheet.
Now that McDonald and Wendy's are one company, their earnings will be combined.  Assuming next year's results were identical, the company would earn $2,146,948,000, or $1.66 per share1.  Remember that goodwill must be amortized, meaning 1/40 the amount must be deducted from next year's earnings.  McDonald must deduct $56,619,400 from earnings next year as a charge against goodwill2.  Now, McDonald can only report earnings of $2,090,328,600, or $1.62 per share (compared to the $1.66 they would have been able to report before the goodwill charge).  Goodwill reduced earnings by 4¢ per share.
If the pooling of interest method had been used, no goodwill would have been created, and McDonald would have reported EPS (earnings per share) of $1.66.  Meaning that depending on how the accounting was handled, the exact same transaction could have two vastly different impacts on earnings per share.
It is no wonder that managements, in order to avoid this reduction in reportable earnings, frequently opt to use the pooling of interest method when they complete a merger.  Since no goodwill is created, over-eager managers are able to pay outrageous prices for acquisitions with little or no accountability on the balance sheet.  Since it makes no sense to have two different ways for accounting for a merger, the FASB (the folks in charge of coming up with these accounting rules) decided they should eliminate the pooling of interest method and force all transactions to be done via the purchase method.  Executives and politicians claimed this will significantly reduce the number of mergers since the new standards would cause reportable earnings to drop as soon as a company had completed an acquisition.  As a concession, the FASB will no longer require goodwill to be written off unless the assets became impaired (which means it becomes clear that the goodwill isn't worth what the company paid for it).
Pay careful attention to the mergers a company has made in the past few years.  Once you are able to value a business, you will want to look at recent acquisitions to determine if they were too expensive.  If you find this to be the case, you will probably want to avoid the stock (why would you want to invest in a company that was throwing your money around?).
1.) Since McDonalds purchased Wendy's, the two companies' profits will be combined.  $1,977,300,000 + $169,648,000 = $2,146,948,000.  To get the earnings per share, you would simply divide it by the number of shares outstanding (1.29 billion).  We're assuming McDonald bought Wendy's for cash.  If stock had been used, the number of shares would change, but for simplicity sake, we are going to assume this not to be the case.
2.) Take the premium $2,264,776,000 and divide it by 40 years = this is the charge against earnings each year
3.) Companies purchased before 1970 are not required to be amortized off the balance sheet.  They can stay there forever.
Intangible Assets
Companies often own things of value that cannot be touched, felt, or seen.  These consist of patents, trademarks, brand names, franchises, and economic goodwill (which is different than the accounting goodwill we've discussed.  Economic goodwill consists of the intangible advantages a company has over its competitors such as an excellent reputation, strategic location, business connections, etc.)  While every effort should be made for businesses to carry them at costs on the balance sheet, they are normally given completely meaningless values.
To prove the point that the intangible value assigned on the balance sheet can be deceptive, here's an excerpt from Michael F. Price's introduction to Benjamin Grahams "The Interpretation of Financial Statements"...
In the spring of 1975, shortly after I began my career at Mutual Shares Fund, Max Heine asked me to look at a small brewery - the F&M Schrieffer Brewing Company.  I'll never forget looking at the balance sheet and seeing a +/- $40 million net worth and $40 million in 'intangibles'.  I said to Max, 'It looks cheap.  It's trading for well below its net worth.... A classic value stock!'  Max said, 'Look closer.'
I looked in the notes and at the financial statements, but they didn't reveal where the intangibles figure came from.  I called Schrieffer's treasurer and said, 'I'm looking at your balance sheet.  Tell me, what does the $40 million of intangibles related to?'  He replied, 'Don't you know our jingle, 'Schrieffer is the one beer to have when you're having more than one.'?'
That was my first analysis of an intangible asset which, of course, was way overstated, increased book value, and showed higher earnings than were warranted in 1975.  All this to keep Schrieffer's stock price higher than it otherwise would have been.  We didn't buy it."
When analyzing a balance sheet, you should generally ignore the amount assigned to intangible assets.  These intangible assets may be worth a huge amount in real life (Coca-Cola's brand name is priceless), but it is the income statement, not the balance sheet, that gives investors insight into the value of these intangible items.
Capital Surplus
To understand what Capital Surplus is, you must first understand the concept of Surplus.  From an accounting standpoint, surplus is the difference between the total par value of the stock outstanding and the shareholder equity and Proprietorship Reserves.  (Don't panic!  It's not as complicated as it sounds!)  You already know what par value and shareholder equity are.  The only thing you haven't learned about is Proprietorship Reserves, which we will discuss in a minute. 
Almost always part of the surplus is a result of retained earnings (which would increase the shareholder equity).  There is a specific part of the surplus that comes from other sources (such as increasing the value of fixed assets carried on the balance sheet, the sale of stock at a premium, or the lowering of the par value on common stock).  These "other" sources are frequently called "Capital Surplus" and placed on the balance sheet.  In other words, Capital Surplus tells you how much of the company's shareholder equity is not due to retained earnings.
Reserves & Proprietorship Reserves
Reserves deserve special attention when analyzing a company.  When a business creates a "Reserve", they are essentially setting aside a certain amount of money for a specific purpose.  Often times, reserves are monies set aside to act as a buffer against future losses. Let's look at a few examples:
  • If a company had a substantial amount of their current assets in receivables, they would set aside money in case some of the customers didn't pay their bills.  This is a reserve for doubtful and bad accounts.
  • If a business had a build up of inventories that risked losing their value, management would create a reserve to offset losses.
  • If a manufacturing corporation decided to save money to build a new widget plant, they would put money in a reserve until they had saved enough to pay for it.
Proprietorship Reserves are set up to alert investors that a certain part of the shareholder's equity cannot be paid out as cash dividends since they have another purpose.



Post a Comment