Accounting: The Language of Business - Vol. 1 (Part 106)

"Cost Accounting is enemy number one of productivity." - Eliyahu M. Goldratt 

 Financial Statement Analysis (Part E)

by

Charles Lamson

Rate Earned on Common Stockholders' Equity

A corporation may have both preferred and common stock outstanding. In this case, common stockholders have the residual claim on earnings. The rate earned on common stockholders' equity focuses only on the rate of profits earned on the amount invested by the common stockholders. It is computed by subtracting preferred dividend requirements from the net income and dividing by the average common stockholders' equity.

Lincoln Company has $150,000 of 6% nonparticipating preferred stock outstanding on December 31, 2023 and 2022. Thus, the annual preferred dividend requirement is $9,000 ($150,000 * 6%). The common stockholders' equity equals the total stockholders' equity, including retained earnings, less the par of the preferred stock ($150,000). The basic data and the rate earned on common stockholders' equity for Lincoln Company are as follows:

The rate earned on common stockholders' equity differs from the rates earned by Lincoln Company on total assets and total stockholders' equity. This occurs if there are borrowed funds and also preferred stock outstanding, which ranked ahead of the common shares and their claim on earnings. Thus, the concept of leverage, as we discussed in part 105, can also be applied to the use of funds from the sale of preferred stock as well as borrowing. Funds from both sources can be used in an attempt to increase the return on common stockholders' equity.

Earnings per Share on Common Stock

One of the profitability measures often quoted by the financial press is earnings per share (EPS) on common stock. It is also normally reported in the income statement in corporate annual reports. If a company has issued only one claim of stock, the earnings per share is computed by dividing net income by the number of preferred dividend requirements.

The data on the earnings per share of common stock for Lincoln Company are as follows:

Price-Earnings Ratio

Another profitability measure quoted by the financial press is the price earnings (P/E) ratio on common stock. The price earnings ratio is an indicator of a firm's future earnings prospects. It is computed by dividing the market price per share of common stock at a specific date by the annual earnings per share. To illustrate, assume that the market prices per common share are 41 at the end of 2023 and 27 at the end of 2022. The price earnings ratio on common stock of Lincoln Company is computed as follows:

The price earnings ratio indicates that a share of common stock of Lincoln Company was selling for 20 times the amount of earnings per share at the end of 2022. At the end of 2023, the common stock was selling for 25 times the amount of earnings per share.

Dividends per Share and Dividend Yield

Since the primary basis for dividends is earnings, dividends per share and earnings per share on common stock are commonly used by investors in assessing alternative stock investments. The dividends per share for Lincoln Company were $0.80 ($40,000 / 50,000 shares) for 2023 and $0.60 ($30,000 / 50,000 shares) for 2022.

Dividends per share can be reported with earnings per share to indicate the relationships between dividends and earnings. Comparing these two per share amounts indicates the extent to which the corporation is returning its earnings for use in operations. Exhibit 9 shows these relationships for Lincoln Company.

EXHIBIT 9 Dividends and Earnings per Share of Common Stock

The dividend yield on common stock is a profitability measure that shows the rate of return to common stockholders in terms of cash dividends. It is of special interest to investors whose main investment objective is to receive current returns (dividends) on an investment rather than an increase in the market price of the investment. The dividend yield is computed by dividing the annual price of the investment dividends paid per share of common stock by the market price per share on a specific date. To illustrate, assume that the market price was 41 at the end of 2023 and 27 at the end of 2022. The dividend yield on common stock of Lincoln Company is as follows:

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 706-708*

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