Chapter 14 - Company Analysis (Easy)

Questions and Answers

What type of report can you use to obtain information about a company's preferred shares?

Individual company annual reports.

How can a change in the rating of preferred shares impact their market price?

An unexpected downgrade usually has negative implications, while an upgrade is favorable.

What features should you consider when selecting preferred shares?

Cumulative dividends, sinking funds, and protective provisions.

What is a crucial consideration when evaluating the yield from preferred shares?

It should be compared to yields from other similar investments. Signup and view all the answers

What additional questions should be asked if the preferred shares are convertible?

Is the outlook for the common stock positive, and is the life of the conversion privilege long enough? Signup and view all the answers

How does the market price of common stock relate to the conversion privilege of preferred shares?

The conversion privilege is valuable only if the market price of the common rises above the conversion price. Signup and view all the answers

Why is research coverage by investment firms important for preferred shares?

It influences marketability and informs investors of the shares' investment potential. Signup and view all the answers

What is the implication of having a longer life for the conversion privilege?

It provides a greater opportunity for the market price of the common and preferred to respond to favorable developments. Signup and view all the answers

What is the total capitalization of both Company A and Company B?

$1 million each Signup and view all the answers

How do you calculate the percentage return on common shares for Company A in Year One?

Divide $50,000 by $1,000,000 and convert to percentage. Signup and view all the answers

What is the formula for determining the Earnings Per Share (EPS) for Company B in Year One?

EPS = Earnings available for common shares ÷ Common shares outstanding. Signup and view all the answers

Why is the stock of Company A considered less risky than that of Company B?

Company A pays no dividends to preferred shareholders, making it less vulnerable. Signup and view all the answers

What are the primary components of Company B's capitalization?

50,000 preferred shares and 50,000 common shares. Signup and view all the answers

What is the percentage return on common shares for Company B in Year One?

5% Signup and view all the answers

What impact does the business cycle have on the stock prices of Company A and Company B?

Company B is more sensitive to earnings shrinkage, impacting its stock more. Signup and view all the answers

What qualitative factors should be considered when analyzing a company's stock?

Liquidity of common shares and continuous monitoring. Signup and view all the answers

How does the Dividend Discount Model (DDM) apply to Company A and Company B?

DDM can be applied to Company A since it has stable dividends, unlike Company B. Signup and view all the answers

In terms of financial ratios, what is a key difference between Company A and Company B?

Company A has a higher earnings stability ratio compared to Company B. Signup and view all the answers

What is the profit per share for Company ABC before adjusting for diluted earnings?

$3.73 per share Signup and view all the answers

How does the fully diluted EPS change after accounting for warrants?

$3.37 per share Signup and view all the answers

Why might directors of a company decide to pay dividends even in growth companies?

Directors may pay dividends to provide income to shareholders, acknowledging their need for returns even in growth phases. Signup and view all the answers

What factors influence shareholders' decision regarding dividends when profits are low?

If profits are low or a loss occurs, directors may decide not to pay dividends. Signup and view all the answers

What is the importance of describing earnings in terms of common shares?

It shows shareholders the profitability of their ownership interest in the company. Signup and view all the answers

What does the Dividend Discount Model (DDM) indicate about a stock's intrinsic value?

The DDM indicates the intrinsic value of a stock based on expected dividends, required return, and growth rate of dividends. Signup and view all the answers

How is intrinsic value calculated using DDM?

Intrinsic value is calculated using the formula: <code>Price = Div / (r - g)</code>, where Div is the expected dividend, r is the required return, and g is the growth rate. Signup and view all the answers

If a stock is selling at $25 while its intrinsic value is $33.33, how should investors perceive it?

Investors should perceive the stock as undervalued since it is selling below its intrinsic value. Signup and view all the answers

What happens to stock prices during an economic downturn according to the business cycle?

During an economic downturn, stock prices tend to decrease due to reduced earnings and investor confidence. Signup and view all the answers

Why are preferred shares evaluated differently than common shares?

Preferred shares are evaluated differently because they offer fixed dividends and do not provide voting rights, resembling more of a bond investment. Signup and view all the answers

What is one critical question when assessing the investment quality of preferred shares?

One critical question is whether the company's earnings provide ample coverage for preferred dividends. Signup and view all the answers

How can comparing financial ratios help investors make better investment decisions?

Comparing financial ratios can help investors determine which company offers better investment prospects based on operational efficiency and financial health. Signup and view all the answers

What does it mean if a company’s financial ratios are significantly better than its competitor's?

If a company's financial ratios are significantly better, it indicates that the company may be a more attractive investment due to better operational performance. Signup and view all the answers

What key aspects influence the required return (r) in the DDM?

Key aspects influencing the required return include market conditions, interest rates, and the risk profile of the stock. Signup and view all the answers

What does a growth rate (g) in the DDM signify?

The growth rate (g) signifies the expected annual growth in dividends paid by the company. Signup and view all the answers

What is the per common share earnings for Company A in Year Two?

$1.00 Signup and view all the answers

How much were the preferred dividends for Company B each year?

$25,000 Signup and view all the answers

In which year did Company B have no earnings available for common shareholders?

Year Three Signup and view all the answers

What is the percentage return earned on common shares for Company B in Year Two?

15% Signup and view all the answers

What was the effect of leverage on the per common share earnings of Company A in Year One?

$0.50 Signup and view all the answers

How did the earnings available for common shares change from Year One to Year Three for Company A?

Decreased from $50,000 to $25,000 Signup and view all the answers

What was Company B's per common share earnings in Year One?

$0.50 Signup and view all the answers

Which company experienced a greater percentage increase in return on common shares from Year One to Year Two?

Company B Signup and view all the answers

For Company A, what factors contribute to the percentage of return earned on common shares?

Earnings and dividend payout to common shareholders. Signup and view all the answers

What was the total earnings available for dividends for both companies in Year One?

$50,000 each Signup and view all the answers

Study Notes

Credit Assessment of Preferred Shares

Preferred shares may receive ratings from recognized securities rating services, similar to bonds.
Ratings influence the market price of preferred shares; downgrades typically lead to price declines while upgrades can enhance prices.

Selecting Preferred Shares

When evaluating preferred shares, consider marketability, trading volume, and research coverage.
Investigate specific features like cumulative dividends and sinking funds.
Determine if the yield is acceptable compared to similar investments.
For convertible preferred shares, assess:
- The outlook for the underlying common stock.
- The timing of the conversion privilege relative to market price movements.

Dividend Discount Model (DDM)

The intrinsic value of a stock can be calculated using DDM; exemplified by:
- Formula: Price = Div1 / (r - g)
- Example calculation gives an intrinsic value of $33.33 for expected dividends.
Market price comparison indicates investment attractiveness:
- Stock is undervalued if priced below intrinsic value ($25).
- Stock is overvalued if priced above intrinsic value ($40).

Company Analysis

Practice company analysis using examples like fictitious NFR Inc., calculating various ratios.
Comparison of performance can highlight better investment opportunities.

Preferred shares differ from common shares: they offer fixed dividends and no voting rights.
Assessment focuses on:
- Earnings sufficiency to cover preferred dividends.

Example Company Earnings Analysis

Companies A and B both have $1 million in capitalization.
Company A's common shares yield: Year One 5%, Year Two 10%, Year Three 2.5% (no preferred dividends).
Company B needs to pay preferred dividends; the earnings available for common shareholders are more constrained.
Example illustrates Company A is less risky due to no leverage and more stable earnings.

Impact of Leverage on Earnings

Preferred shares can affect earnings per share (EPS) due to leverage:
- Company A: No leverage means all earnings available for common dividends.
- Company B: With 50% leverage, earnings available for common shares decrease after paying preferred dividends.

Calculated by adjusting the number of shares for potential conversions (e.g., warrants).
Example shows adjusted profit leads to fully diluted EPS of $3.37, reflecting the company’s profitability per common share.

Dividend Payment Consideration

Shareholders must evaluate profit levels to predict dividend distributions.
High profitability generally leads to higher dividends, while losses may result in no dividends issued.
The Trans-Canada Retail Stores case reflects a common share earning of $3.12, serving as a benchmark for assessing dividend potential.

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Description

This quiz focuses on understanding how to assess credit ratings of companies and their preferred shares using annual reports. You will explore the significance of these ratings and the impact of changes on investment decisions. Prepare to dive into the world of securities rating services.