The fifth chapter primarily delves into the concept of equity analysis. Equity analysis is typically the process of analyzing sectors and companies, to provide advice to professional fund managers as well as private clients in regards to the types of shares to buy. Via the determination of the future cash flow of the company, one can infer the value of a stock price and determine whether the current value of the company is overvalued or undervalued. In the same manner, the earnings of a company are used as a measure of the company’s performance which is often alluded to in terms of returns on investments.
The chapter claims that there are three primary pressures that affect the likelihood of management and they include:
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Executive compensation on the basis of earning targets
Reporting increased earnings; and
Beating or meeting the target by analysts.
The most significant of these measures is to change company policy so that more costs are capitalized instead of being expensed immediately. However, the chapter fails to mention the fact that a change in accounting practices ought to be explained to the readers of financial statements as they are typically stated within the footnotes of the financial statements.
Other types of variables for a company’s financial performance such as pro forma earnings, core earnings, earnings per share, price earnings ratio, dividends etc., were also discussed but with an emphasis on the dividends and its evaluation models. When delving into the aspect of pro forma earnings, the chapter claims that it is an unreliable source of financial information as it typically entails the companies’ own methods in financial reporting. Pro forma earnings shares similarity with core earnings because it fails to account for some of the non-recurring expenses such as litigations. Although the chapter provided brief explanations of such concepts, the explanations were holistic as they touched on the core aspects of the subjects under study.
In regards to earnings per share, the chapter claims that it is the earnings available for commons shareholders, divided by the number of common shares outstanding. The definition of earnings per share is more mathematical but in the layman’s definition, they are figures that describe a public company’s profit per outstanding share of stock, which is typically calculated on an annual or quarterly basis.
The formula is written as follows:
In the case of Apple for example their earnings per share is $4.50. In addition, the chapter should mention the relationship between earnings per share and profitability. This is because the higher the earnings per share of a company, the higher its profitability and this is also true for vice versa. Nevertheless, the chapter mentions some of the facts on the aspects of earnings per share by stating that it can be misleading particularly under certain economic conditions, such as when the company is under economic duress and this can be beneficial for the readers.
Dividends were also delved into in the chapter as they are described as cash payments made by corporations to its owners. Some of the aspects of dividends such as dividend yields, plow-out ratio, and dividend payout were also discussed in detail. The chapter provides a holistic overview of each element by providing their particular mathematical formulas. For instance, dividend yield is the ratio of dividend over market price of shares, while dividend payout is obtained by dividing the dividends by the earnings available to the owners. Lastly, the chapter embarks on the dividend valuation model and this is the section the chapter emphasizes on as it expounds on it by using different examples and is thus a thorough and in-depth evaluation of the dividend valuation model.
