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PART One
What Is a Stock?
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CHAPTER 1
Equity Fundamentals (Part 1) Introduction to Financial Statements
INTRODUCTION
In this chapter and the next we lay out a general framework for answering the most fundamental question for anyone working in equities or equity derivatives: âWhat is a share of stock and how much is it worth?â The goal is to develop sufficient understanding of the relevant concepts and terminology from financial accounting to ensure that the reader can understand, participate in, and benefit from, the sort of general stock analysis and valuation discussions that are held on a trading floor.
The presentation of the material is deliberately of a general characterâthe focus is on developing a clear conceptual understanding without getting bogged down in the details that, while essential to the work of an equity research analyst, are unnecessary for our purposes. Readers interested in a more detailed presentation can consult any of the many well-written books available on equity analysis or financial accounting.
It is worth clarifying that while the material in the first two chapters is basic, that does not mean it is easy. Readers with no previous exposure to financial accounting or valuation may find the writing rather denseâmany of new concepts are introduced in a small number of pages. Because the material is conceptually fundamental, it is presented at the beginning of the book. It is not, however, a prerequisite for understanding the contents of subsequent chapters and readers who find this first section challenging can jump straight to Chapter 3 and come back to these first two chapters either as a reference or for more careful study at a later time.
EQUITY AND CORPORATION
By definition, a share of stock is a unit of ownership in a corporation. This definition does not help us much unless we understand what a corporation is.1 A corporation is actually a rather curious concept: It is an independent legal entity, with its own rights and responsibilities, but distinctly independent from the people who run and own it. In many ways a newly established corporation is like a new citizen born into the state in which it is incorporated. Like people, corporations have rights and responsibilities, and can be held legally liable for their actions. Whether the question is over the purchase of a piece of property, the payment of a tax, or the pollution of a river, the answers âArchibald Gricklegrass did itâ or âXYZ Incorporated did it,â while not identical, are similarly valid.
Although businesses may adopt any one of many different legal structures, there are two very important characteristics of corporations that make it by far the most popular option. The first is that a corporation can be divided into fractional units (shares) that can be owned by multiple parties and purchased or sold freely between them. These shares give ownership of the âequityâ in the corporationâthat is, the benefits that remain after paying off all debts, taxes, and other obligations, both now and for the indefinite future. They also give the holders a fractional say in the decisions of the corporation (voting rights). The holder of even one share of stock has the right to attend the annual shareholdersâ meeting and ask whatever questions they choose of the management and, if enough other shareholders agree, to replace the management or even dissolve the corporation and liquidate its assets. It is, in the truest sense, ownership of the corporation in fractional percentage with the number of shares held and the number of shares outstanding.
The second important concept is that the fractional ownersâthe shareholdersâhave limited liability in the event of financial or legal challenge to the corporation. While the holder of a share of stock is, in fact, a partial owner of the company, the most that he or she can lose in the event the company were sued or faced financial hardship is the value of the stock he holds. This makes stock ownership a remarkable concept: the holder of stock gets all the benefits of owning the company with no more risk than the invested capital. Once a stockâs price has gone to zero, there is nothing more that can be done to reclaim additional responsibility from the shareholderâa stock price can never go below zero. Were this not the case, stock ownership would be significantly more risky and trading on the stock market would be considerably less active as investors would have to assess much more carefully the potential risks of association with the activities and management of the company in question.
While the owners of the corporation are actually the shareholders, the actual day-to-day running of the business is left in the hands of the officers of the corporation (from the President on down) whose actions are then supervised by an executive board whose job it is to insure that the actions of the corporation are in the best interest of the shareholders.
INTRODUCTION TO FINANCIAL STATEMENTS
For a potential investor to make an informed decision as to whether to purchase shares of a company, he or she needs some information about its internal operation and financial status. What does the company own? What does it owe to others? How much money is it making? How is it using that money? In the United States, publicly traded companies are required to publish, and make available to investors, a quarterly report summarizing all the financial details of the company. To ensure that this report is accurate and understandable to investors and can be compared with the equivalent disclosures by other firms, there is a set of generally accepted accounting principles (GAAP) that specify the definitions and conventions that must be adhered to in presenting the information. Because these quarterly public disclosures are generally the only information the public has about the internal operations of the company, they must be verified by an external independent auditor who verifies that the information is accurate and that there is no attempt by the management to deceive investors by manipulating the data.
There are three statements that provide the majority of the information in the quarterly financial disclosures, which we will examine in more detail here:
1. Balance sheet: Summarizes the assets (things owned) and liabilities (things owed) of the company and how they are financed through a mixture of debt (borrowed money) and equity (funds contributed by the shareholder owners).
2. Income statement: Summarizes the revenue, expenses, and resulting income in the period.
3. Statement of cash flows: Summarizes the sources and uses of cash.
In this chapter, samples of each of these three financial statements are presented, along with definitions and explanations of their contents.
Because all publicly traded companies in the United States must adhere to GAAP, the structure of the financial statements, and the definitions of the various components are deliberately general. This âone size fits allâ approach facilitates the comparison of different companies but in doing so, removes a great deal of important detail. In practice, companies usually provide many clarifications and additional insights through footnotes to the statements and supplementary disclosures.
To maximize the comprehension and retention of the material, I would strongly recommend that readers choose a simple small business with which they feel comfortable and think about what the definition of each new concept would mean in this specific context. (Personally, I find a bakery a particularly useful example.) I have deliberately not provided my own example because it is the act of thinking about the meaning of each concept and applying it to the tangible example that actually leads to understanding and retention. Readers who make the effort should find that these first two chapters provide sufficient foundation in financial accounting and fundamental analysis (the subject of the next chapter) to be able to understand a typical analystâs research report or discuss investment ideas with coworkers.
THE BALANCE SHEET
The balance sheet summarizes the assets and liabilities of the company at the time of publication. Unlike the income statement and statement of cash flows, the balance sheet is a freeze-frame snapshot of the company, rather than an analysis of the performance over the period. The changes in the mix of assets and liabilities of the company can be seen by comparing the current composition of the balance sheet with that of previous periods. While these changes are not explicitly shown on the balance sheet, the previous quarter and one-year ago data are usually presented alongside for comparison.
The contents of a sample balance sheet for a hypothetical company, XYZ Inc., are shown in Exhibit 1.1. While our example is deliberately simple, the structure and layout of the balance sheet of even a large multinational corporation would be quite similar (which emphasizes the need for additional disclosures). To make the example as clear as possible, the formatting and notation are somewhat nonstandard and the potentially distracting previous period values have been excluded.
Balance Sheet Fundamentals
The balance sheet is structured with assets on the left-hand side and liabilities and shareholdersâ equity on the right. For an item to be considered an
asset, it must have been acquired in the past and have the potential to generate a quantifiable economic benefit in the future.
Liabilities are obligations acquired in the past that require economic sacrifices in the future. The difference between the assets and liabilities of the company is what is left over for the owners (shareholders) of the company. This is called
shareholdersâ equity. This leads us to one of the fundamental identities of accounting:
EXHIBIT 1.1 Balance Sheet for XYZ Inc.
That is, the things a company has (assets) are either paid for with borrowed money (liabilities) or belong to the owners (shareholdersâ equity). This identity means that the sum of the items on each side of the balance sheet must be the sameâthatâs why itâs called the âbalanceâ sheet.
In order for the two sides of the balance sheet to remain equal, the assets and liabilities of the company must be recorded using a process called double-entry bookkeeping. A single item cannot be added to the balance sheet in isolationâthere must always be an equal and offsetting adjustment somewhere else to keep things balanced. This offsetting entry can be an equivalent addition to the other side of the balance sheet, or a reduction in another item on the same side.
This is best illustrated by an example. Consider a brand new company that has yet to begin operation and whose only asset is $1,000 of cash invested by the founders. The companyâs balance sheet looks quite simple:
The company now purchases a piece of equipment for $600. The management has three ways to pay for it: they can spend the cash they have, they can buy it on credit (get a loan), or the owners of the company can contribute more capital to pay for it. The three approaches are recognized differently on the ...
