Reading Financial Reports for Dummies (31 page)

Some companies pay a portion of their earnings directly to their shareholders using dividends. Growth companies, which reinvest all their profits, rarely pay out dividends, but older, mature companies usually do. Older companies that no longer need to reinvest large sums in growing their businesses pay out the highest dividends.

To determine how well investors did with their stock holding, you can calculate the
dividend payout ratio.

Determining dividend payout

To find the dividend payout ratio, divide yearly dividend per share (the total amount per share paid out to investors during the year in dividends) by earnings per share:

Yearly dividend per share ÷ Earnings per share = Dividend payout ratio
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You can use numbers from Mattel’s 2007 income statement to practice calculating the dividend payout ratio:

$0.75 (Dividends per share) ÷ $1.54 (Diluted EPS) = 48.7% (Dividend payout ratio)

Mattel paid out 48.7 percent of its diluted earnings per share to investors in 2007. If you subtract this percentage from 100 percent, you can find how much the company plowed back into its operations toward future growth. In Mattel’s case, 51.3 percent of its earnings were reinvested in the growth of the company. You can find the earnings reinvested in the company over the years in the retained earnings line in the shareholders’ equity section of the balance sheet. (See Chapter 6 for a more detailed discussion of shareholders’

equity.) Each year, any additional retained earnings are added to this line item. Mattel’s retained earnings were over $1.977 billion during its lifespan, according to the 2007 balance sheet (see Appendix A).

Following are numbers from Hasbro’s 2007 income statement. You can use them to calculate the dividend payout ratio.

$0.64 (Dividends per share) ÷ $1.97 (Diluted EPS) = 32.5% (Dividend payout ratio)

Hasbro paid out 32.5 percent of its diluted earnings per share to investors and plowed 67.5 percent (subtract 32.5 from 100) back into the company to use for future growth. Hasbro’s retained earnings on its 2007 balance sheet were more than $2.26 billion.

Digging into companies’

profits with dividends

Should the dividend payout ratio make a difference to you? In the past, investors expected dividend payouts. In fact, dividends made up as much as 40

percent of most investors’ portfolio returns about 20 years ago. But investors’ priorities have changed in the past 20 years. Today, investors look toward
capital gains,
which are the profits investors make when selling a share of stock for more than they paid for that stock, for portfolio growth.

The big question is what better serves the investor and the company: immediate cash payouts of dividends or long-term growth resulting from reinvesting profits each year. The answer to this question isn’t an easy one. Younger companies rarely pay dividends because they need the money for growth, but as companies mature, the correct answer is more difficult to determine.

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For example, Microsoft held billions in cash and refused to pay dividends for years, claiming that it may need the cash for growth. Not until investors screamed long and loud did Microsoft finally pay its first dividend in 2003: only 8¢ per share, or a total of about $857 million!

You should definitely check how the dividend payout ratio compares with that of similar companies. If the dividend payout ratio is considerably smaller than that of other similar companies, be sure you understand what the company does with the money and whether it’s making good use of the funds it’s reinvesting. If the company pays out a significantly larger portion of earnings to investors than most other companies in the industry, it may not have any good ideas for growth and is therefore just milking the cash cow, which may eventually run dry.

High dividend payout ratios could be a sign that a decrease in profits may soon be on the way. If a company continually increases its dividend payout ratio even as profits fall, you’ve encountered a warning sign that future trouble is brewing.

Who has the highest dividend payout ratios?

Investors who purchase stock primarily for cur-

saving for future needs. If the firm is paying

rent income look to industries that traditionally

out most of its cash and saving very little,

have high dividend payout ratios. Utility compa-

that may be a sign that the cash could run

nies traditionally have some of the highest divi-

out at some point because the business

dend payout ratios, but you find good dividend

is no longer reinvesting anything in main-

payers in many mature, older industries. If you

taining its market or updating its products.

want to look for a good stock to buy based on

Eventually, the company will lose out to

dividend payout, here are two key factors to

competition and earn less, bringing in less

consider:

cash.

✓
Cash stash:
When you read the annual ✓
Dividend consistency:
As you read the report, pay close attention to how much

annual report, also look for information

cash the company reports on its books.

about dividends paid out over the past few

Remember that the dividend comes from

years. You can find that information for the

extra cash flow. Most companies need to

past three years at the bottom of the income

hold onto some of their cash so they have

statement. You can get information for more

money for acquisitions, research and devel-

than three years by looking up the company

opment, and other capital needs to keep

at Yahoo! Finance and other financial Web

them competitive, even if they’re not in a

sites. You want to find companies that pay

high-growth industry. Use your calculation

dividends at a consistent level or, even

of the dividend payout ratio to determine

better, that are able to increase their divi-

how much cash the company is using to

dend payouts regularly.

cover its dividends and how much cash it’s

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163

If the dividend payout ratio looks extremely high or extremely low, look at the financial statements before you get too concerned. Did some extraordinary event dramatically impact net income, such as a significant loss from a plant closing or the sale or purchase of a subsidiary? A one-time event that impacts net income can explain an unusually high or low dividend payout ratio and needn’t raise a red flag for investors.

Return on Sales

You can test how efficiently a company runs its operations (that is, the making and selling of its products) by calculating its
return on sales
(ROS).

This ratio measures how much profit the company is producing per dollar of sales. By analyzing the numbers in the income statement using ROS, you can get a picture of the company’s profit per dollar of sales and gauge how much extra cash the company is bringing in per sale.

Remember that the firm needs that cash to cover its expenses, develop new products, and keep itself competitive. Investors also hope that at some point in the future they may even be paid some dividends. At the very least, investors want to be sure the company is generating enough cash from sales to keep itself competitive in the market through advertising, new product development, and new market development.

Figuring out ROS

To calculate ROS, divide the net income before taxes by sales. You can find both numbers on the income statement. Net sales (sometimes called net revenue) is the top number on the income statement. Net income before taxes is in the expense section of the income statement, just before tax expenses are reported.

Net income before taxes ÷ Sales = Return on sales

You can calculate Mattel’s ROS based on information in its income statement for 2007:

$703,398,000 (Net income before taxes) ÷ $5,970,090,000 (Sales) =

11.8% (ROS)

Mattel made 11.8 percent on each dollar of sales. Compare that number with Hasbro’s ROS using numbers on its income statement for 2007: $462,382,000 (Net income before taxes) ÷ $3,837,557,000 (Sales) =

12% (ROS)

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Hasbro made 12 percent on each dollar of sales.

Investors can use the ROS ratio to determine how much profit is being made on a dollar of sales. In comparing Mattel and Hasbro, you can see that Mattel and Hasbro had similar ROS ratios.

Reaching the truth about profits with ROS

In reading analysts’ reports on Mattel and Hasbro, I found that Hasbro’s historical ROS has been about 7 percent, so the results for Hasbro in the preceding section show improvement. Mattel is stagnating with its efforts to improve operating income. Its ROS in 2001 was 12.5 percent, and it dropped to 11.8 percent in 2007. Mattel wants to get back to its previous historical average of about 15 to 16 percent. The ROS for Mattel was impacted by the $42 million it had to pay for costs related to the recalls of toys made in China in 2007. Lost sales because of these recalls also probably impacted Mattel’s numbers. You can find out more details about the full impact of the China recalls in the notes to the financial statements (see chapter 9) and in the management’s discussion and analysis (see Chapter 5).

ROS is just one part of the puzzle. You need to fully analyze the information you see in the annual reports to find all the pieces and make a determination about whether to invest in a company. This chapter focuses on profitability.

You also need to analyze a company’s liquidity, which I discuss in Chapter 12, and its cash flow, which I discuss in Chapter 13.

Return on Assets

You can judge how well a company uses its assets by calculating the
return
on assets
(ROA). If the ROA is a high percentage, the company is likely managing its assets well. As an investor, that’s important because your shares of stock represent a claim on those assets. You want to be sure that your claim is being used wisely. If you haven’t invested yet, be sure your investment will go toward stock in a company that invests its assets well. As with all ratios, you need to compare results with those of similar companies in an industry in order for the numbers to mean anything.

To calculate ROA, divide net income by total assets. You can find net income at the bottom of the income statement, and you can find total assets at the bottom of the assets section of the balance sheet.

Net income ÷ Total assets = Return on assets

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Doing some dividing to get ROA

Using the numbers from Mattel’s income statement and balance sheet, you can determine its ROA:

$599,993,000 (Net income) ÷ $4,805,455,000 (Total assets) = 12.5% (ROA) So Mattel made 12.5 percent on each dollar of assets. Compare this number with Hasbro’s ROA:

$333,003,000 (Net income) ÷ $ 3,237,063,000 (Total assets) = 10.3% (ROA) Hasbro made 10.3 percent on each dollar of assets. Mattel earned about 2

percent more than Hasbro on each dollar of assets.

Ranking companies with the help of ROA

The ROA ratio shows you how much a company earns from its assets or capital invested. This ratio gives investors and debtors a clear view of how well a company’s management uses its assets to generate a profit. Both
shareholders’ equity
(claims on assets by shareholders) and
debt funding
(claims on assets by creditors) factor into this calculation, meaning that the ratio looks at the income generated using money raised by borrowing funds from creditors and selling stock to shareholders.

ROA can vary significantly depending on the type of industry. Companies that must use their capital to maintain manufacturing operations with factories and expensive machinery have a much lower ROA than companies that don’t require heavy manufacturing, like service companies. Businesses with low asset requirements average an ROA of 20 percent or higher, whereas companies that require a large investment in assets can have ROAs below 5 percent.

Return on Equity

Return on equity
(ROE) measures how well a company does earning money for its investors. In fact, you’ll probably find it easier to determine an ROE for a company than an ROA. Although the ROE is an excellent measure of how profitable the company is in comparison with other companies in the industry, you should look at the ROA as well, because that ratio looks at returns for both investors and creditors.

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Calculating ROE

You calculate ROE by dividing net income earned by the company (which you find at the bottom of the income statement) by the total shareholders’ equity (which you find at the bottom of the equity section of the balance sheet): Net income ÷ Shareholders’ equity = Return on equity

You can figure out Mattel’s ROE based on its 2007 income statements and balance sheets:

$599,993,000 (Net income) ÷ $2,306,742,000 (Shareholders’ equity) = 26%

(ROE)

Mattel made 26 percent on each dollar of shareholders’ equity. Following is Hasbro’s ROE, also based on 2007 income statements and balance sheets: $333,003,000 (Net income) ÷ $1,385,092,000 (Shareholders’ equity) = 24%

(ROE)

Hasbro made 24 percent on each dollar of assets. Comparing Mattel and Hasbro, you can see that Mattel generated slightly more than Hasbro on its shareholders’ equity.

Reacting to companies with

ROEs assistance

Investors most often cite the ROE ratio when they want to see how well a company is doing for them. This can be a huge mistake because ROE ignores the impact of debt on profitability, so it doesn’t give investors the full picture of a company’s financial position. ROE doesn’t consider the impact of a company’s debt position on its future earnings potential.