Chapter 10: Corporate Stockholders’ Equity, Dividends, and Treasury Stock

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We all see these big companies around us every day.

But have you ever wondered, like, who really controls them?

Who really has the power?

Yeah, that's a really interesting question.

It all comes down to ownership, right?

How it's structured, how it can change, and what happens when these companies make big decisions about their money.

Exactly.

And today we're going deep on a topic that's fundamental to all of this.

Stockholders' equity.

We've gathered some really insightful information and we're going to break it down for you so you can truly grasp this essential area of corporate finance.

That's right.

We're going to get into the nitty gritty of stockholders' equity, you know.

We're going to explore how corporations are different from other types of businesses, what your rights are as a stockholder, the different kinds of stock that a company can issue, and how all of these financial moves are accounted for.

And we'll also look at how companies give back to their owners through things like dividends and stock splits.

And we'll learn how to use key financial ratios related to equity to really assess how well a company is performing.

It's going to be a comprehensive dive, that's for sure.

For sure.

So let's start with the very basics.

We've got different ways to set up a business, right?

You've got your small businesses, your partnerships.

But corporations, they're in a league of their own.

What sets them apart?

What makes them so different?

One of the biggest differences is their lifespan.

Corporations, they have this thing called continuous life.

What that means is that ownership can change hands over and over again.

Shares can be bought and sold, gifted, inherited, you name it.

But the corporation itself, it keeps going.

It just exists.

So it's got that sense of permanence.

Exactly.

And that's a big contrast to sole proprietorships or partnerships where, you know, if ownership changes, the business itself often has to be restructured legally or it might even just cease to exist.

So that continuity must be a huge plus for long term planning and investments, right?

Absolutely.

It provides stability and predictability.

Now, let's talk about the people who actually put their money into these corporations, the stockholders.

If things go south, what are they on the hook for?

What kind of risk are they taking?

That's where limited liability comes in.

And this is a big one, a major reason why people invest in corporations.

As a stockholder, you're generally not personally responsible for the corporation's debts.

The most you can lose is the money you invested.

OK, so your personal finances are protected.

Exactly.

Your liability is limited.

And this protection encourages more people to invest, which makes it easier for corporations to raise the large amounts of capital they often need to grow.

You contrast that with other business structures where the owners might be personally liable for all the debts.

That can be a huge deterrent to investment.

Yeah, that makes sense.

So if you own stock, you're an owner, but you're not necessarily running the show every day, right?

How does that all work in a corporation?

It's the separation of ownership and management.

So stockholders, they're the owners, but they elect a board of directors to basically represent them.

This board oversees the general direction of the company, and then this board, they hire the executive team, the CEO, the CEO, all those folks to manage the daily operations.

OK, so you got this chain of command.

Right.

But here's the thing.

While ideally those managers are working to increase the value for the stockholders,

this separation can sometimes lead to, well, let's say, conflicts of interest.

Managers might act in their own self -interest and not always put the owners first.

That's the classic agency problem.

So how do corporations address this?

How do they keep things in check?

Corporate governance.

That's the key.

These are the rules and practices designed to make sure the company is run ethically and with the best interests of the stockholders in mind.

Like a set of checks and balances.

Yeah, exactly.

It includes things like having internal and external auditors, people who scrutinize the financial statements and making sure there are independent members on the board of directors.

These are people who aren't closely tied to the company's management so they can provide an objective perspective.

It's all about accountability and transparency.

Right.

Keeping everybody honest.

Yeah.

Now, let's talk taxes.

We always hear about this double taxation thing with corporations.

What's that all about?

OK, so corporations, they're legally seen as separate from their owners, right?

So they pay their own income taxes on their profits.

That's the first level of taxation.

Then when those after -tax profits are given to the stockholders as dividends, those dividends are taxed again as the stockholders' personal income.

That's the double taxation.

So the same earnings get taxed twice.

Exactly.

And that's a big difference from sole proprietorships or partnerships, where the income typically passes through to the owners and is only taxed at their individual income tax rates.

So that's a major financial consideration for both corporations and their investors.

OK.

Now, given this limited liability for stockholders, do corporations face more scrutiny from government regulators?

Definitely.

Because creditors can only go after the corporation's assets, not the personal assets of the stockholders, governments want to keep a close eye on things to protect both creditors and stockholders.

Makes sense.

So how do they do that?

Primarily through regulations.

Corporations are required to disclose a lot of financial and operational information.

This transparency allows investors and creditors to make informed decisions about where to put their money.

And accounting plays a crucial role in providing this necessary disclosure.

It's all about transparency.

So let's walk through the process of turning an idea into a real legal corporation.

What are the steps involved?

It's a formal process for sure.

Typically, the founders pay fees to the state.

They sign a corporate charter, which lays out the basics of the company, like its name and purpose.

They file this charter with the state.

And they also have to establish bylaws, which are the internal rules for how the corporation will operate.

Once all that's done, the corporation is officially a thing.

Okay.

And once it's all set up, who's really in charge?

Who has the ultimate say?

The stockholders.

They have the ultimate control.

They exercise this control through electing the board of directors.

And remember the board, they set the overall strategy and policies.

They appoint the key officers like the CEO, the COO, and the CFO.

They also often elect a chairperson.

That person can have a lot of influence and might even be the CEO as well.

The president, often the COO, is usually responsible for daily management.

Then below them, you've got vice presidents who handle different parts of the business, like sales, manufacturing, and finance.

So it's stockholders, board, then management.

Okay, that's clear.

Now, let's say you become a stockholder.

Beyond just hoping the stock price goes up, what are your rights?

What are you actually entitled to?

There are four basic rights that come with owning stock.

The first is the right to vote.

You get to have a say in important company matters, like electing the board of directors.

One share, one vote, right?

Generally, yes, for common stock.

Second, you have the right to receive dividends.

If the corporation decides to distribute some of its profits, each share of a particular class of stock, like common stock, gets an equal share of that dividend.

Okay, so that's a direct financial benefit.

What's the third right?

The third is the right to a portion of the company's assets if it liquidates.

If the company goes out of business, sells its assets, pays off its debts, whatever's left over is distributed to the stockholders based on their ownership percentage.

So if the company folds, you potentially get a piece of what remains.

And the fourth right?

The preemptive right.

This gives existing stockholders the first dibs on buying any new shares, the corporation issues.

So they can maintain your percentage of ownership and avoid having their stake diluted.

So it's a protection against losing your ownership stake.

Exactly.

However, it's important to note that this right isn't always automatic for all stockholders.

It might be in the corporate charter or apply only to large shareholders or specific situations.

Now we've talked about stockholders and corporations.

Let's really get into stockholders' equity.

What does it actually represent?

It's basically the owner's claim on the company's assets after all the liabilities have been paid.

Think of it as the company's net worth from the owner's perspective.

On the balance sheet, it's usually split into two main parts, paid -in capital and retained earnings.

Paid -in capital and retained earnings.

Why are they kept separate?

What's the big difference?

Mostly legal and financial reasons.

A lot of places have rules against paying dividends out of paid -in capital.

Paid -in capital is the money or assets that stockholders put directly into the company by buying stock.

Retained earnings, on the other hand, are the accumulated profits the company has earned over time minus any dividends they've already paid out.

So there are rules about how the company can distribute profits to its owners.

Exactly.

And speaking of different types of ownership, we've got common stock and preferred stock.

What's the difference between those two?

Common stock is the basic type of ownership.

When we just say stock, we usually mean common stock.

Common stockholders usually have all four of those basic rights we talked about.

Voting, dividends, getting proceeds if the company liquidates, and sometimes that preemptive right.

They're the biggest risk takers because they're last in line to get paid if the company goes under, but they also stand to gain the most if the company does really well.

So higher risk, higher reward.

What about preferred stock?

How does that work?

Preferred stock gives its owner some advantages over common stockholders.

The main ones are dividend priority and asset priority and liquidation.

So preferred stockholders usually get a fixed dividend before any dividends are paid to common stockholders.

And if the company goes belly up, they get to claim assets before the common stockholders.

Preferred stock can be a bit less risky.

Okay, so there's a trade -off there.

Do you see preferred stock in most corporations?

You might think so, but it's actually not as common as you might think.

One study found that only about 9 % of corporations had issued preferred stock.

You look at a company like the Home Depot, they don't have any preferred stock listed on their balance sheet.

Every corporation has common stock, but preferred stock is more of a niche thing.

Interesting.

So common stock is the bread and butter.

Yeah.

Now let's talk about this par value thing.

What is it?

Does it even matter anymore?

Par value is just a nominal value assigned to each share of stock when the company is first allowed to issue it.

It's stated in the company's charter.

Historically, it was more important.

It was related to legal capital, the minimum amount of equity the company had to maintain to protect creditors.

But nowadays, companies usually set a very low par value for their common stock, like a few cents per share.

So it's more of a technicality than a reflection of what the stock is actually worth.

Exactly.

It doesn't really tell you much about the stock's market value.

Then you have something called no par value stock, which as the name suggests, doesn't have a par value.

And then there's no par stock with a stated value, where the director is assigned a value to the shares.

But for accounting purposes, it's treated similarly to par value stock.

So the accounting folks have ways to handle all these variations.

Yeah, they've got rules for everything.

Now, let's get into how companies account for issuing stock.

What happens when a company first sells its stock to the public?

It gets cash or other assets in exchange, which increases its total assets, and specifically its stockholders' equity.

It's pretty straightforward.

Like let's say the Home Depot issues 10 million shares of common stock with a par value of $10 per share, and they sell them for exactly $10 each.

The journal entry would be a debit to the cash account for $100 million, that's an increase, and a credit to the common stock account for $100 million, also an increase.

Okay, but what happens when a stock is sold for more than its par value?

That's usually the case, right?

Right.

That's where the paid in capital account comes in.

Specifically, an account called paid in capital in excess of par.

It's also sometimes called additional paid in capital.

Let's say the Home Depot stock has a very low par value, like zero of a fives per share, but they issue it for $10 per share.

That extra $9 .95 per share is the additional amount investors paid above the par value.

So if they issue 10 million shares at $10 each, the cash account still gets debited for $100 million.

But the common stock account is only credited for the par value, which is $500 ,000 in this case.

The remaining $99 .5 million goes to paid in capital in excess of par comment.

So the par value goes into the common stock account and the extra money goes into this paid in capital account.

Why is that distinction important?

It has to do with legal capital.

The par value is often seen as the minimum legal capital the company needs to have in its equity.

Paid in capital in excess of par is the additional capital from shareholders.

And it's also considered part of the company's total paid in capital.

It's important to remember that when a corporation deals with its own stockholders, whether it's selling new shares or buying back existing shares, it doesn't recognize a gain or loss like it would when selling products or services.

These are equity transactions dealing with the owners.

It's not like selling a product, it's an internal transaction.

And we're talking about the corporation itself issuing new stock, right?

Not when existing stockholders are buying and selling shares among themselves.

Exactly, those transactions between stockholders don't directly involve the corporation so they're not recorded on the company's books.

Okay, now what about no par value stock?

How is the accounting handled in that case?

Well, with no par value, the entire amount received from selling the stock is credited to the common stock account.

So if a company like Krispy Kreme, which might issue no par common stock, gets $266 .7 million from selling shares, the accounting entry is a debit to cash for $266 .7 million and a credit to common stock for the same amount.

No need for a separate additional paid in capital account with true no par stock.

Simple enough.

Well, what if the stock is no par, but it has a stated value?

Then it's treated like par value stock.

The common stock account gets credited with the stated value per share times the number of shares and any amount received above that stated value is credited to additional paid in capital.

And what happens when a company issues stock for something other than cash, like equipment or a building?

In those cases, the assets the corporation receives are recorded at their fair market value at the time of the transaction.

The common stock account is credited with the par value of the shares issued and any excess of the market value of those assets over the par value is credited to additional paid in capital.

The book value of the assets on the seller's books doesn't matter.

The corporation is basically trading stock, which has a market value for assets of presumably equal value.

Okay, so fair market value is key.

But you mentioned an ethical issue earlier about exchanging non -cash assets for stock.

What are the concerns there?

The problem arises when it's hard to determine the fair market value of the non -cash asset.

Like imagine a startup issues a ton of stock in exchange for software they develop internally.

If that software hasn't been validated externally or doesn't have a clear market price, there's a temptation to inflate its value.

This can overstate the company's assets and equity, which can mislead investors.

So reliable valuations are really important and auditors play a crucial role in making sure these types of transactions are reasonable.

So transparency and proper valuation are key.

Now we've mainly talked about common stock.

What about preferred stock?

Is the accounting different?

It's similar to common stock.

When preferred stock is issued, the preferred stock account is credited with the par value.

And any amount above par value is credited to paid in capital in excess of par preferred.

Some companies keep separate additional paid in capital accounts for preferred and common stock while others combine them as long as they disclose the details properly.

The accounting for no par preferred stock works the same way as no par common stock.

Okay, so the same principles apply.

Is there a standard order for how these different stock related accounts appear on the balance sheet?

Usually you'll see preferred stock first, then common stock.

After that comes additional paid in capital and then retained earnings.

It's a logical way to present the equity section.

Okay, that provides some structure.

You also mentioned convertible preferred stock earlier.

How does that work?

Convertible preferred stock is like regular preferred stock initially, but it gives the stockholder the option to convert their preferred shares into a certain number of common shares, usually under certain conditions like when the common stock price hits a certain level.

When that conversion happens, the preferred stock account and the related paid in capital in excess of par preferred account are reduced and the common stock account is increased along with additional paid in capital common if needed.

It's basically shifting from one type of equity to another.

So it's like transforming one type of ownership into another.

Now let's talk about treasury stock.

What is that and why do companies buy back their own stock?

Treasury stock is stock the company has issued and then later bought back from the market.

They do this for a few reasons.

Sometimes they need stock for employee stock option plans, especially if they've already issued all their authorized shares.

They might also buy back stock if they think it's undervalued to boost earnings per share or to defend against a hostile takeover.

Or if they have extra cash, they might buy back stock to return that cash to shareholders instead of paying dividends.

So it can be a strategic move.

How is treasury stock recorded on the books?

It's recorded at cost, meaning the price the company paid to buy it back.

It doesn't matter what the par value is.

Treasury stock is a contrast stockholders equity account, which means it has a debit balance.

On the balance sheet, it's shown as a negative amount, usually subtracted from total stockholders equity.

A negative equity account.

So when a company buys back stock, it's shrinking its equity.

Right, it's like they're returning some of that equity to the shareholders who sold the stock back to them.

What can companies do with treasury stock once they bought it back?

They have a few options.

They can hold onto it and reissue it later, maybe for employee stock options.

They can retire the shares, which permanently reduces the number of shares out there.

Or they can use it for employee compensation.

If they resell treasury stock, their cash and equity go up.

If they retire it, it's just removed from the books.

And if they use it for compensation, they usually adjust the equity accounts accordingly.

So treasury stock is a flexible tool.

Now let's move on to dividends.

We've got cash dividends and stock dividends.

What are the key differences?

A cash dividend is a straight up cash payment to the stockholders.

The board of directors decides how much to pay based on the company's profits and financial needs.

A stock dividend is a distribution of more of the company's stock to its stockholders.

They get more shares, but no cash changes hands.

Okay, so cash dividends are actual cash payouts.

And stock dividends are like getting more pieces of the company.

What does it take for a company to declare a cash dividend?

They need two things, enough retained earnings and enough cash.

Retained earnings are the accumulated profits that are legally available to pay dividends.

And they need the actual cash on hand to make the payment.

Having a lot of retained earnings doesn't necessarily mean they have the cash to pay dividends.

Retained earnings isn't the same as a big pile of cash.

Right.

There are three main dates involved with cash dividends.

The declaration date, the date of record, and the payment date.

On the declaration date, the board announces they're paying a dividend.

This creates a liability for the company.

On the date of record, they determine who's eligible to receive the dividend.

And on the payment date, they actually send out the payments.

So it's declare,

determine, and distribute.

You got it.

How do preferred dividends work?

Preferred stockholders get paid first.

They get their stated dividend in full before any dividends can be paid to common stockholders.

The preferred dividend rate is usually a percentage of the par value or a fixed dollar amount per share.

And what's the difference between cumulative and non -cumulative preferred stock?

With cumulative preferred stock, if the company misses a dividend payment, they have to make it up in the future before they can pay any dividends to common stockholders.

Non -cumulative preferred stock means if they skip a dividend, the preferred stockholders don't get that dividend, period.

So cumulative preferred stock is safer for the investor.

Why would a company issue a stock dividend instead of a cash dividend?

A few reasons.

It lets them give something back to shareholders without using up their cash.

Stock dividends aren't taxed as income to the recipients right away, and it can make the stock price look more affordable, attracting more investors.

Okay, so it's a way to reward shareholders without spending cash.

How does the accounting for stock dividends work?

It involves moving a chunk of retained earnings to other equity accounts.

They reduce retained earnings and increase common stock based on the par value of the new shares.

If the stock's market value is higher than the par value, they also increase paid -in capital in excess of par common.

The amount they move is usually based on the market value of the stock dividend, if it's a small one.

For a larger one, they might use par value.

The total equity doesn't change, it's just reclassified, and it doesn't affect assets or liabilities.

Okay, so it's like rearranging the furniture but not buying new furniture.

What about stock splits?

How are those different from stock dividends?

Stock splits also increase the number of shares, but they usually come with a proportionate decrease in the par value per share.

So if there's a two -for -one split, your one share becomes two shares, and the par value per share is cut in half.

The main goal is to lower the stock price and make it more accessible to more investors.

Unlike stock dividends, stock splits don't require a journal entry, you just adjust the number of shares and the par value in the records.

So a stock split is more about changing the stock's price and the number of shares, and a stock dividend involves moving money between equity accounts.

Exactly.

There's a table here summarizing the effects of these different transactions on the accounting equation.

Issuing stock increases assets and equity.

Buying treasury stock decreases both.

Selling treasury stock increases both.

Cash dividends decrease both.

Stock dividends don't change total equity, and stock splits don't change total equity either.

That's a good summary.

It shows how these actions affect the company's financial picture.

Now, let's talk about how investors actually use this information to evaluate a company.

What are some important financial ratios that incorporate stockholders' equity?

Return on equity, or ROE, is a big one.

It measures how well a company uses its stockholders' equity to generate profit.

It's like a report card for the company's management.

The formula is net income divided by average common stockholders' equity.

We usually focus on common equity because preferred dividends are often fixed.

So higher ROE is better, right?

Generally, yes.

It means the company is generating more profit for each dollar of equity invested by its owners.

What is this DuPont analysis?

DuPont analysis is a way to break down ROE into three parts.

Net profit margin, asset turnover, and the equity multiplier, or leverage ratio.

Net profit margin tells you how much profit they make for every dollar of sales.

Asset turnover shows how efficiently they're using their assets to generate sales.

And the equity multiplier tells you how much debt they're using to finance their assets.

By looking at these three components, we can get a better understanding of what's driving the company's ROE.

So it's like a deeper dive into ROE.

Exactly.

It helps you see the bigger picture.

For example, a high ROE might be because of strong profit margins, efficient operations, or high debt levels.

We have an example here with the Home Depot.

Their ROE was really high in 2017, like 149 .4%.

Why was that?

The DuPont analysis for the Home Depot showed that they had a good net profit margin and asset turnover, but the main reason for their sky -high ROE was their high leverage ratio.

They were using a lot of debt.

Debt can boost returns when times are good, but it also makes the company riskier because they have to pay back that debt with interest.

So it's a trade -off between risk and reward.

What's a good ROE, the return on assets?

Around 10 % is often considered good, but it really depends on the industry.

Things like operational efficiency, product differentiation, and pricing power all affect ROE.

Now, what about earnings per share, or EPS?

That's a popular one.

EPS is a key profitability measure.

It tells you how much net income is attributed to each share of common stock.

Investors use it a lot to gauge the company's value and performance.

The formula is net income minus preferred dividends divided by the average number of common shares outstanding.

We subtract preferred dividends because they get paid first.

So it's the profit allocated to each common share.

Right.

We have some examples here about how treasury stock and preferred dividends affect EPS.

Let's hear about the treasury stock example first.

When a company buys back its own stock as treasury stock, it reduces the number of shares out there.

So if their net income stays the same, the EPS goes up because you're dividing by a smaller number.

That's why companies buy back stock.

It can make their earnings per share look better.

Okay, so buybacks can boost EPS.

What about preferred dividends?

Preferred dividends reduce the net income available to common stockholders.

So if a company has big preferred dividends, it'll lower the EPS.

So they eat into the common stockholders share of the pie.

Now, how does a company's financing strategy affect EPS?

There are trade -offs with each approach.

Using retained earnings is the least risky, but it limits their cash for other things.

Issuing new stock avoids debt, but dilutes ownership and might lower EPS.

Issuing debt doesn't dilute ownership and might boost EPS if they use the borrowed money wisely, but it increases their financial risk.

It's a balancing act.

Yes, definitely.

We have an example with the Home Depot needing $500 million.

If they use bonds, their EPS would be higher in that scenario because of the leverage.

Okay, so borrowing can magnify returns, but it also comes with risks.

Let's talk about market capitalization and the P -E ratio.

Market capitalization is the total market value of all the company's outstanding common stock.

You get it by multiplying the stock price by the number of shares outstanding.

The P -E ratio is the stark price divided by the earnings per share.

It shows you how much investors are willing to pay for each dollar of earnings.

What do different P -E ratios mean?

A high P -E ratio usually means the market is optimistic about the company's future growth.

Investors are willing to pay more because they expect earnings to grow significantly.

A low P -E ratio might mean the company is undervalued or that the market is worried about its future.

P -E ratios vary a lot between industries and companies.

Okay, so it's all about expectations.

What about dividend yield?

Dividend yield tells you the annual dividend per share as a percentage of the stock price.

It's basically the return you get from dividends alone, not counting any increase in the stock price.

A 2 % yield is generally considered pretty good, especially compared to interest rates.

So it's a measure of the income you get from the stock.

Now, where do we find all this information in the financial statements?

The statement of cash flows and the statement of stockholders' equity.

What about the statement of cash flows?

You'll find it in the financing activities section.

When they issue stock, it's a positive cash flow.

When they buy back stock or pay dividends, it's a negative cash flow.

Stock dividends don't show up because there's no cash involved.

Makes sense.

What about the statement of stockholders' equity?

That statement gives you a detailed breakdown of all the changes in the equity accounts over time.

You'll see the beginning balance, any increases or decreases, and the ending balance for each account, like common stock, paid -in capital, retained earnings, treasury stock, and accumulated other comprehensive income.

You can see how things have changed from year to year.

So it's a detailed history of the equity section.

What should investors look for when they're reviewing the statement?

Look at the beginning and ending balances.

See how they've changed and what caused those changes.

Pay attention to things like new stock issuances, treasury stock transactions, net income, dividends, and changes in accumulated other comprehensive income.

You can calculate outstanding shares, see the order of the accounts, and get a good grasp of how the company's equity has evolved.

So it tells the story of the company's ownership and profits.

We also have a section on investing in stock.

What are some basic things to think about before investing?

You need to know your risk tolerance.

Are you okay with big price swings or do you prefer something more stable?

And you need to know your goals.

Do you want income from dividends or are you looking for long -term growth?

Risk and goals, those are crucial.

Absolutely, and we've got a glossary of all the key terms we've covered just to make sure you're comfortable with the vocabulary.

That's helpful.

It's important to understand these terms if you wanna get deeper into finance.

So we've covered a lot.

We've talked about ownership, the rights of stockholders, different types of stock, how companies manage their finances, and how investors can use this information.

It's been a deep dive into an essential part of the business world.

It's crucial to understand stockholders' equity if you want to really grasp how companies work and how they generate value for their owners.

Now, thinking about all the different ways companies can finance their operations and reward their shareholders,

it begs the question, what's the best long -term strategy for a company to grow and maximize value for its stockholders?

Is there one right answer or does it depend on the company and its industry?

That's something to consider as you continue your exploration of finance.

Thanks for joining us today for this deep dive into stockholders' equity.

It's been a pleasure diving deep with you.

And we'll see you next time.