Stockholders' Equity: Classes of Capital Stock

Analyzing and using the financial results – Return on average common stockholders' equity

Stockholders' equity is particularly important to managers, creditors, and investors in determining the return on equity, which is the return on average common stockholders' equity.

The return on average common stockholders' equity measures what a given company earned for its common stockholders from all sources as a percentage of the common stockholders' investment. From the common stockholders' point of view, it is an important measure of the income-producing ability of the company. The ratio's formula is:

\text { Return on average common stockholders' equity }=\frac{\text { Net income available for common stockholders }}{\text { Average common stockholders'equity }}

If preferred stock is outstanding, the numerator is net income minus the annual dividend on preferred stock, and the denominator is the average total book value of common stock. If no preferred stock is outstanding, the numerator is net income, and the denominator is average stockholders' equity.

The Procter & Gamble Company reported the following information in its 2001 financial statements (USD millions):

Net earnings $ 2,922
Stockholders' equity, beginning 12,287
Stockholders' equity, ending 12,010

The return on average common stockholders' equity for Procter & Gamble is 24.1 percent, or USD 2,922/[(USD 12,287 + USD 12,010)/2]. Investors view any increase from year to year as favorable and any decrease as unfavorable.

Since the stock market is frequently referred to as an economic indicator, the knowledge you now have on corporate stock issuances should help you relate to stocks traded in the market. Chapter 13 continues the discussion of paid-in capital and also discusses treasury stock, retained earnings, and dividends.

An ethical perspective:
Belex corporation

Joe Morrison is the controller for Belex Corporation. He is involved in a discussion with other members of management concerning how to get rid of some potentially harmful toxic waste materials that are a byproduct of the company's manufacturing process.

There are two alternative methods of disposing of the materials. The first alternative is to bury the waste in steel drums on a tract of land adjacent to the factory building. There is currently no legal prohibition against doing this. The cost of disposing of the materials in this way is estimated to be USD 50,000 per year. The best estimate is that the steel drums would not leak for at least 50 years, but probably would begin leaking after that time. The second alternative is to seal the materials in lead drums that would be disposed of at sea by a waste management company. The cost of this alternative is estimated to be USD 400,000 per year. The federal government has certified this method as the preferred method of disposal. The best estimate is that the lead drums would never rupture or leak.

Belex Corporation has seen some tough economic times. The company suffered losses until last year, when it showed a profit of USD 750,000 as a result of a new manufacturing project. So far, the waste materials from that project have been accumulating in two large vats on the company's land. However, these vats are almost full, so soon management must decide how to dispose of the materials.

One group of managers is arguing in favor of the first alternative because it is legally permissible and results in annual profits of about USD 700,000. They point out that using the second alternative would reduce profits to about USD 350,000 per year and cut managers' bonuses in half. They also claim that some of their competitors are now using the first alternative, and to use the second alternative would place the company at a serious competitive disadvantage.

Another group of managers argues that the second alternative is the only safe alternative to pursue. They claim that when the steel drums start leaking they will contaminate the ground water and could cause serious health problems. When this contamination occurs, the company will lose public support and may even have to pay for the cleanup. The cost of that cleanup could run into the millions.