Welcome to VoraPrep Audio.
Picture a common scenario. A new client comes to you. Let's call her Evelyn. She's smart and has been investing for a while. But she tells you, "Every time I hear about a company's PE ratio on the news, my eyes just glaze over. I don't really get what makes a stock 'valuable' versus just 'expensive'."
That is a fantastic question. And it’s exactly what we're going to cover today. We'll break down the language of stocks. This includes corporate capitalization and basic valuation metrics. These concepts are fundamental for the exam and for being a competent adviser.
Let's start with the basics of how a company's stock is structured. Think of it like a pizza parlor.
When a company first incorporates, its charter sets a maximum number of shares it can create. Let's say that number is 100 million shares. That's the absolute max. This number is the authorized shares.
It's like the pizza parlor's business plan says they can, in theory, make 100 million slices of pizza. They can't make more unless they get shareholder permission to change the plan.
Now, the company probably won't sell all 100 million shares at once. They might decide to sell 70 million to the public to raise money. Those 70 million shares that have been sold are called issued shares. They've been issued from the company out into the world.
So now, investors are holding those 70 million shares. These are considered outstanding shares. They are literally 'out standing' in the market, in people's brokerage accounts. This number is critical. It's the one you'll use for almost all of your calculations.
But what if the company later decides to buy back 10 million of its own shares? They might do this from the open market. Maybe they think the stock is cheap, or they need shares for employee stock options.
That stock the company buys back is called treasury stock. It's like the pizza parlor buying back 10 million of its own slices. Those slices are no longer in customers' hands.
So, the company still has 70 million issued shares. But 10 million of them are now in its own treasury. This means the number of outstanding shares is now only 60 million.
The formula is simple: outstanding shares equals issued shares minus treasury shares. Remember that. Outstanding is what matters for valuation, because that’s what the public actually owns.
And treasury stock? It gets no voting rights and no dividends. It's basically sitting in the company's vault, inert.
Now that we have the share structure, how do we figure out what a company is worth?
The most straightforward metric is Market Capitalization, or market cap. This is the big-picture number. To calculate it, you take the current stock price and multiply it by the number of outstanding shares.
That's the total value the market is placing on the company. This calculation is how we get terms like large-cap, mid-cap, and small-cap.
But total value doesn't tell you about profitability on a per-share basis. For that, we need Earnings Per Share, or EPS. This one is a big deal on the exam.
The formula is Net Income, minus any dividends paid to preferred stockholders. Then you divide that whole result by the number of outstanding shares.
EPS tells you how much profit the company made for each single share of stock. A higher EPS is generally better, as it shows more profitability.
Now, let's connect those two ideas. What if you take the stock price and divide it by the Earnings Per Share? You get the Price-to-Earnings Ratio, or the PE ratio.
This is the metric your client Evelyn was asking about. It tells you how much investors are willing to pay for one dollar of the company's earnings.
A high PE ratio might mean investors are optimistic and expect a lot of future growth. A low PE ratio could mean it's an undervalued company... or maybe a company with some problems. It's a relative measure, not a simple "good" or "bad" number.
There are other metrics, too. For income investors, Dividend Yield is key.
To find it, you take the annual dividend per share and divide it by the current stock price. It’s the return you get just from dividends.
There's also a more theoretical model called the Dividend Discount Model. The exam just wants you to know the basic idea.
This model tries to find a stock's true value. It does this by predicting all of its future dividends and then discounting them back to today's value.
A simple version of the formula is for a company with constant dividend growth. The price equals next year's dividend, divided by the required return minus the dividend growth rate.
Don't stress too much on that one. Just know it's a way to value a stock based on its dividends.
Now, companies can do things that change these numbers. These are called corporate actions.
The most common is a stock split. In a two-for-one split, for example, the number of shares an investor owns doubles. At the same time, the price per share is cut in half.
Your total investment value is exactly the same. It's like exchanging a ten-dollar bill for two five-dollar bills. You haven't gotten richer. The company just made its shares cheaper and more accessible to investors.
The opposite can also happen. This is called a reverse stock split.
In a one-for-two reverse split, your number of shares would be cut in half. And the price per share would double. Again, your total investment value is unchanged. Companies often do this to raise a very low stock price, perhaps to avoid being delisted from an exchange.
And one more action: a stock dividend. Instead of paying a cash dividend, the company gives you more shares.
For example, with a ten percent stock dividend, the number of shares you own increases by ten percent.
Just like a stock split, your total value doesn't change in that moment. Your cost basis per share just gets spread out over more shares.
And an important point for the exam: stock dividends are not taxable until you sell the shares.
Let's walk through a classic exam question.
A company has 100 million authorized shares, 80 million issued shares, and zero treasury stock. Net income was 120 million dollars. The company also paid 20 million dollars in preferred dividends. The stock price is 25 dollars.
The question asks: what is the EPS.?
First, what number of shares do we use? We need the outstanding shares. The problem says there are 80 million issued shares and zero treasury stock. So, 80 million minus zero is 80 million outstanding shares. Perfect.
Next, what are the earnings we should use? The formula is Net Income minus Preferred Dividends. That's 120 million dollars minus the 20 million for preferred shareholders. This leaves 100 million dollars in earnings available for common stockholders.
The last step is to divide. 100 million dollars in earnings divided by 80 million outstanding shares. That gives you an EPS of one dollar and twenty-five cents.
See how the question might try to trick you? It gives you the "authorized shares" number—100 million—but that's irrelevant. It gives you the stock price—25 dollars—but you don't need it for an EPS calculation.
You just need to focus on the pieces of the formula. The biggest trap is almost always using the wrong share count. Always use outstanding shares for these per-share metrics.
This methodical approach is what gets you points on the exam.
So, to wrap this all up, what are the key takeaways?
First, know the difference between authorized, issued, outstanding, and treasury stock. And remember that outstanding shares are issued shares minus treasury shares. This is your foundation.
Second, memorize the key formulas. That means Market Cap, EPS, and the PE ratio. They will come up, either in a direct calculation or a conceptual question.
Third, for stock splits and stock dividends, remember the ten-dollar bill analogy. The total value doesn't change, you just slice it differently. The number of shares and the price per share move in opposite directions, keeping your total investment value the same.
And finally, think about that PE ratio. It’s not just a number. It's a story about market expectations. A high PE ratio often means a growth story. A low PE ratio might mean value… or trouble. Context is everything.
If you can keep these points straight, you’ll be in great shape to handle these questions. You'll be able to explain it clearly to your clients, just like you would for Evelyn.
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