Lesson 5 of 10
The statement of shareholders equity
The fourth statement holds every change in equity, including buybacks, issuance, stock pay and gains that never went through profit.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
Who writes thisEditorial processLinkedIn (opens in a new tab)X (opens in a new tab)
In one minute
- The fourth statement itemises every change in equity, including the ones that never passed through profit: buybacks, issuance, stock pay and gains routed around the income statement.
- A buyback below book value per share raises book value per share, and the same buyback above book value lowers it, every time.
- Return on equity has three defensible denominators, opening, closing or average equity, and this statement is where you see why they differ.
A company can report its best net income in five years and end the year with less equity than it started with. Nothing is wrong and nothing is hidden. The statement of shareholders equity itemises the buybacks, issuance, stock pay and other comprehensive income that did it.
Same buyback, opposite effect on book value per share
- Bought back at 0.8 times book · 20 shares retired$10.50
- Bought back at 3 times book · 20 shares retired$5.00
Book value per share before: $10.00
What the statement is shaped like
It is a grid. The columns are the components of equity, usually paid-in capital, retained earnings, treasury stock and accumulated other comprehensive income. The rows are the events of the year: profit, dividends, share-based pay, issuance, repurchases. The corners are opening and closing total equity, and the closing figure is the one printed on the balance sheet.
A buyback's arithmetic, and what it does not settle
A repurchase reduces equity by the cash paid and reduces the share count by the shares retired. Whether book value per share rises or falls depends only on the price paid relative to book value per share before the purchase.
Return on equity has three denominators
Return on equity divides net income by equity, and equity moved all year, so three denominators are in use: opening equity, closing equity, or the average of the two. ValueScreener prints closing equity; the average is the textbook form. A year with a large buyback or a large issuance is the year they diverge most, and that is exactly the year someone quotes the figure.
One year, three answers for return on equity
- Opening equity, 1,00010.0%
- Average equity, 95510.5%
- Closing equity, 91011.0%
Buffett's 1979 letter set the primary test of management as a high rate of earnings on equity capital employed, without undue leverage and without accounting distortion. This statement is where the second qualification gets checked. Did equity fall because capital was returned, or because a charge was routed around profit?
Gains that bypass net income
The last column holds gains and losses that bypass net income in the year they happen: currency translation of overseas subsidiaries and the remeasurement of a pension obligation are the common ones. A manufacturer with large overseas operations can carry a translation balance that moves by more than a year of profit when a currency moves. None of that movement appears in the year's earnings; under US rules the balance reaches net income only if the subsidiary is sold or wound up.
Check yourself
A company retires shares at a price below book value per share. What happens to book value per share?
- It falls
- It rises
- It is unaffected
Show the answer
Answer: B.
Buying below book value per share raises book value per share, arithmetically. Buying above it lowers book value per share instead.Return on equity for the same company and year can differ depending on what?
- Which of three equity denominators, opening, closing or average, was used
- Whether the company uses last-in or first-out inventory accounting
- The fiscal year end the company chose
Show the answer
Answer: A.
Net income over opening equity, closing equity, or their average are three defensible conventions, and a year with a large buyback or issuance is when they diverge most.A company's currency translation balance moves sharply this year. What happens to this year's net income?
- It absorbs the movement as a one-time gain or loss
- Nothing: the movement goes to equity and reaches net income only if the subsidiary is sold or wound up
- Diluted earnings per share fall by the same amount
Show the answer
Answer: B.
Translation gains and losses go straight to accumulated other comprehensive income. Under US rules they move into net income only when the foreign subsidiary is sold or substantially liquidated.Sources
- Berkshire Hathaway shareholder letter, 1979, on return on equity as the test of management.
What this leaves out
- A company with negative total equity produces a return on equity that is negative while the business is profitable. The figure is not small. It is not meaningful, and ValueScreener shows it as n/m.
- This lesson describes the equity statement as presented by a US commercial or industrial filer. Some companies present it as a note rather than a primary statement.
- Book value per share excludes internally developed brands and research entirely, so comparing two companies on book value per share is partly a comparison of their acquisition histories.
- The worked example uses round invented numbers so the arithmetic can be checked by hand. Nothing here is advice about any security.