that a year of losses need not bankrupt the firm and cause its stockholders
to lose all of their investments. The reader need only look at Lucent or
America Online (AOL) to see large operating deficits of firms that are not
bankrupt. We will use the retained earnings concept in calculating the Alt-
man Z bankruptcy prediction statistic in Chapter 3.
Book Value of Common Stock
The book value of the common stock is not directly indicated on the bal-
ance sheet, but it is readily derived from the balance sheet data. The book
value is the net asset value of a share of common stock as presented by ac-
counting convention on the balance sheet. To obtain this figure we subtract
the total liabilities from total assets shown on the balance sheet, subtract
the voluntary liquidation value of the preferred stock plus any accumu-
lated dividends, and divide the remainder by the number of common
shares outstanding. Alternatively, the book value per share equals the
stated or par value of the common shares issued and outstanding, plus all
the capital surplus, earned surplus, and surplus reserve accounts, less any
liquidation premium or accrued dividends on the preferred shares, divided
by the number of common shares outstanding.
Preferred stock is not included in book value either as a sum or as part
of the divisor. If the term “book value” is used, it is usually understood as
referring to the book value of the common stock, since the concept of book
value of the preferred is not important or useful. Except in rare instances
the preferred stockholders are not conceived of as having any ownership or
interest in the surplus accounts; it is the common shares’ pro rata equity in
the surplus account that lends meaning to the concept of book value.
Calculating and understanding the concept of book value is not diffi-
cult; it shows the net equity per share of the common stock. The book
value of a share of stock, however, reflects only the information given for-
mally by the accounting data on the balance sheet. Although book value
has some significance in indicating the worth of a share, it cannot give the
earning power per share of stock, its market value, its value for control, or
its probable future value. Book value is only one of many financial bench-
marks. The role of book value in the stock selection process, as we see in
Chapter 8, is becoming very important and controversial.
Consolidated Balance Sheets
If a company like Johnson & Johnson has numerous subsidiaries and owns
a major part of another firm, it may wish to present the financial position