Proprietary Theory of Equity
Within any company, there are several stakeholders who believe their interests merit greater consideration than those of other parties. Schroeder, Clark, and Cathey argue that this is the result of conflicting theories of equity. The authors identify several pertinent theories, including the proprietary, entity, commander theories. Under the proprietary theory of equity, a business’s proprietors, or owners, retain the rights to a business’s assets. This mode of thinking dictates that the profit or loss of a firm is immediately owned by the company’s owners. In the case of CVS, Walgreen, and Rite Aid, the term “proprietors” refers to the group of stockholders of each firm, including common and, in the case of Rite Aid, preferred shareholders.
The entity theory of equity holds that, in exchange for “limited liability to the owners,” and the “separation of ownership and management,” the business becomes a separate, artificial being. Further, revenues, expenses, profits, and losses all belong to the firm, and with these items the business is free to choose its own course of action. Of course, the entity theory is a reminder that businesses are artificial and cannot, therefore, function without the help of actors. This is where the conflict of commander theory arises. This third theory follows that a business merely takes the direction its managers point it in. The desires of managers is considered most important under this method, as their control of the company dictates its future success or failure.
The following financial analysis references figures contained in Exhibit 1, and which have been sourced from the annual filing document Form 10-Ks of each CVS, Walgreen, and Rite Aid. The assess the calculations contained in Exhibit 1, it is necessary to develop the proper equity mindset, as discussed above. This analysis assumes the reader to be a company shareholder, and therefore adopts the proprietary theory as a framework for understanding. Accordingly, the various determinations of Return on Common Shareholders’ Equity (ROCSE) come to 9.33%, 14.53%, and -32.56% for CVS, Walgreen, and Rite Aid, respectively. What ROCSE indicates is the return that a particular company is obtaining for every dollar of shareholder worth contributed. Walgreen presents the most favorable return, at 14.53%. This implies that Walgreen Company is putting its shareholder contributed capital to better use than either CVS or Rite Aid.
Next, the Common Stock Earning Leverage Ratio for the three firms comes out to 0.91, 0.97, and 16.65, for CVS, Walgreen, and Rite Aid, respectively. For this ratio, a lower value is better, as it suggests that a greater portion of operating income is attributable to a company’s common shareholders. Rite Aid is a near-bankruptcy business that has taken on massive amounts of debt in recent years to cover operating losses and debt service payments, and to stave off court-mandated liquidation. With such a lopsided balance sheet, it is difficult to even consider this ratio for Rite Aid. Between CVS and Walgreen, however, very similar values suggest that a shareholder would generally be indifferent to the metric, with CVS earning a slight win.
The third ratio considered, Financial Structure Ratio, is known to many as simply “leverage.” It reveals what portion of a firm’s assets have been financed by shareholders versus by debtors. A lower figure can be considered healthy, as lower debt service payments reduce operating expenses. On the contrary, a low figure may indicate that a firm is failing to pursue opportunities in the marketplace. General business thought holds that projects which have a lower cost of capital than the projected return on capital, should be engaged. A figure of -5.17 for Rite Aid is of no value to analyze, as all the negative sign indicates is that this firm has accumulated net losses in excess of shareholder contributions to the firm. As a shareholder, this would be frustrating and is generally a bad sign, as the company has earned negative value on your ownership position to date. CVS and Walgreen, on the other hand, present leverage ratios of 1.69 and 1.79, respectively. These results are close together, with Walgreen’s ratio indicating the firm funds its asset base with a slightly higher percentage of debt than does CVS. The fact that Walgreen earns a significantly higher ROCSE than CVS suggests that the higher leverage is paying off. The combination of Walgreen’s ROCSE and Financial Structure Leverage metrics appear a better value from the shareholder perspective. Under the lens of proprietary equity theory, Walgreen is the better choice of firm.
Cathey Jack M, Clark Myrtle W & Richard G. Schroeder (2011). Financial Accounting Theory and Analysis: Text and Cases. 10th Edition, NJL John Wiley and Sons Publications, pg 483
Ibid. pg 484
Ibid. pg 486
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