copyright © 2011 pearson prentice hall. all rights reserved. chapter 6 common stocks

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Chapter 6

Common Stocks

Copyright © 2011 Pearson Prentice Hall. All rights reserved.6-2

Common Stocks

• Learning Goals

1. Explain the investment appeal of common stocks and why individuals like to invest in them.

2. Describe stock returns from a historical perspective and understand how current returns measure up to historical standards of performance.

3. Discuss the basic features of common stocks, including issue characteristics, stock quotations, and transaction costs.


Common Stocks

• Learning Goals (cont’d)

4. Understand the different kinds of common stock values.

5. Discuss common stock dividends, types of dividends, and dividend reinvestment plans.

6. Describe various types of common stocks, including foreign stocks, and note how stocks can be used as investment vehicles.


The Appeal of Common Stocks

• Residual Owners: stockholders of a firm are the owners, who are entitled to dividend income and a prorated share of the firm’s earnings only after all the firm’s other obligations have been met

– Stocks allow investors to tailor investments to meet individual needs and preferences

– Stocks may provide a steady stream of current income through dividends

– Stocks may increase in value over time through capital gains


Sometimes You Win, Sometimes You Lose: Five years of the S&P 500 Index and the Nasdaq Composite

FIGURE 6.1 A Snapshot of U.S. Stock and Housing Indexes (mid-2003 through mid-2009)


Table 6.1 Historical Returns on the S&P 500 Index (1950-2008)


From Stock Prices to Stock Returns

• Stock Returns: take into account both price changes and dividend income

– Returns from capital gains range from an average of 15.3% during the 1990s to -5.3% from 2000–2008

– Returns from dividends vary too, but not nearly as much, ranging from 5.4% in the 1950s to 1.7% since 2000

– The big returns (or losses) come from capital gains


From Stock Prices to Stock Returns (cont’d)

– Stocks generally earn positive returns over long periods of time.

– From 1950–2000, the average total return on the S&P 500 was 13.7% per year

– Investing in stocks is clearly not without risk

– From 2000–2008, the U.S. stock market lost 3.6% per year


What is a Bear Market?

• Routine Decline: a drop of 5% or more in one of the major market indexes, like the Dow Jones Industrial Average (DJIA)

• Correction: a drop of 10% or more in one of the major market indexes

• Bear Market: a drop of 20% or more in one of the major market indexes


Advantages of Stock Ownership

• Provide opportunity for higher returns than other investments

• Over past 100 years, stocks earned annual returns that we roughly double the returns provided by corporate bonds

• Good inflation hedge since returns typically exceed the rate of inflation

• Easy to buy and sell stocks• Price and market information is easy to find in financial

media• Unit cost per share of stock is low enough to encourage

ownership


Disadvantages of Stock Ownership

• Stocks are subject to many different kinds of risk:– Business risk– Financial risk– Purchasing power risk– Market risk– Event risk

• Hard to predict which stocks will go up in value due to wide swings in profits and general stock market performance

• Low current income compared to other investment alternatives


Figure 6.2 The Current Income of Stocks and Bonds


Basic Characteristics of Common Stock

• Equity Capital: evidence of ownership position in a firm, in the form of shares of common stock. This is why stocks are sometimes called “equities”. Common stocks has no maturity date- it remains outstanding indefinitely

• Publicly Traded Issues: shares of stock that are readily available to the general market and are bought and sold in the open market

• Public Offering: an offering to sell to the investing public a set number of shares of a firm’s stock at a specified price


Figure 6.3 An Announcement of a New Stock Issue


Basic Characteristics of Common Stock (cont’d)

• Rights Offering: an offering of a new issue of stock to existing stockholders, who may purchase new shares in proportion to their current ownership

• Stock Spin-Off: conversion of one of a firm’s subsidiaries to a stand-alone company by distribution of stock in the new company to existing shareholders

• Companies execute spin off if they believe the subsidiary is no longer a good fit or if they feel that they became so diversified and want to focus more on their core products.



• Stock Split: when a company increases the number of shares outstanding by exchanging a specified number of new shares of stock for each outstanding share– Usually done to lower the stock price to make it more

attractive to investors– Stockholders end up with more shares of stock that

sells for a lower price– Investor with 200 shares in a 2-for-1 stock split would

have 400 shares after the stock split– If the stock price was $100 before the split, the price

would be near $50 after the split



• Treasury Stock: shares of stock that were originally sold by the company and have been repurchased by the company. Share repurchases are often called “buybacks.”– Reduces the number of shares outstanding to public

– Companies buyback when they believe stock is undervalued and a good buy

– Companies may try to raise undervalued stock price or prop up overvalued stock price

– May be used for mergers, acquisitions or employee stock option plans



• Classified Common Stock: common stock issued in different classes, each of which offers different privileges and benefits to its holders

– Different shares may have different voting rights

– Often used to allow a relatively small group to control the voting of a publicly-trade company

– Ford family owns “B” shares and other investors own “A” shares; Ford family controls 40% of Ford Motor Company

– May have different dividend payout schedules


Figure 6.4 Stock Quotations


Watch Those Transaction Costs

• Round-Lot: buying 100 shares of stock or multiples of 100 shares

• Odd-Lot: buying less than 100 shares of stock– Buying odd lots or small numbers of shares can result

in higher costs to buy and sell shares– Frequent trading can increase transactions

costs substantially , higher fees are connected with the purchase or sale of odd lot, which requires a specialist known as odd-lot leader.


Common Stock Values

• Par Value: the stated, or face, value of a stock– Mainly an accounting term and not very useful to investors

• Book Value: the amount of stockholders’ equity– The difference between the company’s assets minus the

company’s liabilities and preferred stock

• Market Value: the current price of the stock in the stock market


Common Stock Values

• Market Capitalization: the overall current value of the company in the stock market – Total number of shares outstanding multiplied by the market

value per share

• Investment Value: the amount that investors believe the stock should be trading for, or what they think it’s worth– Probably the most important measure for a stockholder


Dividends

• Dividend income is one of the two basic sources of return to investors

• Dividend income is more predictable than capital gains, so preferred by investors seeking lower risk

• Dividends are taxed at maximum 15% tax rate, same as capital gains

• Dividends tend to increase over time as companies’ earnings grow; average annual increase around 3% to 5%

• Dividends represent the return of part of the profit of the company to the owners, the stockholders


The dividend decision• By paying dividends, companies share with their

stockholders some of the profits they have earned.• A firm board of directors decide how much to pay in

dividends.• The directors evaluate the firm’s operating results

and financial conditions to determine whether dividends should be paid and if so , what amount..

• They consider whether the firm should distribute some of its cash to investors by paying a dividend or by buying back


Corporate versus market factors

• When the board of directors assembles to consider the question of paying dividends, it weights a variety of factors.

• The directors look at the firm’s earnings. Even though a company doesn’t have to show a profit to pay dividends, profits are still considered a vital link in the dividend decision


Dividends and Earnings Per Share

• Earnings Per Share: the amount of annual earnings available to common stockholders, stated on a per-share basis– Earnings are important to stock price– Earnings help determine dividend payouts


Some important dates• Lets assume the directors decide to declare a

dividend• Once that’s done, they must indicate the date of

payment and other important dates• Three dates are particularly important to the

stockholder• Date of record, payment date, and ex-dividend

date• The date of record: is the date on which the

investor must be a registered shareholder of the firm to be entitled to a dividend


Some important dates

• All investors who are official stockholders as of the close of business on that day will receive the dividends that have just been declared.

• These stockholders are often referred to as holders of record.

• The payment date: also set by the board of directors, follows the date of record by a week or two. It’s the actual date on which the company will mail dividend checks to holders of record ( and is also known as the payable date)


Some important dates• Because of the time needed to make bookkeeping

entries after the stock is traded. The stock will sell without dividends for three business days up to and including the date of record.

• The reason is that the buyer of the stock wont have held the stock on the date of record. Instead you ( the seller) will still be the holder of the record.

• The opposite will occur if you sell the stock before the ex-dividend date, the new shareholders will receive the dividend because he will be the holder of record


Key Dates for Dividends


Dividends and Dividend Yield

• Dividend Yield: a measure to relate dividends to share price on a percentage basis– Indicates the rate of current income earned on the investment

dollar– Convenient method to compare income return to other

investment alternatives


Dividends and Dividend Payout Ratio

• Dividend Payout Ratio: the portion of earnings per share (EPS) that a firm pays out as dividends– Companies are not required to pay dividends– Some companies have high EPS, but reinvest all

money back into company


Other Dividend Characteristics

• Stock Dividend: payment of a dividend in the form of additional shares of stock

• Dividend Reinvestment Plans (DRIPs): plans where cash dividends are automatically reinvested into additional shares of the firm’s common stock– Over 1,000 companies offer DRIPs– Usually have no brokerage fees– Uses dollar-cost averaging


Types of Stock

• Blue Chip Stocks: financially strong, high-quality stocks with long and stable records of earnings and dividends– Companies are leaders in their industries– Relatively lower risk due to financial stability

of company– Popular with investing public looking for steady growth

potential, perhaps dividend income– Provide shelter during unsettled markets– Examples: AT&T, Chevron, Johnson & Johnson,

McDonald’s, Pfizer


Figure 6.5 A Blue-Chip Stock


Types of Stock (cont’d)

• Income Stocks: stocks with long and sustained records of paying higher-than average dividends– Good for investors looking for relatively safe and high level of

current income– Dividends tend to increase over time (unlike interest payments on

bonds)– Some companies pay high dividends because they offer limited

growth potential– More subject to interest rate risk– Examples: Duke Energy, Conagra Foods, Sara Lee, Altria Group



• Growth Stocks: stocks that experience high rates of growth in operations and earnings– Have sustained rate of growth in earnings above general

market– Investors expect higher price appreciation due to increasing

earnings– Riskier investment because price may fall if earnings growth

cannot be maintained– May include blue chip stocks as well as

speculative stocks– Typically pay little or no dividends– Examples: Netflix, eBay, Research in Motion, Berkshire Hathaway,

Starbucks



• Tech Stocks: stocks representing the technology sector of the market– Range from speculative stocks of small companies that have

never shown a profit to blue chip stocks of large companies that are growth-oriented

– Potential for attractive returns

– Considerable risk and volatility

– Difficult to put value on due to erratic or no earnings

– Examples: Microsoft, Cisco Systems, Yahoo!, NVIDIA, SanDisk, Electronic Arts


Figure 6.6 A Tech Stock



• Speculative Stocks: stocks that offer potential for substantial price appreciation, usually due to some special situation such as a new product– Companies lack sustained track record of business and financial

success– Earnings may be uncertain or highly unstable– Potential for substantial price appreciation– Stock price subject to wide swings up and down in value– Examples: Sirius XM Radio, Dreamworks Animation, Liberty Media,

NitroMed, Under Armour



• Cyclical Stocks: stocks whose earnings and overall market performance are closely linked to the general state of the economy– Stock price tends to move up and down with the

business cycle– Tend to do well when economy is growing, especially in

early stages of economic recovery– Tend to do poorly in slowing economy– Best for investors willing to move in and out of market

as economy changes– Examples: Alcoa, Caterpillar, Genuine Parts, Lennar,

Brunswick, Timken



• Defensive Stocks: stocks that tend to hold their value, and even do well, when the economy starts to falter– Stock price remains stable or increases when general economy is

slowing– Products are staples that people use in good times and bad times,

such as electricity, beverages, foods and drugs– Gold stocks are a form of defensive stock– Best for aggressive investors looking for “parking place” during

slow economy– Examples: Walmart, Checkpoint Systems, WD-40


Market Capitalization

• U.S. stock market segments based on stock market capitalization:

– Small-Cap Stocks: less than $2 billion

– Mid-Cap Stocks: $2 billion to $10 billion

– Large-Cap Stocks: more than $10 billion



• Large-Cap Stocks: large companies with market capitalizations over $10 billion– Number of companies is smaller, but account for 80% to 90% of

the total market value of all U.S. equities

– Bigger is not necessarily better

– Tend to lag behind small-cap and mid-cap stocks, but typically have less volatility

– Examples: Walmart, Home Depot, Comcast, Microsoft



• Mid-Cap Stocks: medium-sized companies with market capitalizations between $2 billion and $10 billion– Provide opportunity for greater capital appreciation than Large-

Cap stocks, but less price volatility than Small-Cap stocks– Usually have long-term track records for profits and stock

valuation– “Baby Blues” offer same characteristics of Blue Chip stocks

except size– Examples: Abercrombie & Fitch, Dollar Tree, Hasbro, Nordstrom,

Whole Foods



• Small-Cap Stocks: small companies with market capitalizations less than $2 billion– Provide opportunity for above-average returns

(or losses)

– Usually do not have a financial track record

– Earnings tend to grow in spurts and can have dramatic impact on stock price

– Usually not widely-traded; liquidity is an issue

– “Initial Public Offerings” (IPOs)

– Examples: Callaway Golf, California Pizza Kitchen, Winn-Dixie Stores, Shoe Carnival


Investing in Foreign Stocks

• Globalization of financial markets is growing

– U.S. equity market represents roughly 35% of world equity markets

– Six countries make up 80% of world equity market

– U.S. market remains largest equity market in world with a total value of about $12 trillion

– Some of the returns in non-U.S. markets are due to currency exchange rates, and not just markets themselves


Going Global

• Buying Shares Directly in Foreign Markets– Most adventuresome approach– Logistical problems: fluctuating currency rates, different

regulatory and accounting standards, tax problems, “red tape”

• Buying American Depositary Shares (ADSs)– Simpler approach– Bought and sold on U.S. markets just like stocks in

U.S. companies– Transactions are in U.S. dollars

• Buying International Mutual Funds


Going Global

• International investing is more complex and riskier than domestic investing

• International investing requires investors to be right on more factors:– Must pick right stock– Must pick right market– Must pick correct direction for currency exchange rate

fluctuations


Returns on International Investments

• Stronger U.S. dollar has negative impact on foreign investments

• Weaker U.S. dollar has positive impact on foreign investments


Alternative Investment Strategies

• Storehouse of Value– Safety of investment is primary goal– Investors use high-quality blue chip and non-speculative stocks

• To Accumulate Capital– Growth of investment is primary goal– Investors use growth-oriented stocks to generate capital gains

• Source of Income– Current income is primary goal– Investors use stocks with dependable flow of dividends


Stock Investment Strategies

• Buy-and-Hold– Investors buy high-quality stocks and hold them for extended

time periods

– Goal may be current income and/or capital gains

– Investors often add to existing stocks over time

– Very conservative approach; value-oriented


Stock Investment Strategies (cont’d)

• Current Income

– Investors buy stocks that have high dividend yields

– Safety of principal and stability of income are primary goals

– May be preferable to bonds because dividends levels tend to increase over time

– Often used to provide to supplement other income, such as in retirement



• Quality Long-Term Growth

– Investors buy high-quality growth stocks, mid-cap stocks and tech stocks

– Capital gains are primary goal

– Higher level of risk due to emphasis on capital gains

– Significant trading of stocks may occur over time

– Diversification is used to spread risk

– “Total Return Approach” is version that emphasizes both capital gains and high income



• Aggressive Stock Management

– Investors buy high-quality growth stocks, blue chip stocks, mid-cap stocks, tech stocks and cyclical stocks

– Capital gains are primary goal

– High level of risk due to emphasis on capital gains

– Investors aggressively trade in and out of stocks, often holding for short periods

– Timing the market is key element

– Time consuming to manage



• Speculation and Short-Term Trading– Also called “day trading” – Investors buy speculative stocks, small-cap stocks and

tech stocks– Capital gains are primary goal– Highest level of risk due to emphasis on capital gains in

short time period– Investors aggressively trade in and out of stocks, often

holding for extremely short periods– Looking for “big score” on unknown stock– Time consuming & high trading costs


Chapter 6 Review

• Learning Goals

1. Explain the investment appeal of common stocks and why individuals like to invest in them.

2. Describe stock returns from a historical perspective and understand how current returns measure up to historical standards of performance.

3. Discuss the basic features of common stocks, including issue characteristics, stock quotations, and transaction costs.


Chapter 6 Review (cont’d)

• Learning Goals (cont’d)

4. Understand the different kinds of common stock values.

5. Discuss common stock dividends, types of dividends, and dividend reinvestment plans.

6. Describe various types of common stocks, including foreign stocks, and note how stocks can be used as investment vehicles.


Table 6.2 Cash or Reinvested Dividends?


Table 6.3 Comparative Annual Returns in the World’s Major Equity Markets, 1984–2008

copyright © 2011 pearson prentice hall. all rights reserved. chapter 6 common stocks

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