Chapter 6

Investing in Common Stocks

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Investing in Common Stocks

Learning Goals

1. Explain the investment appeal of common stocks.

2. Describe historical stock returns

3. Discuss the basis features of common stocks.

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Investing in Common Stocks

Learning Goals

4. Understand the different kinds of common stock values.

5. Discuss common stock dividends, types of dividends.

6. Describe various types of common stocks, including foreign stocks.

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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

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From Stock Prices to Stock Returns Stock Returns: take into account both price

changes and dividend income

Over the past 50 years, stock returns have ranged from +42.7% in 1975 to -21.45% in 1974

Stock returns over the past 50 years have averaged around 12%

Speculative growth in the last half of the 1990s was eliminated beginning in early 2000 by one of the worst Bear markets in recent history

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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

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Advantages of Stock Ownership

Provide opportunity for higher returns than other investments

Over past 50 years, stocks averaged 12% and high-grade corporate bonds averaged 6%

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

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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

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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”

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

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Basic Characteristics of Common Stock 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

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Basic Characteristics of Common Stock

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

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Basic Characteristics of Common Stock (cont’d)

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

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Basic Characteristics of Common Stock

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

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Stock Quotations

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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

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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 Common stockholders’ equity The difference between the company’s assets minus

the company’s liabilities and preferred stock Book Value = Assets – Liabilities – Preferred Stock

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

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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

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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

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Key Dates for Dividends

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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

EPS

Net profitafter taxes

Preferred dividends

Number of shares ofcommon stock outstanding

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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

Dividend yield Annual dividends received per share

Current market price of the stock

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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

Dividend payout ratio Dividends per share

Earnings per share

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Reasons to Love Dividends

Stocks that pay dividends tend to produce higher returns than those that do not S&P dividend payers were up 6.5% vs. 3.6% for

non-dividend payers

Since 1928, dividends have accounted for 40% of total return on stocks

Since 1980, dividend-payers have averaged annualized returns of 15.1% vs. 12.8% for non-payers

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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

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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: Citigroup, Pfizer, DuPont, Nike, Procter &

Gamble, Home Depot

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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: Bell South (no more), Conagra Foods, Ford

Motor, Bank of America, Duke Energy

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Types of Stock (cont’d)

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: Medtronics, Boston Scientific, Countrywide

Financial (not now), Wellpoint, Genentech

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Types of Stock (cont’d)

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: Hewlett-Packard, Intel, Dell, Yahoo!,

Electronic Arts

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Types of Stock (cont’d)

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 Satellite Radio, Dreamworks Animation,

Liberty Media

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Types of Stock (cont’d)

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 Economic &

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: Caterpillar, Lennar, Alcoa, Brunswick

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Types of Stock (cont’d)

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: Checkpoint Systems, WD-40

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Market Capitalization

Small-Cap Stocks: under $1 billion

Mid-Cap Stocks: $1 billion to $4 or $5 billion

Large-Cap Stocks: more than $4 or $5 billion

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Types of Stock

Large-Cap Stocks: large companies with market capitalizations over $4 or $5 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: Wal-Mart, General Motors, Microsoft

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Types of Stock

Mid-Cap Stocks: medium-sized companies with market capitalizations between $1 billion and $4 or $5 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: Barnes & Noble, Williams-Sonoma, Reebok International

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Types of Stock

Small-Cap Stocks: small companies with market capitalizations less than $1 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: Playboy Enterprises, Denny’s, Sanderson Farms, Build-A-Bear Workshops

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Investing in Foreign Stocks

Globalization of financial markets is growing U.S. equity market is less than 50% of world

equity markets

Six countries make up 80% of world equity market

U.S. market remains largest equity market in world

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

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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

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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

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Returns on International Investments Stronger U.S. dollar has negative impact on

foreign investments

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

Total return(in U.S. dollars)

Current income

(dividends)

Capital gains(or losses)

Changes in currency

exchange rates

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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

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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

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Stock Investment Strategies

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

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Stock Investment Strategies

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

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Stock Investment Strategies

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

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Stock Investment Strategies

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

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Chapter 6 Review

1. Explained the investment appeal of common stocks.

2. Described historical stock returns.

3. Discussed the basis features of common stocks.

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Chapter 6 Review

4. Explained the different kinds of common stock values.

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

6. Described various types of common stocks.

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The End!

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Figure 6.3 An Announcement of a New Stock Issue

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Table 6.2 Cash or Reinvested Dividends?

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Figure 6.6 A Growth Stock

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Figure 6.7 A Tech Stock

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Figure 6.8 A Mid-Cap Stock

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Table 6.3 Comparative Annual Returns in the World’s Major Equity Markets, 1981–2005