Download Chapter 6 Common Stocks

Chapter 6
Common Stocks
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
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.
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6-2
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.
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6-3
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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6-4
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 mid2009)
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6-5
Table 6.1 Historical Returns on the S&P 500 Index
(1950-2008)
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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
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6-7
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
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6-8
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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6-9
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
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6-10
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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6-11
Figure 6.2 The Current Income of Stocks and Bonds
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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”. 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
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6-13
Figure 6.3 An Announcement of a New Stock Issue
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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.
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6-15
Basic Characteristics of Common Stock (cont’d)
• 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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6-16
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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6-17
Basic Characteristics of Common Stock (cont’d)
• 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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6-18
Figure 6.4 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 , higher fees are connected with
the purchase or sale of odd lot, which requires a
specialist known as odd-lot leader.
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6-20
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
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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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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
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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
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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
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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
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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)
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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
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6-29
Key Dates for Dividends
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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
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6-31
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
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6-32
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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6-33
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
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6-34
Figure 6.5 A Blue-Chip Stock
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6-35
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
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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: Netflix, eBay, Research in Motion, Berkshire Hathaway,
Starbucks
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6-37
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: Microsoft, Cisco Systems, Yahoo!, NVIDIA, SanDisk,
Electronic Arts
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6-38
Figure 6.6 A Tech Stock
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6-39
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 XM Radio, Dreamworks Animation, Liberty Media,
NitroMed, Under Armour
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6-40
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
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
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6-41
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: Walmart, Checkpoint Systems, WD-40
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6-42
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
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6-43
Types of Stock (cont’d)
• 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
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6-44
Types of Stock (cont’d)
• Mid-Cap Stocks: medium-sized companies with market
capitalizations between $2 billion and $10 billion
– Provide opportunity for greater capital appreciation than LargeCap 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
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6-45
Types of Stock (cont’d)
• 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
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6-46
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
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6-47
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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6-48
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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6-49
Returns on International Investments
• Stronger U.S. dollar has negative impact on
foreign investments
• Weaker U.S. dollar has positive impact on
foreign investments
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6-50
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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6-51
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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6-52
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
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6-53
Stock Investment Strategies (cont’d)
• 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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6-54
Stock Investment Strategies (cont’d)
• 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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6-55
Stock Investment Strategies (cont’d)
• 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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6-56
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.
Copyright © 2011 Pearson Prentice Hall. All rights reserved.
6-57
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.
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6-58
Chapter 6
Additional
Chapter Art
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Table 6.2 Cash or Reinvested Dividends?
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6-60
Table 6.3 Comparative Annual Returns
in the World’s Major Equity Markets, 1984–2008
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6-61