Download Investing in Common Stocks

Chapter 6
Investing in
Common Stocks
Investing in Common Stocks
• Learning Goals
1. Explain the investment appeal of common stocks and
why individuals like to invest in them.
2. Describe historical stock returns and how current
returns measure up to historical standards
of performance.
3. Discuss the basis features of common stocks,
including issue characteristics, stock quotations, and
transaction costs.
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6-2
Investing in 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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Figure 6.1
Thirteen
Years of the
Dow, the
S&P, and
the Nasdaq
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Sometimes You Win,
Sometimes You Lose
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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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From Stock Prices to Stock Returns
• Stock Returns: take into account both price
changes and dividend income
– Over past 50 years, stock returns have ranged
from +48.28% in 1954 to -21.45% in 1974
– Stock returns over past 50 years have averaged
around 11%
– From 1998 through mid-’03, DJIA
averaged 1.7%
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Table 6.3 Comparative Returns
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Figure 6.2
Bulls, Bubbles, and Bears
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Advantages of Stock Ownership
• Provide opportunity for higher returns than
other investments
• Over past 50 years, stocks averaged 11% 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
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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Figure 6.3 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”
• 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 (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
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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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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 (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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Figure 6.5 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 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; increases average 3-5% per year.
• 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 profit
 Preferred dividends
after taxes
Number of shares of
common 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
Annual dividends received per share
Dividend yield 
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
Dividends per share
Dividend payout ratio 
Earnings per share
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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: Wal-Mart, Proctor & Gamble, Microsoft,
United Parcel Service, Pfizer and 3M Company
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Figure 6.7 A Blue Chip Stock
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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: Verizon, Conagra Foods, Pitney Bowes,
R.R. Donnelley, Bank of America and AmSouth
Bancorp
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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: Lowe’s, Harley-Davidson, Starbucks, Kohls
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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: Microsoft, Cisco Systems, Dell
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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: P.F. Chang’s, Quicksilver, Dollar General
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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
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, Maytag Corp.
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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: Proctor & Gamble, 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
• 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 issue
– “Initial Public Offerings (IPOs)
– Examples: Hancock Fabrics, Hot Topic, Sonic Corp.
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Types of Stock (cont’d)
• 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: Wendy’s, Barnes & Noble, Petsmart,
Cheesecake Factory
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Types of Stock (cont’d)
• 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: AT&T, General Motors, Microsoft
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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 and one of best
performing equity markets
– Much of performance of non-U.S. markets is due to
changes in currency exchange rates
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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 Receipts (ADRs)
– Simper 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
Current income
Capital gains
Changes in currency



(in U.S. dollars)
(dividends)
(or losses)
exchange rates
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6-44
Alternative Investment Strategies
• Storehouse of Value
– Safety of investment is primary goal
– Investors use high-quality blue chip and nonspeculative 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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6-46
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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6-47
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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6-48
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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6-49
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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6-50
Chapter 6 Review
• Learning Goals
1. Explain the investment appeal of common stocks and
why individuals like to invest in them.
2. Describe historical stock returns and how
current returns measure up to historical standards
of performance.
3. Discuss the basis features of common stocks, including
issue characteristics, stock quotations, and
transaction costs.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
6-51
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.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.
6-52