Chapter 6 Common Stock InvestmentsPresentation Transcript
Chapter 6 Common Stock Investments
Key topics include:
advantages and disadvantages;
characteristics, new issues, stock quotations and transaction costs;
measures of common stock value;
different kinds of common stock; and
uses and strategies of common stock investing.
Represents ownership in a corporation and allows investors to participate in the profits
Stocks offer investors the opportunity to shape an investment program to their individual needs
Stock returns come mainly from capital appreciation
Stock market returns have averaged about 12% per year over the past 50 years, but over 18% during the past decade
Advantages: Common Stock
Potential for high returns; no upper limits.
May provide current income return from dividends.
Shares are highly liquid and easily transferred.
Transaction costs are relatively low; on-line trades can be very cheap.
Low unit prices relative to other securities.
Disadvantages: Common Stock
Earnings and performance are subject to wide swings.
Selection of common stocks is complex.
Current income is relatively low, compared to bonds.
Publicly Traded Stocks (1 of 3)
an offering to sell to the investing public a set number of shares of a firm's stock at a specified price
an offering of a new issue of stock to existing shareholders, who may purchase new shares in proportion to their current ownership position
Publicly Traded Stocks (2 of 3)
a conversion of one of a firm's subsidiaries to a stand-alone company by distribution of stock in that new company to existing shareholders
a maneuver in which a company increases the number of shares outstanding by exchanging a specified number of new shares of stock for each outstanding share
Publicly Traded Stocks (3 of 3)
stock that has been sold and subsequently repurchased by the issuing firm
Classified common stock
Stock issued by a company in different classes, each of which offers different privileges and benefits to its holders
Buying and Selling Stocks
The investor must be familiar with stock quotes
The investor must also consider transaction costs
NYSE – New York Stock Exchange
AMEX – American Stock Exchange
Published in a twelve-column format
Column Titles (1 of 5)
52 weeks Hi
highest price within past year, adjusted for stock splits if any
52 weeks Lo
lowest price w/n past year
name of company
Column Titles (2 of 5)
ticker symbol; 1-3 characters on NYSE and AMEX; 4-5 on NASDAQ.
Column Titles (3 of 5)
dividend yield based on current annual dividend divided by market price PE - price-earnings ratio based on most recent four quarters of earnings
number of shares traded yesterday (in 100s)
Column Titles (4 of 5)
highest price at which stock traded yesterday
lowest price yesterday Close - closing price yesterday
Column Titles (5 of 5)
closing price yesterday
change in price from close of previous day
average 1-5% of value of transaction when using a full-service broker
Odd-lot trades (less than 100 shares) carry an added cost called odd-lot differential
Transaction Costs (continued)
Discount brokers can save an investor up to 70% on commission
On-line trades can now cost less than $ 10 per trade
Measures of Value
the stated or face value (meaningless for investment purposes )
the amount of shareholder equity in a company; equals the amount of the firm's assets minus liabilities and preferred stock
Measures of Value (continued)
the prevailing price of a security .
the amount that investors believe a security should be trading for, or what they think it's worth .
Dividends and Earnings per Share (EPS)
The directors make the dividend decisions based on several factors.
Earnings per share (EPS) represents the amount that is earned per share
EPS = (net profit after taxes - pfd dividends)
# shares outstanding
Dividends and Earnings per Share (EPS) (continued)
Dividends are paid out of earnings, but do not have to be paid even when the firm is profitable
Generally, however, higher EPS lead to higher dividends
Dividends (Important dates)
date on which an investor must be a registered shareholder to be entitled to receive a dividend
3 business days prior to the date of record; determines if one is an official shareholder and thus eligible to receive a declared dividend
the actual date on which the company pays the dividend
Cash Dividends and the Dividend Yield
Dividends are normally paid in cash, although stock dividends are also common.
Cash dividends are current income, which can be expressed as the dividend yield.
Dividend yield = annual dividend per share market price per share
Dividend Payout Ratio (DPR)
One measure of stability of the cash dividend is the dividend payout ratio (DPR).
DPR = dividend per share / current market price per share.
A high DPR could suggest difficulty in paying future dividends.
Dividend Reinvestment Plans and Stock Dividends
Dividend reinvestment plans (DRIPs)
plans in which shareholders have cash dividends automatically reinvested into additional shares.
A dividend payment in the form of additional shares of stock.
Market Classifications of Common Stock (1 of 3)
Blue chip stocks
financially strong, high quality stocks with long and stable records of earnings and dividends.
Have long and sustained records of paying higher-than-average dividends.
experience high rates of growth in operations and earnings.
Market Classifications of Common Stock (2 of 3)
offer the potential for substantial price appreciation, usually because of some special situation, such as new management or the introduction of a promising new product.
Stocks whose earnings and overall market performance are closely linked to the general state of the economy.
Market Classifications of Common Stock (3 of 3)
tend to hold their own, and even do well, when the economy starts to falter.
medium-sized stocks, generally with market value of less than $3-4 billion, but more than $750 million.
have market value of less than $750 million, and may offer above-average returns.
Foreign equity markets
outperform US markets in most years
Investors can buy foreign stocks directly
Has many logistical problems
American Depository Receipts (ADRs)
Backed by foreign securities held by US banks
Foreign Stocks (continued)
Both direct purchase and ADRs
have usual risks associated with common stocks, plus the currency exchange rate risk that drastically can affect total return.
Total return in US$ = dividends + cap gains (losses) + (or) - changes in FOREX rates.
Investment strategies can be employed to satisfy one of three basic investment needs:
warehouse of value
accumulation of capital
and/or as a source of income
Buy-and-Hold Strategy and The High-Income Approach
The most basic strategy is the buy-and-hold.
High-quality stocks are selected and held for extended periods; a strategy popular with value-oriented investors.
The high-income approach
uses common stocks for current income. Since dividends mostly increase through time, the level of current income increases as well.
Quality Long-Term Growth and Aggressive Stock Management
Quality long-term growth
a less conservative strategy. This strategy relies on capital gains as the primary source of return.
Aggressive stock management
uses quality issues to seek attractive rates of return in a fully managed portfolio.
has substantial risk and requires a substantial amount of investor time.
Speculation and Short-Term Trading
Speculation and short-term trading
the highest risk strategy.
investor seeks returns from capital gains while holding the stock only a short period of time.
Using Investment Strategies
The first three strategies go well with the objective to use stocks as a warehouse of value
All five could be used to accumulate capital
The high-income strategy fits best with the objective of using stocks as a source of income
Popular Investment Strategies
Some Popular Investment Strategies Include:
Growth Investing, which is investing in stocks with above average forecasts of earnings growth and high price/earnings ratios in expectation of higher returns.
Value Investing, which is investing in stock of companies that are out of favor with the market for some reason, as reflected by low price/earnings ratios and low prices compared to their fundamentals.
Sector Investing, which is an investing style based on the premise that certain industry sectors perform better during specific stages of the economic cycle.
Momentum Investing, which is an investing style that focuses on using relative stock price movement to determine when to buy and sell.