Common Stocks


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Common Stocks

  1. 1. Chapter 6 Investing in Common Stocks
  2. 2. Investing in Common Stocks <ul><li>Learning Goals </li></ul><ul><ul><li>Explain the investment appeal of common stocks and why individuals like to invest in them. </li></ul></ul><ul><ul><li>Describe historical stock returns and how current returns measure up to historical standards of performance. </li></ul></ul><ul><ul><li>Discuss the basis features of common stocks, including issue characteristics, stock quotations, and transaction costs. </li></ul></ul>
  3. 3. Investing in Common Stocks <ul><li>Learning Goals (cont’d) </li></ul><ul><ul><li>Understand the different kinds of common stock values. </li></ul></ul><ul><ul><li>Discuss common stock dividends, types of dividends, and dividend reinvestment plans. </li></ul></ul><ul><ul><li>Describe various types of common stocks, including foreign stocks, and note how stocks can be used as investment vehicles. </li></ul></ul>
  4. 4. The Appeal of Common Stocks <ul><li>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 </li></ul><ul><ul><li>Stocks allow investors to tailor investments to meet individual needs and preferences </li></ul></ul><ul><ul><li>Stocks may provide a steady stream of current income through dividends </li></ul></ul><ul><ul><li>Stocks may increase in value over time through capital gains </li></ul></ul>
  5. 5. Figure 6.1 A Decade of the Dow and the Nasdaq (mid-1997 through mid-2006)
  6. 6. From Stock Prices to Stock Returns <ul><li>Stock Returns : take into account both price changes and dividend income </li></ul><ul><ul><li>Over the past 50 years, stock returns have ranged from +42.7% in 1975 to -21.45% in 1974 </li></ul></ul><ul><ul><li>Stock returns over the past 50 years have averaged around 10% </li></ul></ul><ul><ul><li>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 </li></ul></ul>
  7. 7. Sometimes You Win, Sometimes You Lose Table 6.1 50 Years of Annual Returns in the Stock Market, 1956–2005 (returns based on performance of the DJIA)
  8. 8. What is a Bear Market? <ul><li>Routine Decline : a drop of 5% or more in one of the major market indexes, like the Dow Jones Industrial Average (DJIA) </li></ul><ul><li>Correction : a drop of 10% or more in one of the major market indexes </li></ul><ul><li>Bear Market : a drop of 20% or more in one of the major market indexes </li></ul>
  9. 9. Advantages of Stock Ownership <ul><li>Provide opportunity for higher returns than other investments </li></ul><ul><li>Over past 50 years, stocks averaged 10% and high-grade corporate bonds averaged 6% </li></ul><ul><li>Good inflation hedge since returns typically exceed the rate of inflation </li></ul><ul><li>Easy to buy and sell stocks </li></ul><ul><li>Price and market information is easy to find in financial media </li></ul><ul><li>Unit cost per share of stock is low enough to encourage ownership </li></ul>
  10. 10. Disadvantages of Stock Ownership <ul><li>Stocks are subject to many different kinds of risk: </li></ul><ul><ul><li>Business risk </li></ul></ul><ul><ul><li>Financial risk </li></ul></ul><ul><ul><li>Purchasing power risk </li></ul></ul><ul><ul><li>Market risk </li></ul></ul><ul><ul><li>Event risk </li></ul></ul><ul><li>Hard to predict which stocks will go up in value due to wide swings in profits and general stock market performance </li></ul><ul><li>Low current income compared to other investment alternatives </li></ul>
  11. 11. Figure 6.2 The Current Income of Stocks and Bonds
  12. 12. Basic Characteristics of Common Stock <ul><li>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” </li></ul><ul><li>Publicly Traded Issues : shares of stock that are readily available to the general market and are bought and sold in the open market </li></ul><ul><li>Public Offering : an offering to sell to the investing public a set number of shares of a firm’s stock at a specified price </li></ul>
  13. 13. Basic Characteristics of Common Stock (cont’d) <ul><li>Rights Offering : an offering of a new issue of stock to existing stockholders, who may purchase new shares in proportion to their current ownership </li></ul><ul><li>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 </li></ul>
  14. 14. Basic Characteristics of Common Stock (cont’d) <ul><li>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 </li></ul><ul><ul><li>Usually done to lower the stock price to make it more attractive to investors </li></ul></ul><ul><ul><li>Stockholders end up with more shares of stock that sells for a lower price </li></ul></ul><ul><ul><li>Investor with 200 shares in a 2-for-1 stock split would have 400 shares after the stock split </li></ul></ul><ul><ul><li>If the stock price was $100 before the split, the price would be near $50 after the split </li></ul></ul>
  15. 15. Basic Characteristics of Common Stock (cont’d) <ul><li>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.” </li></ul><ul><ul><li>Reduces the number of shares outstanding to public </li></ul></ul><ul><ul><li>Companies buyback when they believe stock is undervalued and a good buy </li></ul></ul><ul><ul><li>Companies may try to raise undervalued stock price or prop up overvalued stock price </li></ul></ul><ul><ul><li>May be used for mergers, acquisitions or employee stock option plans </li></ul></ul>
  16. 16. Basic Characteristics of Common Stock (cont’d) <ul><li>Classified Common Stock : common stock issued in different classes, each of which offers different privileges and benefits to its holders </li></ul><ul><ul><li>Different shares may have different voting rights </li></ul></ul><ul><ul><li>Often used to allow a relatively small group to control the voting of a publicly-trade company </li></ul></ul><ul><ul><li>Ford family owns “B” shares and other investors own “A” shares; Ford family controls 40% of Ford Motor Company </li></ul></ul><ul><ul><li>May have different dividend payout schedules </li></ul></ul>
  17. 17. Figure 6.4 Stock Quotations
  18. 18. Watch Those Transaction Costs <ul><li>Round-Lot: buying 100 shares of stock or multiples of 100 shares </li></ul><ul><li>Odd-Lot: buying less than 100 shares of stock </li></ul><ul><ul><li>Buying odd lots or small numbers of shares can result in higher costs to buy and sell shares </li></ul></ul><ul><ul><li>Frequent trading can increase transactions costs substantially </li></ul></ul>
  19. 19. Common Stock Values <ul><li>Par Value : the stated, or face, value of a stock </li></ul><ul><ul><li>Mainly an accounting term and not very useful to investors </li></ul></ul><ul><li>Book Value : the amount of stockholders’ equity </li></ul><ul><ul><li>The difference between the company’s assets minus the company’s liabilities and preferred stock </li></ul></ul><ul><li>Market Value : the current price of the stock in the stock market </li></ul>
  20. 20. Common Stock Values <ul><li>Market Capitalization : the overall current value of the company in the stock market </li></ul><ul><ul><li>Total number of shares outstanding multiplied by the market value per share </li></ul></ul><ul><li>Investment Value : the amount that investors believe the stock should be trading for, or what they think it’s worth </li></ul><ul><ul><li>Probably the most important measure for a stockholder </li></ul></ul>
  21. 21. Dividends <ul><li>Dividend income is one of the two basic sources of return to investors </li></ul><ul><li>Dividend income is more predictable than capital gains, so preferred by investors seeking lower risk </li></ul><ul><li>Dividends are taxed at maximum 15% tax rate, same as capital gains </li></ul><ul><li>Dividends tend to increase over time as companies’ earnings grow; average annual increase around 3% to 5% </li></ul><ul><li>Dividends represent the return of part of the profit of the company to the owners, the stockholders </li></ul>
  22. 22. Key Dates for Dividends
  23. 23. Dividends and Earnings Per Share <ul><li>Earnings Per Share : the amount of annual earnings available to common stockholders, stated on a per-share basis </li></ul><ul><ul><li>Earnings are important to stock price </li></ul></ul><ul><ul><li>Earnings help determine dividend payouts </li></ul></ul>
  24. 24. Dividends and Dividend Yield <ul><li>Dividend Yield : a measure to relate dividends to share price on a percentage basis </li></ul><ul><ul><li>Indicates the rate of current income earned on the investment dollar </li></ul></ul><ul><ul><li>Convenient method to compare income return to other investment alternatives </li></ul></ul>
  25. 25. Dividends and Dividend Payout Ratio <ul><li>Dividend Payout Ratio : the portion of earnings per share (EPS) that a firm pays out as dividends </li></ul><ul><ul><li>Companies are not required to pay dividends </li></ul></ul><ul><ul><li>Some companies have high EPS, but reinvest all money back into company </li></ul></ul>
  26. 26. Three Reasons to Love Dividends <ul><li>Stocks that pay dividends tend to produce higher returns than those that do not </li></ul><ul><ul><li>S&P dividend payers were up 6.5% vs. 3.6% for non-dividend payers </li></ul></ul><ul><li>Since 1928, dividends have accounted for 40% of total return on stocks </li></ul><ul><li>Since 1980, dividend-payers have averaged annualized returns of 15.1% vs. 12.8% for non-payers </li></ul>
  27. 27. Other Dividend Characteristics <ul><li>Stock Dividend : payment of a dividend in the form of additional shares of stock </li></ul><ul><li>Dividend Reinvestment Plans (DRIPs) : plans where cash dividends are automatically reinvested into additional shares of the firm’s common stock </li></ul><ul><ul><li>Over 1,000 companies offer DRIPs </li></ul></ul><ul><ul><li>Usually have no brokerage fees </li></ul></ul><ul><ul><li>Uses dollar-cost averaging </li></ul></ul>
  28. 28. Types of Stock <ul><li>Blue Chip Stocks : financially strong, high-quality stocks with long and stable records of earnings and dividends </li></ul><ul><ul><li>Companies are leaders in their industries </li></ul></ul><ul><ul><li>Relatively lower risk due to financial stability of company </li></ul></ul><ul><ul><li>Popular with investing public looking for steady growth potential, perhaps dividend income </li></ul></ul><ul><ul><li>Provide shelter during unsettled markets </li></ul></ul><ul><ul><li>Examples: Citigroup, Pfizer, DuPont, Nike, Procter & Gamble, Home Depot </li></ul></ul>
  29. 29. Figure 6.5 A Blue Chip Stock
  30. 30. Types of Stock (cont’d) <ul><li>Income Stocks : stocks with long and sustained records of paying higher-than average dividends </li></ul><ul><ul><li>Good for investors looking for relatively safe and high level of current income </li></ul></ul><ul><ul><li>Dividends tend to increase over time (unlike interest payments on bonds) </li></ul></ul><ul><ul><li>Some companies pay high dividends because they offer limited growth potential </li></ul></ul><ul><ul><li>More subject to interest rate risk </li></ul></ul><ul><ul><li>Examples: Bell South, Conagra Foods, Ford Motor, Bank of America, Duke Energy </li></ul></ul>
  31. 31. Types of Stock (cont’d) <ul><li>Growth Stocks : stocks that experience high rates of growth in operations and earnings </li></ul><ul><ul><li>Have sustained rate of growth in earnings above general market </li></ul></ul><ul><ul><li>Investors expect higher price appreciation due to increasing earnings </li></ul></ul><ul><ul><li>Riskier investment because price may fall if earnings growth cannot be maintained </li></ul></ul><ul><ul><li>May include blue chip stocks as well as speculative stocks </li></ul></ul><ul><ul><li>Typically pay little or no dividends </li></ul></ul><ul><ul><li>Examples: Medtronics, Boston Scientific, Countrywide Financial, Wellpoint, Genentech </li></ul></ul>
  32. 32. Types of Stock (cont’d) <ul><li>Tech Stocks : stocks representing the technology sector of the market </li></ul><ul><ul><li>Range from speculative stocks of small companies that have never shown a profit to blue chip stocks of large companies that are growth-oriented </li></ul></ul><ul><ul><li>Potential for attractive returns </li></ul></ul><ul><ul><li>Considerable risk and volatility </li></ul></ul><ul><ul><li>Difficult to put value on due to erratic or no earnings </li></ul></ul><ul><ul><li>Examples: Hewlett-Packard, Intel, Dell, Yahoo!, Electronic Arts </li></ul></ul>
  33. 33. Types of Stock (cont’d) <ul><li>Speculative Stocks : stocks that offer potential for substantial price appreciation, usually due to some special situation such as a new product </li></ul><ul><ul><li>Companies lack sustained track record of business and financial success </li></ul></ul><ul><ul><li>Earnings may be uncertain or highly unstable </li></ul></ul><ul><ul><li>Potential for substantial price appreciation </li></ul></ul><ul><ul><li>Stock price subject to wide swings up and down in value </li></ul></ul><ul><ul><li>Examples: Sirius Satellite Radio, Dreamworks Animation, Liberty Media </li></ul></ul>
  34. 34. Types of Stock (cont’d) <ul><li>Cyclical Stocks : stocks whose earnings and overall market performance are closely linked to the general state of the economy </li></ul><ul><ul><li>Stock price tends to move up and down with the business cycle </li></ul></ul><ul><ul><li>Tend to do well when economy is growing, especially in early stages of economic recovery </li></ul></ul><ul><ul><li>Tend to do poorly in slowing economy </li></ul></ul><ul><ul><li>Best for investors willing to move in and out of market as economy changes </li></ul></ul><ul><ul><li>Examples: Caterpillar, Lennar, Alcoa, Brunswick </li></ul></ul>
  35. 35. Types of Stock (cont’d) <ul><li>Defensive Stocks : stocks that tend to hold their value, and even do well, when the economy starts to falter </li></ul><ul><ul><li>Stock price remains stable or increases when general economy is slowing </li></ul></ul><ul><ul><li>Products are staples that people use in good times and bad times, such as electricity, beverages, foods and drugs </li></ul></ul><ul><ul><li>Gold stocks are a form of defensive stock </li></ul></ul><ul><ul><li>Best for aggressive investors looking for “parking place” during slow economy </li></ul></ul><ul><ul><li>Examples: Checkpoint Systems, WD-40 </li></ul></ul>
  36. 36. Market Capitalization <ul><li>Small-Cap Stocks: under $1 billion </li></ul><ul><li>Mid-Cap Stocks: $1 billion to $4 or $5 billion </li></ul><ul><li>Large-Cap Stocks: more than $4 or $5 billion </li></ul>
  37. 37. Types of Stock (cont’d) <ul><li>Large-Cap Stocks : large companies with market capitalizations over $4 or $5 billion </li></ul><ul><ul><li>Number of companies is smaller, but account for 80% to 90% of the total market value of all U.S. equities </li></ul></ul><ul><ul><li>Bigger is not necessarily better </li></ul></ul><ul><ul><li>Tend to lag behind small-cap and mid-cap stocks, but typically have less volatility </li></ul></ul><ul><ul><li>Examples: Wal-Mart, General Motors, Microsoft </li></ul></ul>
  38. 38. Types of Stock (cont’d) <ul><li>Mid-Cap Stocks : medium-sized companies with market capitalizations between $1 billion and $4 or $5 billion </li></ul><ul><ul><li>Provide opportunity for greater capital appreciation than Large-Cap stocks, but less price volatility than Small-Cap stocks </li></ul></ul><ul><ul><li>Usually have long-term track records for profits and stock valuation </li></ul></ul><ul><ul><li>“ Baby Blues” offer same characteristics of Blue Chip stocks except size </li></ul></ul><ul><ul><li>Examples: Barnes & Noble, Williams-Sonoma, Reebok International </li></ul></ul>
  39. 39. Types of Stock (cont’d) <ul><li>Small-Cap Stocks : small companies with market capitalizations less than $1 billion </li></ul><ul><ul><li>Provide opportunity for above-average returns (or losses) </li></ul></ul><ul><ul><li>Usually do not have a financial track record </li></ul></ul><ul><ul><li>Earnings tend to grow in spurts and can have dramatic impact on stock price </li></ul></ul><ul><ul><li>Usually not widely-traded; liquidity is an issue </li></ul></ul><ul><ul><li>“ Initial Public Offerings (IPOs) </li></ul></ul><ul><ul><li>Examples: Playboy Enterprises, Denny’s, Sanderson Farms, Build-A-Bear Workshops </li></ul></ul>
  40. 40. Investing in Foreign Stocks <ul><li>Globalization of financial markets is growing </li></ul><ul><ul><li>U.S. equity market is less than 50% of world equity markets </li></ul></ul><ul><ul><li>Six countries make up 80% of world equity market </li></ul></ul><ul><ul><li>U.S. market remains largest equity market in world </li></ul></ul><ul><ul><li>Some of the returns in non-U.S. markets are due to currency exchange rates, and not just markets themselves </li></ul></ul>
  41. 41. Going Global <ul><li>Buying Shares Directly in Foreign Markets </li></ul><ul><ul><li>Most adventuresome approach </li></ul></ul><ul><ul><li>Logistical problems: fluctuating currency rates, different regulatory and accounting standards, tax problems, “red tape” </li></ul></ul><ul><li>Buying American Depositary Shares (ADSs) </li></ul><ul><ul><li>Simpler approach </li></ul></ul><ul><ul><li>Bought and sold on U.S. markets just like stocks in U.S. companies </li></ul></ul><ul><ul><li>Transactions are in U.S. dollars </li></ul></ul><ul><li>Buying International Mutual Funds </li></ul>
  42. 42. Going Global <ul><li>International investing is more complex and riskier than domestic investing </li></ul><ul><li>International investing requires investors to be right on more factors: </li></ul><ul><ul><li>Must pick right stock </li></ul></ul><ul><ul><li>Must pick right market </li></ul></ul><ul><ul><li>Must pick correct direction for currency exchange rate fluctuations </li></ul></ul>
  43. 43. Returns on International Investments <ul><li>Stronger U.S. dollar has negative impact on foreign investments </li></ul><ul><li>Weaker U.S. dollar has positive impact on foreign investments </li></ul>
  44. 44. Alternative Investment Strategies <ul><li>Storehouse of Value </li></ul><ul><ul><li>Safety of investment is primary goal </li></ul></ul><ul><ul><li>Investors use high-quality blue chip and non-speculative stocks </li></ul></ul><ul><li>To Accumulate Capital </li></ul><ul><ul><li>Growth of investment is primary goal </li></ul></ul><ul><ul><li>Investors use growth-oriented stocks to generate capital gains </li></ul></ul><ul><li>Source of Income </li></ul><ul><ul><li>Current income is primary goal </li></ul></ul><ul><ul><li>Investors use stocks with dependable flow of dividends </li></ul></ul>
  45. 45. Stock Investment Strategies <ul><li>Buy-and-Hold </li></ul><ul><ul><li>Investors buy high-quality stocks and hold them for extended time periods </li></ul></ul><ul><ul><li>Goal may be current income and/or capital gains </li></ul></ul><ul><ul><li>Investors often add to existing stocks over time </li></ul></ul><ul><ul><li>Very conservative approach; value-oriented </li></ul></ul>
  46. 46. Stock Investment Strategies (cont’d) <ul><li>Current Income </li></ul><ul><ul><li>Investors buy stocks that have high dividend yields </li></ul></ul><ul><ul><li>Safety of principal and stability of income are primary goals </li></ul></ul><ul><ul><li>May be preferable to bonds because dividends levels tend to increase over time </li></ul></ul><ul><ul><li>Often used to provide to supplement other income, such as in retirement </li></ul></ul>
  47. 47. Stock Investment Strategies (cont’d) <ul><li>Quality Long-Term Growth </li></ul><ul><ul><li>Investors buy high-quality growth stocks, mid-cap stocks and tech stocks </li></ul></ul><ul><ul><li>Capital gains are primary goal </li></ul></ul><ul><ul><li>Higher level of risk due to emphasis on capital gains </li></ul></ul><ul><ul><li>Significant trading of stocks may occur over time </li></ul></ul><ul><ul><li>Diversification is used to spread risk </li></ul></ul><ul><ul><li>“ Total Return Approach” is version that emphasizes both capital gains and high income </li></ul></ul>
  48. 48. Stock Investment Strategies (cont’d) <ul><li>Aggressive Stock Management </li></ul><ul><ul><li>Investors buy high-quality growth stocks, blue chip stocks, mid-cap stocks, tech stocks and cyclical stocks </li></ul></ul><ul><ul><li>Capital gains are primary goal </li></ul></ul><ul><ul><li>High level of risk due to emphasis on capital gains </li></ul></ul><ul><ul><li>Investors aggressively trade in and out of stocks, often holding for short periods </li></ul></ul><ul><ul><li>Timing the market is key element </li></ul></ul><ul><ul><li>Time consuming to manage </li></ul></ul>
  49. 49. Stock Investment Strategies (cont’d) <ul><li>Speculation and Short-Term Trading </li></ul><ul><ul><li>Also called “day trading” </li></ul></ul><ul><ul><li>Investors buy speculative stocks, small-cap stocks and tech stocks </li></ul></ul><ul><ul><li>Capital gains are primary goal </li></ul></ul><ul><ul><li>Highest level of risk due to emphasis on capital gains in short time period </li></ul></ul><ul><ul><li>Investors aggressively trade in and out of stocks, often holding for extremely short periods </li></ul></ul><ul><ul><li>Looking for “big score” on unknown stock </li></ul></ul><ul><ul><li>Time consuming & high trading costs </li></ul></ul>
  50. 50. Chapter 6 Review <ul><li>Learning Goals </li></ul><ul><ul><li>Explain the investment appeal of common stocks and why individuals like to invest in them. </li></ul></ul><ul><ul><li>Describe historical stock returns and how current returns measure up to historical standards of performance. </li></ul></ul><ul><ul><li>Discuss the basis features of common stocks, including issue characteristics, stock quotations, and transaction costs. </li></ul></ul>
  51. 51. Chapter 6 Review (cont’d) <ul><li>Learning Goals (cont’d) </li></ul><ul><ul><li>Understand the different kinds of common stock values. </li></ul></ul><ul><ul><li>Discuss common stock dividends, types of dividends, and dividend reinvestment plans. </li></ul></ul><ul><ul><li>Describe various types of common stocks, including foreign stocks, and note how stocks can be used as investment vehicles. </li></ul></ul>
  52. 52. Chapter 6 Additional Chapter Art
  53. 53. Figure 6.3 An Announcement of a New Stock Issue
  54. 54. Table 6.2 Cash or Reinvested Dividends?
  55. 55. Figure 6.6 A Growth Stock
  56. 56. Figure 6.7 A Tech Stock
  57. 57. Figure 6.8 A Mid-Cap Stock
  58. 58. Table 6.3 Comparative Annual Returns in the World’s Major Equity Markets, 1981–2005