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Chapter 6 Common Stock Investments


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Chapter 6 Common Stock Investments

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