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Chapter 6.doc


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Chapter 6.doc

  1. 1. Part Three Investing in Common Stocks Part Three Includes Chapter 6 Common Stocks Chapter 7 Analyzing Common Stocks Chapter 8 Stock Valuation Chapter 9 Market Price Behavior
  2. 2. Chapter 6 Common Stocks   Outline Learning Goals I. What Stocks Have to Offer A) The Appeal of Common Stocks B) Putting Stock Price Behavior into Perspective C) From Stock Prices to Stock Returns D) The Dow, the S&P, and the Nasdaq 1. Comparative Performance of the Three Market Measures 2. Bulls, Bubbles, and Bears E) The Pros and Cons of Stock Ownership 1. The Advantages of Stock Ownership 2. The Disadvantages Concepts in Review II. Basic Characteristics of Common Stock A) Common Stock as a Corporate Security 1. Issuing New Shares 2. Stock Spin-Offs 3. Stock Splits 4. Treasury Stock 5. Classified Common Stock B) Buying and Selling Stocks 1. Reading the Quotes 2. Transaction Costs C) Common Stock Values 1. Par Value 2. Book Value 3. Market Value 4. Investment Value Concepts in Review
  3. 3. 102  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition III. Common Stock Dividends A) The Dividend Decision 1. Corporate Versus Market Factors 2. Some Important Dates B) Types of Dividends 1. Cash 2. Stock Dividends C) Dividend Reinvestment Plans Concepts in Review IV. Types and Uses of Common Stock A) Types of Stocks 1. Blue Chips Stocks 2. Income Stocks 3. Growth Stocks 4. Tech Stocks 5. Speculative Stocks 6. Cyclical Stocks 7. Defensive Stocks 8. Mid-Cap Stocks 9. Small-Cap Stocks B) Investing in Foreign Stocks 1. Comparative Returns 2. Going Global: Direct Investments 3. Going Global with ADR’s 4. Putting Global Returns in Perspective 5. Measuring Global Returns 6. Currency Exchange Rates C) Alternative Investment Strategies 1. Buy-and-Hold 2. Current Income 3. Quality Long-Term Growth 4. Aggressive Stock Management 5. Speculation and Short-Term Trading Concepts in Review
  4. 4. Chapter 6 Common Stocks  103 Summary Putting Your Investment Know-How to the Test Discussion Questions Problems Case Problems 6.1 Sara Decides to Take the Plunge 6.2 Wally Wonders Whether There’s a Place for Dividends Excel with Spreadsheets Trading Online with OTIS   Key Concepts 1. The investment appeal of common stock. 2. Historical returns in the stock market. 3. Basic issue characteristics of common stock, including the advantages and disadvantages of ownership. 4. Stock quotations and transaction costs. 5. Different types of stock offerings and common stock values. 6. Transaction costs of buying and selling stocks. 7. The importance of dividends to stocks and stock valuation, including how dividend decisions are made, types of dividends, and dividend policies. 8. The kinds of common stocks and their investment merits. 9. Investing in foreign stocks, including the impact of currency exchange rates in returns to U.S. stockholders. 10. Uses of common stocks as investment vehicles, and the strategies that can be employed to meet various investment goals.   Overview This chapter is one of four that examines common stocks as an investment vehicle. Common stocks are one of the most interesting of investment vehicles, and this chapter provides an essential foundation to the students’ understanding of equity securities; as such, the instructor should plan to cover it in detail. 1. Several characteristics of common stocks make them an important investment vehicle: (1) Common stocks provide an attractive ownership feature in addition to income potential. (2) Common stockholders lay claim to all the residual profits of the firm. (The instructor should explain the meaning of residual profits.) (3) Owners of common stock do not receive all the residual profits as income, but only that part of profits declared as dividends. (4) Because a wide variety of common stocks may be purchased, the investor may choose from a broad spectrum of risk-return combinations.
  5. 5. 104  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition 2. Because of widespread misunderstandings, it’s important to put stock returns into perspective. Students seem to have all sorts of ideas about how stock perform, so it’s best to address this issue early on in the discussion. Table 6.1 provides over 50 years (1950–2002) of annual returns and holding period returns. Spend some time on: historical returns in the stock market; how these can be used as a benchmark of performance; and the relative importance of dividends and capital gains to total stock returns. While discussing historical returns, it’s the perfect time to discuss the market crashes of October 1987 & October 1997 and their causes. Students appreciate information about stock returns since the book was published. It is good to bring information about the recent returns on the Dow, S&P, and Nasdaq indexes to class. 3. The following features of common stocks presented in the text should be discussed in detail in class: ownership rights, rights offerings, kinds of issues, deferred equity securities, stock splits, treasury stock, and classified common stock. The costs incurred in making common stock transactions of different sizes should also be mentioned. 4. The alternative ways of defining the value of common stock are: par value, book value, market value, and investment value. The meaning and usefulness of each of these value measures to the investor should be discussed in class. Current copies of stock quotes can be weaved into the discussion of market value. 5. The dividend decision of a firm is important to the investor and to the firm, so the following aspects of dividends should be highlighted: how the dividend decision is made; important dates that affect dividends; tax effects of different types of dividends; and the basic principles behind the creation of and participation in dividend reinvestment plans. Examples of earnings per share (EPS) and dividend yield computations should be worked out in class. Current common stock yields can be compared to bond yields and local savings account yields. 6. In the latter part of the chapter, common stocks are classified into different types, based on different features. These types are blue chips, income stocks, growth stocks, speculative stocks, cyclical stocks, defensive stocks, mid-cap, and small-cap stocks. The instructor should indicate the risk-return characteristics of each type. The instructor should also outline the steps involved in investing in foreign stocks, with special emphasis on ADRs and the impact of currency exchange on total return. 7. Finally, the alternative strategies that investors can follow when using stocks should be explained, and the instructor should emphasize that investors choose different types of stocks according to their investment objectives.   Answers to Concepts in Review 1. A common stock is an equity investment that represents ownership in a corporate form of business. Each share represents a fractional ownership interest in the firm. The key attribute of this investment security is that it enables investors to participate in the profits of the firm. As residual owners of the company, common stockholders are entitled to dividend income and a prorated share of the firm’s earnings after all other obligations of the firm have been met. They have no guarantee they will ever receive any return on their investment.
  6. 6. Chapter 6 Common Stocks  105 2. One important investment attribute of common stocks is that they enable investors to participate in the profits of the firm and as such, they can offer attractive return opportunities. Another attribute is the versatility of the security—it can be used to meet just about any type of investment objective. In addition, as investment vehicles go, common stocks are fairly simple and straightforward, so they’re easy to understand (though that certainly doesn’t mean they’re easy to value). They are easy to buy and sell, and the transactions costs are modest. Moreover price and market information is widely disseminated in the news and financial media. 3. The stock market has been very volatile over the past 15 years. A bull market, was followed by a bubble, that became a bear market, and once again appears to be quite bullish. Although stocks provided average annual returns of around 11% from 1953–2002, there was a significant sell-off in October 1987. While the first half of the 1990’s witnessed returns that were slightly below average, average annual returns during the second half of the decade were 26%. Then came a bear market that resulted one of the few three-year stretches with negative annual returns. However, by December of 2003, the stock market had rebounded off of the 2002 lows, and the Dow Jones Industrial Average once again reached 10,000. In early 2004, the Dow Jones Industrial Average stood at 10,700. The Nasdaq index showed even more volatility than the Dow. Over the entire 1990 to mid-2003 period the Dow outperformed both the S&P and Nasdaq. The Dow also had less of a loss during the period from 2000 to mid-2003. (Instructors may also point out that these figures reflect the general behavior of the market as a whole, not necessarily that of individual stocks.) 4. While they don’t provide the “bang” that capital gains do, dividends are an important source of return to stockholders. Dividend returns are always positive, although the dividend yield recently has been under 2.5 percent. Capital gains have ranged from 43.96 percent in 1954 to –27.57% in 1974. Over the past 50 years, dividends have accounted for a little less than 50% of the average annual total return from stocks. There’s no question that capital gains provide the really big returns, though they also lead to wider swings in year-to-year yields. Dividends, in contrast, provide an element of stability and tend to shore up returns in off years. Currently, dividends are taxed at five percent and fifteen percent rates, the same as capital gains. 5. The major advantage of common stock ownership is the returns it offers. Because stockholders are entitled to participate in the prosperity of a firm, there is almost no limit to a stock’s capital gains potential. In addition, many stocks provide regular current income in the form of annual dividends—and for most income-producing stocks, those dividends tend to grow over time, adding even more to the stockholder’s return. Common stocks are also highly liquid and easily transferable; their transaction costs are relatively low, market information is readily available, and unit price is nominal. The risky nature of common stocks is the most significant disadvantage of common stock ownership. As residual owners of the firm, no return is guaranteed. Furthermore, prices are subject to wide swings, making valuation difficult. Finally, the sacrifice in current income is a disadvantage relative to other investments (like bonds, for instance) that pay higher and more certain returns.
  7. 7. 106  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition The principal risks to stockholders include: business and financial risk, purchasing power risk, and, of course, market risk. Business risk is related to the kind of business the company is in and deals with both sales volatility and the amount of variability in the firm’s earnings. Financial risk is associated with the mix of debt and equity financing. The more debt (financial leverage) the firm uses, the greater the likelihood that it will default on its principal and interest payments—which in turn will have a negative impact on the stock. Purchasing power risk refers to the possibility of price increases and the corresponding decline in the value of the dollars invested in common stock. Market risk is caused by factors independent of the firm that affect the return on the firm’s common stock. Such things as economic fluctuations, threat of war, and political factors affect market risk and therefore can have a bearing on the market price of a stock. The market itself has an impact on the price performance of a stock—which, of course, is what beta is all about (i.e., a stock’s beta is a measure of the extent to which the stock reacts to the market). 6. A stock split occurs when a firm announces its intention to increase the number of shares of stock outstanding by exchanging a specified number of new shares for each outstanding share of stock. Most stock splits are executed with a view to lowering the price of the stock and enhancing its trading appeal. If the stock split is not accompanied by an increase in the level of dividends, stock prices will fall to account for the split. Thus, a $100 stock will fall to $50 after a 2 for 1 split. If the company had changed its dividend rate—say, by increasing dividends—the stock price will rise after adjusting for the split. In the above case, the stock price will end up above $25 per share, depending on the size of the dividend increase. Thus, other things being equal, a change (increase) in the dividend rate will have a positive impact on the stock’s price, after adjusting for the stock split. 7. Stock spin-offs involve conversion of one of firm’s subsidiaries to a stand alone company by distribution of stock in that new company to existing shareholders. For e.g. Pepsico spun off its restaurant operations—Pizza Hut, KFC, and Taco Bell—into a new company called Tricon Global Restaurants (now called Yum Brands). Investors have shares in both the old and new firm, allowing them to keep those divisions they want to hold and selling the other. 8. (a) Firms do not “issue” treasury stock; these are simply shares of common stock that have been issued and subsequently repurchased by the issuing firm. This is generally done because the firm views the stock as an attractive investment; perhaps the price is unusually low. Most treasury stock is later reissued by the firm and used for such purposes as mergers and acquisitions, employee stock option plans, or for payment of stock dividends. Treasury stock is not a form of classified stock. Classification of common stock simply breaks common stock into different classes or groups. Each class has different voting rights and/or dividend obligations. For example, class A stock might designate nonvoting shares that receive preferential dividends, while class B stock might designate voting shares with lower dividends. Some classes pay stock dividends to appeal to individuals interested in capital gains; other classes pay higher cash dividends that attract income-seeking investors. (b) Common stock can be bought or sold in round or odd lots. A round lot is 100 shares of stock, or multiples of 100 shares. An odd lot is a transaction involving less than 100 shares. (c) The par value of a stock is its stated or face value and exists primarily for accounting purposes. Many stocks are issued with no par value. It is a relatively useless number. The liquidation value of a stock is an estimate of the market value of the firm’s assets, if sold at auction, less the liabilities and preferred stock outstanding. While this measure of value is vitally important to the high-stakes LBO and take-over artists, it is very difficult to determine and is generally of little interest to the typical individual investor who tends to view the firm as a going concern.
  8. 8. Chapter 6 Common Stocks  107 (d) Book value is an accounting measure of the amount of stockholder’s equity in the firm. Book value indicates the amount of stockholder funds used to finance the firm. Investment value, perhaps the most important measure for a stockholder, indicates what value investors place on the stock. Investment value is based on the expectations of the risk and return patterns of a stock: the returns come from dividends and capital gains, and the risk is based on the exposure to holding the stock. 9. An odd-lot differential is the additional transactions costs an investor must pay to an odd-lot dealer to trade in odd lots. The differential can be as high as 10 to 25 cents per share over and above normal commission fees. These costs can be avoided by trading in round lots, or units of 100 shares. (a) odd-lot differential added to fees (b) no differential added (c) odd-lot differential added to fees 10. The question on the amount of dividends to be paid is decided by the firm’s board of directors. The directors evaluate the firm’s operating results and financial conditions to determine whether dividends should be paid and, if so, in what amount. During a Board of Directors meeting, a variety of factors are considered in making the investment decision. These include: (a) The firm’s current earnings or profits are considered a vital link in the dividend decision. (b) The Board also looks at the firm’s growth prospect. Firms with good investment opportunities pay less dividends; using the retained earnings for new investment. (c) The Board also considers the firm’s cash position to make sure it has sufficient liquidity to meet a cash dividend of a given size. (d) The Board also ensures that it is meeting all legal and contractual constraints that might be imposed by loans. (e) The Board also makes an effort to meet the dividend expectations of its shareholders; failure to meet these expectations can lead to disastrous results in the stock market. 11. The ex-dividend date (which occurs two business days prior to the date of record) determines who is eligible to receive the declared dividend when the stock is sold. If the stock is sold on or after the ex- dividend date, the owner (seller) receives the dividend; if it is sold prior to the ex-dividend date, the new shareholder (buyer) receives the dividend. Thus, if the stock is sold on the ex-dividend date, the seller receives the dividend—going “ex-dividend” means the buyer is not entitled to the dividend since the stock is being sold “without” the dividend. 12. Cash dividends are simply dividend payments made to the stockholder in cash. This form of dividend represents something of value. A stock dividend is an issue of new shares expressed and distributed as a percentage of each shareholder’s existing shares. It really has no value, since the market responds to stock dividends by adjusting the market price accordingly. As an example, consider a stock that is trading at $50 per share; if the issuing firm declared a 10 percent stock dividend, the price of this stock would drop by 10 percent to $45.45 ($50/1.1). Thus, an investor who held 100 shares before the stock dividend would hold 110 shares after, but the total market value of these shares would be basically the same: $50 × 100 = $45.45 × 110. When a stock dividend is declared by the firm, additional shares of the stock are issued to existing shareholders. Stock dividends may be used as a substitute for cash dividends, but they have no value because the stock prices adjusts to the stock dividend accordingly. Stock splits occur when the firm gives shareholders new shares in exchange for each share they own. The central difference between stock dividends and stock splits is that dividends are additional issues and stock splits are exchanges.
  9. 9. 108  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition In a 200 percent stock dividend, the investor receives additional shares equaling 200 percent of existing shares (i.e., 100 shares already owned × 200% = 200 new shares distributed in addition to the original 100). In a 3-for-1 stock split, the investor receives 3 new shares for each existing share (100 × 3 = 300 shares held after split). 13. Firms with dividend reinvestment plans (DRPs) allow shareholders to automatically reinvest their dividends into additional shares of the firm. DRPs provide investors with a convenient and inexpensive way to accumulate capital without paying brokerage commissions. Despite these cost savings, the dividends paid through DRPs are taxable as ordinary income in the year they are received, just as if they had been received in cash. 14. (a) Blue chips are common stocks of very high quality that have a long and proven record of earnings and dividends. They offer respectable dividend yields and modest growth potential. They are often viewed as long-term investment vehicles, have low risks, and provide modest but dependable rates of return. (b) Income stocks are issues that have a long and sustained record of higher than average dividends. These are ideal for investors who desire high current income with little risk. Unlike other types of income securities (bonds, for instance), holders of income stocks can expect the amount of dividends they receive to increase regularly over time. One disadvantage with these stocks is their generally low to modest growth potential. (c) Mid-cap stocks are stocks with capitalization value between $1 billion and $4–$5 billion. Mid-caps offer investors attractive return opportunities—they have the sizzle of small-cap stocks without the high price volatility. They also provide characteristics of the big, established stocks. This mid-cap range is probably most appropriate for investors willing to tolerate a bit more risk and price volatility than large stocks. One type of mid-cap stock, a “baby blue chip,” has all the characteristics of regular blue chip, except for size. (d) American Depository Receipts (ADRs) are negotiable instruments issued by American banks. Each ADR represents a specific number of shares of stock in a specific foreign company. They are used as a way to purchase foreign stocks and are traded on U.S. exchanges (for example, the NYSE) or in the OTC markets; they trade just like shares of American stocks. Beyond the simplified trading, the investment merits of an ADR are a function of the investment merits of the foreign company that issued the stock, as well as the value of the dollar relative to the currency of the foreign company. (e) IPOs are initial public offerings of primarily small, relatively new companies. As the name suggests, these stocks are offered to the public for the first time. IPOs offer a chance to earn phenomenal capital gains. At the same time, it is very likely that investing in IPO stocks might result in a loss. As such, these should be considered only by experienced and knowledgeable investors. IPOs must be considered to be highly risky investments. (f) Tech stocks are issued by companies in the technology sector. Issuing firms produce everything from computers to Internet content. They typically are growth stocks or speculative stocks, because they pose considerable risk to the investor. This sector has done extremely well in good times and depreciated significantly in bear markets. 15. Income stocks generally have limited capital gains potential because they pay out large amounts of their earnings in dividends; in essence, little of their income is plowed back into the company to finance growth. Returns from income stocks come mostly from current income rather than capital gains, a distinction favored by many investors. This does not mean these stocks are unprofitable; most, in fact, are highly profitable, with excellent long-term future prospects.
  10. 10. Chapter 6 Common Stocks  109 16. Less than 50 percent of the world equity market is in U.S. stocks. For the most part, the U.S. stock market has been one of the best places to invest over the past two decades. However, the U.S. finished first in only one year during the 1980–2002 period. Thus, to achieve greater returns on their portfolio in a given year, investors should also consider foreign markets. Furthermore, the appreciated value of a foreign currency relative to the U.S. dollar would enhance foreign equity returns. The U.S. investor can either invest directly in foreign markets or indirectly by buying American Depository Receipts (ADRs). All things considered, American investors are probably better off with ADRs because they avoid many logistical problems that arise with direct investing. ADRs are dollar- denominated and are about as easy to buy/trade as U.S. stocks. 17. A quality conscious investor would probably do best with a simple and conservative buy-and hold strategy. With this strategy, the investor purchases income, quality, and blue chip stocks, and watches them grow over time. On the other hand, if an investor is willing to tolerate a lot of risk, an aggressive stock management strategy is the most appropriate. Here the investor aggressively trades in and out of the various types of quality stocks in order to earn above average return from both dividends and capital gains. An individual’s investment approach depends upon whether common stock is viewed primarily as a storehouse of value, way to accumulate capital, or source of income.   Suggested Answers to Investing in Action Questions Anatomy of a Market Meltdown (p. 238) (a) What factors contributed to the 2000 market meltdown? (b) What steps can you take to protect yourself in the future? Answers: (a) Factors leading up to the meltdown included: (1) Unsustainable annual average returns of 26% during the prior five years, (2) Investors eagerly buying shares in new technology companies, without regard to track records, products, or profits, (3) Individuals investing with the expectation that there would not be another recession, and (4) Extra money being pumped into the economy by the Federal Reserve to guard against any year-2000 computer problems. Then in early 2000: (1) The Federal Reserve raised interest rates, (2) Business investment in technology decreased, (3) Lower sales at Dell and the antitrust suit against Microsoft worried investors, (4) The September 11, 2001 terrorist bombings and stock market closure for a week following terrorist bombings, (5) Corporate scandals at Enron eroded investor confidence and brought into question the validity of numbers produced by Arther Andersen and others, (6) Subsequent terrorist threats and anxiety arising from the looming war in Iraq caused the markets to drop even farther, and (7) Simply the fear that matters could get even worse pushed investors to give up (even if it meant taking a loss) and move their money into bonds.
  11. 11. 110  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition (b) Diversifying allows you to spread out the risk that a unique firm or industry event will have a devastating impact on your investment. You have to analyze the track record, products and profits of firms before investing. Investors will want to reallocate their portfolio, even if it means selling winners so that their wealth is not a closely tied to the success of a single firm. It also is good to include both stock and bonds in your portfolio. The surge of interest in bonds and falling interest rates as the economy stagnated drove prices of these securities upward. In International Investing, Currencies can Make or Break You (p. 268) (a) How does a strengthening dollar erode returns from non-U.S. investments? (b) Is the dollar currently weak or strong, and what does this mean for investors? Answers: (a) If the dollar strengthens between the time the investor buys and sells the stock, the local currency buys fewer dollars at the time of the sale. If foreign currency values decline by more than the rate of return in the foreign currency, positive foreign returns may net out to a negative return for the U.S. investor. (b) Due to the varying relationship of the U.S. dollar with foreign currencies, instructors will have to get current information. Also, instructors may locate instances where the U.S. dollar is appreciating relative to one currency, but depreciating relative to another.   Suggested Answers to Ethics in Investing Questions Boards of Directors: Who Do They Represent? (at Web site) Should company directors be required to own the stock of companies they represent? Answer: The sad reality of many corporate boards is that they are filled with outside directors, who have little or no financial interest in a company they are suppose to oversee. Rather than requiring directors to put their money at stake to buy company stock, corporations often granted them free stock options instead. Unfortunately, these options were often treated as perks and giveaways and did little to align directors’ financial interests with that of the stockholders as many recent corporate scandals have indicated. One possible solution to this problem, and to provide directors with incentives to own company stock, would be matching grants where companies would establish a fund to match the director’s own purchase of shares.   Suggested Answers to Discussion Questions 1. (a) Returns during the 1970’s were only one third of those earned during the 1980’s. There were four declines during the 1970’s, but only two during the 1980’s. Average returns during the 1990’s were the highest of any decade, at 18.3%. Furthermore, there was only one year with a decline, 1990, during the period from 1990–1999. In both the 1980’s and 1990’s, there were seven years with during which the Dow Jones Industrial Average rose by over ten percent. By contrast, the stock market fell in each of the full years since 1999 reported in Table 6.1, and averaged a loss of 4.3%. (b) All three measures of stock market performance had an average positive rate of return exceeding 18% during the 1990s. During the portion of the 2000s available, all three indexes had a loss of at least 5%. While the Nasdaq market rose the most on average during the 1990s, it also declined the most during the 2000–2003 period. The Nasdaq Composite is more volatile during the period covered by Figure 6.2.
  12. 12. Chapter 6 Common Stocks  111 (c) There is a wide difference in the average annual rates of return, between the first half of 1990s and the second half. From 1990–1994, the Dow Jones Industrial Average’s average rate of return was 10.26%, while in the 1995–1999 period the average rate of return was 27.03%. A better indicator of future returns may be the average annual rate of return for the past fifty years, as presented in Table 6.2, which is 10.7 percent. Obviously, there is quite a range in actual returns around this average. 2. (a) Wednesday, April 9 (b) 189.12 (c) +6.8% (d) 15 The ratio of the daily market price to the current earnings (e) 189.12 (f) $6.00/share (g) 254.00, 150.50 (h) 75,500 (i) –3.88, 193.00 3. Answers will vary with each student. 4. (a) A combination of growth and value stock in a 50–50 weighting such as Microsoft for growth and a public utility for value (income). Another appropriate approach would be a total-return approach, that seeks to high rates of growth in dividend income or capital gains. A buy-and-hold strategy invested in a portfolio of large growth companies would also be appropriate. (b) Those with smaller amounts to invest are better off to focus on quality long-term growth and less on aggressive stock management. If she were more risk averse, we may want to allocate more value than growth to the weighting such as 75–25 or 60–40. 5. The three sources of return to U.S. investors from foreign stocks are the share of profit payments in the form of dividends, the capital gain as the value of the stock increases in market price and the appreciation of the foreign currency against the U.S.$. Currency exchange rates are critical, small foreign rates of return are elevated as the value of the U.S.$ declines. It is best to buy foreign currencies after the dollar has appreciated relative to those currencies and sell when the dollar has declined relative to the foreign currency. (a) British pounds have appreciated in value as compared to the U.S.$ giving greater returns to the U.S. investor who holds pounds. Australian dollars have depreciated against the U.S.$ as well as the Mexican peso giving the investor who holds these currencies less return. (b) ADRs are not directly affected by exchange rate changes since they trade in the U.S. financial markets in U.S.$. But since the underlying asset is a foreign stock denominated in a foreign currency, the change in exchange rates will eventually impact the price of the ADRs in U.S.$s. 6. (a) A buy-and-hold strategy is a long-term program that seeks capital growth with as well as preservation of capital, a well-balanced combination of growth and value stocks are most appropriate. (b) A current-income portfolio focuses on the current dividend yield of stocks. Safety of principal and stability of income are vital, while capital gains have secondary importance. The benefits of this strategy have increased with the decline in dividend tax rates. (c) Long-term total return would emphasize more growth stock as well as a lesser percentage in value stocks. Beyond the current dividend yield, attention would be paid to the anticipated dividend growth rate.
  13. 13. 112  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition (d) Aggressive stock management would call for a frequent rebalancing of the portfolio weights to represent the latest economic condition in the markets. These investors would hold a greater portion of their wealth in small-cap issues, speculative tech stocks, foreign shares, and ADRs.   Solutions to Problems 1. If a $50 stock splits 5 for 2, the new price of a share immediately after the split would be $20. Using the approach noted in the chapter, we have: [$50/(5/2)] = $20. If an investor owned 200 shares before the split, he would own 500 shares afterward: 200 × 5/2 = 500 shares. The market value of his holdings, however, would be unchanged: Before the split: 200 shares × $50 = $10,000 After the split: 500 shares × $20 = $10,000 2. Commissions on trades. The investor began with $20,000 and made $1,000 on his trade of stock. This totals $21,000. His balance, however, is $20,900. Therefore, Item 4 should be: Commissions on Trades – $100.00. 3. Book value = Total assets – Total debt – Preferred stock For Kracked Pottery: Book value = $2,500,000 − $1,800, 000 − $200, 000 = $500, 00 Book value Book value per share = Number of shares of common stock outstanding For Kracked Pottery: $500, 000 Book value per share = = $10 per share 50, 000 4. Market Capitalization = share price ×x number of shares outstanding. $25 ×x 250,000,000 = $6,250,000,000 Net profits after taxes − Preferred dividends 5. (a) Earnings per share (EPS) = Number of shares of common stock outstanding Net profits after taxes – Preferred dividends Number of shares of common stock outstanding For Med Tech Co.: $15,800, 000 − $1, 000, 000 EPS = = $5.92 2, 500, 000
  14. 14. Chapter 6 Common Stocks  113 Cash dividends per share (b) Dividend yield = Market price per share For Med Tech Co.: $2 Dividend yield = = 3.33% $60 Dividends per share (c) Dividend payout ratio = EPS For Med Tech Co.: $2 Dividend payout ratio = = 33.8% $5.92 6. Initial Investment = 200 × $50 = $10,000 Sales Proceeds = 200 × $55 = $11,000 Dividends = $0.25 × 4 × 200 = $200 Total Proceeds = $200 + $11,000 = $11,200 Net Proceeds Before Tax = $1,200 Tax @ 15% = 0.15 × $1,200 $180 Net Proceeds After Tax = $1,200 – $180 = $1,020 7. (a) Book value = Total assets – Total debt – Preferred stock For Truly Good Coffee: Book value = $240M – $115M – $25M = $100M Which is equal to common stockholders’ equity. Book Value (b) Book value per share = Number of shares of common stock outstanding For Truly Good Coffee: $100, 000, 000 Book value per share = = $10 per share 10, 000, 000 Net profits after taxes − Preferred dividends (c) Earnings per share (EPS) = Number of shares of common stock outstanding For Truly Good Coffee: $22, 500, 000 − $2, 000, 000 EPS = = $2.05 per share 10, 000, 000 shares Dividends per share (d) Dividend payout ratio = Earning per share For Truly Good Coffee: $0.75 Dividend payout ratio = = 36.59% $2.05
  15. 15. 114  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition Cash dividends per share (e) Dividend yield on common stock = Market price per share For Truly Good Coffee: $0.75 Dividend yield on CS = = 3.0% $25.0 Preferred dividends per share (f) Dividend yield on preferred stock = Market price of preferred share For Truly Good Coffee: $2.00 Dividend yield on PS = = 6.5% $30.75 8. $0.28 × 4 = $1.12 per annum in dividends. $1.12/$28 = 4%. 9. Earnings per share are $900M/$900M = $1.00. Dividends per share = $0.90. Payout ratio = $0.90/$1.00 = 90%. 10. (a) If Colin sells his stock on March 20th, he will be selling after the stock’s ex-dividend date (which will occur on March 19th) and, therefore, he will be the holder of record and is entitled to receive the dividend of $100 ($.50 × 200 shares). (b) Colin will be credited with $100 that will be used in the dividend reinvestment plan to purchase more of the company’s stock. A 5 percent discount on the $40 share price is $2.00, so the purchase price would be $38 per share ($40 − $2); thus, Colin will be able to purchase 2.632 shares of common stock ($100/$38). Unfortunately, Colin will have to pay taxes on the $100, since it’s still treated as a cash dividend. .1 The dividends paid under the two systems would be as follows: Dividends Paid 40% Payout Regular Dividend Year EPS Ratio of $1 per share 2000 $1.40 $0.56 $1.00 2001 2.10 0.84 1.00 2002 1.00 0.40 1.00 2003 3.25 1.30 1.00 2004 0.80  0.32 1.00 Total Dividends $3.42 $5.00 Total dividends are highest with regular dividends of $1 per share. Also, note how dividend payments fluctuate with the fixed payout ratio procedure. 12. There is no set solution to this problem, since the answer will vary with the companies selected by the student. The students should be encouraged (required?) to actually compute the requested information, rather than simply look up the numbers in something like Value Line. To compute the latest B/V per share, EPS, dividend payout ratio, and dividend yield, the student will have to refer to a couple of different sources to come up with the necessary input (e.g., Mergent or S&P for balance sheet and income statement information, and The Wall Street Journal or Barron’s for dividends and prices). Several Internet sites can also be employed.
  16. 16. Chapter 6 Common Stocks  115 Ending price − Beginning price + Current income 13. (a) Holding Period Return (HPR) = Beginning Price (1) (2) (3) (4) (5) (6) Current Ending Beginning Capital Gain Annual Return HPR Year Price Price (1) – (2) Income (3) + (4) (5)/(2) 2000 $54.00 $42.50 $11.50 $0.82 $12.32 28.99% 2001 74.25 54.00 20.25 1.28 21.53 39.87 2002 81.00 74.25 6.75 1.64 8.39 11.30 2003 91.25 81.00 10.25 1.91 12.16 15.01 2004 128.75 91.25 37.50 2.30 39.80 43.62 Over the five-year period, on average Engulf and Devour has returned 27.76% per year. This is well above the average return on the stock market over the same period. 14. (a) Ignoring the currency effect: (1) Total return to Siemens AG: Ending Value in Euros + Dividends in Euros = −1 Beginning Value in DM 60e + 1.5e = −1 53.25e = 0.1549 or 15.49% (2) Total return to Swisscom: Ending Value in Sf + Dividends in Sf = −1 Beginning Value in Sf 760 Sf + 15 Sf = −1 715 Sf = 0.0839 or 8.39% Ignoring the currency effect, Siemens promises the higher total return. Based on total returns in foreign currency form, it is the better investment. (b) Note: The Euro depreciated, while the Swiss franc appreciated. Considering the currency effect: (1) Total return to Siemens in U.S. dollars: Exchange Rate at Ending Value in Euros and Dividends in Euros End of Period × −1 Beginning Value in Euros Exchange Rate at Beginning of Period 60.0e + 1.5e 0.9852 = × −1 53.25e 1.1080 = (1.1549) (0.8892) − 1 = 0.027 or 2.7%
  17. 17. 116  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition <Eq>
  18. 18. Chapter 6 Common Stocks  117 (2) Total return to Swisscom in U.S. dollars: 760 Sf + 15 Sf 0.85 = × −1 715 Sf 0.75 = 0.2284 or 22.84% Exchange rates worked against the German investment because the higher returns were offset by an appreciation in the dollar relative to the euro. Conversely, the dollar depreciated relative to the Swiss franc, yielding an even higher total return on the Swiss stock. Given exchange rates, select the stock issued by Swisscom. 15. If the stock falls by 50%, Bob’s stock would be worth $12,500 ($25,000/2). To get back to $25,000, the stock would have to increase by 100%. 16. (a) You should buy Eurodollars. You expect that the euro will become more valuable in six months, such that the cost of one dollar will go from 1.02 Euros to 0.8941 Euros in six months. (b) At a rate of 1.02 Euros/Dollar, $10,000 will buy 10,200 Euros. At a rate of 0.8941 Euros/Dollar, 10,200 Euros will buy $11,408.12. Profit is $11,408.12 – $10,000 = $1,408.12.   Solutions to Case Problems Case 6.1   Sara decides to take the plunge The purpose of this case is to provide the student with the opportunity to identify investment needs, establish investment goals, and design an investment program. (a) Since Sara is so successful, she can easily provide for the necessities of life. Other than a minimum savings account to meet emergency needs, her savings should not be held for the long haul in these accounts. Keeping money tied up in low yielding savings accounts is costly, since the lower yields mean much slower growth of capital—in short, Sara will end up with a lot less money than if she’d put it into something with a higher return (like stocks). As an aside, Sara should make sure that any money she keeps in savings (i.e., for emergency purposes) is put into higher yielding short-term vehicles such as money funds, short-term CD’s, or MMDA’s. Although common stocks involve more risk and may not be a perfect hedge against inflation, they will generally earn higher returns than basic savings accounts and as such, Sara should seriously consider putting some of her money into stocks (or some other form of equity security). Because of the positive effects that such investments have on the long-run accumulation of capital, equity securities should be a part of most portfolios, especially for younger people. (b) Because of her high current income, Sara does not need investments to provide income now. She does need securities for capital accumulation and as a store of value (protect loss in purchasing power due to inflation) 1. North Atlantic Swimsuit Company (NASS) might meet Sara’s needs, but it is a highly speculative stock. The capital accumulation and storage of value benefits from this security are difficult to predict. Certainly Sara’s income and personal position justify some risk, but probably not as her only investment. If she purchases NASS, she needs to be able to monitor the firm closely. She should be prepared to sell if its growth prospects suddenly dim. And she should purchase other, less risky securities as well. 2. Town and Country Computer best fills these needs. It is a classic growth firm: long record of growth, quality firm, excellent prospects. The modest dividend is unimportant now, and the stock should provide for storage of value as well as capital accumulation.
  19. 19. 118  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition 3. Southeastern Public Utility Company does not meet Sara’s needs; it has a high current dividend and low growth prospects. Without at least average growth, the stock cannot serve as a store of value, since inflation will cause the value of the investment to fall. On the other hand, given the recent changes in the tax laws for dividends, this stock could represent a decent growth opportunity if the dividends are reinvested. This would also provide some income in the event her employment situation changes. 4. International Gold Mines may serve as a source of capital accumulation, but its price volatility makes it questionable as a store of value. Certainly its defensive characteristics make it attractive during periods of high inflation when the price of gold is increasing. However, when inflation moderates, it may fail to provide the spectacular performance it has had in inflationary times. A key here should be Sara’s expectations concerning inflation. If she expects inflation to accelerate at a high rate, this stock may suit her. Of the four options, Town and Country best serves her needs, and Southeastern Utilities is least attractive. The other two, more speculative stocks, fall in between with their appeal a function of their long-term growth prospects (NASS) and expectations about inflation (International Gold Mines). (c) Sara should follow a buy-and-hold or a quality long-term growth strategy. A high-income strategy does not fit her needs; she does not have the expertise to handle aggressive stock management (although her investment advisor might help her here); and the speculative, short-term strategy does not match her requirements or abilities. Given her new entry into the area of investments, she should probably begin with the buy-and-hold strategy and plan to adopt a quality long-term growth strategy as she develops a better understanding of the market and if she has the time to devote to investment management. Through such a program, common stocks should enable her to enjoy long-term growth in capital. For Sara, common stocks are an ideal investment vehicle since they should provide the type of investment return (capital gain) she is (or should be) seeking. One of the key attributes of common stock is its potential for capital appreciation, and this is precisely what Sara should go after. Case 6.2   Wally Wonders Whether There’s A Place for Dividends This case illustrates the common practice of changing investment vehicles in reaction to market changes. This case should allow students to experience some of the steps involved in following an investment strategy, as it demonstrates that during an economic downswing, even an investor interested in long-term growth may have something to gain by going after stocks that offer attractive dividend yields. (a) Wally’s existing plan is one of long-term growth, obtained by investing in quality issues. Given his high income and the limited time he has to devote to his security holdings, this strategy (of quality growth) seems appropriate for him. (b) 1. Expected dividends for Hydro-Electric: (2) (3) (1) Expected (1) × (2) Year Expected EPS Dividend Payout Ratio Expected Dividend 2004 $3.25 40% $1.30 2005 3.40 40 1.36 2006 3.90 45 1.76 2007 4.40 45 1.98 2008 5.00 45 2.25
  20. 20. Chapter 6 Common Stocks  119 2. Wally could purchase 100 shares of Hydro-Electric stock ($6,000 investment/$60 per share). Expected returns would be a function of dividends and capital gains. First, dividend income over the five years would be:
  21. 21. 120  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition Dividends Year per Share × 100 Shares = Total 2004 $1.30 × 100 = $130 2005 1.36 × 100 = 136 2006 1.76 × 100 = 176 2007 1.98 × 100 = 198 2008 2.25 × 100 = 225
  22. 22. Chapter 6 Common Stocks  121 Total dividends for 5 years: $865
  23. 23. 122  Gitman/Joehnk • Fundamentals of Investing, Ninth Edition Now, assuming he can sell the stock for $80 per share in five years, his 100 shares will bring $8,000 and his capital gains would be: $8,000 – $6,000 = $2,000. Therefore: Total return = Total dividends + Capital gains = $865 + $2,000 = $2,865 3. If Wally joins the company’s Dividend Reinvestment Plan, he can obtain shares at reduced prices and hence can achieve his goal of capital appreciation. Wally will obtain additional shares as follows:
  24. 24. Chapter 6 Common Stocks  123 (1) (2) (3) (4) (5) (6) No. of Shares Held at Purchase No. of Shares Beginning Dividends Total Price Purchased Year of Year per Share Dividends per Share (4) + (5) 2004 100.00 $1.30 $130.00 $50 2.60 2005 102.60 1.36 139.54 55 2.54 2006 105.14 1.76 185.05 60 3.08 2007 108.22 1.98 214.28 65 3.30 2008 111.52 2.25 250.92 70 3.58 Number of additional shares purchased through the DRP 15.10 Number of shares bought originally 100.00 Total 115.10 Using the Dividend Reinvestment Plan, Wally would have accumulated 15.10 additional shares, for a total of 115.10 shares by the end of 2008. With the stock trading at $80 on December 31, 2008, his shares would be worth 115.10 × $80 = $9,208. Note: The figure shown in column (2) is the number of shares held at the beginning of the year; this number will increase each year with the dividends reinvested. This increases the total dividends received each year. Compare this answer with 2(b). Thus, dividend reinvestment plans have a cascading effect. (c) Wally would not be going to a different investment strategy if he buys the shares of Hydro-Electric; he would merely be changing the thrust of it. This is a common strategy used by aggressive investors following a long-term growth program. Of course, when conditions change, Wally would go back to investing in long-term growth stocks. In that sense, his trading would be increased. However, since the number of trades should not be too many, this should not be a serious drain on his time.   Outside Project Chapter 6: Just What Kind of Stock Is It, Anyway? The text describes a number of different types of common stocks: blue chips, income stocks, growth stocks, speculative, cyclical, defensive, and small cap stocks. Each type can be characterized by their sensitivity to the economy, which is an important market factor and which may be measured by the beta of the company. They may also be characterized by their dividend yield. High yielding companies have fewer investment opportunities, so they pay higher dividends and investors expect more of their return in the form of dividends. The purpose of this project is to see if betas and dividend yields do, indeed, behave as expected for the various types of stocks identified above. Value Line publishes betas and dividend yields for about 1700 companies. Using the companies listed in the text, and other similar companies that you can identify in Value Line, find the betas and dividend yields for five companies in each of the seven (7) stock categories defined above (i.e., find the betas and dividend yields for 5 blue chips, 5 income stocks, 5 growth companies, 5 speculative stocks, 5 cyclicals, 5 defensive, and 5 small cap stocks). Next, calculate the average beta and average dividend yield for each type of stock—that is, find the average beta and dividend yield for the 5 blue chip stocks, then find the average beta and dividend yield for the 5 income stocks, etc. Now, what conclusions can you draw about risk and return based on your observations for each type of stock? (Note: Be sure your information is current.