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  1. 1. Personal Finance: An Integrated Planning Approach Winger & Frasca Chapter 11 Common Stock
  2. 2. Major Topics <ul><li>Characteristics of Common Stock </li></ul><ul><li>Fundamental Analysis of Common Stocks </li></ul><ul><li>Technical Analysis </li></ul>
  3. 3. Characteristics of Common Stock <ul><li>Shareholders’ Rights </li></ul><ul><li>Distributions to Shareholders </li></ul><ul><li>Opportunities in Common Stocks </li></ul><ul><li>How to Read Stock Quotations </li></ul>
  4. 4. Shareholders’ Rights <ul><li>Right to Vote--Usually, One Share Earns One Vote </li></ul><ul><li>Preemptive Right </li></ul><ul><ul><li>Allows Shareholders to Maintain Their Proportionate Ownership Share in the Corporation </li></ul></ul><ul><li>Right to Share in Earnings or Asset Distributions </li></ul>
  5. 5. Shareholders Come Last <ul><li>Shareholders Have a Residual Claim on Assets, Which Means All Other Claims Must Be Paid Before Shareholders Can Receive Any Distribution </li></ul><ul><li>However, Other Claims Are Fixed: </li></ul><ul><ul><li>So, if the Company Has Good Earnings, Shareholders Benefit Considerably </li></ul></ul><ul><ul><li>But Poor Earnings Can Be Damaging </li></ul></ul>
  6. 6. An Example of Earnings Distribution <ul><li>Poor Earnings of only $9,000 </li></ul><ul><ul><li>Interest to bondholders $5,000 </li></ul></ul><ul><ul><li>Dividends to preferred shareholders 3,000 </li></ul></ul><ul><ul><li>The balance to common shareholders 1,000 </li></ul></ul><ul><li>Good Earnings of $20,000 </li></ul><ul><ul><li>Interest to bondholders $5,000 </li></ul></ul><ul><ul><li>Dividends to preferred shareholders 3,000 </li></ul></ul><ul><ul><li>The balance to common shareholders 12,000 </li></ul></ul>
  7. 7. Distributions to Common Shareholders <ul><li>Cash Distributions </li></ul><ul><ul><li>Regular (Quarterly) Dividend </li></ul></ul><ul><ul><li>Periodic Share Repurchases </li></ul></ul><ul><li>Non-cash Distributions </li></ul><ul><ul><li>Stock Dividend </li></ul></ul><ul><ul><li>Stock Split </li></ul></ul>
  8. 8. Stock Dividends and Splits <ul><li>Although Favored by Some Shareholders, Stock Dividends and Splits Do Not Increase Shareholder Wealth </li></ul><ul><li>They Simply Provide Shareholders with a Greater Number of Shares, But: </li></ul><ul><li>The Prices of Shares Fall so that the Total Market Value Remains the Same </li></ul>
  9. 9. Opportunities in Common Stocks <ul><li>Growth Companies: Earnings Are Expected to Grow Substantially </li></ul><ul><li>Income Stocks: Provide a Good Dividend Return </li></ul><ul><li>Blue Chips: High Quality Stocks </li></ul><ul><li>Cyclical Stocks: Very Responsive to Changes in the Economy </li></ul><ul><li>Special Situations: eg., a Takeover </li></ul>
  10. 10. Example of a Stock Quotation <ul><li>High Low Stock Div Yld P-E </li></ul><ul><li>% Ratio </li></ul><ul><li>40 30 ABC .40 1.0 17 </li></ul><ul><li>Sales High Low Close Net </li></ul><ul><li>100s Chg </li></ul><ul><li>243 41 39 40 +3/4 </li></ul>Quote Continued
  11. 11. Fundamental Analysis of Common Stocks <ul><li>Applications of the CAPM </li></ul><ul><li>Price-to-Earnings Analysis </li></ul><ul><li>Fundamental Value and Book Value </li></ul>
  12. 12. Determining Expected Return <ul><li>A Stocks Expected Total Return (TR) Consists of: </li></ul><ul><ul><li>Expected Current Return (CR) and </li></ul></ul><ul><ul><li>Expected Future Return (FR) </li></ul></ul><ul><li>Current Return is the Expected Dividend Yield for the Upcoming Year </li></ul><ul><li>Future Return is the Expected Annual Growth in Dividends in the Future </li></ul>
  13. 13. Calculating Expected Return <ul><li>Data for ABC Company: </li></ul><ul><ul><li>Current Stock Price = $20/share </li></ul></ul><ul><ul><li>Expected Dividend Next Year = $1.20 </li></ul></ul><ul><ul><li>Current Return (CR) = ($1.20/$20) = .06 </li></ul></ul><ul><ul><li>Expected Annual Growth in Dividends in the Foreseeable Future (FR)= 0.08 </li></ul></ul><ul><li>Total Return = Current Return + Future Return </li></ul><ul><li>TR = CR + FR </li></ul><ul><li>TR = 0.06 + 0.08 = 0.14, or 14.0% </li></ul>
  14. 14. Review of CAPM Approach <ul><li>The Method Provides a Pertinent View of a Company’s Risk--its Beta Value </li></ul><ul><li>It Brings a Company’s Risk Into the Picture Through the Required Return Equation, Which Expresses How Much Return You Should Earn on the Stock </li></ul><ul><li>Comparing This Return to What You Expect the Company to Earn Provides a Clear Decision Signal--the Alpha Value </li></ul>
  15. 15. Fig. 11.5 Comparing Mead’s required rate of return with its expected rate of return, 1998 Required Rate of Return Expected Rate of Return
  16. 16. Fig. 11.5 Comparing Mead’s required rate of return with its expected rate of return, 1998 Required rate of return Expected rate of return = 12.9% = 11.5% Alpha = - 1.1% Sell
  17. 17. Price-To-Earnings Analysis <ul><li>A Stock’s P/E Ratio is the Ratio of a Stock’s Price (P) to Its Expected Future Earnings Per Share (EPS) </li></ul><ul><li>P/E = P/EPS </li></ul><ul><li>If P = $50.00 and EPS = $2.50, then </li></ul><ul><li>P/E = $50.00/$2.50 = 20.0 </li></ul><ul><li>Investors Pay $20 for Each $1.00 of the Company’s Earnings </li></ul>
  18. 18. Finding P/E Ratios <ul><li>Three Methods </li></ul><ul><ul><li>Use the Current P/E Ratio </li></ul></ul><ul><ul><li>Use the Average of P/E Ratios Over Previous Time Periods </li></ul></ul><ul><ul><li>Use the Company’s Expected Dividend Growth Rate (Ignore % Sign) </li></ul></ul><ul><li>The Three Methods Can Lead to Quite Different Values </li></ul>
  19. 19. Using Book Value <ul><li>A Company’s Book Value is Simply Its Net Worth (Assets minus Liabilities) Divided by the # of Shares Outstanding </li></ul><ul><li>Book Value May Not Provide A Realistic Estimate of True Value Because: </li></ul><ul><ul><li>Assets May Have Replacement Costs Much Higher then Book Value </li></ul></ul><ul><ul><li>Some Assets May Not Appear on the Company’s Books: eg., The Coca Cola Trademark </li></ul></ul>
  20. 20. The Market-to-Book Ratio <ul><li>Despite Book Value’s Limitations, Some Analysts Use the Market-to-Book Ratio </li></ul><ul><li>This Ratio Divides the Stock’s Price by its Book Value. Example: if Price is $40/Share and Book Value is $10/Share, Market-to-Book = 4.0 </li></ul><ul><li>All Other Things Equal, Analysts Prefer Low Values for this Ratio </li></ul>
  21. 21. The PEG Ratio <ul><li>Shows the Relationship between the PE Ratio and the Long-Term Growth Rate </li></ul><ul><ul><li>PEG = (P/E)/Growth </li></ul></ul><ul><li>All Things Equal, Low Numbers Are Desirable--You’re Buying Growth at a Low Price </li></ul>
  22. 22. Technical Analysis <ul><li>A Method of Evaluating Stocks that Does Not Review Underlying Fundamentals, Such as Earnings or Dividends </li></ul><ul><li>Two Primary Approaches: </li></ul><ul><ul><li>Pressure Indicators (Compares Two Values in a Ratio Format) </li></ul></ul><ul><ul><li>Graphic Analysis </li></ul></ul>
  23. 23. Pressure Indicators <ul><li>The Advance Decline Line </li></ul><ul><ul><li>The Number of Stocks Increasing in Price Relative to the Number Decreasing </li></ul></ul><ul><li>Relative Strength Line </li></ul><ul><ul><li>The Price Movements of Two Variables, such as One Price Index Versus Another </li></ul></ul><ul><li>New Highs-New Lows </li></ul><ul><ul><li>The Number of Stocks Recording their Highest Prices of the Past Year Versus the Number Recording Their Lowest Prices </li></ul></ul>
  24. 24. A Time Graph Support Line Resistance Line 1999 2000 Break Out Price Volume
  25. 25. Point-and-Figure Graph x x x o o o x x x x o o x x x x o o o o x x x x x x P r i c e x’s record price increases; o’s record price decreases; only price changes greater than a pre-set amount are recorded Time
  26. 26. Calculating a 3-Day Moving Average <ul><li>Day Price Calculation Mov. Avg. </li></ul><ul><li>_________________________________ </li></ul><ul><li>1 $10 - </li></ul><ul><li>2 12 - </li></ul><ul><li>3 16 (16+12+10)/3 = 12.67 </li></ul><ul><li>4 14 (14+16+12)/3 = 14.00 </li></ul><ul><li>5 13 (13+14+16)/3 = 14.33 </li></ul><ul><li>6 9 ( 9 +13+14)/3 = 12.00 </li></ul>
  27. 27. How Useful Is Technical Analysis? <ul><li>Unfortunately, Technical Indicators Often Do Not Lead Stock Prices </li></ul><ul><li>Following Technical Indicators </li></ul><ul><ul><li>Often Leads to Excessive Trading and Commissions Erode Any Slight Advantage the Method Might Offer </li></ul></ul><ul><ul><li>Puts the Wrong Emphasis on Investing by Focusing on Short-Term Trading Instead of Long-Term Investing </li></ul></ul>
  28. 28. Next Chapter 12 Fixed-Income Securities