chapter 6 investing in common stocks. copyright © 2005 pearson addison-wesley. all rights reserved....

Chapter 6

Investing in Common Stocks

Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-2


• Learning Goals

1. Explain the investment appeal of common stocks and why individuals like to invest in them.

2. Describe historical stock returns and how current returns measure up to historical standards of performance.

3. Discuss the basis features of common stocks, including issue characteristics, stock quotations, and transaction costs.



• Learning Goals (cont’d)

4. Understand the different kinds of common stock values.

5. Discuss common stock dividends, types of dividends, and dividend reinvestment plans.

6. Describe various types of common stocks, including foreign stocks, and note how stocks can be used as investment vehicles.


The Appeal of Common Stocks

• 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

– Stocks allow investors to tailor investments to meet individual needs and preferences.

– Stocks may provide a steady stream of current income through dividends.

– Stocks may increase in value over time through capital gains.


Figure 6.1 Thirteen Years of the Dow, the S&P, and the Nasdaq


Sometimes You Win, Sometimes You Lose


What is a Bear Market?

• Routine Decline: a drop of 5% or more in one of the major market indexes, like the Dow Jones Industrial Average (DJIA)

• Correction: a drop of 10% or more in one of the major market indexes

• Bear Market: a drop of 20% or more in one of the major market indexes


From Stock Prices to Stock Returns

• Stock Returns: take into account both price changes and dividend income

– Over past 50 years, stock returns have ranged from +48.28% in 1954 to -21.45% in 1974

– Stock returns over past 50 years have averaged around 11%

– From 1998 through mid-’03, DJIA averaged 1.7%


Table 6.3 Comparative Returns


Figure 6.2 Bulls, Bubbles, and Bears


Advantages of Stock Ownership

• Provide opportunity for higher returns than other investments

• Over past 50 years, stocks averaged 11% and high-grade corporate bonds averaged 6%

• Good inflation hedge since returns typically exceed the rate of inflation

• Easy to buy and sell stocks• Price and market information is easy to find in

financial media• Unit cost per share of stock is low enough to

encourage ownership


Disadvantages of Stock Ownership

• Stocks are subject to many different kinds of risk:– Business risk– Financial risk– Market risk– Event risk

• Hard to predict which stocks will go up in value due to wide swings in profits and general stock market performance

• Low current income compared to other investment alternatives


Figure 6.3 The Current Income of Stocks and Bonds


Basic Characteristics of Common Stock

• 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”

• Publicly Traded Issues: shares of stock that are readily available to the general market and are bought and sold in the open market

• Public Offering: an offering to sell to the investing public a set number of shares of a firm’s stock at a specified price


Basic Characteristics of Common Stock (cont’d)

• Rights Offering: an offering of a new issue of stock to existing stockholders, who may purchase new shares in proportion to their current ownership

• 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



• 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– Usually done to lower the stock price to make it more

attractive to investors– Stockholders end up with more shares of stock that sells

for a lower price– Investor with 200 shares in a 2-for-1 stock split would

have 400 shares after the stock split– If the stock price was $100 before the split, the price

would be near $50 after the split



• 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.”– Reduces the number of shares outstanding to public

– Companies buyback when they believe stock is undervalued and a good buy

– Companies may try to raise undervalued stock price or prop up overvalued stock price

– May be used for mergers, acquisitions or employee stock option plans



• Classified Common Stock: common stock issued in different classes, each of which offers different privileges and benefits to its holders– Different shares may have different voting rights

– Often used to allow a relatively small group to control the voting of a publicly-trade company

– Ford family owns “B” shares and other investors own “A” shares; Ford family controls 40% of Ford Motor Company

– May have different dividend payout schedules


Figure 6.5 Stock Quotations


Watch Those Transaction Costs

• Round-Lot: buying 100 shares of stock or multiples of 100 shares

• Odd-Lot: buying less than 100 shares of stock– Buying odd lots or small numbers of shares can

result in higher costs to buy and sell shares– Frequent trading can increase transactions

costs substantially


Common Stock Values

• Par Value: the stated, or face, value of a stock– Mainly an accounting term and not very useful

to investors

• Book Value: the amount of stockholders’ equity– The difference between the company’s assets minus the

company’s liabilities and preferred stock

• Market Value: the current price of the stock in the stock market


Common Stock Values

• Market Capitalization: the overall current value of the company in the stock market – Total number of shares outstanding multiplied by the

market value per share

• Investment Value: the amount that investors believe the stock should be trading for, or what they think it’s worth– Probably the most important measure for a stockholder


Dividends

• Dividend income is one of the two basic sources of return to investors.

• Dividend income is more predictable than capital gains, so preferred by investors seeking lower risk.

• Dividends are taxed at maximum 15% tax rate, same as capital gains.

• Dividends tend to increase over time as companies’ earnings grow; increases average 3-5% per year.

• Dividends represent the return of part of the profit of the company to the owners, the stockholders.


Key Dates for Dividends


Dividends and Earnings Per Share

• Earnings Per Share: the amount of annual earnings available to common stockholders, stated on a per-share basis– Earnings are important to stock price– Earnings help determine dividend payouts

EPS

Net profitafter taxes

Preferred dividends

Number of shares ofcommon stock outstanding


Dividends and Dividend Yield

• Dividend Yield: a measure to relate dividends to share price on a percentage basis– Indicates the rate of current income earned on the

investment dollar– Convenient method to compare income return to other

investment alternatives

Dividend yield Annual dividends received per share

Current market price of the stock


Dividends and Dividend Payout Ratio

• Dividend Payout Ratio: the portion of earnings per share (EPS) that a firm pays out as dividends– Companies are not required to pay dividends– Some companies have high EPS, but reinvest

all money back into company

Dividend payout ratio Dividends per share

Earnings per share


Other Dividend Characteristics

• Stock Dividend: payment of a dividend in the form of additional shares of stock

• Dividend Reinvestment Plans (DRIPs): plans where cash dividends are automatically reinvested into additional shares of the firm’s common stock– Over 1,000 companies offer DRIPs– Usually have no brokerage fees– Uses dollar-cost averaging


Types of Stock

• Blue Chip Stocks: financially strong, high-quality stocks with long and stable records of earnings and dividends– Companies are leaders in their industries– Relatively lower risk due to financial stability

of company– Popular with investing public looking for steady growth

potential, perhaps dividend income– Provide shelter during unsettled markets– Examples: Wal-Mart, Proctor & Gamble, Microsoft,

United Parcel Service, Pfizer and 3M Company


Figure 6.7 A Blue Chip Stock


Types of Stock (cont’d)

• Income Stocks: stocks with long and sustained records of paying higher-than average dividends– Good for investors looking for relatively safe and high

level of current income– Dividends tend to increase over time (unlike interest

payments on bonds)– Some companies pay high dividends because they offer

limited growth potential– More subject to interest rate risk– Examples: Verizon, Conagra Foods, Pitney Bowes, R.R.

Donnelley, Bank of America and AmSouth Bancorp



• Growth Stocks: stocks that experience high rates of growth in operations and earnings– Have sustained rate of growth in earnings above

general market– Investors expect higher price appreciation due to

increasing earnings– Riskier investment because price may fall if earnings

growth cannot be maintained– May include blue chip stocks as well as

speculative stocks– Typically pay little or no dividends– Examples: Lowe’s, Harley-Davidson, Starbucks, Kohls



• Tech Stocks: stocks representing the technology sector of the market– Range from speculative stocks of small companies that

have never shown a profit to blue chip stocks of large companies that are growth-oriented

– Potential for attractive returns

– Considerable risk and volatility

– Difficult to put value on due to erratic or no earnings

– Examples: Microsoft, Cisco Systems, Dell



• Speculative Stocks: stocks that offer potential for substantial price appreciation, usually due to some special situation such as a new product– Companies lack sustained track record of business and

financial success

– Earnings may be uncertain or highly unstable

– Potential for substantial price appreciation

– Stock price subject to wide swings up and down in value

– Examples: P.F. Chang’s, Quicksilver, Dollar General



• Cyclical Stocks: stocks whose earnings and overall market performance are closely linked to the general state of the economy– Stock price tends to move up and down with the

business cycle– Tend to do well when economy is growing, especially

in early stages of economic recovery– Tend to do poorly in slowing economy– Best for investors willing to move in and out of market

as economy changes– Examples: Caterpillar, Maytag Corp.



• Defensive Stocks: stocks that tend to hold their value, and even do well, when the economy starts to falter– Stock price remains stable or increases when general

economy is slowing– Products are staples that people use in good times and bad

times, such as electricity, beverages, foods and drugs

– Gold stocks are a form of defensive stock– Best for aggressive investors looking for “parking place”

during slow economy– Examples: Proctor & Gamble, WD-40


Market Capitalization

• Small-Cap Stocks: under $1 billion

• Mid-Cap Stocks: $1 billion to $4 or $5 billion

• Large-Cap Stocks: more than $4 or $5 billion


Types of Stock

• Small-Cap Stocks: small companies with market capitalizations less than $1 billion– Provide opportunity for above-average returns

(or losses)

– Usually do not have a financial track record

– Earnings tend to grow in spurts and can have dramatic impact on stock price

– Usually not widely-traded; liquidity is issue

– “Initial Public Offerings (IPOs)

– Examples: Hancock Fabrics, Hot Topic, Sonic Corp.



• Mid-Cap Stocks: medium-sized companies with market capitalizations between $1 billion and $4 or $5 billion– Provide opportunity for greater capital appreciation

than Large-Cap stocks, but less price volatility than Small-Cap stocks

– Usually have long-term track records for profits and stock valuation

– “Baby Blues” offer same characteristics of Blue Chip stocks except size

– Examples: Wendy’s, Barnes & Noble, Petsmart, Cheesecake Factory



• Large-Cap Stocks: large companies with market capitalizations over $4 or $5 billion– Number of companies is smaller, but account for 80%

to 90% of the total market value of all U.S. equities

– Bigger is not necessarily better

– Tend to lag behind small-cap and mid-cap stocks, but typically have less volatility

– Examples: AT&T, General Motors, Microsoft


Investing in Foreign Stocks

• Globalization of financial markets is growing

– U.S. equity market is less than 50% of world equity markets

– Six countries make up 80% of world equity market

– U.S. market remains largest and one of best performing equity markets

– Much of performance of non-U.S. markets is due to changes in currency exchange rates


Going Global

• Buying Shares Directly in Foreign Markets– Most adventuresome approach– Logistical problems: fluctuating currency rates,

different regulatory and accounting standards, tax problems, “red tape”

• Buying American Depositary Receipts (ADRs)– Simper approach– Bought and sold on U.S. markets just like stocks in

U.S. companies– Transactions are in U.S. dollars

• Buying International Mutual Funds


Going Global

• International investing is more complex and riskier than domestic investing

• International investing requires investors to be right on more factors:– Must pick right stock– Must pick right market– Must pick correct direction for currency

exchange rate fluctuations


Returns on International Investments

• Stronger U.S. dollar has negative impact on foreign investments

• Weaker U.S. dollar has positive impact on foreign investments

Total return(in U.S. dollars)

Current income

(dividends)

Capital gains(or losses)

Changes in currency

exchange rates


Alternative Investment Strategies

• Storehouse of Value– Safety of investment is primary goal– Investors use high-quality blue chip and non-speculative

stocks

• To Accumulate Capital– Growth of investment is primary goal– Investors use growth-oriented stocks to generate

capital gains

• Source of Income– Current income is primary goal– Investors use stocks with dependable flow of dividends


Stock Investment Strategies

• Buy-and-Hold– Investors buy high-quality stocks and hold

them for extended time periods

– Goal may be current income and/or capital gains

– Investors often add to existing stocks over time

– Very conservative approach; value-oriented


Stock Investment Strategies (cont’d)

• Current Income

– Investors buy stocks that have high dividend yields

– Safety of principal and stability of income are primary goals

– May be preferable to bonds because dividends levels tend to increase over time

– Often used to provide to supplement other income, such as in retirement



• Quality Long-Term Growth– Investors buy high-quality growth stocks, mid-cap

stocks and tech stocks

– Capital gains are primary goal

– Higher level of risk due to emphasis on capital gains

– Significant trading of stocks may occur over time

– Diversification is used to spread risk

– “Total Return Approach” is version that emphasizes both capital gains and high income



• Aggressive Stock Management

– Investors buy high-quality growth stocks, blue chip stocks, mid-cap stocks, tech stocks and cyclical stocks

– Capital gains are primary goal

– High level of risk due to emphasis on capital gains

– Investors aggressively trade in and out of stocks, often holding for short periods

– Timing the market is key element

– Time consuming to manage



• Speculation and Short-Term Trading– Also called “day trading” – Investors buy speculative stocks, small-cap stocks and

tech stocks– Capital gains are primary goal– Highest level of risk due to emphasis on capital gains in

short time period– Investors aggressively trade in and out of stocks, often

holding for extremely short periods– Looking for “big score” on unknown stock– Time consuming & high trading costs


Chapter 6 Review

• Learning Goals

1. Explain the investment appeal of common stocks and why individuals like to invest in them.

2. Describe historical stock returns and how current returns measure up to historical standards of performance.

3. Discuss the basis features of common stocks, including issue characteristics, stock quotations, and transaction costs.


Chapter 6 Review (cont’d)

• Learning Goals (cont’d)

4. Understand the different kinds of common stock values.

5. Discuss common stock dividends, types of dividends, and dividend reinvestment plans.

6. Describe various types of common stocks, including foreign stocks, and note how stocks can be used as investment vehicles.

chapter 6 investing in common stocks. copyright © 2005 pearson addison-wesley. all rights reserved....

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