Common Stocks
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
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From Stock Prices to Stock Returns
• Stock Returns: take into account both
price changes and dividend income
– Returns from capital gains range from an
average of 15.3% during the 1990s to -2.7%
from 2000–2010
– Returns from dividends vary too, but not nearly
as much, ranging from 5.4% in the 1950s to
1.8% since 2000
– The big returns (or losses) come from capital
gains
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From Stock Prices to Stock Returns
(cont’d)
– Stocks generally earn positive returns over long periods of
time.
– From 1950–2000, the average total return on the S&P 500
was 11% per year
– Investing in stocks is clearly not without risk
– From 2000–2010, the U.S. stock market lost 1% per year
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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
Comment: These are rule of thumb
numbers, not exact science.
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Advantages of Stock Ownership
• Provide opportunity for higher returns than other
investments
• Over past 100 years, stocks earned annual returns
that we roughly double the returns provided by
corporate bonds
• 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
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Disadvantages of Stock Ownership
• Stocks are subject to many different kinds of risk:
– Business risk
– Financial risk
– Purchasing power risk: Chance that return lags inflation
rate
– Market risk: market goes up and down
– Event risk: corporate event
• 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
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Figure 6.2 The Current Income of
Stocks and Bonds
(Source: Data from Federal Reserve Board of Governors and
www.multpl.com/s-p-500-dividend-yield/table.)
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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
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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
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Basic Characteristics of Common
Stock (cont’d)
• 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
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Basic Characteristics of Common
Stock (cont’d)
• 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
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Figure 6.4 A Stock Quote for
Abercrombie & Fitch
(Source: Yahoo! Finance, http://finance.yahoo.com/q?s=ANF&ql=0.)
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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
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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
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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 tend to increase over time as companies’ earnings
grow; average annual increase around 3% to 5%
• Dividends represent the return of part of the profit of the
company to the owners, the stockholders
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Key Dates for Dividends
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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
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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
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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
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Other Dividend Characteristics
• Stock Dividend: payment of a dividend in the
form of additional shares of stock
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Types of Stock
• Blue Chip Stocks: financially strong, highquality 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: AT&T, Chevron, Johnson & Johnson,
McDonald’s, Pfizer
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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
– Examples: Duke Energy, Conagra Foods, General Mills,
Altria Group
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Types of Stock (cont’d)
• 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: Amazon, Apple, Google, eBay, Berkshire
Hathaway, Starbucks
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Types of Stock (cont’d)
• 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
– Examples: Microsoft, Cisco Systems, Yahoo!, NVIDIA,
SanDisk, Intel, Electronic Arts
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Types of Stock (cont’d)
• Speculative Stocks: stocks that offer potential
for substantial price appreciation, usually due to
some special situation such as a new product
–
–
–
–
Earnings may be uncertain or highly unstable
Potential for substantial price appreciation
Stock price subject to wide swings up and down in value
Examples: Sirius XM Radio, Dreamworks Animation,
Liberty Media, Under Armour
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Types of Stock (cont’d)
• 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, Genuine Parts, Lennar,
Brunswick, Timken
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Types of Stock (cont’d)
• 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 tacking that people use in good times and
bad times, such as electricity, beverages, foods and drugs
– Gold stocks are a form of defensive stock
– Examples: Walmart, Checkpoint Systems, WD-40
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Market Capitalization
• U.S. stock market segments based on stock
market capitalization:
– Small-Cap Stocks: less than $2 billion
– Mid-Cap Stocks: $2 billion to $10 billion
– Large-Cap Stocks: more than $10 billion
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Types of Stock (cont’d)
• Large-Cap Stocks: large companies with market
capitalizations over $10 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: Walmart, Exxon Mobil, Apple
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Investing in Foreign Stocks
• Globalization of financial markets is growing
– U.S. equity market represents roughly 35% of world
equity markets
– Six countries make up 80% of world equity market
– U.S. market remains largest equity market in world with a
total value of about $16 trillion in 2012
– Some of the returns in non-U.S. markets are due to
currency exchange rates, and not just markets themselves
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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 Shares (ADSs)
– Simpler 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
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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
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Returns on International
Investments
• Stronger U.S. dollar has negative impact on
foreign investments
• Weaker U.S. dollar has positive impact on
foreign investments
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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
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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
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Stock Investment Strategies (cont’d)
• Quality Long-Term Growth
– Investors buy high-quality growth stocks, mid-cap stocks
and tech stocks
– 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
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Stock Investment Strategies (cont’d)
• 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
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Stock Investment Strategies (cont’d)
• 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
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