Common Stock
Investing in common stock
Dividends and capital gains
Stodgy and safe vs. fledgling and risky
Copyright ©2007 Stephen G. Buell
Corporate securities
Corporations raise money or capital from
investors like you and me by issuing or
selling their securities
These securities are either shares of stock
or bonds
Some well-known corporations
AT&T, Coca-Cola, DuPont, Exxon-Mobil, GE,
GM, IBM, Microsoft, Nike, Xerox, Enron,
WorldCom
Copyright ©2007 Stephen G. Buell
Basic definitions
Corporation: state-chartered legal entity that
conducts business
Stock: share of ownership – it’s equity
Stockholders are the owners of the firm
Two types of stock: preferred and common
Preferred stock: relatively unimportant, safer than common
stock but provides very limited gains
Common stock: ultimate owners of the company, risky,
unlimited earnings potential
Bond: corporate IOU – it’s debt
Bondholders are creditors, not owners of the firm
Safer position but lower expected returns than stock
Copyright ©2007 Stephen G. Buell
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Divide and conquer
We’ll cover common stock in this module
in enough detail to get you started
Then we’ll cover preferred stock and
bonds in the next module
Odd breaking point, you wonder?
Not really, preferred stock, even though it’s
legally equity and ownership, behaves much
more like bonds than common stock
Copyright ©2007 Stephen G. Buell
Common stock
Basic form of ownership – to own stock is
to own common stock, not preferred stock
Common shareholders are the ultimate
owners of the firm or corporation
Residual claim on income and assets
(stand last in line behind everybody else)
They don’t get paid a dime until everyone else
is completely satisfied – bear ultimate risk
No maturity date – you want out? Sell!
Copyright ©2007 Stephen G. Buell
What do you get for being last?
Right to vote for the board of directors
Who cares?
Limited liability – huge selling point to the
corporate form of business organization
If the company fails and you’re a shareholder
Creditors can’t come to your house to repossess
your car and attach your salary
Your liability is limited only to your investment
You own a percentage of the profits (cool!)
Copyright ©2007 Stephen G. Buell
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Your share of the pie
Your return on common stock comes from:
Quarterly dividends (cash disbursement)
As firm becomes more profitable, its dividends
normally rise over time – unique to common
Price appreciation or capital gains
Market price of your shares will normally rise over
time and you can sell them for a capital gain
Historically returns on common stock
have been twice the returns on
preferred stock and bonds
Copyright ©2007 Stephen G. Buell
Common stock dividends
Usually quarterly, paid out of current
profits
Dividend payout rate = dividends/net
income or DPS/EPS
Typical mature, stodgy firm pays out roughly
50%
Typical new, fledgling firm pays 0 to 10%
Retained profits may be its only source of funding
Actually good if firm can reinvest at rate of return
higher than stockholder can earn on dividends
Copyright ©2007 Stephen G. Buell
Only two places to go
Stodgy firm
Fledgling firm
Net profits
Net profits
50%
50%
Retained
earnings
Dividends
100%
Retained
earnings
0%
Dividends
Copyright ©2007 Stephen G. Buell
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More dividends
(Dividend) Yield = DPS/P = .50/16.00 =
3.1%
Usually low for stocks compared to bonds
Much of the return might be from capital gains
Especially true for small firms
Most firms allow stockholders to buy more
shares of common stock with their
dividends – commission free
Automatic dividend reinvestment plan
Copyright ©2007 Stephen G. Buell
Common stock values
Book value = (assets – liabilities or debt)/number
of shares outstanding
Theoretically what stockholder would get at liquidation
(bankruptcy)
Usually a very unimportant, unrealistic number
Market value
Price at which stock is currently trading
Determined by supply and demand
Based upon future expectations of profits
Look up in WSJ or on-line
Absolutely no reason to think MV = BV
Copyright ©2007 Stephen G. Buell
Splits and stock dividends
Stock split – little economic significance
If price of stock is getting very high so smaller
investors are turned off, firm will split its stock
Split stock 4 for 1
Yesterday you had 200 shares worth $100/sh = $20,000
Today you have 800 shares but worth only $25/sh = $20,000
Stock dividend -even less economic significance
Mail out more pieces of paper (stock certificates)
5% stock dividend
Yesterday you had 200 shares worth $100/sh = $20,000
Today you have 210 shares worth $95.24 = $20,000
But you feel better???
Copyright ©2007 Stephen G. Buell
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Market to book
Market-to-book ratio = price/book value
Usually between 1 and 2
Below 1, firm is undervalued and may be a
take-over target
If BV = $5.00 per share and the stock is
selling for a price of $8.50 a share, the MV/BV
ratio is 8.50 / 5.00 = 1.70
Copyright ©2007 Stephen G. Buell
Price to Earnings ratio
Price-earnings (P-E) ratio = Price/EPS
The most widely-used indicator when making
a buy or sell decision
Is the stock over, under or fairly valued?
How much per share is the market willing to
pay for a dollar of current EPS?
EPS = net earnings / # shares common stock
Copyright ©2007 Stephen G. Buell
Crowded on ground floor
Price is based on future expectations,
EPS is what is
P = $60 and EPS = $3.00, stock’s P-E
multiple is 20X
< 8 is low: poor growth prospects, high yields,
less risk
8 to 25 are normal P-E ratios
40 to 50+: speculative, paying a lot for little or
no earnings as investors try to get in on the
ground floor, internet P-E’s=∞
Copyright ©2007 Stephen G. Buell
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Beta
Beta or beta coefficient (Β)
Measures a stock’s price volatility (or risk)
relative to the entire stock market (average
beta = 1.0)
Beta measures systematic or market risk
Beta is based on the past 5 years of
monthly data and each stock’s beta is
published in stock guides
But will history repeat itself?
Copyright ©2007 Stephen G. Buell
Offensive
If beta = 1.5, stock historically moves 1.5X
as much as the entire market
Bull market: market up 10%, stock up 15%??
Bear market: market down 6%, stock down
9%??
If beta > 1, it’s an aggressive stock to add to your
portfolio: cars, steel, airlines
Copyright ©2007 Stephen G. Buell
Defensive
If beta = .4, stock historically moves only
.4X as much as the entire market
Bull market: market up 10%, stock up 4%??
Bear market: market down 6%, stock down
2.4%??
If beta < 1, it’s a defensive stock to add to your
portfolio: utilities
Copyright ©2007 Stephen G. Buell
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Classifying stocks
Income stocks
Pay higher dividends than most, year after
year (possibly bad for you tax-wise)
Provide a steady income stream
Retain low percentage of their profits
Have low betas
Are boring but stable
Utilities are a good example
Copyright ©2007 Stephen G. Buell
More exciting (riskier) stocks
Growth stocks
Consistently have high growth in profits
Return is mostly from capital gains
High P-E ratios
So you’re paying more to buy these
High betas (over 1.5)
Bad in downturns
Coca-Cola, Nike, Walmart
Copyright ©2007 Stephen G. Buell
Most exciting (riskiest) stocks
Speculative stocks
Very high potential but are yet unproven
Will potential be realized?
Spotty past records
Many, many fail
Betas > 2
Internet companies, video game makers
Copyright ©2007 Stephen G. Buell
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Bluest of the blue
Blue chip stocks
Large, well-known firms
Good past history of earnings
Industry leaders who won’t fail
Growth rate ≈ same as the economy
Dow Chemical, GE, HJ Heinz
Safe way to invest but little chance for
spectacular returns
Copyright ©2007 Stephen G. Buell
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