Chapter 6
Common Stocks
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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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Sometimes You Win, Sometimes You Lose: Five years of
the S&P 500 Index and the Nasdaq Composite
FIGURE 6.1 A Snapshot of U.S. Stock and Housing Indexes (mid-2003 through mid2009)
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Sometimes You Win,
Sometimes You Lose
Table 6.1
50 Years of
Annual Returns
in the Stock
Market, 1956–
2005
(returns based
on performance
of the DJIA)
13 years of negative total returns (6 double digit); 37
years of positive total returns (25 double digit)
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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 -5.3% from 2000–2008
– Returns from dividends vary too, but not nearly as much,
ranging from 5.4% in the 1950s to 1.7% since 2000
– The big returns (or losses) come from capital gains
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Figure 6.2 The Current Income of Stocks and Bonds
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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
• 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
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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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Basic Characteristics of Common Stock (cont’d)
• 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
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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
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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 are taxed at maximum 15% tax rate, same as capital
gains
• 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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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
• 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
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Three Reasons to Love
Dividends
• Stocks that pay dividends tend to produce higher
returns than those that do not
– S&P dividend payers were up 6.5% vs. 3.6% for nondividend payers
• Since 1928, dividends have accounted for 40% of
total return on stocks
• Since 1980, dividend-payers have averaged
annualized returns of 15.1% vs. 12.8% for nonpayers
• * New tax code changes: tax dividends are a much
lower rate than ordinary income and interest income
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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: AT&T, Chevron, Johnson & Johnson,
McDonald’s, Pfizer
http://www.youtube.com/watch?v=5jg6o3icTKA&featur
e=player_detailpage
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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
– More subject to interest rate risk
– Examples: Duke Energy, Conagra Foods, Sara Lee, 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: Netflix, eBay, Research in Motion, 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
– Difficult to put value on due to erratic or no earnings
– Examples: Microsoft, Cisco Systems, Yahoo!, NVIDIA, SanDisk,
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
– 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: Sirius XM Radio, Dreamworks Animation, Liberty Media,
NitroMed, 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: Alcoa, 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 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: Walmart, Checkpoint Systems, WD-40
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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, Home Depot, Comcast, Microsoft
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Types of Stock (cont’d)
• Mid-Cap Stocks: medium-sized companies with market
capitalizations between $2 billion and $10 billion
– Provide opportunity for greater capital appreciation than LargeCap 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: Abercrombie & Fitch, Dollar Tree, Hasbro, Nordstrom,
Whole Foods
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Types of Stock (cont’d)
• Small-Cap Stocks: small companies with market
capitalizations less than $2 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 an issue
– “Initial Public Offerings” (IPOs)
– Examples: Callaway Golf, California Pizza Kitchen,
Winn-Dixie Stores, Shoe Carnival
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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
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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; value-oriented
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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
– 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
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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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