Chapter 6
Investing in Common
Stocks
Investing in Common Stocks
 Learning Goals
1.
Explain the investment appeal of common stocks.
2.
Describe historical stock returns
3.
Discuss the basis features of common stocks.
2
Investing in Common Stocks
 Learning Goals
4.
Understand the different kinds of common stock
values.
5.
Discuss common stock dividends, types of dividends.
6.
Describe various types of common stocks, including
foreign stocks.
3
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
4
From Stock Prices to Stock
Returns
 Stock Returns: take into account both price
changes and dividend income

Over the past 50 years, stock returns have
ranged from +42.7% in 1975 to -21.45% in
1974

Stock returns over the past 50 years have
averaged around 12%

Speculative growth in the last half of the 1990s
was eliminated beginning in early 2000 by one
of the worst Bear markets in recent history
5
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
6
Advantages of Stock Ownership
 Provide opportunity for higher returns than other investments
 Over past 50 years, stocks averaged 12% 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
7
Disadvantages of Stock Ownership
 Stocks are subject to many different kinds of risk:
 Business risk
 Financial risk
 Purchasing power 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
8
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
9
Basic Characteristics
of Common Stock
 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
10
Basic Characteristics
of Common Stock
 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
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be near $50 after the split
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
12
Basic Characteristics
of Common Stock
 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
13
Stock Quotations
14
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
15
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 Common stockholders’
equity

The difference between the company’s assets minus
the company’s liabilities and preferred stock
Book Value = Assets – Liabilities – Preferred Stock
 Market Value: the current price of the stock in the
stock market
16
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
17
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
18
Key Dates for Dividends
19
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 profit
 Preferred dividends
after taxes
Number of shares of
common stock outstanding
20
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
Annual dividends received per share
Dividend yield 
Current market price of the stock
21
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
Dividends per share
Dividend payout ratio 
Earnings per share
22
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
non-dividend 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
23
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
24
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: Citigroup, Pfizer, DuPont, Nike, Procter &
Gamble, Home Depot
25
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: Bell South (no more), Conagra Foods, Ford
Motor, Bank of America, Duke Energy
26
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: Medtronics, Boston Scientific, Countrywide
Financial (not now), Wellpoint, Genentech
27
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: Hewlett-Packard, Intel, Dell, Yahoo!,
Electronic Arts
28
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 Satellite Radio, Dreamworks Animation,
Liberty Media
29
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 Economic &
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, Lennar, Alcoa, Brunswick
30
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: Checkpoint Systems, WD-40
31
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
32
Types of Stock
 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: Wal-Mart, General Motors, Microsoft
33
Types of Stock
 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 SmallCap stocks
Usually have long-term track records for profits and stock
valuation
“Baby Blues” offer same characteristics of Blue Chip stocks
except size
Examples: Barnes & Noble, Williams-Sonoma, Reebok
International
34
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 an issue

“Initial Public Offerings” (IPOs)

Examples: Playboy Enterprises, Denny’s, Sanderson Farms,
Build-A-Bear Workshops
35
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 equity market in world

Some of the returns in non-U.S. markets are due to
currency exchange rates, and not just markets
themselves
36
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
37
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
38
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
Current income
Capital gains
Changes in currency



(in U.S. dollars)
(dividends)
(or losses)
exchange rates
39
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
40
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
41
Stock Investment Strategies
 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
42
Stock Investment Strategies
 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
43
Stock Investment Strategies
 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
44
Stock Investment Strategies
 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
45
Chapter 6 Review
1.
Explained the investment appeal of common stocks.
2.
Described historical stock returns.
3.
Discussed the basis features of common stocks.
46
Chapter 6 Review
4.
Explained the different kinds of common
stock values.
5.
Discussed common stock dividends, types of
dividends, and dividend reinvestment plans.
6.
Described various types of common stocks.
47
The End!
48
Figure 6.3 An Announcement of a
New Stock Issue
49
Table 6.2 Cash or Reinvested
Dividends?
50
Figure 6.6 A Growth Stock
51
Figure 6.7 A Tech Stock
52
Figure 6.8 A Mid-Cap Stock
53
Table 6.3 Comparative Annual Returns
in the World’s Major Equity Markets, 1981–
2005
54