Transcript Chapter 6

Common Stocks
Common Stocks
• Learning Goals
1. Explain the investment appeal of common
stocks and why individuals like to invest in
them.
2. Describe stock returns from a historical
perspective and understand how current returns
measure up to historical standards of
performance.
3. Discuss the basic features of common stocks,
including issue characteristics, stock quotations,
and transaction costs.
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Common Stocks
• 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 investments.
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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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Table 6.1 Historical Returns on the
Standard and Poor’s 500, 1950-2010
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Figure 6.1 A Snapshot of U.S. Stock Prices and
Housing Indexes (mid-2003 through mid-2012)
(Source: Data from Yahoo! Finance and Standard & Poor’s.)
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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
• 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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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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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
• 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
• Through 2012, dividends were taxed at maximum 15% tax
rate, same as capital gains
• Since 2013, dividend tax rate is as high as 20% for high
earners (not counting a 3.8% Medicare tax on investment
income that high earners must also pay)
• 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
• 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
Still subject to tax
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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
– More subject to interest rate risk
– 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
– Difficult to put value on due to erratic or no earnings
– 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
– 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, 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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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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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
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: Logitech, American Eagle Outfitters, Garmin
Ltd.
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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, Wendy’s, Shoe
Carnival
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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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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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Table 6.2 Cash or Reinvested
Dividends?
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Figure 6.7 Average Annual Stock Returns
Around the World (1900 to 2011)
(Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Credit Suisse Global Investment Returns Sourcebook 2012,
https://www.credit-suisse.com/investment_banking/doc/cs_global_investment_returns_yearbook.pdf.)
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