1. Investing in Common Stocks
Chapter 6
Investing in Common Stocks

2. Investing in Common Stocks
Learning Goals
Explain the investment appeal of common stocks.
Describe historical stock returns
Discuss the basis features of common stocks.

3. Investing in Common Stocks
Learning Goals
Understand the different kinds of common stock values.
Discuss common stock dividends, types of dividends.
Describe various types of common stocks, including foreign stocks.

4. 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

5. 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 % 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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 be near $50 after the split

12. 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

13. 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

14. Stock Quotations

15. 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

16. Book Value = Assets – Liabilities – Preferred Stock
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

17. 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

18. 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

19. Key Dates for Dividends

20. 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

21. 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

22. 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

23. 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 non- payers

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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 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: Barnes & Noble, Williams-Sonoma, Reebok International

35. 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

36. 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

37. 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

38. 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

39. Returns on International Investments
Stronger U.S. dollar has negative impact on foreign investments
Weaker U.S. dollar has positive impact on foreign investments

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. Chapter 6 Review Explained the investment appeal of common stocks.
Described historical stock returns.
Discussed the basis features of common stocks.

47. Chapter 6 Review Explained the different kinds of common stock values.
Discussed common stock dividends, types of dividends, and dividend reinvestment plans.
Described various types of common stocks.

48. The End!

49. Figure 6.3 An Announcement of a New Stock Issue

50. Table 6.2 Cash or Reinvested Dividends?

51. Figure 6.6 A Growth Stock

52. Figure 6.7 A Tech Stock

53. Figure 6.8 A Mid-Cap Stock

54. Table 6.3 Comparative Annual Returns in the World’s Major Equity Markets, 1981–2005