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Common StocksCommon Stocks

Residual Owners:

o Stockholders of a firm are entitled to dividend income derived from the firm’s earnings. 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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Market PerformanceMarket Performance

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

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Stock Returns:

Both price changes, called capital gains, and dividend income:

Over past 50 years, stock returns have ranged from +48.28% in 1954 to -21.45% in 1974

Stock returns over past 50 years have averaged around 11%

From 1998 through mid-’03, DJIA averaged 1.7%

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Provide opportunity for higher returns than other investments

Over past 50 years, stocks averaged 11% 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

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Stocks are subject to many different kinds of risk: Business risk Financial 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

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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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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 employee stock option plans

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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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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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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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Earnings Per Share: the amount of annual earnings available to common stockholders, stated on a per-share basis

EPS

Net profitafter taxes

Preferred dividends

Number of shares ofcommon stock outstanding

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DividendsDividends

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; increases average 3-5% per year.

Dividends represent the return of part of the profit of the company to the owners, the stockholders.

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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

Dividend payout ratio Dividends per share

Earnings per share

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Key Dates for DividendsKey Dates for Dividends

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Dividends and Dividend YieldDividends 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

Dividend yield Annual dividends received per share

Current market price of the stock

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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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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: Wal-Mart, Proctor & Gamble, Microsoft, United

Parcel Service, Pfizer and 3M Company

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A Blue Chip StockA Blue Chip Stock

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Income Stocks: stocks with long and sustained records of paying higher-than average dividends Dividends tend to increase over time (unlike interest

payments on bonds) Examples: Verizon, Conagra Foods, Pitney Bowes.

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Growth Stocks: stocks that experience high rates of growth in operations and earnings Investors expect higher price appreciation due to increasing

earnings; pay little or no dividends Examples: Lowe’s, Harley-Davidson, Starbucks, Kohls

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Speculative Stocks: stocks that offer potential for substantial price appreciation, usually due to some special situation such as a new product. Examples: Chipotle, P.F. Chang’s, Quicksilver.

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Tech Stocks: stocks representing the technology sector of the market Small companies that have never shown a profit and blue

chip stocks of large companies that are growth-oriented

Difficult to put value on due to erratic or no earnings

Examples: Microsoft, Cisco Systems, Dell.

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Cyclical Stocks: stocks whose earnings and overall market performance are closely linked to the general state of the economy Best for investors willing to move in and out of market as

economy changes Examples: Caterpillar, Maytag Corp.

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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.

Best for aggressive investors looking for “parking place” during slow economy

Examples: Proctor & Gamble, WD-40

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Market CapitalizationMarket 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

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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 issue Examples: Rubio’s, Hot Topic, Sonic Corp.

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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: Wendy’s, Barnes & Noble, Petsmart, Cheesecake Factory

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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: AT&T, General Motors, Microsoft

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Investing in Foreign StocksInvesting 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 and one of best performing equity markets

Much of performance of non-U.S. markets is due to changes in currency exchange rates

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Going GlobalGoing 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 InvestmentsReturns 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(in U.S. dollars)

Current income

(dividends)

Capital gains(or losses)

Changes in currency

exchange rates

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Stock Investment StrategiesStock 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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StrategiesStrategies

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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StrategiesStrategies

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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StrategiesStrategies

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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StrategiesStrategies

Speculation and Short-Term Trading Also called “day trading” Buy speculative stocks, small-cap stocks and tech stocks Capital gains are primary goal High risk due to emphasis on capital gains in short time

period 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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ReviewReview

1. The investment appeal of common stocks.

2. Historical stock returns and how measured.

3. Dividends.

4. Different kinds of common stock values.

4. Types of common stocks.

5. Strategies.