Lecture 7
Chapter 6
Common Stocks
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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.
4. Understand the different kinds of common stock values.
5. Discuss common stock dividends, types of dividends, and dividend reinvestment plans.
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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 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
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
Residual owner
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Basic Characteristics of Common Stock
Equity securities (aka equity capital) evidence of ownership position in a firm every share entitles the holder an ownership
and participation rights in firms earnings and dividends, voting and voice in management
New issuance
Public Offering an offering to sell to the investing public a set number of
shares of a firms stock at a specified price
Rights Offering an offering of a new issue of stock to existing stockholders,
who may purchase new shares in proportion to their current ownership
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Basic Characteristics of Common Stock (contd)
Stock Spin-Off
conversion of one of a firms subsidiaries to a stand-alone company by distribution of stock in the new company to existing shareholders
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
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Basic Characteristics of Common Stock (contd)
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 (contd)
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
May have different dividend payout schedules
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Buying and Selling Stocks
Round-Lot
Buying/selling 100 shares of stock or multiples of 100 shares
Odd-Lot
Buying/selling less than 100 shares of stock
Frequent trading can increase transactions costs substantially
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Common Stock 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 tend to increase over time as companies earnings grow
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) where cash dividends are automatically
reinvested into additional shares of the firms common stock
Over 1,000 companies offer DRIPs Usually have no brokerage fees
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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, McDonalds, Pfizer
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Types of Stock (contd)
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 (contd)
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
Typically pay little or no dividends
May include blue chip stocks as well as speculative stocks
Examples: Amazon, Apple, Google, eBay, Berkshire Hathaway, Starbucks
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Types of Stock (contd)
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 (contd)
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 (contd)
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 (contd)
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 (contd)
Market capitalization:
Small-Cap Stocks: (stock capitalisation 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
Mid-Cap Stocks: $2 billion to $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
Examples: Logitech, American Eagle Outfitters, Garmin Ltd.
Large-Cap Stocks: more than $10 billion
Tend to lag behind small-cap and mid-cap stocks, but typically have less volatility
Examples: Walmart, Exxon Mobil, Apple
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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 (contd)
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 (contd)
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 (contd)
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 (contd)
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
Chapter 7
Analyzing Common Stocks
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What is Security Analysis?
The process of gathering information, organizing it into a logical framework, and then using it to determine the intrinsic value of a share of common stock.
Intrinsic Value
The underlying or inherent value of a stock, as determined through fundamental analysis
Intrinsic value depends upon several factors: Estimates of future cash flows
Discount rate
Amount of risk
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Top Down Approach
A traditional security analysis comprising: Step 1: Economic Analysis
State of overall economy
Step 2: Industry Analysis Outlook for specific industry
Level of competition in industry
Step 3: Fundamental Analysis (aka company analysis) Financial condition of specific company Historical behavior of specific companys stock
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Step 1: Economic Variables and the Stock Market
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Step 2: Industry Analysis
Evaluate the competitive position of a particular industry in relation to other industries Looking for new opportunities & growth potential
Identify companies within the industry that look promising Looking for strong market positions, pricing
leadership, economies of scale, etc.
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Step 3: Fundamental Analysis (aka Company Analysis)
Study of the business by looking into financial statements to identify strengths and weaknesses
Rest on the belief that the value of a stock is influenced by the performance of the company that issued the stock
Purpose is to develop information about the past that can be used to get a handle on the future X-rays of the financial statements to look for meaningful
relationships between numbers
Types of assets owned and efficiency in assets employed
Profit margins
Capital structure
Liquidity
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Major Financial Ratios
Liquidity Ratios
the company s ability to meet day-to-day operating expenses and satisfy short-term obligations as they become due Current Ratio
Net Working Capital
Activity Ratios
how well the company is managing its assets Accounts Receivable Turnover
Inventory Turnover
Total Assets Turnover
Leverage Ratios
amount of debt used by the company Debt-Equity Ratio
Times Interest Earned
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Major Groups of Financial Ratios
Profitability Ratios
measures how successful the company is at creating profits Net Profit Margin
ROA and ROE
Common Stock Ratios
converts key financial information into per-share basis to simplify financial analysis P/E ratio
Dividend pershare
Payout Ratio
Book Value per share