lecture 7.pdf port

Lecture 7

Chapter 6

Common Stocks

Copyright 2014 Pearson Education, Inc. All rights reserved. 6-2

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.


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


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


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


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



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



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


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


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


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


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


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


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


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


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



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



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



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



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



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



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


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


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



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



Aggressive Stock Management

Investors buy high-quality growth stocks, blue chip stocks, mid-cap stocks, tech stocks and cyclical stocks


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



Speculation and Short-Term Trading

Also called day trading

Investors buy speculative stocks, small-cap stocks and tech stocks


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


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


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


Step 1: Economic Variables and the Stock Market


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.


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


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


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

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