Lecture 7

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.

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
investment alternatives

compared

to

other

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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6-6

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
undervalued and a good buy

they

believe

stock

is

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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6-8

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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6-9

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
dividends

are

not

required

to

Some companies have high EPS,

reinvest all money back into company

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pay
but

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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
of company

risk

due

to

financial

stability

Popular with investing public looking for steady growth

potential, perhaps dividend income
Provide shelter during unsettled markets
Examples: AT&T,
McDonalds, Pfizer

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Chevron,

Johnson

&

Johnson,

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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, midcap 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 and tech stocks

stocks,

small-cap

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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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
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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
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