chapter 6 common stock investments

Chapter 6

Common Stock Investments

©2005 Kaplan Financial6-2

Key Topics Key topics include:

long-term perspective; advantages and disadvantages; characteristics, new issues, stock quotations

and transaction costs; measures of common stock value; dividends; different kinds of common stock; and uses and strategies of common stock

investing.


Common Stock Represents ownership in a

corporation and allows investors to participate in the profits

Stocks offer investors the opportunity to shape an investment program to their individual needs


Stock Returns Stock returns come mainly from

capital appreciation Stock market returns have

averaged about 12% per year over the past 50 years, but over 18% during the past decade


Advantages: Common Stock Potential for high returns; no upper limits. May provide current income return from

dividends. Shares are highly liquid and easily

transferred. Transaction costs are relatively low; on-line

trades can be very cheap. Low unit prices relative to other securities.


Disadvantages: Common Stock Earnings and performance are

subject to wide swings.

Selection of common stocks is complex.

Current income is relatively low,

compared to bonds.


Publicly Traded Stocks (1 of 3)

Public offering an offering to sell to the investing

public a set number of shares of a firm's stock at a specified price

Rights offering an offering of a new issue of stock to

existing shareholders, who may purchase new shares in proportion to their current ownership position



Stock spin-off a conversion of one of a firm's subsidiaries

to a stand-alone company by distribution of stock in that new company to existing shareholders

Stock splits a maneuver in which a company increases

the number of shares outstanding by exchanging a specified number of new shares of stock for each outstanding share



Treasury stock stock that has been sold and

subsequently repurchased by the issuing firm

Classified common stock Stock issued by a company in different

classes, each of which offers different privileges and benefits to its holders


Buying and Selling Stocks The investor must be familiar with

stock quotes

The investor must also consider transaction costs


Stock Quotes NYSE – New York Stock Exchange AMEX – American Stock Exchange NASDAQ

Published in a twelve-column format


Column Titles (1 of 5)

52 weeks Hi highest price within past year, adjusted

for stock splits if any 52 weeks Lo

lowest price w/n past year Stock

name of company



Sym ticker symbol; 1-3 characters on NYSE

and AMEX; 4-5 on NASDAQ. Div

annual dividend



Yld % dividend yield based on current annual

dividend divided by market price PE - price-earnings ratio based on most recent four quarters of earnings

Vol 100s number of shares traded yesterday (in

100s)



Hi highest price at which stock traded

yesterday Lo

lowest price yesterday Close - closing price yesterday



Close closing price yesterday

Net Chg change in price from close of previous

day


Transaction Costs average 1-5% of value of

transaction when using a full-service broker

Odd-lot trades (less than 100 shares) carry an added cost called odd-lot differential


Transaction Costs (continued)

Discount brokers can save an investor up to 70% on commission

On-line trades can now cost less than $ 10 per trade


Measures of Value Par value

the stated or face value (meaningless for investment purposes)

Book value the amount of shareholder equity in a

company; equals the amount of the firm's assets minus liabilities and preferred stock


Measures of Value (continued)

Market value the prevailing price of a security.

Investment value the amount that investors believe a

security should be trading for, or what they think it's worth.


Dividends and Earnings per Share (EPS) The directors make the dividend

decisions based on several factors. Earnings per share (EPS)

represents the amount that is earned per share

EPS = (net profit after taxes - pfd dividends)

# shares outstanding


Dividends and Earnings per Share (EPS) (continued)

Dividends are paid out of earnings, but do not have to be paid even when the firm is profitable

Generally, however, higher EPS lead to higher dividends


Dividends (Important dates) Record date

date on which an investor must be a registered shareholder to be entitled to receive a dividend

Ex-dividend date 3 business days prior to the date of record;

determines if one is an official shareholder and thus eligible to receive a declared dividend

Payment date the actual date on which the company pays

the dividend


Cash Dividends and the Dividend Yield Dividends are normally paid in cash,

although stock dividends are also common.

Cash dividends are current income, which can be expressed as the dividend yield.

Dividend yield = annual dividend per share market price per share


Dividend Payout Ratio (DPR) One measure of stability of the

cash dividend is the dividend payout ratio (DPR).

DPR = dividend per share / current market price per share.

A high DPR could suggest difficulty in paying future dividends.


Dividend Reinvestment Plans and Stock Dividends Dividend reinvestment plans

(DRIPs) plans in which shareholders have

cash dividends automatically reinvested into additional shares.

Stock dividend A dividend payment in the form of

additional shares of stock.


Market Classifications of Common Stock (1 of 3)

Blue chip stocks financially strong, high quality stocks with

long and stable records of earnings and dividends.

Income stocks Have long and sustained records of paying

higher-than-average dividends. Growth stocks

experience high rates of growth in operations and earnings.



Speculative stocks offer the potential for substantial price

appreciation, usually because of some special situation, such as new management or the introduction of a promising new product.

Cyclical stocks Stocks whose earnings and overall market

performance are closely linked to the general state of the economy.



Defensive stocks tend to hold their own, and even do well,

when the economy starts to falter. Mid-cap stocks

medium-sized stocks, generally with market value of less than $3-4 billion, but more than $750 million.

Small-cap stocks have market value of less than $750 million,

and may offer above-average returns.


Foreign Stocks Foreign equity markets

outperform US markets in most years Investors can buy foreign stocks

directly Has many logistical problems

American Depository Receipts (ADRs) Backed by foreign securities held by

US banks


Foreign Stocks (continued)

Both direct purchase and ADRs have usual risks associated with

common stocks, plus the currency exchange rate risk that drastically can affect total return.

Total return in US$ = dividends + cap gains (losses) + (or) - changes in FOREX rates.


Investment Strategies Investment strategies can be

employed to satisfy one of three basic investment needs:

warehouse of value accumulation of capital and/or as a source of income


Buy-and-Hold Strategy and The High-Income Approach The most basic strategy is the buy-and-

hold. High-quality stocks are selected and held

for extended periods; a strategy popular with value-oriented investors.

The high-income approach uses common stocks for current income.

Since dividends mostly increase through time, the level of current income increases as well.


Quality Long-Term Growth and Aggressive Stock Management Quality long-term growth

a less conservative strategy. This strategy relies on capital gains as the primary source of return.

Aggressive stock management uses quality issues to seek attractive

rates of return in a fully managed portfolio.

has substantial risk and requires a substantial amount of investor time.


Speculation and Short-Term Trading Speculation and short-term trading

the highest risk strategy. investor seeks returns from capital

gains while holding the stock only a short period of time.


Using Investment Strategies The first three strategies go well

with the objective to use stocks as a warehouse of value

All five could be used to accumulate capital

The high-income strategy fits best with the objective of using stocks as a source of income


Popular Investment Strategies Some Popular Investment Strategies Include:

Growth Investing, which is investing in stocks with above average forecasts of earnings growth and high price/earnings ratios in expectation of higher returns.

Value Investing, which is investing in stock of companies that are out of favor with the market for some reason, as reflected by low price/earnings ratios and low prices compared to their fundamentals.

Sector Investing, which is an investing style based on the premise that certain industry sectors perform better during specific stages of the economic cycle.

Momentum Investing, which is an investing style that focuses on using relative stock price movement to determine when to buy and sell.

chapter 6 common stock investments

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