Common Stocks_Ch06

download report

Transcript Common Stocks_Ch06

Chapter 6
Investing in
Common
Stocks
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
Investing in Common Stocks
• Learning Goals
1. Explain the investment appeal of common stocks and
why individuals like to invest in them.
2. Describe historical stock returns and how current
returns measure up to historical standards
of performance.
3. Discuss the basis features of common stocks,
including issue characteristics, stock quotations, and
transaction costs.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-2
Investing in Common Stocks
• Learning Goals (cont’d)
4. Understand the different kinds of common stock values.
5. Discuss common stock dividends, types of dividends,
and dividend reinvestment plans.
6. Describe various types of common stocks, including
foreign stocks, and note how stocks can be used as
investment vehicles.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-3
The Appeal of Common Stocks
• Residual Owners: stockholders of a firm are the
owners, who are entitled to dividend income and a
prorated share of the firm’s earnings only after all
the firm’s other obligations have been met
– Stocks allow investors to tailor investments to meet
individual needs and preferences
– Stocks may provide a steady stream of current income
through dividends
– Stocks may increase in value over time through
capital gains
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-4
Figure 6.1 A Decade of the Dow and
the Nasdaq (mid-1997 through mid-2006)
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-5
From Stock Prices to Stock
Returns
• Stock Returns: take into account both price
changes and dividend income
– Over the past 50 years, stock returns have ranged
from +42.7% in 1975 to -21.45% in 1974
– Stock returns over the past 50 years have
averaged around 10%
– Speculative growth in the last half of the 1990s
was eliminated beginning in early 2000 by one of
the worst bear markets in recent history
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-6
Sometimes You Win,
Sometimes You Lose
Table 6.1
50 Years of
Annual Returns
in the Stock
Market, 1956–
2005
(returns based
on performance
of the DJIA)
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-7
What is a Bear Market?
• 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-8
Advantages of Stock
Ownership
• Provide opportunity for higher returns than
other investments
• Over past 50 years, stocks averaged 10% 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-9
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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-10
Figure 6.2 The Current Income
of Stocks and Bonds
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-11
Basic Characteristics
of Common Stock
• Equity Capital: evidence of ownership position in
a firm, in the form of shares of common stock.
This is why stocks are sometimes called “equities”
• Publicly Traded Issues: shares of stock that are
readily available to the general market and are
bought and sold in the open market
• Public Offering: an offering to sell to the investing
public a set number of shares of a firm’s stock at a
specified price
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-12
Basic Characteristics
of Common Stock (cont’d)
• Rights Offering: an offering of a new issue of
stock to existing stockholders, who may purchase
new shares in proportion to their current
ownership
• Stock Spin-Off: conversion of one of a firm’s
subsidiaries to a stand-alone company by
distribution of stock in the new company to
existing shareholders
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-13
Basic Characteristics
of Common Stock (cont’d)
• 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-14
Basic Characteristics
of Common Stock (cont’d)
• 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-15
Basic Characteristics
of Common Stock (cont’d)
• 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-16
Figure 6.4 Stock Quotations
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-17
Watch Those Transaction
Costs
• Round-Lot: buying 100 shares of stock or
multiples of 100 shares
• Odd-Lot: buying less than 100 shares
of stock
– Buying odd lots or small numbers of shares can
result in higher costs to buy and sell shares
– Frequent trading can increase transactions
costs substantially
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-18
Common Stock Values
• 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-19
Common Stock Values
• 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-20
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 are taxed at maximum 15% tax rate, same as capital gains
• Dividends tend to increase over time as companies’ earnings grow;
average annual increase around 3% to 5%
• Dividends represent the return of part of the profit of the company to
the owners, the stockholders
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-21
Key Dates for Dividends
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-22
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
EPS 
Net profit
 Preferred dividends
after taxes
Number of shares of
common stock outstanding
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-23
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
Annual dividends received per share
Dividend yield 
Current market price of the stock
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-24
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
Dividends per share
Dividend payout ratio 
Earnings per share
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-25
Three Reasons to Love Dividends
• Stocks that pay dividends tend to produce
higher returns than those that do not
– S&P dividend payers were up 6.5% vs. 3.6% for
non-dividend payers
• Since 1928, dividends have accounted for
40% of total return on stocks
• Since 1980, dividend-payers have averaged
annualized returns of 15.1% vs. 12.8% for
non-payers
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-26
Other Dividend Characteristics
• 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-27
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: Citigroup, Pfizer, DuPont, Nike, Procter &
Gamble, Home Depot
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-28
Figure 6.5 A Blue Chip Stock
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-29
Types of Stock (cont’d)
• 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: Bell South, Conagra Foods, Ford Motor,
Bank of America, Duke Energy
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-30
Types of Stock (cont’d)
• 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
– May include blue chip stocks as well as
speculative stocks
– Typically pay little or no dividends
– Examples: Medtronics, Boston Scientific, Countrywide
Financial, Wellpoint, Genentech
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-31
Types of Stock (cont’d)
• 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: Hewlett-Packard, Intel, Dell, Yahoo!,
Electronic Arts
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-32
Types of Stock (cont’d)
• 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 Satellite Radio, Dreamworks
Animation, Liberty Media
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-33
Types of Stock (cont’d)
• 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: Caterpillar, Lennar, Alcoa, Brunswick
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-34
Types of Stock (cont’d)
• 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: Checkpoint Systems, WD-40
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-35
Market 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-36
Types of Stock (cont’d)
• 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: Wal-Mart, General Motors, Microsoft
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-37
Types of Stock (cont’d)
• 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: Barnes & Noble, Williams-Sonoma, Reebok
International
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-38
Types of Stock (cont’d)
• 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 an issue
– “Initial Public Offerings (IPOs)
– Examples: Playboy Enterprises, Denny’s, Sanderson
Farms, Build-A-Bear Workshops
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-39
Investing 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 equity market in world
– Some of the returns in non-U.S. markets are due to
currency exchange rates, and not just markets
themselves
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-40
Going Global
• Buying Shares Directly in Foreign Markets
– Most adventuresome approach
– Logistical problems: fluctuating currency rates, different
regulatory and accounting standards, tax problems, “red
tape”
• Buying American Depositary Shares (ADSs)
– Simpler approach
– Bought and sold on U.S. markets just like stocks in
U.S. companies
– Transactions are in U.S. dollars
• Buying International Mutual Funds
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-41
Going 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-42
Returns 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
Current income
Capital gains
Changes in currency



(in U.S. dollars)
(dividends)
(or losses)
exchange rates
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-43
Alternative Investment
Strategies
• Storehouse of Value
– Safety of investment is primary goal
– Investors use high-quality blue chip and non-speculative
stocks
• To Accumulate Capital
– Growth of investment is primary goal
– Investors use growth-oriented stocks to generate
capital gains
• Source of Income
– Current income is primary goal
– Investors use stocks with dependable flow of dividends
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-44
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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-45
Stock Investment Strategies
(cont’d)
• 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-46
Stock Investment Strategies
(cont’d)
• 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-47
Stock Investment Strategies
(cont’d)
• 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-48
Stock Investment Strategies
(cont’d)
• 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
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-49
Chapter 6 Review
• Learning Goals
1. Explain the investment appeal of common stocks and
why individuals like to invest in them.
2. Describe historical stock returns and how
current returns measure up to historical standards
of performance.
3. Discuss the basis features of common stocks, including
issue characteristics, stock quotations, and
transaction costs.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-50
Chapter 6 Review (cont’d)
• Learning Goals (cont’d)
4. Understand the different kinds of common stock values.
5. Discuss common stock dividends, types of dividends,
and dividend reinvestment plans.
6. Describe various types of common stocks, including
foreign stocks, and note how stocks can be used as
investment vehicles.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-51
Chapter 6
Additional
Chapter Art
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
Figure 6.3 An Announcement of a
New Stock Issue
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-53
Table 6.2 Cash or Reinvested
Dividends?
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-54
Figure 6.6 A Growth Stock
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-55
Figure 6.7 A Tech Stock
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-56
Figure 6.8 A Mid-Cap Stock
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-57
Table 6.3 Comparative Annual Returns
in the World’s Major Equity Markets,
1981–2005
Copyright © 2008 Pearson Addison-Wesley. All rights reserved.
6-58