Chapter 6
Common Stocks
What Stocks Have to Offer
Common stock shareholders are part owners of the
firm, and thus have a claim on the wealth created by
the company. This claim is not without limitations.
– Residual owners: a common stockholder’s claim on
company wealth is subordinate to the claims of other
investors, such as lenders, and thus there is no guarantee
that they will receive any return on their investment.
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What Stocks Have to Offer
• The Appeal of Common Stocks
– Popular investment choice for both individual and
institutional investors.
• Stocks may increase in value over time and generate
significant capital gains.
• Stocks may provide a periodic income stream through
dividends.
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What Stocks Have to Offer
• Putting Stock Price Behavior in Perspective
– When the market is strong, you can generally expect to
benefit from price appreciation.
– When markets falter, so do investor returns.
– Bad market days are the exception, rather than the rule;
• The Dow Jones Industrial Average (DJIA) over the 118-
year period from 1897-2014: dropped (for the year)
just 40 times.
• Other roughly 2/3 of the time, the market was up from
less than 1% to nearly 82% on the year.
– Upside potential: DJIA grew more than 500% over a 12-
year period (from the end of 1987 to early 2000) at an
average annual rate of nearly 17%.
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What Stocks Have to Offer
• From Stock Prices to Stock Returns
– Stock returns: take into account both price behavior and
dividend income.
• The big returns (or losses) come from capital gains.
– Returns from capital gains range from an average of
16.5% during the 1990s to -1.4% in the 1930s.
– Returns from dividends vary too, but not nearly as much,
ranging from 5.8% in the 1940s to 1.8% in the 2000-
2009 period.
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What Stocks Have to Offer
• From Stock Prices to Stock Returns
– Several interesting historical patterns:
• Big returns (or losses) come from capital gains, rather
than from dividends.
• Stocks generally earn positive returns over long periods
of time:
– From 1930 to 2014, the average total return on the S&P
500 was 11.4% per year.
• Investing in stocks is clearly not without risk:
– In 2008, the S&P 500 lost roughly 36% of its value.
– From 2000 through 2009, the U.S. stock market’s average
annual return was only 1.1% per year.
• Average market performance of stocks give a
benchmark against which to assess current stock
returns and our own expectations.
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Table 6.1 Historical Average Annual
Returns on the Standard and Poor’s 500,
1930-2014
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What Stocks Have to Offer
• A Real Estate Bubble Goes Bust and So Does the
Market
– U.S. stocks rose along with housing prices for many years,
but when weakness in the housing sector spilled over into
banking, stock prices plummeted (drop sharply).
• The average home price peaked in July 2006, and over
the next three years fell sharply, falling 31% by
summer of 2009.
• Over the same three year period, the S&P 500 Index
lost 28% of its value.
• U.S. economy fell into a deep recession.
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What Stocks Have to Offer
• The Pros and Cons of Stock Ownership
– The Advantages of Stock Ownership
• Provide opportunity for substantial returns
• Stocks typically outperform bonds, and usually by a wide
margin.
– Over the last century, stocks earned annual returns roughly
double that of the returns provided by high-grade corporate
bonds.
• Stocks provide protection from inflation because over time
their returns exceed the inflation rate.
• Stocks are easy to buy and sell.
• Costs associated with trading stocks are modest.
• Price and market information is easy to find in the news
and financial media.
• Unit cost per share of stock is low enough to encourage
ownership.
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What Stocks Have to Offer
• The Pros and Cons of Stock Ownership
– The Disadvantages of Stock Ownership
• Stocks are subject to various types of risk:
– Business risk
– Financial risk
– Purchasing power risk
– Tax risk
– Market risk
– Event risk
– Currency exchange risk
• Stock returns are highly volatile and very hard to predict,
so it is difficult to consistently select top performers.
• Stocks generally distribute less current income compared
to other investment alternatives.
– Bonds pay more current income and do so with much greater
certainty.
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Basic Characteristics of Common
Stock
Equity capital: every share of common stock
represents an equity (ownership) position in a
company. This is why stocks are sometimes called
“equity securities”.
• Common Stock as a Corporate Security
• Buying and Selling Stocks
• Common Stock Values
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Basic Characteristics of Common
Stock
• Common Stock as a Corporate Security
– Publicly traded issues: shares of stock that are readily
available to the general public and that are bought and
sold in the open market.
– Issuing New Shares
• Public offering
• Rights offering
• Private placement
• In all types of offerings, the net result is the same:
– The firm ends up with more equity in its capital structure,
and the number of shares outstanding increases.
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Basic Characteristics of Common
Stock
• Common Stock as a Corporate Security
– Stock Spin-off
• Stock spin-off: when a company gets rid of one of its
subsidiaries or divisions to create a new company.
• The company will not sell the subsidiary to a some other
firm. Rather, the shares of the new company will be
owned by its existing stakeholders.
• Example: News Corporation by 21st Century Fox.
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Basic Characteristics of Common
Stock
• Common Stock as a Corporate Security
– Stock Splits
• 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.
– 2-for-1 stock split: 2 new shares of stock are exchanged for
each old share.
– 3-for-2 stock split: 3 new shares of stock are exchanged for
every 2 old shares outstanding.
• Usually done to lower the stock price to make it more
attractive to investors.
– Normally, the price of the stock falls roughly in proportion to
the terms of the split.
– Example: Starbucks Corporation 2-for-1 stock split on April 9,
2015.
» Price day before split: $95.23
» Opening price day split went into effect: $47.65
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Basic Characteristics of Common
Stock
• Common Stock as a Corporate Security
– Treasury Stock
• 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 the public.
– Kept by the corporation and may be used later for
mergers, acquisitions, to pay stock dividends or to meet
employee stock option plans.
• Companies buyback when they believe their stock is
undervalued and a good buy.
• Companies also repurchase shares as an alternative to
paying dividends.
• Short-term impact usually positive: stock prices
generally go up.
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Basic Characteristics of Common
Stock
• Common Stock as a Corporate Security
– Classified Common Stock
• Classified Common Stock: common stock issued in
different classes, each of which entitles holders to
different privileges and benefits.
– Different shares have different voting rights.
– May also be used to grant different dividend rights.
• Often used to allow a relatively small group to control
the voting of a publicly-traded company.
• Example: Facebook IPO in 2012 issued Class A and B
shares
– Class A shares, available to public, were entitled 1 vote
per share
– Class B shares, held by Facebook CEO and other insiders,
were entitled to 10 votes per share.
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Basic Characteristics of Common
Stock
• Buying and Selling Stocks
– Reading the Quotes
• Stock quotes appear daily in the financial press and
online
• Market capitalization: total number of shares
outstanding multiplied by the share price (market value
per share).
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Basic Characteristics of Common
Stock
• Buying and Selling Stocks
– Transaction Cost
• An investor incurs certain transaction costs when buying
or selling stock.
– The fee consists of transfer fees, taxes, and brokerage
fee.
• Another type of transaction cost is the bid-ask spread.
– The bid-ask spread is the difference between the bid and
ask price for a stock.
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Basic Characteristics of Common
Stock
• Common Stock Values
– Par Value: arbitrary amount assigned to a stock when it is
first issued.
• Set very low, representing a minimum value (floor) for
the value of the stock.
• Mainly an accounting term and not very useful to
investors
– Book Value: Stockholders’ equity in the firm as reported
on the balance sheet.
• Accounting term
• Difference between the company’s assets and liabilities
(less any preferred stock)
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Basic Characteristics of Common
Stock
• Common Stock Values
– Market Value: the current price of the stock in the stock
market.
• Forward-looking, reflecting investors’ expectations
about how the company will perform in the future.
• Stocks usually trade at market prices that exceed their
book values, sometimes to a very great degree.
• When a stock’s market value drops below its book
value, the firm is usually dealing with some sort of
financial distress and doesn’t have good prospects for
growth.
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Basic Characteristics of Common
Stock
• Common Stock Values
– Investment Value: the amount that investors believe the
stock should be trading for, or what they think it is worth.
• Probably the most important measure for a stockholder.
• Determined by a complex process of evaluating risk and
return information to place a value on the stock that
represents the maximum price an investor should be
willing to pay for the issue.
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Common Stock Dividends
Dividend income is one of the two basic sources of
return to investors. Dividends represent the return of
part of the profit of the company to the owners (the
stockholders).
Dividend income is more predictable than capital
gains, so it is preferred by investors seeking lower
risk.
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Common Stock Dividends
• The Dividend Decision
– A firm’s board of directors evaluates the firm’s operating
results and financial condition to determine whether
dividends should be paid out and in what amount.
– Corporate versus Market Factors
• Corporate:
– Earnings Per Share: the amount of annual earnings
available to common stockholders, stated on a per-share
basis.
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Common Stock Dividends
• The Dividend Decision
– Corporate versus Market Factors
• Other Corporate:
– Growth prospects: how much does the firm need of their
earnings to invest and finance future growth?
– Cash position: Make sure dividends won’t lead to a cash
shortfall.
– Loan agreements: Is the firm legally limited in the amount
of dividends it can pay?
• Market:
– Can the firm justify to investors retaining the earnings
and reinvesting them at a favorable rate of return to
achieve faster growth and higher profits?
– What are the dividend expectations of its shareholders?
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Common Stock Dividends
• The Dividend Decision
– Some Important Dates
• Once a dividend is declared, the firm must indicate
certain dates associated with that dividend:
– Date of record: date on which the investor must be a
registered shareholder of the firm (holder of record) to be
entitled to a dividend.
– Payment date (payable date): actual date on which the
company will mail dividend checks to holders of record;
generally follows the date of record by a week or two.
– Ex-dividend date: dictates whether you were an official
shareholder and therefore eligible to receive the declared
dividend.
» Stock will sell without the dividend for three business
days up to and including the date of record because of
time needed to make bookkeeping entries
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Common Stock Dividends
• The Dividend Decision
– Some Important Dates
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Common Stock Dividends
• Types of Dividends
– Two main types:
• Cash dividend: dividend paid out in the form of cash
• Stock dividend: dividend paid out in the form of stock
• Rarely, dividends may be paid out in other forms such
as stock spin-offs or perhaps samples of the company’s
products.
– Cash Dividends
• Most common
• Tend to increase over time as companies’ earnings
grow; Average annual increase 3% to 5%.
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Common Stock Dividends
• Types of Dividends
– Cash Dividends
• Dividend yield: a measure of dividends on a relative
(percentage) basis rather than on an absolute (dollar)
basis.
• Dividend Payout Ratio: measures the percentage of
earnings that a firm pays in dividends.
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Common Stock Dividends
• Types of Dividends
– Stock Dividends
• A stock dividend means the firm pays its dividend by
distributing additional shares of stock.
• A 10% stock dividend would mean that you would
receive 1 new share of stock for each 10 shares you
currently own.
– This dividend would normally lead to a decline of around
10% in the stock’s share price.
• Stock dividends, unlike cash dividends, are not taxed
until you actually sell the stock.
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Types and Uses of Common
Stock
• Types of Stocks
– Blue-Chip Stocks: stocks issued by large, well-
established firms with long track records of earning profits
and paying dividends.
• Companies are often leaders in their industries
• Not all blue-chips are alike:
– Some provide consistently high dividend yields: AT&T,
Chevron, McDonald’s, Johnson & Johnson, Pfizer.
– Others are more growth-oriented: Nike, Procter &
Gamble, Home Depot, Walgreen’s, Lowe’s Companies,
United Parcel Service
• Less risky than most stocks; Appeal to investors who
want to earn higher returns than bonds typically offer
without taking a great deal of risk.
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Types and Uses of Common
Stock
• Types of Stocks
– Income Stocks: stocks with a long history of regularly
paying higher-than-average dividends.
• Ideal for investors seeking relatively safe and high level
of current income.
• Dividends tend to increase regularly over time
• Some companies pay high dividends because they offer
limited growth potential
• Subject to a fair amount of interest rate risk
• Examples: Many public utilities such as American
Electric Power and Duke Energy, as well as Conagra
Foods, General Mills, and Altria Group.
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Types and Uses of Common
Stock
• Types of Stocks
– Growth Stocks: stocks issued by companies experiencing
rapid growth in revenues and earnings.
• Have sustained earnings growth well above general
market.
• Typically pay little or no dividends.
• May include blue chip stocks as well as
speculative stocks.
• Appeal to investors looking for attractive capital gains,
rather than dividends, and willing to bear more risk.
• Riskier investment because price may fall if earnings
growth cannot be maintained, particularly in a down
market.
• Examples: Amazon.com, Apple, Google, eBay, Berkshire
Hathaway, Starbucks
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Types and Uses of Common
Stock
• Types of Stocks
– Tech Stocks: stocks representing the technology sector of
the market.
• Includes companies that produce computers,
semiconductors, data storage devices, and software as
well as those that provide Internet services, networking
equipment, and wireless communications.
• Range from speculative stocks of small companies to
stocks of large companies that are growth-oriented,
some of which are legitimate blue chips.
• Vast majority of these stocks are traded on the Nasdaq
• Offer potential for very high returns but also involve
considerable risk and volatility.
• Examples: Apple, Cisco Systems, Google, Intel, NVIDIA,
Marvell Technology, LinkedIn, SanDisk, Electronic Arts
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Types and Uses of Common
Stock
• Types of Stocks
– Speculative Stocks: stocks that offer potential for
substantial price appreciation, but that lack sustained records
of success.
• Attractive particularly when the market is bullish
(optimistic).
• Offer attractive growth prospects with the chance to “hit it
big” in the market.
• Highly risky
– Companies lack a sustained track record of business and
financial success.
– Earnings may be uncertain or highly unstable.
» Stock price subject to wide swings in price.
» Usually pay out little or no dividends.
• Examples: Sirius XM Radio, Bona Film Group, Destination
Maternity, Global Power Equipment Group, Iridium
Communications.
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Types and Uses of Common
Stock
• Types of Stocks
– Cyclical Stocks: stocks issued by companies whose
earnings are closely linked to the overall economy.
• Stock price tends to move up and down with the
business cycle.
• Best for investors willing to trade in and out of these
stocks as the economy changes.
– Tend to do well when the economy is growing, especially
in early stages of economic recovery.
– Tend to perform poorly in a weakening economy.
• Examples:
– Alcoa, Caterpillar, Genuine Parts, Lennar, Brunswick,
Timken
– Companies that serve markets tied to capital equipment
spending by business or to consumer spending for big
ticket, durable items like houses and cars.
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Types and Uses of Common
Stock
• Types of Stocks
– Defensive Stocks: stocks that tend to hold their value,
and even do well, when the economy starts to falter.
• Tend to be less susceptible to downswings in the
business cycle than the average stock.
• Commonly used by aggressive investors looking for a
“parking place” during a slow economy.
• Include stocks of public utilities, industrial and
consumer goods companies that produce or market
stapes such as beverages, foods and drugs.
• Examples: Walmart, Checkpoint Systems, WD-40,
Extendicare
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Types and Uses of Common
Stock
• Investing in Foreign Stocks
– Globalization of financial markets is growing
• U.S. share of the world equity market is roughly 40% in
2015 compared to 2/3 in 1970.
– Comparative Returns
• Over a long period of time, stock returns in the U.S.
have been unremarkable relative to those in other
markets around the world.
• There are definitely attractive returns awaiting investors
willing to venture in to foreign markets.
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Types and Uses of Common
Stock
• Investing in Foreign Stocks
– Putting Global Returns in Perspective
• International investing is more complex and riskier than
domestic investing
– Investor must choose the right stock
– Investor must choose the right market
– Currency exchange rate fluctuations
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Types and Uses of Common
Stock
• Investing in Foreign Stocks
– Measuring Global Returns
• The “exchange rate” represents the value of the foreign
currency in U.S. dollars, or how much one unit of
foreign currency is worth in U.S. money.
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Types and Uses of Common
Stock
• Investing in Foreign Stocks
– Currency Exchange Rates
• A stronger U.S. dollar has negative impact on foreign
investments
• A weaker U.S. dollar has positive impact on foreign
investments
• You want the value of both the foreign stock and the
foreign currency to go up over your investment horizon.
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Types and Uses of Common
Stock
• Alternative Investment Strategies
– Investors may use common stocks as a:
• storehouse of value
– Safety of investment most important
– Use high-quality blue chip and non-speculative stocks
• way to accumulate capital
– Capital gains and/or dividends build up wealth
– Growth stocks and/or income stocks
– Long-term investment horizon
• source of income
– Dependable flow of dividends
– High-yield, good quality income shares preferred
– Depending on their investment goals, investors use various
investment strategies.
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