Final Exam Study Guide Book Chapter 11 Common Stocks What stocks have to offer o Common stocks enable investors to participate in the profits of a firm Their claim is subordinate to the claims of other investors such as lenders firm must meet all its other financial obligations Has no guarantee that they will receive any return on their investment The Appeal of Common Stocks o Prospect that they will increase in value over time and generate significant capital gains o The dividends paid in any particular year pale in comparison to the capital gains loss that are the natural consequence of stock price fluctuation From stock prices to stock returns o Stock returns take into account both price behavior and dividend income S P500 tracks 500 companies most of which are large firms so many experts consider it to be a better indicator of the market s overall performance than the DIJA which only tracks 30 firms A real estate Bubble Goes Bust and so does the market o As homeowners fell behind on their mortgage payments the stock prices of financial institutions began to drop raising serious concerns about the health of the entire US financial system When top tier investment bank Lehman Brothers filed for bankruptcy in September 2008 the event sparked a free fall in the stock market The Pros and Cons of Stock Ownership o Investors own stocks for all sorts of reasons the potential for capital gains for their current income or perhaps the high degree of market liquidity o Advantages Substantial return opportunities they offer Compare very favorably to other investment outlets such as long term corporate bonds and US treasury securities o High grade corporate bonds earned annual returns that were about half as large as the returns on common stocks Provide investors protection from inflation because over time their returns exceed the inflation rate Increase purchasing power They are easy to buy and sell and transaction costs are modest Unit cost of a share of common stock is usually within the reach of most individual investors Bonds normally carry minimum denominations of at least 1000 and some mutual funds that have fairly hefty minimum investments common stocks don t have such minimums o Disadvantages Risk is perhaps the most significant Stocks are subject to various types of risk including business and financial risk purchasing power risk market risk and event risk o All of these can adversely affect a stock s earnings and dividends its price appreciation rate of return earned by an investor The earnings and general performance of stocks are subject to wide swings so it is difficult to value common stocks and consistently select top performers The future outcome of the company and its stock are uncertain as well as the evaluation and selection process itself Sacrifice of current income Several types of investments example bonds pay higher levels of current income and do so with much greater certainty Characteristics of Common Stock o Each share of common stock represents an equity ownership position in a company o It s equity position that explains why common stocks are often referred to as equity securities or equity capital The more shares an investor owns the bigger his or her ownership position o Common stock has no maturity date it remains outstanding indefinitely Common stock as a corporate security o All corporations issue common stock of one type or another Many are never traded because the firms either are too small or are family controlled o Issuing new shares Companies can issue shares of common stock in several different ways Public offering the corporation offers the investing public a number of shares of its stock at a certain price o The cash raised from selling of the remaining stocks unsold in a public offering goes to the firm s existing shareholders and not the company Rights offering existing shareholders are given the first opportunity to buy the new issue o A stock right gives a shareholder the right but not the obligation to purchase new shares of the company s stock in proportion to his or her current ownership position Example if a stockholder currently owns 1 of a firm s stock and the firm issues 10 000 additional shares the rights offering will give that stockholder the opportunity to purchase 1 100 shares of the new issue Stock spin offs occurs when a company gets rid of one of its subsidiaries or divisions o Doesn t sell subsidiary to some other firm it creates a new stand alone company and then distributes stock in that company to its existing shareholders Stock Spits the firm announces that it will increase the number of share outstanding by exchanging a specified number of new shares for each outstanding share of stock o For example in a 2 for 1 stock split two new shares of stock are exchange for each old share o Use when want to enhance its stock s trading appeal by lowering its market price o Desired results the price of the stock tends to fall in close relation to the terms of the split Treasury stock instead of increasing the number of outstanding shares corporation sometimes find it desirable to reduce the number of share by buying back their own stock o Generally when they believe the stock is undervalued in the market place o When acquired stock is known as treasury stock can be used in later date by the firm o The impact of the share repurchases buybacks is not clear Classified common stock o Stockholders in a corporation enjoy the same benefits of ownership o Company will issue different classes of common stock each with entitles holders to different privileges and benefits o Used to denote either different voting rights or different dividend obligation Example class A could designate nonvoting shares and class B would carry normal voting right o Notable for classified stock is Ford Motor Company which as two classes of stocks Class A is owned by the investing public Class B I owned by the ford family and their trusts or corporations Two classes of stock share equally in the dividends by class A has one vote per share while class B is structured to give the ford family a 40 absolute control of the company Buying and Selling Stocks o Reading the quotes Common stock values Rely on highly efficient information systems that quickly disseminates market prices to the public o Transaction costs A round lot is 100 shares of stock or multiples thereof Odd lot is a transaction involving fewer than 100 shares Investors incurs certain transaction costs when
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