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FSU FIN 3244 - Chapter 11: Common Stocks

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Chapter 11: Common Stocks• Common stock holders are really “Residual Owners”o As a part-owner of the firm, a common holder has a claim on the wealth created by the companyo However, their claim is subordinate to the claims of other investors like lenders, so for stockholders to get rich the firm must meet their other financial obligations firsto In other words, as a residual owner, common stock holders have no guarantee that they will receive any return on their investmentThe Appeal of Common Stocks• Popular among both individual and institutional investorso Popular due to the prospect that they gain value over time and generate capital gainso Dividends are usually much less significant than the capital gains (or losses) • Stock Behavior in perspectiveo Despite down times, stocks have always appreciated in the long run Bad day are the exception rather than the rule!• From Stock Prices to Stock Returnso Stock returns take into account BOTH price behavior and dividend incomeo S&P500 considered better indicator of market that DJIA because it contains 500 firms rather than just 30 Reflects general market behavior, not necessarily that of individual stocks Think of them as return behavior on a well-balanced portfolio of common stockso Several patterns: Big returns and losses come from capital gains or losses, not dividends Stocks generally earn positive total returns over LONG periods of time Investing in stocks is definitely not without risko Long-run returns of only 6-8% are considered substandard, you can get the same return with bonds and take less riskPros and Cons• Advantageso Substantial return potentialo Stocks typically outperform bonds, and usually by a wide margino Provide investors protection from inflation (hedge against inflation) because over time their returns exceed the inflation rate. (investors gradually increase purchasing power over time)o EASY to buy and sell, transaction costs are modest (highly liquid)o Price and market information easy to findo Unit cost of shares are usually in reach of most individual investors  Any amount can be bought, so there’s no minimum like bonds and mutual funds• Disadvantages o Most significantly……RISK, both internal and externalo Earnings and performance are subject to wide swings Difficult to value common stocks and consistently select top performers o Sacrifice of current income (coupon yield on bonds typically is much better than dividends given out by stocks, in terms of CURRENT income)Basic Characteristics• Introo Each share represents EQUITY (ownership) in a company, hence why they are often called “equity securities” or “equity capital”o Entitled to participation in coporations earnings, an equal vote in management, and an equal voice in management. More shares = bigger ownership positiono Common stock has no maturity date – it remains outstanding o Typically, as stock prices go up, bond prices go down. And vice versa.• Common Stock as a Corporate Security!o Shares of most companies are not traded because the firm is too small or family controlled “Publicly traded issues” = the ones available to the publico Issuing New Shares: public offering, rights offeringo Stock Spin-Offs Occurs when a company gets rid of one of its subsidiaries or divisions and it becomes its own company• Often work out well for the investor tooo Stock Split The announcement of a firm that it will increase number of shares outstanding by exchanging a specified number of new shares for each outstanding share• (in a 2-1 split, 2 new shares are given for every 1….in a 3-2 split, same thing) Used to enhances its stock’s trading appeal by lowering its market price• A $100 stock after a 3-2 split would become $67 (100 divided by 3/2)• A $100 stock after 2-1 split would be $50, etco Treasury Stock Shares of stock that have been issues and rebought by the company (“buybacks”)• Companies do this to reduce their stock in the market to make it more appealing and look like more of an investment o Usually when they view their stock as undervalued• Possible uses of repurchased shares:o Merger, acquisition or employee stock option plano Classified Common Stock Issues of different classes of stock, which entitles holders to different privileges and benefits (unlike typical common stock, where everyone has equal rights)• Usually done to denote different voting rights or different dividend obligations• Buying and Selling Stockso Transaction Costs “Round lot” = 100 shares or multiples thereof • “Odd lot” = transaction of fewer than 100 shares• Higher fees are associated with odd-lot transactions, which require an “odd-lot dealer”o “odd-lot differential” = 10-25 cents/share tacked on to normal commission charge• Hence, it’s usually much better to deal in round lots if possible• Common Stock Valueso Par Value Stated value of a stock Except for accounting purposes, relatively useless and has little or no significance to investorso Book Value Amount of stockholders’ equity in a firm Another accounting measure, calculated by: Assets – (Liabilities + preferred stock) Commonly used it stock valuation• Most stocks have market prices well above their book value Can be converted to per-share (book value per share)o Market Value Simply the prevailing market price of an issue• So its based off the supply and demand Basically, indicates how the market participants as a hole have assessed the worth of a share of stock Market Capitalization (“market cap”) = market value of the firm itself• Number of shares outstanding X market price per shareo Investment Value The MAXIMUM price an investor should be willing to pay for the issue Indicates the worth investors put on a stock • What they think it SHOULD be trading for• Based on:o Expectations of return (dividends + capital gains) o And risk characteristics Most important measure for a stockholder• Common Stock Dividendso Firm’s board of directors decides everything regarding dividendso Earnings Per Share (EPS) How annual earnings of a firm are usually measured and reported Basically EPS shows the aggregate firm’s profits in the form of per-share basiso Important Dates Date of Record• Date investor must be a registered shareholder of a firm to be entitled to a dividend Payment Date• Actual date the company mails dividend checks


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