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 company o 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 first o In other words as a residual owner common stock holders have no guarantee that they will receive any return on their investment The Appeal of Common Stocks Popular among both individual and institutional investors o Popular due to the prospect that they gain value over time and generate capital gains o Dividends are usually much less significant than the capital gains or losses Stock Behavior in perspective o 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 Returns o Stock returns take into account BOTH price behavior and dividend income o 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 stocks o 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 risk o Long run returns of only 6 8 are considered substandard you can get the same return with bonds and take less risk Pros and Cons Advantages o Substantial return potential o Stocks typically outperform bonds and usually by a wide margin o 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 find o 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 Basic Characteristics Intro o Most significantly RISK both internal and external o 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 o 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 position o 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 public o Issuing New Shares public offering rights offering o 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 too o 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 etc o Treasury Stock buybacks Shares of stock that have been issues and rebought by the company 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 plan o 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 Stocks o 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 Values o Par Value Stated value of a stock Except for accounting purposes relatively useless and has little or no significance to investors o 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 share o 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 Dividends o Firm s board of directors decides everything regarding dividends o 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 basis o Important Dates Date of Record to a dividend Payment Date Ex Dividend Date Date investor must be a registered shareholder of a firm to be entitled Actual date the company mails dividend checks to holder of record Because of time needed to make bookkeeping entries the stock will sell without the dividend for 3 business days up to and including the date of record o Dictates if you were an official shareholder and eligible to receive the declared dividend The SELLER receives it if he sells on or after
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