Fin Study GuideFinal ExamExam Date: ____________________Room: ________________1Common StocksChapter 11Stock Ownership•Residual owners - owners/stockholders of a firm, who are entitled to dividend income and a prorated share of the firm’s earnings only after all other obligations have been met•No guarantee that they will receive any return on the investment•The allure of common stocks is that they will increase in value over time and generate significant capital gains and dividends•Bad days are the exception rather than the rule•Big returns (or losses) come from capital gain•Stocks generally earn positive total returns over long time periods•From 1950-2000, the average total return on the S&P 500 was 13.7% per year•At that rate, investors can double their money every 5 or 6 yearsHow long it will take for your money to double = 72 / interest rate•Investing in stocks is clearly not without risk•Advantages•Provide attractive, highly competitive returns in the long haul•Typically outperform bonds, and usually by a wide margin•Provide investor protection from inflation; over time their returns exceed the inflate rate•Easy to buy and sell•Transaction costs are modest•Disadvantages •Subject to various types of risk, including business and financial risk, purchasing power risk, market risk, and event risk•Earnings and general performance are subject to wide swings, so it is difficult to value common stocks a consistently select top performers•The sacrifice in current income•Publicly traded issues - shares that are readily available to the general public and that are bought and sold in the open market•In 2008, the value of stocks was at $12 trillion•Classified common stock - different classes of common stock that are issued and each of which entitles holder to different privileges and benefits•Customarily used to denote either different voting rights or different dividend obligationsIssuing New Shares of Stock•Two ways to issue new shares:1. Rights offering - existing shareholders are given the first opportunity to buy the new issue•Purchase in proportion to his or her current ownership position•Example: if a person owns 1% of a firm’s stock, the rights offering will give that stockholder the opportunity to purchase 1% of the new issue•Can also sell the rights to someone who wants them2. Public offering - the corporation offers the investing public a certain number of shares of its stock at a certain price2Stock Splits•Stock splits - a maneuver in which a company increases the number of shares outstanding by exchanging a specified number of new shares of stock for each outstanding share•Uses stock splits when it wants to enhance its stock’s trading appeal by lowering its market priceStock split = Original price per share / ratio of new shares to oldRound/Odd Lots•Round lot - 100 shares of stock or multiples thereof•Odd lot - a transaction involving fewer than 100 shares•Trading 250 shares of stock would involve a combination of two round lots and an odd lotCommon Stock Values•Par Value - the stated/face value of a stock•Relatively useless except for accounting purposes•Because the term has little or no significance for investors, many stocks today are issued as no-par or low-par stocks•They only have a par value of a penny or two•Book Value - the amount of stockholders’ equity in the firmBook Value = assets - (liabilities + preferred stock)Book value per share = book value / number of common shares outstanding•Market Value - the prevailing market price of an issue•Indicates how the market participants as a whole have assessed the worth of a share of stock•Market capitalization - the market value of the firmMarket capitalization = market price of the stock X number of shares outstandingEarnings Per Share (EPS)•Earnings per share (EPS) - terms in which annual earnings of a firm that are usually measured and reportedEPS = (net profit after taxes - preferred dividends) / number of shares of common stock outstandingTypes of Dividends•Cash dividends - cash flow from stocks•More firms pay cash dividends than any other type of dividend•They tend to increase over time, as companies’ earnings grow•The average annual increase in dividends is around 3% to 5%•A steadily increasing stream of dividends tends to shore up stock returns in soft markets•Dividend yield - indicates the rate of current income earned on the investment dollar•Convenient way of assessing the amount of dividends received Dividend Yield = Annual dividends received per share / current market price of the stock•Dividend payout ratio - describes the portion of earnings per share (EPS) that is paid out as dividendsDividend payout ratio = dividends per share / earnings per share3•Stockholders don’t like to see payout ratios higher than 60% to 70% because high payout ratios are difficult to maintain and may lead the company into trouble•The appeal of cash dividends took a giant leap forward in 2003, when the federal tax code changed to reduce the tax on dividends•Both dividends and capital gains are taxed at the same low, preferential rate (of 15% or less)•Stock dividend - dividend paid by issuing additional shares of stock•Stock dividends really have no value because they represent the receipt of something already owned•The market responds to such dividends by adjusting share prices according to the terms of stock dividend•The market value of you shareholdings after a stock dividend is likely to be the same as it was before the stock dividend•Not taxed until you actually sell the stocksDividend Reinvestment Plans (DRP)•Dividend reinvestment plan (DRP) - a corporate-sponsored program in which shareholders can have their cash dividends automatically reinvested into additional shares of the company’s common stock•If the company’s good enough to invest in, then it’s good enough to reinvest in•Convenient and inexpensive way to accumulate capital•Partial participation - participants specify a portion of their shares for dividend reinvestment and receive cash dividend on the rest•Most plans will credit fractional shares to the investor’s account, and many will even allow investors to buy additional shares of the company’s
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