Chapter 11 Common Stock What Common Stocks have to offer Common stocks lets investors participate in the profits of a firm Every shareholder is a part owner of the firm so they have claim on the wealth created by the company Common Stockholders are the Residual Owners of the company o Their claim is secondary to the claims of other investors such as lenders obligations o So for stockholders to get rich they must satisfy all its other financial As residual owners holders of common stock have no guarantee that they will receive any return on their investment The Appeal of Common Stocks The appeal of common stock is the prospect that they will increase in value over time and generate significant capital gains Many stocks pay dividends providing investors with a periodic income stream Dividends don t compare to the capital gain or loss that can be a natural consequence of stock price fluctuations Putting Stock Price behavior in Perspective When the market is strong investors can expect to benefit from steady price appreciation When the market goes down it can affect it just as much o EX a 100 000 investment goes down to a 66 000 when the market fell by 34 measured by DIJA Bad days in the market are the exception to the rule o That s the case when over 50 years the market went down 32 of the time but went up the other 68 from anywhere from 2 to 40 o There is price unpredictability even in good markets but that s the price you pay From Stock Prices to Stock Returns Stock Returns take into account both price behavior dividend income S P 500 is a barometer of the overall stock market tracks 500 of the more larger firms o Better indicator of the market than the DIJA tracks 30 firms S P 500 measures total return over previous years and what goes into that total return are 2 sources of return o Dividends o Capital Gains individual stocks These figures reflect the general behavior of the market as a whole no that of o Think of it as the return behavior on a well balanced portfolio of common stocks The biggest returns losses come from capital gains losses Stocks generally earn positive total returns over long periods Ex From 1950 2000 the total return on the S P 500 was 13 7 per year which means investors could double their money every 5 or 6 years Investing in stocks is clearly not without risk 2000 2008 there was a 3 6 loss per year your 6 1 portfolio would be worth 4 5 at the end This is all market performance individual stocks can and often do perform differently 13 14 is considered good long term estimate for stocks so 16 18 is extraordinary 6 8 isn t that great A real estate bubble goes bust and so does the market An old investment tip is buy land because they aren t making any more of it People applied this to housing in the US According to S P home price index a measure of a single family home in may 2006 was 206 170 of 2009 o Over the next 3 years home prices fell sharply by 32 by the summer o As prices fell homeowners realized they owed more on their mortgages than their home was worth mortgage defaults began to rise o Some of the biggest investors in home mortgages were US commercial and investment banks which wasn t good o As homeowners fell behind on their mortgage payments stock prices of financial institutions began to drop this raised serious concern about the health of the entire US financial system o Serious concern was raised when Lehman Brothers filed for bankruptcy which sparked a free fall in the stock market So US stocks rose along with housing prices but when weakness in housing spilled over into banking stock prices plummeted and the world economy fell into a deep recession The Pros Cons of stock ownership Investors own stock for many reasons o Potential for Capital Gains o Their Current Income o High degree of market liquidity The Advantages of Stock Ownership Substantial return opportunities they offer Good return over long periods of time Better than other investments like long term corporate bonds US treasury securities o Ex high grade corporate bonds earned annual returns that were about half as large as the returns on common stocks Stocks typically out perform bonds usually by a wide margin Stocks provide investors protection from inflation because over time their returns exceed the inflation rate Investors gradually increase their purchasing power over time Stocks are easy to buy sell Transaction costs are small Price market info is easily obtainable A unit cost of a share of common stock is usually within reach of most individual investors Bonds normally carry a minimum denominations of 1000 Most stocks today are priced 50 or 60 a share The Disadvantages Volatile unstable Risk is the most significant o Business Risk o Financial Risk o Purchasing Power Risk o Market Risk o Even Risk Internal external risks All these can affect a stocks earnings and dividends price appreciation and obv the rate of return Even the best stocks have risk like government control regulation foreign competition and the state of the economy Earnings and general performance of stocks are subject to wide swings so its difficult to value them and their top performers o Aka from notes hard to analyze data even when its right hard to o the selection process is complex because so many elements go into pick future value stock performance Future outcome of the company and its stock is uncertain but the evaluation and selection process is far from perfect Final disadvantage is the sacrifice in current income o Bonds pay higher levels of current income with much greater certainty o Stocks typically have lower current income returns and grater uncertainty compared to debt invesotrs Common Stocks still have a long way to go before catching up with the current income levels available from bonds and most other types of fixed income securities Basic Characteristics of Common Stock Each share of stock represents an equity or ownership in a company AKA referred to as equity capital or equity securities Equity capital funds the firms receives from the sale of stock Every share entitles the holder to an equal ownership position and Stock Equity evidence of ownership position in a firm participation in the corporations earnings and dividends an equal vote and an equal voice in management Together common stockholders own the company The more shares an investor owns the bigger his ownership position is Common Stocks have no maturity date it remains outstanding indefinitely Common Stock as a Corporate
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