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FSU FIN 3244 - Chapter 11 Common Stock

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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 companyo Their claim is secondary to the claims of other investors such as lenderso So for stockholders to get rich, they must satisfy all its other financial obligations- 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 fluctuationsPutting 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 payFrom 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 returno Dividendso Capital Gains-These figures reflect the general behavior of the market as a whole no that of individual stockso 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 greatA 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.o Over the next 3 years home prices fell sharply, by 32% by the summerof 2009o As prices fell, homeowners realized they owed more on their mortgages than their home was worth, & mortgage defaults began to riseo Some of the biggest investors in home mortgages were US commercialand investment banks which wasn’t goodo 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 recessionThe Pros & Cons of stock ownership- Investors own stock for many reasonso Potential for Capital Gainso Their Current Incomeo High degree of market liquidityThe 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 securitieso 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 shareThe Disadvantages- Volatile (unstable)- Risk is the most significanto Business Risko Financial Risko Purchasing Power Risko Market Risko 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 itsdifficult to value them and their top performerso Aka from notes: hard to analyze data even when its right & hard to pick future valueo the selection process is complex, because so many elements go into 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 incomeo Bonds pay higher levels of current income & with much greater certaintyo 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 securitiesBasic 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- Stock Equity: evidence of ownership position in a firm- Every share entitles the holder to an equal ownership position and 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


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