Chapter 11 Common Stocks Stock Price Behavior The economy and average stock returns typically move together Capital gains create higher returns than dividends Stock investing is risky a firm must meet all other financial obligations before paying stockholders o There is no guarantee stocks receive any return on their investment Advantages of Stock Ownership Stocks are so appealing because they have a greater chance for higher returns than long term bonds and U S treasuries o Usually provide attractive highly competitive returns over a long period of time Stocks provide protection from inflation because over time their returns exceed the inflation rate Highly liquid easy to buy and sell with low transaction costs Unit cost per share is cheaper than bonds Tax costs are relatively small Easy accessible market info keeps stocks selling at fair prices Disadvantages of Stock Ownership Prone to business financial purchasing power market and event risks Government control foreign competition and state of the economy can affect sales profits which will affect price behavior of stocks and dividend payments 1 Not only is the future outcome of a company and it s stock uncertain but the evaluation of stock performance is also extremely complex and far from perfect Stock ownership sacrifices current income o Stocks typically have lower returns and greater uncertainty compared to debt investments Wide swings in earnings and stock market performances are common Yield Annual current income current market price Common Stock Equity Capital Evidence of ownership in a firm Each share entitles an owner to an equal ownership position o Equal vote and equal voice in management The common stockholders own the company the more shares you own the bigger your ownership position All corporations issue common stock but most are never traded because the firms are either too small or are family privately controlled Publically trades issues shares that are readily available to the general public o Bought and sold in an open market Issuing New Shares IPO determine number of firm s shares at a specific price that are available to the public o Proceeds from new shares go to the firm o Existing shareholders receive proceeds from selling shares to new investors Rights offering existing stockholders are given the first opportunity to buy the new issued shares in proportion to their current ownership Results from both IPO and Rights Offering 2 o Firms have more equity in it s capital structure o Number of shares outstanding increases Stock Spin offs occurs when a company gets rid of one of its subsidiaries or divisions o Creates a stand alone company and distributes stock in that company to existing shareholders o Normally execute stock spin offs if they believe subsidiary is no longer a good fit or if the company wants to focus on their core products Stock Splits a firm announces that it will increase the number of shares outstanding by exchanging a specified number of new shares for each outstanding share of stock o Companies use stock splits when they want to enhance their stock s trading appeal by lowering its market price Treasury stock Companies buy back their own stock to reduce the number of outstanding shares o Firms do this when they feel their stock is undervalued in the marketplace o Buy back at market price o Treasury stock usually used for mergers to meet employee stock option plans or as a means for paying dividends o Makes stock appealing to outside investors Common Preferred Stock Classified common stock Issues of different classes of common stock each of which entitles holders to different privileges and benefits o Voting rights and dividend amounts usually differ in classes Often lets a small group control major decisions of publicly traded firms Preferred stock Stock with stated dividend rate with preference over common stock dividends of the same firm Common Stock Values Par value Stated or face value of a stock 3 o Except for accounting purposes it is relatively useless Book value represents the amount of stockholders equity in the firm firm o Indicates the amount of stockholder funds used to finance the Market value simply the prevailing market price of an issue o Indicates how the market participants as a whole have assessed the worth of a share of stock o MV of firm market price of stock x of outstanding shares Investment value indicates the worth investors place on the stock in effect what they think the stock should be trading for o Based on predictions of how much money they will make from capital gains and dividends Dividends A firm s board of directors makes the dividend decision o Evaluate firms financial condition to determine if they should pay a dividend or not Pay dividend Repurchase shares Do nothing Though firms don t need a profit to pay a dividend they still play a vital roll in the dividend decision EPS net profit after taxes preferred dividends number of common stock shares outstanding Board of directors also looks at the firm s growth prospects cash position and contractual obligations Tend to increase as company s earnings grow and firm matures over time Dividend Dates Declaration date date dividend is announced Date of record date on which the investor must be a registered shareholder of the firm to be entitled the dividend ends at the close of the business for that day 4 More on Dividends Cash Dividends o These stockholders are referred to as holders of record Payment date generally follows the record date by a week or so and is the actual date the dividend checks are mailed to holders of record Ex dividend date dictates whether you were an official shareholder and therefore eligible to receive the declared dividend o Allows time for bookkeeping o Stock prices fall by dividend amount o Most common type and should increase over time o Average annual growth is 3 5 o Dividend yield annual dividends received per share current market price of the stock o Dividend Payout Ratio dividends per share earnings per o Tax break on dividends has been in effect since 2003 Stock Dividends o Simply means that the dividend is paid in additional shares of share stock o Do not hold any value o Taxes deferred until shares are sold Dividend Reinvestment Plans DRIP o Shareholders can have their cash dividends automatically reinvested into additional shares of the firms common stock o No brokerage commissions and most firms allow partial o Pay taxes as if they were cash dividends in the year the
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