Chapter 6 Common Stock Investments
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Transcript of Chapter 6 Common Stock Investments
Chapter 6
Common Stock Investments
©2005 Kaplan Financial6-2
Key Topics Key topics include:
long-term perspective; advantages and disadvantages; characteristics, new issues, stock quotations
and transaction costs; measures of common stock value; dividends; different kinds of common stock; and uses and strategies of common stock
investing.
©2005 Kaplan Financial6-3
Common Stock Represents ownership in a
corporation and allows investors to participate in the profits
Stocks offer investors the opportunity to shape an investment program to their individual needs
©2005 Kaplan Financial6-4
Stock Returns Stock returns come mainly from
capital appreciation Stock market returns have
averaged about 12% per year over the past 50 years, but over 18% during the past decade
©2005 Kaplan Financial6-5
Advantages: Common Stock Potential for high returns; no upper limits. May provide current income return from
dividends. Shares are highly liquid and easily
transferred. Transaction costs are relatively low; on-line
trades can be very cheap. Low unit prices relative to other securities.
©2005 Kaplan Financial6-6
Disadvantages: Common Stock Earnings and performance are
subject to wide swings.
Selection of common stocks is complex.
Current income is relatively low,
compared to bonds.
©2005 Kaplan Financial6-7
Publicly Traded Stocks (1 of 3)
Public offering an offering to sell to the investing
public a set number of shares of a firm's stock at a specified price
Rights offering an offering of a new issue of stock to
existing shareholders, who may purchase new shares in proportion to their current ownership position
©2005 Kaplan Financial6-8
Publicly Traded Stocks (2 of 3)
Stock spin-off a conversion of one of a firm's subsidiaries
to a stand-alone company by distribution of stock in that new company to existing shareholders
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
©2005 Kaplan Financial6-9
Publicly Traded Stocks (3 of 3)
Treasury stock stock that has been sold and
subsequently repurchased by the issuing firm
Classified common stock Stock issued by a company in different
classes, each of which offers different privileges and benefits to its holders
©2005 Kaplan Financial6-10
Buying and Selling Stocks The investor must be familiar with
stock quotes
The investor must also consider transaction costs
©2005 Kaplan Financial6-11
Stock Quotes NYSE – New York Stock Exchange AMEX – American Stock Exchange NASDAQ
Published in a twelve-column format
©2005 Kaplan Financial6-12
Column Titles (1 of 5)
52 weeks Hi highest price within past year, adjusted
for stock splits if any 52 weeks Lo
lowest price w/n past year Stock
name of company
©2005 Kaplan Financial6-13
Column Titles (2 of 5)
Sym ticker symbol; 1-3 characters on NYSE
and AMEX; 4-5 on NASDAQ. Div
annual dividend
©2005 Kaplan Financial6-14
Column Titles (3 of 5)
Yld % dividend yield based on current annual
dividend divided by market price PE - price-earnings ratio based on most recent four quarters of earnings
Vol 100s number of shares traded yesterday (in
100s)
©2005 Kaplan Financial6-15
Column Titles (4 of 5)
Hi highest price at which stock traded
yesterday Lo
lowest price yesterday Close - closing price yesterday
©2005 Kaplan Financial6-16
Column Titles (5 of 5)
Close closing price yesterday
Net Chg change in price from close of previous
day
©2005 Kaplan Financial6-17
Transaction Costs average 1-5% of value of
transaction when using a full-service broker
Odd-lot trades (less than 100 shares) carry an added cost called odd-lot differential
©2005 Kaplan Financial6-18
Transaction Costs (continued)
Discount brokers can save an investor up to 70% on commission
On-line trades can now cost less than $ 10 per trade
©2005 Kaplan Financial6-19
Measures of Value Par value
the stated or face value (meaningless for investment purposes)
Book value the amount of shareholder equity in a
company; equals the amount of the firm's assets minus liabilities and preferred stock
©2005 Kaplan Financial6-20
Measures of Value (continued)
Market value the prevailing price of a security.
Investment value the amount that investors believe a
security should be trading for, or what they think it's worth.
©2005 Kaplan Financial6-21
Dividends and Earnings per Share (EPS) The directors make the dividend
decisions based on several factors. Earnings per share (EPS)
represents the amount that is earned per share
EPS = (net profit after taxes - pfd dividends)
# shares outstanding
©2005 Kaplan Financial6-22
Dividends and Earnings per Share (EPS) (continued)
Dividends are paid out of earnings, but do not have to be paid even when the firm is profitable
Generally, however, higher EPS lead to higher dividends
©2005 Kaplan Financial6-23
Dividends (Important dates) Record date
date on which an investor must be a registered shareholder to be entitled to receive a dividend
Ex-dividend date 3 business days prior to the date of record;
determines if one is an official shareholder and thus eligible to receive a declared dividend
Payment date the actual date on which the company pays
the dividend
©2005 Kaplan Financial6-24
Cash Dividends and the Dividend Yield Dividends are normally paid in cash,
although stock dividends are also common.
Cash dividends are current income, which can be expressed as the dividend yield.
Dividend yield = annual dividend per share market price per share
©2005 Kaplan Financial6-25
Dividend Payout Ratio (DPR) One measure of stability of the
cash dividend is the dividend payout ratio (DPR).
DPR = dividend per share / current market price per share.
A high DPR could suggest difficulty in paying future dividends.
©2005 Kaplan Financial6-26
Dividend Reinvestment Plans and Stock Dividends Dividend reinvestment plans
(DRIPs) plans in which shareholders have
cash dividends automatically reinvested into additional shares.
Stock dividend A dividend payment in the form of
additional shares of stock.
©2005 Kaplan Financial6-27
Market Classifications of Common Stock (1 of 3)
Blue chip stocks financially strong, high quality stocks with
long and stable records of earnings and dividends.
Income stocks Have long and sustained records of paying
higher-than-average dividends. Growth stocks
experience high rates of growth in operations and earnings.
©2005 Kaplan Financial6-28
Market Classifications of Common Stock (2 of 3)
Speculative stocks offer the potential for substantial price
appreciation, usually because of some special situation, such as new management or the introduction of a promising new product.
Cyclical stocks Stocks whose earnings and overall market
performance are closely linked to the general state of the economy.
©2005 Kaplan Financial6-29
Market Classifications of Common Stock (3 of 3)
Defensive stocks tend to hold their own, and even do well,
when the economy starts to falter. Mid-cap stocks
medium-sized stocks, generally with market value of less than $3-4 billion, but more than $750 million.
Small-cap stocks have market value of less than $750 million,
and may offer above-average returns.
©2005 Kaplan Financial6-30
Foreign Stocks Foreign equity markets
outperform US markets in most years Investors can buy foreign stocks
directly Has many logistical problems
American Depository Receipts (ADRs) Backed by foreign securities held by
US banks
©2005 Kaplan Financial6-31
Foreign Stocks (continued)
Both direct purchase and ADRs have usual risks associated with
common stocks, plus the currency exchange rate risk that drastically can affect total return.
Total return in US$ = dividends + cap gains (losses) + (or) - changes in FOREX rates.
©2005 Kaplan Financial6-32
Investment Strategies Investment strategies can be
employed to satisfy one of three basic investment needs:
warehouse of value accumulation of capital and/or as a source of income
©2005 Kaplan Financial6-33
Buy-and-Hold Strategy and The High-Income Approach The most basic strategy is the buy-and-
hold. High-quality stocks are selected and held
for extended periods; a strategy popular with value-oriented investors.
The high-income approach uses common stocks for current income.
Since dividends mostly increase through time, the level of current income increases as well.
©2005 Kaplan Financial6-34
Quality Long-Term Growth and Aggressive Stock Management Quality long-term growth
a less conservative strategy. This strategy relies on capital gains as the primary source of return.
Aggressive stock management uses quality issues to seek attractive
rates of return in a fully managed portfolio.
has substantial risk and requires a substantial amount of investor time.
©2005 Kaplan Financial6-35
Speculation and Short-Term Trading Speculation and short-term trading
the highest risk strategy. investor seeks returns from capital
gains while holding the stock only a short period of time.
©2005 Kaplan Financial6-36
Using Investment Strategies The first three strategies go well
with the objective to use stocks as a warehouse of value
All five could be used to accumulate capital
The high-income strategy fits best with the objective of using stocks as a source of income
©2005 Kaplan Financial6-37
Popular Investment Strategies Some Popular Investment Strategies Include:
Growth Investing, which is investing in stocks with above average forecasts of earnings growth and high price/earnings ratios in expectation of higher returns.
Value Investing, which is investing in stock of companies that are out of favor with the market for some reason, as reflected by low price/earnings ratios and low prices compared to their fundamentals.
Sector Investing, which is an investing style based on the premise that certain industry sectors perform better during specific stages of the economic cycle.
Momentum Investing, which is an investing style that focuses on using relative stock price movement to determine when to buy and sell.