L13 Common stock - Lehigh University

[Pages:8]Common Stock

Investing in common stock Dividends and capital gains Stodgy and safe vs. fledgling and risky

Copyright ?2007 Stephen G. Buell

Corporate securities

Corporations raise money or capital from investors like you and me by issuing or selling their securities These securities are either shares of stock or bonds Some well-known corporations

AT&T, Coca-Cola, DuPont, Exxon-Mobil, GE, GM, IBM, Microsoft, Nike, Xerox, Enron, WorldCom

Copyright ?2007 Stephen G. Buell

Basic definitions

Corporation: state-chartered legal entity that conducts business Stock: share of ownership ? it's equity

Stockholders are the owners of the firm Two types of stock: preferred and common

Preferred stock: relatively unimportant, safer than common stock but provides very limited gains Common stock: ultimate owners of the company, risky, unlimited earnings potential

Bond: corporate IOU ? it's debt

Bondholders are creditors, not owners of the firm Safer position but lower expected returns than stock

Copyright ?2007 Stephen G. Buell

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Divide and conquer

We'll cover common stock in this module in enough detail to get you started Then we'll cover preferred stock and bonds in the next module

Odd breaking point, you wonder? Not really, preferred stock, even though it's legally equity and ownership, behaves much more like bonds than common stock

Copyright ?2007 Stephen G. Buell

Common stock

Basic form of ownership ? to own stock is to own common stock, not preferred stock Common shareholders are the ultimate owners of the firm or corporation Residual claim on income and assets (stand last in line behind everybody else)

They don't get paid a dime until everyone else is completely satisfied ? bear ultimate risk

No maturity date ? you want out? Sell!

Copyright ?2007 Stephen G. Buell

What do you get for being last?

Right to vote for the board of directors

Who cares?

Limited liability ? huge selling point to the corporate form of business organization

If the company fails and you're a shareholder

Creditors can't come to your house to repossess your car and attach your salary Your liability is limited only to your investment

You own a percentage of the profits (cool!)

Copyright ?2007 Stephen G. Buell

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Your share of the pie

Your return on common stock comes from:

Quarterly dividends (cash disbursement)

As firm becomes more profitable, its dividends normally rise over time ? unique to common

Price appreciation or capital gains

Market price of your shares will normally rise over time and you can sell them for a capital gain

Historically returns on common stock have been twice the returns on preferred stock and bonds

Copyright ?2007 Stephen G. Buell

Common stock dividends

Usually quarterly, paid out of current profits Dividend payout rate = dividends/net income or DPS/EPS

Typical mature, stodgy firm pays out roughly 50% Typical new, fledgling firm pays 0 to 10%

Retained profits may be its only source of funding Actually good if firm can reinvest at rate of return higher than stockholder can earn on dividends

Copyright ?2007 Stephen G. Buell

Only two places to go

Stodgy firm

Net profits

Fledgling firm

Net profits

50%

Retained earnings

50%

Dividends

100%

Retained earnings

0%

Dividends

Copyright ?2007 Stephen G. Buell

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More dividends

(Dividend) Yield = DPS/P = .50/16.00 = 3.1%

Usually low for stocks compared to bonds Much of the return might be from capital gains

Especially true for small firms

Most firms allow stockholders to buy more shares of common stock with their dividends ? commission free

Automatic dividend reinvestment plan

Copyright ?2007 Stephen G. Buell

Common stock values

Book value = (assets ? liabilities or debt)/number of shares outstanding

Theoretically what stockholder would get at liquidation (bankruptcy)

Usually a very unimportant, unrealistic number

Market value

Price at which stock is currently trading Determined by supply and demand

Based upon future expectations of profits

Look up in WSJ or on-line Absolutely no reason to think MV = BV

Copyright ?2007 Stephen G. Buell

Splits and stock dividends

Stock split ? little economic significance

If price of stock is getting very high so smaller investors are turned off, firm will split its stock Split stock 4 for 1

Yesterday you had 200 shares worth $100/sh = $20,000 Today you have 800 shares but worth only $25/sh = $20,000

Stock dividend -even less economic significance

Mail out more pieces of paper (stock certificates) 5% stock dividend

Yesterday you had 200 shares worth $100/sh = $20,000 Today you have 210 shares worth $95.24 = $20,000

But you feel better???

Copyright ?2007 Stephen G. Buell

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Market to book

Market-to-book ratio = price/book value

Usually between 1 and 2 Below 1, firm is undervalued and may be a take-over target If BV = $5.00 per share and the stock is selling for a price of $8.50 a share, the MV/BV ratio is 8.50 / 5.00 = 1.70

Copyright ?2007 Stephen G. Buell

Price to Earnings ratio

Price-earnings (P-E) ratio = Price/EPS

The most widely-used indicator when making a buy or sell decision

Is the stock over, under or fairly valued?

How much per share is the market willing to pay for a dollar of current EPS?

EPS = net earnings / # shares common stock

Copyright ?2007 Stephen G. Buell

Crowded on ground floor

Price is based on future expectations, EPS is what is

P = $60 and EPS = $3.00, stock's P-E multiple is 20X < 8 is low: poor growth prospects, high yields, less risk 8 to 25 are normal P-E ratios 40 to 50+: speculative, paying a lot for little or no earnings as investors try to get in on the ground floor, internet P-E's=

Copyright ?2007 Stephen G. Buell

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Beta

Beta or beta coefficient ()

Measures a stock's price volatility (or risk) relative to the entire stock market (average beta = 1.0) Beta measures systematic or market risk

Beta is based on the past 5 years of monthly data and each stock's beta is published in stock guides

But will history repeat itself?

Copyright ?2007 Stephen G. Buell

Offensive

If beta = 1.5, stock historically moves 1.5X as much as the entire market

Bull market: market up 10%, stock up 15%?? Bear market: market down 6%, stock down 9%??

If beta > 1, it's an aggressive stock to add to your portfolio: cars, steel, airlines

Copyright ?2007 Stephen G. Buell

Defensive

If beta = .4, stock historically moves only .4X as much as the entire market

Bull market: market up 10%, stock up 4%?? Bear market: market down 6%, stock down 2.4%??

If beta < 1, it's a defensive stock to add to your portfolio: utilities

Copyright ?2007 Stephen G. Buell

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Classifying stocks

Income stocks

Pay higher dividends than most, year after year (possibly bad for you tax-wise) Provide a steady income stream Retain low percentage of their profits Have low betas Are boring but stable Utilities are a good example

Copyright ?2007 Stephen G. Buell

More exciting (riskier) stocks

Growth stocks

Consistently have high growth in profits Return is mostly from capital gains High P-E ratios

So you're paying more to buy these

High betas (over 1.5)

Bad in downturns

Coca-Cola, Nike, Walmart

Copyright ?2007 Stephen G. Buell

Most exciting (riskiest) stocks

Speculative stocks

Very high potential but are yet unproven

Will potential be realized?

Spotty past records Many, many fail Betas > 2 Internet companies, video game makers

Copyright ?2007 Stephen G. Buell

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Bluest of the blue

Blue chip stocks

Large, well-known firms Good past history of earnings Industry leaders who won't fail Growth rate same as the economy Dow Chemical, GE, HJ Heinz Safe way to invest but little chance for spectacular returns

Copyright ?2007 Stephen G. Buell

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