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
1
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
2
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
3
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
4
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
5
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
6
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
7
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
8
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