Common Stock. Corporate securities. Basic definitions

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1 Common Stock Investing in common stock Dividends and capital gains Stodgy and safe vs. fledgling and risky 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 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 1

2 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 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! 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!) 2

3 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 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 Only two places to go Stodgy firm Net profits Fledgling firm Net profits 50% Retained earnings 50% Dividends 100% Retained earnings 0% Dividends 3

4 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 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 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??? 4

5 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 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 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= 5

6 Beta Beta or beta coefficient (Β) 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? 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 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 6

7 Income stocks Classifying 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 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 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 7

8 Blue chip stocks Bluest of the blue 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 8