At the start of the semester, we studied rates of return,
standard deviation and geometric mean of stocks and bonds. We
noticed that stocks have far outpaced and outperformed bonds since 1926
[stocks do not and have not outperformed stocks every year, but
they have for most years].
Stocks represent ownership in the firm. Stockholders hold an
equity
interest in the company. Firms raising capital through stock issues are
equity financing.
Stockholders have a say in the operation of the company. Not directly,
but through electing a Board of Directors who in turn hire management to
oversee the business on a daily basis. Directors set policy and help
develop operating procedures. One main Board function is to declare
dividends and stock splits to stockholders.
Common stocks are the "riskiest type" of corporate security as reflected
in the standard deviation of returns. Common
stockholders are called residual claimants - they are entitled to what
remains of a company after all other claims have been paid in the case
of bankruptcy. They are
compensated by being offered the greatest opportunity for reward:
Dividends and Capital Gains = Total Return.
STOCK VALUES
PAR VALUE
Unlike the par value of a bond,
the par value of a stock is strictly a legal concept. Most companies
issue stock with one cent or even zero as the par value. Bonds have a $1000 par
value due to the bond being sold for that amount when issued. Stock,
when issued, takes on a market value, what the investment community is
willing to pay for the prospects of the company. The par value keeps
the attorneys happy when registering the stock with the Securities and
Exchange Commission.
BOOK VALUE
The of a company is simply the assets minus
liabilities. This is an accounting concept. Much analysis is
made using the book value of the firm. But, the price that matters to us
as investors is the market price.
MARKET VALUE
Price on the stock exchange. Set
by supply and demand. This is how much we will pay for ownership in
the firm.
VOTING RIGHTS
As mentioned above,
stockholder, while owners of the firm, do not run the firm on a
daily basis. We exercise our rights of ownership through the
election of members of the Board of Directors. Board members
hire management and set policy. When you own stock, you will
eventually get an invitation to the firm's annual stockholder
meeting. Held annually, this meeting provides an opportunity
for shareholders to meet, listen to reports given by directors and
management of the firm and to cast your vote for Board members.
As an example, a company may have a Board consisting
of nine members, each member has a three-year term to serve on the
board. They meet monthly to hear from management, set or
change policy, etc. Each year, this sample board will have
three directors coming up for re-election. Stockholders will
be asked to vote on these vacating seats on the board. Of the
three members up for re-election, a fourth person may be on the
ballot, running for a seat. A stockholder owning 100 shares of
stock, has 100 votes for each vacant seat on the board, called
Ordinary Voting. If you owned 10,000 shares, you would be able
to cast 10,000 votes for each vacant seat. If you want to take
over a company, buy a BUNCH of shares, vote yourself and friends
onto the board! This is the way companies get 'taken over.'
ORDINARY VOTING
Stockholder may cast one vote per
share owned for each vacancy on the Board of Directors.
CUMULATIVE
VOTING
Stockholder may accumulate all of
his votes and vote for one director. This benefits the small
stockholder. If you own 100 shares, you could 'accumulate' 100
votes for the three vacant seats (a total of 300 votes) and place
those votes on one seat. Stockholders that have a relatively
few shares would benefit by having at least one director of their
choice on the board.
DIVIDENDS and SPLITS
Some companies will pay dividends on their stock.
Dividend theory is a big conversation in finance. When a company
is newly formed, they rarely have the money to pay a cash dividend.
They use what money could be paid out in dividends to help expand the firm and obtain a foothold in
the industry. Firms like Wal-Mart, Home Depot, AOL, Microsoft
pay little or no dividend. Imagine a company like Wal-Mart, that
may have 2 billion shares outstanding, that they pay $1
per share per year as a cash dividend. Wal-Mart management will
argue that the $2 billion could better be spent opening new stores,
refurbishing existing stores or expanding into other areas of retail,
like groceries (Super Wal-Mart).
When a company reaches a stage of maturity and rapid expansion is
no longer likely, they will distribute some of their profits back to
the stockholders. General Motors' days of rapid,
above average growth rates are probably over. A firm like GM
will pay a dividend per share per year that will yield an amount equal
to a savings account at a bank. For example, if GM stock is
trading at $50 per share, an annual cash dividend of about $1 per
share would be expected.
STOCK SPLITS and BUYBACKS
As a firm's stock increases in price, management will
have an idea when they will declare a Stock Split. Put simply,
to an existing stockholder a 2:1 (read, "two-for-one") split is like
getting two five dollar bills for a ten. If you own 100 shares
at $100 per share before the split, you will have 200 shares at $50
per share after the split.
A split keeps the existing stockholder's
position of ownership equal to their position before the split.
A split is done for two reasons:
First, it puts the shares in a more affordable trading range for
the individual investor. At $100 per share, $10,000 would be
required to purchase a round lot of 100 shares. The individual
investor would be encouraged, by a 2:1 (read two-for-one) split and purchase her 100
shares after the split for $5000. i.e. the share price
"splits" by the ratio of the split. If you owned 100 shares at
$100 per share, after the split, you would have 200 shares worth $50
per share. If you were not a shareholder at the time of the
split, you could buy the shares at the post-split price of $50 per
share.
Some companies split their stock 3:1, 4:1, even
5:1.
The more important reason for a split is that it is a signal by management
that the future outlook for the firm looks bright. NO firm would
want to split their stock if they expect the stock price to fall in
the future. During the 1990's, splits were common. Stock
prices were growing at rapid paces and expected to continue to do so,
splits of 2:1, 3:1, 4:1 and even 5:1 were being declared. Dell
Computer's stock price increased 4200% between the years 1996 and
1998. Dell stock was splitting every 6 months. Cisco systems'
stock increased 9000% in value within the first 6 years of the
company's operation, they declared many splits.
During the year 2000 and 2001, splits were uncommon. The
market was falling, the economy was trying to avoid a recession, and
the terrorist attack in New York and Washington prompted news of war.
All together, this made the future of company earnings uncertain. Wall
Street hates uncertainty. When the market fell the week after
the terrorist attack, an unprecedented number of firms were buying
back their own stock on the stock exchanges. This action is
encouraging. Who best knows the direction of the company than
the company management? When management buys back $500 million
of their stock as some companies did, the signal was that a bottom was
near or that the shares were very under priced. The buyback also
takes the dividend liability from the company as they do not pay
dividends on stock that they own.
PREFERRED STOCKS
Preferred stocks hold a position of preference between bond holders
and common stock holders. In case of bankruptcy, bond holders
get paid first, followed by preferred stock holders, followed by
common stock holders. Because of their position, they share
some of the characteristics of both bonds and stocks.
Preferreds look like
a stock because:
Preferreds look like
a bond because:
1. They do represent ownership of the
firm.
2. They are shares of stock.
3. Sometimes they have voting rights like common stock.
4. They do not mature.
1. They have a stated rate of
return stamped on the face of the stock, like a bond.
2.
They do not generally share in
increased earnings of the firm.
3. Par value is different from common shares. Typical
par value is $25, $50, $75, $100 per share.
4.
Dividends must be paid to
preferred holders before common stockholders get paid any dividend.
5. They have several issues of preferred stock.
6. They are rated like bonds.
PARTICIPATING
PREFERRED
Share in common stock dividends.
After preferred holders get their regular dividend, they may share in
the common stockholders dividend (if firm declares a common dividend).
These shares 'participate' in the common stock dividend in addition
to their own dividend.
CUMULATIVE
PREFERRED
Dividends in arrears occurs when
the company cannot afford to pay dividends to preferred holders. They
accumulate the liability "in arrears". When a stock dividend is
again declared, arrearages must first be satisfied before common
stockholders receive their dividend. Cumulative Preferred: cash
dividends accumulate to be paid.
CALL
FEATURES
Preferred
stocks are usually perpetual (no maturity date) but can be called by
the firm, just like a bond.
Blue Chip - Major firms, strong financial statements.
Examples are Exxon, General
Electric.
Growth Stocks - Rapid growth companies, reinvesting dividends.
Wal-Mart, Home Depot, Google
Cyclical - Earnings move with business cycle. Examples are Auto stocks.
Income - Stable earnings, high dividend yields. Utilities.
ADVANTAGES OF COMMON STOCK OWNERSHIP
Growing Values. Capital gains.
Safety. Matches in quality.
Growing Dividends. Quality companies with increasing dividends.
Liquidity. Stocks traded on major exchanges.
RISKS OF COMMON STOCK OWNERSHIP
Total and permanent loss of capital.
Stock market risk. Stock price subject to market movements.
Interest Rate Risk. Interest rate swings cause stock prices to change
rapidly.
