Investing in Stocks – (Chapter 14)
I. Trivia:
The two most common stock markets, the NYSE and the NASDAQ (see below) compete to have companies list their stock on one of these two exchanges.
You can tell on which exchange a stock is listed by the number of letters in their “symbol”.
NYSE stocks have “symbols” of 1,2, or 3 letters. For instance, Ford’s symbol is “F”.
NASDAQ stocks have “symbols” of 4 letters or more. For instance, Google’s symbol is “GOOG”.
NASDAQ has listings for most of the internet stocks and technology stocks.
NYSE has the listings for most traditional companies (banks, manufacturers, “old economy” stocks).
Because NYSE would like to have Microsoft’s business, they have reserved the letter “M” for Microsoft. There is no company with the symbol “M” because the NYSE is holding it for Microsoft in hopes of one day gaining their listing. Microsoft is currently listed on the NASDAQ with the symbol, “MSFT”.
II. Stocks – What are
they?
Stocks represent an ownership interest in the company.
For instance, Yahoo (YHOO) has 1,300,000,000 shares outstanding (that’s 1.3 billion).
If you own 100,000 shares of Yahoo, then you own:
100,000 / 1,300,000,000 of the company.
Also, since Yahoo stock sells for $26 per share, then the total value of Yahoo (also called the “market capitalization”, or “market cap”) is 1.3 billion * $26,
or roughly $33.8 billion.
To the company: Stocks are part of the Capital Structure. The company can sell more stock to raise money; or it can issue more debt. This would be a Capital Structure decision.
To the individual: Stocks are an investment. The individual buys stocks for the (1) dividend income, and (2) the capital gain or loss (hoping the stock will go up in value).
III. Who Buys Stocks?
Individual investors
Mutual Funds
Pension Plans
College Endowments
Non-profit Endowments
How are stocks
traded?
The company can also sell additional shares to raise money. This is sometimes called a “supplemental offering”. For instance, a rapidly growing company may sell more shares to expand.
C. Prominent Secondary Markets
The two most prominent secondary
markets in the
NYSE – in
Specialists (also called “market makers”) are in charge of certain stocks. The specialist must buy (when no one else is buying) and sell (when no one else is selling) to insure an orderly market. Specialist maintains a bid and ask price.
Bid price: price at which the investor can sell (the specialist will buy).
Ask price: price at which the investor can buy (the specialist will sell).
The difference between the two is called the “spread” or the “bid ask spread”.
NASDAQ – no actual physical location. A web of computers manned by brokers with bid and ask quotations. More efficient because most trades are processed electronically.
IV. Why invest in
stocks?
Investors buy stocks for future benefits –
Dividends
Capital gains (or losses)
If you could estimate the present value of those future dividends and the present value
of the future price of the stock,
then you would know the present value of
the stock.
Further, if the dividend is growing at a constant rate (or not growing), then, finance theorists have produced formulas to find the present value of the stock. Here they are:
V. Valuation Methods
1.Zero Growth Stock - The dividend is not increasing. The dividend is constant.
The value of the stock is: Price = Dividend / Required Return
You should remember this formula. It is the formula for a perpetuity (it is also the formula for a preferred stock).
Example 1: Pacific Electric Company pays a $5 dividend that will remain the same. The required return is 10%. What is the price of the stock?
P = D / r
P = $5/.10 = $50
Example 2: Entergy Electric pays a $6 dividend that will remain the same. The stock is selling for $120. What must be the market’s required return on Entergy stock?
P = D / r
$120 = $6 / r
R = .05 or 5%
2.Constant Growth Stock – The dividend is growing at a constant percent each year.
The value of the stock is:
Price at time zero =
Dividend at time one / (Required return – Growth rate)
Or, written more succinctly,
P0 = D1 / (r – g)
This formula is called the “Dividend Growth Model”.
Notice that the dividend used in the formula is NOT the current dividend, but rather, NEXT YEAR’S dividend.
Example 3:
P0 = D1 / (r – g)
P0 = $4 / (.12 - .10)
P0 = $200
Example 4: Acme Bricks will pay a dividend of $2.50 next year. The dividend will grow at a constant rate. The stock is trading for $40 per share today. The market requires a 15% return on this stock. What must be the growth rate of the dividend?
P0 = D1 / (r – g)
$40 = $2.50 / (.15 – g)
G = .0875 or 8.75%
VI. Features of
Common Stock
A. Voting:
1. Cumulative voting
vs. straight voting
The best way to demonstrate is an example. Suppose a company is electing 5 directors to their Board of Directors. You own 100 shares.
With “cumulative voting”, you can cast 500 votes for 1 person.
With “straight voting”, you must cast 100 votes each for 5 different people.
You can see that with cumulative voting, if you own more than 20% of the stock of the company, you are assured of being able to elect one director. With straight voting, you are not.
Many states require “cumulative voting” so as to provide less ability to “control” the company.
2. Proxy voting
Proxy voting refers to the assigning of your rights to someone else (your “proxy”), who can, in turn, vote your shares on any matter that comes up at the annual meeting.
B. Classes of Stock
Many companies issue different “classes of stock” (such as Class A, Class B). These “classes of stock” may have different voting rights. Classes of stock are usually used by original founders of companies to maintain “control of the company” even after going public.
C. Rights of
Shareholders
In general, shareholders have these rights:
Important: Remember
from an earlier lecture: Dividends are
not an expense to the corporation. Thus,
the income is Double Taxed. Dividends are paid out of corporate after tax
profits. Then, the “dividend income” is
taxed again as income to the shareholder.
D. Features of
Preferred Stock
a. Preferred Stock is something of a hybrid between being a stock or a bond. Indeed, in the case of bankruptcy, here’s how people are paid: First, bondholders. Second, preferred stockholders. Third, Common Stockholders.
1 Similar to a bond:
Preferred stock’s dividend does not increase. (much as a bond’s coupon rate doesn’t increase).
Thus, owners of preferred stock do NOT participate in the growth of the company.
Preferred stockholders generally do not vote. (Common stockholders can vote).
2. Similar to stock:
Dividends are paid out of corporate after tax profits (the company does not get a deduction for the payment of preferred dividends.). Double taxation.
Preferred stockholders are not creditors. They cannot foreclose on the company.
b.Preferred
stock dividends can be either Cumulative or Non-cumulative.
Cumulative: If a dividend has been missed in a previous year (due to financial distress), the company must go back and pay that dividend also.
Non-cumulative: Any dividend not paid (due to financial distress) is lost. The preferred shareholder will not get the dividend.
VII. Building a
Portfolio of Stocks
A. Portfolio: a combination of assets designed to suit the investor’s return/risk profile. The portfolio will hold assets in varying percentages so as to maximize the “expected return” for a given “risk tolerance”.
B. Expected Return:
There are two examples of calculations for Expected Return. For both, you use a “weighted average” to calculate the expected return.
First, when a single investment faces different scenarios.
Example: Suppose Home Depot is expected to return 30% if the economy does well, but only 5% if the economy does badly. According to an economist, there is a 40% chance of the economy doing well, and a 60% chance of the economy doing badly.
The expected return for Home Depot is:
E(R) = (.4*.3) + (.6*.05) = .12 + .03 = .15 = 15%
Notice that the “expected return” is not even one of the “possible” returns. It is a weighted average of the possible returns.
Secondly, when combining multiple investments into a portfolio.
Example: An investor decides to diversify. He puts 20% of his money in small cap stocks, which he expects to return 15%. He puts 40% of his money in large cap stocks, which he expects to return 10%. Finally, he puts 40 of his money into long term govt. bonds which he expects to return 5%. What is the expected return of his entire portfolio?
E(R) = (.2*.15) + (.4*.10) + (.4*.05) = .03 + .04 + .02 = .09 or 9%
Quick question: Why not just put all of his money into small cap stocks? Because, as we learned earlier, they are riskier.
Other General Tips
Know the definition of Record Date and Ex-Dividend Date.
Know these different classifications of stocks:
Blue Chip
Income Stock
Growth Stock
Cyclical Stock
Defensive Stock
Large Cap Stock
Small Cap Stock
Penny Stock
Know these terms and how to calculate them:
Earnings per Share = After-tax income / Number of shares outstanding
Price-earnings (PE) ratio = Price per share / Earnings per share
Dividend Payout Ratio = Dividend per share / Earnings per share
Know these terms:
Market Order
Limit Order
Stop Order (also called Stop Loss Order)