Chapter 2 Securities Markets and Transactions 15
Chapter 6
Common Stocks
Outline
Learning Goals
I. What Stocks Have to Offer
A. The Appeal of Common Stocks
B. Putting Stock Price Behavior in Perspective
C. From Stock Prices to Stock Returns
D. A Real Estate Bubble Goes Bust and So Does the Market
E. The Pros and Cons of Stock Ownership
1. The Advantages of Stock Ownership
2. The Disadvantages of Stock Ownership
Concepts in Review
II. Basic Characteristics of Common Stock
A. Common Stock as a Corporate Security
1. Issuing New Shares
2. Stock Spin-Offs
3. Stock Splits
4. Treasury Stock
5. Classified Common Stock
B. Buying and Selling Stocks
1. Reading the Quotes
2. Transaction Costs
C. Common Stock Values
1. Par Value
2. Book Value
3. Market Value
4. Investment Value
Concepts in Review
III. Common Stock Dividends
A. The Dividend Decision
1. Corporate versus Market Factors
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2. Some Important Dates
B. Types of Dividends
1. Cash Dividends
2. Stock Dividends
C. Dividend Reinvestment Plans
Concepts in Review
IV. Types and Uses of Common Stock
A. Types of Stocks
1. Blue-Chip Stocks
2. Income Stocks
3. Growth Stocks
4. Tech Stocks
5. Speculative Stocks
6. Cyclical Stocks
7. Defensive Stocks
8.Market-Cap Stocks
B. Investing in Foreign Stocks
1. Comparative Returns
2. Going Global: Direct Investments
3. Going Global with ADRs
4. Putting Global Returns in Perspective
5. Measuring Global Returns
6. Currency Exchange Rates
C. Alternative Investment Strategies
1. Buy-and-Hold
2. Current Income
3. Quality Long-Term Growth
4. Aggressive Stock Management
5. Speculation and Short-Term Trading
Concepts in Review
Summary
Key Terms
Discussion Questions
Problems
Case Problems
6.1 Sara Decides to Take the Plunge
6.2 Wally Wonders Whether There’s a Place for Dividends
Excel@Investing
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Chapter 2 Securities Markets and Transactions 17
Key Concepts
1. The investment appeal of common stock
2. Historical returns in the stock market
3. Basic issue characteristics of common stock, including the advantages and disadvantages of
ownership
4. Stock quotations and transaction costs
5. Different types of stock offerings and common stock values
6. Transaction costs of buying and selling stocks
7. The importance of dividends to stocks and stock valuation, including how dividend decisions are
made, types of dividends, and dividend policies
8. The kinds of common stocks and their investment merits
9. Investing in foreign stocks, including the impact of currency exchange rates on returns to
U.S. stockholders
10. Uses of common stocks as investments and the strategies that can be employed to meet various
investment goals
Overview
This chapter is one of four that examines common stocks. Common stocks are some of the most
interesting investments, and this chapter provides an essential foundation for the students’ understanding
of equity securities; as such, the instructor should plan to cover them in detail.
1. Several characteristics of common stocks make them important investment options: (1) Common
stocks provide an attractive ownership feature in addition to income potential. (2) Common
stockholders lay claim to all the residual profits of the firm. (The instructor should explain the
meaning of residual profits.) (3) Owners of common stock do not receive all the residual profits as
income but only that part of profits declared as dividends. (4) Because a wide variety of common
stocks may be purchased, the investor may choose from a broad spectrum of risk-return
combinations.
2. Because of widespread misunderstandings, it’s important to put stock returns into perspective.
Students seem to have all sorts of ideas about how stocks perform, so it’s best to address this issue
early on in the discussion. Table 6.1 provides over 8 decades (1930–2014) of annual returns and
holding period returns. Spend some time on historical returns in the stock market, how these can be
used as a benchmark of performance, and the relative importance of dividends and capital gains to
total stock returns. While discussing historical returns, it’s the perfect time to discuss the market
crashes of October 1987, October 1997, and the most recent 2007–2009 collapse, including an
analysis of their causes. Students have appreciated information about stock returns since the book
was published. It is good to bring information about the recent returns on the Dow, S&P, and Nasdaq
indexes to class. Classes equipped with Internet access can easily obtain historical price information
and up-to-the-minute data on individual stocks and the major indexes as well as long-term historical
charts of the major indexes and individual stocks..
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3. The following features of common stocks presented in the text should be discussed in detail in
class: ownership rights, rights offerings, kinds of issues, deferred equity securities, stock splits,
treasury stock, and classified common stock. The costs incurred in making common stock
transactions of different sizes should also be mentioned.
4. The alternative ways of defining the value of common stock are: par value, book value, market
value, and investment value. The meaning and usefulness of each of these value measures to the
investor should be discussed in class. Current copies of stock quotes can be weaved into the
discussion of market value.
5. The dividend decision of a firm is important to the investor and to the firm, so the following
aspects of dividends should be highlighted: how the dividend decision is made, important dates that
affect dividends, tax effects of different types of dividends, and the basic principles behind the
creation of and participation in dividend reinvestment plans. Examples of earnings per share (EPS)
and dividend yield computations should be worked out in class. Current common stock yields can be
compared to bond yields and local savings account yields.
6. In the latter part of the chapter, common stocks are classified into different types, based on
different features. These types are blue chips, income stocks, growth stocks, speculative stocks,
cyclical stocks, defensive stocks, mid-cap, and small-cap stocks. It is worth noting that the categories
can overlap significantly; tech stocks such as Microsoft can be blue-chip stocks; income stocks such
as Merck can be defensive stocks as well, etc. The instructor should indicate the risk-return
characteristics of each type. The instructor should also outline the steps involved in investing in
foreign stocks, with special emphasis on ADRs and the impact of currency exchange rates on total
return.
7. Finally, the alternative strategies that investors can follow when using stocks should be explained,
and the instructor should emphasize that investors choose different types of stocks according to their
investment objectives.
Answers to Concepts in Review
6.1 A common stock is an equity investment that represents ownership in a corporate form of business.
Each share represents a fractional ownership interest in the firm. The key attribute of this investment
6.2 One important investment attribute of common stocks is that they enable investors to participate in
the profits of the firm, and as such, they can offer attractive return opportunities. Another attribute is
the versatility of the security—it can be used to meet just about any type of investment objective. In
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Chapter 2 Securities Markets and Transactions 19
6.3 The stock market has been very volatile over the past 20 years. A bull market was followed by a
bubble that became a bear market, turned bullish, and was followed by a significant decline in share
prices. Although stocks provided average annual returns of around 11% from1930-2014, there was
a significant sell-off in October 1987. While the first half of the 1990s witnessed returns that were
slightly below average, average annual returns during the second half of the decade were 26%. The
2000s have been a real roller coaster ride. The decade began with a bear market that resulted in one of
the few three-year stretches with negative annual returns. Although stocks have generated rates of
6.4 While they don’t provide the “bang” that capital gains do, dividends are an important source of return
to stockholders. Dividend returns are always positive, although the dividend yield has been under
2.5% during the past decade. Capital gains have ranged from 38.32% in 1975 to –27.57% in 1974.
Over the past 50 years, dividends have accounted for a little less than 50% of the average annual total
return from stocks. There’s no question that capital gains provide the really big returns, though they
6.5 The major advantage of common stock ownership is the return it offers. Because stockholders are
entitled to participate in the prosperity of a firm, there is almost no limit to a stock’s capital gains
potential. In addition, many stocks provide regular current income in the form of annual
dividends—and for most income-producing stocks, those dividends tend to grow over time, adding
even more to the stockholder’s return. Common stocks are also highly liquid and easily transferable,
The principal risks to stockholders include: business and financial risk, purchasing power risk, and
of course, market risk. Business risk is related to the kind of business the company is in and deals
with both sales volatility and the amount of variability in the firm’s earnings. Financial risk is
associated with the mix of debt and equity financing. The more debt (financial leverage) the firm
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the market price of a stock. The market itself has an impact on the price performance of a stock—
which, of course, is what beta is all about (i.e., a stock’s beta is a measure of the extent to which the
stock reacts to the market).
6.6 A stock split occurs when a firm announces its intention to increase the number of shares of stock
outstanding by exchanging a specified number of new shares for each outstanding share of stock.
6.7 Stock spin-offs involve conversion of one of a firm’s subsidiaries to a stand-alone company by
distribution of stock in that new company to existing shareholders. For example, eBay recently spun
off Paypal into a separate company, and the pharmaceutical giant Bristol-Myer Squibb had a very
6.8 a. Firms do not “issue” treasury stock; these are simply shares of common stock that have
been issued and subsequently repurchased by the issuing firm. This is generally done because the
firm views the stock as an attractive investment; perhaps the price is unusually low. Most
treasury stock is later reissued by the firm and used for such purposes as mergers and
c. The par value of a stock is its stated or face value, which exists primarily for accounting
d. Book value is an accounting measure of the amount of stockholder’s equity in the firm. Book
value equals the difference between a firm’s assets and its liabilities as recorded on the balance
sheet. Book value indicates the amount of stockholder funds used to finance the firm plus any
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Chapter 2 Securities Markets and Transactions 21
6.9 An odd-lot differential is the additional transactions costs an investor must pay to an odd-lot dealer to
trade in odd lots. These costs can be avoided by trading in round lots, or units of 100 shares.
a. A purchase of 90 shares would be an odd lot transaction.
cost.
6.10 The question on the amount of dividends to be paid is decided by the firm’s board of directors. The
directors evaluate the firm’s operating results and financial conditions to determine whether dividends
should be paid and, if so, in what amount.
During a board of directors meeting, a variety of factors are considered in making the investment
decision. These include:
6.11 The ex-dividend date (which occurs two business days prior to the date of record) determines who is
eligible to receive the declared dividend when the stock is sold. If the stock is sold on or after the
6.12 Cash dividends are simply dividend payments made to the stockholder in cash. This form of dividend
represents something of value. A stock dividend is an issue of new shares expressed and distributed as
a percentage of each shareholder’s existing shares. It really has no value since the market responds to
When a stock dividend is declared by the firm, additional shares of the stock are issued to existing
shareholders. Stock dividends may be used as a substitute for cash dividends, but they have no value
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In a 200% stock dividend, the investor receives additional shares equaling 200% of existing shares
6.13 Firms with dividend reinvestment plans (DRPs) allow shareholders to automatically reinvest their
dividends into additional shares of the firm. DRPs provide investors with a convenient and
6.14 a. Blue chips are common stocks of very high quality that have a long and proven record of
earnings and dividends. They offer respectable dividend yields and modest growth potential.
b. Income stocks are issues that have a long and sustained record of higher than average dividends.
These are ideal for investors who desire high current income with little risk. Unlike other types of
income securities (bonds, for instance), holders of income stocks can expect the amount of
c. Mid-cap stocks are stocks with market capitalization value between $2 billion and $10 billion.
Mid-caps offer investors attractive return opportunities—they have the sizzle of small-cap stocks
without the high price volatility. They also provide characteristics of the big, established stocks.
d. American depositary receipts (ADRs) are negotiable instruments issued by American banks. Each
ADR represents a specific number of shares of stock in a specific foreign company. They are
e. IPOs are initial public offerings of primarily small, relatively new companies. As the name
suggests, these stocks are offered to the public for the first time. IPOs offer a chance to earn
f. Tech stocks are issued by companies in the technology sector. Issuing firms produce everything
from computers to Internet content. They typically are growth stocks or speculative stocks
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Chapter 2 Securities Markets and Transactions 23
6.15 Income stocks generally have limited capital gains potential because they pay out large amounts of
their earnings in dividends; in essence, little of their income is plowed back into the company to
finance growth. Returns from income stocks come mostly from current income rather than capital
6.16 Approximately 40% of the world equity market is in U.S. stocks and this percentage has been slowly
declining for many years. For the most part, the U.S. stock market has been one of the best places to
invest over the past 25 years. However, the United States markets seldom produce the world’s highest
The U.S. investor can either invest directly in foreign markets or indirectly by buying American
depositary receipts (ADRs). All things considered, American investors are probably better off with
6.17 A quality-conscious investor would probably do best with a simple and conservative buy-and-hold
strategy. With this strategy, the investor purchases income, quality, and blue chip stocks and watches
them grow over time. On the other hand, if an investor is willing to tolerate a lot of risk, an
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