Part Three
Investing in Common Stocks
Part Three Includes
Chapter 6 Common Stocks
Chapter 7 Analyzing Common Stocks
Chapter 8 Stock Valuation
Chapter 9 Market Efficiency, Behavioral Finance, and Technical Analysis
Chapter 6
Common Stocks
◼ Outline
Learning Goals
I. What Stocks Have to Offer
A. The Appeal of Common Stocks
B. Putting Stock Price Behavior into 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
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
Chapter 6 Common Stocks 103
III. Common Stock Dividends
A. The Dividend Decision
1. Corporate Versus Market Factors
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. Mid-Cap Stocks
9. Small-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
104 Gitman/Joehnk/Smart • Fundamentals of Investing, Eleventh Edition
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 with Spreadsheets
◼ 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.
108 Gitman/Joehnk/Smart • Fundamentals of Investing, Eleventh Edition
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
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.
Most stock splits are executed with a view to lowering the price of the stock and enhancing its trading
appeal. If the stock split is not accompanied by an increase in the level of dividends, stock prices will
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, PepsiCo spun off its
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
dividends that attract income-seeking investors.
(c) The par value of a stock is its stated or face value and exists primarily for accounting purposes.
Many stocks are issued with no par value. It is a relatively useless number. The liquidation value
Chapter 6 Common Stocks 109
(d) Book value is an accounting measure of the amount of stockholder’s equity in the firm. Book
value indicates the amount of stockholder funds used to finance the firm. Investment value,
9. An odd-lot differential is the additional transactions costs an investor must pay to an odd-lot dealer to
trade in odd lots. The differential can be as high as 10 to 25 cents per share over and above normal
10. The question on the amount of dividends to be paid is decided by the firm’s board of directors. The
During a board of directors meeting, a variety of factors are considered in making the investment
decision. These include:
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
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
110 Gitman/Joehnk/Smart • Fundamentals of Investing, Eleventh Edition
When a stock dividend is declared by the firm, additional shares of the stock are issued to existing
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
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
(c) Mid-cap stocks are stocks with capitalization value between $1 billion and $4–$5 billion.
Mid-caps offer investors attractive return opportunities—they have the sizzle of small-cap stocks
(d) American depository 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
