3. Investment Planning. 2. Equities Flashcards
Anne was a quiet woman living alone. Her neighbors rarely saw her outside her apartment. She never took a vacation, never bought any furniture, never spent any money on clothes, and never ate out. It wasn’t until her death in 1995 that she received much attention. In her will, Anne revealed that she had a $22 million fortune. She bequeathed most of the money to Yeshiva University in New York.
How did Anne amass such a fortune?
Anne worked as an auditor for the IRS and she had the opportunity to scrutinize the investment habits of the wealthy people she audited. Over time, she thought that what worked for the wealthy could work for her. She invested her retirement money of $5,000 in common stock, in 1953. Initially, she invested in companies she was familiar with, like Universal Studios and Paramount; then she bought stock in soft drink companies like Coca-Cola and PepsiCo, as well as drug companies. In the 42 years leading up to her death, Anne’s holdings increased in value over 4,000-fold, making her a millionaire. While Anne may have not lived like a millionaire, she invested like one.
You are probably thinking that you would also like to be a smart investor like Anne. Keep in mind that investing in stocks is not only associated with higher potential returns, but also with higher exposure to downside risk.
The Equities module, which should take approximately three hours to complete, will give an overview of topics related to stock investments.
Upon completion of this module, you should be able to:
Define common stocks
Define preferred stocks
Discuss warrants and rights, and
Discuss market indices.
Module Overview
The boom and bust cycle of stocks often leads to the exchanging of epic tales of gains and losses made in the stock market. In the late 1990s, many novice investors were lured into the stock market by common stories of large profits made in Internet stocks. However, the lack of understanding of stock investments attributed to many of these novice investors losing their money by the end of 2000. We saw a similar pattern form in the housing market in the next several years leading to the financial crisis of 2008 - 2009. We are likely seeing a similar pattern now as equity markets have appreciated in value over the last ten years with only minor speed bumps presented by unexpected policy changes and a global pandemic.
To ensure that you have an understanding of Equities, the following lessons will be covered in this module:
* Common Stocks
* Preferred Stocks
* Warrants and Rights
* Market Indices
Section 1 – Common Stocks
Common stock represents ownership (equity) in a publicly traded corporation. Holders of common stock exercise control by electing a board of directors and voting on certain corporate matters. Common shareholders are at the bottom of the priority ladder in terms of claims to the company’s earnings and assets. A company must make interest payments on debt instruments and preferred stock dividends before common stock dividends will be paid. In the event of liquidation, common shareholders have rights to the company’s assets only after bondholders, preferred shareholders, and other creditors have been paid in full.
To ensure that you have an understanding of common stocks, the following topics will be covered in this lesson:
* Benefits of Stock Investing
* Stock Value
* Stock Exchanges
* Classifications of Common Stocks
Upon completion of this lesson, you should be able to:
* List the benefits of stock investing,
* Describe various expressions of stock value,
* Describe the stock exchanges, and
* Differentiate classifications of common stocks.
Match the descriptions with the corresponding common shareholder.
Voting
Preemptive
Information
Dividends
* Regulation enforces full disclosure of all material and relevant information
* Maintain the same amount of control when company issues new shares
* Receive a share of the company’s profits
* The right to influence/control the company increases proportionately with the number of shares owned
- Voting - The right to influence/control the company increases proportionately with the number of shares owned
- Preemptive - Maintain the same amount of control when company issues new shares
- Information - Regulation enforces full disclosure of all material and relevant information
- Dividends - Receive a share of the company’s profits
Describe Stock Splits
A company’s management may decide to alter the value of the stock by either a stock split or a reverse stock split. Splits and reverse splits only affect the price per share. A stock split adds shares based on a ratio; therefore the price per share declines. A reverse split would combine shares and therefore raise the price per share.
Example (Stock Split)
If a $100 par value stock is split 2-for-1, the holder of 200 old shares will receive 400 new $50 par value shares, and none of the dollar figures in stockholders’ equity will change. If the shareholder’s total market value for the shares was $50,000, the total market value will remain the same. The only change is that the number of shares he or she owns has doubled.
Stock splits do not change anything for the company in terms of revenue or expenses. However, it can sometimes generate excitement around the stock. A stock split can signal that the firm’s management believes the stock to be undervalued in the market. It can also bring the share price to a more desirable trading range. Either way, these reasons can cause a short-term abnormal increase of activities around the stock.
Practitioner Advice: Many investors are mistakenly led to believe that they are somehow better off following a stock split. This misconception may stem from the fact that companies tend to split their stock if they are confident of future growth. It is not uncommon to see a run up in a stock price following a split, which may be somewhat of a self-fulfilling prophecy.
Example (Stock Split)
If a $100 par value stock is split 2-for-1, the holder of 200 old shares will receive 400 new $50 par value shares, and none of the dollar figures in stockholders’ equity will change. If the shareholder’s total market value for the shares was $50,000, the total market value will remain the same. The only change is that the number of shares he or she owns has doubled.
Stock splits do not change anything for the company in terms of revenue or expenses. However, it can sometimes generate excitement around the stock. A stock split can signal that the firm’s management believes the stock to be undervalued in the market. It can also bring the share price to a more desirable trading range. Either way, these reasons can cause a short-term abnormal increase of activities around the stock.
Practitioner Advice: Many investors are mistakenly led to believe that they are somehow better off following a stock split. This misconception may stem from the fact that companies tend to split their stock if they are confident of future growth. It is not uncommon to see a run up in a stock price following a split, which may be somewhat of a self-fulfilling prophecy.
Section 1 – Common Stocks Summary
Common stock represents ownership in a corporation. Holders of common stock exercise certain rights and privileges. However, these stockholders have rights to a company’s earnings and assets only after bondholders, preferred shareholders, and other debt holders have been paid in full in the event of liquidation.
In this lesson, we have covered the following:
* Common Stocks represent ownership in a corporation. In event of liquidation, common shareholders have rights to a company’s assets only after all other debt holders have been paid in full.
- Benefits of Stock Investing: Owners of common stock have certain rights and privileges, such as the right to vote. Although it carries a greater downside risk, investing in stocks for the long term tends to yield a greater total return than other types of investment vehicles.
- Stock Value may be expressed in terms of its par value, book value or market value.
- Stock Exchanges: Stocks are traded in organized exchanges, either in live, face-to-face auctions in physical locations like the NYSE, or virtually, through electronic markets like the Nasdaq.
- Stock Classifications: Stocks can vary in classifications based on their size, growth of earnings, ability to pay dividends, or trends with or against the market as a whole.
Match the price or value to the correct definition or formula.
Par Value
Book Value
Bid Price
Ask Price
* The price that buyers pay for a stock.
* The price that sellers receive for a stock.
* Retained Earnings + Common Stock + Capital Contributed in Excess of Par
* The value of Common Stocks listed in Shareholder’s Equity
- Par Value - The value of Common Stocks listed in Shareholder’s Equity
- Book Value - Retained Earnings + Common Stock + Capital Contributed in Excess of Par
- Bid Price - The price that sellers receive for a stock.
- Ask Price - The price that buyers pay for a stock.
For any holding period, stocks will outperform all other investment vehicles.
* False
* True
False
* Stocks typically outperform other investments in the long run. However, stocks carry a lot of risk for shorter holding periods. Stock prices can drop below your original purchase and you would have received a better return from a bank CD or something less volatile within the same short-term holding period.
Identify the main characteristics of common stock. (Select all that apply)
* It is a security that represents ownership in a corporation.
* Holders may elect a board of directors and vote on corporate policy.
* Common shareholders have priority rights to a company’s assets.
* First in line to receive company profits.
It is a security that represents ownership in a corporation.
Holders may elect a board of directors and vote on corporate policy.
* Common stock is a security that represents ownership in a corporation. Holders of common stock elect board of directors and vote on corporate policy. They have rights to the company’s assets and earnings only after all preferred shareholders and debt holders have been paid in full.
Choose the correct statement(s). (Select all that apply)
* Cyclical stocks perform well when the economy is booming.
* Growth stocks consistently pay dividends from their earnings.
* Blue chip stocks are traded in the OTC market and are very volatile.
* Blue chip stocks are considered small cap stocks because of their size.
* Defensive stocks may perform better in economic downturns.
Cyclical stocks perform well when the economy is booming.
Defensive stocks may perform better in economic downturns.
* Cyclical stocks’ performance correlates with the economy. Defensive stocks are less sensitive to the movement of the economy. Growth stocks tend to keep earnings as retained earnings rather than paying dividends. Blue chip stocks are from large and well-established companies, therefore are likely to be traded in the NYSE as conservative large cap stocks.
Section 2 - Preferred Stocks
Aside from common stocks, a company can also issue preferred stocks. Preferred stock is a form of equity investment that receives only a stipulated dividend. Owners of preferred stocks have a right to a company’s earnings before common stock shareholders. Payments on preferred stocks are called dividends and do not qualify as a tax-deductible expense for the issuing corporation. Preferred dividends are stated as a percent and are required to be paid to shareholders before common stock shareholders receive any dividends. There are various provisions protecting the preferred stockholders against potentially harmful actions. Many issues of preferred stock are callable at a stated redemption price.
Some firms issue more than one class of preferred stock. In the event of dissolution of the firm, preferred stockholders receive preferential treatment as it relates to assets. Many preferred stocks are traded on major exchanges in a manner similar to common stocks. Trading prices are reported in the financial press in the same format used for common stocks.
To ensure that you have an understanding of preferred stock, the following topics will be covered in this lesson:
* Preferred Stockholder Rights
* Other Preferred Stock Characteristics
* Types of Preferred Stock
Upon completion of this lesson, you should be able to:
* List the rights of a preferred stockholder,
* Identify characteristics of preferred stock, and
* Discuss types of preferred stock.
Section 2 - Preferred Stocks Summary
Types of Preferred Stock
Preferred stock is another type of stock. Like common stock, preferred stock represents partial ownership in a company. The main benefit of owning preferred stock is that preferred shareholders always receive their dividends first before common stockholders. For this reason, preferred stock shareholders tend to be more interested in current income than capital appreciation. Like bonds, issuers will seek ways to alleviate the dividend payment expense if prevailing market financing rates become lower than the dividend expense. They will do this by exercising the call feature or enticing owners to convert to common stock.
In this lesson we have covered the following:
* Preferred Stockholder. Rights are similar to those of common stockholders except that they have preferential rights to a company’s earnings and assets.
* Other Preferred Stock Characteristics include par value, callable, and convertible to common stocks.
* Types of Preferred Stocks: There are different types of preferred stocks. Some preferred stocks have cumulative rights while others do not. Some may be convertible, while others have different dividend rates.
Select the primary reason for an investor to purchase preferred stock.
* Right to vote
* Current income from dividends
* High potential return
* Callable feature
Current income from dividends
* The biggest benefit to investing in preferred stocks is their promise to pay dividends. Only some preferred stocks have the right to vote. Since some preferred stocks are likely to be called or converted, the potential capital appreciation is limited. The call feature is an advantage for the issuer, compensated through higher yield than non-callable shares, but would not be the most attractive feature to a preferred stock.
Match the description to the type of preferred stock.
Cumulative
Non-cumulative
Adjustable
Convertible
* Dividend rate changes
* Does not receive dividends in arrears
* Can exchange shares for common stock
* Receive dividends in arrears
- Cumulative - Receive dividends in arrears
- Non-cumulative - Does not receive dividends in arrears
- Adjustable - Dividend rate changes
- Convertible - Can exchange shares for common stock
Section 3 - Warrants and Rights
A warrant is also called a stock purchase warrant and may be distributed to stockholders in lieu of a stock or cash dividend or sold directly as a new security issue. It is a call option (contract for the option to buy shares at a fixed price) issued by a company with its stock as the underlying security.
A right is similar to a warrant in that it is like a call option issued by the firm whose stock serves as the underlying security. Rights are issued to give existing stockholders their preemptive right to subscribe to a new issue of common stock before the general public is given an opportunity.
To ensure that you have an understanding of warrants and rights, the following topics will be covered in this lesson:
* Warrants
* Rights
Upon completion of this lesson, you should be able to:
* Define warrants,
* Discuss the features of warrants,
* Define rights, and
* Discuss the features of rights.
Section 3 - Warrants and Rights Summary
Investors who purchase or own warrants are hoping that the price of the underlying stock will rise above the stated exercise price. They can sell the warrant for profit, assuming that there are buyers, because its value will rise with the underlying stock. Or they can exercise the warrant, purchase the stock at the lower exercise price and sell it in the market at the higher market value.
When companies are about to issue new shares of stock, they give existing shareholders a chance to maintain their proportion of ownership by offering them a chance to purchase new shares by issuing rights. Investors who want to maintain a certain percentage of ownership will exercise the right, or they may sell the right into the secondary market and let someone else purchase the new shares.
In this lesson, we have covered the following:
* Warrants: May be distributed to stockholders in lieu of a stock or cash dividend or sold directly as a new security issue. They give holders the option to purchase stocks at a specified exercise price.
* Rights: Are issued to give existing stockholders a right to subscribe to a new issue of common stock before the general public is given an opportunity. Each share of stock receives one right.
