chap 6

Question 1

The Appeal of Common Stocks

Answer 1

Stocks may increase in value over time and generate significant capital gains.

Stocks may provide a periodic income stream through dividends

Question 2

Stock Price Behavior in Perspective

Answer 2

When the market is strong, you can generally expect to benefit from price appreciation.

–When markets falter, so do investor returns.

–Bad market days are the exception, rather than the rule

Question 3

Stock returns:

Answer 3

take into account both price behavior and dividend income

Question 4

Stock Prices to Stock Returns , what general pattern happens?

Answer 4

Big returns (or losses) come from capital gains, rather than from dividends.

Stocks generally earn positive returns over long periods of time:–From 1930 to 2014, the average total return on the S&P 500 was 11.4% per year.

Investing in stocks is clearly not without risk:–In 2008, the S&P 500 lost roughly 36% of its value.–From 2000 through 2009, the U.S. stock market’s average annual return was only 1.1% per year.

Average market performance of stocks give a benchmark against which to assess current stock returns and our own expectations

Question 5

The Advantages of Stock Ownership

Answer 5

Provide opportunity for substantial returns

Stocks typically outperform bonds, and usually by a wide margin.

–Over the last century, stocks earned annual returns roughly double that of the returns provided by high-grade corporate bonds.

Stocks provide protection from inflation because over time their returns exceed the inflation rate.Stocks are easy to buy and sell.

Costs associated with trading stocks are modest.

Price and market information is easy to find in the news and financial media.

Unit cost per share of stock is low enough to encourage ownership

Question 6

The Disadvantages of Stock Ownership

Answer 6

Stocks are subject to various types of risk:

–Business risk
–Financial risk
–Purchasing power risk
–Market risk
–Event risk

Stock returns are highly volatile and very hard to predict, so it is difficult to consistently select top performers.

Stocks generally distribute less current income compared to other investment alternatives.

–Bonds pay more current income and do so with much greater certainty

Question 7

Equity capital:

Answer 7

every share of common stock represents an equity (ownership) position in a company. This is why stocks are sometimes called “equity securities”.

–Common Stock as a Corporate Security

–Buying and Selling Stocks

–Common Stock Values

Question 8

Publicly traded issues:

Answer 8

shares of stock that are readily available to the general public and that are bought and sold in the open market.

Question 9

Public offering:

Answer 9

an offering to sell to the investing public a set number of shares of a firm’s stock at a specified price

Question 10

Rights offering:

Answer 10

Existing stockholders are given the first opportunity to purchase new shares of the company’s stock in proportion to his or her current ownership position.

Question 11

Stock spin-off:

Answer 11

conversion of one of a firm’s subsidiaries or divisions to a stand-alone company by distribution of stock in the new company to existing shareholders

Question 12

Stock split:

Answer 12

when a company increases the number of shares outstanding by exchanging a specified number of new shares of stock for each outstanding share.

Question 13

Treasury stock:

Answer 13

shares of stock that were originally sold by the company and have been repurchased by the company. Share repurchases are often called “buybacks.”

Reduces the number of shares outstanding to the public.

Kept by the corporation and may be used later for mergers, acquisitions, to pay stock dividends or to meet employee stock option plans.

–Companies buyback when they believe their stock is undervalued and a good buy.

–Companies also repurchase shares as an alternative to paying dividends.

–Short-term impact usually positive: stock prices generally go up

Question 14

Classified Common Stock:

Answer 14

common stock issued in different classes, each of which entitles holders to different privileges and benefits

Question 15

Market capitalization:

Answer 15

total number of shares outstanding multiplied by the share price (market value per share)

Question 16

Bid-ask spread

Answer 16

difference between the bid and ask prices for a stock

Question 17

Par Value

Answer 17

arbitrary amount assigned to a stock when it is first issued.

Set very low, representing a minimum value (floor) for the value of the stock.

Mainly an accounting term and not very useful to investors

Question 18

Book Value:

Answer 18

Stockholders’ equity in the firm as reported on the balance sheet.

Accounting term

Difference between the company’s assets and liabilities (less any preferred stock)

Backward-looking estimate of value

Question 19

Market Value

Answer 19

the current price of the stock in the stock market.

Forward-looking, reflecting investors’ expectations about how the company will perform in the future.

Stocks usually trade at market prices that exceed their book values, sometimes to a very great degree.

When a stock’s market value drops below its book value, the firm is usually dealing with some sort of financial distress and doesn’t have good prospects for growth

Question 20

Investment Value:

Answer 20

he amount that investors believe the stock should be trading for, or what they think it is worth.

Probably the most important measure for a stockholder.

Determined by a complex process of evaluating risk and return information to place a value on the stock that represents the maximum price an investor should be willing to pay for the issue.

Question 21

Dividend income

Answer 21

is one of the two basic sources of return to investors. Dividends represent the return of part of the profit of the company to the owners (the stockholders)

more predictable than capital gains, so it is preferred by investors seeking lower risk

Current tax laws put dividends on the same plane as capital gains; both now are taxed at the same rate

Question 22

The Dividend Decision

Answer 22

A firm’s board of directors evaluates the firm’s operating results and financial condition to determine whether dividends should be paid out and in what amount.

Question 23

Earnings Per Share:

Answer 23

the amount of annual earnings available to common stockholders, stated on a per-share basis

Question 24

Date of record:

Answer 24

date on which the investor must be a registered shareholder of the firm (holder of record) to be entitled to a dividend.

Question 25

Payment date (payable date):

Answer 25

actual date on which the company will mail dividend checks to holders of record; generally follows the date of record by a week or two.

Question 26

Ex-dividend date:

Answer 26

dictates whether you were an official shareholder and therefore eligible to receive the declared dividend.

•Stock will sell without the dividend for three business days up to and including the date of record because of time needed to make bookkeeping entries

Question 27

Cash dividend:

Answer 27

dividend paid out in the form of cash

Most common

Tend to increase over time as companies’ earnings grow; Average annual increase 3% to 5%

Question 28

Stock dividend:

Answer 28

dividend paid out in the form of stock

Rarely, dividends may be paid out in other forms such as stock spin-offs or perhaps samples of the company’s products

Question 29

Dividend yield:

Answer 29

a measure of dividends on a relative (percentage) basis rather than on an absolute (dollar) basis

Question 30

Dividend Payout Ratio:

Answer 30

measures the percentage of earnings that a firm pays in dividends

Question 31

Dividend Reinvestment Plan (DRIP):

Answer 31

A corporate-sponsored program where shareholders can have their cash dividends automatically reinvested into additional shares of the company’s stock

Question 32

Blue-Chip Stocks:

Answer 32

stocks issued by large, well-established firms with long track records of earning profits and paying dividends.

Companies are often leaders in their industries

Not all blue-chips are alike:

–Some provide consistently high dividend yields: AT&T, Chevron, McDonald’s, Johnson & Johnson, Pfizer.

–Others are more growth-oriented: Nike, Procter & Gamble, Home Depot, Walgreen’s, Lowe’s Companies, United Parcel Service

Less risky than most stocks; Appeal to investors who want to earn higher returns than bonds typically offer without taking a great deal of risk

Question 33

Income Stocks:

Answer 33

stocks with a long history of regularly paying higher-than-average dividends.

Ideal for investors seeking relatively safe and high level of current income.

Dividends tend to increase regularly over timeSome companies pay high dividends because they offer limited growth potential

Subject to a fair amount of interest rate risk

Examples: Many public utilities such as American Electric Power and Duke Energy, as well as Conagra Foods, General Mills, and Altria Group.

Question 34

Growth Stocks:

Answer 34

stocks issued by companies experiencing rapid growth in revenues and earnings.

Have sustained earnings growth well above general market.

Typically pay little or no dividends.

May include blue chip stocks as well as speculative stocks.

Appeal to investors looking for attractive capital gains, rather than dividends, and willing to bear more risk.

Riskier investment because price may fall if earnings growth cannot be maintained, particularly in a down market.

Examples: Amazon.com, Apple, Google, eBay, Berkshire Hathaway, Starbucks

Question 35

Tech Stocks:

Answer 35

stocks representing the technology sector of the market.

Includes companies that produce computers, semiconductors, data storage devices, and software as well as those that provide Internet services, networking equipment, and wireless communications.

Range from speculative stocks of small companies to stocks of large companies that are growth-oriented, some of which are legitimate blue chips.

Vast majority of these stocks are traded on the Nasdaq

Offer potential for very high returns but also involve considerable risk and volatility.

Examples: Apple, Cisco Systems, Google, Intel, NVIDIA, Marvell Technology, LinkedIn, SanDisk, Electronic Arts

Question 36

Speculative Stocks:

Answer 36

stocks that offer potential for substantial price appreciation, but that lack sustained records of success.

Attractive particularly when the market is bullish.

Offer attractive growth prospects with the chance to “hit it big” in the market.

Highly risky–Companies lack a sustained track record of business and financial success.–Earnings may be uncertain or highly unstable.•Stock price subject to wide swings in price.•Usually pay out little or no dividends.

Examples: Sirius XM Radio, Bona Film Group, Destination Maternity, Global Power Equipment Group, Iridium Communications.

Question 37

Cyclical Stocks:

Answer 37

stocks issued by companies whose earnings are closely linked to the overall economy.

Stock price tends to move up and down with the business cycle.

Best for investors willing to trade in and out of these stocks as the economy changes.
–Tend to do well when the economy is growing, especially in early stages of economic recovery.
–Tend to perform poorly in a weakening economy.

Examples:–Alcoa, Caterpillar, Genuine Parts, Lennar, Brunswick, Timken–Companies that serve markets tied to capital equipment spending by business or to consumer spending for big ticket, durable items like houses and cars.

Question 38

Defensive Stocks:

Answer 38

stocks that tend to hold their value, and even do well, when the economy starts to falter.

Tend to be less susceptible to downswings in the business cycle than the average stock.

Commonly used by aggressive investors looking for a “parking place” during a slow economy.

Include stocks of public utilities, industrial and consumer goods companies that produce or market stapes such as beverages, foods and drugs.

Examples: Walmart, Checkpoint Systems, WD-40, Extendicar

Question 39

Large-cap stocks:

Answer 39

stocks of large companies with market capitalizations over $10 billion–Few in number, but account for over 75% of the total market value of all U.S. equities.–Bigger is not necessarily better: small-cap stocks tend to earn higher returns.–Examples: Walmart, Exxon Mobil, Apple

Question 40

Mid-cap Stocks:

Answer 40

stocks of medium-sized companies with market capitalizations between $2 billion and $10 billion.

–Provide opportunity for greater capital appreciation than large-cap stocks, but less price volatility than small-cap stocks.

–Usually have long-term track records

–Examples: Dick’s Sporting Goods, Hasbro, Wendy’s, and Williams-Sonoma.

–“Baby blues” : a type of mid-cap stock that offers the same characteristics of blue chip stocks, except size.
•Ideal for investors seeking quality long-term growth
•Examples: Logitech, American Eagle Outfitters, Garmin Ltd.

Question 41

Small-cap stocks:

Answer 41

stocks of small companies with market capitalizations less than $2 billion

–Generally have annual revenues of less than $250 million.–Spurts of growth can have dramatic effects on earnings and stock price.

–Usually not widely-traded; liquidity is an issue.

–Potential for high returns, but along with that comes high-risk exposure.

–Examples: Callaway Golf, MannKind, and Shoe Carnival–Special Category: Initial Public Offering (IPO)

Question 42

Investors may use common stocks as a:

Answer 42

storehouse of value
–Safety of investment most important
–Use high-quality blue chip and non-speculative stocks

way to accumulate capital
–Capital gains and/or dividends build up wealth
–Growth stocks and/or income stocks
–Long-term investment horizon

source of income
–Dependable flow of dividends–High-yield, good quality income shares preferred