Chapter 2- The stock exchange Flashcards
Common stock
- entitles common stockholders to voting rights
- common stockholders may benefit from dividends but issuance of dividends to common stockholders is not guaranteed
- dividends received (if declared by board of directors) varies in amount
- common stockholders have the least priority in distribution or payment during a liquidation
- price of common stocks is mainly determined by its supply and demand in the market
- relatively riskier than preferred stocks
Preferred stock
- preferred stockholders do not have voting rights
- preferred stockholders have priority over common stockholders in a company’s residual assets and earnings
- preferred stockholders have greater share in the company’s assets and earnings; they have higher dividend yield
- dividends are fixed and paid at regular periods
- the par value of a preferred stock is inversely affected by market interest rates
- less risky than common stocks
Dividends
- one of the two basic sources of return to investors
- represent the return of part of the profit of the company to the owners, the shareholders
- more predictable than capital gains, so preferred by investors seeking lower risk
- dividends tend to increase over time as companies earnings grow
- dividends are taxed 30% in Belgium
Dividend yield
- a measure to relate dividends to share price on a percentage basis
- indicated the rate of current income earned on the investment
- convenient method to compare income return to other investment alternatives
Formula:
actual dividends received per share/current market price of the stock
Voting rights
The owners are permitted to vote on key matters concerning the company:
- election of the board of directors
- authorization to issue new shares
Management typically received the majority of the votes and can elect its own candidates as directors
Transaction costs:
exchange tax + brokerage wage
Relationship between risk and return
The smaller the risk, the lower the return
The higher the risk, the higher the return
Rate of return
The net gain or loss of an investment over a specified time period, expressed as a percentage of the investments initial cost
Measuring performance of investment
- profit can be measured in absolute terms (currency)
- or we can use rate of return and measure profit in relative terms (as a %)
Primary and secondary market
A firm issuing stock for the first time engages in an IPO (Initial public offering)
A secondary stock offering
- a new stock offering by a firm whose stock is already publicly traded
- undertaken to raise more equity to expand operations
- usually facilitated by an investment bank
Existing shareholders of the stock have the right to purchase newly issued stock (rights offering)
Shareholder dilution
A business has 10 shareholders, and each shareholder owns a share (10%). If each investor receives voting rights for the company based on share ownership, every shareholder has 10% control.
Suppose that the company issues 10 new shares and that one single investor buys them all:
- there are now 20 shares outstanding and the new investor owns 50% of the company
- meanwhile, each original investor now owns just 5% of the company (1 share out of the 20), because their ownership has been diluted by the new shares.
Rights offering
An offering of a new issue of stock to existing shareholders, who may purchase new shares in proportion to their current ownership.
What to do with these rights? (from rights offering)
- Exercise the rights- accept the invitation to buy more shares at the price offered.
- Sell the rights on the market in most cases you can sell your rights on the market at the price they are trading for at the time of the sale.
- Ignore the rights offer/ let the rights lapse- you will essentially be in the exact same position as you were before the rights offer. You may however experience the lowering in the value of shares = shareholder dilution.
Stock split
When a company increases the number of shares outstanding by exchanging a specified number of new shares of stock for each outstanding share.
- usually done to lower the stock price to make it more attractive to investors
- stockholders end up with more shares of stock that sells for a lower price
- investors with 200 shares in a 2 for 1 stock split would have 400 shares after the stock split
- if the stock price was $100 before the split, the price would be near $50 after the split
–> also reverse split (the opposite)
Buybacks
Shares that were originally sold by the company and have been repurchased by the company
- reduce the number of shares outstanding to the public–> EPS (earnings per share) increases
- companies buy back when they believe stock is undervalued and a good buy- creation of shareholder value
- companies protect themselves from hostile takeover
- may be used for mergers, acquisitions or employee stock option plans
What is a bull/bear market?
Routine decline: a drop of 5% or more in one of the major market indexes
Correction: a drop of more than 10% or more in one of the major market indexes
Bear market: a drop of 20% or more in one of the major market indexes
> < bull market
Types of stocks
Value and growth stocks
Value stocks- characteristics
- slower earnings and growth rates
- higher dividend yields
- mature businesses with steady cash flows
Value stocks- metrics
- lower price-to-earnings ratio (P/E)
- lower price-to-book ratio (P/B)
- lower debt-to-equity ratio (D/E)
- higher free cash flow (FCF)
Value stocks- common examples
- Johnson & Johnson
- Sheng Siong Group Ltd
- Procter & Gamble
- Citigroup Inc
Growth stocks- characteristics
- faster earnings and growth rates
- little to no dividends yields
- tend to be “disruptive” business models
