Equity Fundamentals Econ 173A Summer 2013

1. Equity FundamentalsEcon 173ASummer 2013

2. Money Market Certificates of Deposit U.S. Treasury Bills Money Market Funds Bond Market Treasury Notes and Bonds Municipal Bonds Corporate Bonds Equity Market Common Stock Preferred Stock Derivative Market Options Futures Financial Instruments

3. Prices and Coupon Rates Risk and expected Return Return Risk

4. Equity Basics • Equity Securities: Evidence of an ownership share in a corporation. Fixed Income Securities vs. Equity Securities Fixed Claim Residual Claim High Priority on cash flows Lowest Priority on cash flows Tax Deductible Not Tax Deductible Fixed Maturity Infinite life No Management Control Management Control Bonds Hybrids (Combinations Common Stock of debt and equity)

5. The Appeal of Common Stocks • Residual Owners: stockholders of a firm are the owners, who are entitled to dividend income and a prorated share of the firm’s earnings only after all the firm’s other obligations have been met • Stocks allow investors to tailor investments to meet individual needs and preferences. • Stocks may provide a steady stream of current income through dividends. • Stocks may increase in value over time through capital gains.

6. From Stock Prices to Stock Returns • Stock Returns: take into account both price changes and dividend income • Over past 50 years, stock returns have ranged from +48.28% in 1954 to -21.45% in 1974 • Stock returns over past 50 years have averaged around 11% • From 1998 through mid-’03, DJIA averaged 1.7%

8. DJIA annual Returns since 2003 Average 5.95% Standard Deviation 16.02%

9. Current Income from Stocks versus Bonds

10. Equity Basics • Equity can either be: • Privately held • Publicly held • There are two types of equity: • common stock • preferred stock

11. Advantages of Stock Ownership • Higher returns than bonds. • Over past 50 years, stocks averaged 11% and high-grade corporate bonds averaged 6%. • Inflation hedge – stock returns typically exceed the rate of inflation. • Easy to buy and sell stocks. • Price and market information is easy to find in financial media. • Unit cost per share of stock is lower than for bonds.

12. Disadvantages of Stock Ownership • Stocks are subject to many different kinds of risk: • Business risk • Financial risk • Market risk • Event risk • Difficult to predict which stocks will go up in value due to wide swings in profits and general stock market performance • Low current income compared to other investment alternatives

13. Common Stock Values • Par Value: the stated, or face, value of a stock • Mainly an accounting term and not very useful to investors • Book Value: the amount of stockholders’ equity • The difference between the company’s assets minus the company’s liabilities and preferred stock • Market Value: the current price of the stock in the stock market

14. Common Stock Values • Market Capitalization: the overall current value of the company in the stock market • Total number of shares outstanding multiplied by the market value per share • Investment Value: the amount that investors believe the stock should be trading for, or what they think it’s worth • Probably the most important measure for a stockholder

15. Shareholder Rights • If a dividend is declared, the dividend each shareholder receives must be in proportion to the shareholder’s ownership interest in the firm. • the right to vote – one vote for each share held • Attend annual meetings and vote in person. • Sending in a proxy statement. • the right to maintain ownership percentage • rights offering. • Preemptive right is sometimes waived in the corporate charter.

16. Stock Splits • A stock split is an accounting decision tochange the number of shares outstanding without selling any more to the public – a neutral occurrence. • With a forward split, also called a regular wayor direct split, shareholders end up with a greater number of shares than before the split. • With a reverse split, the number of existing shares is reduced.

17. Stock Splits The value of a firm cannot be increased by splitting, or combining, its shares. • Examples AT&T (Nov 2002) 1-for-5 split Netflix (Feb 2004) 2-for-1 split

18. Stock Splits • The primary motivation for a stock split isusually a desire to reduce the share price – optimal trading range. • People prefer to buy round lots. • Large reverse splits often reduce the number of shareholders. • The difference between a stock split and a stock dividend is purely an accounting phenomenon. • With a stock split, the par value of the stock changes by the split factor. • With a stock dividend, the par value is not affected.

19.  new 52-week high  new 52-week low cc PE ratio > 100 dd loss in the most recent four quarters g dividends and earnings in Canadian dollars n newly issued in the past 52 weeks pf preferred stocks s stock split/stock dividend > 10% in past 52 weeks wt warrant x ex-dividend The Financial Page Listing

20. Dividends • Dividend income is one of the two basic sources of return to investors. • Dividend income is more predictable than capital gains, so preferred by investors seeking lower risk. • Dividends are taxed at maximum 15% tax rate, same as capital gains. • Dividends tend to increase over time as companies’ earnings grow; increases average 3-5% per year. • Dividends represent the return of part of the profit of the company to the owners, the stockholders.

21. Dividends and Earnings Per Share • Earnings Per Share: the amount of annual earnings available to common stockholders, stated on a per-share basis • Earnings are important to stock price • Earnings help determine dividend payouts

22. Dividends and Dividend Yield • Dividend Yield: a measure to relate dividends to share price on a percentage basis • Indicates the rate of current income earned on the investment dollar • Convenient method to compare income return to other investment alternatives

23. Dividends and Dividend Payout Ratio • Dividend Payout Ratio: the portion of earnings per share (EPS) that a firm pays out as dividends • Companies are not required to pay dividends • Some companies have high EPS, but reinvest all money back into company

24. Dividends: Types of Dividends • cash dividends • paid in cash • some firms have an optional dividend reinvestment plan (DRIP). • stock dividends • paid in additional shares of stock

25. Dividends: Special Distributions • spin-offs • a parent firm divests itself of a subsidiary, and all the shares in the subsidiary are distributed proportionally to the shareholders in the parent • split-offs • a parent firm divests itself of a subsidiary, and the shareholders must make a choice between keeping shares in the parent, or exchanging them for shares in the separated subsidiary • tracking stock • These shares track the performance of a subsidiary, and in many respects, are just a new class of shares.

26. The Dividend Payment Procedure • A dividend paid in accordance with apreviously announced corporate policy is a regular dividend. • Companies try to establish a regular pattern and usually pay dividends quarterly. • A firm that wishes to make an extra • distribution of cash to the shareholders does • so through a special dividend, also called an extra or extraordinary dividend.

27. The Chronology of Events 1. date of declaration Ex-dividend date (2 business days prior to the date of record) 2. date of record 3. date of payment The Dividend Payment Procedure

28. Why Dividends Do Not Matter • Paying dividends reduces the amount in a firm’s checking account, and hence the shares are worth less. • On the ex-dividend date, share prices tend to fall by about the amount of the dividend. • Dividends can provide insights to the company’s thoughts about the future.

29. Categories of Stock • blue chip • Income stocks are those that historically have a higher-than-average payout ratio. • Cyclical stock is one whose fortune is directly tied to the state of the overall national economy. • Defensive stock is largely immune to changes in the economy.

30. Categories of Stock • Growth stocks reinvest most of their earnings rather than paying them out as dividends and may be good candidates for above-average returns. • Speculative stock has a high probability of a loss and a small probability of a large profit. • Penny stocks refer to unusually risky, especially inexpensive shares. • Category overlap: The stock categories are not mutually exclusive.

31. Types of Stock • Blue Chip Stocks: financially strong, high-quality stocks with long and stable records of earnings and dividends • Companies are leaders in their industries • Relatively lower risk due to financial stability of company • Popular with investing public looking for steady growth potential, perhaps dividend income • Provide shelter during unsettled markets • Examples: Wal-Mart, Proctor & Gamble, Microsoft, United Parcel Service, Pfizer and 3M Company

32. Types of Stock (cont’d) • Income Stocks: stocks with long and sustained records of paying higher-than average dividends • Good for investors looking for relatively safe and high level of current income • Dividends tend to increase over time (unlike interest payments on bonds) • Some companies pay high dividends because they offer limited growth potential • More subject to interest rate risk • Examples: Verizon, Conagra Foods, Pitney Bowes, R.R. Donnelley, Bank of America and AmSouth Bancorp

33. Types of Stock (cont’d) • Income Stocks: stocks with long and sustained records of paying higher-than average dividends • Dividends tend to increase over time (unlike interest payments on bonds) • Some companies pay high dividends because they offer limited growth potential • Examples: Verizon, Conagra Foods, Pitney Bowes, Wrigley

34. Types of Stock (cont’d) • Growth Stocks: stocks that experience high rates of growth in operations and earnings • High rate of growth in earnings > market • Higher price appreciation (due to increasing earnings) • Riskier investment because price will fall if earnings growth cannot be maintained • Typically pay little or no dividends • Examples: Lowe’s, Harley-Davidson, Starbucks, Apple

35. Types of Stock (cont’d) • Cyclical Stocks: stocks whose earnings and overall market performance are closely linked to the general state of the economy • Stock price tends to move with the business cycle • Tend to do well when economy is growing, poorly in slowing economy • Best for investors willing to move in and out of market as economy changes • Examples: Caterpillar, Maytag Corp.

36. Types of Stock (cont’d) • Defensive Stocks: stocks that tend to hold their value, and even do well, when the economy starts to falter • Stock price remains stable or increases when general economy is slowing • Products are staples that people use in good times and bad times, such as electricity, beverages, foods and drugs • Best for aggressive investors looking for “parking place” during slow economy • Examples: Proctor & Gamble, WD-40, Walmart

37. Market Capitalization • Small-Cap Stocks: under $1 billion • Mid-Cap Stocks: $1 billion to $4 or $5 billion • Large-Cap Stocks: more than $4 or $5 billion

38. Types of Stock • Small-Cap Stocks: small companies with market capitalizations less than $1 billion • Provide opportunity for above-average returns (or losses) • Short financial track record • Erratic earnings • Not widely-traded; liquidity is issue

39. Types of Stock (cont’d) • Mid-Cap Stocks: medium-sized companies with market capitalizations between $1 billion and $4 or $5 billion • Provide opportunity for greater capital appreciation than Large-Cap stocks, but less price volatility than Small-Cap stocks • Long-term track records for profits and stock valuation • “Baby Blues” offer same characteristics of Blue Chip stocks except size • Examples: Wendy’s, Barnes & Noble, Petsmart, Cheesecake Factory

40. Types of Stock (cont’d) • Large-Cap Stocks: large companies with market capitalizations over $4 or $5 billion • Number of companies is smaller, but account for 80% to 90% of the total market value of all U.S. equities • Bigger is not necessarily better • Tend to lag behind small-cap and mid-cap stocks, but typically have less volatility • Examples: AT&T, General Motors, Microsoft

41. Investing in Foreign Stocks • Globalization of financial markets is growing • U.S. equity market is less than 50% of world equity markets • Six countries make up 80% of world equity market • U.S. market remains largest and one of best performing equity markets • Much of performance of non-U.S. markets is due to changes in currency exchange rates

42. Stock Investment Strategies • Buy-and-Hold • Investors buy high-quality stocks and hold them for extended time periods • Goal may be current income and/or capital gains • Investors often add to existing stocks over time • Very conservative approach; value-oriented

43. Stock Investment Strategies (cont’d) • Current Income • Investors buy stocks that have high dividend yields • Safety of principal and stability of income are primary goals • May be preferable to bonds because dividends levels tend to increase over time • Often used to provide to supplement other income, such as in retirement

44. Stock Investment Strategies (cont’d) • Quality Long-Term Growth • Investors buy high-quality growth stocks, mid-cap stocks and tech stocks • Capital gains are primary goal • Higher level of risk due to emphasis on capital gains • Significant trading of stocks may occur over time • Diversification is used to spread risk • “Total Return Approach” is version that emphasizes both capital gains and high income

45. Stock Investment Strategies (cont’d) • Aggressive Stock Management • Investors buy high-quality growth stocks, blue chip stocks, mid-cap stocks, tech stocks and cyclical stocks • Capital gains are primary goal • High level of risk due to emphasis on capital gains • Investors aggressively trade in and out of stocks, often holding for short periods • Timing the market is key element • Time consuming to manage

46. Stock Investment Strategies (cont’d) • Speculation and Short-Term Trading • Also called “day trading” • Investors buy speculative stocks, small-cap stocks and tech stocks • Capital gains are primary goal • Highest level of risk due to emphasis on capital gains in short time period • Investors aggressively trade in and out of stocks, often holding for extremely short periods • Looking for “big score” on unknown stock • Time consuming & high trading costs

47. What is Security Analysis? • “The process of gathering and organizing information and then using it to determine the intrinsic value of a share of common stock.”

48. What is Intrinsic Value? • Intrinsic Value • The underlying or inherent value of a stock, as determined through fundamental analysis • A prudent investor will only buy a stock if its market price does not exceed what the investor thinks the stock is worth. • Intrinsic value depends upon several factors: • Estimates of future cash flows • Discount rate • Amount of risk

49. “Top Down” Approach to Traditional Security Analysis • Step 1: Economic Analysis • State of overall economy • Step 2: Industry Analysis • Outlook for specific industry • Level of competition in industry • Step 3: Fundamental Analysis • Financial condition of specific company • Historical behavior of specific company’s stock

50. Efficient Market Hypothesis • Efficient Market: the concept that the market is so efficient in processing new information that securities trade very close to or at their correct values at all times • Efficient market advocates believe: • Securities are rarely substantially mispriced in the marketplace • No security analysis is capable of finding mispriced securities more frequently than using random chance