Fundamentals of investing
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12.1 Investing in Common Stock LEARNING OBJECTIVE 12.1 LEARNING OBJECTIVE 12.1 Describe the characteristics and classifications of common stock.
Before you consider investing in common stock, there's a lot you need to know. Many beginning investors make the mistake of jumping in without really understanding what they're buying. If they're lucky, or if the economy happens to be in a growth phase, their investment portfolios might do well. Unfortunately, inexperienced investors have too often lost their life savings by making poorly-thought-out investment decisions. What Is Common Stock? You already know from Chapter 11 that when you buy shares of stock, you're actually becoming a part owner of a business. You wouldn't consider buying into a local business, even if it was owned by your best friend, without checking whether the business is in good financial shape. Is it making a profit? Does the company have the potential for future growth? If you invest in the company, will you make a reasonable return on your investment? Your decision to buy shares of stock isn't really much different, and it deserves the same careful deliberation. To evaluate your stock investment alternatives, you'll first need to understand the terminology used by stock investors and the rights and obligations of corporate stockholders. Each share of common stock represents a proportionate share of ownership in a corporation, equal to the number of shares owned divided by the total number of shares owned by all investors in the firm. A corporation is a type of business organization that exists as a legal entity separate from its owners, the shareholders. The corporate form of organization enables the company to have many owners with limited rights and obligations. In contrast, the owners of companies organized as sole proprietorships and partnerships have more extensive rights (such as the ability to directly participate in the management of the business), but they also have greater responsibility (such as personal liability for the debts of the business). Corporations can be classified as private or public. Shareholders of private corporations do not buy or sell their shares. This chapter focuses on publicly traded companies whose stock can be bought and sold by investors in the securities market.
Why Do Companies Issue Stock? Even multibillion-dollar companies such as McDonald's, Inc., and Facebook, Inc., began as small private companies with only a few owners. Those owners eventually found it necessary to sell shares of stock to the public to acquire the funds they needed to grow their companies. After selling shares to the public, the original owners have a smaller proportional ownership interest in their companies, but they generally expect their return on investment to increase as a result of the expansion. As a company continues to grow larger over time, it may again need funds, which can come from current earnings, borrowed funds, or the sale of additional shares of stock. Most large publicly traded companies have millions, or even billions of shares of stock outstanding, so each individual share represents only a very small ownership interest in the firm.
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What Are the Rights and Obligations of Stock Ownership? Investors who buy a company's stock are hoping to share in the future income and growth of that company. Their investment comes with very few strings attached. Shareholders have limited rights to influence the management of the firm, but they also have limited liability for the firm's losses. This section summarizes shareholders’ rights and obligations.
•Sharing the profits In return for providing equity capital to the firm, a common shareholder expects to share in the profits of the firm, either through dividends or through increases in the stock price. A common shareholder's claim on the firm is said to be a residual claim. That means the shareholder has a right to share in the assets and income of the firm only after higher-priority claims (such as interest payments on bonds) are satisfied. If the firm's revenues are greater than its expenses, the board of directors can decide to distribute a cash dividend to the shareholders, or it can decide to reinvest the funds for future growth. Shareholders benefit in either case. As a shareholder, if you receive dividend income, you have the immediate benefit of cash flow to spend or invest. Alternatively, if the firm reinvests the money instead of distributing it to you, the value of your shares should go up to reflect the firm's new investment in its earning power and the potential for future dividends. If you choose to sell at that point, you'll realize a capital gain—the difference between the price you get for your shares and what you paid for them previously. In some cases, a firm issues a stock dividend in place of a cash dividend. Rather than receiving cash, you get additional shares of the firm's stock in proportion to the number of shares you already hold. While a stock dividend doesn't immediately provide as much benefit as a cash dividend or capital gain, it has the potential to produce benefits in the future. Because all stockholders receive these additional shares, everyone's percentage of ownership remains the same. One of the risks of stock ownership is that firms are not required to pay dividends to shareholders. Even if a firm has issued dividends in the past, it may choose to reduce or eliminate them in the future. Conversely, firms that never issued dividends in the past may decide to begin doing so. This creates some inherent uncertainty, because you don't know in advance just how much current income you'll earn on your investment. You also take the risk that the firm might go bankrupt, in which case you'll be entitled only to a proportionate share of whatever is left over after all the firm's creditors are paid. But in return for bearing these risks, shareholders have the opportunity for unlimited gain. If the firm you've invested in does poorly, you might lose all of your initial investment. But if it does unusually well, you'll share in the bounty. •Voting rights Each common stockholder has the right to vote for members of the board of directors at an annual meeting. The board is responsible for selecting the top-level management of the firm and for making major policy decisions. In general, corporations follow a one-vote-per-share system, so if you own 100 shares of a particular firm's stock, you'll be able to cast 100 votes in the annual election. Of course, your 100 votes won't make a huge difference in the outcome of an election when there are millions of shares outstanding. Often, a few shareholders hold large blocks of stock. Mark Zuckerberg, for example, owns about 12 million Class A and 400 million Class B shares of Facebook, Inc., which gives him 53.3% of the voting rights in the firm. If you own some shares, but can't go to the annual meeting, you're allowed to pass your voting right to someone else through a written agreement called a proxy. Generally, the current management team and opposing candidates will ask for your proxy vote before the election.
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•Limited liability By state law, stockholders of corporations have the important protection of limited liability, which means that the most you can lose when you own a share of stock is the value of the share itself. Without the limited liability right, no one would be willing to buy shares of stock, because doing so would put their personal assets at risk of being taken to pay for corporate debts in the event of company failure. •Preemptive rights When companies sell additional shares of stock, it's a bit like cutting the same pizza into a larger number of smaller slices. If you have only one slice, you'll have less of the total pizza. Similarly, if you have the same number of shares after the new stock is issued as you had before, your ownership interest in the company will be proportionately smaller. In some cases, shareholders are entitled to maintain their proportionate interest in a company as the number of shares outstanding increases with new issues. This is called a preemptive right. For example, suppose you own 100 shares in a company that currently has one million shares outstanding. If the company decides to issue another 250,000 shares, and if you have preemptive rights, you'll be able to buy 25 shares of the new issue before it goes on sale to the public in order to maintain your current percentage ownership •Stock splits Corporations sometimes decide to declare a stock split, which is similar to a stock dividend in that each shareholder gets a number of new shares in proportion to the number of shares already held. The most frequent type of stock split is a two-for-one split, but three-for-one or three- for-two splits are also relatively common. The price of each share usually adjusts so that the total value remains the same. Interactive: How Are Stock Splits Like Pizza Slices? illustrates this with an analogy to slicing up a pizza.
INTERACTIVE See Interactive: How Are Stock Splits Like Pizza Slices? in WileyPLUS.
Investors tend to view a stock split as favorable information about the company's prospects for future growth, so the company's market value often increases a little when a company announces a split. Why is a split good news? The logic is that management likes to keep the company's share price below some maximum value perceived as affordable to the company's investors. Announcement of a split is seen as a signal that management expects the stock price to continue to rise above this maximum value. To the extent that this is news to investors, they'll respond by buying the stock and driving up the price. If it has occurred to you that this stock price reaction might create an opportunity to make a quick profit, you're not alone. A lot of investors buy shares just as the split announcement is made, hoping to sell them after the company's value increases in response to the announcement of the split. However, market efficiency implies that any price change will occur incredibly quickly. In fact, by the time you get your order in to buy the shares after the split, the price might have already gone up.
Advantages of Stock Investing Chapter 11 introduced several of the advantages of investing as an owner rather than as a lender: no management responsibility, higher long-run returns, greater liquidity, less sensitivity to interest, and the ability to diversify a portfolio to reduce company-specific risk. Let's explore these advantages and a
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few others in a bit more detail.
No Management Responsibility Stock investing allows you to participate in the profits of a firm without having to contribute anything except money to the venture. While you might earn as much or more by starting your own business and keeping all the profits for yourself, it would require a lot more effort on your part. Your stock ownership interest also protects you with limited liability—you can never be held personally responsible for losses incurred as a result of poor management.
Higher Long-Run Returns Recall that riskier assets usually earn a higher rate of return. Over long time periods, large-company stocks have averaged a 12 percent return compared with about 6 percent for Treasury bonds. How much would that difference in investment return affect your long-term wealth accumulation? You can use your financial calculator to answer this question. Assume that you plan to put $1,000 in an investment account today. What will it be worth in 20 years if you invest in government bonds, earn 6 percent interest, and reinvest all your interest earnings? To find the answer, solve for the future value of a lump sum. With the financial calculator, you would enter and and solve for This is the amount you'd have in 20 years if you invested in government bonds. Now, what if you invest in stocks instead and earn 12 percent per year? Using the same method, you can determine that your $1,000 investment will be worth $9,646 at the end of 20 years—almost three times as much. (If your $1,000 is held in a taxable account, the after-tax investment returns will be lower for both asset classes.) Even though stocks have yielded better returns than other investments over time, there can be fairly big differences between different stocks and over different time periods. Figure 12.1 shows the stock price history for two familiar companies, Walmart (WMT) and International Business Machines Inc. (IBM). Although both increased in value from 2009 to 2019, WMT showed slow and steady growth, whereas IBM had a lot more ups and downs. That's because IBM is in a riskier industry. Technology companies are more strongly affected by economic conditions than discount department stores, which have steady customers regardless of the state of the economy.
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Figure 12.1Walmart and IBM Monthly Stock Prices, 2009-2019Investors in both IBM and Walmart enjoyed the benefits of a bull stock market between 2009 and 2019. Demonstration Problem 12.1 shows how you can compare the rate of return on different investments. DEMONSTRATION PROBLEM 12.1 Comparing Returns on Different Stocks Problem Suppose you had $1,000 to invest at the beginning of 2009. At that time, Walmart stock was priced at $37 per share and IBM stock at $68 per share. If these stocks grew in value to $95 and $133, respectively, by January 1, 2019, including both capital gains and dividends, would Walmart or IBM have been the better investment?
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Strategy Calculate the rate of return for each stock for the 10 year period to find the growth in value of your $1,000 investment in both stocks. Because the prices are already adjusted for dividends, we can simply look at the change in each price over the period and then annualize it.
Liquidity Another advantage of stocks is that they are fairly liquid investments. As you know, a liquid asset is one that can be converted to cash quickly without loss of value. Bad news, such as a product recall that will cost the firm millions of dollars, can cause a stock's value to decline rapidly, so we wouldn't place this asset in the same category as liquid savings and checking accounts. However, you can usually sell shares of stock quickly, easily, and at relatively low cost. This is an important factor if you need cash in a hurry.
Low Interest-Rate Sensitivity Recall from Chapter 11 that the value of bonds and other debt securities is highly influenced by interest rates, creating interest-rate risk that increases with the term to maturity on the bond. When rates go up, bond prices fall, and vice versa. One of the advantages of stocks in a portfolio is that stock values are less sensitive to interest-rate movements. Even though higher discount rates can reduce the present value of future cash flows from stock investments, there are often offsetting factors. For example, if the reason interest rates are increasing is that the economy is in an expansionary period of the business cycle, the cash flows of the firm will increase as well, so the value of the firm will not necessarily decline.
Diversifiable Risk One of the fundamental principles of investing is that you can lower your risk, as measured by variability of returns, by having a variety of investments in your portfolio. We introduced diversification in Chapter 11 in conjunction with the concept of asset allocation, because holding several different asset classes has a diversifying effect on your portfolio. But diversification can reduce risk within asset classes as well, as long as you select individual investments that aren't too similar. If you hold a portfolio of many different stocks, some of them will do well when others are doing poorly. Holding a number of stocks will therefore allow you to cancel out much of the company-specific variability in returns. What you'll be left with is market risk, the risk that can't be diversified away because it comes from factors common to all stocks. ONLINE CALCULATOR DEMONSTRATION VIDEO See Online Calculator Demonstration Video: Asset Allocation in WileyPLUS.
As you saw above, the stock prices of both IBM and Walmart increased in value between 2009 and 2019, despite being in different sectors and having different sensitivities to economic conditions. If you look closely at the stock price chart in Figure 12.1, though, you can see that the ups and downs of the two companies’ share prices were often opposite each other in a given month. This means that if you had owned shares of both companies in your portfolio, the IBM price declines would have been at least partially offset by Walmart price increases.
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Figure 12.2 compares $1,000 investments in IBM, WMT, and a portfolio split equally between these two stocks over the years 2009-2019. You can see that at first IBM outperformed WMT and the 50/50 portfolio, though it began to lose value in 2013. By late 2014, all three investments had approximately doubled in value. Then IBM's value experienced another decline, while WMT's value increased, a trend that continued through 2019. The 50/50 portfolio ended up somewhere in the middle, earning an annualized 8.6% over the 10-year period. Although investing in the 50/50 portfolio resulted in slightly lower accumulated value than investing in Walmart stock alone, it also smoothed out some of the ups and downs you would have experienced if you had invested in only one of the stocks.
Figure 12.2The Effects of DiversificationInvesting in a 50/50 portfolio of WMT and IBM smoothed out some of the ups and downs associated with investing in only one of the stocks.
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Disadvantages of Stock Investing Although stock investing clearly offers some advantages for long-run investors, it might not be for everyone. Investing in stocks exposes you to substantial risk that you cannot control, other than by selling your shares if you don't like the actions taken by the management of the company. Depending on your personal risk preferences, financial goals, and investment time horizon, you might not be willing or able to bear this level of risk in your portfolio.
Risk An old saying warns, “If you can't take the heat, get out of the kitchen.” Stock investors must be prepared to “take the heat” in the form of ups and downs in stock prices, as illustrated in Figure 12.3, which shows the price history of the S&P 500 Index over a span of 21 years, from 1998 to 2019. This was clearly a very volatile period for the stock market, with terrorist attacks, a global financial crisis, and political uncertainly resulting in two large stock market declines and subsequent recoveries. Investors lost about 40 percent of their wealth between 2000 and 2003, regained it between 2003 and 2007, then lost even more between 2007 and 2008, recovering again through 2014 and beyond. The first decade of the 2000s was not kind to stock investors. In fact, a diversified portfolio from the early peak in 2000 through the end of 2012 would have earned you a whopping 0 percent return for more than a decade of investing. Clearly, this was not what investors expected to happen based on prior historical performance of the stock market. However, investors who were in for the long haul saw their portfolios almost triple in value between 1998 and 2019. This illustrates an important lesson about stock investing—even though stocks may be a good long-term investment, you'll have substantial risk of ups and downs in the short term.
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Figure 12.3S&P 500 Index, 1998-2019The stock market has been on a roller coaster ride since the late 1990s.
No Control We've already seen that, as a stock investor—particularly in a large, publicly held corporation—you have little power to influence the actions of management. And management can do many things that cause your share value to decline. Top managers can make business decisions that increase the company's risk or reduce its competitive advantage. Their financial decisions might dilute your ownership interest if they issue more shares or decrease your residual interest if they take on more debt. In the extreme, they may make self-interested decisions that line their own pockets at your expense. Even if you know what they're doing and object to it, you have little recourse because your limited voting rights make it almost impossible to effect any managerial change. For this reason, it's commonly said that stockholders “vote with their feet.” In other words, if you don't like what management is doing, you can walk away by selling your shares. Unfortunately, by the time you know what's wrong, the value of the stock will probably already reflect the bad news, so you're likely to lose money.
Classification of Common Stock
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Common stock is usually classified according to broad, and sometimes overlapping, categories related to cash flow, risk, and line of business. Although these classifications have no official status, understanding the common lingo used by investment professionals will help you to better communicate with financial advisors, make allocation decisions for your employer-sponsored retirement plan, and comprehend what you read in the financial press. An important cautionary note if you are investing in individual stocks rather than mutual funds: Companies differ widely from one another, so it's always important to analyze the individual companies independently rather than to rely solely on these classifications to make judgments about the suitability of their stock for your portfolio. We look at some of the more common classifications of common stocks in this section.
Income versus Growth Stocks As previously discussed, investors usually expect to receive some combination of current cash flow and price appreciation in return for providing capital to a firm. Stocks are often classified based on whether the company tends to reward its investors primarily with current income or with capital gains. An income stock is one that pays investors a regular dividend rather than concentrating on reinvestment of profits. Because these stocks pay most of their profits in dividends instead of reinvesting for future growth, there is usually less capital appreciation. The relative certainty of a dividend cash flow stream makes these stocks attractive to more conservative stock investors and to those who desire a regular income stream, such as retirees. A growth stock is one that compensates investors primarily through increases in the value of the shares over time. Stocks issued by younger companies that are experiencing high growth in earnings and assets are more likely to be classified as growth stocks. During a high-growth phase, firms tend to reinvest profits to meet capital needs rather than distribute profits as dividends. Obviously, the attraction of growth stocks to investors is the opportunity to share in the future profits of these companies as investments in growth eventually pay off. As you might expect, growth stocks also expose investors to greater uncertainty, because there are no guarantees that today's reinvestment will translate into tomorrow's growth in value. Younger investors who have long investment time horizons are more likely to focus on growth stocks, while investors who want investment income and stability are less inclined to invest in them. Some growth stocks are highly risky—their prices fluctuate widely, and they have very uncertain future prospects. Investors in recent years have flocked to buy Internet stocks, even when the companies were not yet profitable. For every success story, such as Google, Facebook, and Amazon, there are a dozen failures—companies whose anticipated future profits never materialized or were overestimated.
Blue Chip Stocks A blue chip stock is one issued by a large, stable, mature company. The earnings and growth of these multibillion-dollar companies tend to track the overall market. As consistent performers, they're considered less risky than growth stocks; however, they don't offer opportunities for unexpectedly high returns. They are the slow and steady performers, often leaders in their industry, and they commonly pay dividends in addition to offering the opportunity for some growth in value over time. Examples of such companies include Anheuser-Busch, Procter & Gamble, and Coca-Cola.
Cyclical versus Defensive Stocks
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In the earlier example, we saw that IBM's stock price was more sensitive to economic conditions than Walmart's stock price. A cyclical stock exhibits above-average sensitivity to the business cycle—that is, it tends to perform well during strong economic climates and poorly in downturns. Cyclical companies include firms that produce consumer durable goods and luxury items—automobiles, appliances, technology, furniture, and sporting equipment. Purchases of such goods can nearly always be put off when money is tight. Companies connected to the home-building industry (such as Home Depot) and companies that provide services or goods to other businesses (such as transportation and technology firms) are also cyclical, because during recessions, construction and investment projects tend to be put on hold. The opposite of a cyclical stock is a defensive stock, such as Walmart stock, which is less sensitive to market ups and downs. These stocks might still go down in bear markets, but can be expected to lose less than others. As a result, they can help to stabilize your portfolio during market downturns. Stocks that are related to food and beverages (Anheuser-Busch and Coca-Cola) and to health care (Pfizer and CVS) are examples, because they are in industries that provide essential products and services that are in demand regardless of economic conditions. A measure commonly used to estimate the risk of stock investments held in a diversified portfolio is the beta. A stock's beta measures its market risk, as discussed in Chapter 11, or how much it tends to move with the overall market. The risk measured by beta is also sometimes called nondiversifiable risk because it's the risk that remains when you've already diversified your portfolio. Cyclical stocks will usually have higher betas, and defensive stocks will have lower betas. A beta equal to 1 means that the stock has the same degree of volatility as the overall market and is expected to earn a similar long-term rate of return if held in a diversified portfolio. A beta less than 1 means that the stock is less volatile than the market average and investors should expect a proportionally lower return. A beta greater than 1 means that the stock is more volatile than average and should provide a proportionally higher return. Because most stocks tend to go up and down simultaneously with the general market, just in different degrees, most beta values are between 0.5 and 1.5, and it is rare to find a stock with a negative beta.
Industry and Sector Stocks are also categorized by the sector and industry of the issuing companies. Table 12.1 provides sector classifications, along with some examples of representative companies and their industries. In this table, the “sensitive” classification includes companies with average sensitivity to the business cycle. Industries in the financial services sector include banks and insurance companies. Companies selling household and personal products are in the consumer defensive sector because people need to purchase their products even when the economy is in a slump. Beverage companies, such as Coca- Cola, are also considered to be defensive. Note that the table also lists the ticker symbols of the representative companies. These are the abbreviations used to identify the companies on the various securities exchanges. Table12.1Sector Classifications with Industry and Company Examples Sector Industry Representative Company Stock Ticker Symbol Cyclical
Basic materials Building materials Owens Corning OC Consumer cyclical Airlines Delta Airlines, Inc. DAL Financial services Banking Wells Fargo & Company WFC
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Sector Industry Representative Company Stock Ticker Symbol Sensitive
Communication servicesTelecom services Verizon Communications, Inc. VZ Energy Oil and gas—diversified Exxon Mobile Corporation XOM Industrials Diversified industrials 3M Co. MMM Technology Internet content/information Alphabet, Inc. GOOG
Defensive Consumer defensive Household & personal productsProctor & Gamble Co. PG Health care Health-care plans CVS Health Corporation CVS Utilities Utilities—diversified Public Service Enterprise Group, Inc.PEG
Market Capitalization Market capitalization is the total value of a company's shares at a share's current market price. It is calculated according to Equation 12.1:
(12.1) On the basis of capitalization, companies are classified as large-cap, mid-cap, or small-cap. Here, we consider the general parameters for these classifications, but these definitions aren't engraved in stone—investors tend to include companies in these groups based on not only market capitalization but also revenue, growth potential, and past history.
•Large-cap companies have market capitalization of $10 billion or more. These are the largest firms in the country and include all the companies in the Dow Jones Industrial Average and the S&P 500 Index. Historically, large-cap stocks have been viewed as having lower risk than the stocks of small-cap and mid-cap firms. That rule of thumb doesn't really apply to large-cap technology and Internet companies, however, because many of them are still in a high-growth stage, which makes them riskier. The Coca-Cola Company (ticker: KO) traded at around $46 per share in early 2019 and had 4.3 billion shares outstanding, giving it a market cap of nearly $200 billion. In contrast to KO, which has been in existence for a very long time, Facebook, Inc. (ticker: FB) went straight to large-cap status after its first offering of stock to the public in 2012. In mid-2019, the stock traded at $199 per share, and the company had 2.8 billion shares outstanding, for a total market cap of more than $568 billion. •Mid-cap companies have $2 billion to $10 billion in market capitalization—they're still large, but not giants. A few examples of mid-caps in 2019 include The Cheesecake Factory Incorporated (ticker: CAKE), Stitch Fix, Inc. (ticker: SFIX), and Etsy, Inc. (ticker: ETSY). •A small-cap company generally has market capitalization of less than $2 billion. Although that might not seem very small to you, these firms are small relative to many others and generally are young, growing companies. You're less likely to recognize many of these companies by name, but one you might have heard of is BJ's Restaurants, Inc. (ticker: BJRI), which had a market cap of less than $1 billion in 2019. Although rates of return on small-cap stocks have been greater than the returns on other asset classes over time, their prices tend to be more sensitive to market movement,
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and the companies usually don't pay dividends. This means that small-cap investors are subject to a lot more risk. This effect is even more pronounced for the micro-caps—companies with less than $300 million in capitalization.
Reflection Question 1 If you had some money to invest in stocks, what types of companies would you choose? Would it make sense to invest in companies that produce products that you like? Why or why not?
Measures of Common Stock Performance You should select individual stocks for your investment portfolio based on your evaluation of expected returns as well as an assessment of how much risk the investment will add to your portfolio. In addition to looking at historical rates of return on particular investments, investors commonly use earnings per share and the price-to-earnings ratios to help them estimate future rates of return. In this section, we explain how each of these measures is used to evaluate stock investments. In Chapter 11, you learned that the annual rate of return on an investment comes from two components, the current income and the growth in value over the year. For stock investors, the current yield is usually called the dividend yield, because the current income to a stock investor is the annual dividend payment. The two components of a stock's rate of return, dividend yield and capital gains yield, are calculated according to Equation 12.2 and Equation 12.3:
(12.2)
(12.3) As an example, suppose you're considering purchasing a stock with a market price of $50 per share. If the stock pays an annual dividend of $1 per share, you'll earn a dividend yield of 2 percent . Your total annual return on the stock will be the 2 percent dividend yield plus the expected capital gains yield. If, historically, the stock has increased in value an average of 10 percent per year, you might expect the price to rise to $55 by the end of the year. In this case, you'd earn a total rate of return of 12 percent on your stock investment for the year—2 percent in dividend yield and 10 percent in capital gains yield. Normally, the price that you'll use in the denominator of Equation 12.2 or 12.3 will be the price you paid, or expect to pay, for the shares.
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Investors’ expectations about future capital gains and future dividend income will have an impact on the value of stock. Because there are so many factors that enter into this assessment, there's no easy formula to determine the value of a firm or its future returns. However, investors commonly look at financial ratios that have been found to be good indicators of future performance. Perhaps the most closely watched ratio is the company's earnings per share (EPS), which is calculated according to Equation 12.4:
(12.4) Stock investors own a proportionate share of the company, so they have an interest in a proportionate share of the firm's annual after-tax net income, commonly called earnings. The company can use those dollars to pay dividends, or it can reinvest them to grow the firm. Either way, stockholders stand to benefit if earnings go up. When a company reports better than expected earnings, its stock price tends to go up, because investors see that as a good sign for the future. When earnings are lower than expected, the stock price tends to go down. EPS provides a rough measure of profitability and can be compared over time for a particular firm. However, it's not very useful as a decision-making tool, because there isn't a universally accepted “good” or “bad” value (as long as EPS is positive and increasing over time). To see why this is the case, consider two similar companies that had earnings per share equal to $2 last year. You can't conclude that they'd be equally profitable to you as an investor, because it depends on what you'd have to pay to get this level of earnings. If one company's stock is half as expensive as the other's, you'd have to conclude that the lower-priced stock was giving you a better relative level of earnings. Generally, differences in company size, industry, and share price all make it difficult to directly compare companies based on EPS. To account for other company differences, investors typically consider EPS relative to some other variable. For example, you can use the price-to- earnings (P/E) ratio, which measures the relation of share price to earnings per share. We can calculate the P/E ratio using Equation 12.5:
(12.5) The P/E ratio is seen as a measure of potential for future growth in earnings. A high P/E ratio, relative to those of other similar firms, is considered a positive indicator of a firm's potential for future growth. The implication is that investors perceive the firm as being “worth” the extra price. However, a high P/E ratio can also be an indication that a stock is currently overpriced relative to similar stocks that have lower P/E ratios. Although P/E ratios differ over time and across industries, the average for large-cap stocks is usually between 10 and 25, whereas P/E ratios for high- growth stocks can be much higher. For example, the average P/E ratio for companies in the Consumer Discretionary sector in 2019 was 27, and Amazon.com, Inc., had a P/E ratio of 83. In contrast, the average P/E ratio for banks was 13, and the P/E for large bank Wells Fargo & Company was only 10. Interactive: Stock Valuation Measures gives you an opportunity to test your understanding of stock valuation measures.
2/15/2021 Investing in Stocks and Bonds
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INTERACTIVE See Interactive: Stock Valuation Measures in WileyPLUS.
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