Stocks Economics 71a: Spring 2007 Mayo, chapter 10 Lecture notes 4.1

Goals  Stock basics  Historical stock performance

Common Stock  Ownership of piece of a firm  Key parts Voting rights (control) Dividends Right to assets Limited liability

1. Voting and Control  Voting rights In proportion to share holdings Annual meetings Proxy  Firm control Shareholders elect Board of Directors Oversee management Sometimes difficult to remove

Voting Methods  Traditional Everyone votes on each candidate Like regular election  Cumulative One vote per board position  5 members - get 5 votes per share Can cast all votes for one candidate Increases power of minority voting blocks  Can group all votes for one candidate

2. Dividends  Payments to shareholders from firm Usually cash  Usually paid quarterly  Firm sets amounts  Dividends paid after all other obligations are met  Amount can be zero

Dividend Timing  Declaration date (June 3rd)  Ex-dividend date (June 16)  Date of record (June 18)  Payment date (June 30)  Key date: Ex-dividend date Purchase before: get dividend Purchase after: no dividend

Dividend Decisions  Profits of the firm (earnings) Shareholders (dividends) Retained earnings (investment)  Payout ratio = (dividends)/earnings  Dividend yield = (dividends per share)/(price per share)

Does Dividend Policy Matter?  Example: Assets - Liabilities = 100 = Shareholder equity Shares = 100, price per share = 100/100 = 1 Earnings = Pay out earnings as dividends 10/100 = 0.1 per share 2. Hold earnings as cash  Value of the firm goes from 100 to 110 (A-L)  Price per share goes to 110/100 = 1.10  Shareholders gain 0.1 per share

Does Dividend Policy Matter?  In theory, No  In real life, Yes Worry about firm investing funds wisely Worry about firm running off with funds Stock may not be priced correctly

Dividend Reinvestment  Firm allows you to buy stock with dividends  No fees or commissions  Sometimes below market prices

What is a Stock Return?  Stock held from time t to t+1  Pays dividend during this time of d(t+1)  Why is this sensible? Increase of 1 dollar after investment t to t+1

Two Parts to a Stock Return = (capital gain) + (dividend yield)

Numerical Example  Price(last year) = 100 (per share)  Price(today) = 110  Dividend = 3 (per share)

3. Rights to Assets  Shareholders have rights to residual assets in a bankruptcy case  Value distributed after other obligations met Bills Tax payments Bond holders  Often this can be zero

4. Limited Liability  Liabilities of shareholders are limited  Not responsible for amounts firm owes  Or lawsuits against the firm  What does this mean? If you buy a stock for $10, the most you can lose is $10

Preferred Stock (Debt like)  Fixed, promised dividend Similar to interest payments on debt Cumulative basis: missed dividends must be paid  No voting rights (usually)  Call option Firm can buy back

Bankruptcy Priorities  Bills owed and tax payments  Debt holders  Preferred stock holders  Common stock holders

Issuing and Increasing Shares  Initial Public Offering (IPO) at start  New issues (issue more shares) “Dilution” Rights offering Stock options  Stock spin-offs Spin off subsidiaries  Stock splits 2 for 1 split  Stock dividends

Stock Splits  Example: 2-1 split Number of shares increases by 2 Price falls by 1/2 Dividend reduced by 1/2  No real impact  Why? Lower price, more investors  Reverse split: 1-2 split Increase price, why??

Reducing Shares  Buy back shares (share repurchase) Treasury stock Reverse dilution

Stock Dividends  Pay dividends with shares of stock  Similar to stock split  No change for investors More shares Price goes down

Tax Treatments  Firm Interest payments on debt are tax deductible Dividend payments are not Example  (Profits – debt interest payments)  Pay taxes on this amount This gives a tax advantage to the firm for using debt financing

Tax Treatments  Individual Investors Capital gains (lower rates) Dividends (some at lower rates)  2003 tax law change  Before 2003 dividends taxed at higher rates

Goals  Stock basics  Historical stock performance

Goals  Stock basics  Historical stock performance

Real Portfolio Values (Inflation Adjusted, dividends reinvested)

Total Portfolios (log scale)

Dividend Comparison

Real Portfolio Values (Inflation Adjusted)

Long Term Annual Returns (1/28-6/2005) Dividends Reinvested Raw ReturnsInflation Adjusted Stocks12.4%9.2% Corp Bonds6.3%3.2% Gov’t Bonds5.8%2.8% TBills3.8%0.7%

Goals  Stock basics  Historical stock performance