Chapter 14

Learning Objectives (part 1 of 3) Explain what common stock represents Describe the role of a Board of Directors Discuss the voting process at an annual meeting Explain why the payment of dividends is not crucial to an investor

Learning Objectives (part 2 of 3) Indicate why forward and reverse stock splits and stock dividends are usually meaningless Value a share of stock using a simple dividend growth model Compute the degree of diversification of a portfolio

Learning Objectives (part 3 of 3) Understand what is meant by the different types of stocks Describe the concept of classes of stock Define the differences between preferred and common stock Describe rights, warrants, and put and call options

Features of Common Stock A portion of ownership of the firm (usually an incredibly small percentage) Privilege to vote at shareholder meetings Entitlement to any dividends paid Stocks have par value (like bonds), but this is a meaningless number

Board of Directors Elected by shareholders to represent the shareholder’s interests Elects its own Chairman of the Board A position is called a seat Two types of directors Inside director: also employed by comp. Outside director: not an employee

Voting at annual meetings Most shareholders sign proxies Most common voting system is majority Ownership or control of 50% + 1 of the voting shares allows complete control of the Board Alternative system is cumulative voting Multiply number of seats to be elected by shares held and can cast all for one person

Payment of dividends (1 of 3) Must be declared by Board of Directors each time Should not be declared if company can keep the profits and reinvest them at a rate of return higher than that required by the shareholders Successful reinvestment leads to a higher stock price later

Payment of dividends (2 of 3) Key dates Declaration date Ex-dividend date Record date Payment date

Payment of dividends (3 of 3) Types of dividends Regular (Same nominal amount paid on a regular quarterly interval Increase or decrease (paid or normal time, but a different nominal amount) Irregular Monthly, semiannual, annual

Stock Splits and Stock Dividends (1 of 2) Splits change the par value and shares adjusted to keep par value owned by an investor constant Forward split: increases shares outstanding (e.g., 3 x 1 split) Reverse split: reduces shares outstanding (e.g., 1 x 10 reverse split)

Stock Splits and Stock Dividends (2 of 2) Stock dividends are simply additional shares given to existing shareholders (e.g., a 3% stock dividend) Neither splits not dividends alter the value of the underlying company (cutting a pie into 2 pieces or 20 pieces does not alter the total size of the pie)

Constant dividend growth model Easiest model for understanding the determinants of stock value V 0 = D 1 / (r - g) V 0 = value of the stock today D 1 = the value of the dividend expected to be paid in the coming year r = the appropriate risk-adjusted discount rate g = the rate at which dividends are expected to grow in the future.

Determining Degree of Portfolio Diversification Woerheide-Persson Index Compute the percentage weight of each holding Square each weight Sum the squared terms Subtract this sum from one Compare this value to various values of 1 – 1/n

Different types of stocks People categorize to simplify communication and understanding No universal definitions or agreement as to how any one stock classified Common categorizations Blue chip, Value, Growth, Income, Cyclical, Defensive, Speculative

Classes of Common Stock No universal definition of what a particular class designation means Common classes: Class A and Class B Typical distinctions Differential dividend rates Different voting power One convertible into the other

Preferred Stock A cross between a stock and a bond Dividend rate is fixed, hence there is no growth Dividends are cumulative if missed Preferred stock priced like a fixed return investment Preferred stock is usually callable

Rights Used by some companies to raise new money Rights distributed free to current investors (usually 1 right per share of common stock held) Have a short life, and give owner privilege to buy stock at a below market price Allows investors to retain pro rata ownership

Warrants Similar to rights allows holders to buy stock from the company at a designated price Usually have an expiration date (some have no maturity) Usually issued attached to bonds or given to a lender in exchange for a lower interest rate on the debt

Options (1 of 2) Two types of options Put option Call option Call option allows the holder to buy a fixed number of shares (usually 100) of stock of a designated company at a fixed price (called the exercise price) for a give period of time (expiration date)

Options (2 of 2) Put option allows the holder to sell a fixed number of shares (usually 100) of stock of a designated company at a fixed price (called the exercise price) for a give period of time (expiration date) Buy a call if expect stock price to go up Buy a put if expect stock price to go down