Lesson 1:

Common stocks
What are common stocks?

• Owners of common stocks are part owners of the firm

⇒ Have claim on company’s wealth

Residual ownership
• A stockholder’s (shareholders) claim on a company’s wealth is subordinate to other
investors (such as lenders).
⇒ No guarantee stockholder receives any return on investment

What is the appeal of common stocks?

• Popular investment for individual and institutional investors
⇒ Stocks can increase in value over time – capital gains
⇒ Stocks can pay dividends – income stream
Stock price behaviour

A strong stock market generally means rising stock prices.

When the market is weak, stocks prices generally fall.

A weak market is the exception.

⇒ Total return on the S&P500 in the 92 years from 1926 to 2017
was negative only 24 times.
⇒ A $1,000 investment in the S&P500 in 1926 grew to $7.3 million in 2017.
Average annual returns on the S&P500 from 1930 to 2017
Advantages of stock ownership

• Opportunity for substantial returns

• Typically outperform bonds by a wide margin
• Over last 100 years, annual returns from stocks were roughly 2x returns
from high-grade corporate bonds
• Provide protection from inflation
• Returns exceed inflation over time
• Easy to buy and sell
• Low transaction costs
• Price, market, and company information is relatively easy to find
• Unit cost per share is low
• Allows widespread ownership
Disadvantages of stock ownership

• Exposed to various types of risk

• Business risk
• Financial risk
• Purchasing power risk
• Market risk
• Event risk
• Returns are highly volatile and can be hard to predict
• Difficult to consistently select best performers
• Generate less income compared to other alternatives (bonds)
• Bonds pay more income (interest payments) with much higher certainty
Income from stocks and bonds
Basic characteristics of common stocks

Equity capital

Each share of common stock represents an equity (ownership) position in a company.

• Stocks are sometimes referred to as ‘equities’.
Common stocks as a corporate security

Publicly traded issues

• Shares that are available to the general public and traded in the open market

Issuing new shares

• Public offering
• Offering to sell a set number of the company’s shares to the public at a
specified price

• Rights offering
• Offering to sell new shares to existing shareholders in proportion to their
ownership position

• Result
⇒ Increase in the number of shares outstanding
⇒ Level of equity finance in company rises relative to debt finance
Common stocks as a corporate security
Stock spin-offs
• Conversion of one of company’s sub-divisions to a new, separate company through
distribution of stock in new company to existing shareholders
• Why?
• Sub-division is no longer a good fit
• Company is too diversified and needs to focus

Stock split
• Company increases the number of shares outstanding by exchanging a specified
number of new shares for each outstanding share
• Usually done to lower stock price to make shares more attractive/accessible to
investors
• Stock prices usually fall in proportion to the terms of the split

Examples
• 2-for-1 stock split – 2 new shares for each old share
• 3-for-2 stock split – 3 new shares for every two old shares
Common stocks as a corporate security
Treasury stock
• Shares originally sold to the public that have been repurchased by the company
(‘buyback’)
• Kept by the company and can be used later
• Mergers, acquisitions, stock dividends, employee stock options

Share buyback
• Companies buyback their shares with they believe their stock is undervalued
• Alternative to paying dividends
• Positive short-term impact
⇒ Stock prices usually rise after buyback
Common stocks as a corporate security

Classified common stock

• Common stock issued in different classes

• Each class entitles holders to different privileges and benefits
• Different voting rights
• Different dividend types
• Often used to allow a small group to control the voting in a publicly traded company

Example – Facebook IPO in 2012

• Class A shares
• 1 vote per share
• Class B shares
• Held by Facebook CEO and other insiders
• 10 votes per share
Common stock values

Market capitalisation
⇒ Total number of shares outstanding x share price (market value per share)

Par value
• Arbitrary value assigned to stock when it is first issued
• Set very low to represent a minimum value (floor) for the stock

Book value
• Difference between the company’s assets and liabilities
• Backward-looking
Common stock values

Market value
• Current price of stock in the market
• Forward-looking
• Represents investors’ expectations about company’s future performance
• Market value usually exceeds book value
• When market value falls below book value, the company is in financial distress with
poor prospects.

Investment value
• Amount that investors believe that a stock is worth
• Most important measure for a shareholder
• Determined by a process of evaluating risk and return information
• Represents the maximum price an investor should be willing to pay for stock