Common Stock Fundamentals | Reference Notes

CHAPTER 6
COMMON STOCK FUNDAMENTALS

1. Common Stock Concept

Common stocks also called the shares are long term source of financing issued or sold
by the firms in order to raise the required funds or the capital. A firm sells common
stocks in the market, whereby a firm raise the capital equal to the par value of each
share sold. However, a stock can be sold in the discount or the premium. A commons
stocks or shares represent an equity ownership in a firm as common stockholders are
the real owners of a firm/company. The common stock investments have two return
components namely dividend yield and capital gain yield. In other words, the common
stock holders can earn dividend distributed by a firm out of its profit in certain years
and an appreciation in the price of a stock when it is sold in the market. The common
stocks are easy to understand and trade because the common stock data and
information are readily available in the market.

2. Advantages and Disadvantages of Common Stocks

The followings are the advantages to the common stock holders:

i. The common stocks are easy to understand and trade.

ii. The common stock holders have right to vote in the AGM by which they can
elect the director/s of their choice to represent them in the Board.
iii. The common stock holders have limited liability (equal to paid up value per
share) whereas the there is no upper limit of gain.
iv. The common stocks are easily tradable in the market due to which the common
stock investments are highly liquid.
v. The common stockholders have preemptive rights which entitle them to buy
additional share during the right issue.
vi. The common stockholders can participate in the profit of the firm unlike
preferred stocks and bonds.

The followings are the disadvantages of the common stocks:

i. The common stocks have residual claim in case of the liquidation of the firm. It
means the common stock holders have the last priority over the income and
asset.
ii. The dividends are discretionary but not an obligation. It means the stock
holders may or may not receive dividends in certain years for which they do
not have right to enforce the firm to pay.
iii. The common stock prices are highly volatile which makes the common stock
investment risky in comparison to the preferred stocks and the bonds.
iv. The valuation of common stocks relies on various assumptions due to which the
investment decision in common stock is very complex decision.

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3. Common Stock Values

The common stocks have different values which are used and calculated in
different ways. Some of the common stock values are discussed as follows:

i. Par Value
The par value of the common stock is the face value or stated price or the
quoted price per unit of the common stock. The par value does not have
significant use; however, the par value is used for the accounting purpose.
The common stock amount or share capital in the equity section of the
balance sheet is calculated by multiplying the numbers of share outstanding
and par value per share. In addition, the par value can be used as the
reference value in distribution of the cash dividends if the percentage of
dividend is expressed in terms of the par value of each unit of stock.

ii. Book Value

The book value per share is the sum of the total stockholder’s equity divided
by the numbers of shares outstanding. The stockholder’s equity consists of
the share capital or paid up capital, share premium or the additional paid in
capital and retained earnings. Book value per share is also called the net
worth per share.

iii. Market Value

The market value of the share is the price at which the share is being traded
in the stock market. The market value per share is determined by the
interaction of the demand and supply of the particular stock in the stock
market. The market value per share tends to fluctuate as it is stimulated by
the demand and supply. The market value rises when the demand of the
stock is relatively high than the supply and vice versa.

iv. Liquidation Value

The value of the stock leftover after the payment of all liabilities during the
liquidation of the firm is known as the liquidation value. The common
stockholder’s have residual priority over the distribution of assets in case of
the liquidation.

v. Intrinsic Value or Investment Value

The present value of the future cash flows (dividends and selling price) that
are expected to be generated from the common stock is known as the
intrinsic or investment value. All the expected cash flows are discounted
using an appropriate discount rate to arrive at the worth of stock today. It I
also called the fair price. Intrinsic value is used in making the buy or sells
decision of the common stocks.

4. Types of Common Stocks

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Companies have different characteristics that make their stock prices react differently
to economic data. Consequently, you should know the types of stocks that you invest
in. Blue-chip stocks pay dividends, and growth stocks generally do not pay dividends.
Stocks can be classified into various categories, which is useful for investors because
different types of stocks vary with regard to their returns, quality, stability of earnings
and dividends, and relationship to the various risks affecting the companies and the
market.

i. Blue-Chip Stocks
Blue-chip stocks refer to companies with a long history of sustained earnings
and dividend payments. These established companies have developed
leadership positions in their respective industries and, because of their
importance and large size, have stable earnings and dividend records. Blue-
chip companies appeal to investors who seek quality companies with histories
of growing profits and regular dividend payouts. These types of companies tend
to be less risky in periods of economic uncertainty because of their dependable
earnings.

ii. Income Stocks

Income stocks have high dividend payouts, and the companies are typically in
the mature stages of their industry life cycles. Stocks of companies that have
established a pattern of paying higher-than average dividends can be defined
as income stocks. Income stocks tend not to appreciate in price as much as
blue-chip stocks do because income stock companies are more mature and are
not growing as quickly as are blue-chip companies. On the contrary, they have
stable earnings and cash flow, but they choose to pay out much higher ratios of
their earnings in dividends than other companies do. Utility companies and real
estate investment trusts (REITs) are examples of income stocks.

iii. Growth Stocks

Growth stocks are issued by companies expected to have sustained high rates
of growth in sales and earnings. These companies generally have high
price/earnings (P/E) ratios and do not pay dividends. Both pay out small
amounts of their earnings in dividends. In addition, because of their leadership
positions in their respective industries, they also could be classified as blue-chip
companies. Rather than pay out their earnings in dividends, growth companies
retain their earnings and reinvest them in the expansion of their businesses.
Growth stocks are often referred to as high P/E ratio stocks because their
greater growth prospects make investors more willing to buy them at higher
prices. Investors do not receive returns in the form of dividends, so they buy
these stocks for their potential capital appreciation.

iv. Value Stocks

Value stocks are stocks that have lower prices relative to their fundamental
values (growth in sales and earnings). Value stocks tend to have low P/E ratios,
low price-to-book ratios, low price-to-sales ratios, and high dividend yields, and
they also may be out of favor with investors. Because investors have relatively
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low expectations for the immediate growth of these companies, their stocks
trade at lower prices relative to their earnings and dividends. Patient investors
with longer time horizons are willing to purchase these stocks and wait for their
prospective earnings to increase.

v. Cyclical Stocks
Cyclical stock prices move with the economy. Cyclical stocks often reach their
high and low points before the respective peaks and troughs of the economy.
When the economy is in recession, these stocks see a decline in sales and
earnings. During periods of expansion, these stocks grow substantially in sales
and earnings. Examples of cyclical stocks are stocks issued by capital
equipment companies, home builders, auto companies, and companies in other
sectors tied to the fortunes of the economy as a whole.

vi. Defensive Stocks

Defensive stocks are the stocks of companies that tend to hold their price
levels when the economy declines. Generally, these stocks resist downturns in
the economy because these companies produce necessary goods (food,
beverages, and pharmaceutical products). However, during periods of economic
expansion, defensive stocks move up more slowly than other types of stocks.
Defensive stocks are the stocks of companies whose prices are expected to
remain stable or do well when the economy declines because they are immune
to changes in the economy and are not affected by downturns in the business
cycle. Examples of stocks of this type are drug companies, food and beverage
companies, utility companies, and consumer goods companies. Many investors
buy defensive stocks ahead of an economic downturn and hold them until
better economic times.

vii. Speculative Stocks

Speculative stocks have the potential for above-average returns, but they also
carry above-average risk of loss if the company does poorly or goes bankrupt.
Speculative stocks are stocks issued by companies that have a small probability
for large increases in the prices of their stocks. These companies do not have
earnings records and are considered to have a high degree of risk. In other
words, these companies are quite likely to incur losses and not as likely to
experience profits, so they have a higher possibility of larger price gains or
losses than other types of stocks. Speculative stocks are more volatile than the
other stock types. Speculative stocks are often issued by new companies with
promising ideas that are in the development stages.

viii. Foreign Stocks

Foreign stocks are stocks issued by companies outside the country of origin.
Although the U.S. stock markets still account for the largest market
capitalization of all the stock markets in the world, the foreign stock markets
are growing in market share. Foreign stocks provide the opportunity to earn
greater returns and to diversify the portfolio.

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ix. Large-, Medium-, and Small-Cap Stocks

Stocks also can be classified by size: small-cap stocks, medium-cap stocks, and
large-cap stocks. Cap is short for “market capitalization,” which is the market
value of a company (determined by multiplying the company’s stock price in
the market by the number of outstanding shares). Market capitalization
changes all the time, and although the definitions include a market value for
each category, these market value threshold classifications also change over
time. Below are the differentiating values for the groupings of companies by
size:
Large-cap stocks are the stocks of large companies with considerable earnings
and large amounts of common stock outstanding. This group has a market
capitalization of greater than $5 billion. These are blue-chip, established
companies that can be either growth or value companies. Some examples are
Intel, Microsoft, IBM, General Motors, ExxonMobil, and many other large
leading companies in their respective industries.

Medium-cap stocks are the stocks of medium-sized companies with market

capitalizations of between $1 billion and $5 billion. Medium-cap companies
have the safety net of having significant assets in terms of their capitalization,
but they also may not be so well known to average investors. Small-cap stocks
are the stocks of small-sized companies with a market capitalization of less
than $1 billion. Small-cap companies generally are not household names,
although they offer the most attractive return opportunities. This group of
stocks has, according to studies, outperformed the large-cap stocks over long
periods. Small-cap stock prices tend to be more volatile than those of large-
and medium-cap companies because of their greater exposure to risk.

5. Dividend
The portion of the net income or profit distributed to the shareholders of the firm is
known as the dividend. The dividend represents the current income to the
shareholders. Dividend generally refers to the payment of cash dividend. However,
the firm can distribute dividend in various forms like stock dividend or bonus share,
stock splits, reverse splits and stock repurchases. However, the dividend is not an
obligation. The payment of the dividend is on the discretion of the management.

Cash dividend: The dividend is paid in the form of cash to the shareholders. It causes
the cash out flows from the firm which results in the decrease of the total asset of the
firm. The market price per share declines by the amount of dividend per share after
the cash dividend.

Stock Dividend or Bonus Share: The dividend is paid in the form of additional stocks
or shares. The numbers of shares outstanding increases after the payment of stock
dividend. The market price of the share declines in proportion to the percentage of
the stock dividend. However, the total shareholder value or the wealth remains
unchanged. The firm opts for stock dividend due to several reasons such as
inadequate cash; desire to lower the market price, retaining the profit for the future

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investment etc. The main benefit of the stock dividend is that the shareholders need
not pay the taxes unlike the tax on cash dividend.

Stock Split: The stock spilt (Straight Split) increases the numbers of share
outstanding. But in the mean time, the par value and the market price per share
decline proportionately. However, the net worth or the wealth of investors and total
shareholder’s equity remains constant. The firm employs stock split to bring the stock
price at the tradable range.

Reverse Split: The reverse split decreases the numbers of shares outstanding and
increases the par value and the market price. The firm goes for the reverse split to
increase the market price of the stocks. However, the net worth of the investors and
total shareholder’s equity remains unchanged.

6. Common Stock Investment Strategies

There could be several strategies the investors use in common stock investments.
Some of the major common stock investment strategies are as follows:

i. Buy and Hold Strategy: It is the conservative investment strategy in

which the investors buys the quality stocks and hold it for the considerably
longer duration. The investors buy blue chip and income stocks under this
strategy. The major focus is on the current income and growth of the
investment value over time. However, the investors can have aggressive
management of the stock portfolio in which they can buy and sell several
stocks.

ii. Current Income: Under this strategy the investors look for some quality
income stocks which have more than average dividend payment history.
The major concern is the growth in the dividends over the time.

iii. Quality Long Term Growth: Under this strategy the investors invest in
the quality growth stocks and tech stocks which are believed to have
remarkable growth over the time. It is less conservative and focuses on the
capital appreciation.

iv. Aggressive Stock Management: In this strategy, the investors form the
quality and diversified stock portfolio including the blue chip, quality, income
and growth stocks. The frequent portfolio review is carried out and changes
in portfolio stocks are frequent. It provides substantial benefit; however also
carries the substantial risk if not managed properly.

v. Speculation and Short Term Trading: It is the highest risk strategy in

which the investors depend on the rumors and market information to reap
the quick profit in the short term basis. The speculator expects to earn from
the quick capital gain based on some insider news and information.

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