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Chapter6CommonStocks101

PartThree
InvestinginCommonStocks
PartThreeIncludes
Chapter6

CommonStocks

Chapter7

AnalyzingCommonStocks

Chapter8

StockValuation

Chapter9

MarketPriceBehavior

101Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Chapter6
CommonStocks
.1

Outline

Learning Goals
I.

WhatStocksHavetoOffer
A) TheAppealofCommonStocks
B) PuttingStockPriceBehaviorintoPerspective
C) FromStockPricestoStockReturns
D) TheDow,theS&P,andtheNasdaq
1. ComparativePerformanceoftheThreeMarketMeasures
2. Bulls,Bubbles,andBears
E) TheProsandConsofStockOwnership
1. TheAdvantagesofStockOwnership
2. TheDisadvantages
ConceptsinReview

II.

BasicCharacteristicsofCommonStock
A) CommonStockasaCorporateSecurity
1. IssuingNewShares
2. StockSpinOffs
3. StockSplits
4. TreasuryStock
5. ClassifiedCommonStock

B) BuyingandSellingStocks
1. ReadingtheQuotes
2. TransactionCosts
C) CommonStockValues
1. ParValue
2. BookValue
3. MarketValue
4. InvestmentValue
ConceptsinReview

103Gitman/JoehnkFundamentalsofInvesting,NinthEdition

III. CommonStockDividends
A) TheDividendDecision
1. CorporateVersusMarketFactors
2. SomeImportantDates
B) TypesofDividends
1. Cash
2. StockDividends
C) DividendReinvestmentPlans
ConceptsinReview
IV. TypesandUsesofCommonStock
A) TypesofStocks
1. BlueChipsStocks
2. IncomeStocks
3. GrowthStocks
4. TechStocks
5. SpeculativeStocks
6. CyclicalStocks
7. DefensiveStocks
8. MidCapStocks
9. SmallCapStocks
B) InvestinginForeignStocks
1. ComparativeReturns
2. GoingGlobal:DirectInvestments
3. GoingGlobalwithADRs
4. PuttingGlobalReturnsinPerspective
5. MeasuringGlobalReturns
6. CurrencyExchangeRates
C) AlternativeInvestmentStrategies
1. BuyandHold
2. CurrentIncome
3. QualityLongTermGrowth
4. AggressiveStockManagement
5. SpeculationandShortTermTrading
ConceptsinReview

Chapter6CommonStocks104

Summary

105Gitman/JoehnkFundamentalsofInvesting,NinthEdition

PuttingYourInvestmentKnowHowtotheTest
DiscussionQuestions
Problems
CaseProblems
6.1 SaraDecidestoTakethePlunge
6.2 WallyWondersWhetherTheresaPlaceforDividends
ExcelwithSpreadsheets
TradingOnlinewithOTIS

.2

Key Concepts

1.

Theinvestmentappealofcommonstock.

2.

Historicalreturnsinthestockmarket.

3.

Basicissuecharacteristicsofcommonstock,includingtheadvantagesanddisadvantagesof
ownership.

4.

Stockquotationsandtransactioncosts.

5.

Differenttypesofstockofferingsandcommonstockvalues.

6.

Transactioncostsofbuyingandsellingstocks.

7.

Theimportanceofdividendstostocksandstockvaluation,includinghowdividenddecisionsare
made,typesofdividends,anddividendpolicies.

8.

Thekindsofcommonstocksandtheirinvestmentmerits.

9.

Investinginforeignstocks,includingtheimpactofcurrencyexchangeratesinreturnstoU.S.
stockholders.

10. Usesofcommonstocksasinvestmentvehicles,andthestrategiesthatcanbeemployedtomeet
variousinvestmentgoals.

.3

Overview

Chapter6CommonStocks106

Thischapterisoneoffourthatexaminescommonstocksasaninvestmentvehicle.Commonstocksare
oneofthemostinterestingofinvestmentvehicles,andthischapterprovidesanessentialfoundationtothe
studentsunderstandingofequitysecurities;assuch,theinstructorshouldplantocoveritindetail.
1.

2.

Severalcharacteristicsofcommonstocksmakethemanimportantinvestmentvehicle:(1)Common
stocksprovideanattractiveownershipfeatureinadditiontoincomepotential.(2)Common
stockholderslayclaimtoalltheresidualprofitsofthefirm.(Theinstructorshouldexplainthe
meaningofresidualprofits.)(3)Ownersofcommonstockdonotreceivealltheresidualprofitsas
income,butonlythatpartofprofitsdeclaredasdividends.(4)Becauseawidevarietyofcommon
stocksmaybepurchased,theinvestormaychoosefromabroadspectrumofriskreturn
combinations.
Becauseofwidespreadmisunderstandings,itsimportanttoputstockreturnsintoperspective.
Studentsseemtohaveallsortsofideasabouthowstockperform,soitsbesttoaddressthisissue
earlyoninthediscussion.Table6.1providesover50years(19502002)ofannualreturnsand
holdingperiodreturns.Spendsometimeon:historicalreturnsinthestockmarket;howthesecanbe
usedasabenchmarkofperformance;andtherelativeimportanceofdividendsandcapitalgainsto
totalstockreturns.Whilediscussinghistoricalreturns,itstheperfecttimetodiscussthemarket
crashesofOctober1987&October1997andtheircauses.Studentsappreciateinformationabout
stockreturnssincethebookwaspublished.Itisgoodtobringinformationabouttherecentreturnson
theDow,S&P,andNasdaqindexestoclass.

3.

Thefollowingfeaturesofcommonstockspresentedinthetextshouldbediscussedindetailinclass:
ownershiprights,rightsofferings,kindsofissues,deferredequitysecurities,stocksplits,treasury
stock,andclassifiedcommonstock.Thecostsincurredinmakingcommonstocktransactionsof
differentsizesshouldalsobementioned.

4.

Thealternativewaysofdefiningthevalueofcommonstockare:parvalue,bookvalue,marketvalue,
andinvestmentvalue.Themeaningandusefulnessofeachofthesevaluemeasurestotheinvestor
shouldbediscussedinclass.Currentcopiesofstockquotescanbeweavedintothediscussionof
marketvalue.

5.

Thedividenddecisionofafirmisimportanttotheinvestorandtothefirm,sothefollowingaspects
ofdividendsshouldbehighlighted:howthedividenddecisionismade;importantdatesthataffect
dividends;taxeffectsofdifferenttypesofdividends;andthebasicprinciplesbehindthecreationof
andparticipationindividendreinvestmentplans.Examplesofearningspershare(EPS)anddividend
yieldcomputationsshouldbeworkedoutinclass.Currentcommonstockyieldscanbecomparedto
bondyieldsandlocalsavingsaccountyields.

6.

Inthelatterpartofthechapter,commonstocksareclassifiedintodifferenttypes,basedondifferent
features.Thesetypesarebluechips,incomestocks,growthstocks,speculativestocks,cyclical
stocks,defensivestocks,midcap,andsmallcapstocks.Theinstructorshouldindicatetheriskreturn
characteristicsofeachtype.Theinstructorshouldalsooutlinethestepsinvolvedininvestingin
foreignstocks,withspecialemphasisonADRsandtheimpactofcurrencyexchangeontotalreturn.

7.

Finally,thealternativestrategiesthatinvestorscanfollowwhenusingstocksshouldbeexplained,
andtheinstructorshouldemphasizethatinvestorschoosedifferenttypesofstocksaccordingtotheir
investmentobjectives.

.4

Answers to Concepts in Review

107Gitman/JoehnkFundamentalsofInvesting,NinthEdition

1.

Acommonstockisanequityinvestmentthatrepresentsownershipinacorporateformofbusiness.
Eachsharerepresentsafractionalownershipinterestinthefirm.Thekeyattributeofthisinvestment
securityisthatitenablesinvestorstoparticipateintheprofitsofthefirm.Asresidualownersofthe
company,commonstockholdersareentitledtodividendincomeandaproratedshareofthefirms
earningsafterallotherobligationsofthefirmhavebeenmet.Theyhavenoguaranteetheywillever
receiveanyreturnontheirinvestment.

2.

Oneimportantinvestmentattributeofcommonstocksisthattheyenableinvestorstoparticipatein
theprofitsofthefirmandassuch,theycanofferattractivereturnopportunities.Anotherattributeis
theversatilityofthesecurityitcanbeusedtomeetjustaboutanytypeofinvestmentobjective.In
addition,asinvestmentvehiclesgo,commonstocksarefairlysimpleandstraightforward,sotheyre
easytounderstand(thoughthatcertainlydoesntmeantheyreeasytovalue).Theyareeasytobuy
andsell,andthetransactionscostsaremodest.Moreoverpriceandmarketinformationiswidely
disseminatedinthenewsandfinancialmedia.

3.

Thestockmarkethasbeenveryvolatileoverthepast15years.Abullmarket,wasfollowedbya
bubble,thatbecameabearmarket,andonceagainappearstobequitebullish.Althoughstocks
providedaverageannualreturnsofaround11%from19532002,therewasasignificantselloffin
October1987.Whilethefirsthalfofthe1990switnessedreturnsthatwereslightlybelowaverage,
averageannualreturnsduringthesecondhalfofthedecadewere26%.Thencameabearmarketthat
resultedoneofthefewthreeyearstretcheswithnegativeannualreturns.However,byDecemberof
2003,thestockmarkethadreboundedoffofthe2002lows,andtheDowJonesIndustrialAverage
onceagainreached10,000.Inearly2004,theDowJonesIndustrialAveragestoodat10,700.
TheNasdaqindexshowedevenmorevolatilitythantheDow.Overtheentire1990tomid2003
periodtheDowoutperformedboththeS&PandNasdaq.TheDowalsohadlessofalossduringthe
periodfrom2000tomid2003.
(Instructorsmayalsopointoutthatthesefiguresreflectthegeneralbehaviorofthemarketasa
whole,notnecessarilythatofindividualstocks.)

4.

Whiletheydontprovidethebangthatcapitalgainsdo,dividendsareanimportantsourceofreturn
tostockholders.Dividendreturnsarealwayspositive,althoughthedividendyieldrecentlyhasbeen
under2.5percent.Capitalgainshaverangedfrom43.96percentin1954to27.57%in1974.Over
thepast50years,dividendshaveaccountedforalittlelessthan50%oftheaverageannualtotal
returnfromstocks.Theresnoquestionthatcapitalgainsprovidethereallybigreturns,thoughthey
alsoleadtowiderswingsinyeartoyearyields.Dividends,incontrast,provideanelementof
stabilityandtendtoshoreupreturnsinoffyears.Currently,dividendsaretaxedatfivepercentand
fifteenpercentrates,thesameascapitalgains.

5.

Themajoradvantageofcommonstockownershipisthereturnsitoffers.Becausestockholdersare
entitledtoparticipateintheprosperityofafirm,thereisalmostnolimittoastockscapitalgains
potential.Inaddition,manystocksprovideregularcurrentincomeintheformofannual
dividendsandformostincomeproducingstocks,thosedividendstendtogrowovertime,adding
evenmoretothestockholdersreturn.Commonstocksarealsohighlyliquidandeasilytransferable;
theirtransactioncostsarerelativelylow,marketinformationisreadilyavailable,andunitpriceis
nominal.Theriskynatureofcommonstocksisthemostsignificantdisadvantageofcommonstock
ownership.Asresidualownersofthefirm,noreturnisguaranteed.Furthermore,pricesaresubjectto
wideswings,makingvaluationdifficult.Finally,thesacrificeincurrentincomeisadisadvantage
relativetootherinvestments(likebonds,forinstance)thatpayhigherandmorecertainreturns.

Chapter6CommonStocks108

Theprincipalriskstostockholdersinclude:businessandfinancialrisk,purchasingpowerrisk,and,of
course,marketrisk.Businessriskisrelatedtothekindofbusinessthecompanyisinanddealswith
bothsalesvolatilityandtheamountofvariabilityinthefirmsearnings.Financialriskisassociated
withthemixofdebtandequityfinancing.Themoredebt(financialleverage)thefirmuses,the
greaterthelikelihoodthatitwilldefaultonitsprincipalandinterestpaymentswhichinturnwill
haveanegativeimpactonthestock.Purchasingpowerriskreferstothepossibilityofpriceincreases
andthecorrespondingdeclineinthevalueofthedollarsinvestedincommonstock.Marketriskis
causedbyfactorsindependentofthefirmthataffectthereturnonthefirmscommonstock.Such
thingsaseconomicfluctuations,threatofwar,andpoliticalfactorsaffectmarketriskandtherefore
canhaveabearingonthemarketpriceofastock.Themarketitselfhasanimpactontheprice
performanceofastockwhich,ofcourse,iswhatbetaisallabout(i.e.,astocksbetaisameasureof
theextenttowhichthestockreactstothemarket).
6.

Astocksplitoccurswhenafirmannouncesitsintentiontoincreasethenumberofsharesofstock
outstandingbyexchangingaspecifiednumberofnewsharesforeachoutstandingshareofstock.
Moststocksplitsareexecutedwithaviewtoloweringthepriceofthestockandenhancingitstrading
appeal.Ifthestocksplitisnotaccompaniedbyanincreaseinthelevelofdividends,stockpriceswill
falltoaccountforthesplit.Thus,a$100stockwillfallto$50aftera2for1split.Ifthecompanyhad
changeditsdividendratesay,byincreasingdividendsthestockpricewillriseafteradjustingfor
thesplit.Intheabovecase,thestockpricewillendupabove$25pershare,dependingonthesizeof
thedividendincrease.Thus,otherthingsbeingequal,achange(increase)inthedividendratewill
haveapositiveimpactonthestocksprice,afteradjustingforthestocksplit.

7.

Stockspinoffsinvolveconversionofoneoffirmssubsidiariestoastandalonecompanyby
distributionofstockinthatnewcompanytoexistingshareholders.Fore.g.Pepsicospunoffits
restaurantoperationsPizzaHut,KFC,andTacoBellintoanewcompanycalledTriconGlobal
Restaurants(nowcalledYumBrands).Investorshavesharesinboththeoldandnewfirm,allowing
themtokeepthosedivisionstheywanttoholdandsellingtheother.

8.

(a) Firmsdonotissuetreasurystock;thesearesimplysharesofcommonstockthathavebeen
issuedandsubsequentlyrepurchasedbytheissuingfirm.Thisisgenerallydonebecausethefirm
viewsthestockasanattractiveinvestment;perhapsthepriceisunusuallylow.Mosttreasury
stockislaterreissuedbythefirmandusedforsuchpurposesasmergersandacquisitions,
employeestockoptionplans,orforpaymentofstockdividends.Treasurystockisnotaformof
classifiedstock.Classificationofcommonstocksimplybreakscommonstockintodifferent
classesorgroups.Eachclasshasdifferentvotingrightsand/ordividendobligations.For
example,classAstockmightdesignatenonvotingsharesthatreceivepreferentialdividends,
whileclassBstockmightdesignatevotingshareswithlowerdividends.Someclassespaystock
dividendstoappealtoindividualsinterestedincapitalgains;otherclassespayhighercash
dividendsthatattractincomeseekinginvestors.
(b) Commonstockcanbeboughtorsoldinroundoroddlots.Aroundlotis100sharesofstock,or
multiplesof100shares.Anoddlotisatransactioninvolvinglessthan100shares.
(c) Theparvalueofastockisitsstatedorfacevalueandexistsprimarilyforaccountingpurposes.
Manystocksareissuedwithnoparvalue.Itisarelativelyuselessnumber.Theliquidationvalue
ofastockisanestimateofthemarketvalueofthefirmsassets,ifsoldatauction,lessthe
liabilitiesandpreferredstockoutstanding.Whilethismeasureofvalueisvitallyimportanttothe
highstakesLBOandtakeoverartists,itisverydifficulttodetermineandisgenerallyoflittle
interesttothetypicalindividualinvestorwhotendstoviewthefirmasagoingconcern.

109Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(d) Bookvalueisanaccountingmeasureoftheamountofstockholdersequityinthefirm.Book
valueindicatestheamountofstockholderfundsusedtofinancethefirm.Investmentvalue,
perhapsthemostimportantmeasureforastockholder,indicateswhatvalueinvestorsplaceonthe
stock.Investmentvalueisbasedontheexpectationsoftheriskandreturnpatternsofastock:the
returnscomefromdividendsandcapitalgains,andtheriskisbasedontheexposuretoholding
thestock.
9.

Anoddlotdifferentialistheadditionaltransactionscostsaninvestormustpaytoanoddlotdealerto
tradeinoddlots.Thedifferentialcanbeashighas10to25centspershareoverandabovenormal
commissionfees.Thesecostscanbeavoidedbytradinginroundlots,orunitsof100shares.
(a) oddlotdifferentialaddedtofees
(b) nodifferentialadded
(c) oddlotdifferentialaddedtofees

10. Thequestionontheamountofdividendstobepaidisdecidedbythefirmsboardofdirectors.The
directorsevaluatethefirmsoperatingresultsandfinancialconditionstodeterminewhether
dividendsshouldbepaidand,ifso,inwhatamount.
DuringaBoardofDirectorsmeeting,avarietyoffactorsareconsideredinmakingtheinvestment
decision.Theseinclude:
(a) Thefirmscurrentearningsorprofitsareconsideredavitallinkinthedividenddecision.
(b) TheBoardalsolooksatthefirmsgrowthprospect.Firmswithgoodinvestmentopportunities
paylessdividends;usingtheretainedearningsfornewinvestment.
(c) TheBoardalsoconsidersthefirmscashpositiontomakesureithassufficientliquiditytomeet
acashdividendofagivensize.
(d) TheBoardalsoensuresthatitismeetingalllegalandcontractualconstraintsthatmightbe
imposedbyloans.
(e) TheBoardalsomakesanefforttomeetthedividendexpectationsofitsshareholders;failureto
meettheseexpectationscanleadtodisastrousresultsinthestockmarket.
11. Theexdividenddate(whichoccurstwobusinessdayspriortothedateofrecord)determineswhois
eligibletoreceivethedeclareddividendwhenthestockissold.Ifthestockissoldonoraftertheex
dividenddate,theowner(seller)receivesthedividend;ifitissoldpriortotheexdividenddate,the
newshareholder(buyer)receivesthedividend.Thus,ifthestockissoldontheexdividenddate,the
sellerreceivesthedividendgoingexdividendmeansthebuyerisnotentitledtothedividend
sincethestockisbeingsoldwithoutthedividend.
12. Cashdividendsaresimplydividendpaymentsmadetothestockholderincash.Thisformofdividend
representssomethingofvalue.Astockdividendisanissueofnewsharesexpressedanddistributedas
apercentageofeachshareholdersexistingshares.Itreallyhasnovalue,sincethemarketrespondsto
stockdividendsbyadjustingthemarketpriceaccordingly.Asanexample,considerastockthatis
tradingat$50pershare;iftheissuingfirmdeclareda10percentstockdividend,thepriceofthis
stockwoulddropby10percentto$45.45($50/1.1).Thus,aninvestorwhoheld100sharesbeforethe
stockdividendwouldhold110sharesafter,butthetotalmarketvalueoftheseshareswouldbe
basicallythesame:$50100$45.45110.
Whenastockdividendisdeclaredbythefirm,additionalsharesofthestockareissuedtoexisting
shareholders.Stockdividendsmaybeusedasasubstituteforcashdividends,buttheyhavenovalue
becausethestockpricesadjuststothestockdividendaccordingly.Stocksplitsoccurwhenthefirm
givesshareholdersnewsharesinexchangeforeachsharetheyown.Thecentraldifferencebetween
stockdividendsandstocksplitsisthatdividendsareadditionalissuesandstocksplitsareexchanges.

Chapter6CommonStocks110

Ina200percentstockdividend,theinvestorreceivesadditionalsharesequaling200percentof
existingshares(i.e.,100sharesalreadyowned200%200newsharesdistributedinadditiontothe
original100).Ina3for1stocksplit,theinvestorreceives3newsharesforeachexistingshare
(1003300sharesheldaftersplit).
13. Firmswithdividendreinvestmentplans(DRPs)allowshareholderstoautomaticallyreinvesttheir
dividendsintoadditionalsharesofthefirm.DRPsprovideinvestorswithaconvenientand
inexpensivewaytoaccumulatecapitalwithoutpayingbrokeragecommissions.Despitethesecost
savings,thedividendspaidthroughDRPsaretaxableasordinaryincomeintheyeartheyare
received,justasiftheyhadbeenreceivedincash.
14. (a) Bluechipsarecommonstocksofveryhighqualitythathavealongandprovenrecordof
earningsanddividends.Theyofferrespectabledividendyieldsandmodestgrowthpotential.
Theyareoftenviewedaslongterminvestmentvehicles,havelowrisks,andprovidemodestbut
dependableratesofreturn.
(b) Incomestocksareissuesthathavealongandsustainedrecordofhigherthanaveragedividends.
Theseareidealforinvestorswhodesirehighcurrentincomewithlittlerisk.Unlikeothertypesof
incomesecurities(bonds,forinstance),holdersofincomestockscanexpecttheamountof
dividendstheyreceivetoincreaseregularlyovertime.Onedisadvantagewiththesestocksis
theirgenerallylowtomodestgrowthpotential.
(c) Midcapstocksarestockswithcapitalizationvaluebetween$1billionand$4$5billion.
Midcapsofferinvestorsattractivereturnopportunitiestheyhavethesizzleofsmallcapstocks
withoutthehighpricevolatility.Theyalsoprovidecharacteristicsofthebig,establishedstocks.
Thismidcaprangeisprobablymostappropriateforinvestorswillingtotolerateabitmorerisk
andpricevolatilitythanlargestocks.Onetypeofmidcapstock,ababybluechip,hasallthe
characteristicsofregularbluechip,exceptforsize.
(d) AmericanDepositoryReceipts(ADRs)arenegotiableinstrumentsissuedbyAmericanbanks.
EachADRrepresentsaspecificnumberofsharesofstockinaspecificforeigncompany.They
areusedasawaytopurchaseforeignstocksandaretradedonU.S.exchanges(forexample,the
NYSE)orintheOTCmarkets;theytradejustlikesharesofAmericanstocks.Beyondthe
simplifiedtrading,theinvestmentmeritsofanADRareafunctionoftheinvestmentmeritsof
theforeigncompanythatissuedthestock,aswellasthevalueofthedollarrelativetothe
currencyoftheforeigncompany.
(e) IPOsareinitialpublicofferingsofprimarilysmall,relativelynewcompanies.Asthename
suggests,thesestocksareofferedtothepublicforthefirsttime.IPOsofferachancetoearn
phenomenalcapitalgains.Atthesametime,itisverylikelythatinvestinginIPOstocksmight
resultinaloss.Assuch,theseshouldbeconsideredonlybyexperiencedandknowledgeable
investors.IPOsmustbeconsideredtobehighlyriskyinvestments.
(f) Techstocksareissuedbycompaniesinthetechnologysector.Issuingfirmsproduceeverything
fromcomputerstoInternetcontent.Theytypicallyaregrowthstocksorspeculativestocks,
becausetheyposeconsiderablerisktotheinvestor.Thissectorhasdoneextremelywellingood
timesanddepreciatedsignificantlyinbearmarkets.
15. Incomestocksgenerallyhavelimitedcapitalgainspotentialbecausetheypayoutlargeamountsof
theirearningsindividends;inessence,littleoftheirincomeisplowedbackintothecompanyto
financegrowth.Returnsfromincomestockscomemostlyfromcurrentincomeratherthancapital
gains,adistinctionfavoredbymanyinvestors.Thisdoesnotmeanthesestocksareunprofitable;
most,infact,arehighlyprofitable,withexcellentlongtermfutureprospects.

111Gitman/JoehnkFundamentalsofInvesting,NinthEdition

16. Lessthan50percentoftheworldequitymarketisinU.S.stocks.Forthemostpart,theU.S.stock
markethasbeenoneofthebestplacestoinvestoverthepasttwodecades.However,theU.S.
finishedfirstinonlyoneyearduringthe19802002period.Thus,toachievegreaterreturnsontheir
portfolioinagivenyear,investorsshouldalsoconsiderforeignmarkets.Furthermore,theappreciated
valueofaforeigncurrencyrelativetotheU.S.dollarwouldenhanceforeignequityreturns.
TheU.S.investorcaneitherinvestdirectlyinforeignmarketsorindirectlybybuyingAmerican
DepositoryReceipts(ADRs).Allthingsconsidered,Americaninvestorsareprobablybetteroffwith
ADRsbecausetheyavoidmanylogisticalproblemsthatarisewithdirectinvesting.ADRsaredollar
denominatedandareaboutaseasytobuy/tradeasU.S.stocks.
17. Aqualityconsciousinvestorwouldprobablydobestwithasimpleandconservativebuyandhold
strategy.Withthisstrategy,theinvestorpurchasesincome,quality,andbluechipstocks,andwatches
themgrowovertime.Ontheotherhand,ifaninvestoriswillingtotoleratealotofrisk,anaggressive
stockmanagementstrategyisthemostappropriate.Heretheinvestoraggressivelytradesinandoutof
thevarioustypesofqualitystocksinordertoearnaboveaveragereturnfrombothdividendsandcapital
gains.Anindividualsinvestmentapproachdependsuponwhethercommonstockisviewedprimarilyas
astorehouseofvalue,waytoaccumulatecapital,orsourceofincome.

.5

Suggested Answers to Investing in Action Questions

Anatomy of a Market Meltdown (p. 238)


(a) Whatfactorscontributedtothe2000marketmeltdown?
(b) Whatstepscanyoutaketoprotectyourselfinthefuture?
Answers:
(a) Factorsleadinguptothemeltdownincluded:
(1) Unsustainableannualaveragereturnsof26%duringthepriorfiveyears,
(2) Investorseagerlybuyingsharesinnewtechnologycompanies,withoutregardtotrackrecords,
products,orprofits,
(3) Individualsinvestingwiththeexpectationthattherewouldnotbeanotherrecession,and
(4) ExtramoneybeingpumpedintotheeconomybytheFederalReservetoguardagainstanyyear
2000computerproblems.
Theninearly2000:
(1) TheFederalReserveraisedinterestrates,
(2) Businessinvestmentintechnologydecreased,
(3) LowersalesatDellandtheantitrustsuitagainstMicrosoftworriedinvestors,
(4) TheSeptember11,2001terroristbombingsandstockmarketclosureforaweekfollowing
terroristbombings,
(5) CorporatescandalsatEnronerodedinvestorconfidenceandbroughtintoquestionthevalidityof
numbersproducedbyArtherAndersenandothers,
(6) SubsequentterroristthreatsandanxietyarisingfromtheloomingwarinIraqcausedthemarkets
todropevenfarther,and
(7) Simplythefearthatmatterscouldgetevenworsepushedinvestorstogiveup(evenifitmeant
takingaloss)andmovetheirmoneyintobonds.

Chapter6CommonStocks112

(b) Diversifyingallowsyoutospreadouttheriskthatauniquefirmorindustryeventwillhavea
devastatingimpactonyourinvestment.Youhavetoanalyzethetrackrecord,productsandprofitsof
firmsbeforeinvesting.Investorswillwanttoreallocatetheirportfolio,evenifitmeansselling
winnerssothattheirwealthisnotacloselytiedtothesuccessofasinglefirm.Italsoisgoodto
includebothstockandbondsinyourportfolio.Thesurgeofinterestinbondsandfallinginterestrates
astheeconomystagnateddrovepricesofthesesecuritiesupward.

In International Investing, Currencies can Make or Break You (p. 268)


(a) HowdoesastrengtheningdollarerodereturnsfromnonU.S.investments?
(b) Isthedollarcurrentlyweakorstrong,andwhatdoesthismeanforinvestors?
Answers:
(a) Ifthedollarstrengthensbetweenthetimetheinvestorbuysandsellsthestock,thelocalcurrencybuys
fewerdollarsatthetimeofthesale.Ifforeigncurrencyvaluesdeclinebymorethantherateofreturn
intheforeigncurrency,positiveforeignreturnsmaynetouttoanegativereturnfortheU.S.investor.
(b) DuetothevaryingrelationshipoftheU.S.dollarwithforeigncurrencies,instructorswillhavetoget
currentinformation.Also,instructorsmaylocateinstanceswheretheU.S.dollarisappreciating
relativetoonecurrency,butdepreciatingrelativetoanother.

.6

Suggested Answers to Ethics in Investing Questions

Boards of Directors: Who Do They Represent? (at Web site)


Shouldcompanydirectorsberequiredtoownthestockofcompaniestheyrepresent?
Answer:
Thesadrealityofmanycorporateboardsisthattheyarefilledwithoutsidedirectors,whohavelittleorno
financialinterestinacompanytheyaresupposetooversee.Ratherthanrequiringdirectorstoputtheir
moneyatstaketobuycompanystock,corporationsoftengrantedthemfreestockoptionsinstead.
Unfortunately,theseoptionswereoftentreatedasperksandgiveawaysanddidlittletoaligndirectors
financialinterestswiththatofthestockholdersasmanyrecentcorporatescandalshaveindicated.One
possiblesolutiontothisproblem,andtoprovidedirectorswithincentivestoowncompanystock,would
bematchinggrantswherecompanieswouldestablishafundtomatchthedirectorsownpurchaseof
shares.

.7
1.

Suggested Answers to Discussion Questions


(a) Returnsduringthe1970swereonlyonethirdofthoseearnedduringthe1980s.Therewerefour
declinesduringthe1970s,butonlytwoduringthe1980s.Averagereturnsduringthe1990s
werethehighestofanydecade,at18.3%.Furthermore,therewasonlyoneyearwithadecline,
1990,duringtheperiodfrom19901999.Inboththe1980sand1990s,thereweresevenyears
withduringwhichtheDowJonesIndustrialAveragerosebyovertenpercent.Bycontrast,the
stockmarketfellineachofthefullyearssince1999reportedinTable6.1,andaveragedaloss
of4.3%.

113Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(b) Allthreemeasuresofstockmarketperformancehadanaveragepositiverateofreturnexceeding
18%duringthe1990s.Duringtheportionofthe2000savailable,allthreeindexeshadalossofat
least5%.WhiletheNasdaqmarketrosethemostonaverageduringthe1990s,italsodeclined
themostduringthe20002003period.TheNasdaqCompositeismorevolatileduringtheperiod
coveredbyFigure6.2.
(c) Thereisawidedifferenceintheaverageannualratesofreturn,betweenthefirsthalfof1990s
andthesecondhalf.From19901994,theDowJonesIndustrialAveragesaveragerateofreturn
was10.26%,whileinthe19951999periodtheaveragerateofreturnwas27.03%.Abetter
indicatoroffuturereturnsmaybetheaverageannualrateofreturnforthepastfiftyyears,as
presentedinTable6.2,whichis10.7percent.Obviously,thereisquitearangeinactualreturns
aroundthisaverage.
2.

(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)

Wednesday,April9
189.12
6.8%
15Theratioofthedailymarketpricetothecurrentearnings
189.12
$6.00/share
254.00,150.50
75,500
3.88,193.00

3.

Answerswillvarywitheachstudent.

4.

(a) Acombinationofgrowthandvaluestockina5050weightingsuchasMicrosoftforgrowthand
apublicutilityforvalue(income).Anotherappropriateapproachwouldbeatotalreturn
approach,thatseekstohighratesofgrowthindividendincomeorcapitalgains.Abuyandhold
strategyinvestedinaportfoliooflargegrowthcompanieswouldalsobeappropriate.
(b) Thosewithsmalleramountstoinvestarebetterofftofocusonqualitylongtermgrowthandless
onaggressivestockmanagement.Ifsheweremoreriskaverse,wemaywanttoallocatemore
valuethangrowthtotheweightingsuchas7525or6040.

5.

ThethreesourcesofreturntoU.S.investorsfromforeignstocksaretheshareofprofitpaymentsin
theformofdividends,thecapitalgainasthevalueofthestockincreasesinmarketpriceandthe
appreciationoftheforeigncurrencyagainsttheU.S.$.Currencyexchangeratesarecritical,small
foreignratesofreturnareelevatedasthevalueoftheU.S.$declines.Itisbesttobuyforeign
currenciesafterthedollarhasappreciatedrelativetothosecurrenciesandsellwhenthedollarhas
declinedrelativetotheforeigncurrency.
(a) BritishpoundshaveappreciatedinvalueascomparedtotheU.S.$givinggreaterreturnstothe
U.S.investorwhoholdspounds.AustraliandollarshavedepreciatedagainsttheU.S.$aswellas
theMexicanpesogivingtheinvestorwhoholdsthesecurrencieslessreturn.
(b) ADRsarenotdirectlyaffectedbyexchangeratechangessincetheytradeintheU.S.financial
marketsinU.S.$.Butsincetheunderlyingassetisaforeignstockdenominatedinaforeign
currency,thechangeinexchangerateswilleventuallyimpactthepriceoftheADRsinU.S.$s.

6.

(a) Abuyandholdstrategyisalongtermprogramthatseekscapitalgrowthwithaswellas
preservationofcapital,awellbalancedcombinationofgrowthandvaluestocksaremost
appropriate.

Chapter6CommonStocks114

(b) Acurrentincomeportfoliofocusesonthecurrentdividendyieldofstocks.Safetyofprincipal
andstabilityofincomearevital,whilecapitalgainshavesecondaryimportance.Thebenefitsof
thisstrategyhaveincreasedwiththedeclineindividendtaxrates.
(c) Longtermtotalreturnwouldemphasizemoregrowthstockaswellasalesserpercentagein
valuestocks.Beyondthecurrentdividendyield,attentionwouldbepaidtotheanticipated
dividendgrowthrate.
(d) Aggressivestockmanagementwouldcallforafrequentrebalancingoftheportfolioweightsto
representthelatesteconomicconditioninthemarkets.Theseinvestorswouldholdagreater
portionoftheirwealthinsmallcapissues,speculativetechstocks,foreignshares,andADRs.

.8
1.

Solutions to Problems
Ifa$50stocksplits5for2,thenewpriceofashareimmediatelyafterthesplitwouldbe$20.Using
theapproachnotedinthechapter,wehave:
[$50/(5/2)]$20.
Ifaninvestorowned200sharesbeforethesplit,hewouldown500sharesafterward:
2005/2500shares.
Themarketvalueofhisholdings,however,wouldbeunchanged:

2.

Beforethesplit:

200shares$50$10,000

Afterthesplit:

500shares$20$10,000

Commissionsontrades.Theinvestorbeganwith$20,000andmade$1,000onhistradeofstock.This
totals$21,000.Hisbalance,however,is$20,900.Therefore,Item4shouldbe:
CommissionsonTrades$100.00.

3.

BookvalueTotalassetsTotaldebtPreferredstock
ForKrackedPottery:
=$2,500,000 $1,800, 000 $200, 000
$500, 00
Bookvalue
Bookvaluepershare=
Numberofsharesofcommonstockoutstanding

Bookvalue

ForKrackedPottery:
Bookvaluepershare
4.

$500, 000
$10 pershare
50, 000

MarketCapitalizationsharepricexnumberofsharesoutstanding.
$25x250,000,000$6,250,000,000

5.

(a) Earningspershare(EPS)

Netprofitsaftertaxes Preferreddividends
Numberofsharesofcommonstockoutstanding

115Gitman/JoehnkFundamentalsofInvesting,NinthEdition

NetprofitsaftertaxesPreferreddividends
Numberofsharesofcommonstockoutstanding
ForMedTechCo.:
EPS

$15,800, 000 $1, 000, 000


2, 500, 000

$5.92

Chapter6CommonStocks116

Cashdividendspershare
Marketpricepershare
ForMedTechCo.:

(b) Dividendyield

Dividendyield
(c) Dividendpayoutratio

$2
3.33%
$60

Dividendspershare
EPS

ForMedTechCo.:
Dividendpayoutratio

$2
33.8%
$5.92

6.
InitialInvestment200$50
SalesProceeds200$55
Dividends$0.254200
TotalProceeds$200$11,000
NetProceedsBeforeTax
Tax@15%0.15$1,200
NetProceedsAfterTax$1,200$180
7.

$10,000
$11,000
$200
$11,200
$1,200
$180
$1,020

(a) BookvalueTotalassetsTotaldebtPreferredstock
ForTrulyGoodCoffee:
Bookvalue$240M$115M$25M$100M
Whichisequaltocommonstockholdersequity.
BookValue
(b) Bookvaluepershare
Numberofsharesofcommonstockoutstanding
ForTrulyGoodCoffee:
Bookvaluepershare

$100, 000, 000


$10pershare
10, 000, 000

(c) Earningspershare(EPS)

Netprofitsaftertaxes Preferreddividends
Numberofsharesofcommonstockoutstanding

ForTrulyGoodCoffee:
EPS
(d) Dividendpayoutratio

$22, 500, 000 $2, 000, 000


$2.05pershare
10, 000, 000shares

Dividendspershare
Earningpershare

ForTrulyGoodCoffee:
Dividendpayoutratio

$0.75
36.59%
$2.05

117Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(e) Dividendyieldoncommonstock

Cashdividendspershare
Marketpricepershare

ForTrulyGoodCoffee:
$0.75
3.0%
$25.0
Preferreddividendspershare
(f) Dividendyieldonpreferredstock
Marketpriceofpreferredshare
DividendyieldonCS

ForTrulyGoodCoffee:
DividendyieldonPS

$2.00
6.5%
$30.75

8.

$0.284$1.12perannumindividends.$1.12/$284%.

9.

Earningspershareare$900M/$900M $1.00.
Dividendspershare $0.90.
Payoutratio

$0.90/$1.0090%.

10. (a) IfColinsellshisstockonMarch20th,hewillbesellingafterthestocksexdividenddate(which


willoccuronMarch19th)and,therefore,hewillbetheholderofrecordandisentitledtoreceive
thedividendof$100($.50200shares).
(b) Colinwillbecreditedwith$100thatwillbeusedinthedividendreinvestmentplantopurchase
moreofthecompanysstock.A5percentdiscountonthe$40sharepriceis$2.00,sothe
purchasepricewouldbe$38pershare($40$2);thus,Colinwillbeabletopurchase
2.632sharesofcommonstock($100/$38).Unfortunately,Colinwillhavetopaytaxesonthe
$100,sinceitsstilltreatedasacashdividend.
.9

Thedividendspaidunderthetwosystemswouldbeasfollows:
DividendsPaid
Year
2000
2001
2002
2003
2004
TotalDividends

EPS
$1.40
2.10
1.00
3.25
0.80

40%Payout
Ratio
$0.56
0.84
0.40
1.30
0
.32
$3.42

RegularDividend
of$1pershare
$1.00
1.00
1.00
1.00
1
.00
$5.00

Chapter6CommonStocks118

Totaldividendsarehighestwithregulardividendsof$1pershare.Also,notehowdividend
paymentsfluctuatewiththefixedpayoutratioprocedure.
12. Thereisnosetsolutiontothisproblem,sincetheanswerwillvarywiththecompaniesselectedbythe
student.Thestudentsshouldbeencouraged(required?)toactuallycomputetherequested
information,ratherthansimplylookupthenumbersinsomethinglikeValueLine.Tocomputethe
latestB/Vpershare,EPS,dividendpayoutratio,anddividendyield,thestudentwillhavetorefertoa
coupleofdifferentsourcestocomeupwiththenecessaryinput(e.g.,MergentorS&Pforbalance
sheetandincomestatementinformation,andTheWallStreetJournalorBarronsfordividendsand
prices).SeveralInternetsitescanalsobeemployed.

119Gitman/JoehnkFundamentalsofInvesting,NinthEdition

13. (a) HoldingPeriodReturn(HPR)

Endingprice Beginningprice Currentincome


BeginningPrice

(1)

(2)

(3)

Ending
Year
2000
2001
2002
2003
2004

Beginning
Price
$54.00
74.25
81.00
91.25
128.75

Capital
Price
$42.50
54.00
74.25
81.00
91.25

(4)
Current
Gain
(1)(2)
$11.50
20.25
6.75
10.25
37.50

(5)

(6)

Annual
Income
$0.82
1.28
1.64
1.91
2.30

Return
(3)(4)
$12.32
21.53
8.39
12.16
39.80

HPR
(5)/(2)
28.99%
39.87
11.30
15.01
43.62

Overthefiveyearperiod,onaverageEngulfandDevourhasreturned27.76%peryear.Thisis
wellabovetheaveragereturnonthestockmarketoverthesameperiod.
14. (a) Ignoringthecurrencyeffect:
(1) TotalreturntoSiemensAG:
EndingValueinEuros DividendsinEuros
1
BeginningValueinDM
60e 1.5e

1
53.25e
0.1549or15.49%

(2) TotalreturntoSwisscom:
EndingValueinSf+DividendsinSf
1
BeginningValueinSf
760Sf 15Sf

1
715Sf
0.0839or8.39%

Ignoringthecurrencyeffect,Siemenspromisesthehighertotalreturn.Basedontotalreturnsin
foreigncurrencyform,itisthebetterinvestment.
(b) Note:TheEurodepreciated,whiletheSwissfrancappreciated.Consideringthecurrencyeffect:
(1) TotalreturntoSiemensinU.S.dollars:

ExchangeRateat
EndingValueinEurosandDividendsinEuros EndofPeriod

1
BeginningValueinEuros
ExchangeRateat
BeginningofPeriod
60.0e 1.5e 0.9852

1
53.25e
1.1080
(1.1549) (0.8892) 1 0.027 or 2.7%

Chapter6CommonStocks120

<Eq>
(2) TotalreturntoSwisscominU.S.dollars:
760 Sf 15 Sf 0.85

1
715Sf
0.75
0.2284or22.84%

ExchangeratesworkedagainsttheGermaninvestmentbecausethehigherreturnswereoffsetby
anappreciationinthedollarrelativetotheeuro.Conversely,thedollardepreciatedrelativetothe
Swissfranc,yieldinganevenhighertotalreturnontheSwissstock.Givenexchangerates,select
thestockissuedbySwisscom.
15. Ifthestockfallsby50%,Bobsstockwouldbeworth$12,500($25,000/2).Togetbackto$25,000,
thestockwouldhavetoincreaseby100%.
16. (a) YoushouldbuyEurodollars.Youexpectthattheeurowillbecomemorevaluableinsixmonths,
suchthatthecostofonedollarwillgofrom1.02Eurosto0.8941Eurosinsixmonths.
(b) Atarateof1.02Euros/Dollar,$10,000willbuy10,200Euros.Atarateof0.8941Euros/Dollar,
10,200Euroswillbuy$11,408.12.Profitis$11,408.12$10,000$1,408.12.

.10 Solutions to Case Problems


Case 6.1Sara decides to take the plunge
Thepurposeofthiscaseistoprovidethestudentwiththeopportunitytoidentifyinvestmentneeds,
establishinvestmentgoals,anddesignaninvestmentprogram.
(a) SinceSaraissosuccessful,shecaneasilyprovideforthenecessitiesoflife.Otherthanaminimum
savingsaccounttomeetemergencyneeds,hersavingsshouldnotbeheldforthelonghaulinthese
accounts.Keepingmoneytiedupinlowyieldingsavingsaccountsiscostly,sincetheloweryields
meanmuchslowergrowthofcapitalinshort,Sarawillendupwithalotlessmoneythanifshed
putitintosomethingwithahigherreturn(likestocks).Asanaside,Sarashouldmakesurethatany
moneyshekeepsinsavings(i.e.,foremergencypurposes)isputintohigheryieldingshortterm
vehiclessuchasmoneyfunds,shorttermCDs,orMMDAs.Althoughcommonstocksinvolvemore
riskandmaynotbeaperfecthedgeagainstinflation,theywillgenerallyearnhigherreturnsthanbasic
savingsaccountsandassuch,Sarashouldseriouslyconsiderputtingsomeofhermoneyintostocks
(orsomeotherformofequitysecurity).Becauseofthepositiveeffectsthatsuchinvestmentshaveon
thelongrunaccumulationofcapital,equitysecuritiesshouldbeapartofmostportfolios,especially
foryoungerpeople.
(b) Becauseofherhighcurrentincome,Saradoesnotneedinvestmentstoprovideincomenow.Shedoes
needsecuritiesforcapitalaccumulationandasastoreofvalue(protectlossinpurchasingpowerdue
toinflation)
1. NorthAtlanticSwimsuitCompany(NASS)mightmeetSarasneeds,butitisahighlyspeculative
stock.Thecapitalaccumulationandstorageofvaluebenefitsfromthissecurityaredifficultto
predict.CertainlySarasincomeandpersonalpositionjustifysomerisk,butprobablynotasher
onlyinvestment.IfshepurchasesNASS,sheneedstobeabletomonitorthefirmclosely.She
shouldbepreparedtosellifitsgrowthprospectssuddenlydim.Andsheshouldpurchaseother,
lessriskysecuritiesaswell.

121Gitman/JoehnkFundamentalsofInvesting,NinthEdition

2. TownandCountryComputerbestfillstheseneeds.Itisaclassicgrowthfirm:longrecordof
growth,qualityfirm,excellentprospects.Themodestdividendisunimportantnow,andthestock
shouldprovideforstorageofvalueaswellascapitalaccumulation.
3. SoutheasternPublicUtilityCompanydoesnotmeetSarasneeds;ithasahighcurrentdividend
andlowgrowthprospects.Withoutatleastaveragegrowth,thestockcannotserveasastoreof
value,sinceinflationwillcausethevalueoftheinvestmenttofall.Ontheotherhand,giventhe
recentchangesinthetaxlawsfordividends,thisstockcouldrepresentadecentgrowth
opportunityifthedividendsarereinvested.Thiswouldalsoprovidesomeincomeintheevent
heremploymentsituationchanges.
4. InternationalGoldMinesmayserveasasourceofcapitalaccumulation,butitspricevolatility
makesitquestionableasastoreofvalue.Certainlyitsdefensivecharacteristicsmakeitattractive
duringperiodsofhighinflationwhenthepriceofgoldisincreasing.However,wheninflation
moderates,itmayfailtoprovidethespectacularperformanceithashadininflationarytimes.A
keyhereshouldbeSarasexpectationsconcerninginflation.Ifsheexpectsinflationtoaccelerate
atahighrate,thisstockmaysuither.
Ofthefouroptions,TownandCountrybestservesherneeds,andSoutheasternUtilitiesisleast
attractive.Theothertwo,morespeculativestocks,fallinbetweenwiththeirappealafunctionof
theirlongtermgrowthprospects(NASS)andexpectationsaboutinflation(InternationalGold
Mines).
(c) Sarashouldfollowabuyandholdoraqualitylongtermgrowthstrategy.Ahighincomestrategy
doesnotfitherneeds;shedoesnothavetheexpertisetohandleaggressivestockmanagement
(althoughherinvestmentadvisormighthelpherhere);andthespeculative,shorttermstrategydoes
notmatchherrequirementsorabilities.Givenhernewentryintotheareaofinvestments,sheshould
probablybeginwiththebuyandholdstrategyandplantoadoptaqualitylongtermgrowthstrategy
asshedevelopsabetterunderstandingofthemarketandifshehasthetimetodevotetoinvestment
management.Throughsuchaprogram,commonstocksshouldenablehertoenjoylongtermgrowth
incapital.ForSara,commonstocksareanidealinvestmentvehiclesincetheyshouldprovidethetype
ofinvestmentreturn(capitalgain)sheis(orshouldbe)seeking.Oneofthekeyattributesofcommon
stockisitspotentialforcapitalappreciation,andthisispreciselywhatSarashouldgoafter.

Case 6.2Wally Wonders Whether Theres A Place for Dividends


Thiscaseillustratesthecommonpracticeofchanginginvestmentvehiclesinreactiontomarketchanges.
Thiscaseshouldallowstudentstoexperiencesomeofthestepsinvolvedinfollowinganinvestment
strategy,asitdemonstratesthatduringaneconomicdownswing,evenaninvestorinterestedinlongterm
growthmayhavesomethingtogainbygoingafterstocksthatofferattractivedividendyields.
(a) Wallysexistingplanisoneoflongtermgrowth,obtainedbyinvestinginqualityissues.Givenhis
highincomeandthelimitedtimehehastodevotetohissecurityholdings,thisstrategy(ofquality
growth)seemsappropriateforhim.
(b) 1. ExpecteddividendsforHydroElectric:

Chapter6CommonStocks122

Year
2004
2005
2006
2007
2008

(1)
ExpectedEPS
$3.25
3.40
3.90
4.40
5.00

(2)
Expected
DividendPayoutRatio
40%
40
45
45
45

(3)
(1)(2)
ExpectedDividend
$1.30
1.36
1.76
1.98
2.25

123Gitman/JoehnkFundamentalsofInvesting,NinthEdition

2. Wallycouldpurchase100sharesofHydroElectricstock($6,000investment/$60pershare).
Expectedreturnswouldbeafunctionofdividendsandcapitalgains.First,dividendincomeover
thefiveyearswouldbe:
Year
2004
2005
2006
2007
2008

Dividends
perShare
$1.30
1.36
1.76
1.98
2.25

100Shares

100

100

100

100

100

Totaldividendsfor5years:

Total
$130
136
176
198
225

$865

Now,assuminghecansellthestockfor$80pershareinfiveyears,his100shareswillbring
$8,000andhiscapitalgainswouldbe:$8,000$6,000$2,000.
Therefore:
Totalreturn
TotaldividendsCapitalgains
$865$2,000
$2,865
3. IfWallyjoinsthecompanysDividendReinvestmentPlan,hecanobtainsharesatreducedprices
andhencecanachievehisgoalofcapitalappreciation.
Wallywillobtainadditionalsharesasfollows:
(1)

(2)
(3)
(4)
No.ofShares
Heldat
Beginning
Dividends
Total
Year
ofYear
perShare Dividends
2004
100.00
$1.30
$130.00
2005
102.60
1.36
139.54
2006
105.14
1.76
185.05
2007
108.22
1.98
214.28
2008
111.52
2.25
250.92
NumberofadditionalsharespurchasedthroughtheDRP
Numberofsharesboughtoriginally

(5)
Purchase
Price
perShare
$50
55
60
65
70

(6)

No.ofShares
Purchased
(4)(5)
2.60
2.54
3.08
3.30
3
.58
15.10
100.00
Total
115.10

Chapter6CommonStocks124

UsingtheDividendReinvestmentPlan,Wallywouldhaveaccumulated15.10additionalshares,
foratotalof115.10sharesbytheendof2008.Withthestocktradingat$80onDecember31,
2008,hisshareswouldbeworth115.10$80$9,208.
Note:Thefigureshownincolumn(2)isthenumberofsharesheldatthebeginningoftheyear;
thisnumberwillincreaseeachyearwiththedividendsreinvested.Thisincreasesthetotal
dividendsreceivedeachyear.Comparethisanswerwith2(b).Thus,dividendreinvestmentplans
haveacascadingeffect.
(c) WallywouldnotbegoingtoadifferentinvestmentstrategyifhebuysthesharesofHydroElectric;he
wouldmerelybechangingthethrustofit.Thisisacommonstrategyusedbyaggressiveinvestors
followingalongtermgrowthprogram.Ofcourse,whenconditionschange,Wallywouldgobackto
investinginlongtermgrowthstocks.Inthatsense,histradingwouldbeincreased.However,sincethe
numberoftradesshouldnotbetoomany,thisshouldnotbeaseriousdrainonhistime.

.11 Outside Project


Chapter 6:Just What Kind of Stock Is It, Anyway?
Thetextdescribesanumberofdifferenttypesofcommonstocks:bluechips,incomestocks,growth
stocks,speculative,cyclical,defensive,andsmallcapstocks.Eachtypecanbecharacterizedbytheir
sensitivitytotheeconomy,whichisanimportantmarketfactorandwhichmaybemeasuredbythebetaof
thecompany.Theymayalsobecharacterizedbytheirdividendyield.Highyieldingcompanieshavefewer
investmentopportunities,sotheypayhigherdividendsandinvestorsexpectmoreoftheirreturninthe
formofdividends.Thepurposeofthisprojectistoseeifbetasanddividendyieldsdo,indeed,behaveas
expectedforthevarioustypesofstocksidentifiedabove.
ValueLinepublishesbetasanddividendyieldsforabout1700companies.Usingthecompanieslistedin
thetext,andothersimilarcompaniesthatyoucanidentifyinValueLine,findthebetasanddividend
yieldsforfivecompaniesineachoftheseven(7)stockcategoriesdefinedabove(i.e.,findthebetasand
dividendyieldsfor5bluechips,5incomestocks,5growthcompanies,5speculativestocks,5cyclicals,
5defensive,and5smallcapstocks).Next,calculatetheaveragebetaandaveragedividendyieldforeach
typeofstockthatis,findtheaveragebetaanddividendyieldforthe5bluechipstocks,thenfindthe
averagebetaanddividendyieldforthe5incomestocks,etc.Now,whatconclusionscanyoudrawabout
riskandreturnbasedonyourobservationsforeachtypeofstock?(Note:Besureyourinformationis
current.