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Investing in Common Stocks

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Investing in Common Stocks Insights Volume 1, Number 225 From the Investing in T. Rowe Price Information Common Stocks Library here is nothing common about proportional share of the company’s earnings common stocks. They have out- after the interest on bonds and dividends on performed other financial assets preferred stocks have been paid. on an average annual basis during the past 80 years. One dollar How Are Common Stocks Bought and Sold? invested in stocks at the end of All stocks are either listed or unlisted. Listed stocks 1926 would have grown to trade on one of the established securities exchanges, T such as the national New York and American Stock $2,908.33 by the end of 2007. Had that dollar been invested in Treasury bonds or Treasury bills Exchanges, or on a regional exchange. Unlisted instead, it would have been worth far less, as can stocks are bought and sold on Nasdaq, which does be seen in the table below. not have a physical location, but is rather an elec- tronic network where brokerage firms “make mar- I. Return on $1 Invested at Year-End 1926 kets” and negotiate stock prices among themselves. Through 2007 The Nasdaq system serves as a national electronic marketplace for a broad variety of unlisted stocks, Stocks (S&P 500) $2,908.33 but many smaller stocks trade outside the system via Bonds (U.S. Gov’t. Intermediate) 67.51 the “pink sheets,” a daily publication that details the Treasury Bills (30-Day) 19.55 bid and asked prices of thousands of over-the- Inflation (CPI) 11.89 (amount needed to maintain purchasing power) counter stocks. While most Fortune 500 corporations list their Source: Ibbotson Associates. stocks on the national exchanges, many major This table is for illustrative purposes only and does not repre- sent an investment in any specific security. Past performance companies in various industries choose to remain cannot guarantee future results. Unlike stocks, Treasury unlisted for a number of reasons. Some do not feel bonds and Treasury bills are guaranteed as to the timely pay- ment of interest and principal. It is not possible to invest that they need a physical marketplace since there directly in the index. is already a continuous market for their shares. Others may not want to comply with the proce- What Are Stocks? dures and paperwork involved in getting listed. Unlike corporate bonds, which are securities rep- resenting debt owed by companies to investors, How Are Stock Prices Set? The market value of any stock—the price people stocks are shares of ownership or equity in the are willing to buy and sell it for—is strictly a func- corporation that issued them. The common stocks tion of the marketplace. Stocks are just like any of publicly owned companies trade in a liquid other commodity: Buyers and sellers come together market—that is, an open market such as a stock in a competitive marketplace and transact business exchange where shares are bought and sold. We at mutually agreeable prices. Supply and demand will talk more about these markets a little later. rule the stock market, as all free markets. Prices are Holders of common stock are the actual own- largely driven by corporate earnings and the level ers of the issuing corporation in proportion to of dividends paid to shareholders. The relationship their number of shares. If you own stocks, you between earnings and stock returns is illustrated R have certain rights, including the right to your Insights as a protective cushion during volatile market II. Relationship of Stock Prices to Earnings and Dividends periods as well as a good indicator of a company’s Standard & Poor’s 500 Stock Index S&P 500 Per Share overall financial health. $1,600 $100 The compounding effect of dividends over Year-End Price (left scale) time is even more impressive. As illustrated in Annual Earnings (right scale) 1,200 Annual Dividends (right scale) 75 chart III, a hypothetical $1,000 investment in stocks composing the S&P 500 Index at the end of 1987 would have grown to $5,943 by the end 800 50 III. Source of Stock Returns: S&P 500 Stock Index 1987–2007 400 25 $ Thousands 12 Total Value Principal Growth of Investment 0 0 10 Total Value of Investment ’55 ’60 ’65 ’70 ’75 ’80 ’85 ’90 ’95 ’00 ’05 $9,330 100% Total This chart is for illustrative purposes only and does not represent the 8 Value of performance of any specific security. Past performance cannot guarantee Reinvested future results. It is not possible to invest directly in the index. Dividends Source: Standard & Poor’s. 6 $3,386 36% 4 Total in chart II. During years of increasing corporate Initial Principal earnings, such as the 2002 to 2007 period, stocks Investment Growth 2 $1,000 $5,943 rose. When earnings contract, as they did after 64% 2000, stock prices have tumbled as well. 0 Institutional forces, such as mutual fund ’87 ’89 ’91 ’93 ’95 ’97 ’99 ’01 ’03 ’05 ’07 Source: Ibbotson Associates. demand for particular stocks at any moment, Past performance cannot guarantee future results. This chart is for illustrative purposes and does not represent an investment in any specific and a host of psychological factors can either security. It is not possible to invest directly in the index. boost or depress stock prices. Investor sentiment also plays a major role in moving the market. At of 2007. With dividends reinvested, the same times, it can drive prices beyond reasonable val- investment would have been worth an additional uations, as evidenced by the dot-com bubble of $3,386, amounting to 36% of the total return. Of the late 1990s, while at other times investor dis- course, not all stocks pay dividends, and dividend interest pushes stock prices lower and lower. levels may fluctuate. The political climate is also a major influence on stock prices, as is the general state of the How Can You Tell if a Stock Price Is High or Low? economy, the level of interest rates, and the Stock analysts and investors review certain measures of value to arrive at what they think is attractiveness of competing investments. For a reasonable price for a stock or for stocks in these and other reasons, investors may be will- general. Just as you would not pay $50,000 for ing to pay $25 today for a stock that seems a compact car, neither would you want to pay fairly valued at $20, and six months from now $50 for a share of stock that, by most reasonable pass up the opportunity to buy it for $15. assumptions, has an intrinsic worth closer to $15 What Role Do Dividends Play in Stock Performance? or $20 per share. Some of the major measures of Dividends play a vital role in overall stock mar- value are: ket performance, since they are a guarantee that ■ Price/earnings. A stock’s price/earnings one of the two components of investment multiple (P/E) provides some idea of whether returns—capital appreciation and dividend a stock is overvalued or undervalued. To find income—will be positive. For example, in 1994, the P/E, you divide the current market price stock returns measured by the change in the by earnings per share. For example, let’s say principal value of the Standard & Poor’s 500 that pharmaceutical stocks are currently trading Stock Index were negative for the year. (The at an average P/E of 14. If ABC Pharmaceutical’s S&P 500 measures the performance of 500 large- current stock price is $25 and the company company U.S. stocks.) However, the 2.9% aver- earns $2.50 per share, the P/E is 10, or less than age dividend yield at the end of 1994 pushed the industry average. The stock appears under- S&P 500 stocks into positive territory with a valued based on this measure, but other data yearly total return of 1.3%. Dividends also serve have to be considered to be sure it is a good buy. Insights ■ Dividend yield. This measure gives you the since their high earnings growth makes them percentage income return on your investment. more attractive. Value stocks tend to come into You can calculate the dividend yield by dividing their own when the economy is booming, then the stock’s dividend per share by the current fade when a recession looks imminent. stock price. We’ll assume that the current average In reality, market timing is an inexact science dividend yield in the utility sector is 5%. If at best, which would explain why investors XYZ Electric pays a dividend of $1.60 and its have been notoriously unsuccessful at predict- stock is selling for $40 per share, the 4% yield ing changes in market leadership. For that rea- is below the industry average. The stock may son, they are better off owning both types of be overvalued according to this measure since stocks—growth for long-term appreciation the yield is low, but once again investors should and value for both appreciation and the divi- look at other factors to see if this is the case. dends that are a significant component of total ■ Price/book value. This refers to the relationship return over time. between a stock’s current price and its intrinsic In addition to growth and value stocks, worth or book value, which is a company’s assets many investors focus on other criteria when minus its liabilities. By dividing the stock price selecting stocks. Some prefer blue chip stocks, by the book value per share, you come up with others emerging growth or foreign stocks, yet the price/book value ratio.
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