3.5: Stock Characteristics and Measurements

Video - Audio - YouTube

We will turn our attention to various stock characteristics and measurements.

Stock Spinoffs

A stock spin-off is the conversion of one of a firm’s subsidiaries to a stand-alone company by distribution of stock in that new company to existing shareholders. After the spin-off, the investor will still have shares in the previous firm but will now also have shares in the company that was spun off. Sometimes, the new company is still majority-owned by the company that spun it off. Examples include Kraft Foods which was spun off from Altria, the makers of Philip Morris and Virginia Slims cigarettes. Altria then divested itself of its international tobacco business, now called Philip Morris International. After both spin-offs were spun off, investors held shares in Altria, Kraft, and Philip Morris International.

Some investors show keen interest in spin-offs. They believe that the-spin off is being undertaken because the management believes the spun off company will be successful on its own. You will hear some in the industry say, “This spin-off will unlock value.” However, the history of spin-offs has been checkered. Some spin-offs have done better than the companies that spun them off. Examples of this are the Baby Bells after being spun off from the old AT&T 1984. Two of the companies grew to be Verizon Communications and SBC Communications. Verizon used to be Bell Atlantic. SBC Communications bought the old AT&T in 2005 and changed its name to AT&T. Some spin-offs have not fared so well. Examples of this are Coca-Cola Enterprises, spun off from Coca-Cola, and Lucent Technologies, spun off from the old AT&T. Both were disappointments to their investors.

Stock Splits

A stock split is an accounting maneuver in which a company increases the number of shares outstanding by exchanging a specified number of new shares of stock for each outstanding share. The most popular split is 2 for 1 split. For example, in a 2 for 1 split, if you had 100 shares, after the split, you would now have 200 shares. Of course, the price will also experience a 2 for 1 split. The price will fall in half. There is no increased value from stock splits. If you had 100 shares at $20, now you have 200 shares at $10; the value is still $2,000. It is a psychological increase at best. Warren Buffett of Berkshire Hathaway has refused to split his stock since its inception. As of April 2022, a single share was selling for over $500,000!

Historically, the investment community encouraged companies to split their stock prices because of the historical face-to-face double auction system. Recall that to facilitate trading, investors were encouraged to buy round lots in multiples of 100. When a stock price starts to get into the 100’s of dollars, 100 shares can become very pricey and out of the reach of many investors. With the new technology, there is no longer any advantage to buying and selling round lots. The computer system does not care if there are 100 or 17 or 5 or even one share. Therefore, stock splits are not as common as they once were.

Two for 1 splits are not the only types of splits. There are 5 for 1 splits, 3 for 2 splits, etc. There are even reverse splits. For example: a 1 for 10 split means that the company will replace 10 of your shares with only 1 share. What is the rationale for this? When a stock price falls below approximately $5, the company’s standing in the investment community suffers. Not only that, but the listing requirements of the NYSE and NASDAQ come into play and the company may become in danger of being delisted. To compensate, the company will issue a reverse split. For example, if an investor owned 100 shares of a stock that were selling for $2 and the stock split 1 for 10, the investor would now only own 10 shares. However, the price would jump to $20. Recall that the value does not change, only the accounting. A reverse split is usually a sign of a company in distress.

Treasury Stock and Share Buybacks

Treasury stock are shares of stock that have been issued to the public and then subsequently repurchased by the issuing firm. The process of repurchasing stock by a company is called a share buyback, also known as a share repurchase or simply a buyback. The shares are taken out of circulation. Hence, share buybacks reduce the number of outstanding shares. The logic being that after the buyback, there is less supply of outstanding stock. And any first semester student of economics will tell you if the supply of a product or service is reduced, assuming the demand does not change, the price should rise. Existing shareholders now have a larger percentage ownership of the corporation.

During the run-up of the 1990’s, share buybacks were often seen as a better alternative to dividend increases. The belief was that investors were more interested in capital gains than dividends and that buybacks increased the potential for capital gains by reducing the supply of stock. Recently, with interest rates at generational lows, companies borrowed money to repurchase shares of their stock, as well as pay additional dividends. The dramatic lowering of corporate tax cuts in 2017 also prompted many corporations to accelerate their share buybacks, instead of the promised productivity and wage gains.

Common Stock Classes

From time to time, some corporations will issue different classes of common stock. Typically, there might be two classes but sometimes more. At one time, General Motors is reported to have had seven classes of stock. One typical reason for two different classes of stock is to allow the original owners or family to have specific privileges that retail investors do not receive. For example, the A shares of a company stock would be for the general public and the B shares would be owned only by the family and they would receive a much higher dividend. Sometimes, the B shares have far more voting rights per share allowing the original owner or the family to keep ultimate control over the company. This is how Facebook structured their two share classes. The A shares are owned by the general public while the B shares are owned by the CEO and executive team. The B shares have 10 votes for every 1 share and give the CEO 58% of the voting rights, essentially ensuring that no other shareholders will ever have a voice in the operations of the company. This structure is increasingly being used in many technology companies such as Lyft and Google. Recently, The Council of Institutional Investors (CII) and other shareholder groups have begun to petition the NYSE and NASDAQ to limit the use of these techniques, arguing that these structures are ultimately not in the best long-term interests of retail shareholders.

There is an interesting story about multiple shares classes and Berkshire Hathaway, the holding company run by the famed investor Warren Buffett. You may recall that Mr. Buffett refused to split the shares of Berkshire Hathaway. Hence, the price of one share had ballooned to $30,000 by the mid-1990’s. The financial world pressed Mr. Buffett to make it easier for retail investors to invest in the company, not so subtly threatening to take action if Berkshire Hathaway did not comply. Berkshire Hathaway responded by issuing class B shares at 1/30^th of the price of the original shares, now renamed class A. In typical fashion, the class B shares had much lower voting rights than the class A shares. In the prospectus for the Initial Public Offering of the class B shares, Mr. Buffett said that he would not buy the class B shares and recommended that others not buy them, either. However, later on, in 2010, Mr. Buffett and Berkshire Hathaway found a new usage for the class B shares. They split the B shares 50 for 1 in 2010 and started using the B shares like cash to purchase new investments. The price of a single B share was close to $310 as of February of 2023.

Par Value, Book Value, and Market Value

The par value of stock is the nominal value, also called face value, of the stock. It may be as low as a penny or even much less. For example, the par value of Apple shares is $0.00001. This number is sometimes required for legal purposes and is fairly meaningless to investors. A more important measure is book value. Book value is the amount of shareholders’ equity in a firm. It is computed by taking the firm’s assets and subtracting the firm’s liabilities and preferred stock. Students of accounting will instantly recognize this calculation. In our BUS-121, Principles of Money Management, class we call it our net worth. However, the book value is usually ignored by investors who instead concentrate on the market value. The market value is the prevailing market value of a security. It’s the current price of the stock set by the forces of supply and demand. In other words, what is the company worth? What is its valuation? What should I pay for a share of a company’s stock? This is an enormously difficult question to answer. We will introduce valuation techniques in our next chapter.

Stock Dividends, Earnings per Share, and Dividend Yield

Dividends are optional distributions of earnings given to stockholders. Companies in the United States and countries that were associated at one time or another with the United Kingdom normally pay dividends quarterly. Companies from other countries typically pay dividends either semi-annually or annually. The corporation’s Board of Directors decides how much, if any, dividends should be paid and when to pay them. Dividends are usually a percentage of the earnings per share, a very important statistic. Earnings per share, often expressed as EPS, are the amount of annual earnings available to common stockholders, as stated on a per share basis.

For example, the annual earnings of a company may be $1,000,000 and there are 500,000 shares outstanding. Therefore, earnings per share = $1,000,000 earnings / 500,000 shares = $2.00 earnings per share. The Board of Directors might decide to pay out 50% of the earnings per share in the form of dividends. Hence, each shareholder would receive a $1.00 dividend for each share of stock they owned. In this case, the company is paying out 50% of their earnings to shareholders in the form of dividends. The percentage of dividends paid out from earnings per share is called the dividend payout ratio. Larger, more mature companies tend to pay out larger percentages of their earnings in the form of dividends. Smaller, growing companies typically pay out a much smaller percentage of the earnings or, more likely, they will not pay out any dividends at all. This is because the company needs the earnings to invest back in the business to help with the growth. Accounting students will remember that the portion of earnings that are not paid out in the form of dividends is called retained earnings. (We take this opportunity to remind you yet again that we will not be doing any accounting in this class. We will simply utilize the financial statements and other statistics that the accountants create for us.)

Earnings and dividends are two very important measures of the value of a company. We will be discussing these for the remainder of our time together. Dividends are the only statistic that we know absolutely for sure is correct. All the other statistics could be pure fantasy, and sadly, sometimes they are. However, we know the reported dividend is true because the company sent us a check. Well, actually, they don’t send us checks anymore; dividends are now paid electronically and deposited automatically into our brokerage account. Nevertheless, we can emphatically say once again, “Dividends don’t lie!”

The dividend yield is another very important statistic. It is a measure that relates the dividends paid by a stock to the share price of the stock. This puts stock dividends on a relative percentage basis rather than an absolute dollar basis. Continuing the example from above, if our stock that was paying us $1 dividend were currently selling for $20, the dividend yield would be 5%. Dividend yield = $1 dividend per share / $20 market price of one share = 0.05 or 5%. The dividend yield allows us to compare stocks with other income-oriented vehicles such as bonds or savings accounts. You may recall that traditionally, 3% to 6% was a typical dividend yield. In the 1990’s dividends went to 2% and eventually 1% at the peak of the Internet bubble in March of 2000. Dividends then went above 3% in the 2008/2009 turmoil as stock prices plummeted. They are now back down below 2% as of February 2023.

Important Stock Dividend Dates

There are four dates to remember with regard to dividends. The first is the declaration date. This is the date that the Board of Directors declares the dividend. For example, on May 15^th, the Board might say, “On June 17^th, shareholders of record will be eligible for our quarterly dividend of $1.” In this example, June 17^th is the date of record, the date on which an investor must be a registered shareholder of a firm to be entitled to receive the dividend. It is also called the record date. The date of record is typically a few weeks after the declaration date.

Now here is where it gets a bit tricky. You may believe that you could purchase the shares of the stock before June 17^th and hence be eligible for the dividend. This is not the case. You must purchase the shares before the ex-dividend date. The ex-dividend date is actually two business days before the date of record. Only those shareholders who have purchased the shares before the ex-dividend will be eligible to receive the dividend. Why is the ex-dividend two days before the date of record? This is because stock transactions clear in 2 business days. When you buy a stock, you don’t actually become the official shareholder for 2 business days. Likewise, when you sell shares of stock, because stock transactions clear in 2 business days, the proceeds from the sale aren’t actually deposited into your account for 2 business days.

Once you have a good working relation with your brokerage, because of this characteristic of stock transactions, your broker may allow you to initiate a stock purchase without the sufficient cash in your account. You then have 2 business days to get the money into the account. Some brokerage firms will not allow a purchase to occur if sufficient cash is not in the account. When you sell shares, again, with a good relationship with your brokerage firm, the brokerage firm may deposit the cash proceeds the day of the sale in anticipation of receiving the funds 2 business days later, sometimes as a loan with minimal interest charged.

If you research the ex-dividend date, you may find some sources still claiming that stock transactions clear in 3 business days. The reason for this is that the move to 2-day settlement is fairly recent, starting in 2017, so some sources may still report a 3-day settlement. In 1993, the Securities and Exchange Commission changed the settlement to 3 business days from 5 business days. You had to wait an entire week to get your shares or receive your cash! Technology has enabled much faster transaction settlements.

In our example from above, if the date of record were June 17^th, assuming that June 17^th were not on a Monday or Tuesday, then the ex-dividend date would be June 15^th. Of course, if the date of record is a Monday or Tuesday or if there is a holiday just before the date of record, the ex-dividend date is modified accordingly.

The last date to be aware of is the payment date. This is the date on which the company pays the dividend and the cash arrives in your account. This is normally a few weeks after the date of record.

Theoretically, the opening share price on the ex-dividend date should reflect a drop in price commensurate with the amount of the dividend. In our example above, the $1 per share dividend should result in the opening stock price being reduced by $1. Of course, it never really works that way in the marketplace since prices are changing all the time.

“Don’t Buy the Dividend!” is a common saying in the industry. Those who advance this technique believe investors are often better off waiting until the ex-dividend date before buying a stock. The logic behind this admonition is thus: Dividends are taxable transactions. If you “buy the dividend” – buy the stock just before the ex-dividend date – you will be responsible for paying the tax, and presumably, the stock price will fall commensurate with the amount of the dividend, so you are better off waiting until after the ex-dividend date so that you will get the stock at a better price and not generate a taxable transaction. This might be a useful strategy for those dealing in large-scale investments involving significant sums of money. Of course, for the vast majority of us retail investors, the initial purchases will be modest and the price and tax savings will be negligible. (When and if the purchases become gargantuan, congratulations! You are very welcome, by the way.)

Cash Dividends versus Stock Dividends

There are two types of dividends, cash dividends and stock dividends. If the following definitions and comparison escape you, remember this: You Want Cash Dividends! With cash dividends, payments are in the form of cash. Before modern telecommunications and information processing, the company would send you a check. Now, the cash is automatically deposited into your brokerage account. If you were using the dividends for income expenses, most brokerage firms will allow you to set up your account so that the dividends are sent electronically to your bank or credit union. Cash dividends are taxable transactions. Every January, you will receive a Form 1099 that lists your cash dividends and you would be required to declare them on your tax return. If your investments are in tax-qualified accounts such as IRAs or 401(k) plans, the transactions would not be reported and you would not pay any taxes until you withdrew the money. (If you have a Roth IRA and you wait until retirement age, all distributions are tax-exempt! More later.)

In contrast, stock dividends are dividend payments in the form of additional shares of stock. All other things being equal (and they never are, by the way), stock dividends have no value because they constitute a dilution of ownership and there is no change in value. They are similar to stock splits. For example: The Board of Directors declares a 10% stock dividend. For every 10 shares, an investor will receive 1 extra share. However, similar to a stock split, the price of the shares will drop 10%. Thankfully, unlike a cash dividend, a stock dividend is not taxed. “Gee, thanks, IRS, for not taxing me on something that isn’t worth anything!” Prudent, long-term investors are normally never interested in stock dividends.

Bottom line: You Want Cash Dividends!

Dividend Reinvestment Plans (DRIPs)

Dividend reinvestment plans, often referred to as DRIPs, are plans in which shareholders have cash dividends automatically reinvested into additional shares of the firm’s common stock. These are not to be confused with stock dividends. DRIPs are cash dividends. However, instead of receiving the cash in your account, the plan purchases shares of the stock on the open market with the cash dividends. No new shares are issued and hence, no dilution of ownership occurs. Since these are cash dividends, these are taxable transactions. DRIPs are an excellent way to own stock for those interested in long-term growth and not interested in current income. It allows an investor to take advantage of compounding automatically with normally no, or very small, transaction costs. There is an example along with a commentary about a DRIP on the class website. Many corporations sponsor DRIPs for their stocks and you deal directly with the corporation at a very low cost. Also, most brokerage firms now offer DRIPs to their clients. Plus, won’t your friends and family members think it’s cool when you tell them that you have a DRIP?

Here is an example of a dividend reinvestment plan (DRIP) from Sempra Energy, the parent company of San Diego Gas and Electric. Notice that Sempra Energy does not administer the DRIP. They hired a company called Equiserve (which is now part of Computershare) to do the accounting for them. Most DRIPs are very low cost. Every so often, in the [Fees] box, we would be charged $0.03 or $0.06 or $0.09. Pretty good deal! However, how would you like to keep track of 18 different DRIPs? For this reason, most brokerage firms now offer DRIPs for their clients and you can have your DRIPs all together in one place. (I just love writing and saying DRIP!)

Price-to-Earnings Ratio, aka P/E, PE

By far, the most watched stock valuation statistic is the price-to-earnings ratio. It is also written as price to earnings ratio and often abbreviated as P/E or just PE. It is a simple calculation. The price-to-earnings ratio is calculated by taking the market price of one share of stock divided by the earnings per share. However, there is never any end to the mountain of analysis, research, conjecture, opinion, predictions, weeping, gnashing of teeth, and beating of breasts that accompany price-to-earnings ratios. In our previous example with a $20 market price and $2 earnings per share, the price-to-earnings ratio would be $20 price / $2 earnings = 10 P/E. The price-to-earnings ratio is unit-less. We don’t place a $ or % next to our result.

Traditionally, stocks typically sold for P/E ratios of between 5 to 15. A P/E ratio of 20 or above was only reserved for the fastest growing stocks. During times of market manias and bubbles, a P/E of 20 was not unusual. During market downturns, P/E ratios come down greatly. We will spend a great deal of time learning P/E and other valuation techniques in the next two chapters.

Before moving to the next section, it is time to work through Stock Worksheet #2. As with most all worksheets in our class, there is also a commentary and answer key on the class website.