Investment Banking: Characteristics of Stock - dummies

Investment Banking: Characteristics of Stock

By Matt Krantz, Robert R. Johnson

Stock investors are typically seen as being among the daredevils of the investment banking world. Stocks are generally high-risk, high-return types of investments. Stocks typically generate some of the highest returns of any major investment. Stocks typically deliver returns to investors in the form of

  • Dividends: Companies, if they choose, may make periodic (usually quarterly) cash payments to the shareholders of record. These payments, typically made from cash generated by the business, can be an important part of the total return investors receive by holding a stock. Companies may also choose to make large one-time dividend payments. Dividends can be a very significant part of a company’s total return to investors.

    Investors typically look at dividends in terms of a dividend yield. The dividend yield puts the dividend in relation to the stock price, by dividing the annual dividend by the stock price to arrive at a percentage return. For instance, if a stock that is trading for $50 a share pays an annual $1-per-share dividend, the dividend yield is 0.02, or 2 percent of the share price.

  • Stock price appreciation: After companies first sell shares to the public, the investors who buy those shares are free to buy and sell at will in the secondary market. Investors are constantly buying and selling the shares based on what they think the future of the company will be. The price investors are willing to pay for the share ebbs and flows as new information comes into the market.

  • Special business transactions: Although not nearly as common as dividends and stock price appreciation, some companies may look to special transactions to unlock value. One of the most common events, and one that involves investment bankers, are spinoffs. Spinoffs occur when companies break out a part of their business and set it up as a separate company, often with its own stock.

    Year Ending Total Return Change Stock-Price Appreciation Dividend Yield
    December 31, 2012 16.0% 13.4% 2.6%
    December 30, 2011 2.1% 0.0% 2.1%
    December 29, 2000 –9.1% –10.1% 1.0%
    December 31, 1995 37.6% 34.1% 3.5%
    December 31, 1990 –3.1% –6.6% 3.5%

Source: S&P Dow Jones Indices

Stock sounds pretty ideal so far, with the dividends and the chance at stock price appreciation. But there are some pretty grave downsides to equity that are the constant boogeyman for stockholders to think about, including the following:

  • Dividends can be suspended or canceled at any time. Unlike interest payments on bonds, which must be paid by companies, dividends can be halted or cut at any time. And cutting dividends is a constant danger when times get tough. During the financial crisis that erupted in 2007, most large banks cut their dividends to a penny a share or eliminated them completely.

  • Stocks can go down, too. Stocks aren’t for the weak of heart. They can fall or even plummet during times of economic uncertainty or crisis. Sometimes stock declines can be complete, resulting in a total loss for investors. Complete losses on stock investments were commonplace for many dot-com investors in the 1999–2000 time period.

  • Stocks investors’ claims to assets are inferior. If things go really wrong at a company, stockholders are last in line at the asset buffet. If a company sells itself off, or liquidates, the assets generated are first paid to the employees and short-term creditors and then to the bondholders.

    When things go really bad, when companies enter bankruptcy protection for instance, it’s pretty typical for stockholders to wind up with nothing and the bondholders to end up as the new owners of the company.