Monday, July 6, 2009

Common Stock – Value, Growth, Large, Small?

Common stock (frequently referred to as equity) represents ownership in a corporation. Stock owners participate in the profitability of a company by receiving dividends, which is the distribution of a company’s profits (usually quarterly). As a company grows, its dividends commonly increase, motivating investors to pay more for the stock. This appreciation of a stock’s value is another way investors profit from stock ownership. Historically, dividends have accounted for approximately 40% of a stocks return, and the other 60% has come from appreciation.

Common stock owners have the ability to vote in elections for a company’s board of directors. If the company goes bankrupt, common shareholders only receive what remains after bond holders and preferred stock holders have been paid. This makes equities more risky to own than bonds, but stocks frequently rewards investors with higher returns over the long run.

Value stocks generally have low price-to-earnings ratios, and are considered to be undervalued in relation to other equity investment options. Traditionally, value stocks pay out the majority of their earnings in dividends. Investors buy value stocks at low prices, and hope their prices increase.

Growth stocks have a high price-to-earnings ratio, and usually pay either a small or no dividend because earnings are constantly reinvested into the company. This allows the company to grow at a faster rate. Investors buy growth stocks at high prices and hope their prices go even higher.

Of course, companies come in various sizes, as measured by market capitalization (number of common shares multiplied by the price of the stock). Generally, a small company is a firm with a market cap of less than $2 billion. A mid-sized company is a corporation with a market cap between $2 billion and $10 billion. Lastly, a large company has a market capitalization above $10 billion. Smaller companies are usually considered to be a more risky investment, and thus, traditionally have provided a higher return than large cap stocks.

Stocks have a place in every investment portfolio, if for nothing other than diversification benefits. Speak to an independent financial planner who can help allocate your assets between stocks, bonds, and cash.

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