Chapter 12
Investing in Stocks
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
12-1
Investing in Stocks
Chapter Learning Objectives
LO12.1 Identify the most important features of common and
preferred stock.
LO12.2 Explain how you can evaluate stock investments.
LO12.3 Analyze the numerical measures that cause a stock to
increase or decrease in value.
LO12.4 Describe how stocks are bought and sold.
LO12.5 Explain the trading techniques used by long-term
investors and short-term speculators.
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Learning Objective LO12.1
Identify the Most Important Features of Common
and Preferred Stocks
Common and Preferred Stocks
• Two concerns for beginning investors
– Where to get the information
– What the information means
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Why Corporations Issue
Common Stock
• Common Stock = most basic form of corporate
ownership
• Stock = equity financing
• Reasons why corporations issue Stock
– Raise money to start or expand business
– Pay ongoing business expenses
– Need not repay the money
– Dividends not mandatory
• Board of Directors votes on each dividend
payment
• But:
– Shareholders have voting rights and elect the board
of directors
12-4
Why Investors Purchase
Common Stock
Investors can make money in three ways
– Income from dividends
• Cash
• Stock dividend
– Dollar appreciation of stock value
• Price appreciation
• Capital gain
– Possible increased value from
stock splits
• No guarantee price will go up after a split
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Dividend Dates
• Declaration date = Board of Directors votes to
pay a dividend
• Record date = a stockholder must be
registered on the firm’s books to receive the
dividend
• Ex-Dividend date = 2nd business day before
the record date stock begins to trade without
the dividend
– Investors buying on or after the ex-div date do not
receive the dividend
• Payment date = dividend is paid
12-6
Preferred Stock
• A middle investment between common
stock (equity) and corporate bonds (debt)
– Stockholders know the amount of cash
dividend when the stock is purchased
– Conservative equity position like common stock
but usually non-voting
• Dividends paid before common stock
– Dividend may be omitted by action of the board
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Learning Objective LO12.2
Evaluating a Stock Issue
12-8
Learning Objective LO12.2
Evaluating a Stock Issue
• The Internet
– Firm’s home page more current than printed
materials
• Look for “Investor Relations” link
– http://finance.yahoo.com
• Research on a company
• Stock screener to help choose investments
• Professional advisory services
http://www.standardandpoors.com/
www.mergentonline.com
http://www.valueline.com
12-9
Where Can You Find a Stock Quote,
and What Does One Look Like?
• Print sources
– The Wall Street Journal http://www.wsj.com
– The local newspaper
• Online sources:
–
–
–
–
–
–
–
http://finance.yahoo.com
http://www.thestreet.com
http://money.cnn.com
http://moneycentral.msn.com
http://marketwatch.com
www.reuters.com
www.freecharts.com
12-10
Common Stock Price Quotes Online
at http://finance.yahoo.com
First enter
stock symbol
Resulting
screen
12-11
Common Stock Price Quotes
Last trade price = $75.43
Annual dividend = $1.76
P/E = 14.13 Earnings per share = 75.43/14.13 = $5.34
12-12
Evaluating a Stock Issue
Stock Advisory Services
• Research materials = more detailed
information compared to other
sources of information
• Most charge a fee
• Three most popular:
– Standard and Poor’s reports
– Value Line
– Mergent’s Handbook of Nasdaq Stocks
12-13
Corporate News
• Prospectus lists all necessary information
as dictated by the Federal government
• All publicly traded corporations send their
stockholders an annual report
• Securities and Exchange Commission
website (http://www.sec.gov)
• Business periodicals:
– Bloomberg Businessweek, Fortune, Forbes,
Money, Kiplinger’s Personal Finance Magazine
12-14
Learning Objective LO12.3
Numerical Measures that Influence Investment
Decisions
• Corporate earnings
– One of the most significant factors in
changes in the value of a stock
• Earnings per share (EPS)
– Corporation’s earnings divided by the
number of outstanding shares of common
stock
– EPS Increase = generally a healthy sign
12-15
Numerical Measures That
Influence Investment Decisions
• Price-earnings ratio (PE)
– Price per share of stock divided by the firm’s
earnings per share
– How much an investor is paying for a company’s
earning power
– P/E > 20  investor optimism
– P/E < 20  lower earnings expectations
– Compare to firms in same industry
• Projected Earnings
– EPS and PE based on historical data
– Future expectations more relevant
12-16
Other Factors that Influence the
Price of a Stock
• Dividend yield
– Annual dollar dividend divided by current price per
share
– Dividend yield increase = healthy sign
• Total return
– Dividends plus capital gains
– Cash income + Price appreciation
• Book value per share
– (Assets – Liabilities) divided by Number of shares
– Market price per share is often > book value
12-17
Other Factors that Influence the
Price of a Stock
• Predicting the future value of a share of stock uses
the Time Value of Money concepts from Chapter 1.
• The price an investor is willing to pay is determined
by:
– Expected future dividends
– Potential increase in price
– A combination of the first two
• Stock market bubble
– Stocks are trading above their actual worth
– Driven by investor optimism and irrational expectations
– Bubbles “burst”
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Learning Objective LO12.4
Buying and Selling Stocks
Primary Market
• Investor buys securities from issuer of those
securities via an investment bank
– Investment bank = financial firm that assists corporations in
raising funds, usually by helping sell new security issues
(underwriting)
• IPO = when a corporation sells stock to the
general public for the first time
• Key factor:
• Cash from security sales goes to issuing company
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Buying and Selling Stocks
Secondary Market
• Market for existing financial securities
• Traded among investors via brokers and
dealers
• Markets
– Securities exchanges
– Over-the-counter markets
12-20
Securities Exchanges
(NYSE)
• Securities exchange = Marketplace where members,
representing investors, meet to buy and sell
securities
• Securities sold on an exchange must be listed,
or accepted for trading, on that exchange
• “A Listed Market” = NYSE
• Designated “Specialists”
– Buy or sell a particular stock
– Responsibility for maintaining a
fair and orderly market
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The Over-the-Counter (OTC) Market
(NASDAQ)
• Network of dealers who buy and sell the
stocks of companies from inventory
– Dealer = “Market Maker”
• NASDAQ = electronic marketplace for
approximately 3,600 companies
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Brokerage Firms and
Account Executives
• Account executive (stockbroker)
– Licensed individual who buys and
sells securities for his or her clients
• Churning (Beware!)
– Excessive buying and selling of
securities to generate
commissions
– Illegal under SEC regulations
12-23
Discount vs. Full Service Brokers
Service vs. Cost
•
•
•
•
•
•
•
How much advice do you want?
Can you buy and sell stocks over the phone
Can you trade stocks online?
Where is the nearest office located?
Toll-free number for customer use?
How often are statements issued?
Is there a charge for statements, research
reports, and other financial reports?
• Are there any fees in addition to the
commissions to buy and sell?
12-24
Computerized Transactions
Reasons that justify trading online
1. Size of investment portfolio
2. Ability and desire to manage own
portfolio
3. Ability to monitor investments
closely
4. Capability of computer and
software
12-25
Stock Transaction Orders
• Market order
– Order to buy or sell stock at the current
market value
• Limit order
– Order to buy or sell a stock at a specified
price
• Stop-loss order
– Order to sell a stock at the next available
opportunity after its market price reaches a
specified amount
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Commission Charges
• Brokerage minimum commissions
– Range = $5 to $25
– Depends on the number of shares traded
and stock value
• Full service vs. discount brokers
– Full service fees > Discount broker fees
– Online broker little advice and you make
your own decisions
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Learning Objective LO12.5
Long-Term and Short-Term Investment
Strategies
Long-Term Investment Strategies
• Buy and hold
• Dollar cost averaging
• Direct investment and
dividend reinvestment
plans (DRIPS)
– http://www.directinvesting.com
– http://www.dripcentral.com
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Dollar Cost Averaging
• Long-term technique
• Invest equal dollar amount in the same stock
at equal intervals
• Goals:
– Minimize average cost per share
– Avoid “Buy High – Sell Low”
Year
Investment
2010
2011
2012
Total
Average
$2,000
$2,000
$2,000
$6,000
Stock
Price
Shares
Purchased
$60
$68
$58
33.3
29.4
34.5
97.2
$61.73
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Short-Term Investment Strategies
• Buying stock on margin
– Borrowing money from broker
– Margin requirement set by the Fed
– 50% Initial, 25% Maintenance
– “Bullish”
• Selling short
– Borrowing stock
– “Sell high, buy low”
– “Bearish”
12-30
Short-Term Investment Strategies
• Trading in options
– Option = the right but not the obligation to
buy or sell a stock at a predetermined price
during a specified period of time
• Call option
– Right to buy
– “Bullish”
• Put option
– Right to sell
– “Bearish”
– Not for amateurs or beginning investors
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Chapter Summary
Learning Objective LO12.1
• Corporations sell stock (a form of equity) to finance their
business start-up costs and help pay ongoing business costs.
• Common stockholders have the right to elect the board of
directors. They must also approve major changes to corporate
policies.
• Possible reasons for stock investments include:
– Dividend income
– Appreciation of value
– The possibility of gain through stock splits
• A few corporations may issue preferred stock.
– Preferred stockholders receive cash dividends before any
cash dividends are paid to common stockholders
– Dividend distributions to both preferred and common
stockholders must be approved by the board of directors
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Chapter Summary
Learning Objective LO12.2
• Start the stock evaluation process with the
classification of different types of stock
investments ranging from very conservative
to very speculative—see Exhibit 12–3.
• Information for stock evaluation is available
from:
–
–
–
–
–
–
The internet
Stock advisory services
The newspaper
The corporations that issue stocks
Business and personal finance periodicals
Government publications
12-33
Chapter Summary
Learning Objective LO12.3
• Many analysts believe that a corporation’s
ability or inability to generate earnings in the
future may be one of the most significant
factors that account for an increase or
decrease in the value of a stock.
– Generally, higher earnings equate to higher stock
value, and lower earnings equate to lower stock
value.
• Earnings per share and a price-earnings ratio
are historical numbers based on what a
corporation has already done.
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Chapter Summary
Learning Objective LO12.3
• Investors can obtain earnings estimates for
most corporations.
• Other calculations that help evaluate stock
investments include:
– Dividend yield
– Total return
– Book value
• Stock prices are also affected by:
– The amount of future dividends
– A potential increase in the price of a share of stock
– What another investor will pay for a share of stock
12-35
Chapter Summary
Learning Objective LO12.4
• A corporation may sell a new stock issue with the
help of an investment banking firm.
• Once the stock has been sold in the primary market
(IPO), it can be sold time and again in the
secondary market.
– In the secondary market, investors purchase stock listed on
a securities exchange or traded in the over-the-counter
market.
• Securities transactions are made through:
– An account executive who works for a full-service
brokerage firm
– A discount brokerage firm
– Online brokerage firm
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Chapter Summary
Learning Objective LO12.4
• Basic order types include:
– Market order
– Limit order
– Stop-loss order
• Brokerage firms typically charge a minimum
commission for buying or selling stock.
Additional commission charges are based
on:
– The number of shares bought or sold
– The value of the shares
– You can use a full-service or discount brokerage
firm or trade online.
12-37
Chapter Summary
Learning Objective LO12.5
• Purchased stock may be classified as either
a long-term investment or a speculative
investment.
• Long-term investors typically hold their
investments for at least a year or longer.
• Techniques long-term investors use include:
–
–
–
–
Buy-and-hold
Dollar cost averaging
Direct investment plans
Dividend reinvestment plans
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Chapter Summary
Learning Objective LO12.5
• Speculators (sometimes referred to as
traders) usually sell their investments within a
shorter time period
• Techniques they use include:
– Buying on margin
– Selling short
– Trading in options
12-39