Chapter 12: Investing in Stocks

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12
•
Investing in Stocks
Stocks – shares of ownership in the assets and
earnings of a business corporation.
•
Common Stock – the most basic form of
ownership of a corporation.
•
Shareholder – the owner of a stock.
•
Voting Rights – proportionate authority to
express a choice in matters affecting the company.
•
Proxy – written authorization given by shareholder
to someone else to represent him or her and vote
his or her shares at a stockholder’s meeting.
12-1
Objective 1
Identify the Most Important Features of
Common and Preferred Stocks
• Two types of stock
– Common Stock- provides investors with an
ownership interest in a corporation or (growth
oriented)
– Preferred Stock- a cross between a stock
and a bond (income oriented)
• On average, common stocks have
outperformed all other assets over time
• Need to be patient and do research
12-2
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 (like bonds)
– Dividends (distributions to shareholders) not mandatory
• Board of Directors votes each dividend payment
• But:
– Shareholders have voting rights; control of company
– Management must often make concessions
12-3
Why Investors Purchase
Common Stock
Investors can make money in three ways
– Income from dividends
– Dollar appreciation of stock value
• Price appreciation = capital gain
– Possible increased value from stock splits
• No guarantee price will go up after a split
•
Stock Split – when the shares of stock owned by existing
shareholders are divided into a larger number of shares;
done to change (lower) price
–
•
Example: 2:1- twice as many shares worth half as much
A reverse stock split results in smaller number of shares.
–
Example: 1:2- half as many shares worth twice as much
12-4
Dividend Dates
• Declaration Date = Board of Directors votes
to pay a dividend (usually quarterly)
• Record Date = A stockholder must be
registered on the firm’s books to receive the
dividend
• Ex-Dividend Date = 2nd day before the
record date; stock begins to trade without the
dividend
– Investors buying after the ex-dividend date do not
receive a dividend for that quarter
• Payment Date = Dividend is paid to investors
12-5
Preferred Stock
• Hybrid Security
– Known cash dividend is about equal to bond interest
– Equity position is about equal to common stock but usually
non-voting; low % of all stock issued
• Dividends paid before common stock
– Dividend may be omitted
• Cumulative Preferred Stock
– Unpaid cash dividends accumulate
– Must be paid before any cash dividends are paid to common
stockholders (versus noncumulative preferred stock)
• Convertible Preferred Stock
– Can be traded for shares of common stock
– Provides investor with added safety of preferred stock and
greater speculative gain through conversion to common stock
12-6
Classifications of Stocks
• Income Stock – may not grow too quickly, but
pays a cash dividend higher than that offered
by most companies year after year.
– Example: utility companies
• Growth Stock – a company that offers the
promise of much higher profits tomorrow and
has a consistent record of relatively rapid
growth in earnings in all economic conditions.
– Example: technology companies
More Classifications of Stocks
• Speculative Stock – a company that has a
potential for substantial earnings in the future.
• Blue-Chip Stocks – a company that has been
around for a long time, has a well-regarded
reputation, dominates its industry, and is known
for being a solid, relatively safe investment.
• Value Stock – a company with stock that is
selling for less than the true worth of its assets.
Other Characterizations for
Common Stocks (continued)
• Cyclical Stocks – stock from a company
whose profits are greatly influenced by changes
in the economic business cycle.
– Examples?
• Countercyclical (or Defensive) Stocks –
stock from a company that performs well even
in an environment characterized by weak
economic activity.
– Examples?
Objective 2
Explain How You Can Evaluate Stock
Investments
• The Internet
– Firm’s home page more current than printed materials
– http://finance.yahoo.com
• Stock Advisory Services
– Most charge a fee
– Three most popular: Standard and Poor’s reports, Value Line
and Mergent’s Handbook of Common Stock
• Prospectus- Lists all necessary information as dictated by the
Federal government
• Annual Report- All publicly traded corporations send to their
stockholders
• Securities and Exchange Commission Web site
(http://www.sec.gov)
• Business Periodicals:
– Business Week, Fortune, Forbes, Money, Smart Money, Kiplinger’s
Personal Finance Magazine
12-10
Objective 3
Analyze the Numerical Measures that
Cause a Stock to Increase or Decrease
in Value
• Corporate Earnings
– One of the most significant factors in
changes in the value of a stock
• Earnings per share (EPS)
– Formula: Corporation’s after-tax income
divided by number of outstanding shares of
common stock
– Example: $5,000,000/10,000.000 = $0.50
– EPS Increase = generally a healthy sign
12-11
Numeric Measures That
Influence Investment
• Price-Earnings Ratio (PE)
– Price per share of stock divided by the firm’s
earnings per share
– Example: $10 price/0.50 EPS = a PE ratio of 20
– Tells 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
12-12
Common Stock Price Quotes
Last trade price = $44.37
Annual dividend = $1.68
P/E = 15.41 Earnings per share = 44.37/15.41 = $2.8793
12-13
Other Factors than 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)/ # shares (net worth of company)
– Market price per share should be > book value
12-14
Objective 4
Describe How Stocks are
Bought and Sold
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 general public for first time
– Cash from security sales goes to issuing company
– Generally considered a high-risk investment
Secondary Market
•
•
•
Market for existing financial securities
Traded among investors via brokers and dealers
Markets
– Stock exchanges (NYSE, foreign securities exchanges)
– Over-the-counter markets
12-15
Secondary Markets for Stocks
Securities Exchanges (NYSE)
•
Marketplace where members, representing investors, meet to buy and
sell securities (almost 4,000 companies)
•
Securities sold on an exchange must be listed, or accepted for trading,
on that exchange
•
“The Listed Market” = NYSE
•
“Specialist” buys or sells a particular stock
The Over-the-Counter (OTC) Market (NASDAQ)
•
Network of dealers who buy and sell the stocks of companies from
inventory (several thousand companies)
– Dealer = “Market Maker”
•
NASDAQ = electronic marketplace for over 3,200 companies
12-16
Brokerage Firms and
Account Executives
• Account Executive (Stockbroker)
– Licensed individual who buys and sells
securities for his or her clients
• Churning
– Excessive buying and selling of securities to
generate commissions
– Illegal under SEC regulations
– Can be difficult to prove; clients subject to
arbitration
12-17
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
and other financial reports?
reports,
• Are there any fees in addition to commissions to buy
and sell?
12-18
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
12-19
Stock Transaction Orders
• Market Order
– Request to buy or sell stock at the current market value
• Limit Order
– Request to buy or sell a stock at a specified price
• Stop Order (Stop-loss order)
– Request to sell a stock at the next available opportunity after
its market price reaches a specified amount
– Can lose a lot of money in a “flash crash”
• Brokerage minimum commissions
– Range = $7 to $35
– Depends on the number of shares traded and stock value
• Full service vs. discount brokers
– Full service fees > 1% to 2% of transaction amount
– Online broker little advice or service
12-20
Objective 5
Explain the Trading Techniques Used by
Long-term Investors and Short-term
Speculators
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
12-21
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
2006
2007
2008
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
12-22
Short-Term Investment Strategies
• Buying Stock on Margin
– Borrowing money from broker
– Margin requirement set by the Fed
– “Bullish” (expect stock price increase)
• Selling short
– Borrowing stock to sell
– “Sell high, buy low”
– “Bearish” (expect stock market decrease)
12-23
Wrap Up
• Chapter Quiz
• Concept Check 12-1- Common Stock and
Preferred Stock
• Concept Check 12-2-Prospectus and Annual
Report
• Figure It Out- Earnings per Share, PE Ratio,
Dividend Yield
• Concept Check 12-4- How Would You Buy
Stock?
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