Chapter 12: Investing in Stocks

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.
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
– 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
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
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
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
• Ex-Dividend Date = 2nd day before the
record date; stock begins to trade without the
– Investors buying after the ex-dividend date do not
receive a dividend for that quarter
• Payment Date = Dividend is paid to investors
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
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
• The Internet
– Firm’s home page more current than printed materials
• 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
• Securities and Exchange Commission Web site
• Business Periodicals:
– Business Week, Fortune, Forbes, Money, Smart Money, Kiplinger’s
Personal Finance Magazine
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
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
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
Other Factors than Influence the
Price of a Stock
• Dividend Yield
– Annual dollar dividend divided by current price per
– 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
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
– Stock exchanges (NYSE, foreign securities exchanges)
– Over-the-counter markets
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
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
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?
• Are there any fees in addition to commissions to buy
and sell?
Computerized Transactions
Reasons that justify trading online:
1. Size of investment portfolio
2. Ability and desire to manage own
3. Ability to monitor investments
4. Capability of computer and
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
Objective 5
Explain the Trading Techniques Used by
Long-term Investors and Short-term
Long-Term Investment Strategies
• Buy and hold
• Dollar cost averaging
• Direct investment and
dividend reinvestment
plans (DRIPS)
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”
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)
Wrap Up
• Chapter Quiz
• Concept Check 12-1- Common Stock and
Preferred Stock
• Concept Check 12-2-Prospectus and Annual
• Figure It Out- Earnings per Share, PE Ratio,
Dividend Yield
• Concept Check 12-4- How Would You Buy
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