14
INVESTING IN STOCKS
CHAPTER OVERVIEW
Initially, this chapter describes both common and preferred stock as investment alternatives. We discuss the topics of why corporations sell common
stocks and why investors purchase those stocks. Next, we examine the major differences between common stock and preferred stock. Methods that
investors can use to evaluate stock investments are presented. Then the steps involved in buying and selling stocks are described. We also explain the
long-term techniques of buy and hold, dollar cost averaging, direct investment plans, and dividend reinvestment plans. Finally, the speculative
techniques of day trading, margin transactions, selling short, and stock options are also discussed.
LEARNING OBJECTIVES
CHAPTER SUMMARY
After studying this chapter, students will be able to:
Obj. 1
Identify the most
important features of
common and preferred
stock.
Corporations sell common stock to finance their business
expansion. People invest in common stock because of dividend
income and appreciation of value. There is also the possibility of
gain through stock splits. Dividend payments must be approved by
a corporation’s board of directors. In return for providing the
money needed to finance the corporation, stockholders have the
right to elect the board of directors. They must also approve
changes to the corporate charter that include (1) an amendment to
the corporate charter, (2) the sale of certain assets, (3) possible
mergers, (4) the issuance of preferred stock or corporate bonds,
and (5) changes in the amount of common stock.
The most important priority that an investor in preferred stock
enjoys is receiving cash dividends before any cash dividends are
paid to common stockholders. Still, dividend distributions to both
preferred and common stockholders must be approved by the
board of directors. To make preferred stock issues more attractive,
corporations may add a cumulative feature and/or a conversion
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feature to these issues.
Obj. 2
Explain how you can
evaluate stock
investments.
LEARNING OBJECTIVES
Depending on specific characteristics associated with a stock,
investment, account executives, financial planners, and investors
often classify a particular stock investment as blue chip, income,
growth, cyclical, defensive, large-cap, mid-cap, small-cap, or
penny. A number of factors can make a share of stock increase or
decrease in value. When evaluating a particular stock issue, most
investors begin with the information contained in daily
newspapers or on the Internet. Stock advisory services, annual
reports, information contained on the SEC web site, and in
business periodicals, can all be used to evaluate potential stock
investments.
CHAPTER SUMMARY
Obj. 3
Analyze the numerical
measures that cause a
stock to increase or
decrease in value.
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. In addition to the total
amount of earnings reported by the corporation, it is possible to
calculate earnings per share and a price-earnings ratio to evaluate
a stock investment. While both earnings per share and a priceearnings ratio are historical numbers based on what a corporation
has already done, it is possible to obtain earnings estimates for
most corporations. Other calculations that help evaluate stock
investments include dividend payout, current yield, total return,
annualized holding period yield, beta, and book value.
Fundamental analysis, technical analysis, and the efficient market
theory can also be used to explain the price movements that occur
in the stock market.
Obj. 4
Describe how stocks are
bought and sold.
A corporation may sell a new stock issue through an investment
bank or directly to current stockholders. Once the stock has been
sold in the primary market, it can be sold time and again in the
secondary market. In the secondary market, investors purchase
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stock listed on a securities exchange or traded in the over-thecounter market. Most securities transactions are made through an
account executive who works for a brokerage firm. A growing
number of investors are using computers to complete security
transactions online. In fact, a good investment software package
can help you evaluate potential investments, monitor the value of
your investments, and place buy and sell orders online. Most
brokerage firms charge a minimum commission for buying or
selling stock. Additional commission charges are based on the
number and value of the stock shares that are bought and sold and
if you use a full-service or discount broker or trade online.
Obj. 5
Explain the trading
techniques used by longterm investors and shortterm speculators.
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;
speculators (sometimes referred to as traders) usually sell their
investments within a shorter period of time. Traditional trading
techniques used by long-term investors include the buy and hold
technique, dollar cost averaging, direct investment plans, and
dividend reinvestment plans. More speculative techniques include
day trading, buying on margin, selling short, and trading in
options.
INTRODUCTORY ACTIVITIES

Ask students to comment on the opening case for the chapter (p. 441).

Point out the learning objectives (p. 440) in an effort to highlight the key points in the chapter.

Ask students to share various attitudes toward investing in stock (p. 441).

Discuss factors that would make certain stocks an attractive investment. (p. 441)
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CHAPTER 14 OUTLINE
I.
Common and Preferred Stock
A. Why Corporations Issue Common Stock
1. A Form of Equity
2. Dividends Not Mandatory
3. Voting Rights and Control of the Company
B. Why Investors Purchase Common Stock
1. Income from Dividends
2. Dollar Appreciation of Stock Value
3. What Happens When a Corporation Splits Its Stock?
C. Preferred Stock
II.
Evaluating a Stock Issue
A. Classification of Stock Investments
B. The Internet
C. Stock Advisory Services
D. How to Read the Financial Section of the Newspaper
E. Corporate News
III.
Numerical Measures that Influence Investment Decisions
A. Why Corporate Earnings Are Important
B. Other Factors that Influence the Price of a Stock
C. Investment Theories
IV.
Buying and Selling Stocks
A. Primary Markets for Stocks
B. Secondary Markets for Stocks
1. Securities Exchanges
2. The Over-the-Counter Market
C. Brokerage Firms and Account Executives
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5
D. Should You Use a Full-Service or a Discount Brokerage Firm?
E. Computerized Transactions
F. Commission Charges
G. A Sample Transaction
VI.
Long-Term and Short-Term Investment Strategies
A. Long-Term Techniques
1. The Buy and Hold Technique
2. Dollar Cost Averaging
3. Direct Investment and Dividend Reinvestment Plans
B. Short-Term Techniques
1. Day Trading
2. Buying Stock on Margin
3. Selling Short
4. Trading in Options
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CHAPTER 14 LECTURE OUTLINE
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I. COMMON AND PREFERRED STOCK (p. 442)
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This chapter is all about evaluating stock investments. The overall objective is to learn how to
evaluate a stock and to make money from your investment decisions.
Today a lot of people buy and sell stocks. Why? The most obvious answer is simple: they want
larger returns than those more conservative investments offer.
Although stocks have returned approximately 10 percent a year over the past 100 years—
substantially more than U.S. Treasury bills or bonds—there are periods when stock have
declined in value.
According to Ibbotson Associates, stock investments will continue to grow at about the same
pace between now and the year 2025.
Why Corporations Issue Common Stock (p. 442)
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Corporations sell common stock to finance expansion.
Corporate managers prefer selling common stock for a number of reasons.
1. It is a form of equity and does not have to be repaid.
2. Dividends must be approved by the board of directors and are not mandatory.

In return for the financing, management must make concessions to stockholders that may restrict
corporate policy.
1. Corporations are required to have an annual meeting.
2. Stockholders vote in person or by proxy.
3. Common stockholders elect the board of directors and approve major changes in corporate
policies.
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CHAPTER 14 LECTURE OUTLINE
What Happens When a Corporation Splits Its Stocks? (p. 445)
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A stock split is a procedure in which the shares of stock owned by existing stockholders are
divided into a larger number of shares.
1. Why do corporations split their stock? In many cases, a firm’s management has a theoretical
ideal price range for the firm’s stock.
2. The lower market value for each share of stock is the result of dividing the dollar value of
the company by a larger number of shares of common stock.
3. Also, a decision to split a company’s stock and the resulting lower market value may make
the stock more attractive to the investing public.
4. This attraction is based on the belief that most corporations split their stock only when their
financial future is improving and on the upswing.
Be Warned: There are no guarantees that a stock’s market value will go up after a stock split.
The effects of a 2-for-1stock split on the common stock split issued by Martin & Martin, Inc. are
illustrated in Exhibit 14-3.
While there is no evidence to support that a corporation’s long-term performance is improved by
a stock split, some investors do profit from stock splits on a short-term basis.
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II. EVALUATING A STOCK ISSUE (p. 448)

A wealth of information is available to investors in stock, and a logical place to start is with the
classification of stock investments.
Classification of Stock Investments (p. 448)

We describe nine classifications for stock investment that are commonly used by investors,
financial planners, and stockbrokers. They are:
1. Blue chip stocks—an investment that generally attracts conservative investors.
2. Income stocks—stocks that pay higher than average dividends.
3. Growth stocks—stocks issued by corporations that earn profits above the average profits of
all the firms in the economy.
4. Cyclical stocks—stocks that follow the business cycle of advances and declines in the
economy.
5. Defensive stocks—stocks that remain stable during declines in the economy.
6. Large-cap stocks—stocks issued by a large corporation that has a large amount of stock
outstanding and a large amount of capitalization, usually in excess of $5 billion.
7. Mid-cap Stocks—stocks issued by corporations that have capitalization between $1 billion
and $5 billion.
8. Small-cap stocks—stocks issued by a corporation that has a capitalization of $500 million
or less.
9. Penny stocks—stocks that typically sell for less than $1 a share.
The Internet (p. 450)
As pointed out in the last chapter, it is impossible to describe all the Web sites that deal with
personal finance and investments. We will examine some Web sites that are logical starting
points when evaluating stock investments. These include:
1. A corporation’s home page
2. Web sites like Yahoo and other search engines
3. Professional advisory services like Standard & Poor’s, Morningstar, and Value Line
CHAPTER 14 LECTURE OUTLINE
Stock Advisory Services (p. 451)
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In choosing among the hundreds of stock advisory services that charge fees for their information,
the investor must be concerned about both the quality and the quantity of the information they
provide.
Four popular advisory services are:
1. Standard & Poor’s Reports
2. Value Line
3. Morningstar
4. Mergent’s Investors Service
A detailed research report for Reebok is illustrated in Exhibit 14-5.
How to Read the Financial Section of the Newspaper (p. 451)
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Although not all newspapers print exactly the same information, the basic information is usually
provided.
Stocks are listed alphabetically, so your first task is to move down the table to find the stock
you’re interested in.
Then, to read the stock quotation, you simply read across the table—See Exhibit 14.6.
If a corporation has more than one stock issue, the common stock is always listed first. Preferred
stock issues are indicated by the letters “pf” that follow the company’s name.
Corporate News (p. 453)
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The federal government requires corporations selling new issues of securities to disclose
information about corporate earnings, assets, and liabilities, products or services, and the
qualifications of top management in a prospectus that they must give to investors.
After stock is sold, the federal government also requires that corporations report financial
information to the Securities Exchange Commission (SEC).
In addition to a prospectus, all publicly owned corporations send their stockholders an annual
report that contains detailed financial data.
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CHAPTER 14 LECTURE OUTLINE
III. NUMERICAL MEASURES THAT INFLUENCE INVESTMENT DECISIONS (p. 454)
Why Corporate Earnings Are Important (p. 455)
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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.
Simply put, higher earnings generally equate to higher stock value.
Unfortunately, the reverse is also true. If a corporation’s earnings decline, generally the stock’s
value will also decline.
To help evaluate a stock issue, many investors calculate earnings per share and price-earnings
ratios.
While these calculations are based on historical numbers, it is also possible to obtain projected
earnings for most corporations.
Other Factors that Influence the Price of a Stock (p. 456)
 Today, many investors purchase stocks for dividend income. Because dividends are a distribution
of a corporation’s earnings, these same investors must be concerned about the firm’s future
earnings and the dividend payout.
 The dividend payout is the percentage of a firm’s earnings paid to stockholders in cash.
 In addition to the above numerical measures, a current yield calculation can help investors
compare returns for different investments.
 The total return calculation includes not only the yearly dollar amount of income as well as any
increase or decrease in the original purchase price of the investment.
 The annualized holding period yield calculation takes into account the total return, the original
investment, and the time the investment is held.
 The beta is an index reported in many financial publications that compares the risk associated
with a specific stock issue with the risk of the stock market in general.
1. The beta for the stock market in general is 1.0.
2. The majority of stocks have betas between 0.5 and 2.0.
3. Generally, conservative stocks have low betas and speculative stocks have high betas.
CHAPTER 14 LECTURE OUTLINE
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It is also possible to calculate a firm’s book value. Book value for a share of stock is determined
by deducting all liabilities from the corporation’s assets and dividing the remainder by the
number of outstanding shares of common stock.
Investment Theories
Finally, investors often use three different investment theories to determine a stock’s value.
1. The fundamental theory is a theory based on the assumption that a stock’s intrinsic or real
value is determined by the future earnings of the company.
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CHAPTER 14 LECTURE OUTLINE
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The American Stock Exchange and various regional exchanges also transact stocks for
corporations and investors.
The over-the-counter (OTC) market is a network of dealers who buy and sell the securities of
corporations that are not listed on a securities exchange.
Most over-the-counter securities are traded through NASDAQ—an electronic marketplace for
approximately 3,300 stocks.
Brokerage Firms and Account Executives (p. 463)
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An account executive is a licensed individual who buys or sells securities; also called a
stockbroker.
Most account executives also provide securities information and advise their clients regarding
investments.
Needless to say, account executives may err in their investment recommendations. To help avoid
a situation in which your account executive’s recommendations are automatically implemented,
you should be actively involved in your investment program.
In particular, avoid letting your broker use his or her discretion with regard to your account.
Also, watch for the practice of churning.
Should You Use a Full-Service or a Discount Brokerage Firm? (p. 463)

Today, a healthy competition exists between full-service brokerage firms and discount brokerage
firms. When deciding which to use you should consider:
1. The amount of research information that is available and how much it costs.
2. How much help you need when making an investment decision.
3. How easy it is to buy or sell stock and other securities.
Computerized Transactions (p. 464)
While most people still prefer to use telephone orders to buy and sell stocks, a growing number
of investors are using computers to complete security transactions.
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CHAPTER 14 LECTURE OUTLINE
Commission Charges (p. 464)
 Most brokerage firms have a minimum commission charge for buying or selling stock, usually
between $7 and $55. Additional commission charges are based on the number of shares and the
value of stock bought and sold.
 Also, the commission charged by a full-service broker is generally higher than the commission
charged by a discount broker.
 See Exhibit 14-7 to see typical charges for trades, research, and extras charged by a number of
discount and online brokerage firms.
A Sample Stock Transaction (p. 466)

Once an investor and his or her account executive have decided on a particular transaction, the
investor gives the account executive an order for that transaction.
1. A market order is a request that a stock be bought or sold at the current market price.
2. A limit order is a request that a stock be bought or sold at a specified price.
3. A stop order is a request that an order be executed at the next available opportunity after the
market price reaches a specified price.
4. A discretionary order is an order to buy or sell a security that lets the account executive
decide when to execute the transaction and at what price.
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CHAPTER 14 LECTURE OUTLINE
V. LONG-TERM AND SHORT-TERM INVESTMENT STRATEGIES (p. 467)

Generally, individuals who hold an investment for a long period of time are referred to as
investors. Individuals who buy and then sell stocks within a short period of time are called
speculators or traders.
Long-Term Techniques (p. 467)

Long-term investment strategies include:
1. The buy and hold technique
2. Dollar cost averaging—See Exhibit 14-8
3. Direct investment
4. Dividend reinvestment plans
Short-Term Techniques (p. 468)
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In addition to the long-term techniques presented in the preceding section, we discuss several
short-term, speculative techniques. These methods are quite risky and should not be used by
investors who do not fully understand the underlying risks.
For example, a day trader is an individual who buys and then later sells stocks and other
securities in a very short period of time. Be warned: Most day traders lose money. This is only
one of many highly speculative techniques.
Other highly speculative techniques include buying stock on margin, selling short, and trading in
options.
Buying Stock on Margin (p. 469)
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When buying stock on margin, an investor borrows part of the money necessary to buy a
particular stock.
The steps of a typical margin transaction are illustrated in Exhibit 14-9.
Selling Short (p. 470)
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Investors oriented to greater risk often use a procedure called selling short to make money when
the price of a security is falling.
Selling short is selling stock that has been borrowed from a stockbroker and must be replaced at a
later date.
The steps involved in selling short are illustrated in Exhibit 14-10.
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Trading in Options (p. 471)

An option gives an investor the right to buy or sell stock at a predetermined price during a
specified period of time.
1. A call option is sold by a stockholder and gives the purchaser the right to buy 100 shares of a
stock at a guaranteed price before a definite expiration date.
2. A put option is the right to sell 100 shares of a stock at a guaranteed price before a definite
expiration date.
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