Chapter 14
Investing in Stocks
Chapter 14
Learning Objectives
 Identify the most important features of common
and preferred stocks
 Explain how you can evaluate stock investments
 Analyze the numerical measures that cause a stock
to increase or decrease in value
 Describe how stocks are bought and sold
 Explain the trading techniques used by long-term
investors and short-term speculators
2
Common and Preferred Stocks
Objective 1: Identify the most important features
of common and preferred stocks
 Good investors know something about the company before
they invest in the company’s stock
 Gather information to evaluate a potential investment in a
stock
 Learn what the information you gather means
 There are periods where stocks decline in value
 The key to success is to allow investments to work for you
over the long-term
3
Legal Forms of Businesses
1) Sole Proprietorship
 A business owned by a single individual.
 Owner maintains title to the firm’s assets.
 Owner has unlimited liability.
2) Partnership
 Similar to a sole proprietorship, except that
there are two or more owners.
4
Legal Forms of Businesses
3) Corporation
 A business entity that legally functions separate
and apart from its owners.
 Owners’ liability is limited to the amount of
their investment in the firm.
 Owners hold common stock certificates, and
ownership can be transferred by selling the
certificates.
5
Comparison of Three Forms

Advantage of corporations:
-- limited liability
-- ease in raising capital
6
The Corporation and Financial Markets

Corporation
cash
Investors
securities
reinvest
Secondary
markets
Cash flow
dividends,
etc.
tax
Government
7
Movement of Savings
 Direct Transfer of Funds
cash
firm
saver
securities
8
Movement of Savings
 Indirect Transfer using Investment Banker
funds
funds
saver
investment
banker
securities
firm
securities
9
Movement of Savings
 Indirect Transfer using a Financial Intermediary
funds
saver
funds
financial
intermediary
intermediary
securities
firm
firm
securities
10
Common Stock
 Is a variable-income security.
 Dividends may be increased or decreased,
depending on earnings.
 Represents equity or ownership.
 Limited liability: liability is limited to amount of
owners’ investment.
 Priority: lower than debt and preferred.
11
Common Stock
 Claim on Income - a stockholder has a claim on the
firm’s residual income.
 Claim on Assets - a stockholder has a residual claim
on the firm’s assets in case of liquidation.
 Preemptive Rights - stockholders may share
proportionally in any new stock issues.
 Voting Rights - right to vote for the firm’s board of
directors.
12
Why Corporations Issue Common Stock
 To raise money for start-up costs and help pay for
expansion and their ongoing business activities
 They don’t have to repay the money a
stockholder pays for stock
 Dividends are not mandatory. Most corporations
distribute 30-70% of their earnings to stockholders
 In return for investing in the company,
stockholders have voting rights
13
Why Investors Purchase Common Stock
 They can make money in three ways
 Income from dividends in the form of cash or additional
stock (record day and ex-dividend)
 Dollar appreciation of stock value
 Possible increased value from stock splits
 WHAT HAPPENS WHEN A CORPORATION
SPLITS ITS STOCK?
 A stock split happens when the shares owned by
existing stockholders are divided into a larger number
of shares
14
Preferred Stocks
PREFERRED STOCK
 Investors in preferred stocks receive cash dividends
before common stock holders are paid any cash
dividends
 The dividend amount is either a stated amount of money
for each share of preferred stock, or a percentage of the
par value
 Par value is an assigned dollar value that is printed on a
stock certificate
15
Preferred Stocks
 Usually sold for $25, $50, or $100 per share.
 Example: In 2002, Xerox issued $75 million of
8.25% preferred stock at $50 per share.
 $4.125 is the fixed, annual dividend per share.
16
Preferred Stocks
A hybrid security:
 It’s like common stock - no fixed maturity.
 Technically, it’s part of equity capital.
 It’s like debt - preferred dividends are fixed.
 Missing a preferred dividend does not constitute
default
17
Preferred Stocks (continued)
 You are an owner of the stock but have a known
rate of return. Shares are safer than common stock
because the dividends are more secure
 Firms may have multiple classes of preferreds,
each with different features.
 Priority: lower than debt, higher than common
stock.
18
Preferred Stocks (continued)
 Protective provisions are common.
 PIK Preferred: Pay-in-kind preferred stocks pay
additional preferred shares to investors rather than
cash dividends.
 Retirement: Most preferreds are callable, and many
include a sinking fund provision to set cash aside for
the purpose of retiring preferred shares.
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Preferred Stocks (continued)

Cumulative Preferred stock
 Unpaid cash dividends accumulate and must
be paid before any cash dividends are paid to
the common stock holders
 Convertible preferred stock
 Can be traded for shares of common stock in
the same company
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Evaluating a Stock Issue
Objective 2: Explain how you can evaluate stock
investments
CLASSIFICATION OF STOCKS
Blue chip stock
Cyclical
Defensive
Growth
Income
Large cap
Mid cap
Small cap
Micro cap
Penny stock
21
Evaluating a Stock Issue
 Blue chip: financially strong, high quality stocks with
long and stable records of earnings and dividends
eg: General Electric, Merck, Wal-Mart, SBC
Communications, Home Depot
 Income stock: long and sustained records of paying
higher than average dividends
eg: AT&T, American Electric Power, Duke Energy
 Cyclical stock: earnings and overall market
performance are closely lined to the economy
eg: Caterpillar, Maytag Corp, Timken
22
Evaluating a Stock Issue
 Defensive stock: tend to hold their own, and even do
well, when the economy starts to falter
eg: Bandag, Checkpoint Systems
 Growth stock: experience high rates of growth
eg: General Dynamics, Google, Starbucks
 Tech stock: represent new technology
eg: computers, semiconductors, data storage,
software, internet service, wireless communication
23
Evaluating a Stock Issue
 Large cap: greater than 10 billion
 Midcap: 2 to 10 billion
 Small cap: 250 million to 2 billion
 Penny stock: below $1
24
Evaluating a Stock Issue (continued)
THE INTERNET
 Most corporations have a Website, and the information is
useful in the following ways
 The Website is easily accessible
 More up to date information than the printed material
 Websites like Yahoo and other search engines can also be
used to obtain information about stock investments
 The Internet can also be used to access professional
advisory services like



www2.standardpoors.com
www.valueline.com
www.morningstar.com
25
Evaluating a Stock Issue (continued)
STOCK ADVISORY SERVICES
 Prepare printed materials that are a good supplement to
information in newspapers and the Internet
 Charge a fee
 Hundreds to choose from
 Standard and Poor’s reports (library)
 Value Line (library)
 Mergent’s Handbook of Common Stock
 Morningstar
 As an investor, your job is to interpret the information
provided
26
Evaluating a Stock Issue (continued)
HOW TO READ THE FINANCIAL SECTION OF THE
NEWSPAPER
 You will see stock quotes in newspapers such as The Wall
Street Journal
52 weeks
Yld
Vol
Net
Hi Lo Sym Div % PE 100s Hi Lo Close Chg
134 80 IBM .52 .5 21 143402 98 95 9549 -3
115 40 MSFT
…
29 558918 55 52 5194 -475
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Numerical Measures That Influence Investment
Decisions
Objective 3: Analyze the numerical measures that
cause a stock to increase or decrease in value
Why corporate earnings are important?
 Corporate earnings play a large part in the increase or
decrease in the value of a stock
 Earnings per share are the corporation’s after-tax earnings
divided by the number of outstanding shares of a common
stock. An increase in earnings is generally a healthy sign
 Price-earnings (PE) ratio
 Price of one share of stock divided by the earnings per
share of stock over the last 12 months
28
Numerical Measures That Influence Investment
Decisions (continued)
OTHER FACTORS THAT INFLUENCE THE PRICE
OF A STOCK
 Dividend payout = Dividend amount
EPS
 Dividend yield = Annual income amount
Market value
 Total return = Current return + Capital gain
 Annualized holding period yield =
Total return
X1
Original investment
N
29
Numeric Measures That Influence
Investment Decisions (continued)
 Beta: measure of volatility
 Book value per share
 Net worth of company determined by deducting all
liabilities from the corporations assets and dividing
the remainder by the number of outstanding shares
of common stock
30
Numeric Measures That Influence
Investment Decisions (continued)
 Market-to-Book ratio
 The current market value divided by the book value
 A measurement ratio that, in part, may be used to
determine the value of a stock
 If the market-to-book ratio is high, that may mean
that the stock is overvalued
 If the market-to-book ratio is low, that may mean
that the stock is undervalued
31
Numeric Measures That Influence
Investment Decisions (continued)
INVESTMENT THEORIES
 Fundamental analysis
 Based on the assumption that a stock’s intrinsic or
real value is determined by the company’s future
earnings
 Fundamentalists consider the…
 Financial strength of the company
 Type of industry company is in
 New-product development
 Economic growth of the overall economy
32
Numeric Measures That Influence
Investment Decisions (continued)
Fundamental analysis:
 Financial statement: balance sheet, income statement,
cash flow statement
 Key financial ratios:
-- liquidity ratios: Do we have enough liquid assets to
meet approaching obligations?
eg: current ratio, acid ratio
-- operating efficiency ratio: how efficiently the firm’s
assets generate operating profits.
eg: return on investment, profit margin, asset turnover
33
Numeric Measures That Influence
Investment Decisions (continued)
Fundamental analysis:
 Key financial ratios:
-- leverage ratio: the use of debt to finance assets.
eg: debt ratio, times interest earned
-- return on equity: How well are the firm’s managers
maximizing shareholder wealth?
eg: return on equity ratio
34
Numeric Measures That Influence
Investment Decisions (continued)
 Technical analysis
 Based on the assumption that a stock’s value is
determined by the forces of supply and demand
in the stock market as a whole
 Not based on expected earnings or the intrinsic
value of a stock but rather on factors found in the
market
 Chartists plot past price movements and other
market averages to observe trends they use to
predict a stock’s future value
35
Numeric Measures That Influence
Investment Decisions (continued)
36
Numeric Measures That Influence
Investment Decisions (continued)
 Efficient market theory
 Based on the assumption that stock price movements
are purely random
 A stock’s current market price reflects its true value
 It is impossible for an investor to outperform the
average for the stock market as a whole over a period of
time
 Wall Street Journal’s “darts vs the experts” finds
sometimes experts win, sometimes not
37
Buying and Selling Stocks
Objective 4: Describe how stocks are bought
and sold
 Corporate financing sources
From 1999 through 2001, capital has been raised
through the following sources:
Corporate Bonds and Notes
76.9%
Equities
23.1%
38
Financial Market Components
Public Offering
 Firm issues securities, which are made available
to both individual and institutional investors.
Private Placement
 Securities are offered and sold to a limited
number of investors.
39
Financial Market Components
Money Market
 Market for short-term debt instruments
(maturity periods of one year or less).
Capital Market
 Market for long-term securities (maturity
greater than one year).
40
Buying and Selling Stocks
 Primary market
 A market in which an investor purchases financial
securities through an investment bank, or other
representative, from the issuer of those securities
 An IPO occurs when a corporation sells stock to
the general public for the first time
 Secondary market
 A market for existing financial securities that are
currently traded among investors through brokers
41
Investment Banking
 An investment bank is a financial firm that assists
corporations in raising funds, usually by helping to sell
new security issues
How do investment bankers help firms issue securities?
 Underwriting the issue.
 Distributing the issue.
 Advising the firm.
42
Stock Issue Example:
Our firm needs to raise approximately $100 million
for expansion. Our stock price is $20. We Select
Merrill Lynch to underwrite the issue for a 2%
underwriting spread.
 What type of issue is this?
 It’s a negotiated purchase.
43
Stock Issue Example:
Our firm needs to raise approximately $100 million
for expansion. Our stock price is $20. We Select
Merrill Lynch to underwrite the issue for a 2%
underwriting spread.
 How many shares will be sold?
 $100,000,000 / $20 = 5 million new shares of
common stock.
44
Stock Issue Example:
Our firm needs to raise approximately $100 million for
expansion. Our stock price is $20. We Select Merrill
Lynch to underwrite the issue for a 2% underwriting
spread.
What are the flotation costs?
 Underwriting spread: 2% of $100 million = $2 million.
 Issuing costs: printing and engraving costs; legal,
accounting, and trustee fees.
45
Stock Issue Example:
Our firm needs to raise approximately $100 million for
expansion. Our stock price is $20. We Select Merrill
Lynch to underwrite the issue for a 2% underwriting
spread.
 What are the risks?
 The investment bank accepts the risk of being able to
sell the new stock issue for $20 per share. If the stock
price falls, the investment bank could lose money.
46
Invest in IPO
Company
IPO date IPO price 1st day price 1st day gain Now
Vignette
2/18/99
$19
42
124%
7
FlashNet
3/16/99
17
43
156
acqu
Arriba
6/22/99
23
89
291
N/A
7/24 Solu
1/27/00
26
71
176
N/A
Antigenics
2/3/00
18
61
241
0.45
Buy.com
2/7/00
13
25
93
Deli
Nuance Com 4/12/00
17
34
100
12.67
47
Buying and Selling Stocks (continued)
SECURITY EXCHANGES
 A marketplace where member brokers who represent
investors meet to buy and sell securities
 The securities sold at an exchange must be listed, or accepted
for trading, at the exchange
 New York Stock and American Stock Exchanges (9:30 am –
4:00 pm ET)
 The Over-the-Counter (OTC) market
 Network of dealers who buy and sell the stocks of
companies not listed on a securities exchange
 Most OTC securities are traded over the NASDAQ which
is an electronic marketplace for approximately 3,200
stocks
48
Buying and Selling Stocks (continued)
Market average and index
 DJIA – Dow Jones Industrial Average: made up of 30 high-
quality stocks selected for total market and broad public
ownership and believed to reflect overall market activity.
 Standard and Poor’s indexes: true indexes that measure the
current price of a group of stocks relative to a base
49
Buying and Selling Stocks (continued)
BROKERAGE FIRMS AND ACCOUNT EXECUTIVES
 An account executive, or stockbroker, is a licensed
individual who buys and sells securities for his or her
clients
 Financial objectives should be communicated to the
account executives, and the investor must be actively
involved in the investment decisions
 Discount broker versus full service brokers
 How much advice do you want?
 Nearest office and toll-free phone number?
 Online and phone trading services and costs?
 Fees, charges and commissions?
50
Buying and Selling Stocks (continued)
STOCK TRANSACTIONS
 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 or price range
 Stop order: Request to sell a stock at the next available
opportunity after its market price reaches a specified
amount
51
Long-Term and Short-Term Investment
Strategies
Objective 5: Explain the trading techniques used by
long-term investors and short-term speculators
 Long-term techniques
 Buy and hold
 Dollar cost averaging
 Direct investment and dividend re-investment plans
(DRIPS)
 Short-term techniques
 Day trading
 Buying stock on margin (borrowing money)
 Selling short (borrowing stock)
 Trading in options (predetermined price)
52
Online Activity
Go to an online source such as www.fool.com,
www.morningstar.com, or www.cnnfn.com.
Research some stocks and find one that looks like a
good investment.
…Why do you think that this stock would be a good
investment for you?
53