Chapter 12
Investing in Stocks
1
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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 longterm investors and short-term speculators.
12-2
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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
12-3
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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
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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
12-5
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Income from Dividends:
Dividend Dates

Declaration date

Record date

Ex-Dividend date

Payment date
◦ Board of Directors votes to pay a dividend
◦ Stockholder must be registered on the firm’s
books to receive the dividend
◦ 2nd business day before the record date stock
begins to trade without the dividend
◦ Investors buying after the ex-div date do not
receive the dividend
◦ Dividend is paid
12-6
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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 not a legal obligation that company
must pay
◦ Dividend may be omitted by action of the board
12-7
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Learning Objective LO12.2
Evaluating a Stock Issue
12-8
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Sources of Information about
Stocks and Investing

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.standardpoors.com/
◦
◦
www.mergentonline.com
http://www.valueline.com
12-9
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Where Can You Find a Stock Quote,
and What Does One Look Like?

Print sources

Online sources:
◦ The Wall Street Journal http://www.wsj.com
◦ The local newspaper
◦
◦
◦
◦
◦
◦
◦
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
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Common Stock Price Quotes Online
at http://finance.yahoo.com
First enter
stock symbol
Resulting
screen
1211
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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
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Evaluating a Stock Issue
Stock Advisory Services

Research materials


Most charge a fee
Three most popular
◦ More detailed information compared to
other sources of information
◦ Standard and Poor’s reports
◦ Value Line
◦ Mergent’s
12-13
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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
12-14
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Learning Objective LO12.3
Numerical Measures that Influence
Investment Decisions

Corporate earnings

Earnings per share (EPS)
◦ One of the most significant factors in changes
in the value of a stock
◦ Source of dividend payments
◦ Often a reflection of the health of the firm
◦ Corporation’s earnings divided by the number
of outstanding shares of common stock
◦ EPS Increase = generally a healthy sign
12-15
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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
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Dividend Yield and Total Return

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
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Other Factors that Influence the
Price of a Stock

Beta

The price an investor is willing to pay is
determined by:
◦ Volatility of a stock relative to the market
◦ Market has beta = 1.0, higher beta for stock means
greater volatility (risk)
◦ Expected future dividends
◦ Potential increase in price
◦ Price uses time value to find present value of first 2

Stock market bubble
◦ Stocks are trading above their actual worth
◦ Driven by investor optimism and irrational
expectations
◦ Bubbles “burst”
12-18
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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
12-19
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Buying and Selling Stocks
Secondary Market
Market for existing financial securities
 Traded among investors via brokers and
dealers

◦ Issuing company gets no cash from trades

Markets
◦ Securities exchanges
 Physical trading location
◦ Over-the-counter markets
 Network of dealers
12-20
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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
12-21
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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 3,300 companies
12-22
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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
◦ Excessive buying and selling of
securities to generate
commissions
◦ Illegal under SEC regulations
12-23
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Discount vs. Full Service Brokers vs.
Online
Service vs. Cost
How much advice do you want?
 Can you buy and sell stocks using the Internet or
over the phone?
 What is the typical commission for a stock
transaction?
 Toll-free number for customer use?
 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
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Computerized Transactions
Reasons that justify trading online




Size of investment portfolio
Ability and desire to manage own
portfolio
Ability to monitor investments
closely
Capability of computer and
software
12-25
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Stock Transaction Orders

Market order

Limit order

Stop-loss order
◦ Order to buy or sell stock at the current market
value
◦ Order to buy or sell a stock at a specified price
◦ Order to sell a stock at the next available
opportunity after its market price reaches a
specified amount
12-26
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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
12-27
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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
12-28
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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
2012
2013
2014
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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12-29
Direct Investment and Dividend
Reinvestment Plans
Offered directly by company

Direct Investment Plan
◦ Allows purchase of stock directly from company
◦ No broker or account executive

Dividend Reinvestment Plan (DRIP)
◦ Allows option of reinvesting dividends to
purchase more stock of the company
12-30
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Short-Term Investment Strategies

Buying stock on margin
◦ Borrowing money from broker
◦ Margin requirement set by the Fed
◦ “Bullish”
 Expecting price to increase

Selling short
◦ Borrowing stock
◦ “Sell high, buy low”
◦ “Bearish”
 Expecting price to decrease
12-31
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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
12-32
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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.
12-33
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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
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12-34
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.
12-35
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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
12-36
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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 overthe-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
12-37
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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.
12-38
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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
12-39
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