Chapter 12
Investing in Stocks
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Investing in Stocks
Chapter Objectives
1. Identify the most important features of
common and preferred stock.
2. Explain how you can evaluate stock
investments.
3. Analyze the numerical measures that cause
a stock to increase or decrease in value.
4. Describe how stocks are bought and sold.
5. Explain the trading techniques used by longterm investors and short-term speculators.
12-2
Objective 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
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 each dividend payment
• But:
– Shareholders have voting rights; control of the company
– Dividends are NOT tax deductible
12-4
Why Corporations Issue
Common Stock
Investors can make money in three ways
– Income from dividends
• Cash
• Shares of stock
– 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
Dividend Dates
• Declaration date = Board of Directors votes
to pay a dividend
• 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-div date do not
receive the dividend
• Payment date = dividend is paid
12-6
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
• Dividends paid before common stock
– Dividend may be omitted
12-7
Features of Preferred Stock
• Cumulative preferred stock
– Unpaid cash dividends accumulate
– Must be paid before any cash dividends are
paid to common stockholders
• 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
12-8
Objective 2
Explain How You Can Evaluate Stock
Investments
Evaluate the company and the industry
• The Internet
– Firm’s home page more current than printed
materials
– 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
Where Can You Find a Stock Quote,
and What Does One Look Like?
• Print sources
– The Wall Street Journal http://www.wsj.com
– The local newspaper
• Online sources:
–
–
–
–
http://finance.yahoo.com
http://www.thestreet.com
http://money.cnn.com
http://moneycentral.msn.com/investor
12-10
Common Stock Price Quotes Online
at http://finance.yahoo.com
First enter
stock symbol
Resulting
screen
12-11
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
12-12
Evaluating a Stock Issue
Stock Advisory Services
• Research materials = good
supplement to other sources of
information
• Most charge a fee
• Three most popular:
– Standard and Poor’s reports
– Value Line
– Mergent’s Handbook of Common Stock
12-13
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:
– BusinessWeek, Fortune, Forbes, Money,
Kiplinger’s Personal Finance Magazine
12-14
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)
– Corporation’s after-tax income divided by
the number of outstanding shares of
common stock
– EPS Increase = generally a healthy sign
12-15
Numeric Measures That
Influence Investment
• 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
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
– Market price per share should be > book value
12-17
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 the
general public for the first time
• Key factor:
• Cash from security sales goes to issuing company
12-18
How Stocks are Bought and Sold
Secondary Market
• Market for existing financial securities
• Traded among investors via brokers and
dealers
• Markets
– Stock exchanges
– Over-the-counter markets
12-19
Secondary Markets for Stocks
Securities Exchanges (NYSE)
• 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
• “The Listed Market” = NYSE
• “Specialist” buys or sells
a particular stock
12-20
Secondary Markets for Stocks
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 over
3,200 companies
12-21
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
12-22
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
reports, and other financial reports?
• Are there any fees in addition to the
commissions to buy and sell?
12-23
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
12-24
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
12-25
Commission Charges
• 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 >
– Online broker little advice or service
12-26
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
12-27
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
12-28
Short-Term Investment Strategies
• Buying stock on margin
– Borrowing money from broker
– Margin requirement set by the Fed
– “Bullish”
• Selling short
– Borrowing stock
– “Sell high, buy low”
– “Bearish”
12-29
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
12-30