12 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.

12-1

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 oriented)

– 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 research12-2

• 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 Corporations Issue Common Stock

12-3

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

Why Investors PurchaseCommon Stock

12-4

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 dividend

• Ex-Dividend Date = 2nd day before the record date; stock begins to trade without the dividend– Investors buying after the ex-dividend date do not

receive a dividend for that quarter

• Payment Date = Dividend is paid to investors

12-5

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

12-6

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 2Explain How You Can Evaluate

Stock Investments• The Internet

– Firm’s home page more current than printed materials– http://finance.yahoo.com

• 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 stockholders

• Securities and Exchange Commission Web site (http://www.sec.gov)

• Business Periodicals:– Business Week, Fortune, Forbes, Money, Smart Money, Kiplinger’s

Personal Finance Magazine12-10

Objective 3Analyze 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

12-11

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

12-12

Common Stock Price Quotes

Last trade price = $44.37 Annual dividend = $1.68

P/E = 15.41 Earnings per share = 44.37/15.41 = $2.879312-13

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 (net worth of company)

– Market price per share should be > book value

12-14

Objective 4Describe How Stocks are

Bought and SoldPrimary 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• Markets

– Stock exchanges (NYSE, foreign securities exchanges)– Over-the-counter markets

12-15

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

12-16

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

arbitration

12-17

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 commissions to buy and sell?

12-18

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

12-19

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 12-20

Objective 5Explain 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

12-21

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 InvestmentStock Price

Shares Purchased

2006 $2,000 $60 33.32007 $2,000 $68 29.42008 $2,000 $58 34.5

Total $6,000 97.2Average $61.73

12-22

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)

12-23

Wrap Up

• Chapter Quiz

• Concept Check 12-1- Common Stock and Preferred Stock

• Concept Check 12-2-Prospectus and Annual Report

• Figure It Out- Earnings per Share, PE Ratio, Dividend Yield

• Concept Check 12-4- How Would You Buy Stock?