Chapter 12

Investing in Stocks

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Investing in Stocks

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 long-term investors and short-term speculators.

Chapter Objectives

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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

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• 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

Why Corporations Issue Common Stock

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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

Why Corporations Issue Common Stock

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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

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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

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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

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Objective 2Explain 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 serviceshttp://www.standardpoors.com/www.mergentonline.com http://www.valueline.com

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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

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First enter stock symbol

Resulting screen

Common Stock Price Quotes Online

at http://finance.yahoo.com

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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

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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

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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:

– BusinessWeek, Fortune, Forbes, Money, Kiplinger’s Personal Finance Magazine

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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)– Corporation’s after-tax income divided by

the number of outstanding shares of common stock

– EPS Increase = generally a healthy sign

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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

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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

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Objective 4Describe 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

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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

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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

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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

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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

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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?

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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

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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

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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

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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

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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 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

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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”

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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

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