chapter 9 section 9.2 – evaluation of a stock issue

Stocks Chapter 9

Section 9.2 – Evaluation of a Stock Issue

Types of Stock Investments

Stocks are classified into the following categories:1. Blue-Chip Stock2. Income Stock 3. Growth Stock4. Cyclical Stock5. Defensive Stock6. Large Cap Stock and Small Cap Stock7. Penny Stocks


Blue Chip Stocks – considered a safe investment that generally attracts conservative investors• Issued by the strongest and most respected

companies AT&T, General Electric, and Kellogg

• Look for leadership in an industry, a history of stable earnings, and consistency in the payment of dividends


Income stock – pays higher than average dividends compared to other stock issues• People who buy preferred stock are also

attracted to this type of stock• Examples: Bristol-Myers Squibb and Dow

Chemical and gas and electric companies


Growth stock – issued by a corporation whose potential earnings may be higher than the average earnings predicted for all the firms in the country• Generally don’t pay dividends• Look for signs that the company is engaged in

activities that produce higher earnings and revenues: Building new facilities; introducing new, high quality

products; or conducting recognized research and development

• In the early 2000s included Home Depot and Southwest Airlines


Cyclical stock – has a market value that tends to reflect the state of the economy• When the economy is improving the market

value of cyclical stock usually goes up and if the economy is declining then it tends to go down Why? Because the companies are linked directly with

activities of a strong economy.• Investors buy when right before the economy

improves and sell right before the economy starts to decline

• Ford and Centex are considered cyclical stocks


Defensive stock – a stock that remains stable during declines in the economy• Companies that issue defensive stocks have

steady earnings and can continue to pay dividends

• Many blue chip stocks and income stocks may also be considered defensive stocks Proctor & Gamble and Kellogg


Large cap and small cap stocks – • Large cap stock – the stock of a

corporation that has issued a large number of shares of stock and has a large amount of capitalization (the total amount of stocks and bonds issued by a corporation) Stocks listed in the Dow Jones averages are

typically large cap stocks These stocks appeal to conservative investors

because they are considered secure


Large cap and small cap stocks – • Small cap stocks – issued by a company

with a capitalization of $150 million or less Considered higher investment risk because

smaller, less established companies issue this type of stock


Penny stock – typically sells for less than $1 a share, although it can sell for as much as $10 a share• Issued by new companies or companies whose

sales are very unsteady• Prices of penny stocks can go up and down

wildly• Hard to keep up with performance because the

information is hard to find • Very risky and should be purchased only by

investors who understand all the risks

Sources for Evaluating Stocks

Financial section of newspapers Internet Stock Advisory Services Corporate News Publications

Factors that Influence the Price of Stock

When you are deciding whether to buy or sell stock you must first consider the overall condition of the stock market:• Bull market – a market condition that

occurs when investors are optimistic about the economy and buy stocks

• Bear market – a market condition that occurs when investors are pessimistic about the economy and sell stocks


Numerical Measures for a Corporation• One of the most common calculations

investors use to track the value of their investments is the current yield (the annual dividend divided by the investment’s current market value) Generally, an increase in current yield is a

healthy sign for any investment


Numerical Measures for a Corporation continued• Also need to know whether your investment is

increasing or decreasing in dollar value…Total return is a calculation that includes the annual dividend as well as any increase or decrease in the original purchase price of the investment Total Return = Current Return + Capital Gain Current Return = Dividend x Number of Shares x

Years held Capital Gain = (Selling Price Per Share – Purchase

Price Per Share) x Number of Shares held


Numerical Measures for a Corporation continued• Earnings per share are a corporation’s

net, or after tax earnings divided by the number of outstanding shares of common stock. This measures the amount of corporate profit that can be assigned to each share of common stock. Gives a stockholder an idea of how profitable the

company is…an increase in earnings per share is a good sign for any investment.


Numerical Measures for a Corporation continued• Price-earnings (PE) ratio – the price of one share of

stock divided by the corporation’s earnings per share of stock outstanding over the last 12 months Used to compare corporate earnings to the market price of a

corporation’s stock Key factor that serious investors as well as beginners can use

to decide to invest in stock A low PE ratio indicates that a stock may be a good investment; the

company has a lot of earnings compared to the price of the stock A high PE ratio indicates that a stock may not be a good investment;

the company has little earnings compared to the price of the stock Although PE ratios vary by industry, they range between 5 and

35 for most corporations

Investment Theories Fundamental theory – assumes that a

stock’s real value is determined by looking at the company’s future earnings

Technical theory – based on the idea that a stock’s value is really determined by forces in the stock market itself

Efficient market theory – stock price movements are purely random

chapter 9 section 9.2 – evaluation of a stock issue

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