Transcript Common Stock Valuation - Frank Paiano, Professor

CHAPTERS 5, 2, Lecture Notes
The Stock Market (Chapter 5)
Buying and Selling Securities (Chapter 2)
Introduction to Stocks (Lecture)
“Don’t gamble! Take all your savings and buy some good
stock and hold it till it goes up. If it don’t go up, don’t buy it.”
-- Will Rogers
1
What Are Stocks?

Where did the term “Common
Stocks” come from? The investors
are “Shareholders in Common.”
Stocks represent ownership in a corporation
 Stocks are Equity Financing – “Equities”
 Enable investors to participate in the profits and
growth generated by the business enterprise
 But stockholders are limited liability owners
 Can only lose their investment (unlike a sole proprietor)

Stockholders receive …
 Dividends
 Optional payments of earnings
 Capital Gains – a.k.a. Capital Appreciation
 Value of corporation rises as business grows
Contrary to what many believe (and how many behave), stocks are not simply
millions upon millions of worthless pieces of paper that people trade each
day for no reason. They represent ownership in real businesses.
2
3
Historical Performance

Over the long-term of modern finance …
 The return from the stock market (as measured by
the S&P 500) has averaged around 10% to 11%
annually for the last eighty years

But in any one year …
 It is unlikely that the return will be 10% or 11%
 The return has varied from a high of 53.8% to a
low of -43.4%
 2008’s return was -38.5%, one of the worst!

And in any given year …
 There has been a one-in-three or one-in-four
chance of a down market
The major exception was the great run-up from 1982 to 2000
4
Historical Performance
(continued)
5
Rolling 10-Year Period Returns
20%
15
10
5
2003-12
1998–07
1993–02
1988–97
1983–92
1978–87
1973–82
1968–77
1963–72
1958–67
1953–62
1948–57
1943–52
1938–47
1933–42
Rolling
10-Year
Periods
1928–37
0
Source: The unmanaged Dow Jones Industrial Average, based on average annual compound returns over 10-year periods.
6
Historical Performance

(continued)
Traditionally, close to half of the return from
stocks was from reinvested dividends
 Stockholders used to expect 4% to 6% in dividends each year –
That was as much or more than bonds returned in interest since
stocks were considered much riskier than bonds
 The S&P 500 dividend average from 1936 to 2008 is 3.8%

But dividends fell to less than 2% & even 0%!
 Capital gains & growth were what people wanted in the 1990’s
 The S&P 500 dividend averaged 1.5% from 1997 to 2007

Reasons given are varied
 Dividends were taxed at a higher rate than capital gains
 People wanted the business to reinvest the earnings for growth
instead of distributing it to the investors
 Stocks were no longer considered riskier than bonds
 Savings accounts were also paying less than 2%
 People lost track of their senses and bid up the prices
7
Historical Performance
(continued)
16%
14%
Yield on Bonds
12%
10%
8%
6%
4%
2%
Yield on Stocks
0%
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
8
Historical Performance

(continued)
The Pendulum Swings…
 The Bear Markets of 2000-2002 and 2008 have
changed investors’ perception about dividends
 We now see investors and companies focusing
more and more attention on dividends
 Many companies that never paid dividends in the
past are doing so now
 Example: Many tech companies are no longer
growth stocks. They are mature industries.
 Also, the tax law has changed dividends so that
they are taxed roughly the same as capital gains
“Dividends Don’t Lie.” − Geraldine Weiss
“Do you know the only thing that gives me pleasure? It’s to see
my dividends coming in.” − attributed to John D. Rockefeller
9
Pros & Cons of Stock Ownership

Pros
 Allow general public to share in the rewards of
business enterprise
 Best investment returns over time
 Dividends and capital gains
 Easy to buy & sell – liquid investment
 Limited liability
 Increased standard of living for all

Cons
 Risky
 “Volatile” (industry’s popular euphemism for losing money)
 Corporate and financial industry hanky-panky!
10
“Volatility” Examined
S&P 500 for Year 2014
$11,500
$11,000
$10,500
$10,000
$9,500
31-Dec-2013 19-Feb-2014
7-Apr-2014 23-May-2014
11-Jul-2014 27-Aug-2014
14-Oct-2014 1-Dec-2014
11
Primary versus Secondary Market

Primary Market
 The market in which new issues of securities are
sold to the public
 Initial Public Offering (IPO)
 The first public sale of a company’s stock
 a.k.a. “Going public”, “Taking the company public”
 Most retail investors do not participate in the
primary market
 (And my recommendation is that we really shouldn’t)

Secondary Market
 The market in which securities are traded after they
have been issued to the public
 The vast majority of transactions take place in the
secondary market
12
Primary Market
 Why “Go Public?”
 Why do corporations issue common stock?
 To raise money to start or expand a business
 To help pay for ongoing business expenses
 As a way to gain prestige and respect within the
investment and industrial communities
 As a reward for those who started the business
 And also simply because once a business becomes
sufficiently large, it becomes very difficult for the
owners to “divvy up the spoils” without going public
 If you were one of the people who started GE or Coca-Cola
or Walmart, how would you sell your share of the business?
What are some of the largest private companies?
13
Primary Market

(continued)
Why “Go Public?” (continued)
 The corporation does not have to repay the money
 It is under no obligation to repurchase the shares of
the stock
 The shareholder may or may not be able to find
someone who will purchase the shares from them
 But the corporation is now a public entity
 As such, it now has many rights and responsibilities
that private companies do not need to worry about
 Must file 10K’s & 10Q’s with the SEC
 Must have at least one public meeting annually
Chapter 5 goes into much detail about IPOs. IPOs do not usually live up
to their expectations. The typical IPO loses 50% of its value in one year.
Secondary Markets

14
Markets in which securities are sold after
they have been issued
 a.k.a. Aftermarket

Secondary markets provide…
 Liquidity
 Easy method for transferring ownership of
securities
 Mechanism for pricing and valuation of securities
When people talk about the “stock market,” they are almost always
referring to the secondary market.
Types of Secondary Markets

15
Organized Securities Exchanges
 Centralized institutions in which transactions are
made in outstanding securities
 “Double Auction” Market (Face-to-Face)

Over-the-counter (OTC) Market
 Widely scattered telecommunications network
through which transactions are made in
outstanding securities and smaller IPOs
 Quote-based system (On-line)
This is an outdated comparison. Due to technology advancements,
mergers, and acquisitions, the traditional differences between the two
have been erased. And the changes are just gettin’ started!
16
Organized Securities Exchanges

Historically…
 All trading was conducted on an exchange floor
 Trading was conducted using a “double auction”
 Instead of the “one seller, multiple buyers” that you
see at an estate or farm auction, for example,
 There were “multiple sellers and multiple buyers”
 Brokers on the floor call out prices & quantities
 But due to both technology & the sheer massive
volume of shares traded, things have changed
 Almost all of the trading is now conducted
electronically
 Some large trades still involve human interaction
 But they now consist of far less than 1% of the total
number of trades
17
The New York Stock Exchange


a.k.a. NYSE, the “Big Board”
Traditionally, responsible for over 90% of the
volume of transactions on exchanges – 1,900
companies
 About $20 trillion of market capitalization (Jan 2015)

Established as a members-only entity in 1792
 When Wall Street really was next to a wall

Companies listed on the NYSE must meet
stringent requirements
 The largest and most prestigious (traditionally)

Companies can be de-listed (example: Kodak)
 If they fail to continue to meet the NYSE requirements
18
The New York Stock Exchange
(continued)

Big Changes at the NYSE
 In 2005, purchased Archipelago electronic exchange and the
Pacific regional exchange
 Became a publicly traded corporation in March of 2006
 When they merged with the Euronext electronic exchange
 Phased out face-to-face, double auction trading
 In favor of exclusively trading electronically
 In 2011, Germany’s stock market tried to purchase the
NYSE but was blocked by European regulators
 On November 13, 2013, the NYSE was acquired for $11
billion by a 13-year-old derivatives trading firm from Atlanta,
Intercontinental Exchange
In 1992, on their 200th birthday, if you had told the folks at the NYSE
that the next 20 years would see far more changes than in their first
200 years, they would have thought that you were quite insane.
Press Release from ICE announcing completion of acquisition of NYSE
"The End of the Street" -- The Economist, 16 November 2013
19
The New York Stock Exchange
(continued)

The Floor Brokers
 House Brokers
 Execute orders on behalf of their firm’s customers or
occasionally on behalf of their firm’s own account
 Independent Brokers
 Provide as-needed execution services to house
brokers, member or non-member broker-dealers
 Independent of a particular firm
 a.k.a. “$2 Brokers”
The floor brokers were very worried that the NYSE’s aggressive moves
to all-electronic trading meant the end of their way of life. It was not
really the end; it was just a big change – from face-to-face interaction to
sitting in front of a computer screen all day. Sound familiar?
20
The New York Stock Exchange
(continued)

The Specialists
 Stock exchange members who specialize in making
transactions in one or more stocks
 The job of the specialist is to manage the auction process.
The specialist buys or sells the stock from their own
inventory to provide a continuous, fair, and orderly market
 The role of the specialists is being squeezed out by
technology and the tremendous volume of trading. They are
becoming less & less involved in the typical trading day
 The specialists were replaced by “designated market
makers” and “supplementary liquidity providers” in 2009
From time to time, the specialists are either praised or maligned.
Suffice to say that the specialists are trying to make a profit just like
everyone else. While their goal may seem altruistic, they make sure that
when the market receive benefits from their efforts, so do they.
http://www.investopedia.com/university/electronictrading/trading2.asp
21
The American Stock Exchange

The American Stock Exchange
 a.k.a. the AMEX, the “Curb” (?) – Now the NYSE MKT!
 Where did that name come from? They started on the curb
outside the NYSE! (Image: AMEX Curb Brokers)
 Much smaller than the NYSE
 Only 3% of the volume of all exchanges
 The AMEX started concentrating on securities
other than stocks over 20 years ago
 Purchased by the NASDAQ in 1998
 Went independent again in 2004
 Acquired by the NYSE in 2008
 They then moved down the street to the same
building as the NYSE and their name was changed
to NYSE MKT
The ETFs were first introduced on the AMEX.
22
The Regional Stock Exchanges


The regional stock exchanges were modeled
after the NYSE and AMEX
Only account for 4% of exchange volume






Many of the securities listed on the regional
Chicago
Philadelphia exchanges are also available on the NYSE or
NASDAQ. Traditionally, the regional
Pacific
exchanges were often places where
Boston
undesirable or unethical issues were sold.
Lately, the regional exchanges have tried to
Denver
diversify and differentiate themselves from
Cincinnati
the NYSE and NASDAQ in order to survive.
Plus the regional exchanges have not been immune to the rush to
consolidate. The NYSE bought the Pacific Exchange and the
NASDAQ bought the Philadelphia Exchange.
23
Options and Futures Exchanges

Options allow traders to sell or to buy an
underlying security at a specified price for a
given time
 The Chicago Board Options Exchange (CBOE)

Futures are contracts that guarantee the
delivery of a specified commodity at a specific
future date at an agreed-on price
 Chicago Board of Trade (CBT)
We will discuss options and futures in detail later. Options and
futures are also traded on most all the major and regional exchanges
now as well as the two major exchanges noted above.
24
The Over-the-Counter Market

Widely scattered telecommunications network
through which transactions of securities are
made – a.k.a. OTC
 There is no single location as with an exchange

Quote-based system
 As opposed to the double auction of the exchanges

Three tiers
 NASDAQ – National Association of Securities
Dealers Automated Quotation system
 The NASDAQ does not want to be associated with the OTC anymore
 OTC Bulletin Board – 5,000 securities
The Nether Worlds
Stay Away!
 OTC Markets Group
 nee Pink Sheets – 20,000+ thinly traded securities
 It appears that they are trying to clean up their act: OTC Markets
25
The Role of Dealers in the OTC

Dealers are traders who “make markets” by
offering to buy or sell certain securities at
stated prices – a.k.a. “market makers”
 The dealers offer buy and sell quotes from their
own inventory of stocks
 Whereas brokers simply serve as a go-between
between buyers & sellers. They keep no inventory
 Ask price – “retail price”
 The price a dealer offers to sell a security
 Bid price – “wholesale price”
 The price a dealer offers to purchase a security
 The spread
 The difference between the bid and the ask prices
The dealers / market makers on the NASDAQ perform roughly
the same role as the specialists on the NYSE.
http://www.investopedia.com/university/electronictrading/trading3.asp
26
The Role of Dealers in the OTC
(continued)

Unlike brokers who charge a commission
dealers make money from the spread of the
bid and ask prices
 Just as the Casas de Cambio in San Ysidro make
money on the difference between the prices in
which they buy and sell pesos and dollars

The dealer’s markups or markdowns are not
reported to the customers
 Whereas the broker’s commissions are reported
How do you think the Internet brokers make money on
only $5 or $7 per trade? (More later)
27
The NASD and the NASDAQ

National Association of Securities Dealers
Automated Quotation system – NASDAQ
 National Association of Securities Dealers (NASD)
 Non-governmental organization that used to be
responsible for self-regulation of registered
representatives (stockbrokers) – (Now done by FINRA)
 The NASD is now simply called the NASDAQ
 Created the first electronic communications
network for trading securities in 1971
 Provides up-to-date bid and ask prices on
approximately 2,800 stocks
The NASDAQ used to be the arena for small companies to get started.
Once they became large enough, they would move to the NYSE.
However, since the 1980’s, many prestigious companies decided to stay
on the NASDAQ rather than move to the NYSE.
28
The NASD and the NASDAQ
(continued)

The NASDAQ is now a three-tier system
 NASDAQ Global Select Market
 1,635 “crème de la crème”
 Companies that would easily qualify for the NYSE
 NASDAQ Global Market
 nee NASDAQ National Market
 657 larger companies
 NASDAQ Capital Market
 nee NASDAQ SmallCap Market
 688 smaller companies
The NASDAQ began positioning itself as the “Securities Market of the
Future” as it became apparent that the traditional face-to-face, double
auction model was not adequate to keep up with the massive increase of
trading. The NASDAQ market capitalization is roughly $8 trillion.
Listing of Nasdaq Companies
29
Alternative Trading Systems

Third market
 Over-the-counter transactions made in securities
listed on the NYSE, AMEX, or one of the other
organized exchanges
 Institutional investors who trade in large blocks of
securities get to use the third market
 Mutual funds, insurance companies, pension plans,
etc.
 Reduced transaction costs
 But still facilitated by a dealer
 Example: Intermarket (became the NASDAQ Intermarket)
30
Alternative Trading Systems
(continued)

Fourth market
 Traditionally, transactions made directly between
large institutional buyers and sellers of securities
 Allowed the institutions to bypass the dealers
 Get rid of the middleman
 Electronic Communications Networks (ECNs)
 Privately owned electronic trading networks that
automatically match buy and sell orders that
customers place electronically
 Examples: Archipelago (became the NYSE Arca), BATS
With the advent of the Internet, the third and fourth markets
successfully started to court retail customers. This got the attention of
the NYSE and the NASDAQ!
“But Isn’t the Stock Market All Just
One Big Malignant Casino?”

“Yes”
31
The Answer is “Yes” and “No”
 There are many individuals who see the markets as
one big crap-shoot
 For them, the way to riches is to buy and sell, buy
It is very difficult and you are up
and sell, buy and sell
against the best in the business.
 We call them speculators Neophytes become very upset when

“No”
a.k.a. traders
the market turns against them.
 Many others look at the capital markets as a way to
participate in the growth & prosperity of the global
With a long-term orientation, investors
economy
are usually very well rewarded.
 We call them investors
“An investment operation is one which, upon thorough analysis promises safety
of principal and an adequate return. Operations not meeting these requirements
are speculative.” − The Intelligent Investor, Benjamin Graham
“Oh, Yeah, But What About Enron?
Aren’t Corporations All Crooks?”

32
Fraud and accounting trickery and gimmicks
have always been with us
 They are always going to be with us
 “Because that is where the money is!”
 Normally, but not always, those firms are
relegated to the nether reaches of the OTC
 But for every one Enron, there are hundreds – no,
thousands! – of companies that continue to do
business with integrity and honesty (uh, usually… )
In 1973, it was Equity Funding. In 1986, it was Ivan Boesky and Vagabond
Inns. In 2002, it was Enron, Global Crossing, Tyco, and WorldCom. In 2008,
it was Fannie, Freddie, Lehman, Citi, WaMu, and AIG.
And don’t forget Madoff! Ten or twenty years from now, during the next big
bull market craze, someone else will take their place.
Recap: Securities Markets

The securities markets exist to allow investors
a safe, cost-effective method to participate in
the success of the global economy
 And even with all the underhanded shenanigans,
they have performed very well

33
They are changing at breakneck speed
 And the change is accelerating
Whether or not we ever have one or more global, 24-hour trading
markets remains to be seen. But it is exciting (and, for some, scary)
to watch, especially for those of us who have a stake in the outcome.
Bull Markets vs Bear Markets

34
Bull Market
 Favorable markets normally associated with rising
prices, investor optimism, economic recovery, and
government stimulus

Bear Market
 Unfavorable market normally associated with falling
prices, investor pessimism, economic slowdown,
and government restraint
Where did the terms bull market and bear market come from?
Bear Skin Jobbers: “Don’t sell the bear skin before the bear is caught.”
35
Types of Stock Transactions

Market Order
 “Buy/sell at the current price”

Limit Order
 “Buy/sell only at the price you specify”

Stop-loss Order (a.k.a. Stop Order)
 “Buy/sell at the current price once a trigger point is
reached”

Stop-limit Order
 “Buy/sell only at the price you specify once a trigger
point is reached”
Although you can use limit orders to buy or sell at the price you want,
and stop-loss and stop-limit orders to “lock-in” profits or protect
against losses, remember that they trigger automatically. If for some
reason, you change your mind, it is often too late to cancel the order.
36
Types of Stock Transactions
(continued)
I normally use and recommend market orders. Short-term traders
tell me they prefer limit orders or stop orders on all their trades.
37
Types of Stock Transactions
(continued)

Buying on Margin
 Borrowing money from your broker to enhance
your return
 You can borrow up to 50% of the purchase price of
a stock

Selling Short
 Borrowing stock and selling it in the hopes that the
price will go down (Sell stock you do not own! Huh?)
 You must buy it back at some time in the future
The book spends much time discussing margin accounts and selling short
in chapter 2. We will discuss these in detail late in the semester. My
advice to you is never sell short. It is simply too risky. Using a margin
account can be useful once you have built a substantial portfolio. It
allows you to borrow from your portfolio without selling your stocks.
38
Transaction Costs

Traditionally, transaction costs were in the 1%
to 5% range
 Sometimes higher
 The largest percentage of the cost was the
brokerage’s commission

Deep-discount Internet brokers have driven the
commissions down to as low as $5 per trade
 A few firms used to offer free trades (?)

But have transaction costs really gone down?
 Yes, but more and more of the cost is hidden from
the investor
Especially the “Internet garbage” brokers.
(Those aren’t my words!)
39
Transaction Costs

(continued)
Example:
 A deep-discount Internet broker offers trades for $7
 In the fine print of the client-broker agreement is
included a provision for allowing the broker to solely
utilize exclusive stock dealers and market makers
 The quoted price is simply the best price available but
at any one time, there are dozens of prices quoted as
dealers and market-makers compete for buy and sell
orders
 The chosen dealer doesn’t necessarily have the
best price
 Instead of paying $20, the investor might pay $20.05
The investor sees the $7 commission on their confirmation.
The investor does not see the extra $5 they paid on a 100
share purchase because of the dealer’s markup.
40
Transaction Costs

(continued)
The following disclaimer is included in each
trade confirmation e-mail from Scottrade
SCOTTRADE INC. RECEIVES REMUNERATION FOR
DIRECTING ORDERS TO PARTICULAR
BROKER/DEALERS OR MARKET CENTERS FOR
EXECUTION. SUCH REMUNERATION IS CONSIDERED
COMPENSATION TO THE FIRM AND THE SOURCE
AND AMOUNT OF ANY COMPENSATION RECEIVED
BY THE FIRM IN CONNECTION WITH YOUR
TRANSACTION WILL BE DISCLOSED UPON REQUEST
In Scottrade’s defense, at least they prominently disclose this relationship.
Many others hide it in their customer agreement fine print and the
customers are never aware of the relationship.
41
Transaction Costs

(continued)
The SEC says that “your broker has a duty to
seek the best execution that is reasonably
available for its customers' orders”
 But it is not a guarantee
 “… the SEC requires broker/dealers to notify their
customers if their orders are not routed for best
execution. Typically, this disclosure is on the trade
confirmation slip you receive … after placing your order”
– Investopedia
http://investopedia.com/articles/01/022801.asp
 And determining whether or not a customer got
“best execution” can be very difficult
Here is an example of the SEC trying to enforce the rules:
http://lawprofessors.typepad.com/securities/2008/06/scottrade-settl.html
42
Transaction Costs

(continued)
The SEC was looking into making the costs
more transparent
 Possibly showing the customer the difference
between the dealer’s price and the best price
available at the time of the transaction
 Maybe even – gasp! – showing the total cost of the
transaction from the markup/markdown
 Needless to say, the deep-discount brokers cried
that it would drive up the cost of commissions and
ultimately hurt the consumer and the proposal died
 So it is up to you to check if you are getting the
“best execution”
But how can you, a lone investor, determine if you are getting the best
price if even the SEC has trouble watching over the brokerage companies?
43
Round Lot versus Odd Lot

Round Lot
 100 shares or multiples of 100 shares

Odd Lot
 Less than 100 shares

Odd-lot Differential
 Extra cost of trading an odd lot
 Traditionally, the odd-lot differential was 12½¢ - 25¢
 It is now typically 5¢ - 10¢ or less
Some people recommend against odd-lot purchases because of the
higher cost. On 10 shares, an odd-lot differential might be $1. On 80
shares, it might be $4. Big deal.
44
Reading Stock Quotes

Current price during trading hours
 The bid and the ask
 Open, High, Low, Close (a.k.a. Last)
 52-Week High and Low
sources will contain some, all or
 Dividend Yield moreDifferent
of these statistics. But always remember
that the quoted prices are not the only prices
 P/E Ratio
available. At any one time, there are many
prices available from many different
 Volume
dealers/market-makers. The quoted prices are
the best prices available. Plus, usually you are
 Net Change
seeing the current prices 15 to 20 minutes ago.
 Year-to-Date Change
45
Reading Stock Quotes
(continued)
Wall
Street
Journal
Example
“Omigod! You mean you actually wait until the next day to find out
how much your stock is worth?! How Twentieth Century!”
46
Reading Stock Quotes

(continued)
On-line Examples
 finance.yahoo.com
 bloomberg.com
 marketwatch.com (owned by Wall Street Journal)
 morningstar.com
 Any others you want to check out?
Yahoo! used to be my favorite web site but just recently, they have
literally destroyed the Finance home page (after destroying the
Yahoo! home page several months earlier). I still use Yahoo! to
research individual stocks.
(Note to online students: Please see the accompanying presentation
on how to use Yahoo! Finance to do your research.)
47
Market Averages and Indexes
 How can we say that “stocks have returned
approximately 10% over the past 70 years?”
 The industry uses market averages and indexes
 “Benchmarks” used to measure the general
behavior of securities prices by reflecting either the
average price behavior (market average) or relational
price behavior (market index) of representative
groups of securities at a given point in time
 You can not help but hear about these every day
in the news
 “The Dow went down! The NASDAQ went up!”
The differences between a market average and market index are
subtle. Most people do not even know there are differences.
48
Market Averages and Indexes
(continued)

Share price calculation (Market Average)
 Looks solely at the price of the stock without
regard to the market value
 Example: Dow Jones Industry Average

Market-weighted calculation (Market Index)
 Stock price times number of shares outstanding
 Takes into account the market value of the stock
in the index
 The larger the market share, the more influence
the security will have in the index
 Example: Standard & Poor’s 500 Stock Index
Market-weighted calculations were generally regarded as a
better measure until the bubble of the late 1990’s.
49
The Dow Jones Industrial Average
 Stock market average made up of 30 high-
quality stocks selected for total market value
and broad public ownership and believed to
reflect overall market activity




Share price calculation
Most famous of the stock market measures
a.k.a. the Dow, the Dow Average, the DJIA
Changes from time to time as companies and
industries evolve
 As such, it now has more non-industrial stocks than
industrial stocks
Dow Jones is the company that publishes the Wall Street Journal.
In 2007, it was purchased by Rupert Murdoch of Fox News fame.
It appears that they sold it and all their other indices to S&P.
50
The Dow Jones Industrial Average
(continued)
The Thirty Stocks in the Dow Jones Industrial Average
American Express General Electric
Nike
AT&T
Goldman Sachs
Pfizer
Boeing
Home Depot
Proctor & Gamble
Caterpillar
IBM
3M
Chevron
Intel
Travelers
Cisco Systems
Johnson & Johnson United Healthcare
Coca Cola
J. P. Morgan Chase United Technologies
Disney
McDonald’s
Verizon
Dupont
Merck
Visa
ExxonMobil
Microsoft
Walmart
51
The Dow Jones Industrial Average
(continued)
Years
1906 ─ 1924
Dow Jones Average
100  100
Rise
-
1924 ─ 1929
100  300
3x
1929 ─ 1954
300  300
-
1954 ─ 1966
300  1000
3x
1966 ─ 1982
1000  1000
-
1982 ─ 2000
1000  11000
11x
2000 ─ 2011
11000  11000
-
So, how do you make money in stocks during times when the
markets and capital gains are flat? The answer depends upon
whether you are an investor or a speculator/trader.
52
Other Dow Jones Averages
 Dow Jones Transportation Average
 20 railroad, airline, freight, etc.
 Dow Jones Utilities Average
 15 public utilities
 Dow Jones 65 Stocks Composite Average
 Industrial, Transportation & Utilities stocks
 Dow Jones U.S. Total Stock Market Index
 nee Dow Jones Wilshire 5000 Total Market Index
 nee Wilshire 5000

Dow Jones U.S. Completion Total Stock Market Index
 nee Dow Jones Wilshire 4500, nee Wilshire 4500
 It is the Wilshire 5000 minus the 500 stocks in the S&P 500
 Dow Jones Internet Index
Standard & Poor’s 500 Composite
Index – a.k.a. the S&P 500, the S&P

53
500 stocks chosen for market size, liquidity,
and industry group representation
 Market-value weighted index
 Traditionally, the largest 500 companies based in
the United States (can now contain foreign stocks)
 Very popular index although has lost some of its
original focus
 Used by many index mutual funds
Because the S&P 500 is market-weighted, it was affected by the tech
bubble of the late 1990’s in a bizarre manner. The market values of a
small percentage of technology companies were inflated to extremes.
This skewed the index even more toward those companies. Consequently,
in 1998, 10% of the gain in the S&P 500 was due to one stock.
54
Other Standard & Poor’s Indices
 Standard & Poor’s Industrial 400
 Standard & Poor’s Midcap 400
 Medium-sized companies
 Standard & Poor’s Smallcap 600
 Small companies
 Standard & Poor’s 1500 Index
 Includes 500 Index, Midcap 400 and Smallcap 600
 Other Standard & Poor’s Indices
 Transportation, Utilities, Financials
 Many other global, international & sector indices
NYSE, AMEX and NASDAQ Indices

55
NYSE Composite Index
 Measure of the current price behavior of
approximately 2,000 stocks listed on the NYSE

AMEX Composite Index
 Now called the NYSE MKT Composite Index

NASDAQ Composite Index (a.k.a. tech index)
 Ditto for the NASDAQ

NASDAQ 100 Index
 Top 100 non-financial firms listed on the NASDAQ
The NASDAQ Composite went from 800 in 1995 to 5000 in 2000 and
then dropped to 1200 in 2002 before starting to recover in 2003.
The NASDAQ indices are technology laden.
Other Popular Stock Market Indices

Total Stock Market Indices
 Dow Jones U.S. Total Stock Market Index
 nee Dow Jones Wilshire 5000 Index
 nee Wilshire 5000
 Now competing with S&P Total Market Index and
 MSCI US Broad Market Index

Extended / Completion Stock Market Indices
 Dow Jones U.S. Completion Total Stock Market
Index
 nee Dow Jones Wilshire 4500
 nee Wilshire 4500
 Now competing with the S&P Completion Index
56
Other Popular Stock Market Indices
57
(continued)

Russell 2000
 Meant to measure small company performance in
the United States
 Russell 1000 is the top 1,000 largest companies
 Russell 3000 is the top 3,000 companies
 Russell 2000 is the top 3,000 without the top 1,000

MSCI Indices
 Morgan Stanley Capital International
 MSCI World Index (Global developed world)
 The MSCI All Country World Index is replacing the World Index
 Includes developing world countries
 MSCI EAFE Index (International developed world)
 The MSCI All Country World ex-USA Index is replacing the
EAFE Index – (again, includes developing countries)
Stock Worksheet #1 contains the indices you should know by name
58
Today's Unstable Stock Market!
17,930
17,925
17,920
17,915
17,910
17,905
10am
11am
12am
1pm
2pm
3pm
4pm
59
stock market index ennui
Today's Stable Stock Market
20,000
16,000
12,000
8,000
4,000
0
10am
11am
12am
1pm
2pm
3pm
4pm
60
“Volatility” Re-examined
You will not see this
S&P 500 for Ye ar 2014 - Boring Ve rsion
graph in the news!
$12,000
$10,000
$8,000
$6,000
$4,000
$2,000
$0
31-Dec-2013 19-Feb-2014
7-Apr-2014 23-May-2014
11-Jul-2014 27-Aug-2014
14-Oct-2014 1-Dec-2014
61
Common Stock Characteristics

Stock Spin-off
 Conversion of one of a firm’s subsidiaries to a
stand-alone company by distribution of stock in that
new company to existing shareholders
 Sometimes, the new company is still majorityowned by the company that spun it off
 Recently, Kraft was spun off from Altria (Philip Morris).
Altria then divested itself of its international tobacco
business (now called Philip Morris International)
The history of spin-offs has been checkered. Some spin-offs have done better
than the companies that spun them off. Examples of this are the Baby Bells
after being spun off from AT&T. Some spin-offs have not fared so well. CocaCola Enterprises (spun off from Coca-Cola) and Lucent Technologies (spun
off from AT&T) are examples of disappointments.
62
Common Stock Characteristics
(continued)

Stock Split
 A maneuver in which a company increases the
number of shares outstanding by exchanging a
specified number of new shares of stock for each
outstanding share
 Example: 2 for 1 split – You had 100 shares; you now
have 200 shares
 “Big Deal!” – the price went from $20 down to $10
 There are 3 for 1 splits, 3 for 2 splits, 1 for 5 splits…
There is no increased value from stock splits. If you had 1 share at $20,
now you have 2 shares at $10; the value is still $20. It is a psychological
increase at best. Warren Buffett of Berkshire Hathaway has refused to split
his stock since its inception. A single share now goes for over $225,000!
63
Common Stock Characteristics
(continued)

Treasury Stock
 Shares of stock that have been sold and
subsequently repurchased by the issuing firm
 a.k.a. Share Buybacks, Buybacks
 Share buybacks reduce the number of outstanding
shares
 The logic being that after the buyback, there is less
supply of outstanding stock
 Existing shareholders now have a larger percentage
ownership of the corporation
During the run-up of the 1990’s, share buybacks were often seen as a
better alternative to dividend increases. The belief was that investors
were more interested in capital gains than dividends and that buybacks
increased the potential for capital gains by reducing the supply of stock.
64
Common Stock Characteristics
(continued)

Classified Common Stock
 Common stock issued by a company in different
classes, each of which offers different privileges
and benefits to its holders
 Class A, Class B, etc.

Example – Berkshire Hathaway
 Class A are the original shares
 Recall that they are selling for over $225,000 each
 In 1996, the financial world pressed Warren Buffett
to offer a lower cost version of his stock
 Class B shares initially sold for around $1,160 each
 In the prospectus, Buffett said he wouldn’t buy them!
 In 2013, they split 50 for 1 and now sell for around $151
65
Common Stock Values

Par Value
 The stated, or face, value of a stock
 Maybe only 1¢ per share, fairly meaningless

Book Value
 The amount of shareholders’ equity in a firm; equals
the amount of the firm’s assets minus the firm’s
liabilities and preferred stock

Market Value
 The prevailing market value of a security
More about valuation in Chapter 6
66
Common Stock Dividends

Share of earnings given to stock holders
 Normally paid quarterly


Board of Directors decides how much, if any,
dividends should be paid and when to pay
them
Dividends are usually a percentage of the
earnings per share
 Earnings Per Share (a.k.a. EPS)
 The amount of annual earnings available to common
stockholders, as stated on a per share basis
67
Common Stock Dividends
(continued)

Earnings Per Share Example
 Company reports net profit of $1 million
 There are 500,000 shares outstanding
 Earnings Per Share = $1,000,000 earnings /
500,000 shares = $2.00 earnings per share
 The Board of Directors might decide to pay out 50%
of the earnings per share in the form of dividends
 Therefore, each shareholder would receive a $1.00
dividend for each share they owned
 This is called the dividend payout ratio
 The company is paying out 50% of their earnings to
shareholders in the form of dividends
68
Common Stock Dividends
(continued)

Dividend Yield
 A measure that relates dividends to share price and
puts stock dividends on a relative (percentage)
basis rather than an absolute (dollar) basis
 Example: If the stock in the previous slide that was
paying a $1 dividend were selling for $20, the
dividend yield would be 5%
 Makes it easier to compare stocks with other income-
oriented vehicles such as bonds or saving accounts
Traditionally, 3% to 6% was
normal. In the 1990’s dividends
$1 dividend
went to 2% or less. Dividends
––––––––––––– = 5% dividend yield went above 3% in the 2008/2009
turmoil and are now back down
$20 price
to approximately 2%.
69
Common Stock Dividends
(continued)

Important Dates
 Declaration Date
 Date that Board of Directors declares dividend
 Date of Record
 The date on which an investor must be a registered
shareholder of a firm to be entitled to receive a
dividend
 Ex-dividend Date
 Three business days before the date of record;
determines whether one is an official shareholder of a
firm and thus eligible to receive a declared dividend
 Payment Date
 The actual date on which the company pays the
dividend
70
Common Stock Dividends
(continued)

Why is the ex-dividend date three days before
the date of record?
 Because stock transactions close in three days
 If you purchase a stock on June 15, you do not
actually get the stock until June 18
 Theoretically, the opening share price on the ex-
dividend date should reflect a drop in price
commensurate with the amount of the dividend
 Example: If there is a $1 per share dividend, the
opening stock price should be reduced by $1
 Of course, it never really works that way in the
marketplace since prices are changing all the time
71
Common Stock Dividends
(continued)

“Don’t Buy the Dividend”
 …is a common saying in the industry
 Translation: You are often better off waiting until the
ex-dividend date before buying a stock
 The logic follows thusly:
 Dividends are taxable transactions
 If you “buy the dividend” – buy the stock just before
the ex-dividend date – you will be responsible for
paying the tax, and…
 Presumably, the stock price will fall commensurate
with the amount of the dividend, so…
 You are better off waiting until after the ex-dividend
date so that you will get the stock at a better price
and not generate a taxable transaction
72
Common Stock Dividends
(continued)

Types of Dividends
Please know this important difference!
 Cash Dividends
 Payment of a dividend in the form of cash
 Stock Dividends
 Payment of a dividend in the form of additional
shares of stock
 All else equal, stock dividends have no value
because they constitute a dilution of ownership
 Example: The Board of Directors declares a 10%
stock dividend
 For every 10 shares, you receive 1 extra share
 Correspondingly, the price of the shares drop 10%
 But, unlike a cash dividend, a stock dividend is not taxed
 “No taxes? Big Deal! It is not worth anything anyway!”
73
Common Stock Dividends
(continued)

Types of Dividends (continued)
 Dividend Reinvestment Plans (DRIPs)
 Plans in which shareholders have cash dividends
automatically reinvested into additional shares of
the firm’s common stock
 This is a taxable transaction
 No additional shares were issued
 Hence, no dilution of ownership occurred
DRIPs are an excellent way to own stock for those interested in long-term
growth and not interested in current income. It allows the investor to take
advantage of compounding automatically with normally no (or very
small) transaction costs. Investing in a company like General Electric or
Johnson & Johnson in this way is almost like investing in a mutual fund.
74
Common Stock Valuation

Price to Earnings Ratio
 a.k.a. P/E, PE
 The price of the stock divided by the earnings per
share
 Previous example: $20 price, $2 earnings per share
 $20 / $2 = 10 Price to Earnings Ratio (a.k.a. 10 P/E)
 Traditionally, stocks sold for P/E ratios of 5 to 14
 A P/E of 20 was only reserved for the fastest growing
stocks
1980’s &
 For many years, a P/E of 20 was not unusual 1990’s
 In the 2008 turmoil, P/E ratios came down greatly
We will spend a great deal of time learning P/E and other
valuation techniques in the next few chapters.
75
Types of Common Stock

Blue-chip Stocks
 Financially strong, high-quality stocks with long and
stable records of earnings and dividends
 Often referred to as value stocks
 Attracts conservative investors
 Examples: General Electric (?), General Motors (?!)

Income Stocks
 Stocks with long and sustained records of paying
higher-than-average dividends
 Also often referred to as value stocks
 Normally slow growth company in a mature industry
 Examples: Utility stocks, Banks
76
Types of Common Stock

(continued)
Growth Stocks
 Stocks that experience high rates of growth in
operations and earnings
 Growth rate 15% to 20% or higher
 Often associated with high P/E ratios
 Often no dividends at all
 Or a very small token amount
 Most of the profits are reinvested into the company
 Stock price should go up
 But usually very volatile
 Examples: Intel, Microsoft, HP (?)
Wait a minute! Are Intel, Microsoft, and HP still growth stocks?
77
“Growth” versus “Value”

The investment world loves to use the terms
“growth” and “value”
 But the meanings of the terms are not exact
 Typically, investors often use “growth” to designate
a high P/E stock while they use “value” to denote a
low P/E stock
 But a high P/E stock might be a great value while a
low P/E stock might not be a good value
In January of 2005, Google was selling for around $200 with a sky-high
P/E while the old GM was selling for $34 with a very low P/E. Today,
Google sells for about $1,100 (split adjusted, with a much lower P/E)
and the old GM stock (a.k.a. Motors Liquidation) last sold for $0.04 in
March of 2011 and is now worthless. Which one was the better value?
78
Types of Common Stock

(continued)
Cyclical Stocks
 Stocks whose earnings and overall market
performance are closely linked to the general state
of the economy
 Follow the business cycle of advances & declines
 Examples: automobiles, timber, and steel

Defensive Stocks
 Stocks that tend to hold their own, and even do
well, when the economy starts to falter
 Remain stable during declines in the market
 Often associated with income stocks
 Examples: Kellogg’s, Procter & Gamble
79
Types of Common Stock

(continued)
Turnaround Stock – a.k.a. “Goner”
 A company that has fallen on hard times
 Is there potential for a rebound?
 Example: Chrysler in the ’80s, Ford & GM now

Asset Play Stock
 A company this is sitting on an asset that could be
sold or spun off
 Example: JCPenney’s retail business was not doing
well several years ago but it had an insurance
division that could easily have been sold to raise
cash to have kept the company afloat

Penny Stock
 Butterfly.com, Flim-Flam Inc. (examples)
80
Types of Common Stock

(continued)
Foreign Stocks / International Stocks
 Direct Investments
 Traditionally, difficult to impossible to transact
 American Depository Receipts (ADRs)
 Global and International Mutual Funds
 Global – Everyone including the United States
 International – Everyone except the United States
 Currency Issues
 Stronger U.S. dollar has a negative impact on U.S.
investors investing in foreign markets
 Weaker U.S. dollar has a positive impact
Will the dollar be stronger or weaker in the coming years?
81
Capitalization

Capitalization
 The current price of the stock times the number of
shares outstanding

Large cap stocks
 $10 billion and up
 Mega cap stocks – $100’s of billions (GE, Walmart)

Mid cap stocks
 $2 billion to $10 billion

Small cap stocks
 $100 million to $2 billion
 Micro cap stocks – $10 million to $50 million

Penny stocks
 Typically sell from less than $1.00 to $5.00 per share
82
Capitalization

(continued)
Example:
 Price
$20.00
 Number of Shares
 5,000,000
———————
 Market capitalization = $100,000,000
 This is a small cap stock
The stock price is (for the most part) irrelevant. You must
look at the market cap to see what the value of the company
is. (Remember Warren Buffett’s Berkshire Hathaway?)
83
Capitalization Examples
Walmart versus Target
Price
($)
Number of shares
outstanding
Market
Capitalization ($)
Walmart
$87.50
3.22 billion
$281.75 billion
Target
$76.22
636.96 million
$48.55 billion
Note: As of 5 February 2015 – Values change daily
84
Capitalization Examples
(continued)
AT&T versus Verizon
Price
($)
Number of shares
outstanding
Market
Capitalization ($)
AT&T
$34.95
5.19 billion
$181.39 billion
Verizon
$49.42
4.16 billion
$205.59 billion
Note: As of 5 February 2015 – Values change daily
85
Investment Strategies

Buy-and-Hold Strategy
 Use fundamental analysis to identify high-quality
companies with good growth prospects and
potential for dividends at reasonable prices
 a.k.a. Value Investing
 a.k.a. Growth-At-a-Reasonable-Price (GARP)
 “Hold it forever”
 Warren Buffett
My personal favorite! “Don’t Lose Perspective” example.
86
Investment Strategies

(continued)
Income Strategy
 a.k.a. Equity-Income
 Emphasize dividends over capital appreciation
 Ideally, looking for growth of dividends
 As noted beforehand, companies that pay
consistently-growing dividends tend to do well when
the market as a whole does poorly
 In general, appropriate for conservative stock
investors
 This strategy works well with DRIPs
Stocks which have had histories of consistent dividend increases
have often been the market’s best long-term investments
87
Investment Strategies

(continued)
Growth Strategy
 Investing in stocks with above-average forecasts of
earnings growth
 Dividends are a secondary concern
 Usually have high price to earnings ratios in
expectation of higher earnings in the future
Growth stocks are stars! Everyone wants to jump on the
bandwagon as a company is experiencing strong growth.
Subsequently, the stock price is bid up to very high levels.
Typically, they are also the stocks that are the riskiest. When the
slightest hint of a slow down in the growth appears, the stock price
is often brutally punished.
88
Investment Strategies
(continued)
 Aggressive Growth Strategy
 a.k.a. Speculation, Short-term Trading
 Investor aggressively trades in and out of stocks in
order to achieve eye-catching returns
 Instead of waiting 3 to 5 years for a stock to move,
an aggressive stock trader would go after the same
investment return in 6 months to a year or less
 Some traders have time horizons in the weeks or days
 And now, there are companies who are using computers to
make millions of trades per day
This is the strategy that many people think they are supposed to use
when they start investing in stocks. It is fraught with perils and
drawbacks, not the least of which are the serious transaction costs
that can be generated as a result of frequent trading. Stockbrokers
simply adore suckers … uh, I mean … traders who use this strategy.
89
Investment Strategies

(continued)
Contrarian Strategy
 Investing in stocks that are out of favor with the
market for some reason, as reflected by low price to
earnings ratios and low prices compared to their
fundamentals
 Contrarian investors actively seek stocks from
companies with sound financial statements that the
market has undervalued
 “I always try to be accommodating. I buy when
others want to sell; I sell when others want to buy.”
Being a contrarian is difficult since historically the market rises about
three times as much as it falls.
“[It’s] not a steady business.” Howard Marks, CEO, Oaktree Capital,
when asked about what it was like to be a contrarian.
90
Investment Strategies

(continued)
Sector Rotation
 Buy stocks in hot sectors; sell stocks in stale ones

Momentum Investing
 Buy stocks as they go up; sell stocks as they go
down (often involves selling stocks short)
 Uses the “Greater Fool” Theory
 “Buy High, Sell Higher”

Market Timing
 Attempting to predict the future direction of the
market
 “Don’t try to buy at the bottom and sell at the top. It
can’t be done except by liars.” – Bernard Baruch
Can you identify the risks inherent in each of these strategies?
91
Investment Strategies
(continued)

Buy-and-Hold
 Income
 Growth
 Aggressive Growth
 Contrarian
 Sector Rotation
 Momentum Investing
 Market Timing
Which strategy
do you favor?
CHAPTERS 5, 2, Lecture Notes
92
The Stock Market (Chapter 5)
Buying and Selling Securities (Chapter 2)
Introduction to Stocks (Lecture)
Next week: Chapter 6, Common Stock Valuations