Transcript Chapter 14 Investing in Stocks

Chapter 14
Investing in Stocks
Chapter 14
Learning Objectives
 Identify the most important features of common
and preferred stocks
 Explain how you can evaluate stock investments
 Analyze the numerical measures that cause a stock
to increase or decrease in value
 Describe how stocks are bought and sold
 Explain the trading techniques used by long-term
investors and short-term speculators
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Common and Preferred Stocks
Objective 1: Identify the most important features
of common and preferred stocks
 Good investors know something about the company before
they invest in the company’s stock
 Gather information to evaluate a potential investment in a
stock
 Learn what the information you gather means
 There are periods where stocks decline in value
 The key to success is to allow investments to work for you
over the long-term
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Legal Forms of Businesses
1) Sole Proprietorship
 A business owned by a single individual.
 Owner maintains title to the firm’s assets.
 Owner has unlimited liability.
2) Partnership
 Similar to a sole proprietorship, except that
there are two or more owners.
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Legal Forms of Businesses
3) Corporation
 A business entity that legally functions separate
and apart from its owners.
 Owners’ liability is limited to the amount of
their investment in the firm.
 Owners hold common stock certificates, and
ownership can be transferred by selling the
certificates.
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Comparison of Three Forms

Advantage of corporations:
-- limited liability
-- ease in raising capital
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The Corporation and Financial Markets

Corporation
cash
Investors
securities
reinvest
Secondary
markets
Cash flow
dividends,
etc.
tax
Government
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Movement of Savings
 Direct Transfer of Funds
cash
firm
saver
securities
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Movement of Savings
 Indirect Transfer using Investment Banker
funds
funds
saver
investment
banker
securities
firm
securities
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Movement of Savings
 Indirect Transfer using a Financial Intermediary
funds
saver
funds
financial
intermediary
intermediary
securities
firm
firm
securities
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Common Stock
 Is a variable-income security.
 Dividends may be increased or decreased,
depending on earnings.
 Represents equity or ownership.
 Limited liability: liability is limited to amount of
owners’ investment.
 Priority: lower than debt and preferred.
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Common Stock
 Claim on Income - a stockholder has a claim on the
firm’s residual income.
 Claim on Assets - a stockholder has a residual claim
on the firm’s assets in case of liquidation.
 Preemptive Rights - stockholders may share
proportionally in any new stock issues.
 Voting Rights - right to vote for the firm’s board of
directors.
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Why Corporations Issue Common Stock
 To raise money for start-up costs and help pay for
expansion and their ongoing business activities
 They don’t have to repay the money a
stockholder pays for stock
 Dividends are not mandatory. Most corporations
distribute 30-70% of their earnings to stockholders
 In return for investing in the company,
stockholders have voting rights
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Why Investors Purchase Common Stock
 They can make money in three ways
 Income from dividends in the form of cash or additional
stock (record day and ex-dividend)
 Dollar appreciation of stock value
 Possible increased value from stock splits
 WHAT HAPPENS WHEN A CORPORATION
SPLITS ITS STOCK?
 A stock split happens when the shares owned by
existing stockholders are divided into a larger number
of shares
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Preferred Stocks
PREFERRED STOCK
 Investors in preferred stocks receive cash dividends
before common stock holders are paid any cash
dividends
 The dividend amount is either a stated amount of money
for each share of preferred stock, or a percentage of the
par value
 Par value is an assigned dollar value that is printed on a
stock certificate
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Preferred Stocks
 Usually sold for $25, $50, or $100 per share.
 Example: In 2002, Xerox issued $75 million of
8.25% preferred stock at $50 per share.
 $4.125 is the fixed, annual dividend per share.
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Preferred Stocks
A hybrid security:
 It’s like common stock - no fixed maturity.
 Technically, it’s part of equity capital.
 It’s like debt - preferred dividends are fixed.
 Missing a preferred dividend does not constitute
default
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Preferred Stocks (continued)
 You are an owner of the stock but have a known
rate of return. Shares are safer than common stock
because the dividends are more secure
 Firms may have multiple classes of preferreds,
each with different features.
 Priority: lower than debt, higher than common
stock.
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Preferred Stocks (continued)
 Protective provisions are common.
 PIK Preferred: Pay-in-kind preferred stocks pay
additional preferred shares to investors rather than
cash dividends.
 Retirement: Most preferreds are callable, and many
include a sinking fund provision to set cash aside for
the purpose of retiring preferred shares.
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Preferred Stocks (continued)

Cumulative Preferred stock
 Unpaid cash dividends accumulate and must
be paid before any cash dividends are paid to
the common stock holders
 Convertible preferred stock
 Can be traded for shares of common stock in
the same company
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Evaluating a Stock Issue
Objective 2: Explain how you can evaluate stock
investments
CLASSIFICATION OF STOCKS
Blue chip stock
Cyclical
Defensive
Growth
Income
Large cap
Mid cap
Small cap
Micro cap
Penny stock
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Evaluating a Stock Issue
 Blue chip: financially strong, high quality stocks with
long and stable records of earnings and dividends
eg: General Electric, Merck, Wal-Mart, SBC
Communications, Home Depot
 Income stock: long and sustained records of paying
higher than average dividends
eg: AT&T, American Electric Power, Duke Energy
 Cyclical stock: earnings and overall market
performance are closely lined to the economy
eg: Caterpillar, Maytag Corp, Timken
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Evaluating a Stock Issue
 Defensive stock: tend to hold their own, and even do
well, when the economy starts to falter
eg: Bandag, Checkpoint Systems
 Growth stock: experience high rates of growth
eg: General Dynamics, Google, Starbucks
 Tech stock: represent new technology
eg: computers, semiconductors, data storage,
software, internet service, wireless communication
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Evaluating a Stock Issue
 Large cap: greater than 10 billion
 Midcap: 2 to 10 billion
 Small cap: 250 million to 2 billion
 Penny stock: below $1
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Evaluating a Stock Issue (continued)
THE INTERNET
 Most corporations have a Website, and the information is
useful in the following ways
 The Website is easily accessible
 More up to date information than the printed material
 Websites like Yahoo and other search engines can also be
used to obtain information about stock investments
 The Internet can also be used to access professional
advisory services like



www2.standardpoors.com
www.valueline.com
www.morningstar.com
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Evaluating a Stock Issue (continued)
STOCK ADVISORY SERVICES
 Prepare printed materials that are a good supplement to
information in newspapers and the Internet
 Charge a fee
 Hundreds to choose from
 Standard and Poor’s reports (library)
 Value Line (library)
 Mergent’s Handbook of Common Stock
 Morningstar
 As an investor, your job is to interpret the information
provided
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Evaluating a Stock Issue (continued)
HOW TO READ THE FINANCIAL SECTION OF THE
NEWSPAPER
 You will see stock quotes in newspapers such as The Wall
Street Journal
52 weeks
Yld
Vol
Net
Hi Lo Sym Div % PE 100s Hi Lo Close Chg
134 80 IBM .52 .5 21 143402 98 95 9549 -3
115 40 MSFT
…
29 558918 55 52 5194 -475
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Numerical Measures That Influence Investment
Decisions
Objective 3: Analyze the numerical measures that
cause a stock to increase or decrease in value
Why corporate earnings are important?
 Corporate earnings play a large part in the increase or
decrease in the value of a stock
 Earnings per share are the corporation’s after-tax earnings
divided by the number of outstanding shares of a common
stock. An increase in earnings is generally a healthy sign
 Price-earnings (PE) ratio
 Price of one share of stock divided by the earnings per
share of stock over the last 12 months
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Numerical Measures That Influence Investment
Decisions (continued)
OTHER FACTORS THAT INFLUENCE THE PRICE
OF A STOCK
 Dividend payout = Dividend amount
EPS
 Dividend yield = Annual income amount
Market value
 Total return = Current return + Capital gain
 Annualized holding period yield =
Total return
X1
Original investment
N
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Numeric Measures That Influence
Investment Decisions (continued)
 Beta: measure of volatility
 Book value per share
 Net worth of company determined by deducting all
liabilities from the corporations assets and dividing
the remainder by the number of outstanding shares
of common stock
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Numeric Measures That Influence
Investment Decisions (continued)
 Market-to-Book ratio
 The current market value divided by the book value
 A measurement ratio that, in part, may be used to
determine the value of a stock
 If the market-to-book ratio is high, that may mean
that the stock is overvalued
 If the market-to-book ratio is low, that may mean
that the stock is undervalued
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Numeric Measures That Influence
Investment Decisions (continued)
INVESTMENT THEORIES
 Fundamental analysis
 Based on the assumption that a stock’s intrinsic or
real value is determined by the company’s future
earnings
 Fundamentalists consider the…
 Financial strength of the company
 Type of industry company is in
 New-product development
 Economic growth of the overall economy
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Numeric Measures That Influence
Investment Decisions (continued)
Fundamental analysis:
 Financial statement: balance sheet, income statement,
cash flow statement
 Key financial ratios:
-- liquidity ratios: Do we have enough liquid assets to
meet approaching obligations?
eg: current ratio, acid ratio
-- operating efficiency ratio: how efficiently the firm’s
assets generate operating profits.
eg: return on investment, profit margin, asset turnover
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Numeric Measures That Influence
Investment Decisions (continued)
Fundamental analysis:
 Key financial ratios:
-- leverage ratio: the use of debt to finance assets.
eg: debt ratio, times interest earned
-- return on equity: How well are the firm’s managers
maximizing shareholder wealth?
eg: return on equity ratio
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Numeric Measures That Influence
Investment Decisions (continued)
 Technical analysis
 Based on the assumption that a stock’s value is
determined by the forces of supply and demand
in the stock market as a whole
 Not based on expected earnings or the intrinsic
value of a stock but rather on factors found in the
market
 Chartists plot past price movements and other
market averages to observe trends they use to
predict a stock’s future value
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Numeric Measures That Influence
Investment Decisions (continued)
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Numeric Measures That Influence
Investment Decisions (continued)
 Efficient market theory
 Based on the assumption that stock price movements
are purely random
 A stock’s current market price reflects its true value
 It is impossible for an investor to outperform the
average for the stock market as a whole over a period of
time
 Wall Street Journal’s “darts vs the experts” finds
sometimes experts win, sometimes not
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Buying and Selling Stocks
Objective 4: Describe how stocks are bought
and sold
 Corporate financing sources
From 1999 through 2001, capital has been raised
through the following sources:
Corporate Bonds and Notes
76.9%
Equities
23.1%
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Financial Market Components
Public Offering
 Firm issues securities, which are made available
to both individual and institutional investors.
Private Placement
 Securities are offered and sold to a limited
number of investors.
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Financial Market Components
Money Market
 Market for short-term debt instruments
(maturity periods of one year or less).
Capital Market
 Market for long-term securities (maturity
greater than one year).
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Buying and Selling Stocks
 Primary market
 A market in which an investor purchases financial
securities through an investment bank, or other
representative, from the issuer of those securities
 An IPO occurs when a corporation sells stock to
the general public for the first time
 Secondary market
 A market for existing financial securities that are
currently traded among investors through brokers
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Investment Banking
 An investment bank is a financial firm that assists
corporations in raising funds, usually by helping to sell
new security issues
How do investment bankers help firms issue securities?
 Underwriting the issue.
 Distributing the issue.
 Advising the firm.
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Stock Issue Example:
Our firm needs to raise approximately $100 million
for expansion. Our stock price is $20. We Select
Merrill Lynch to underwrite the issue for a 2%
underwriting spread.
 What type of issue is this?
 It’s a negotiated purchase.
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Stock Issue Example:
Our firm needs to raise approximately $100 million
for expansion. Our stock price is $20. We Select
Merrill Lynch to underwrite the issue for a 2%
underwriting spread.
 How many shares will be sold?
 $100,000,000 / $20 = 5 million new shares of
common stock.
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Stock Issue Example:
Our firm needs to raise approximately $100 million for
expansion. Our stock price is $20. We Select Merrill
Lynch to underwrite the issue for a 2% underwriting
spread.
What are the flotation costs?
 Underwriting spread: 2% of $100 million = $2 million.
 Issuing costs: printing and engraving costs; legal,
accounting, and trustee fees.
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Stock Issue Example:
Our firm needs to raise approximately $100 million for
expansion. Our stock price is $20. We Select Merrill
Lynch to underwrite the issue for a 2% underwriting
spread.
 What are the risks?
 The investment bank accepts the risk of being able to
sell the new stock issue for $20 per share. If the stock
price falls, the investment bank could lose money.
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Invest in IPO
Company
IPO date IPO price 1st day price 1st day gain Now
Vignette
2/18/99
$19
42
124%
7
FlashNet
3/16/99
17
43
156
acqu
Arriba
6/22/99
23
89
291
N/A
7/24 Solu
1/27/00
26
71
176
N/A
Antigenics
2/3/00
18
61
241
0.45
Buy.com
2/7/00
13
25
93
Deli
Nuance Com 4/12/00
17
34
100
12.67
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Buying and Selling Stocks (continued)
SECURITY EXCHANGES
 A marketplace where member brokers who represent
investors meet to buy and sell securities
 The securities sold at an exchange must be listed, or accepted
for trading, at the exchange
 New York Stock and American Stock Exchanges (9:30 am –
4:00 pm ET)
 The Over-the-Counter (OTC) market
 Network of dealers who buy and sell the stocks of
companies not listed on a securities exchange
 Most OTC securities are traded over the NASDAQ which
is an electronic marketplace for approximately 3,200
stocks
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Buying and Selling Stocks (continued)
Market average and index
 DJIA – Dow Jones Industrial Average: made up of 30 high-
quality stocks selected for total market and broad public
ownership and believed to reflect overall market activity.
 Standard and Poor’s indexes: true indexes that measure the
current price of a group of stocks relative to a base
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Buying and Selling Stocks (continued)
BROKERAGE FIRMS AND ACCOUNT EXECUTIVES
 An account executive, or stockbroker, is a licensed
individual who buys and sells securities for his or her
clients
 Financial objectives should be communicated to the
account executives, and the investor must be actively
involved in the investment decisions
 Discount broker versus full service brokers
 How much advice do you want?
 Nearest office and toll-free phone number?
 Online and phone trading services and costs?
 Fees, charges and commissions?
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Buying and Selling Stocks (continued)
STOCK TRANSACTIONS
 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 or price range
 Stop order: Request to sell a stock at the next available
opportunity after its market price reaches a specified
amount
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Long-Term and Short-Term Investment
Strategies
Objective 5: Explain the trading techniques used by
long-term investors and short-term speculators
 Long-term techniques
 Buy and hold
 Dollar cost averaging
 Direct investment and dividend re-investment plans
(DRIPS)
 Short-term techniques
 Day trading
 Buying stock on margin (borrowing money)
 Selling short (borrowing stock)
 Trading in options (predetermined price)
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Online Activity
Go to an online source such as www.fool.com,
www.morningstar.com, or www.cnnfn.com.
Research some stocks and find one that looks like a
good investment.
…Why do you think that this stock would be a good
investment for you?
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