Chapter 12 Investing in Stocks 1 Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-2 Investing in Stocks Chapter Learning Objectives LO12.1 Identify the most important features of common and preferred stock. LO12.2 Explain how you can evaluate stock investments. LO12.3 Analyze the numerical measures that cause a stock to increase or decrease in value. LO12.4 Describe how stocks are bought and sold. LO12.5 Explain the trading techniques used by long- term investors and short-term speculators. Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-3 Learning Objective LO12.1 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 Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Why Corporations Issue Common Stock 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 on each dividend payment But: Shareholders have voting rights and elect the board of directors 12-4 Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Why Investors Purchase Common Stock Investors can make money in three ways Income from dividends Cash Stock dividend Dollar appreciation of stock value Price appreciation Capital gain Possible increased value from stock splits No guarantee price will go up after a split 12-5 Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-6 Income from Dividends: Dividend Dates Declaration date Board of Directors votes to pay a dividend Record date Stockholder must be registered on the firms books to receive the dividend Ex-Dividend date 2 nd business 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 Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-7 Preferred Stock A middle investment between common stock (equity) and corporate bonds (debt) Stockholders know the amount of cash dividend when the stock is purchased Conservative equity position like common stock but usually non-voting Dividends paid before common stock Dividend not a legal obligation that company must pay Dividend may be omitted by action of the board Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-8 Learning Objective LO12.2 Evaluating a Stock Issue Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-9 Sources of Information about Stocks and Investing The Internet Firms home page more current than printed materials Look for Investor Relations link Research on a company Stock screener to help choose investments Professional advisory services Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-10 Where Can You Find a Stock Quote, and What Does One Look Like? Print sources The Wall Street Journal The local newspaper Online sources: Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. First enter stock symbol Resulting screen Common Stock Price Quotes Online atCopyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-12 Common Stock Price Quotes Last trade price = $75.43 Annual dividend = $1.76 P/E = Earnings per share = 75.43/14.13 = $5.34 Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-13 Evaluating a Stock Issue Stock Advisory Services Research materials More detailed information compared to other sources of information Most charge a fee Three most popular Standard and Poors reports Value Line Mergents Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-14 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)http://www.sec.gov Business periodicals Bloomberg Businessweek, Fortune, Forbes, Money, Kiplingers Personal Finance Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-15 Learning Objective LO12.3 Numerical Measures that Influence Investment Decisions Corporate earnings One of the most significant factors in changes in the value of a stock Source of dividend payments Often a reflection of the health of the firm Earnings per share (EPS) Corporations earnings divided by the number of outstanding shares of common stock EPS Increase = generally a healthy sign Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-16 Numerical Measures that Influence Investment Decisions Price-earnings ratio (PE) Price per share of stock divided by the firms earnings per share How much an investor is paying for a companys 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 Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-17 Dividend Yield and Total Return 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) divided by Number of shares Market price per share is often > book value Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Other Factors that Influence the Price of a Stock Beta Volatility of a stock relative to the market Market has beta = 1.0, higher beta for stock means greater volatility (risk) The price an investor is willing to pay is determined by: Expected future dividends Potential increase in price Price uses time value to find present value of first 2 Stock market bubble Stocks are trading above their actual worth Driven by investor optimism and irrational expectations Bubbles burst Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-19 Learning Objective LO12.4 Buying and Selling Stocks 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 Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-20 Buying and Selling Stocks Secondary Market Market for existing financial securities Traded among investors via brokers and dealers Issuing company gets no cash from trades Markets Securities exchanges Physical trading location Over-the-counter markets Network of dealers Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-21 Securities Exchanges (NYSE) Securities exchange 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 A Listed Market = NYSE Designated Specialists Buy or sell a particular stock Responsibility for maintaining a fair and orderly market Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-22 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 approximately 3,300 companies Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-23 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 Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-24 Discount vs. Full Service Brokers vs. Online Service vs. Cost How much advice do you want? Can you buy and sell stocks using the Internet or over the phone? What is the typical commission for a stock transaction? Toll-free number for customer use? 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? Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-25 Computerized Transactions Reasons that justify trading online Size of investment portfolio Ability and desire to manage own portfolio Ability to monitor investments closely Capability of computer and software Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-26 Stock Transaction Orders Market order Order to buy or sell stock at the current market value Limit order Order to buy or sell a stock at a specified price Stop-loss order Order to sell a stock at the next available opportunity after its market price reaches a specified amount Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-27 Commission Charges Brokerage minimum commissions Range = $5 to $25 Depends on the number of shares traded and stock value Full service vs. discount brokers Full service fees > Discount broker fees Online broker little advice and you make your own decisions Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-28 Learning Objective LO12.5 Long-Term and Short-Term Investment Strategies Long-Term Investment Strategies Buy and hold Dollar cost averaging Direct investment and dividend reinvestment plans (DRIPS) Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-29 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 Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Direct Investment and Dividend Reinvestment Plans Offered directly by company Direct Investment Plan Allows purchase of stock directly from company No broker or account executive Dividend Reinvestment Plan (DRIP) Allows option of reinvesting dividends to purchase more stock of the company Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-31 Short-Term Investment Strategies Buying stock on margin Borrowing money from broker Margin requirement set by the Fed Bullish Expecting price to increase Selling short Borrowing stock Sell high, buy low Bearish Expecting price to decrease Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-32 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 Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-33 Chapter Summary Learning Objective LO12.1 Corporations sell stock (a form of equity) to finance their business start-up costs and help pay ongoing business costs. Common stockholders have the right to elect the board of directors. They must also approve major changes to corporate policies. Possible reasons for stock investments include: Dividend income Appreciation of value The possibility of gain through stock splits A few corporations may issue preferred stock. Preferred stockholders receive cash dividends before any cash dividends are paid to common stockholders. Dividend distributions to both preferred and common stockholders must be approved by the board of directors. Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-34 Chapter Summary Learning Objective LO12.2 Start the stock evaluation process with the classification of different types of stock investments ranging from very conservative to very speculativesee Exhibit 123. Information for stock evaluation is available from: The Internet Stock advisory services The newspaper The corporations that issue stocks Business and personal finance periodicals Government publications Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-35 Chapter Summary Learning Objective LO12.3 Many analysts believe that a corporations ability or inability to generate earnings in the future may be one of the most significant factors that account for an increase or decrease in the value of a stock. Generally, higher earnings equate to higher stock value, and lower earnings equate to lower stock value. Earnings per share and a price-earnings ratio are historical numbers based on what a corporation has already done. Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-36 Chapter Summary Learning Objective LO12.3 Investors can obtain earnings estimates for most corporations. Other calculations that help evaluate stock investments include: Dividend yield Total return Book value Stock prices are also affected by: The amount of future dividends A potential increase in the price of a share of stock What another investor will pay for a share of stock Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-37 Chapter Summary Learning Objective LO12.4 A corporation may sell a new stock issue with the help of an investment banking firm. Once the stock has been sold in the primary market (IPO), it can be sold time and again in the secondary market. In the secondary market, investors purchase stock listed on a securities exchange or traded in the over- the-counter market. Securities transactions are made through: An account executive who works for a full-service brokerage firm A discount brokerage firm Online brokerage firm Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-38 Chapter Summary Learning Objective LO12.4 Basic order types include: Market order Limit order Stop-loss order Brokerage firms typically charge a minimum commission for buying or selling stock. Additional commission charges are based on: The number of shares bought or sold The value of the shares You can use a full-service or discount brokerage firm or trade online. Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 12-39 Chapter Summary Learning Objective LO12.5 Purchased stock may be classified as either a long-term investment or a speculative investment. Long-term investors typically hold their investments for at least a year or longer. Techniques long-term investors use include: Buy-and-hold Dollar cost averaging Direct investment plans Dividend reinvestment plans Copyright 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.