chapter 14 investing in stocks chapter 14 investing in stocks
TRANSCRIPT
Chapter 14
Investing in Stocks
Chapter 14
Investing in Stocks
Chapter 14Learning 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 StocksObjective 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 meansThere are periods where stocks decline in valueThe 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. 4
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.5
Comparison of Three Forms Advantage of corporations: -- limited liability -- ease in raising capital
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The Corporation and Financial Markets
7
cash Investors
Secondarymarkets
Government
securities
Cash flow
reinvest
tax
Corporation
dividends,etc.
Direct Transfer of Funds
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Movement of Savings
cashcash
securitiessecurities
saver
firm
Indirect Transfer using Investment
Banker
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Movement of Savings
securitiessecurities
fundsfundsfundsfunds
securitiessecurities
saver
investmentbanker
firm
Indirect Transfer using a Financial
Intermediary
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Movement of Savings
fundsfunds
intermediaryintermediarysecuritiessecurities
fundsfunds
firmfirmsecuritiessecurities
financialintermediary
firm
saver
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.12
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 Corporations Issue Common Stock
Why Investors Purchase Common Stock
They can make money in three waysIncome from dividends in the form of cash or
additional stock (record day and ex-dividend)Dollar appreciation of stock valuePossible 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.18
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.19
Preferred Stocks (continued)
Cumulative Preferred stockUnpaid cash dividends accumulate and
must be paid before any cash dividends are paid to the common stock holders
Convertible preferred stockCan be traded for shares of common
stock in the same company
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Evaluating a Stock IssueObjective 2: Explain how you can
evaluate stock investments
CLASSIFICATION OF STOCKS Blue chip stock Large capCyclical Mid capDefensive Small capGrowth Micro capIncome Penny stock
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Evaluating a Stock IssueBlue 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, Timken22
Evaluating a Stock IssueDefensive 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 23
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 INTERNETMost corporations have a Website, and the
information is useful in the following waysThe Website is easily accessibleMore up to date information than the printed
materialWebsites 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 SERVICESPrepare printed materials that are a good
supplement to information in newspapers and the Internet
Charge a feeHundreds to choose from
Standard and Poor’s reports (library)Value Line (library)Mergent’s Handbook of Common StockMorningstar
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
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52 weeks Yld Vol NetHi Lo Sym Div % PE 100s Hi Lo Close Chg134 80 IBM .52 .5 21 143402 98 95 9549 -3
115 40 MSFT … 29 558918 55 52 5194 -475
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 stockEarnings 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) ratioPrice of one share of stock divided by the earnings
per share of stock over the last 12 months28
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 amountMarket value
Total return = Current return + Capital gainAnnualized holding period yield =
Total return X 1Original 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 THEORIESFundamental 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 statementKey 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 analysisBased 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 StocksObjective 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%38
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 41
Investment BankingAn 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.44
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. 45
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. 46
Invest in IPOCompany 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) marketNetwork of dealers who buy and sell the stocks
of companies not listed on a securities exchangeMost OTC securities are traded over the
NASDAQ which is an electronic marketplace for approximately 3,200 stocks 48
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 brokersHow much advice do you want?Nearest office and toll-free phone number?Online and phone trading services and costs?Fees, charges and commissions? 50
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 StrategiesObjective 5: Explain the trading techniques
used by long-term investors and short-term speculators
Long-term techniquesBuy and holdDollar cost averagingDirect investment and dividend re-investment plans
(DRIPS)Short-term techniques
Day tradingBuying stock on margin (borrowing money)Selling short (borrowing stock)Trading in options (predetermined price)
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Online ActivityGo 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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