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Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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Chapter 14 Investing in Stocks
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Page 1: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

Chapter 14

Investing in Stocks

Chapter 14

Investing in Stocks

Page 2: 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

2

Page 3: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

3

Page 4: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 5: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 6: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

Comparison of Three Forms Advantage of corporations: -- limited liability -- ease in raising capital

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Page 7: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

The Corporation and Financial Markets

7

cash Investors

Secondarymarkets

Government

securities

Cash flow

reinvest

tax

Corporation

dividends,etc.

Page 8: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

Direct Transfer of Funds

8

Movement of Savings

cashcash

securitiessecurities

saver

firm

Page 9: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

Indirect Transfer using Investment

Banker

9

Movement of Savings

securitiessecurities

fundsfundsfundsfunds

securitiessecurities

saver

investmentbanker

firm

Page 10: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

Indirect Transfer using a Financial

Intermediary

10

Movement of Savings

fundsfunds

intermediaryintermediarysecuritiessecurities

fundsfunds

firmfirmsecuritiessecurities

financialintermediary

firm

saver

Page 11: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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.

11

Common Stock

Page 12: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 13: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

13

Why Corporations Issue Common Stock

Page 14: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 15: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 16: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 17: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 18: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 19: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 20: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 21: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 22: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 23: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 24: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 25: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 26: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 27: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 28: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 29: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 30: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 31: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 32: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 33: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 34: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 35: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 36: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

Numeric Measures That Influence Investment Decisions (continued)

36

Page 37: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 38: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 39: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 40: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 41: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 42: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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.

42

Page 43: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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.

43

Page 44: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 45: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 46: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 47: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 48: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 49: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 50: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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

Page 51: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 52: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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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Page 53: Chapter 14 Investing in Stocks Chapter 14 Investing in Stocks.

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?

53


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