Chapter 12 Investing in Stocks 12.1 Evaluating Stocks 12.2 Buying and Selling Stock Consider THIS Jon worked during the summer and managed to save $500 to invest. He decided he wanted to buy some stock and see if he could double his money in the next year or two. “I’ve been doing research about a medical research company, and I think it’s on the verge of something big,” he said to a discount broker he met through his father. “I’ve been reading about this company and I think the stock price is low now because the company isn’t paying dividends. Instead, they are using company profits to develop new products. Some of those products are on the cutting edge of research. All the information I’ve gathered suggests that the company is solid, growing, and will be a leader in its industry. I think this company’s stock is worth the risk. Please buy me as many shares as my money will purchase.” Chapter 12 Investing in Stocks 261 Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Jon worked during the summer and managed to save $500 to invest. Hedecided he wanted to buy some stock and see if he could double his money inthe next year or two.
“I’ve been doing research about a medical research company, and I thinkit’s on the verge of something big,” he said to a discount broker he metthrough his father. “I’ve been reading about this company and I think thestock price is low now because the company isn’t paying dividends. Instead,they are using company profits to develop new products. Some of thoseproducts are on the cutting edge of research. All the information I’ve gatheredsuggests that the company is solid, growing, and will be a leader in its industry.I think this company’s stock is worth the risk. Please buy me as many shares asmy money will purchase.”
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types of stocks.n Explain how to value a stock anddecide a fair price to pay for astock purchase. T
ERM
S n stockholders, p. 262n dividends, p. 262n common stock, p. 262n proxy, p. 263n preferred stock, p. 263
n income stocks, p. 263n growth stocks, p. 263n blue chip stocks, p. 264n par value, p. 265n market value, p. 265
OWNING STOCK
Nearly 50 million people in the United States own stocks. There are morethan 34,000 public corporations from which to choose. A public corporation isa company whose stock is traded openly on stock markets.People who own shares of stock are called stockholders, or shareholders, of
the corporation. If the corporation does well, stockholders will profit in twoways. One is through dividends. Dividends are money paid to stockholdersfrom the corporation’s earnings (profits). The other way stockholders profit isthrough capital gains. This is an increase in the value of the stock over time.For example, if you bought stock for $5 per share and the corporation thrived,its stock price might go up to $10 per share. If it did, you could sell it for asubstantial profit. Part of the risk in owning stock, however, is that the pricecould also go down below the price initially paid for it, resulting in a capitalloss. Also, a capital gain becomes profit only when you sell the stock. Untilthen, it is a profit only “on paper.”Stockholders can also lose all of their investment if the company fails or
goes out of business. However, one advantage to owning stock is that stock-holders can lose no more than their investment in the stock. The owner of asmall business, on the other hand, can also lose personal assets if the businessfails.Stocks are traded in round lots or odd lots. A round lot is 100 shares or
multiples of 100 shares of a particular stock. An odd lot is fewer than100 shares of a particular stock. Brokerage firms usually charge higher per-share fees for trading in odd lots. Odd lots are usually combined into roundlots before they are traded.
COMMON STOCKCommon stock represents a type of stock that pays a variable dividend and
gives the holder voting rights. The board of directors, which guides the cor-poration and decides the amount of dividends to pay each year, is elected by thecommon stockholders. Common stockholders vote on major policy decisions,
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such as whether to issue additional stock, sell thecompany, or change the board of directors. Eachshare of common stock has the same voting power,so the more shares a stockholder owns, the greaterthe power to influence corporate policy.Common stockholders may vote in person at the
stockholders’ meeting or by proxy. A proxy is astockholder’s written authorization to transfer his orher voting rights to someone else, usually a com-pany manager. Most common stockholders vote byproxy rather than by attending the annual meetings.
PREFERRED STOCKPreferred stock represents a type of stock that
pays a fixed dividend but has no voting rights.Preferred stockholders earn the stated dividend,regardless of how the company is doing. Thus,preferred stock is less risky than common stock. Inthe event the company fails, the preferred stock-holders would be paid ahead of common stockholders. As with most invest-ments, however, the tradeoff for less risk is lower return. Dividends onpreferred stock may be lower than common stockholders would earn, if thecompany is thriving over time.
TYPES OF STOCK INVESTMENTSWhen evaluating stock investments, investors often classify stocks into
different categories. Categories of stocks include income, growth, emerging,blue chip, defensive, and cyclical. Some stocks may fall into more than onecategory. Which category is best for you will depend on how much risk youare willing to assume for a chance to earn larger returns on your invest-ments. Also, most investors buy stocks in several of these categories todiversify their risk.
Income Stocks
Corporations can use their profits in two ways. They can distribute the profitsto stockholders as dividends, or they can reinvest the profits in the business tohelp it grow. Stocks that have a consistent history of paying high dividends areknown as income stocks. Investors choose income stocks in order to receivecurrent income in the form of dividends. Preferred income stocks pay the mostcertain and predictable dividends and are often the choice of retired people andothers needing regular and dependable sources of income.
Growth Stocks
Growth stocks are stocks in corporations that reinvest their profits into thebusiness so that it can grow. These corporations may pay little or no dividends.Instead of current income, investors buy growth stocks for future capital gains. Ifthe reinvested profits do make the business grow, the stock will be worthsubstantially more in the future, when the investor is ready to sell it. As a result,growth stocks are long-term investments. They are often selected by younger
people who have more time to letinvestments grow. If the value of thestock increases, stockholders mustdecide whether to sell it at thehigher price now or to continue tohold it, hoping that it will go upeven more. When stockholdersdecide to sell, the difference betweentheir original purchase price and theselling price they receive is theircapital gain.
Emerging Stocks
Stocks in young, often small cor-porations that have higher overallrisk than stocks of companies thathave been successful for many yearsare called emerging stocks. Theseyoung companies may be on theirway to becoming highly profitable.
Or, they may be among the many small companies that fail every year.Because the future of these companies is so uncertain, their stocks are ofteninexpensive but risky.
Blue Chip Stocks
Blue chip stocks are stocks of large, well-established corporations with a solidrecord of profitability. Most people have heard of these companies becausetheir products and services have been around for decades. They are companieslike IBM and Coca-Cola. Blue chip stocks are a conservative investment.Investors choose them for relatively safe, stable, but moderate returns.
Defensive Stocks
A defensive stock, or non-cyclical stock, is one that remains stable and pays divi-dends during an economic decline. Generally, companies in this category have ahistory of stable earnings. A defensive stock is not affected as much by the ups anddowns of business cycles. Examples include utilities, pharmaceuticals, food, andhealth care stocks. In other words, the demand for these products remains fairlyconsistent regardless of economic conditions. Therefore, stocks in these industriesprotect the investor from sharp losses during bad economic times.
Cyclical Stocks
Cyclical stocks do well when the economy is stable or growing but often dopoorly during recessions, when the economy slows down. Examples of cyclicalstocks are travel-related companies such as airlines and resorts, manufacturingcompanies such as auto makers, and housing/construction companies. Forexample, during a recession, many people lose their jobs or earn less than theywould during good economic times. As a result, people have less money forluxuries, such as leisure travel, causing reduced profits for travel-relatedcompanies. In response to this poor profit performance, the value of the stocksin these companies will likely decline.
Many different types of stocks are available, but notall stocks are right for every investor. Access www.cengage.com/school/pfinance/mypf and click on thelink for Chapter 12. Read about the different kinds ofstocks on the Prudential web site, and then answerthese questions: What kind of stock would be a goodchoice during a recession? What would be a poorchoice? If you wanted to receive an income in dividends,would a growth stock be a good choice? If you havelittle money to invest, should you avoid penny stocks?Why or why not?
www.cengage.com/school/pfinance/mypf
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When you buy stock, you expect to hold it for a period of time and then sellit, hopefully for a profit. Whether or not you make a profit depends on howmuch someone else is willing to pay for it when you are ready to sell.When you purchase stock, you may receive a stock certificate or have it held
electronically. The certificate states the number of shares you own, the nameof the company, the type of stock (common or preferred), and the par value.The par value is an assigned dollar value given to each share of stock. Forcommon stock, par value is often meaningless. Common stock can be issuedwithout a par value (no-par value stock). However, for preferred stock, parvalue is used to calculate dividend payments.Par value has nothing to do with a stock’s market value, which is the price
for which the stock is bought and sold in the marketplace. The market value ofa stock reflects the price investors are willing to pay for the stock. How acompany currently is performing, its track record, and how well it is expectedto perform in the future determine market value.Some stocks perform very well, yet their market value seems too low—or a
“real bargain.” These “undervalued” stocks are worth more than the price forwhich they are selling. Stocks that are undervalued make good bargains forinvestors, while creating a dangerous situation for businesses by leaving themvulnerable to a takeover by a large investor or company. Takeovers may beunfavorable for employees but can be very favorable for stockholders, becausethe market value of the stock is likely to rise.On the other hand, stocks can be “overvalued,” which means they are selling
at a price that is perceived to be too high. The price of the stock is not justifiedby its earnings but is based on its superior growth potential in the future. Thissituation is very risky for the investor, because it is likely that the price of thestock will drop. The wider the price swings, the riskier the stock.
STOCK PRICESeveral factors affect the price you will pay for a share of stock. These factors
include the company’s financial situation, current interest rates, the market forthe company’s products or services, and earnings per share.
n The Company. When a company is performing well (paying its currentdebts and earning a profit), the company’s stock is attractive. Investorsconsider the company’s earning power (its ability to continue to make astrong profit), as well as its debt (how much the company owes). If thecompany seems to be in a good financial position, the stock price willcontinue rising.
n Interest Rates. When interest rates are low, people who would normally putmoney in savings accounts and CDs look for more profitable places to investtheir money. As interest rates rise, however, people tend tomove their moneyto the safer investments. Generally, when interest rates fall below the currentrate of inflation, people buy more stock, and stock prices rise.
n The Market. The marketplace determines a company’s ability to sell itsproduct or service now and in the future. If the company is in a popularindustry and its products or services are selling well, its stock price will rise.For example, when people are buying computers, software, and relateditems, companies in the high-tech industry are considered wise investments.
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If the demand for a particular product or service declines, the price of thestock will decline.
n Earnings per Share. Earnings per share are a corporation’s after-tax earn-ings divided by the number of common stock shares outstanding, that is,shares in the hands of investors. For example, assume that in a given year,XYZ Corporation had after-tax earnings (net profit) of $1,000,000. It had100,000 shares of common stock outstanding. Therefore, its earnings pershare at that time were $10 ($1,000,000/100,000). Stockholders useearnings per share as a measure of a company’s profitability.
RETURN ON INVESTMENTBecause you can make money on stocks from dividends and from an increase
in the price of the stock (capital gain), you should consider both whencomputing the return on your investment. Figure 12.1 shows the formula forcomputing a stock’s return on investment (ROI). Your profit is the differencebetween what you paid for the stock and what you sold it for, plus anydividends you earned. To compute the total costs, add any commission youpaid to the stockbroker to the purchase price of the stock.
STOCK INDEXESA stock index is a benchmark that investors use to judge the performance of
their investments. One widely followed stock index is the Dow JonesIndustrial Average. Often called simply the Dow, it is an average of the pricemovements of 30 major stocks listed on the New York Stock Exchange. Thisaverage provides a general overview of how stock prices are doing in the stockmarket as a whole. Investors compare the price fluctuations of their stocksagainst this average to judge how well their stocks are performing comparedto the overall stock market. Indexes for judging the performance of all kindsof stocks are available online and in print publications. Other commonlyused indexes are the Standard & Poor’s 500 and the NASDAQ CompositeIndex.
FIGURE 12.1 Computing Return on Investment
Current Profit on Stock
Purchase Price � Commission � Return on Investment (ROI)
Example: Selling price (or current stock price): $40/share Dividends received during the year: $1/share Purchase price: $38/share Discount brokerage fee: $19 Number of shares owned: 100
Computations:Current profit: $40/share – $38/share � $2/share � 100 � $200 � $100dividends � total profits of $300
$300
(100 � $38) � $19� � 7.86%
$300
$3,819
Computing a Stock’s One-Year ROI
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Probably the number one career forinspiring others is teaching. As ateacher, one has the opportunity totouch, influence, and change morelives during his or her career thanany other type of job.
Education careers occur atmany levels, including pre-school,elementary, secondary (middle andhigh school), and post-secondary(community college, junior college,and four-year university).
Private industry also has edu-cators. They do corporate trainingand help workers learn new skillsand prepare them for higher posi-tions within the company. Corporateeducators have similar skills to thoseworking at colleges and universities;they impart knowledge and helpstudents reach their full potential.
Employment Outlookl An average rate of employment
growth is expected.
Job Titlesl Teacherl Professorl Corporate trainer
Needed Skillsl Bachelor’s degree in subject
matter; master’s degree ineducation (teaching).
l Licensure in all 50 states forpublic education careers.
l Specialized knowledge andskills for private industryeducators and trainers.
What's it like to work in. . .EducationMike uses his teaching skills to helpprepare workers at a large invest-ment portfolio corporation. With hisdegree in education, he understandsadult learning strategies. He alsohas worked for several years in theindustry, so he has a good under-standing of clients’ needs.
Mike’s company is incorporat-ing a new investment planningstrategy to help clients reach theirinvestment objectives. He hasplanned a two-hour training sessionfor the company’s financial advisers.He will use a combination of printmaterials and visual aids during hispresentation to accommodate alllearning styles. Mike has alsoprepared several learning tools,including a chart that lists a varietyof investment objectives and thecorrelating new stock optionsavailable to clients. These toolsare designed to help advisersimplement the new strategymore quickly and efficiently.
After the training session, Mikewill conduct follow-up sessions withadvisers to answer questions andaddress problems. He will conductthe training program for a newgroup of workers every six months.
What About You?Do you enjoy training others to helpthem improve their performance?Would you like a job as a corporatetrainer?
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KEY TERMS REVIEWMatch the terms with definitions. Some terms may not be used.
1. A class of stock that pays a fixeddividend but has no voting rights
2. Price for which stock is bought andsold in the marketplace
3. An assigned dollar value to eachshare of stock
4. A type of stock that has a history ofpaying high dividends
5. Money paid to stockholders fromearnings of a corporation
6. A written authorization to vote for astockholder
7. Those who own shares of stock
8. Stocks of large, well-established companies
CHECK YOUR UNDERSTANDING9. In what two ways can you make money from owning stock?
10. How is an income stock different from a growth stock?
11. Why do stockholders want to know a corporation’s earnings per share?
APPLY YOUR KNOWLEDGE12. Investing in blue chip stocks is said to be a conservative choice. Can you list
several well-known stocks that are considered blue chip, besides the twomentioned in the text? (Hint: Read through the listing of stocks in thefinancial pages or online and mark the stocks you recognize.)
THINK CRIT ICALLY
13. If you had some money to invest, what stock would you choose? Why?Explain how you would make your stock choice(s). In other words, whatcriteria would you use to evaluate a potential stock purchase?
14. Why should young people (just starting their long-term investment strategy)invest in growth stocks rather than income stocks? Explain how these twotypes of stock are different and what that means to you, as a young person.
a. blue chip stock
b. common stock
c. dividends
d. growth stock
e. income stock
f. market value
g. par value
h. preferred stock
i. proxy
j. stockholders
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n Describe the process of buying andselling stocks.
n Describe short- and long-terminvestment strategies whenbuying and selling stocks.
n Explain how to read the stocklistings and stock indexes.
TERM
S
n securities exchange,p. 269
n bull market, p. 270n bear market, p. 270n leverage, p. 271n short selling, p. 272
n stock split, p. 273n direct investment, p. 274n dividend reinvestment,p. 274
THE SECURITIES MARKET
The securities market consists of the channels through which you buy andsell securities (stocks and bonds). To purchase common or preferred stock, youneed a trading agent. Your agent will buy or sell for you in a securitiesmarketplace, which is either a securities exchange or the over-the-countermarket.
SECURITIES EXCHANGESA securities exchange is a marketplace where
brokers who are representing investors meet tobuy and sell securities. The largest organizedexchange in the United States is the New YorkStock Exchange (NYSE). The smaller AmericanStock Exchange (AMEX) is also in New YorkCity. Regional exchanges are located through-out the country. To have a stock listed with theNYSE or AMEX, a company must meet aminimum number of public shares and dollarmarket-value requirements.In the NYSE building, the trading floor
(where stocks are bought and sold) is abouttwo-thirds the size of a football field. Aroundthe edge of the trading floor are booths withcomputer terminals and room inside for adozen or more floor brokers. Floor brokers buyand sell stocks on the exchange. Only brokerswho are members of the exchange may dobusiness there.Spaced at regular intervals around the trading
floor are trading posts, which are horseshoe-shaped counters, each occupying about100 square feet on the floor. Behind eachcounter are specialists—the brokers to the
floor brokers. All buying and selling is done around trading posts. About90 different stocks are assigned to each post. Post display units above eachcounter show which stocks are sold in each section, the last price of thatstock, and whether that price represents an increase or a decrease from theprevious price.Orders received at a brokerage firm or discount brokerage are phoned or sent
by computer to that firm’s booth at the exchange. A message is printed out andis given to the floor broker to carry out. When the transaction is completed,the brokers who bought and sold the stock report back to their respectivebrokerage firms. The buyer and seller can then be advised that the transactionhas been concluded.The exchange is a form of auction market where buyers and sellers are
brought together to trade securities. Stock trading happens auction-stylebecause in every transaction, stock is sold to the highest bidder (buyer) andbought from the lowest offeror (seller). Securities listed with the NYSE aretraded only during official trading hours—9:30 a.m. to 4 p.m. New Yorktime, Monday through Friday (except holidays).
OVER-THE-COUNTER MARKETWhen securities are bought and sold through brokers but not through a
stock exchange, the transaction is over-the-counter (OTC). The OTCmarket is a network of brokers who buy and sell the securities of corpo-rations that are not listed on a securities exchange. Brokers in the OTCmarket do not deal face-to-face with other brokers. Their marketplace is aslarge as the number of brokers at work that day. Trades with other brokersare completed by telephone, and a computerized system displays currentprice quotations on a terminal in a broker’s office. Brokers operating in theOTC market use an electronic quotation system called NASDAQ. (Theletters were originally an acronym for the National Association of SecuritiesDealers Automated Quotation System.) With nearly 3,200 companies listed,NASDAQ has more trading volume in a day than any other stock exchange inthe world.
BULL AND BEAR MARKET CONDITIONSThe stock market goes through cycles. For a period of time, stocks go up in
value. Then the market corrects itself as people sell (to make a profit) and stockprices decrease. A bull market is a prolonged period of rising stock prices and ageneral feeling of investor optimism. Confidence in the country’s economyalso serves to drive up stock prices.A bear market is a prolonged period of falling stock prices and a general
feeling of investor pessimism. It develops when investors become negativeabout the overall economy and start to sell stocks. In bear markets, stock pricesmay fall 20 percent or more. Bear markets are usually short and savage. Theaverage bull market often lasts three to four times as long as a bear market.Whether the stock market in general is bullish (on an upward trend in prices)
or bearish (on a downward trend in prices) influences your decisions aboutwhen to buy stocks and which stocks to buy. To make a profit, you need tobuy stock when the price is low and sell when the price is high. However,nobody knows, including brokers, when a stock is at its lowest price orwhether or not the price will rise.
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You can approach investing with either a short- or long-term strategy.Generally, if you buy and sell stock within a short period of time, you are aspeculator or day trader. If you hold your investment for a long period of time(a year or more), you are an investor.
SHORT-TERM TECHNIQUESWhen you buy and sell stocks for quick profits, you are “playing the stock
market.” The goal is to buy a stock that will soon increase in value. Then,when the price rises, you sell the stock. Many investors make short-term gainsthrough processes called buying on margin and selling short.
Buy on Margin
You can borrow money from your broker to buy stock if you open a marginaccount and sign a contract called a margin agreement. To establish a marginaccount, you must deposit a minimum of $2,000 in cash or eligible securities(securities your broker considers valuable collateral) with a broker. Let’sassume you have $2,000 in your margin account. You want to buy 100 sharesof XYZ Corporation at $20 per share ($2,000). You could use $1,000 fromyour margin account and borrow $1,000, with interest, from your broker.This strategy is called leverage—the use of borrowed money to buy securities.You use less of your own money and therefore can buy more stocks with lesscash. You would still have $1,000 in your margin account to use towardanother purchase on margin.With a margin purchase, you are betting that the stock will increase in value.
If it does, you sell the stock, repay the loan with interest and commission, andtake your short-term profit. Figure 12.2 shows how margin buying works.
FIGURE 12.2 Buying on Margin
Example: You buy $2,000 worth of stock with $1,000 of your own money and $1,000 borrowed from your broker at 6% annual interest. The stock increases in value, and you sell it after 60 days for $2,800. Your broker’s commission to buy and sell is $200.
Computing Profit:
Interest cost: $1,000 borrowed � .06 annual interest � � $10 interest on the 60-day loan
Costs: $1,000 from margin account � $1,000 borrowed � $10 interest � $200 commission � $2,210 total cost
Unfortunately, if the value of the stock does not increase, you will have tomake up the difference. When the market value of a margined stock decreasesto approximately one-half of the original purchase price, the investor willreceive a margin call from the broker. This means the investor must pledgeadditional cash or securities to serve as collateral for the loan.
Sell Short
Short selling is selling stock borrowed from a broker that must be replacedat a later time. To sell short, you borrow a certain number of shares from thebroker. You then sell the borrowed stock, knowing that you must buy itback later and return it to the broker. You are betting that the price willdrop, so that you can buy it back at a lower price than you sold it for, thusmaking a profit. However, if the stock price increases, you will lose moneybecause you must replace the borrowed stock with stock purchased at ahigher price. Figure 12.3 shows how selling short works. There is usually nobroker fee for selling short. The broker receives a commission when thestock is bought and sold.
LONG-TERM TECHNIQUESAs you may already suspect, investing in the stock market for short-term
gains can be extremely risky. You cannot beat the market all of the time, butyou can make some healthy profits if you study and follow the market care-fully. However, most financial consultants advise you to invest for the longterm. Records have shown that, over a long time, stock investments haveconsistently beaten rates for savings accounts, CDs, and other conservativeoptions.
FIGURE 12.3 Selling Short
Example: You borrow 100 shares of stock of XYZ Corporation from your broker. You then sell 100 shares of XYZ at $28 per share and pay a $100 commission.
Income from sale: 100 shares � $28 per share � $100 commission � $2,700 initial income
Two weeks later, the stock price drops to $22 per share. You buy 100shares to return to the stockbroker and pay a $100 commission.
Cost of buying back the shares: 100 shares � $22 per share � $100 commission � $2,300 cost
Profit from selling short: $2,700 income � $2,300 cost � $400 profit
Return on Investment:$400
$2,300� 17.4% ROI
Selling Short
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Most investors consider stock purchases as long-term investments. All stocksgo up and down, but over a number of years, the overall trend of non-speculative stocks is moderately up. Remember, a profit or loss occurs onlywhen you sell the stock. If you “buy and hold” stocks for many years, you canride out the down times. When you are ready to sell years later, most likelyyour stock will have gained value. In addition, many stocks pay dividends, soyou are earning income while you hold the stock.A stock split can also add to the value of the stock over time. A stock split is
an increase in the number of outstanding shares of a company’s stock. When acompany increases its number of outstanding shares, it lowers the selling pricein direct proportion. For example, if there were 1,000 shares outstanding witha market value of $60, then a 2:1 (two for one) stock split would result in2,000 shares outstanding selling for $30. You will notice that the stock is stillworth a total of $60,000. A stock split lowers the selling price of the stock,making the shares more affordable and encouraging investors to buy more.As investors buy more stock at the lower price, the share price often rises. Ifyou held the stock before the split, then this price increase makes your stockworth more.
Dollar-Cost Averaging
The dollar-cost averaging technique involves the systematic purchase of anequal dollar amount of the same stock at regular intervals. The result is usuallya lower average cost per share. To calculate the average cost per share, dividethe total amount invested by the total number of shares purchased, as shownin Figure 12.4. In this figure, the investor purchased $100 worth of stockevery quarter for one year. Over that time, the average price of the stock was$8. However, by investing at regular intervals over the time period, theinvestor’s average cost per share was lower: $7.41.Investors use this technique so they don’t have to worry about timing their
investment purchases. A regular purchase over a year’s time will usually average
FIGURE 12.4 Dollar-Cost Averaging
Dollar-Cost Averaging
QuarterlyInvestment Amount
Average share price = $8 $32 ÷ 4
Your average cost per share = $7.41
Total $ invested ($400) ÷ Total number of shares (54)
Ending value = $540 Last share price ($10) � Number of shares (54)
Share Price ($)
Total number of shares
Number of Shares
÷÷÷÷
1014.29 20 10 54
====
1075
10$32
$100$100$100$100$400
Total $ invested
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out to a reasonable price per share. With dollar-cost averaging, the investor makesa profit when the selling price per share is higher than the average cost per share.
Direct Investment
You can save money using direct investment, or buying stock directly froma corporation. By buying directly, you avoid brokerage and other purchasingfees. You may also be able to obtain shares at prices lower than on openexchanges. Direct investment is often available to existing stockholders whomay have the privilege of buying additional shares at fixed prices that are at orbelow market value.
Reinvesting Dividends
You can also save money by reinvesting your dividends. Dividend rein-vestment means using dividends previously earned on the stock to buy moreshares. Buying stock this way avoids a broker fee and other costs that apply,such as taxes, when you receive cash dividends on the stock.
READING THE STOCK LISTINGS
To make wise investments in the stock market, it is a good idea to track theprogress of your chosen investments to see how they are performing. Whetheryou are reading The Wall Street Journal or following your stocks online, youshould see a listing similar to Figure 12.5. Follow along in this figure as youread the following explanation of each column.
n Columns 1 and 2. These columns show the highest and lowest price thisstock sold for during the year. For the ExeB stock in Figure 12.5, the high forthe last 52 weeks was 57.00 and the low was 32.00. This means the stocksold for $57 a share at one point (high) and $32 a share at another (low),though it may have sold for many prices in between during the year.
GLOBAL ViewIn May 2007, a Saudi Arabiancompany bought a plastic man-ufacturer in Massachusetts; in
November, a French companybought a new factory in Michigan
(adding 189 automotive jobs); inDecember a British company bought a New
Jersey maker of cough syrup. Foreign investorsbuy businesses in America when the U.S. dollar isweak. At the same time, they make inroads tothe world’s largest market. In 2007, foreigninvestors poured $414 billion into Americancompanies, factories, properties, and publiclytraded stock, up 90 percent from the previousyear. In the first part of 2008, foreign businesses
invested another $22.6 billion. As the dollarcontinues to drop in value, more surge offoreign investment is expected. The weak dollarhas made it easier for foreign companies toinvest in the United States.
THINK CRIT ICALLY
In November 2007, a German company brokeground for a $3.7 billion stainless steel plantin Alabama based on the ability to reach mil-lions of consumers. They cited NAFTA, a tradeagreement which allows goods to flow intoMexico and Canada. How can this type ofinvestment help America?
274 Unit 3 Financial Security
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n Column 3. This column lists stocks alphabetically by name. You willnotice that stock names are abbreviated. This abbreviated name iscalled the stock’s ticker symbol. You may see additional abbreviations,such as “pf” (which means “preferred stock”), beside the name of thestock. There will be a legend at the bottom of the page that explainswhat these abbreviations mean. For example, a small “s” means that thestock has recently split. When a stock splits, each share owned is tradedfor additional shares. A 2:1 split would double your shares. If youowned 10 shares worth $50 each, you would now own 20 shares worth$25 each.
n Column 4. This column shows the cash dividend per share for the year,listed in dollars and cents. For the ExeB stock, 2.50 means that if youowned 100 shares of this company, you would have received a dividend of$250 for the year.
n Column 5. Yld % stands for percent yield, or the percentage of the currentprice the dividends represent. In other words, divide the amount ofannual dividends (Column 4) by the closing price (Column 10).
n Column 6. The P/E ratio (price/earnings ratio) is the price of a share of stockdivided by the corporation’s earnings per share over the last 12 months. Forexample, if XYZ Corporation’s stock is selling for $50 per share and XYZ’searnings per share are $10, the P/E ratio is 5 ($50/$10 ¼ $5). The price/earnings ratio is a key factor that serious investors use to evaluate stockinvestments. A low P/E may indicate a solid investment, and a high P/E mayindicate higher risk.
n Column 7. This column shows sales in hundreds of shares from theprevious day—how many round lots of stock were bought and sold.Multiply the number by 100 to get the number of shares.
n Columns 8, 9, and 10. These columns show the highest, lowest, andclosing price for this stock on the previous day. The closing price is thefinal price at the end of trading for the day.
n Column 11. This column, called net change, compares the closing pricetoday with the closing price of the day before. A minus means the price hasgone down. A plus means the price has risen. Stocks that have a pricechange of more than 5 percent may be set in boldface in some financiallistings.
FIGURE 12.5 Reading the Stock Listings
Excerpt from stock exchange listings:
P/ERatio
6
52 wks
58.7545.0010.5024.00
6.3857.00
�.50+.38
----+.88
----+1.00
46.0025.3810.0020.00
5.5044.00
45.5024.009.50
19.005.12
43.00
46.3826.2510.1321.005.75
46.00
109258
12 300z
48
121037
1511
4.88.91.05.0----5.7
2.202.25.10
1.00----
2.50
EngerEng pfEntldEpscoExlabExeB
44.0023.00
9.0016.00
4.0032.00
NetChange
11
Close
10
Low
9
High
8
Yld%
5
Div
4
Stock
3
Low
2
High
1
Sales100s
7
Chapter 12 Investing in Stocks 275
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Keeping track of your stock port-folio (or stock holdings) can be assimple as checking the closing pricesperiodically. Some people checktheir investments only once a year tosee if they should make changes totheir portfolio. Investors might buyadditional shares, sell, or choose adifferent type of stock after checkingtheir portfolios.The stocks shown in Figure 12.6
have been tracked for ten daysstraight. As you can see, some stockshave done better than others interms of market value as of a certaindate. But remember, this chart doesnot take into account dividendsreceived or the appreciation in valuesince a stock was purchased. Thestock progress chart is merely adevice for monitoring changes in theclosing prices of stocks.Many financial Internet sites
enable you to follow stock prices.Using a stock’s ticker symbol, youcan find the stock’s price up to theminute. If you want stock quotessent to your computer automati-cally, you can sign up for the service
with your Internet service provider. Most sites will allow you to specify thestocks you want to follow.You can even buy and sell stocks online. Most major stockbrokers maintain
web sites that allow online transactions. All you have to do is set up anaccount, deposit some money, and you’re on your way!
INFLATION: WHO GETS HURT?Inflation is an increase in the general level of prices. It is measured yearly to see howmuch prices are rising. The consumer price index (CPI) is the instrument most oftenused as a measure of rising prices. The CPI measures price changes for a “marketbasket” of goods and services typically purchased by consumers. Inflation is alsoevident in rising interest rates. Interest rates reflect the cost of lending and borrowingmoney. As prices increase, interest rates go up as well.
Some people get hurt by rapidly rising prices and interest rates. People who are morelikely to be impacted by inflation include the following:
n People on fixed incomes. Many retired people live on a fixed monthly retirementcheck. When prices rise, their fixed income stays the same. Thus, they are unableto maintain the same standard of living in inflationary times.
n People with a lot of debt. During inflationary times, interest rates charged forloans are rising. Thus, creditors (lenders of money) can charge higher interestrates. This makes it hard for people with a lot of debt to pay off their loans.More of each month’s payment goes toward interest rather than paying offthe debt.
n People who have to borrow. If you need to borrow money, you will pay higherinterest rates in times of inflation. As a result, your monthly payments will behigher or you will have to make payments for a longer time to pay off the loan.
n People working as employees. As an employee, you work for a salary or wage.Although you may get a yearly raise, it may not be enough to keep up withprice increases, such as the rising cost of gasoline. Price increases (inflation) hitimmediately, and you must adapt by making changes in your lifestyle. This lowersyour standard of living as rapidly rising prices erode your purchasing power.
To prepare for periods of inflation, save so you will have resources during hard times.Then you can be a lender rather than a borrower.
THINK CRIT ICALLY
1. Using the keyword “inflation,” conduct Internet research and compare interestrates and rising prices in the United States to those in other countries, suchas Brazil, Mexico, or France. Look at the rates over a three-year or five-yearperiod of time. Report your findings.
2. Have you noticed goods or services you buy frequently increasing in price? Howhave prices of those goods or services affected your lifestyle?
Chapter 12 Investing in Stocks 277
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1. Buying stock directly from a corpora-tion, avoiding costs of purchasing
2. A prolonged period of falling stockprices
3. Selling borrowed stock that must bereplaced at a later time
4. A marketplace where brokers meetto buy and sell securities
5. The use of borrowed money to buysecurities
6. A prolonged period of rising stockprices
7. An increase in the number of outstanding shares of stock
8. Using earned dividends to buy more shares of stock
CHECK YOUR UNDERSTANDING9. What are two kinds of markets where securities are bought and sold?
10. Why is buying on margin risky?
11. How do you save money by reinvesting dividends?
APPLY YOUR KNOWLEDGE12. Search the Web for investment advice. In no more than one page, sum-
marize what the experts are saying about which stocks are hot right nowand which are not. Do the experts seem to agree or disagree with eachother? Some sites you might try include Forbes, MSN Money, CNN Money,Fortune, Kiplinger, and Barron’s.
THINK CRIT ICALLY
13. How can you save money by direct investment? Is this a good idea forlong-term investing? Why or why not?
14. Use the Internet or library resources to research the history of bull andbear markets. List the years when each type of market occurred duringthe 1980s and 1990s. Which type of market is evident today? Why isit important to understand bull and bear market trends?
a. bear market
b. bull market
c. direct investment
d. dividendreinvestment
e. leverage
f. securities exchange
g. short selling
h. stock split
278 Unit 3 Financial Security
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12.1n Stockholders profit through dividends and capital gains.
n Because preferred stock pays a fixed dividend, it is less risky than acompany’s common stock, but generally earns a lower return.
n Corporations that issue income stocks pay profits to stockholders asdividends, while corporations that issue growth stocks reinvest profitsin the business so it can grow.
n Emerging stocks are issued by young companies and have a higher overallrisk.
n Blue chip stocks provide a relatively safe but moderate return.
n Defensive (non-cyclical) stocks remain relatively stable during good andbad economic times.
n Cyclical stocks do well when the economy is growing but do poorly duringrecessions.
n The par value printed on the stock certificate has nothing to do with themarket value investors actually pay for the stock.
n Stock price depends on company performance, general level of interestrates, the market for the company’s products, and the company’s earningsper share.
n Both dividends and capital gains are used to determine the ROI.
12.2n You can buy and sell securities through a securities exchange (physical
place) or over-the-counter (by phone or computer).
n Stock prices are rising during a bull market and falling during a bearmarket.
n Short-term investors are speculators who try to make a quick profit bybuying on margin or selling short.
n Long-term investment strategies are buy and hold, dollar-cost averaging,direct investment, and reinvestment of dividends.
n You can track your stock’s progress by reading the stock listings in printpublications and online.
n You can find information, set up an account, track your stocks, and buyand sell securities online.
Chapter 12 Investing in Stocks 279
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1. If you own 100 shares of common stock, which you purchased for $28 ashare, and the company declares a cash dividend of $.88 for the quarter,how much will you receive in dividends?
2. Assume a company has issued the following stock: 2,000 shares of5 percent preferred stock at $50 per share and 18,000 shares of commonstock at $22 per share. A cash dividend of $1.30 per share is declaredfor common stock, after preferred stockholders have received their5 percent dividend. Compute your total cash dividends for the year ifyou own (a) 100 shares of preferred stock; (b) 100 shares of commonstock; (c) 50 shares of preferred stock and 50 shares of common stock.(Hint: To calculate preferred stock dividends, you must multiply5 percent by the total cost of the number of shares of stock owned.)
3. Suppose you purchased 100 shares of stock in January for $48 a share.You received dividends of $1.25 per share on April 1 and July 1 and$.95 per share on September 1. You sold the stock in December for $50a share. What would be the stock’s return on investment for the year?Assume a broker commission of 3 percent on the purchase and 3 percenton the sale of the stock. (Hint: Use the formula in Figure 12.1.)
4. You have $2,500 in cash in a margin account. You decide to buy stock onmargin. You buy 50 shares of stock selling at $100 per share. Assume thatthe stock rises in value, and 30 days later you sell the stock for $110 a share.Interest on the amount borrowed is 7 percent. The total commissioncharged is $150.What is the total return on investment? Explainwhy buyingon margin is a risky practice. (Hint: Use the formula in Figure 12.2.)
MAKE ACADEMIC CONNECTIONS
5. History The Securities and Exchange Commission (SEC) was formed in1933 to protect investors from corporations that would deceive theminto buying stock. Visit the sec.gov web site and write a report describingthe role of the SEC in the past and today. What do they do to protectinvestors? What kinds of reports do corporations file with the SEC thatare made available to the public online at the SEC web site?
6. Economics Explain the relationship of the economy as a whole to thestock market. For example, stock prices are rising (bull market) whenthe economy is growing. Why is this true? Write a one-page reportexplaining how business cycles affect stock prices and what it meansto you as an investor.
7. Math You wish to sell short. You arrange to borrow from your broker100 shares of stock in XYZ Corporation on January 2. You immediatelysell 100 shares of XYZ at $60 per share. On April 1, you instruct yourbroker to purchase 100 shares of XYZ at $53 per share. You return100 shares of XYZ stock to your broker. Assume the commission was $200.What is your return on investment for this transaction? (Hint: Use theformula in Figure 12.3.)
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8. Suppose you decided to buy stock using dollar-cost averaging. Youpurchased $200 worth of stock every quarter for one year. You paidthe following share prices. Quarter 1: $5; Quarter 2: $10; Quarter 3: $8;Quarter 4: $4. Using Figure 12.4 as a guide, calculate these values:(a) average share price; (b) your average cost per share; (c) ending value.Did you benefit from dollar-cost averaging? Explain.
9. Your friend Janice is considering investing in stocks. She has an extra$5,000 that she wants to invest. She won’t need the money for five years,when she hopes to start medical school. Would you recommend commonor preferred stock? Explain why.
10. Mr. and Mrs. Nelson are in their late fifties and plan to retire withinthe next three to five years. They would like to put some of their moneyinto the stock market because interest rates on savings accounts are low.Which of these options would you recommend to them: Income orgrowth? Emerging stocks or blue chip? Defensive or cyclical? Give abrief reason for each choice.
11. Lucia and Carlo are married and are considering buying some stock tohave a “nest egg” for their future children. Carlo prefers to buy stock ina local company that is small and just getting started. Lucia prefers to buythe stock of a well-known company that is listed on a major exchange.Discuss with them the pros and cons of each course of action.
12. Choose three stocks to follow for a week: one listed on the NYSE, oneon the AMEX, and one on the NASDAQ. Pretend that you invested $1,000in each stock. On the Internet, find the closing price for these stockson the day you “purchased” them and at the end of every day forone week. At the end of the week, prepare a stock progress chart(see Figure 12.6) showing the closing prices for each day for all threestocks. Analyze your findings. Which stock price varied the most? Whichhad the highest high? The lowest low? Which had the most consistentupward trend? If you sold the stocks at the end of the last day, howmuch would you have gained or lost on each one?
EXTEND YOUR LEARNING
13. Ethics and Legal Issues In 2001, Enron Corporation and ArthurAndersen (accounting firm) were involved in a massive stock fraudscheme. Enron’s stock plummeted, and it filed bankruptcy. Stockholderslost their entire investment. Prepare a history of the Enron scandal. Whatethics issues were involved? Discuss reforms that were put in place asa result of the Enron stock scandal, such as the Sarbanes-Oxley (SOX)Act of 2002. How does SOX enhance corporate responsibility and protectyou as an investor?
For related activities and links, go to www.cengage.com/school/pfinance/mypf
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