Investing in Stocks

1
Chapter 13

• Investing in Stocks

2
Learning Objectives

• Invest in stocks.
• Read stock quotes in the newspaper or financial
  periodicals.
• Classify common stock according to basic market
  terminology.
• Value stocks.
• Understand the risks associated with investing in
  common stock.

3
Why Consider Stocks?

• When you buy common stock, you purchase a part of
  the company.
• Returns come from
• Dividends - the companys distribution of profits
  to stockholders.
• Capital appreciation - the increase in the
  selling price of a share of stock.

4
Why Consider Stocks?

• Neither dividends nor capital appreciation is
  guaranteed with common stock.
• Dividends are paid at the boards discretion.
• Can be cash or additional stock.
• Capital appreciation takes place when the company
  does well.

5
Why Consider Stocks?

• Over time, common stocks outperform all other
  investments.
• Stocks reduce risk through diversification.
• Stocks are liquid.
• Growth is determined by more than interest rates.

6
The Language of Common Stocks

• Limited Liability in case of bankruptcy, loss
  limited to amount of investment.
• Claim on Income receive earnings after debt
  holders and preferred stockholders.
• Earnings distributed through dividends or
  reinvested into company.
• Quarterly dividends are not automatic they must
  be declared by board of directors.

7
The Language of Common Stocks

• Claims on Assets paid after all creditors.
• Voting Rights elect board of directors, approve
  changes in corporations rules.
• Voting done in person or by proxy.
• Stock Splits substitute more shares for
  existing ones, thereby lowering the price.
• No immediate gain in wealth for stockholder.

8
The Language of Common Stocks

• Stock Repurchases company buys back its own
  stock.
• Book Value subtract firms liabilities from
  assets.
• Earnings Per Share level of earnings for each
  share of stock.
• Compares performance of different companies.

9
The Language of Common Stocks

• Dividend Yield amount of annual dividend
  divided by market price of stock.
• Calculates return if stock price and dividend is
  unchanged.
• Market-to-Book or Price-to-Book Ratio measures
  how highly valued the firm is.

10
The Dow

• The Dow Jones Industrial Average (DJIA or Dow) is
  the oldest and most widely quoted index.
• Created by Charles Dow in 1896 to gauge the
  well-being of the market, was based on 12
  companies.
• Dow currently has 30 stocks, with GE the only
  original Dow component.
• DJIA weighs stocks on relative prices.

11
The SP 500 and Other Indexes

• The Standard and Poors 500 Stock Index is
  broader than the DJIA. It may better represent
  the markets movements.
• The Russell 1000 is comprised of the 1000 largest
  companies.
• The Russell 2000 is comprised of companies
  ranking in size from 1001-3000.
• Wilshire 5000 is made up of all the stocks on the
  NYSE, AMEX, and NASDAQ.

12
Market Movements

• A bear market is characterized by falling prices.
• A bull market has rising prices.
• Names come from how the animals attack
• Bears swipe downward with their paws.
• Bulls fling their horns upward.

13
General Classificationsof Common Stock

• Blue-Chip Stocks issued by large,
  nationally-known companies with sound financials,
  solid dividend and growth records.
• GE and PG are examples.

14
General Classificationsof Common Stock

• Growth Stocks companies with sales and earnings
  growth well above their industry average.
• Microsoft is an example.

15
General Classificationsof Common Stock

• Income Stocks mature firms paying high
  dividends with little increase in earnings.
• Speculative Stocks carry more risk and
  variability, difficult to forecast, and traded on
  the OTC.

16
General Classificationsof Common Stock

• Cyclical Stocks earnings move with the economy,
  dropping during a recession.
• Defensive Stocks are not nearly as affected by
  economic swings, and perform better during a
  downturn.
• Examples include insurance and auto parts firms.

17
General Classificationsof Common Stock

• Large caps, mid caps, and small caps refer to
  the size of the issuing company its market
  capitalization.
• From 1926-2004, small-cap stocks outperformed
  large-cap stocks.

18
Technical Analysis Approach

• Focuses on demand and supply, using charts and
  computer programs to identify and project price
  trends.
• Believes that 2 factors reinforce trends in the
  market.
• Greed pushes money into a rising market.
• Fear pulls money out of a declining market.

19
Technical Analysis Approach

• Looks into the past for trends or patterns to
  give clues as to where investors might be
  heading.
• Looks for prices where stocks get stuck known
  as support and resistance levels.

20
The Price/Earnings Approach

• The price/earnings ratio measures a stocks
  relative value.
• The P/E ratio price per share/eps
• It indicates how much investors are willing to
  pay for a dollar of the companys earnings.

21
The Price/Earnings Approach

• The more positive investors feel about a stock,
  the higher the P/E ratio.
• A P/E ratio of 20 means it is selling at 20
  times earnings.
• The higher the firms earnings growth rate, the
  higher the P/E ratio.
• The higher the investors required rate of
  return, the lower the P/E ratio.

22
The Discounted DividendsValuation Model

• The value of any investment is the present value
  of the returns received from the investment.
• The value of a share of stock should be the
  present value of the future dividends.

23
The Discounted DividendsValuation Model

• What about a company that does not pay dividends
  right now?
• Earnings eventually turn into dividends.
• As a company earns more, the level of future
  dividends grows larger, and the price should rise.

24
The Discounted DividendsValuation Model

• To determine the value of common stock
• Estimate the future dividends.
• Estimate the required rate of return.
• Discount the dividends back to present values at
  the required rate of return.

25
Why Stocks Fluctuate in Value

• Interest Rates and Stock Valuation inverse
  relationship between interest rates and the value
  of a share of common stock.
• As interest rates rise, investors demand a higher
  return.
• As required return rises, the present value of
  future dividends declines.
• As inflation declines, interest rates drop.

26
Why Stocks Fluctuate in Value

• Risk and Stock Valuation as the stocks risk
  increases, so does the investors required rate
  of return.
• Investors demand additional return for taking on
  additional risk.

27
Why Stocks Fluctuate in Value

• Earnings Growth and Stock Valuation as earnings
  grow, so does the firms ability to pay
  dividends.
• The more earnings a company has, the more it can
  give out in dividends.
• Earnings growth is viewed as the cause of any
  increase in dividends.

28
Dollar Cost Averaging

• Purchasing a fixed dollar amount of stock at
  specified intervals.
• Same dollar amount each period will average out
  the fluctuations.
• Buy more shares at a lower price, fewer shares at
  higher prices.

29
Be Alert

• Checklist 13.2
• Look out for
• Recommendations based on inside or confidential
  information.
• Telephone sales pitches.
• Representations of spectacular profit.
• Guarantees you will not lose money.
• An excessive number of transactions.
• Pressure to trade in an inconsistent manner.

30
Buy and Hold

• Involves buying stock and holding it for a period
  of years.
• Why consider this?
• Avoids timing the market.
• Minimizes brokerage fees and transaction costs.
• Postpones capital gains taxes.
• Gains taxed as long-term capital gains.

31
Dividend ReinvestmentPlans (DRIPs)

• Automatically reinvest the dividends in the
  firms stock without brokerage fees.
• Use a DRIP to reinvest rather than spend your
  dividends.
• Even though you dont receive any cash when the
  dividends are reinvested, you still need to pay
  income taxes.

32
Risks Associated withCommon Stocks

• The Risk-Return Trade-off
• Without the risks, we would not expect the high
  returns that common stocks offer.
• A great deal of potential risk if the firm does
  poorly, a great deal of reward if it does well.

33
Risks Associated withCommon Stocks

• Diversification Reduces Risk
• In a well-diversified portfolio, only systematic
  risk remains.
• As a portfolio increases to 10-20 stocks, 60 of
  total risk is eliminated.
• Measure systematic risk using (ß)eta.

34
Principles Associatedwith Common Stocks

• Diversification Reduces Risk
• ßeta for the market 1
• ßeta 1 means the stock has above average
  systematic risk.
• ßeta systematic risk.
• Most ßetas are positive because they move with
  the market.

35
Principles Associatedwith Common Stocks

• The Time Dimension of Investing
• One year returns are quite variable, making
  short-term investments risky.
• As investment horizons increase, invest in
  riskier assets.
• In the long-term, youll do better with stocks
  rather than other investments.
• Investors can take more long-term risks because
  they have more time to adjust their consumption
  and work habits.

36
Understanding the Conceptof Leverage

• Borrowing the money you invest can affect your
  investment return.
• Leverage refers to the use of borrowed funds to
  increase purchasing power.
• Leverage magnifies the gains and the losses.