Chapter 13

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 company’s 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 board’s 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 corporation’s 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 firm’s 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 S&P 500 and Other Indexes • The Standard and Poor’s 500 Stock Index is broader than the DJIA. It may better represent the market’s 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 P&G 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 stock’s relative value. • The P/E ratio = price per share/eps • It indicates how much investors are willing to pay for a dollar of the company’s 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 firm’s earnings growth rate, the higher the P/E ratio. • The higher the investor’s 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 stock’s risk increases, so does the investor’s 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 firm’s 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 firm’s stock without brokerage fees. • Use a DRIP to reinvest rather than spend your dividends. • Even though you don’t 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 (β)eta.

34. Principles Associatedwith Common Stocks Diversification Reduces Risk • βeta for the market = 1 • βeta > 1 means the stock has above average systematic risk. • βeta < 1 means the stock has below average systematic risk. • Most βetas 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, you’ll 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.