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Chapter 13

Chapter 13. Investing in Stocks . 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.

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Chapter 13

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  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.

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