Chapter 13

1. Chapter 13 Investing in Stocks

2. Learning Objectives • Invest in stocks. • Read stock quotes online or in the newspaper. • Classify common stock according to basic market terminology. • Determine the value stocks. • Understand the risks associated with investing in common stock.

3. Introduction • Investing on the stock market is not without risk • Investing on the stock market is all about risk and return. • Sometimes, it’s all about making a fortune.

4. Why Consider Stocks? • When you buy common stock, you purchase a part of the company. • Returns: • Dividends - the company’s distribution of profits to stockholders. • Capital appreciation - the increase in the selling price of a share of stock.

5. Why Consider Stocks? • Neither dividends nor capital appreciation is guaranteed with common stock. • Dividends are paid at the board’s discretion. • Capital appreciation takes place when the company does well.

6. 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.

7. Figure 13.1

8. The Language of Common Stocks • Limited Liability • Claim on Income • Declaration date • Ex-dividend date • Claim on assets

9. The Language of Common Stocks • Voting Rights • Proxy • Stock Splits • Stock repurchases

10. The Language of Common Stocks • Book Value • Earnings Per Share = net income – preferred stock dividends number of shares of common stock outstanding

11. The Language of Common Stocks • Dividend Yield • Market-to-Book or Price-to-Book Ratio = stock price____ book value per share

12. Stock Indexes: Measuring the Movements in the Market • Stock Market Index—a measure of performance of a group of stocks that represent the market or a sector of the market. • Dow Jones Industrial Average (DJIA) or Dow • Standard & Poor’s 500 (S&P 500) and other indexes

13. Figure 13.2

14. Market Movements • Bear market—characterized by falling prices. • Bull market—characterized by rising prices.

15. Figure 13.3

16. General Classificationsof Common Stock • Blue-Chip stocks • Growth stocks • Income stocks • Speculative stocks

17. General Classificationsof Common Stock • Cyclical stocks • Defensive stocks • Large caps, mid-caps, and small caps

18. Valuation of Common Stock • The Technical Analysis Approach • The Price/Earnings Ratio Approach • The Discounted Dividends Valuation Model

19. Technical Analysis Approach • Focuses on demand and supply • Uses charts and computer programs to identify and project price trends. • Greed pushes money into a rising market. • Fear pulls money out of a declining market.

20. Technical Analysis Approach • Interpretation of charts and graphs and mathematical calculations of trading patterns to spot trend or direction for stocks • Of little value—cannot identify trends before they happen • Avoid—encourages moving in and out of market instead of buying and holding.

21. The Price/Earnings Approach • P/E ratio or earnings multiple—price per share divided by the earnings per share • Higher firm’s earnings growth rate, higher P/E ratio • Higher investor’s required rate of return, lower P/E ratio. • Fundamental analysis

22. Figure 13.4

23. The Discounted DividendsValuation Model • The value of any investment is the present value of the benefits or returns received from the investment. • Value of a share of common stock = present value of the infinite stream of future dividends. • Value of a common stock = dividends next year________ required rate of return – growth rate

24. Why Stocks Fluctuate in Value • Interest Rates and Stock Valuation • Risk and Stock Valuation • Earnings (and Dividend) Growth and Stock Valuation

25. Stock Investment Strategies • Can use more than one of these approaches at once • But be alert

26. 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. • Keeps you from trying to time the market.

27. Table 13.1

28. Buy-and-Hold Strategy • Involves buying stock and holding it for a period of years. • Avoids timing the market. • Minimizes brokerage fees, transaction costs. • Postpones capital gains taxes. • Gains taxed as long-term capital gains.

29. Dividend ReinvestmentPlans (DRIPs) • Automatically reinvest the dividends in same firm’s stock without brokerage fees. • Use a DRIP to reinvest rather than spend your dividends. • Still pay income taxes. • Stuck reinvesting in old company instead of new.

30. Risks Associated withCommon Stocks • Risk and return go hand in hand. • Principle 8—can eliminate risk associated with common stock by diversifying. • Only systematic risk remains. • Measure systematic risk using Beta.

31. Figure 13.5

32. Another look at Principle 7: Risk and Return go hand in hand • Beta—measure of how responsive a stock or portfolio is to changes in the market portfolio. • Beta benchmark for market = 1 • Beta > 1—stock moves up and down more than market • Beta <1—stock moves up and more less

33. Figure 13.6

36. Risks Associated withCommon Stocks • Short-term investments in stocks are very risky • Holding stocks longer reduces variability of average annual return. • Investors can afford to take on more risk as investment time horizons increase—they have more opportunities to adjust saving, consumption, and work habits.

37. Figure 13.7

38. Summary • Common stocks over time outperform all other investments. • Stock indexes such as the Dow and S&P 500 show health of stock market. • Common stocks can be blue-chip, growth, income, speculative, defensive, large- to small-cap stocks.

39. Summary • A number of methods can be used to determine the value of stock—but interest rates, risk, and expected future growth determine the value of common stock. • Use one or more investment strategies such as dollar-cost average, buy-and-hold, and DRIPs. • Stocks are riskier but diversification and watching beta values can help.