Investing in Stocks

13-2 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Learning Objectives 1. Invest in stocks. 2. Read stock quotes online or in the newspaper. 3. Classify common stock according to basic market terminology. 4. Determine the value stocks. 5. Understand the risks associated with investing in common stock.

13-3 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

13-4 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

13-5 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

13-6 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

13-7 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 13.1

13-8 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall The Language of Common Stocks Limited Liability Claim on Income Declaration date Ex-dividend date Claim on assets

13-9 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall The Language of Common Stocks Voting Rights Proxy Stock Splits Stock repurchases

13-10 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall The Language of Common Stocks Book Value Earnings Per Share = net income – preferred stock dividends number of shares of common stock outstanding

13-11 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall The Language of Common Stocks Dividend Yield Market-to-Book or Price-to-Book Ratio = stock price____ book value per share

13-12 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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

13-13 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 13.2

13-14 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Market Movements Bear market—characterized by falling prices. Bull market—characterized by rising prices.

13-15 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 13.3

13-16 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall General Classifications of Common Stock Blue-Chip stocks Growth stocks Income stocks Speculative stocks

13-17 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall General Classifications of Common Stock Cyclical stocks Defensive stocks Large caps, mid-caps, and small caps

13-18 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Valuation of Common Stock The Technical Analysis Approach The Price/Earnings Ratio Approach The Discounted Dividends Valuation Model

13-19 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

13-20 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

13-21 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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

13-22 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 13.4

13-23 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall The Discounted Dividends Valuation 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

13-24 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Why Stocks Fluctuate in Value Interest Rates and Stock Valuation Risk and Stock Valuation Earnings (and Dividend) Growth and Stock Valuation

13-25 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Stock Investment Strategies Can use more than one of these approaches at once But be alert

13-26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

13-27 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Table 13.1

13-28 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

13-29 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Dividend Reinvestment Plans (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.

13-30 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Risks Associated with Common 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.

13-31 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 13.5

13-32 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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

13-33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 13.6

13-34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

13-35 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

13-36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Risks Associated with Common 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.

13-37 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 13.7

13-38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

13-39 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.