Chapter 12 Investing in Stocks Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Investing in Stocks 1.Identify the most important features of common and preferred stock. 2.Explain how you can evaluate stock investments. 3.Analyze the numerical measures that cause a stock to increase or decrease in value. 4.Describe how stocks are bought and sold. 5.Explain the trading techniques used by long- term investors and short-term speculators. Chapter Objectives 12-2

Objective 1 Identify the Most Important Features of Common and Preferred Stocks Common and Preferred Stocks Two concerns for beginning investors –Where to get the information –What the information means 12-3

Common Stock = most basic form of corporate ownership Stock = equity financing Reasons why corporations issue Stock –Raise money to start or expand business –Pay ongoing business expenses –Need not repay the money –Dividends not mandatory Board of Directors votes each dividend payment But: –Shareholders have voting rights; control of the company –Dividends are NOT tax deductible Why Corporations Issue Common Stock 12-4

Investors can make money in three ways –Income from dividends Cash Shares of stock –Dollar appreciation of stock value Price appreciation Capital gain –Possible increased value from stock splits No guarantee price will go up after a split Why Corporations Issue Common Stock 12-5

Dividend Dates Declaration date = Board of Directors votes to pay a dividend Record date = a stockholder must be registered on the firm’s books to receive the dividend Ex-Dividend date = 2 nd day before the record date stock begins to trade without the dividend –Investors buying after the ex-div date do not receive the dividend Payment date = dividend is paid 12-6

Preferred Stock Hybrid Security –Known cash dividend is about equal to bond interest –Equity position is about equal to common stock but usually non-voting Dividends paid before common stock –Dividend may be omitted 12-7

Features of Preferred Stock Cumulative preferred stock –Unpaid cash dividends accumulate –Must be paid before any cash dividends are paid to common stockholders Convertible preferred stock –Can be traded for shares of common stock –Provides investor with added safety of preferred stock and greater speculative gain through conversion to common stock 12-8

Objective 2 Explain How You Can Evaluate Stock Investments Evaluate the company and the industry The Internet –Firm’s home page more current than printed materials – Research on a company Stock screener to help choose investments Professional advisory services

Where Can You Find a Stock Quote, and What Does One Look Like? Print sources –The Wall Street Journal –The local newspaper Online sources: – – – –

First enter stock symbol Resulting screen Common Stock Price Quotes Online at

Common Stock Price Quotes Last trade price = $44.37 Annual dividend = $1.68 P/E =  Earnings per share = 44.37/15.41 = $

E valuating a Stock Issue Stock Advisory Services Research materials = good supplement to other sources of information Most charge a fee Three most popular: –Standard and Poor’s reports –Value Line –Mergent’s Handbook of Common Stock 12-13

Corporate News Prospectus lists all necessary information as dictated by the Federal government All publicly traded corporations send their stockholders an annual report Securities and Exchange Commission website ( Business periodicals: –BusinessWeek, Fortune, Forbes, Money, Kiplinger’s Personal Finance Magazine 12-14

Objective 3 Analyze the Numerical Measures that Cause a Stock to Increase or Decrease in Value Corporate earnings –One of the most significant factors in changes in the value of a stock Earnings per share (EPS) –Corporation’s after-tax income divided by the number of outstanding shares of common stock –EPS Increase = generally a healthy sign 12-15

Numeric Measures That Influence Investment Price-earnings ratio (PE) –Price per share of stock divided by the firm’s earnings per share –How much an investor is paying for a company’s earning power –P/E > 20  investor optimism –P/E < 20  lower earnings expectations –Compare to firms in same industry Projected Earnings –EPS and PE based on historical data –Future expectations more relevant 12-16

Other Factors than Influence the Price of a Stock Dividend yield –Annual dollar dividend divided by current price per share –Dividend yield increase = healthy sign Total return –Dividends plus capital gains –Cash income + Price appreciation Book value per share –(Assets – Liabilities)/ # shares –Market price per share should be > book value 12-17

Objective 4 Describe How Stocks are Bought and Sold Primary Market Investor buys securities from issuer of those securities via an investment bank –Investment bank = financial firm that assists corporations in raising funds, usually by helping sell new security issues (underwriting) IPO = when a corporation sells stock to the general public for the first time Key factor: Cash from security sales goes to issuing company 12-18

How Stocks are Bought and Sold Secondary Market Market for existing financial securities Traded among investors via brokers and dealers Markets –Stock exchanges –Over-the-counter markets 12-19

Secondary Markets for Stocks Securities Exchanges (NYSE) Marketplace where members, representing investors, meet to buy and sell securities Securities sold on an exchange must be listed, or accepted for trading, on that exchange “The Listed Market” = NYSE “Specialist” buys or sells a particular stock 12-20

Secondary Markets for Stocks The Over-the-Counter (OTC) market (NASDAQ) Network of dealers who buy and sell the stocks of companies from inventory –Dealer = “Market Maker” NASDAQ = electronic marketplace for over 3,200 companies 12-21

Brokerage Firms and Account Executives Account executive (stockbroker) –Licensed individual who buys and sells securities for his or her clients Churning –Excessive buying and selling of securities to generate commissions –Illegal under SEC regulations 12-22

Discount vs. Full Service Brokers Service vs. Cost How much advice do you want? Can you buy and sell stocks over the phone Can you trade stocks online? Where is the nearest office located? Toll-free number for customer use? How often are statements issued? Is there a charge for statements, research reports, and other financial reports? Are there any fees in addition to the commissions to buy and sell? 12-23

Computerized Transactions Reasons that justify trading online 1.Size of investment portfolio 2.Ability and desire to manage own portfolio 3.Ability to monitor investments closely 4.Capability of computer and software 12-24

Stock Transaction Orders Market order –Request to buy or sell stock at the current market value Limit order –Request to buy or sell a stock at a specified price Stop order (Stop-loss order) –Request to sell a stock at the next available opportunity after its market price reaches a specified amount 12-25

Commission Charges Brokerage minimum commissions –Range = $7 to $35 –Depends on the number of shares traded and stock value Full service vs. discount brokers –Full service fees > –Online broker  little advice or service 12-26

Objective 5 Explain the Trading Techniques Used by Long-term Investors and Short-term Speculators Long-Term Investment Strategies Buy and hold Dollar cost averaging Direct investment and dividend reinvestment plans (DRIPS) – –

Dollar Cost Averaging Long-term technique Invest equal dollar amount in the same stock at equal intervals Goals: –Minimize average cost per share –Avoid “Buy High – Sell Low” 12-28

Short-Term Investment Strategies Buying stock on margin –Borrowing money from broker –Margin requirement set by the Fed –“Bullish” Selling short –Borrowing stock –“Sell high, buy low” –“Bearish” 12-29

Short-Term Investment Strategies Trading in options –Option = the right but not the obligation to buy or sell a stock at a predetermined price during a specified period of time Call option –Right to buy –“Bullish” Put option –Right to sell –“Bearish” –Not for amateurs or beginning investors 12-30