Chapter 12 Investing in Stocks Copyright © 2012 Pearson Canada Inc. 12-1

Chapter Objectives Identify the functions of stock exchanges Describe how to interpret stock quotations Explain how to execute the purchase or sale of stocks Copyright © 2012 Pearson Canada Inc. 12-2

Chapter Objectives (cont’d) Explain how to analyze a firm and its stock Explain how to value stocks Explain how to assess your stock portfolio’s performance Copyright © 2012 Pearson Canada Inc. 12-3

Stock Exchanges Stock exchanges: facilities that allow investors to purchase or sell existing stocks A stock must be listed on a stock exchange in order to be traded there Canadian stocks are traded on two markets: Toronto Stock Exchange (TSX) TSX Venture Exchange Copyright © 2012 Pearson Canada Inc. 12-4

Stock Exchanges (cont’d) To be listed on the TSX, a firm must meet minimum listing requirements in areas such as: revenue, cash flow, net tangible assets, working capital, and cash Copyright © 2012 Pearson Canada Inc. 12-5

Stock Exchanges (cont’d) Electronic Trading Major exchanges in Canada offer trading services electronically Liquidity is enhanced with the use of market makers Market makers: securities dealers who are required to trade actively in the market so that liquidity is maintained when natural market forces cannot provide sufficient liquidity Copyright © 2012 Pearson Canada Inc. 12-6

Stock Exchanges (cont’d) Over-the-Counter (OTC) Market Over-the-counter (OTC) market: an electronic communications network that allows investors to buy or sell securities Copyright © 2012 Pearson Canada Inc. 12-7

Stock Quotations Where can you find stock quotes? Stockbrokers Financial newspapers (e.g. Globe & Mail) Business sections of local newspapers Financial news television networks (e.g. BNN) Financial websites Copyright © 2012 Pearson Canada Inc. 12-8

Stock Quotations (cont’d) Example of a stock quotation: Copyright © 2012 Pearson Canada Inc. 12-9

Purchasing or Selling Stocks How to selecting a Broker? Analyst Recommendations Copyright © 2012 Pearson Canada Inc

Purchasing or Selling Stocks (cont’d) Copyright © 2012 Pearson Canada Inc Focus on Ethics: Relying on Analyst Recommendations Brokers and analysts tend to be overly optimistic about stocks

Purchasing or Selling Stocks (cont’d) Brokerage Commissions Discount brokerage firm: a brokerage firm that execute transactions but does not offer investment advice Full-service brokerage firm: a brokerage firm that offers investment advice and executes transactions Copyright © 2012 Pearson Canada Inc

Purchasing or Selling Stocks (cont’d) Placing an Order Must specify the following: Name and class of the stock, Buy or sell, Number of shares Market order or limit order Copyright © 2012 Pearson Canada Inc

Purchasing or Selling Stocks (cont’d) Copyright © 2012 Pearson Canada Inc Name and Class of the Stock Ticker symbol: the abbreviated term used to identify a stock for trading purposes Buy or Sell Number of Shares Board lot: shares bought or sold in multiples of typically 100 shares. The size of the board lot depends on the price of the security Odd lot: less than a board lot of that particular stock

Purchasing or Selling Stocks (cont’d) Copyright © 2012 Pearson Canada Inc Market Order or Limit Order Market order: an order to buy or sell a stock at its prevailing market price Limit order: an order to buy or sell a stock only if the price is within the limits that you specify

Purchasing or Selling Stocks (cont’d) Copyright © 2012 Pearson Canada Inc Stop Orders On-stop order: an order to execute a transaction when the stock price reaches a specified level; a special form of limit order Buy stop order: an order to buy a stock when the price rises to a specified level Sell stop order: an order to sell a stock when the price falls to a specified level

Purchasing or Selling Stocks (cont’d) Copyright © 2012 Pearson Canada Inc Buying Stock on Margin On margin: purchasing a stock with a small amount of personal funds and a portion of the funds borrowed from a brokerage firm Enable you to purchase stocks without having the full amount of cash necessary

Purchasing or Selling Stocks (cont’d) Copyright © 2012 Pearson Canada Inc If the value of investments purchased on margin declines, you will receive a margin call Margin call: a request from a brokerage firm for the investor to increase the cash in the account in order to return the margin to the minimum level

Analysis of a Firm Copyright © 2012 Pearson Canada Inc Annual Report Includes a corporate profile, a message from the firm’s CEO, and a section summarizing recent performance and expected future performance Also contains financial statements

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc Firm-Specific Characteristics Liquidity Shows the firm’s ability to cover expenses Current ratio: the ratio of a firm’s short-term assets to its short-term liabilities

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc Financial Leverage Used to determine a firm’s ability to make debt payments Many firms prefer to borrow funds rather than issue stock Financial leverage: a firm’s reliance on debt to support its operations Debt ratio: a measure of financial leverage that calculates the proportion of total assets financed with debt

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc Times interest earned ratio: a measure of financial leverage that indicates the ratio of the firm’s earnings before interest and taxes to its total interest payments Efficiency A firm that generates a relatively low level of sales and earnings with a large amount of assets is not using its assets efficiently

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc Inventory turnover: a measure of how efficiently a firm manages its inventory; computed as the cost of goods sold divided by average daily inventory Average collection period: used to determine the average age of accounts receivable; computed as accounts receivable divided by average daily sales Asset turnover ratio: used to assess how efficiently a firm uses its assets; computed as sales divided by average total assets

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc Profitability Operating profit margin: a firm’s operating profit divided by sales Net profit margin: a measure of profitability that measures net profit as a percentage of sales Return on assets: a measure of profitability; computed as net profit divided by total assets Return on equity: a measure of profitability; computed as net profit divided by the owners’ investment in the firm (shareholder’s equity)

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc Information Provided by Value Line Investment Survey

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc Focus on Ethics: Accounting Fraud Motivation for Fraud Stock price helps determine manager compensation Leads to a short-tem focus Revenue-Inflating Techniques Recognizing revenue before it is earned Recognizing revenue from orders that are likely to be cancelled

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc Preventing Future Accounting Fraud Auditor’s may not always be “independent” Sarbanes-Oxley Act was created in order to restore investor confidence in the markets and to prevent future occurrences of accounting fraud

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc Economic Analysis of Stocks Involves assessing any economic conditions that can affect a firm’s stock price Economic Growth Economic growth: the growth in a country’s economy over a particular period; commonly measured by GDP

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc Fiscal policy: how the government imposes taxes on individuals and corporations and how it spends tax revenues

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc Interest Rates Stocks perform better when interest rates are low The Bank of Canada uses monetary policy to influence interest rates Monetary policy: techniques used by the Bank of Canada to affect the economy of the country

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc Industry Analysis of Stocks Increased demand generally leads to higher stock prices Changes in competition also affect demand, earnings, and stock prices

Analysis of a Firm (cont’d) Copyright © 2012 Pearson Canada Inc

Analysis of a Firm (cont’d) Integrating Your Analyses Copyright © 2012 Pearson Canada Inc

Stock Valuation Price of a stock is based on the demand for that stock versus the supply of stock available for purchase Copyright © 2012 Pearson Canada Inc

Value a stock using technical or fundamental analysis ) Technical analysis: the valuation of stocks based on historical price patterns using various charting techniques Fundamental analysis: the valuation of stocks based on an examination of fundamental characteristics such as revenue, earnings, and/or the sensitivity of the firm’s performance to economic conditions Copyright © 2012 Pearson Canada Inc

Stock Valuation (cont’d) Dividend Discount Model (DDM) Method Dividend discount model (DDM): a method of valuing stocks in which a firm’s future dividend payments are discounted at an appropriate rate of interest Works best for mature firms that pay a large stable dividend Copyright © 2012 Pearson Canada Inc

Stock Valuation (cont’d) Price-Earnings (P/E) Method Based on the value of the firm’s earnings Price-earnings (P/E) method: a method of valuing stocks in which a specific firm’s earnings per share are multiplied by the mean industry price-earnings (P/E) ratio Copyright © 2012 Pearson Canada Inc

Stock Valuation (cont’d) Stock Market Efficiency Efficient stock market: a market in which stock prices full reflect information that is available to investors Inefficient stock market: a market in which stock prices do not reflect all public information that is available to investors Copyright © 2012 Pearson Canada Inc