1. Chapter 14 Investing in Stocks

2. Chapter 14 Learning Objectives
Identify the most important features of common and preferred stocks
Explain how you can evaluate stock investments
Analyze the numerical measures that cause a stock to increase or decrease in value
Describe how stocks are bought and sold
Explain the trading techniques used by long-term investors and short-term speculators

3. Common and Preferred Stocks
Objective 1: Identify the most important features of common and preferred stocks
Good investors know something about the company before they invest in the company’s stock
Gather information to evaluate a potential investment in a stock
Learn what the information you gather means
There are periods where stocks decline in value
The key to success is to allow investments to work for you over the long-term

4. Legal Forms of Businesses
1) Sole Proprietorship
A business owned by a single individual.
Owner maintains title to the firm’s assets.
Owner has unlimited liability.
2) Partnership
Similar to a sole proprietorship, except that there are two or more owners.

5. Legal Forms of Businesses
3) Corporation
A business entity that legally functions separate and apart from its owners.
Owners’ liability is limited to the amount of their investment in the firm.
Owners hold common stock certificates, and ownership can be transferred by selling the certificates.

6. Comparison of Three Forms
Advantage of corporations:
-- limited liability
-- ease in raising capital

7. The Corporation and Financial Markets
cash
Investors
Secondary
markets
Government
securities
Cash flow
reinvest
tax
Corporation
dividends,
etc.

8. Movement of Savings cash firm saver securities
Direct Transfer of Funds
cash
securities
saver
firm

9. Movement of Savings funds saver investment banker firm securities
Indirect Transfer using Investment Banker
securities
funds
saver
investment
banker
firm

10. Movement of Savings funds financial saver intermediary firm securities
Indirect Transfer using a Financial Intermediary
funds
intermediary
securities
firm
financial
saver

11. Common Stock Is a variable-income security.
Dividends may be increased or decreased, depending on earnings.
Represents equity or ownership.
Limited liability: liability is limited to amount of owners’ investment.
Priority: lower than debt and preferred.

12. Common Stock
Claim on Income - a stockholder has a claim on the firm’s residual income.
Claim on Assets - a stockholder has a residual claim on the firm’s assets in case of liquidation.
Preemptive Rights - stockholders may share proportionally in any new stock issues.
Voting Rights - right to vote for the firm’s board of directors.

13. Why Corporations Issue Common Stock
To raise money for start-up costs and help pay for expansion and their ongoing business activities
They don’t have to repay the money a stockholder pays for stock
Dividends are not mandatory. Most corporations distribute 30-70% of their earnings to stockholders
In return for investing in the company, stockholders have voting rights

14. Why Investors Purchase Common Stock
They can make money in three ways
Income from dividends in the form of cash or additional stock (record day and ex-dividend)
Dollar appreciation of stock value
Possible increased value from stock splits
WHAT HAPPENS WHEN A CORPORATION SPLITS ITS STOCK?
A stock split happens when the shares owned by existing stockholders are divided into a larger number of shares

15. Preferred Stocks PREFERRED STOCK
Investors in preferred stocks receive cash dividends before common stock holders are paid any cash dividends
The dividend amount is either a stated amount of money for each share of preferred stock, or a percentage of the par value
Par value is an assigned dollar value that is printed on a stock certificate

16. Preferred Stocks Usually sold for $25, $50, or $100 per share.
Example: In 2002, Xerox issued $75 million of 8.25% preferred stock at $50 per share.
$4.125 is the fixed, annual dividend per share.

17. Preferred Stocks It’s like common stock - no fixed maturity.
A hybrid security:
It’s like common stock - no fixed maturity.
Technically, it’s part of equity capital.
It’s like debt - preferred dividends are fixed.
Missing a preferred dividend does not constitute
default

18. Preferred Stocks (continued)
You are an owner of the stock but have a known rate of return. Shares are safer than common stock because the dividends are more secure
Firms may have multiple classes of preferreds, each with different features.
Priority: lower than debt, higher than common stock.

19. Preferred Stocks (continued)
Protective provisions are common.
PIK Preferred: Pay-in-kind preferred stocks pay additional preferred shares to investors rather than cash dividends.
Retirement: Most preferreds are callable, and many include a sinking fund provision to set cash aside for the purpose of retiring preferred shares.

20. Preferred Stocks (continued)
Cumulative Preferred stock
Unpaid cash dividends accumulate and must be paid before any cash dividends are paid to the common stock holders
Convertible preferred stock
Can be traded for shares of common stock in the same company

21. Evaluating a Stock Issue
Objective 2: Explain how you can evaluate stock investments
CLASSIFICATION OF STOCKS
Blue chip stock Large cap
Cyclical Mid cap
Defensive Small cap
Growth Micro cap
Income Penny stock

22. Evaluating a Stock Issue
Blue chip: financially strong, high quality stocks with long and stable records of earnings and dividends
eg: General Electric, Merck, Wal-Mart, SBC Communications, Home Depot
Income stock: long and sustained records of paying higher than average dividends
eg: AT&T, American Electric Power, Duke Energy
Cyclical stock: earnings and overall market performance are closely lined to the economy
eg: Caterpillar, Maytag Corp, Timken

23. Evaluating a Stock Issue
Defensive stock: tend to hold their own, and even do well, when the economy starts to falter
eg: Bandag, Checkpoint Systems
Growth stock: experience high rates of growth
eg: General Dynamics, Google, Starbucks
Tech stock: represent new technology
eg: computers, semiconductors, data storage, software, internet service, wireless communication

24. Evaluating a Stock Issue
Large cap: greater than 10 billion
Midcap: 2 to 10 billion
Small cap: 250 million to 2 billion
Penny stock: below $1

25. Evaluating a Stock Issue (continued)
THE INTERNET
Most corporations have a Website, and the information is useful in the following ways
The Website is easily accessible
More up to date information than the printed material
Websites like Yahoo and other search engines can also be used to obtain information about stock investments
The Internet can also be used to access professional advisory services like
www2.standardpoors.com

26. Evaluating a Stock Issue (continued)
STOCK ADVISORY SERVICES
Prepare printed materials that are a good supplement to information in newspapers and the Internet
Charge a fee
Hundreds to choose from
Standard and Poor’s reports (library)
Value Line (library)
Mergent’s Handbook of Common Stock
Morningstar
As an investor, your job is to interpret the information provided

27. Evaluating a Stock Issue (continued)
HOW TO READ THE FINANCIAL SECTION OF THE NEWSPAPER
You will see stock quotes in newspapers such as The Wall Street Journal
52 weeks Yld Vol Net
Hi Lo Sym Div % PE s Hi Lo Close Chg
IBM
MSFT …

28. Numerical Measures That Influence Investment Decisions
Objective 3: Analyze the numerical measures that cause a stock to increase or decrease in value
Why corporate earnings are important?
Corporate earnings play a large part in the increase or decrease in the value of a stock
Earnings per share are the corporation’s after-tax earnings divided by the number of outstanding shares of a common stock. An increase in earnings is generally a healthy sign
Price-earnings (PE) ratio
Price of one share of stock divided by the earnings per share of stock over the last 12 months

29. Numerical Measures That Influence Investment Decisions (continued)
OTHER FACTORS THAT INFLUENCE THE PRICE OF A STOCK
Dividend payout = Dividend amount EPS
Dividend yield = Annual income amount
Market value
Total return = Current return + Capital gain
Annualized holding period yield =
Total return X 1 Original investment N

30. Numeric Measures That Influence Investment Decisions (continued)
Beta: measure of volatility
Book value per share
Net worth of company determined by deducting all liabilities from the corporations assets and dividing the remainder by the number of outstanding shares of common stock

31. Numeric Measures That Influence Investment Decisions (continued)
Market-to-Book ratio
The current market value divided by the book value
A measurement ratio that, in part, may be used to determine the value of a stock
If the market-to-book ratio is high, that may mean that the stock is overvalued
If the market-to-book ratio is low, that may mean that the stock is undervalued

32. Numeric Measures That Influence Investment Decisions (continued)
INVESTMENT THEORIES
Fundamental analysis
Based on the assumption that a stock’s intrinsic or real value is determined by the company’s future earnings
Fundamentalists consider the…
Financial strength of the company
Type of industry company is in
New-product development
Economic growth of the overall economy

33. Numeric Measures That Influence Investment Decisions (continued)
Fundamental analysis:
Financial statement: balance sheet, income statement, cash flow statement
Key financial ratios:
-- liquidity ratios: Do we have enough liquid assets to meet approaching obligations?
eg: current ratio, acid ratio
-- operating efficiency ratio: how efficiently the firm’s assets generate operating profits.
eg: return on investment, profit margin, asset turnover

34. Numeric Measures That Influence Investment Decisions (continued)
Fundamental analysis:
Key financial ratios:
-- leverage ratio: the use of debt to finance assets.
eg: debt ratio, times interest earned
-- return on equity: How well are the firm’s managers maximizing shareholder wealth?
eg: return on equity ratio

35. Numeric Measures That Influence Investment Decisions (continued)
Technical analysis
Based on the assumption that a stock’s value is determined by the forces of supply and demand in the stock market as a whole
Not based on expected earnings or the intrinsic value of a stock but rather on factors found in the market
Chartists plot past price movements and other market averages to observe trends they use to predict a stock’s future value

36. Numeric Measures That Influence Investment Decisions (continued)

37. Numeric Measures That Influence Investment Decisions (continued)
Efficient market theory
Based on the assumption that stock price movements are purely random
A stock’s current market price reflects its true value
It is impossible for an investor to outperform the average for the stock market as a whole over a period of time
Wall Street Journal’s “darts vs the experts” finds sometimes experts win, sometimes not

38. Buying and Selling Stocks
Objective 4: Describe how stocks are bought and sold
Corporate financing sources
From 1999 through 2001, capital has been raised through the following sources:
Corporate Bonds and Notes %
Equities %

39. Financial Market Components
Public Offering
Firm issues securities, which are made available to both individual and institutional investors.
Private Placement
Securities are offered and sold to a limited number of investors.

40. Financial Market Components
Money Market
Market for short-term debt instruments (maturity periods of one year or less).
Capital Market
Market for long-term securities (maturity greater than one year).

41. Buying and Selling Stocks
Primary market
A market in which an investor purchases financial securities through an investment bank, or other representative, from the issuer of those securities
An IPO occurs when a corporation sells stock to the general public for the first time
Secondary market
A market for existing financial securities that are currently traded among investors through brokers

42. Investment Banking
An investment bank is a financial firm that assists corporations in raising funds, usually by helping to sell new security issues
How do investment bankers help firms issue securities?
Underwriting the issue.
Distributing the issue.
Advising the firm.

43. Stock Issue Example:
Our firm needs to raise approximately $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwriting spread.
What type of issue is this?
It’s a negotiated purchase.

44. Stock Issue Example:
Our firm needs to raise approximately $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwriting spread.
How many shares will be sold?
$100,000,000 / $20 = 5 million new shares of common stock.

45. Stock Issue Example:
Our firm needs to raise approximately $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwriting spread.
What are the flotation costs?
Underwriting spread: 2% of $100 million = $2 million.
Issuing costs: printing and engraving costs; legal, accounting, and trustee fees.

46. Stock Issue Example:
Our firm needs to raise approximately $100 million for expansion. Our stock price is $20. We Select Merrill Lynch to underwrite the issue for a 2% underwriting spread.
What are the risks?
The investment bank accepts the risk of being able to sell the new stock issue for $20 per share. If the stock price falls, the investment bank could lose money.

47. Invest in IPO Vignette 2/18/99 $19 42 124% 7
Company IPO date IPO price 1st day price 1st day gain Now
Vignette /18/ $ %
FlashNet /16/ acqu
Arriba /22/ N/A
7/24 Solu /27/ N/A
Antigenics 2/3/
Buy.com /7/ Deli
Nuance Com 4/12/

48. Buying and Selling Stocks (continued)
SECURITY EXCHANGES
A marketplace where member brokers who represent investors meet to buy and sell securities
The securities sold at an exchange must be listed, or accepted for trading, at the exchange
New York Stock and American Stock Exchanges (9:30 am – 4:00 pm ET)
The Over-the-Counter (OTC) market
Network of dealers who buy and sell the stocks of companies not listed on a securities exchange
Most OTC securities are traded over the NASDAQ which is an electronic marketplace for approximately 3,200 stocks

49. Buying and Selling Stocks (continued)
Market average and index
DJIA – Dow Jones Industrial Average: made up of 30 high-quality stocks selected for total market and broad public ownership and believed to reflect overall market activity.
Standard and Poor’s indexes: true indexes that measure the current price of a group of stocks relative to a base

50. Buying and Selling Stocks (continued)
BROKERAGE FIRMS AND ACCOUNT EXECUTIVES
An account executive, or stockbroker, is a licensed individual who buys and sells securities for his or her clients
Financial objectives should be communicated to the account executives, and the investor must be actively involved in the investment decisions
Discount broker versus full service brokers
How much advice do you want?
Nearest office and toll-free phone number?
Online and phone trading services and costs?
Fees, charges and commissions?

51. Buying and Selling Stocks (continued)
STOCK TRANSACTIONS
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 or price range
Stop order: Request to sell a stock at the next available opportunity after its market price reaches a specified amount

52. Long-Term and Short-Term Investment Strategies
Objective 5: Explain the trading techniques used by long-term investors and short-term speculators
Long-term techniques
Buy and hold
Dollar cost averaging
Direct investment and dividend re-investment plans (DRIPS)
Short-term techniques
Day trading
Buying stock on margin (borrowing money)
Selling short (borrowing stock)
Trading in options (predetermined price)

53. Online Activity
Go to an online source such as or Research some stocks and find one that looks like a good investment.
…Why do you think that this stock would be a good investment for you?