1. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. 14-1 C HAPTER 14 Personal Finance Investing in Stocks Kapoor Dlabay Hughes 6e

2. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Why do corporations issue common stock?  To raise money to start or expand a business.  To help pay for ongoing business expenses.  They don’t have to repay the money.  Dividends are not mandatory.  Stockholders have voting rights. Investing in Stocks 14-2

3. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Why Do Investors Purchase Stock? Income from dividends. Dollar appreciation of stock value. Possible increased value from stock splits. 14-3

4. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Preferred Stock Preferred stock.  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.  Callable preferred stock is stock a corporation can be exchanged for a specified amount of money.  After calling an issue, they can issue new preferred stock with a lower dividend. 14-4

5. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Features of Preferred Stock Cumulative feature.  Unpaid cash dividends accumulate and must be paid before any cash dividends are paid to the common stock holders. Participation feature.  Rare form of investment used to attract investors.  Can share in earnings beyond stated the dividend amount. Conversion feature.  Can be traded for shares of common stock. 14-5

6. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Classification of Stock Investments Blue chip stock.  Safe investment in strong and respected companies.  Attracts conservative investors.  ex. AT&T, Kellogg's, General Electric Income stock.  Pays higher than average dividends.  ex. utility stock. 14-6

7. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Classification of Stock Investments Growth stock.  Earns above average profits of all firms in the economy.  Less than 30% of profits are paid out as dividends, with rest reinvested in R&D in the company.  Stock price should go up.  ex. Intel and Dell. (continued) 14-7

8. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Classification of Stock Investments Cyclical stock.  Follows the business cycle of advances and declines in the economy.  ex. automobiles, timber, and steel. Defensive stock.  Remains stable during declines in the economy.  ex. Kellogg, Procter & Gamble and utility stocks. (continued) 14-8

9. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Classification of Stock Investments Penny stocks.  Typically sell for $1.00 to $10.00 per share. Large cap stocks.  Issued by a large corporation that has a large amount of stock outstanding. Capitalization.  The total amount of securities--stocks and bonds--issued by a corporation. Small cap stocks.  Issued by a company that has a capitalization of $150 million or less. (continued) 14-9

10. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Stock Advisory Services A good supplement to information in newspapers along with the Internet. Charge a fee. Hundreds to choose from.  Standard and Poor’s reports.  Value Line.  Moody’s Handbook of Common Stock. 14-10

11. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Bull and Bear Markets Bull market.  Investors are optimistic.  More investors are buying stock and the stock market increases. Bear market.  Investors are pessimistic.  More investors are selling stock so and the stock market declines. 14-11

12. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Numeric Measures to Consider When Evaluating a Stock Look at book value of one 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.  If a share costs more than the book value the company may be overextended or it may have a lot of money in research and development. 14-12

13. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Numeric Measures to Consider When Evaluating a Stock Earnings per share are the corporation’s after-tax earnings divided by the number of outstanding shares of common stock. Price-earnings (PE) ratio.  Price of one share of stock divided by the earnings per share of stock over the last 12 months.  A low price-earnings ratio means a stock could be a good investment. Look at the beta of a stock. The beta for stock market in general is 1.0. A stock with a beta >1.0 means it is more volatile or speculative. (continued) 14-13

14. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Investment Theories Fundamental theory.  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. 14-14

15. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Investment Theories Technical theory.  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 as a whole.  Chartists plot past price movements and other market averages to observe trends they used to predict a stock’s future value. (continued) 14-15

16. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Investment Theories Efficient market theory.  Sometimes called the random walk 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. (continued) 14-16

17. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Buying and Selling Stocks Primary market.  A market in which an investor purchases financial securities via an investment bank, or other representative, from the issuer of those securities.  An investment bank is a financial firm that assists corporations in raising fund,s usually by helping to sell new security issues.  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. 14-17

18. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Securities 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 Exchanges. 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 over 4,000 stocks. 14-18

19. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Brokerage Firms and Account Executives An account executive, or stockbroker, is a licensed individual who buys and sells securities for his or her clients. Churning.  Excessive buying and selling of securities to generate commissions. Discount broker versus full service brokers.  How much advice do you want? Both are paid a commission of from 1 to 6%. 14-19

20. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Stock Transactions A market order is a request to buy or sell stock at the current market value. A limit order is a request to buy or sell a stock at a specified price or price range. A stop order is a request to sell a stock at the next available opportunity after its market price reaches a specified amount. A discretionary order lets the account executive decide when to execute the transaction and at what price. 14-20

21. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Stock Transactions (continued) Computerized transactions.  Discount brokerage firms and some full services brokerage firms allow investors to trade online.  It can make the process cheaper and faster. Commission charges.  Wide range depending on the amount of service.  Round lot is 100 shares or multiples of 100 shares. An odd lot is fewer than 100 shares. 14-21

22. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Role of the Securities and Exchange Commission Registers securities (stocks and bonds). Licenses brokers. Prosecutes for stock fraud and insider trading.  Someone obtains information not available to the general public, i.e. knowledge of an upcoming new product or merger.  They use this information to make a profit. 14-21

23. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001. All Rights Reserved. Long-Term and Short-Term Investment Strategies Long-term techniques.  Buy and hold.  Dollar cost average.  Direct investment and dividend investment. Short-term techniques.  Buying stock on margin (borrowing money).  Selling short (borrowing stock).  Trading in options. 14-23