2 Chapter 14 Learning Objectives Identify the most important features of common and preferred stocksExplain how you can evaluate stock investmentsAnalyze the numerical measures that cause a stock to increase or decrease in valueDescribe how stocks are bought and soldExplain 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 stocksGood investors know something about the company before they invest in the company’s stockGather information to evaluate a potential investment in a stockLearn what the information you gather meansThere are periods where stocks decline in valueThe key to success is to allow investments to work for you over the long-term
4 Legal Forms of Businesses 1) Sole ProprietorshipA business owned by a single individual.Owner maintains title to the firm’s assets.Owner has unlimited liability.2) PartnershipSimilar to a sole proprietorship, except that there are two or more owners.
5 Legal Forms of Businesses 3) CorporationA 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 cashInvestorsSecondarymarketsGovernmentsecuritiesCash flowreinvesttaxCorporationdividends,etc.
8 Movement of Savings cash firm saver securities Direct Transfer of Fundscashsecuritiessaverfirm
9 Movement of Savings funds saver investment banker firm securities Indirect Transfer using Investment Bankersecuritiesfundssaverinvestmentbankerfirm
10 Movement of Savings funds financial saver intermediary firm securities Indirect Transfer using a Financial Intermediaryfundsintermediarysecuritiesfirmfinancialsaver
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 StockClaim 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 activitiesThey don’t have to repay the money a stockholder pays for stockDividends are not mandatory. Most corporations distribute 30-70% of their earnings to stockholdersIn return for investing in the company, stockholders have voting rights
14 Why Investors Purchase Common Stock They can make money in three waysIncome from dividends in the form of cash or additional stock (record day and ex-dividend)Dollar appreciation of stock valuePossible increased value from stock splitsWHAT 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 dividendsThe dividend amount is either a stated amount of money for each share of preferred stock, or a percentage of the par valuePar 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 constitutedefault
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 secureFirms 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 stockUnpaid cash dividends accumulate and must be paid before any cash dividends are paid to the common stock holdersConvertible preferred stockCan be traded for shares of common stock in the same company
21 Evaluating a Stock Issue Objective 2: Explain how you can evaluate stock investmentsCLASSIFICATION OF STOCKSBlue chip stock Large capCyclical Mid capDefensive Small capGrowth Micro capIncome Penny stock
22 Evaluating a Stock Issue Blue chip: financially strong, high quality stocks with long and stable records of earnings and dividendseg: General Electric, Merck, Wal-Mart, SBC Communications, Home DepotIncome stock: long and sustained records of paying higher than average dividendseg: AT&T, American Electric Power, Duke EnergyCyclical stock: earnings and overall market performance are closely lined to the economyeg: 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 faltereg: Bandag, Checkpoint SystemsGrowth stock: experience high rates of growtheg: General Dynamics, Google, StarbucksTech stock: represent new technologyeg: computers, semiconductors, data storage, software, internet service, wireless communication
24 Evaluating a Stock Issue Large cap: greater than 10 billionMidcap: 2 to 10 billionSmall cap: 250 million to 2 billionPenny stock: below $1
25 Evaluating a Stock Issue (continued) THE INTERNETMost corporations have a Website, and the information is useful in the following waysThe Website is easily accessibleMore up to date information than the printed materialWebsites like Yahoo and other search engines can also be used to obtain information about stock investmentsThe Internet can also be used to access professional advisory services likewww2.standardpoors.com
26 Evaluating a Stock Issue (continued) STOCK ADVISORY SERVICESPrepare printed materials that are a good supplement to information in newspapers and the InternetCharge a feeHundreds to choose fromStandard and Poor’s reports (library)Value Line (library)Mergent’s Handbook of Common StockMorningstarAs an investor, your job is to interpret the information provided
27 Evaluating a Stock Issue (continued) HOW TO READ THE FINANCIAL SECTION OF THE NEWSPAPERYou will see stock quotes in newspapers such as The Wall Street Journal52 weeks Yld Vol NetHi Lo Sym Div % PE s Hi Lo Close ChgIBMMSFT …
28 Numerical Measures That Influence Investment Decisions Objective 3: Analyze the numerical measures that cause a stock to increase or decrease in valueWhy corporate earnings are important?Corporate earnings play a large part in the increase or decrease in the value of a stockEarnings 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 signPrice-earnings (PE) ratioPrice 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 STOCKDividend payout = Dividend amount EPSDividend yield = Annual income amountMarket valueTotal return = Current return + Capital gainAnnualized holding period yield =Total return X 1 Original investment N
30 Numeric Measures That Influence Investment Decisions (continued) Beta: measure of volatilityBook value per shareNet 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 ratioThe current market value divided by the book valueA measurement ratio that, in part, may be used to determine the value of a stockIf the market-to-book ratio is high, that may mean that the stock is overvaluedIf the market-to-book ratio is low, that may mean that the stock is undervalued
32 Numeric Measures That Influence Investment Decisions (continued) INVESTMENT THEORIESFundamental analysisBased on the assumption that a stock’s intrinsic or real value is determined by the company’s future earningsFundamentalists consider the…Financial strength of the companyType of industry company is inNew-product developmentEconomic growth of the overall economy
33 Numeric Measures That Influence Investment Decisions (continued) Fundamental analysis:Financial statement: balance sheet, income statement, cash flow statementKey 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 analysisBased on the assumption that a stock’s value is determined by the forces of supply and demand in the stock market as a wholeNot based on expected earnings or the intrinsic value of a stock but rather on factors found in the marketChartists 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 theoryBased on the assumption that stock price movements are purely randomA stock’s current market price reflects its true valueIt is impossible for an investor to outperform the average for the stock market as a whole over a period of timeWall 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 soldCorporate financing sourcesFrom 1999 through 2001, capital has been raised through the following sources:Corporate Bonds and Notes %Equities %
39 Financial Market Components Public OfferingFirm issues securities, which are made available to both individual and institutional investors.Private PlacementSecurities are offered and sold to a limited number of investors.
40 Financial Market Components Money MarketMarket for short-term debt instruments (maturity periods of one year or less).Capital MarketMarket for long-term securities (maturity greater than one year).
41 Buying and Selling Stocks Primary marketA market in which an investor purchases financial securities through an investment bank, or other representative, from the issuer of those securitiesAn IPO occurs when a corporation sells stock to the general public for the first timeSecondary marketA market for existing financial securities that are currently traded among investors through brokers
42 Investment BankingAn investment bank is a financial firm that assists corporations in raising funds, usually by helping to sell new security issuesHow 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 NowVignette /18/ $ %FlashNet /16/ acquArriba /22/ N/A7/24 Solu /27/ N/AAntigenics 2/3/Buy.com /7/ DeliNuance Com 4/12/
48 Buying and Selling Stocks (continued) SECURITY EXCHANGESA marketplace where member brokers who represent investors meet to buy and sell securitiesThe securities sold at an exchange must be listed, or accepted for trading, at the exchangeNew York Stock and American Stock Exchanges (9:30 am – 4:00 pm ET)The Over-the-Counter (OTC) marketNetwork of dealers who buy and sell the stocks of companies not listed on a securities exchangeMost 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 indexDJIA – 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 EXECUTIVESAn account executive, or stockbroker, is a licensed individual who buys and sells securities for his or her clientsFinancial objectives should be communicated to the account executives, and the investor must be actively involved in the investment decisionsDiscount broker versus full service brokersHow 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 TRANSACTIONSMarket order: Request to buy or sell stock at the current market valueLimit order: Request to buy or sell a stock at a specified price or price rangeStop 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 speculatorsLong-term techniquesBuy and holdDollar cost averagingDirect investment and dividend re-investment plans (DRIPS)Short-term techniquesDay tradingBuying stock on margin (borrowing money)Selling short (borrowing stock)Trading in options (predetermined price)
53 Online ActivityGo 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?