Bennie D Waller, Longwood University Personal Finance Bennie Waller Longwood University 201 High Street Farmville, VA 23901

Bennie D Waller, Longwood University Stocks

Bennie D Waller, Longwood University Stocks  Investing on the stock market is not without risk  Investing on the stock market is all about risk and return.  Sometimes, it’s all about making a fortune.

Bennie D Waller, Longwood University Stocks Shares of Stock Represent Pieces of a Business  Owning stock in a company in essence indicates that you are part-owner in the company.  Generally each share of stock entitles the stockholder to be have one vote toward the election of the Board of Director (typically charged with the oversight of management).  When organizations need to raise capital (money), they typically have two broad options.  One they can borrow the money (either from a bank or issue debt (bonds) or  they can give up partial ownership in the firm by selling stock.

Bennie D Waller, Longwood University Why Invest in Stocks? When you buy common stock, you purchase a part of the company. Returns: – Dividends—the company’s distribution of profits to stockholders (paid at company’s discretion). – Capital appreciation—the increase in the selling price of a share of stock. Neither dividends nor capital appreciation is guaranteed. Over time, common stocks outperform all other investments. Stocks reduce risk through diversification and offer liquidity

Bennie D Waller, Longwood University Stocks Shares of Stock Represent Pieces of a Business You start you own landscaping business. You decide that you need $1,000 to get started. You divide the company into 10 pieces, or "shares" of stock. You price each new share of stock at $100 which will garner the $1,000 you need to get started. If the business earns $500 after taxes during its first year, each share of stock would be entitled (not guaranteed) to 1/10th of the profit. You'd take $500 and divide it by 10, resulting in $50.00 earnings per share (EPS). Source:

Bennie D Waller, Longwood University Stocks  Stock investors expect to earn a return (no guarantee).  Capital Appreciation –  Income - dividends  Firm’s that pay dividends?  Why firms may not pay a dividend  Types of investors that invest in these firms  Firm’s that don’t pay dividends, and why?  Types of investors that invest in these firms and why  Many/most firms pay some dividends as well as enjoy price appreciation.

Bennie D Waller, Longwood University Stocks

Bennie D Waller, Longwood University Common Stock Language  Limited Liability – only amount invested but unlimited potential  Claim on Income - dividends  Declaration date – date which BOD declares upcoming dividend payment  Ex-dividend date - date on which shareholders must own stock to be eligible  Claim on assets  Voting Rights  Proxy  Stock splits – e.g. 2 for 1  Reverse splits - 1 for 2  Stock repurchases – why would a company choose to repurchase their own stock?

Bennie D Waller, Longwood University Income Statement

Bennie D Waller, Longwood University STOCKS Earnings Per Share (EPS) - measures the earnings of the firm on a per share basis. Payout ratio (PO) - dictates what percent of earnings the firm will payout to stockholders in the form of dividend. Conversely 1-PO indicates what percent of net income the firm plans to retain. A payout ratio of 60% illustrates that the firm is planning on paying out 60% of the firm's net income and retaining 40 percent.

Bennie D Waller, Longwood University STOCKS Dividend Per Share (DPS) - represents the dollar amount of dividends that is paid to stockholders. Price Earnings (PE)- is an earnings multiple. The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 10, the interpretation is that an investor is willing to pay $10 for $1 of current earnings.

Bennie D Waller, Longwood University Stocks  Stock market indices – groups of stocks performance that represent the market or segment of market  DJIA  S&P 500  NASDAQ  Bear market—characterized by falling prices.  Bull market—characterized by rising prices

Bennie D Waller, Longwood University Dow Jones Industrial Average (DJIA)

Bennie D Waller, Longwood University How to Read Stock Quote

Bennie D Waller, Longwood University Stocks  Classification of stocks  Blue-chip – large well known firms  Growth – firms with growth above industry average (many times these are new firms)  Income –  Speculative –  Defensive – stocks that tend not to be affected in economic swings  Large caps - >$5 billion  Small caps - <$1 billion

Bennie D Waller, Longwood University How Stock is Valued  Technical Analysis – charts/graphs/  Uses mathematical and computer models used to predict prices by looking for patterns and trends  Price/Earnings Ratio – is an earnings multiple approach . Higher earnings growth, higher P/E ratio

Bennie D Waller, Longwood University How Stock is Valued  Dividend Discount Model – stock price is based on present value of future dividends.  The value of any investment is the present value of the benefits or returns received from the investment  Value of a share of common stock = present value of the infinite stream of future dividends  Just another example of the importance of present value.  More examples to follow

Bennie D Waller, Longwood University Buy and Hold Stratgey  Involves buying stock and holding it for a period of years.  Avoids timing the market.  Minimizes brokerage fees, transaction costs.  Postpones capital gains taxes.  Gains taxed as long-term capital gains.

Bennie D Waller, Longwood University Risk of Investing in Stocks  Risk and return go hand in hand.  Principle 8—can eliminate risk associated with common stock by diversifying.  Only systematic risk remains.  Measure systematic risk using Beta.  Beta—measure of how responsive a stock or portfolio is to changes in the market portfolio.  Beta benchmark for market = 1  Beta > 1—stock moves up and down more than market  Beta <1—stock moves up and more less

Bennie D Waller, Longwood University Risk of Investing in Stocks  Researchers have shown that the best measure of the risk of a security in a large portfolio is the beta (b)of the security.  Beta measures the responsiveness of a security to movements in the market portfolio (i.e., systematic risk).

Bennie D Waller, Longwood University Risk/Return Trade-off

Bennie D Waller, Longwood University Risks of Common Stocks  Short-term investments in stocks are very risky  Holding stocks longer reduces variability of average annual return.  Investors can afford to take on more risk as investment time horizons increase—they have more opportunities to adjust saving, consumption, and work habits.

Bennie D Waller, Longwood University Stock valuation  Dividend Growth Model – used to value stocks that pay dividends  Taking present value of future cash flows  As you go further out into the future, the impact of the cash flows decrease

Bennie D Waller, Longwood University Stock Valuation Stock Valuation assuming constant growth - Constant Growth Model – used to determine the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate.  Given a dividend per share that is payable in one year, and the assumption that the dividend grows at a constant rate in perpetuity, the model solves for the present value of the infinite series of future dividends. Because the model assumes a constant growth rate, it is generally only used for mature companies (or broad market indices) with low to moderate growth rates.

Bennie D Waller, Longwood University Stock Valuation Example A share of common stock has just paid a dividend of $2.00. If the expected long-run growth rate for this stock is 15 percent, and if investors require a 19 percent rate of return, what is the price of the stock?

Bennie D Waller, Longwood University Stock valuation Stock Valuation assuming abnormal growth – firms with high growth or emerging areas such as technology or pharmaceutical are likely to experience periods of abnormal or super-abnormal growth.

Bennie D Waller, Longwood University Stock valuation Stock Valuation assuming abnormal growth – firms with high growth or emerging areas such as technology or pharmaceutical are likely to experience periods of abnormal or super-abnormal growth.  Assume that a biotech firm discovers a cure for a terminal disease. The firm is expected to have growth rates of 30%, 25% and 20% over the next three years at which time, growth is expected to level off and remain constant at 10% for the foreseeable future. The current required rate of return is 12% for investors (k=.12) and the last dividend paid was $2.00 (D 0 =2.00). Since the growth will become constant in year 4, we can then apply the constant growth formula.

Bennie D Waller, Longwood University Stock Valuation g 1 =.30 – expected growth in year 1 g 2 =.25 – expected growth in year 2 g 3 =.20 – expected growth in year 3 G 4+ =.10 – expected growth in year 4 and thereafter D 0 =2.00 – last dividend paid k=.12 –required rate of return (rate firm must pay to encourage investment in firm) Since the growth will become constant in year 4, we can then apply the constant growth formula using the formula below. We need to calculate the dividends for each of the next 4 years D 1 =D 0 (1+g 1 ) = 2(1.30) =2.60 D 2 =D 1 (1+g 2 ) = 2.60(1.25) =3.25 D 3 =D 2 (1+g 3 ) = 3.25(1.20) = 3.90 D 4 =D 3 (1+g 4 ) = 3.90(1.10) = 4.29

Bennie D Waller, Longwood University Stock Valuation We need to calculate the dividends for each of the next 4 years D 1 =D 0 (1+g 1 ) = 2(1.30) =2.60 D 2 =D 1 (1+g 2 ) = 2.60(1.25) =3.25 D 3 =D 2 (1+g 3 ) = 3.25(1.20) = 3.90 D 4 =D 3 (1+g 4 ) = 3.90(1.10) = 4.29

Bennie D Waller, Longwood University Stock Valuation We need to calculate the dividends for each of the next 4 years D 1 =D 0 (1+g 1 ) = 2(1.30) =2.60 D 2 =D 1 (1+g 2 ) = 2.60(1.25) =3.25 D 3 =D 2 (1+g 3 ) = 3.25(1.20) = 3.90 D 4 =D 3 (1+g 4 ) = 3.90(1.10) = 4.29 So how do we interpret this estimated price?

Bennie D Waller, Longwood University STOCKS The last dividend paid by Klein Company was $1.00. Klein’s growth rate is expected to be a constant 5 percent for 2 years, after which dividends are expected to grow at a rate of 10 percent forever. Klein’s required rate of return on equity (k s ) is 12 percent. How much should a prudent investor be willing to pay for this stock based on the above assumptions?

Bennie D Waller, Longwood University STOCKS g 1 =.05 – expected growth in year 1 g 2 =.05 – expected growth in year 2 g 3+ =.10 – expected growth in year 3 and thereafter D 0 =1.00 – last dividend paid k=.12 –required rate of return (rate firm must pay to encourage investment in firm)

Bennie D Waller, Longwood University STOCKS Assume that you plan to buy a share of XYZ stock today and to hold it for 2 years. Your expectations are that you will not receive a dividend at the end of Year 1, but you will receive a dividend of $9.25 at the end of Year 2. In addition, you expect to sell the stock for $150 at the end of Year 2. If your expected rate of return is 16 percent, how much should you be willing to pay for this stock today?

Bennie D Waller, Longwood University STOCKS Womack Toy Company’s stock is currently trading at $25 per share. The stock’s dividend is projected to increase at a constant rate of 7 percent per year. The required rate of return on the stock, k s, is 10 percent. What is the expected price of the stock 4 years from today?

Bennie D Waller, Longwood University STOCKS

Bennie D Waller, Longwood University STOCKS  The CAPM says that the expected return of a security or a portfolio should equal the risk-free rate plus a risk premium.  Using the CAPM model and the following assumptions, we can compute the expected return of a stock.  Risk-free rate is 3%, the stock’s beta (risk measure) is 2 and the expected market return over the period is 10%,  The expected return on the stock is 17% (3%+2(10%-3%)). The security market line plots the results of the CAPM for all different risks (betas). SML illustrated

Bennie D Waller, Longwood University Security Market Line (SML) β=1 β Return Rm Rf β=0 The security market line plots the results of the CAPM for all different risks (betas).

Bennie D Waller, Longwood University STOCKS The common stock of Anthony Steel has a beta of The risk-free rate is 5 percent and the market risk premium (k M - k RF ) is 6 percent. Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget. What is the company’s cost of retained earnings, k s ?

Bennie D Waller, Longwood University STOCKS Security Market Line (SML) β=1 β Return Rm Rf β=0 β= Overpriced stocks will fall below the SML In the previous example, if the stock was currently trading at $9.00/share, the expected return would only be 11%, which is well below the required return of 12.2%

Bennie D Waller, Longwood University Derivative Securities  Derivative securities – a security whose value is dependent upon the value of some underlying asset, e.g., MBS

Bennie D Waller, Longwood University Options/Futures  Options – a security (financial instrument) that gives the owner the right to buy or sell an asset (typically common stock) for a specified price over a specified period of time.  Call option – gives the owner the right to purchase an asset at a given price (strike price) before the expiration of the option. e.g., if you believe that a stock will increase in price, you could purchase a call option. If the stock goes above the strike price, the option could be exercised and the underlying stock purchased.

Bennie D Waller, Longwood University Call Option Example Suppose the stock of XYZ company is trading at $40. A call option contract with a strike price of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ stock will rise sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ call option covering 100 shares.  Assume the price of XYZ stock rallies to $50 after reported earnings. With this sharp rise in the underlying stock price, your call buying strategy will net you a profit of $800.  If you were to exercise your call option after the earnings report, you invoke your right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in the open market for $50 a share. This gives you a profit of $10 per share. As each call option contract covers 100 shares, the total amount you will receive from the exercise is $1000. Source:

Bennie D Waller, Longwood University Call Option Example Source:

Bennie D Waller, Longwood University Put Option  Put option – give the owner the right to sell an asset at a given price before the expiration of the option.  Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.  If you are right and the price of XYZ stock plunges to $30 after the company reported earnings. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.

Bennie D Waller, Longwood University  If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each.  Although you don't own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share.  This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800 Put Option

Bennie D Waller, Longwood University Put Option

Bennie D Waller, Longwood University Thank You

Bennie D Waller, Longwood University

Learning Objectives 1.Invest in stocks. 2.Read stock quotes online or in the newspaper. 3.Classify common stock according to basic market terminology. 4.Determine the value stocks. 5. Employ different investment strategies. 6. Understand the risks associated with investing in common stock.

Bennie D Waller, Longwood University Summary Common stocks over time outperform all other investments. Stock indexes such as the Dow and S&P 500 show health of stock market. Common stocks can be blue-chip, growth, income, speculative, defensive, large- to small- cap stocks.

Bennie D Waller, Longwood University Summary A number of methods can be used to determine the value of stock—but interest rates, risk, and expected future growth determine the value of common stock. Use one or more investment strategies such as dollar-cost average, buy-and-hold, and DRIPs. Stocks are riskier but diversification and watching beta values can help.