Investing in Stocks Professor Payne, Finance 4100 Chapter 12 Investing in Stocks Professor Payne, Finance 4100

Learning Objectives Invest in stocks. Read stock quotes online or in the newspaper. Understand how stocks are valued and what causes them to go up and down in price. Employ different investment strategies. Understand the risks associated with investing in common stock.

Introduction Investing in the stock market is not without risk. Investing in the stock market is all about risk and return.

Why Consider Stocks? When you buy common stock, you purchase a small part of the company. Returns: Dividends—the company’s distribution of profits to stockholders. Capital appreciation—the increase in the selling price of a share of stock.

Why Consider Stocks? Neither dividends nor capital appreciation is guaranteed with common stock. Dividends are paid at the board’s discretion. Capital appreciation takes place when the company does well.

Why Consider Stocks? Over time, common stocks outperform all other investments. Stocks reduce risk through diversification. Stocks are liquid. Growth is determined by more than interest rates.

The Language of Common Stocks Limited Liability Claims on Income Declaration date Ex-dividend date Claims on Assets

The Language of Common Stocks Voting Rights Proxy Stock Splits Stock Repurchases

The Language of Common Stocks Book Value Earnings per Share

The Language of Common Stocks Dividend Yield Market-to-Book or Price-to-Book Ratio Classification of Stocks Blue-chip Speculative Growth

Stock Indexes and Quotes Stock Market Index—measure of performance of a group of stocks that represent the market or a sector of the market Dow Jones Industrial Average (DJIA) or Dow Standard & Poor’s 500 (S&P 500) and other indexes

Market Movements Bear market—characterized by falling prices. Bull market—characterized by rising prices.

Valuation of Common Stock Fundamental analysis—focuses on such determinants as future earnings and dividends, expected levels of interest rates, and the firm’s risk Technical analysis—focuses on supply and demand

Valuation of Common Stock Price/earnings ratio—indication of how much investors are willing to pay for a dollar of the company’s earnings Higher the firm’s earnings growth rate, the higher the P/E ratio Higher the investor’s required rate of return, the lower the P/E ratio

Valuation of Common Stock SWOT analysis forces you to look both internally to the firm’s Strengths and Weaknesses and externally to the Opportunities and Threats

Stock Investment Strategies Can use more than one of these approaches at once Be alert Dollar cost averaging Buy-and-hold strategy Dividend reinvestment plans

Dollar Cost Averaging Purchasing a fixed dollar amount of stock at specified intervals. Same dollar amount each period will average out the fluctuations. Buy more shares at a lower price, fewer shares at higher prices. Keeps you from trying to time the market.

Buy-and-Hold Strategy 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.

Dividend Reinvestment Plans (DRIPs) Automatically reinvest the dividends in same firm’s stock without brokerage fees. Use a DRIP to reinvest rather than spend your dividends. Still pay income taxes.

As an Investor, What Should You Know? Value: Is this a good price for this stock? Quality: Is this firm in a position that will allow it to be profitable into the future? Strengths and Weaknesses: What are this firm’s strengths and weaknesses, and are they likely to get better or worse? Threats and Opportunities: What are this firm’s threats and opportunities, and are they likely to get better or worse?

Risks Associated with Common Stocks Principle 8—Risk and Return Go Hand in Hand By diversifying your investments, you minimize risk

Another look at Principle 8: Risk and Return Go Hand in Hand Beta—measure of how responsive a stock or portfolio is to changes in the market portfolio Beta benchmark for market = 1 Beta greater than 1—stock moves up and down more than market Beta less than 1—stock moves up and down less than market

Risks Associated with 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.

Summary Common stocks over time outperform all other investments. Stocks are liquid. 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.

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.

End of Chapter 12 Slides