Chapter 14 Investing in Stocks

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

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

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.

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.

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

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

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

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

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

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.

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.

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

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

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

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.

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

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.

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.

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

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

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

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

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

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 www.valueline.com www.morningstar.com

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

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 100s Hi Lo Close Chg 134 80 IBM .52 .5 21 143402 98 95 9549 -3 115 40 MSFT … 29 558918 55 52 5194 -475

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

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

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

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

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

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

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

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

Numeric Measures That Influence Investment Decisions (continued)

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

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 76.9% Equities 23.1%

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.

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).

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

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.

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.

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.

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.

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.

Invest in IPO Vignette 2/18/99 $19 42 124% 7 Company IPO date IPO price 1st day price 1st day gain Now Vignette 2/18/99 $19 42 124% 7 FlashNet 3/16/99 17 43 156 acqu Arriba 6/22/99 23 89 291 N/A 7/24 Solu 1/27/00 26 71 176 N/A Antigenics 2/3/00 18 61 241 0.45 Buy.com 2/7/00 13 25 93 Deli Nuance Com 4/12/00 17 34 100 12.67

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

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

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?

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

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)

Online Activity Go to an online source such as www.fool.com, www.morningstar.com, or www.cnnfn.com. 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?