PART 4: MANAGING YOUR INVESTMENTS Chapter 13 Investing in Stocks

13-2 Why Consider Stocks? When you buy common stock, you purchase a part of the company. When you buy common stock, you purchase a part of the company. Returns come from: Returns come from: Dividends - the company’s distribution of profits to stockholders. Dividends - the company’s distribution of profits to stockholders. Capital appreciation - the increase in the selling price of a share of stock. Capital appreciation - the increase in the selling price of a share of stock.

13-3 Why Consider Stocks? Neither dividends nor capital appreciation is guaranteed with common stock. Neither dividends nor capital appreciation is guaranteed with common stock. Dividends are paid at the board’s discretion. Dividends are paid at the board’s discretion. Can be cash or additional stock. Can be cash or additional stock. Capital appreciation takes place when the company does well. Capital appreciation takes place when the company does well.

13-4 Why Consider Stocks? Over time, common stocks outperform all other investments. Over time, common stocks outperform all other investments. Stocks reduce risk through diversification. Stocks reduce risk through diversification. Stocks are liquid. Stocks are liquid. Growth is determined by more than interest rates. Growth is determined by more than interest rates.

13-5 The Language of Common Stocks Limited Liability – in case of bankruptcy, loss limited to amount of investment. Limited Liability – in case of bankruptcy, loss limited to amount of investment. Claim on Income – receive earnings after debt holders and preferred stockholders. Claim on Income – receive earnings after debt holders and preferred stockholders. Earnings distributed through dividends or reinvested into company. Earnings distributed through dividends or reinvested into company. Quarterly dividends are not automatic – they must be declared by board of directors. Quarterly dividends are not automatic – they must be declared by board of directors.

13-6 The Language of Common Stocks Claims on Assets – paid after all creditors. Claims on Assets – paid after all creditors. Voting Rights – elect board of directors, approve changes in corporation’s rules. Voting Rights – elect board of directors, approve changes in corporation’s rules. Voting done in person or by proxy. Voting done in person or by proxy. Stock Splits – substitute more shares for existing ones, thereby lowering the price. Stock Splits – substitute more shares for existing ones, thereby lowering the price. No immediate gain in wealth for stockholder. No immediate gain in wealth for stockholder.

13-7 The Language of Common Stocks Stock Repurchases – company buys back its own stock. Stock Repurchases – company buys back its own stock. Book Value – subtract firm’s liabilities from assets. Book Value – subtract firm’s liabilities from assets. Earnings Per Share – level of earnings for each share of stock. Earnings Per Share – level of earnings for each share of stock. Compares performance of different companies. Compares performance of different companies.

13-8 The Language of Common Stocks Dividend Yield – amount of annual dividend divided by market price of stock. Dividend Yield – amount of annual dividend divided by market price of stock. Calculates return if stock price and dividend are unchanged. Calculates return if stock price and dividend are unchanged.

13-9 Stock Market Index Is a measure of the performance of a group of stocks that represent the market or a sector of the market. Is a measure of the performance of a group of stocks that represent the market or a sector of the market. Dow Jones Dow Jones S&P 500 S&P 500

13-10 The Dow The Dow Jones Industrial Average (DJIA or Dow) is the oldest and most widely quoted index. The Dow Jones Industrial Average (DJIA or Dow) is the oldest and most widely quoted index. Created by Charles Dow in 1896 to gauge the well-being of the market, was based on 12 companies. Created by Charles Dow in 1896 to gauge the well-being of the market, was based on 12 companies. Dow currently has 30 stocks, with GE the only original Dow component. Dow currently has 30 stocks, with GE the only original Dow component.

13-11 The S&P 500 and Other Indexes The Standard and Poor’s 500 Stock Index is broader than the DJIA. It may better represent the market’s movements. The Standard and Poor’s 500 Stock Index is broader than the DJIA. It may better represent the market’s movements. The Russell 1000 is comprised of the 1000 largest companies. The Russell 1000 is comprised of the 1000 largest companies.

13-12 Market Movements A bear market is characterized by falling prices. A bear market is characterized by falling prices. A bull market has rising prices. A bull market has rising prices. Names come from how the animals attack: Names come from how the animals attack: Bears swipe downward with their paws. Bears swipe downward with their paws. Bulls fling their horns upward. Bulls fling their horns upward.

13-13 General Classifications of Common Stock Blue-Chip Stocks – issued by large, nationally- known companies with sound financials, solid dividend and growth records. Blue-Chip Stocks – issued by large, nationally- known companies with sound financials, solid dividend and growth records. GE and P&G are examples. GE and P&G are examples.

13-14 General Classifications of Common Stock Growth Stocks – companies with sales and earnings growth well above their industry average. Growth Stocks – companies with sales and earnings growth well above their industry average. Microsoft is an example. Microsoft is an example.

13-15 General Classifications of Common Stock Income Stocks – mature firms paying high dividends with little increase in earnings. Income Stocks – mature firms paying high dividends with little increase in earnings. Speculative Stocks – carry more risk and variability, difficult to forecast, and traded on the OTC. Speculative Stocks – carry more risk and variability, difficult to forecast, and traded on the OTC.

13-16 General Classifications of Common Stock Cyclical Stocks – earnings move with the economy, dropping during a recession. Cyclical Stocks – earnings move with the economy, dropping during a recession. Defensive Stocks – are not nearly as affected by economic swings, and perform better during a downturn. Defensive Stocks – are not nearly as affected by economic swings, and perform better during a downturn. Examples include insurance and auto parts firms. Examples include insurance and auto parts firms.

13-17 General Classifications of Common Stock Large caps, mid caps, and small caps – refer to the size of the issuing company – its level of capitalization or market value. Large caps, mid caps, and small caps – refer to the size of the issuing company – its level of capitalization or market value. From , small-cap stocks outperformed large-cap stocks. From , small-cap stocks outperformed large-cap stocks.

13-18 The Price/Earnings Approach The price/earnings ratio measures a stock’s relative value. The price/earnings ratio measures a stock’s relative value. The P/E ratio = price per share/eps The P/E ratio = price per share/eps It indicates how much investors are willing to pay for a dollar of the company’s earnings. It indicates how much investors are willing to pay for a dollar of the company’s earnings.

13-19 The Price/Earnings Approach The more positive investors feel about a stock, the higher the P/E ratio. The more positive investors feel about a stock, the higher the P/E ratio. A P/E ratio of 20 means it is “selling at 20 times earnings.” A P/E ratio of 20 means it is “selling at 20 times earnings.”

13-20 Be Alert Checklist 13.2 Look out for: Look out for: Recommendations based on inside or confidential information. Recommendations based on inside or confidential information. Telephone sales pitches. Telephone sales pitches. Representations of spectacular profit. Representations of spectacular profit. Guarantees you will not lose money. Guarantees you will not lose money. An excessive number of transactions. An excessive number of transactions. Pressure to trade in an inconsistent manner. Pressure to trade in an inconsistent manner.

13-21 Dollar Cost Averaging Purchasing a fixed dollar amount of stock at specified intervals. Purchasing a fixed dollar amount of stock at specified intervals. Same dollar amount each period will average out the fluctuations. Same dollar amount each period will average out the fluctuations. Buy more shares at a lower price, fewer shares at higher prices. Buy more shares at a lower price, fewer shares at higher prices.

13-22 Buy and Hold Involves buying stock and holding it for a period of years. Involves buying stock and holding it for a period of years. Why consider this? Why consider this? Avoids timing the market. Avoids timing the market. Minimizes brokerage fees and transaction costs. Minimizes brokerage fees and transaction costs. Postpones capital gains taxes. Postpones capital gains taxes. Gains taxed as long-term capital gains. Gains taxed as long-term capital gains.

13-23 Dividend Reinvestment Plans (DRIPs) Automatically reinvest the dividends in the firm’s stock without brokerage fees. Automatically reinvest the dividends in the firm’s stock without brokerage fees. Use a DRIP to reinvest rather than spend your dividends. Use a DRIP to reinvest rather than spend your dividends. Even though you don’t receive any cash when the dividends are reinvested, you still need to pay income taxes. Even though you don’t receive any cash when the dividends are reinvested, you still need to pay income taxes.

13-24 Risks Associated with Common Stocks The Risk-Return Trade-off Without the risks, we would not expect the high returns that common stocks offer. Without the risks, we would not expect the high returns that common stocks offer. A great deal of potential risk if the firm does poorly, a great deal of reward if it does well. A great deal of potential risk if the firm does poorly, a great deal of reward if it does well.

13-25 Risks Associated with Common Stocks Diversification Reduces Risk In a well-diversified portfolio, only systematic risk remains. In a well-diversified portfolio, only systematic risk remains. As a portfolio increases to stocks, 60% of total risk is eliminated. As a portfolio increases to stocks, 60% of total risk is eliminated. Measure systematic risk using ( β )eta. Measure systematic risk using ( β )eta.

13-26 Principles Associated with Common Stocks Diversification Reduces Risk β eta for the market = 1 β eta for the market = 1 β eta > 1 means the stock has above average systematic risk. β eta > 1 means the stock has above average systematic risk. β eta < 1 means the stock has below average systematic risk. β eta < 1 means the stock has below average systematic risk.

13-27 Principles Associated with Common Stocks The Time Dimension of Investing One year returns are quite variable, making short- term investments risky. One year returns are quite variable, making short- term investments risky. As investment horizons increase, invest in riskier assets. As investment horizons increase, invest in riskier assets. In the long-term, you ’ ll do better with stocks rather than other investments. In the long-term, you ’ ll do better with stocks rather than other investments. Investors can take more long-term risks because they have more time to adjust their consumption and work habits. Investors can take more long-term risks because they have more time to adjust their consumption and work habits.

13-28 Understanding the Concept of Leverage Borrowing the money you invest can affect your investment return. Borrowing the money you invest can affect your investment return. Leverage refers to the use of borrowed funds to increase purchasing power. Leverage refers to the use of borrowed funds to increase purchasing power. Leverage magnifies the gains and the losses. Leverage magnifies the gains and the losses.