Investing in Stocks

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. Understand the risks associated with investing in common stock.
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Introduction
Investing on the stock market is not

without risk

Investing on the stock market is all about

risk and return.

Sometimes, its all about making a fortune.

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Why Consider Stocks?

When you buy common stock, you

purchase a part of the company.

Returns:
Dividends - the companys distribution of

profits to stockholders.

Capital appreciation - the increase in the

selling price of a share of stock.

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Why Consider Stocks?

Neither dividends nor capital appreciation is guaranteed with common stock.
Dividends are paid at the boards discretion. Capital appreciation takes place when the company does well.

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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.
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Figure 13.1

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The Language of Common Stocks

Limited Liability
Claim on Income
Declaration date
Ex-dividend date

Claim on assets

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The Language of Common Stocks

Voting Rights
Proxy

Stock Splits
Stock repurchases

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The Language of Common Stocks

Book Value
Earnings Per Share

= net income preferred stock dividends number of shares of common stock outstanding

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The Language of Common Stocks

Dividend Yield

Market-to-Book or Price-to-Book Ratio

stock price____ book value per share

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Stock Indexes: Measuring the Movements in the Market

Stock Market Indexa 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 & Poors 500 (S&P 500) and other indexes
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Figure 13.2

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Market Movements
Bear marketcharacterized by falling prices.

Bull marketcharacterized by rising prices.

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Figure 13.3

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General Classifications of Common Stock

Blue-Chip stocks Growth stocks Income stocks Speculative stocks

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General Classifications of Common Stock

Cyclical stocks Defensive stocks Large caps, mid-caps, and small caps

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Valuation of Common Stock

The Technical Analysis Approach The Price/Earnings Ratio Approach The Discounted Dividends Valuation Model

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Technical Analysis Approach

Focuses on demand and supply
Uses charts and computer programs to

identify and project price trends.

Greed pushes money into a rising market. Fear pulls money out of a declining market.
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Technical Analysis Approach

Interpretation of charts and graphs and

mathematical calculations of trading patterns to spot trend or direction for stocks

Of little valuecannot identify trends before they happen Avoidencourages moving in and out of market instead of buying and holding.
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The Price/Earnings Approach

P/E ratio or earnings multipleprice per share divided by the earnings per share Higher firms earnings growth rate, higher P/E ratio Higher investors required rate of return, lower P/E ratio. Fundamental analysis
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Figure 13.4

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The Discounted Dividends Valuation Model

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. Value of a common stock

dividends next year________ required rate of return growth rate

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Why Stocks Fluctuate in Value

Interest Rates and Stock Valuation
Risk and Stock Valuation Earnings (and Dividend) Growth and Stock Valuation

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Stock Investment Strategies

Can use more than one of these approaches at once
But be alert

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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.
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Table 13.1

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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.
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Dividend Reinvestment Plans (DRIPs)

Automatically reinvest the dividends in same

firms stock without brokerage fees.

Use a DRIP to reinvest rather than spend

your dividends.

Still pay income taxes. Stuck reinvesting in old company instead of new.
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Risks Associated with Common Stocks

Risk and return go hand in hand. Principle 8can eliminate risk associated with common stock by diversifying. Only systematic risk remains.

Measure systematic risk using Beta.

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Figure 13.5

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Another look at Principle 7: Risk and Return go hand in hand

Betameasure of how responsive a stock or portfolio is to changes in the market portfolio.

Beta benchmark for market = 1

Beta > 1stock moves up and down more

than market

Beta <1stock moves up and more less

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Figure 13.6

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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.

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Figure 13.7

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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.

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Summary
A number of methods can be used to determine the value of stockbut 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.
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