chapter 12 investing in stocks copyright © 2012 pearson canada inc. 12-1

Chapter 12

Investing in Stocks

Copyright © 2012 Pearson Canada Inc. 12-1

Chapter Objectives

• Identify the functions of stock exchanges

• Describe how to interpret stock quotations

• Explain how to execute the purchase or sale of stocks


Chapter Objectives (cont’d)

• Explain how to analyze a firm and its stock

• Explain how to value stocks

• Explain how to assess your stock portfolio’s performance


Stock Exchanges• Stock exchanges: facilities that allow investors to purchase

or sell existing stocks• A stock must be listed on a stock exchange in order to be

traded there• Canadian stocks are traded on two markets:• Toronto Stock Exchange (TSX)• TSX Venture Exchange


Stock Exchanges (cont’d)• To be listed on the TSX, a firm must meet

minimum listing requirements in areas such as:• revenue,

• cash flow,

• net tangible assets,

• working capital, and

• cash


Stock Exchanges (cont’d)• Electronic Trading

• Major exchanges in Canada offer trading services electronically

• Liquidity is enhanced with the use of market makers

• Market makers: securities dealers who are required to trade actively in the market so that liquidity is maintained when natural market forces cannot provide sufficient liquidity


Stock Exchanges (cont’d)• Over-the-Counter (OTC) Market• Over-the-counter (OTC) market: an electronic

communications network that allows investors to buy or sell securities


Stock Quotations

• Where can you find stock quotes?

• Stockbrokers

• Financial newspapers (e.g. Globe & Mail)

• Business sections of local newspapers

• Financial news television networks (e.g. BNN)

• Financial websites


Stock Quotations (cont’d)

• Example of a stock quotation:


Purchasing or Selling Stocks

• How to selecting a Broker?• Analyst Recommendations


Purchasing or Selling Stocks (cont’d)


• Focus on Ethics: Relying on Analyst Recommendations• Brokers and analysts tend to be overly

optimistic about stocks


• Brokerage Commissions• Discount brokerage firm: a brokerage firm that

execute transactions but does not offer investment advice

• Full-service brokerage firm: a brokerage firm that offers investment advice and executes transactions



• Placing an Order• Must specify the following:

• Name and class of the stock,

• Buy or sell,

• Number of shares

• Market order or limit order




• Name and Class of the Stock• Ticker symbol: the abbreviated term used to identify

a stock for trading purposes

• Buy or Sell

• Number of Shares• Board lot: shares bought or sold in multiples of

typically 100 shares. The size of the board lot depends on the price of the security

• Odd lot: less than a board lot of that particular stock



• Market Order or Limit Order• Market order: an order to buy or sell a stock at its

prevailing market price

• Limit order: an order to buy or sell a stock only if the price is within the limits that you specify



• Stop Orders

• On-stop order: an order to execute a transaction when the stock price reaches a specified level; a special form of limit order

• Buy stop order: an order to buy a stock when the price rises to a specified level

• Sell stop order: an order to sell a stock when the price falls to a specified level



• Buying Stock on Margin

• On margin: purchasing a stock with a small amount of personal funds and a portion of the funds borrowed from a brokerage firm

• Enable you to purchase stocks without having the full amount of cash necessary



• If the value of investments purchased on margin declines, you will receive a margin call

• Margin call: a request from a brokerage firm for the investor to increase the cash in the account in order to return the margin to the minimum level

Analysis of a Firm


• Annual Report

• Includes a corporate profile, a message from the firm’s CEO, and a section summarizing recent performance and expected future performance

• Also contains financial statements

Analysis of a Firm (cont’d)


• Firm-Specific Characteristics

• Liquidity

• Shows the firm’s ability to cover expenses

• Current ratio: the ratio of a firm’s short-term assets to its short-term liabilities



• Financial Leverage• Used to determine a firm’s ability to make debt

payments

• Many firms prefer to borrow funds rather than issue stock

• Financial leverage: a firm’s reliance on debt to support its operations

• Debt ratio: a measure of financial leverage that calculates the proportion of total assets financed with debt



• Times interest earned ratio: a measure of financial leverage that indicates the ratio of the firm’s earnings before interest and taxes to its total interest payments

• Efficiency

• A firm that generates a relatively low level of sales and earnings with a large amount of assets is not using its assets efficiently



• Inventory turnover: a measure of how efficiently a firm manages its inventory; computed as the cost of goods sold divided by average daily inventory

• Average collection period: used to determine the average age of accounts receivable; computed as accounts receivable divided by average daily sales

• Asset turnover ratio: used to assess how efficiently a firm uses its assets; computed as sales divided by average total assets



• Profitability• Operating profit margin: a firm’s operating profit

divided by sales

• Net profit margin: a measure of profitability that measures net profit as a percentage of sales

• Return on assets: a measure of profitability; computed as net profit divided by total assets

• Return on equity: a measure of profitability; computed as net profit divided by the owners’ investment in the firm (shareholder’s equity)



• Information Provided by Value Line Investment Survey



• Focus on Ethics: Accounting Fraud• Motivation for Fraud

• Stock price helps determine manager compensation

• Leads to a short-tem focus

• Revenue-Inflating Techniques• Recognizing revenue before it is earned

• Recognizing revenue from orders that are likely to be cancelled



• Preventing Future Accounting Fraud

• Auditor’s may not always be “independent”

• Sarbanes-Oxley Act was created in order to restore investor confidence in the markets and to prevent future occurrences of accounting fraud



• Economic Analysis of Stocks• Involves assessing any economic conditions

that can affect a firm’s stock price

• Economic Growth• Economic growth: the growth in a country’s

economy over a particular period; commonly measured by GDP



• Fiscal policy: how the government imposes taxes on individuals and corporations and how it spends tax revenues



• Interest Rates

• Stocks perform better when interest rates are low

• The Bank of Canada uses monetary policy to influence interest rates

• Monetary policy: techniques used by the Bank of Canada to affect the economy of the country



• Industry Analysis of Stocks

• Increased demand generally leads to higher stock prices

• Changes in competition also affect demand, earnings, and stock prices

Analysis of a Firm (cont’d)• Integrating Your

Analyses


Stock Valuation• Price of a stock is based on the demand for

that stock versus the supply of stock available for purchase


Value a stock using technical or fundamental analysis

)• Technical analysis: the valuation of stocks based on historical price patterns using various charting techniques

• Fundamental analysis: the valuation of stocks based on an examination of fundamental characteristics such as revenue, earnings, and/or the sensitivity of the firm’s performance to economic conditions


Stock Valuation (cont’d)

• Dividend Discount Model (DDM) Method

• Dividend discount model (DDM): a method of valuing stocks in which a firm’s future dividend payments are discounted at an appropriate rate of interest

• Works best for mature firms that pay a large stable dividend



• Price-Earnings (P/E) Method

• Based on the value of the firm’s earnings

• Price-earnings (P/E) method: a method of valuing stocks in which a specific firm’s earnings per share are multiplied by the mean industry price-earnings (P/E) ratio



• Stock Market Efficiency

• Efficient stock market: a market in which stock prices full reflect information that is available to investors

• Inefficient stock market: a market in which stock prices do not reflect all public information that is available to investors


chapter 12 investing in stocks copyright © 2012 pearson canada inc. 12-1

Documents

pearson canada

stocks contd copyright

stock quotes

functions of stock exchanges

sale of stocks copyright

cash copyright

securities copyright

transactions copyright