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Investing in Stocks
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13-2Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Learning Objectives1. 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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13-3Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Introduction
Investing on the stock market is not without risk
Investing on the stock market is all about risk and return.
Sometimes, it’s 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 company’s distribution of
profits to stockholders.
Capital appreciation - the increase in the selling price of a share of stock.
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13-5Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
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.
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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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13-7Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
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The Language of Common Stocks
Limited Liability
Claim on IncomeDeclaration dateEx-dividend date
Claim on assets
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The Language of Common Stocks
Voting RightsProxy
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 Index—a 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
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13-13Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
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Market Movements
Bear market—characterized by falling prices.
Bull market—characterized by rising prices.
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13-15Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
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13-16Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
General Classificationsof Common Stock
Blue-Chip stocks
Growth stocks
Income stocks
Speculative stocks
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General Classificationsof 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 value—cannot identify trends before they happen
Avoid—encourages moving in and out of market instead of buying and holding.
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The Price/Earnings ApproachP/E ratio or earnings multiple—price per share
divided by the earnings per share
Higher firm’s earnings growth rate, higher P/E ratio
Higher investor’s required rate of return, lower P/E ratio.
Fundamental analysis
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The Discounted DividendsValuation 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 AveragingPurchasing 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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13-28Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Buy-and-Hold StrategyInvolves 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 ReinvestmentPlans (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.
Stuck reinvesting in old company instead of new.
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Risks Associated withCommon Stocks
Risk and return go hand in hand.
Principle 8—can eliminate risk associated with common stock by diversifying.
Only systematic risk remains.
Measure systematic risk using Beta.
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Another look at Principle 7: 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 > 1—stock moves up and down more than market
Beta <1—stock moves up and more less
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13-36Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Risks Associated withCommon 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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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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SummaryA 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.