Investing in Stocks

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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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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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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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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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Market Movements

Bear market—characterized by falling prices.

Bull market—characterized by rising prices.

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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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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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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.