Chapter 14

Chapter 14
Investing in Stocks
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Chapter 14
Learning Objectives
LO14-1 Identify the most important features of common
and preferred stocks.
LO14-2 Explain how you can evaluate stock investments.
LO14-3 Analyze the numerical measures that cause a stock
to increase or decrease in value.
LO14-4 Describe how stocks are bought and sold.
LO14-5 Explain the trading techniques used by long-term
investors and short-term speculators.
14-2
Common and Preferred Stocks
LO14-1:
Identify the most important features of common and
preferred stocks.
• Gather information and use common sense to evaluate a

potential investment in a stock.
• Learn what the information you gather means.
– Are sales revenues increasing?
– Is net income increasing over time?
– Are earnings per share increasing over time?
14-3
Why Corporations Issue Common
Stock (1 of 2)
• To finance their business start-up costs and help pay
for expansion and their ongoing business activities.
• A Form of Equity
- They don’t have to repay the money a
stockholder pays for stock and the company does
not have to buy back shares from stockholders.
- The stockholder may sell a share of stock to
another investor.
14-4
Why Corporations Issue
Common Stock (2 of 2)
• Dividends Not Mandatory
- Dividends are paid out of profits, and dividend
payments must be approved by the board of directors.
- Most corporations distribute 30-70% of their earnings
to stockholders.
• Voting Rights and Control of the Company
- In return for investing in the company, stockholders
have voting rights.
- Common stockholders elect board of directors and must
approve major policy changes.
14-5
Why Investors Purchase
Common Stock
• Investors want the larger returns that stocks offer, even though
they are aware of the potential for losses.
• How do you make money by buying common stock?
- Income from dividends in the form of cash, additional
stock, or company products
- Dollar appreciation of stock value
- Possible increased value from Stock Splits
• A stock split happens when the shares owned by
existing stockholders are divided into a larger number
of shares.
14-6
Preferred Stock (1 of 2)
• Investors in preferred stocks receive cash dividends
before common stockholders are paid any cash
dividends.
• A “middle” investment between common stock
(ownership position for the stockholder) and corporate
bonds (lender position for the bondholder).
• The dollar amount of the dividend is known before the
stock is purchased.
14-7
Preferred Stock (2 of 2)
• Preferred stock dividends are less secure than interest on
corporate bonds.
• Compared to common stocks, preferred stocks are safer
investments that offer more secure dividends.
• More predictable source of income than with common
stock investments.
14-8
Evaluating a Stock Issue
LO14-2:
Explain how you can evaluate stock investments.
• CLASSIFICATION OF STOCK INVESTMENTS
Blue chip (***) Large cap

Cyclical Midcap
Defensive Small cap
Growth (famous) Micro cap
Income Penny stock
14-9
The Internet
• Most corporations have a website.

- The information is often useful and easily
accessible.
- More up-to-date and thorough information than the
printed material.
• Websites like Yahoo! and other search engines can also
be used to obtain information about stock investments.
14-10
Stock Advisory Services
• Provide both printed and online materials to evaluate
potential stock investments.
• Charge a fee
• Hundreds to choose from:
- Standard and Poor’s
- Value Line
- Morningstar
• As an investor, your job is to interpret the information
provided and decide whether the company’s stock is a
good investment.
14-11
Newspaper Coverage and Corporate
News (1 of 2)
• Stock quotes are still available in some metropolitan
newspapers and The Wall Street Journal.
• Basic information is provided:
- Name of company
- Stock symbol
- Price information
14-12
Newspaper Coverage and Corporate
News (2 of 2)
• The Federal government requires corporations selling
new issues of securities to disclose information to the
public in a prospectus.
• Information must be periodically reported to the SEC.
This information can be viewed at their website (SEC).
• Use an annual report to:
- Learn about the company and management.
- Learn about goals and past performance.
14-13
Numerical Measures that Influence
Investment Decisions
LO14-3:
Analyze the numerical measures that cause a stock to
increase or decrease in value.
• WHY CORPORATE EARNINGS ARE IMPORTANT
– Corporate earnings play a large part in the increase or
decrease in the price of a stock.
– Earnings per share (EPS) are the corporation’s after-tax
income divided by the number of outstanding shares of
common stock. An increase in earnings is generally a
healthy sign.
– Price-earnings (P-E) ratio is the price per share divided by
the earnings per share.
14-14
Earnings per Share
• Example: Home Depot
Assume that in a recent year, Home Depot has after-tax
earnings of $6,345 million. Also assume that Home Depot
has issued 1,346 million shares of common stock. This
means Home Depot’s earnings per share are $4.71, as
illustrated below.
EPS = After-tax income /

Number of shares outstanding
= $6,345 million / 1,346 million
= $4.71
14-15
Dividend Calculations
• Dividend payout = Annual dividend amount

Earnings per share
• Dividend yield = Annual dividend amount

Price per share
14-16
Total Return Calculations
• Total return = Dividends + Capital gain
• Annualized holding period yield =

Total return × 1
Original investment N
(N = Number of years investment is held)
14-17
Beta and Book Value Calculations
• Beta
– Compares volatility associated with a specific stock
with the volatility of an index, such as the S&P 500
Stock Index.
Volatility for a stock =
Increase in overall market × Beta for a specific stock
• Book value per share

Assets – Liabilities
Shares Outstanding
14-18
Market-to-Book Calculation
• Market-to-Book Ratio
Market value per share
Book value per share
– A low market-to-book ratio may indicate an
undervalued stock.
– A high market-to-book ratio may indicate an
overvalued stock.
14-19
Investment Theories (1 of 3)
• Fundamental Analysis
– Based on the assumption that a stock’s intrinsic or
real value is determined by the company’s future
earnings.
– Fundamentalists consider the…
• Expected earnings
• Financial strength of the company
• Type of industry company is in
• New product development
• Economic growth of the overall economy
14-20
• Technical Analysis
– Based on the assumption that a stock’s market value is
determined by the forces of supply and demand in the stock
market as a whole.
– Not based on expected earnings or the intrinsic value of a
stock but rather on the assumption that past market trends
can predict the future direction for the market as a whole.
– Chartists plot past price movements and other market
averages to observe trends they use to predict a stock’s
future value.
14-21
• Efficient Market Hypothesis

– Based on the assumption that stock price movements
are purely random.
– A stock’s current market price reflects its true value.
– It is impossible for an investor to outperform the
average for the stock market as a whole over a long
period of time unless they pick riskier investments.
14-22
Buying and Selling Stocks
LO14-4:
Describe how stocks are bought and sold.
• PRIMARY MARKET
– A market in which an investor purchases financial securities
through an investment bank, or other representative, from
the issuer of those securities.
– An investment bank is a financial firm that assists
corporations in raising funds, usually by helping to sell new
security issues.
– An IPO (initial public offering) occurs when a corporation
sells stock to the general public for the first time.
14-23
Secondary Markets for Stocks (1 of 2)
• SECONDARY MARKET
– A market for existing financial securities that are currently
traded among investors through brokers.
• SECURITIES EXCHANGES
– A marketplace where member brokers who represent
investors meet to buy and sell securities.
– The securities sold at an exchange must first be listed, or
accepted for trading, at the exchange.
– New York Stock Exchange, Regional Exchanges, or Foreign
Security Exchanges
• A specialist buys or sells a particular stock in an effort to
maintain an orderly market.
14-24
Secondary Markets for Stocks (2 of 2)
• THE OVER-THE-COUNTER MARKET

– Network of dealers who buy and sell the stocks of
corporations not listed on a securities exchange.
– Most OTC securities are traded over the Nasdaq
which is an electronic marketplace.
14-25
Account Executives
• An account executive, or stockbroker, is a licensed
individual who buys or sells securities for his or her
clients.
• Even though an account executive should help you
develop your investment program, you as the investor
should be actively involved in the investment decisions.
• Generally, account executives are not liable for client
losses that result from their recommendations.
14-26
Brokerage Firms (1 of 2)
• Full-Service, Discount, or Online Brokerage Firm
- Can you buy or sell stocks online or over the phone?
- How easy is it to use the firm’s website and what
services are available online?
- Where is the nearest office located?
- Does the firm have a toll-free phone number?
- Is there a charge for statements, research reports, and
other financial reports?
- What are the fees, charges, and commissions?
14-27
Brokerage Firms (2 of 2)
14-28
Commission Charges
• Most brokerage firms have a minimum commission

ranging from $5 to $25 for buying and selling stock.
• Generally, full-service brokerage firms charge higher
commissions than those charged by discount and online
brokerage firms.
• Many brokerage firms—especially online firms—will
offer a specific number of free trades to attract new
customers.
14-29
Completing Stock Transactions
• Market order: Request to buy or sell stock at the

current market value
• Limit order: Request to buy or sell a stock at a specified
price or better
• Stop-loss order (stop order): Request to sell a stock at
the next available opportunity after its market price
reaches a specified amount
14-30
Long-Term Investment Strategies
LO14-5:
Explain the trading techniques used by long-term
investors and short-term speculators.
• LONG-TERM TECHNIQUES
– Buy-and-Hold
– Dollar Cost Averaging
– Direct Investment and Dividend Reinvestment Plans
14-31
Short-Term Investment Strategies
• SHORT-TERM TECHNIQUES
– Day Trading
– Buying Stock on Margin (borrowing money)
– Selling Short (borrowing stock)
– Trading in Options (predetermined price)
14-32

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Chapter 14

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Chapter 14

• Gather information and use common sense to evaluate a

• CLASSIFICATION OF STOCK INVESTMENTS

Blue chip (***) Large cap

• Most corporations have a website.

EPS = After-tax income /

• Dividend payout = Annual dividend amount

• Dividend yield = Annual dividend amount

• Total return = Dividends + Capital gain

• Annualized holding period yield =

(N = Number of years investment is held)

• Book value per share

• Efficient Market Hypothesis

• THE OVER-THE-COUNTER MARKET

• Most brokerage firms have a minimum commission

• Market order: Request to buy or sell stock at the

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