Chapter 13

Investing in Stocks

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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. Employ different investment strategies.
6. 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:
Dividendsthe companys distribution of profits
to stockholders.
Capital appreciationthe 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 Growth of $100 Invested

in Different Asset Classes, 19512010

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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 The Dow Jones Industrial

Average (DJIA) Since 1990

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Market Movements
Bear marketcharacterized by falling prices.
Bull marketcharacterized by rising prices.

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Figure 13.3 How to Read Online Stock

Quotes

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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 The Average Price/Earnings

Ratio on the S&P 500 Since 1990

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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 Dollar Cost Averaging

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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 The RiskReturn

Relationship

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Another look at Principle 8: 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 A Histogram of Annual

Percentage Returns, 19912010 (20 years)

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Figure 13.6 A Histogram of Annual

Percentage Returns, 19912010 (20 years)
(cont.)

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Figure 13.6 A Histogram of Annual

Percentage Returns, 19912010 (20 years)
(cont.)

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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 increasethey
have more opportunities to adjust saving,
consumption, and work habits.

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Figure 13.7 The Range of Returns on

Common Stocks, 19512010

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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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Checklist 13.1

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Checklist 13.2

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