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Chapter 13

Chapter 13. Investing in Stocks. 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. Why Consider Stocks?.

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Chapter 13

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  1. Chapter 13 Investing in Stocks

  2. 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.

  3. 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.

  4. 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.

  5. Figure 13.1 Growth of $100 Invested in Different Asset Classes, 1951–2010

  6. The Language of Common Stocks • Limited Liability • Claim on Income • Declaration date • Ex-dividend date • Claim on assets

  7. The Language of Common Stocks • Voting Rights • Proxy • Stock Splits • Stock repurchases

  8. 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

  9. Figure 13.2 The Dow Jones Industrial Average (DJIA) Since 1990

  10. Market Movements • Bear market—characterized by falling prices. • Bull market—characterized by rising prices.

  11. General Classificationsof Common Stock • Blue-Chip stocks • Growth stocks • Income stocks • Speculative stocks

  12. General Classificationsof Common Stock • Cyclical stocks • Defensive stocks • Large caps, mid-caps, and small caps

  13. Valuation of Common Stock • The Technical Analysis Approach • The Price/Earnings Ratio Approach • The Discounted Dividends Valuation Model

  14. 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.

  15. 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.

  16. The Price/Earnings Approach • P/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

  17. 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

  18. Why Stocks Fluctuate in Value • Interest Rates and Stock Valuation • Risk and Stock Valuation • Earnings (and Dividend) Growth and Stock Valuation

  19. 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.

  20. 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.

  21. 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.

  22. 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.

  23. Figure 13.5 The Risk–Return Relationship

  24. Another look at Principle 8: 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

  25. 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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