Personal Finance CH 14
Most brokerage firms have a minimum commission ranging from
$5 to $25 for buying and selling stock. Additional commission charges are based on the number of shares and the value of stock bought and sold.
To make money in a short transaction, you must take these steps:
1. Arrange to borrow a stock certificate for a certain number of shares of a particular stock from a brokerage firm. 2. Sell the borrowed stock, assuming it will drop in value in a reasonably short period of time. 3. Buy the stock at a lower price than the price it sold for in step 2. 4. Use the stock purchased in step 3 to replace the stock borrowed from the brokerage firm in step 1.
Open an Account with a Brokerage Firm
1. Develop investment goals and establish an emergency fund. 2. Choose the type of brokerage account that meets your needs. 3. Save some money. 4. Research different brokerage firms. 5. Do the paperwork.
when evaluating potential investments. For example, consider the following questions:
1. Is an increase in sales revenues a healthy sign for a corporation? (Answer: yes) 2. Should a firm's net income increase or decrease over time? (Answer: increase) 3. Should a corporation's earnings per share increase or decrease over time? (Answer: increase)
total return
A calculation that includes the annual dollar amount of dividends as well as any increase or decrease in the original purchase price of the investment. Total return = Dividends + Capital gain
earnings per share
A corporation's after-tax income divided by the number of outstanding shares of a firm's common stock
dividend
A distribution of money, stock, or other property that a corpora- tion pays to stockholders
investment bank
A financial firm that assists corporations in raising funds, usually by helping to sell new security issues.
proxy
A legal form that lists the issues to be decided at a stockholders' meeting and requests that stockholders transfer their voting rights to some individual or individuals.
account executive
A licensed individual who buys or sells securities for clients; also called a stockbroker.
dollar cost averaging
A long-term technique used by investors who purchase an equal dollar amount of the same stock at equal intervals.
secondary market
A market for existing financial securities that are currently traded among investors.
primary market
A market in which an investor pur- chases financial securities, via an investment bank or other representative, from the issuer of those securities.
securities exchange
A marketplace where member brokers who represent investors meet to buy and sell securities.
beta
A measure that com- pares the volatility associ- ated with a specific stock issue with the volatility of the Standard & Poor's 500 Stock Index.
over-the-counter (OTC) market
A network of dealers who buy and sell the stocks of corporations that are not listed on a securities exchange.
dividend reinvestment plan
A plan that allows current stockholders the option to reinvest or use their cash dividends to purchase stock of the corporation.
direct investment plan
A plan that allows stock- holders to purchase stock directly from a corpora- tion without having to use an account executive or a brokerage firm.
stock split
A procedure in which the shares of stock owned by existing stock- holders are divided into a larger number of shares.
limit order
A request to buy or sell a stock at a specified price or better.
market order
A request to buy or sell a stock at the current market value.
stock market bubble
A situation in which stocks are trading at prices above their actual worth.
ex-dividend
A situation when a stock trades "without dividend," and the seller—not the buyer—is entitled to a declared dividend payment.
margin
A speculative technique whereby an investor borrows part of the money needed to buy a particular stock.
preferred stock
A type of stock that gives the owner the advantage of receiv- ing cash dividends before common stockholders are paid any dividends.
annualized holding period yield
A yield calculation that takes into account the total return, the original investment, and the time the investment is held.
Nasdaq
An electronic marketplace for approxi- mately 3,200 different stocks.
day trader
An individual who buys and then later sells stocks and other securities in a very short period of time.
technical analysis
An investment practice based on the assump- tion that a stock's market value is determined by the forces of supply and demand in the stock mar- ket as a whole.
fundamental analysis
An investment practice based on the assumption that a stock's intrinsic or real value is determined by the company's future earnings.
efficient market hypothesis (EMH)
An investment theory based on the assumption that stock price movements are purely random.
stop-loss order
An order to sell a particular stock at the next available oppor- tunity after its market price reaches a specified amount
EXAMPLE: Dividend Yield
Assume Caterpillar is currently selling for $85 a share and the annual dividend is $2.08 a share. The dividend yield is 2.4 percent, calculated as follows:
EXAMPLE: Price-Earnings (P-E) Ratio
Assume Great Exploration Corporation's common stock is selling for $50 a share. As determined earlier, the corporation's earnings per share are $2.50. Great Exploration's price-earnings ratio is 20, as illustrated below.
EXAMPLE: Earnings Per Share
Assume that in 2012, Great Exploration Corporation has after-tax earnings of $25,000,000. Also assume that Great Exploration has 10,000,000 shares of common stock. This means Great Exploration earnings per share are $2.50, as illustrated below.
EXAMPLE: Beta Calculation (Google)
Assume that the overall stock market increases by 10 percent and that Google has a beta of 1.20. Based on the calculation below, Google is 20 percent more volatile than the stock market and will increase 12 percent when the market increases 10 percent.
EXAMPLE: Annualized Holding Period Yield
Assume that two years ago you invested $7,800 to purchase 100 shares of Caterpillar stock and that your total return when you sold your stock was $1,068. The annualized holding period yield is 6.8 percent for each of the two years you held the investment, as illustrated below:
EXAMPLE: Total Return
Assume that you own 100 shares of Caterpillar stock that you purchased for $78 a share and that you hold your stock for two years before deciding to sell it at the current market price of $85 a share. Also, assume that during the two- year period, Caterpillar paid total dividends of $3.68. Your total return for this investment would be $1,068 calculated as follows:
EXAMPLE: Dividend Payout
Assume you own stock issued by Caterpillar Corporation, and the construction equipment manufacturer pays an annual dividend of $2.08. Also, assume that Caterpillar earns $8.48 a share. The dividend payout is 25 percent, calculated as follows:
Full service
Beginning investors with little or no experience.Individuals who are uncomfortable making investment decisions.
When evaluating a stock investment, stockbrokers, financial planners, and inves- tors often classify stocks into different categories
Blue chip A safe investment that generally attracts conservative investors. Cyclical A stock that follows the business cycle of advances and declines in the economy. Defensive A stock that provides consistent dividends and stable earn- ings during declines in the economy. Growth A stock issued by a corporation that has the potential of earning profits above the average profits of all firms in the economy. Income An investment that pays higher-than-average dividends. Large cap A stock issued by a corporation that has a large market capitalization, in excess of $10 billion. Midcap A stock issued by a corporation that has market capitaliza- tion of between $2 and $10 billion. Small cap A stock issued by a company that has a market capitaliza- tion of between $300 million and $2 billion. Micro cap A stock issued by a company that has a market capitaliza- tion of $300 million or less. Penny stock A penny stock is often defined as a stock that sells for $1 or less per share (or in some cases, less than $5 per share).
specialist
Buys or sells a particular stock in an effort to maintain an orderly market.
book value
Determined by deducting all liabilities from the corporation's assets and dividing the remainder by the number of outstanding shares of common stock.
EXAMPLE: Book Value
If First National Corporation has assets of $60 million and liabilities of $30 million and has issued 1,000,000 shares of common stock, the book value for one share of First National stock is $30, as follows:
EXAMPLE: Margin Transaction
If the price of Microsoft's stock increases by $4 a share, your profit will be
equity financing
Money received from the sale of shares of ownership in a business.
initial public offering (IPO)
Occurs when a corporation sells stock to the general public for the first time.
Online
People who understand the "how to" of research- ing stocks and prefer to make their own decisions. Individuals who are comfortable trading stocks online.
Discount
People who understand the "how to" of research- ing stocks and prefer to make their own decisions. Individuals who are uncomfortable trading stocks online.
selling short
Selling stock that has been borrowed from a brokerage firm and must be replaced at a later date.
dividend yield
The annual dividend amount gener- ated by an investment divided by the investment's current price per share.
market-to-book ratio
The current market value of one share of stock divided by the book value for one share of stock.
record date
The date on which a stockholder must be registered on the corporation's books in order to receive dividend payments.
common stock
The most basic form of ownership for a corporation.
dividend payout
The per- centage of a firm's earn- ings paid to stockholders in cash.
price-earnings ratio
The price of a share of stock divided by the corpora- tion's earnings per share of stock.
option
The right to buy or sell a stock at a prede- termined price during a specified period of time.
EXAMPLE: Market-to-Book Ratio
Using First National's $30 per share book value and assuming the stock has a current market price of $36 a share, the market-to-book ratio would be 1.20 as follows:
EXAMPLE: Selling Short
Your profit from the J. C. Penney short transaction was $500 because the price declined from $17 to $12. Note: For illustration purposes, no commission was included in the above example. In reality, the profits for this transaction would be reduced by the commissions to buy and sell the stock.
A call option
is sold by a stockholder and gives the purchaser the right to buy 100 shares of a stock at a guaranteed price before a specified expiration date.
A put option is the right
to sell 100 shares of a stock at a guaranteed price before a specified expiration date. With a put option, the purchaser is betting that the stock will decrease in value before the expiration date. With both call and put options, the price movement must occur before the expiration date, or you lose the money you paid for your option.
Regardless of whether you choose a long-term or short-term method, the following suggestions can be used to reduce anxiety when you make stock investment decisions:
• Evaluate each investment. Too often, investors purchase or sell a stock without doing their homework. A much better approach is to become an expert and learn all that you can about the company (and its stock). • Analyze the firm's finances. Look at the company's financial information, which is available in the firm's annual report or on many investment websites. Examine trends for sales, profits, dividends, and other important financial information. More specific information on how to evaluate a firm's finances is provided later in the chapter. • Track the firm's product line. If the firm's products become obsolete and the com- pany fails to introduce new products, its sales—and ultimately, profits—may take a nosedive. • Monitor economic developments. An economic recovery or an economic reces- sion may cause the value of a stock investment to increase or decrease. Also, watch the unemployment rate, inflation rate, interest rates, and similar economic indicators. • Be patient. The secret of success for making money with stocks is often time. If you choose quality stocks based on quality research and in some cases hold on to the stocks before selling, eventually your stock investments will provide average or even above-average returns. And remember: There are no guarantees. Increased returns are always accompanied by increased risk when investing in stocks.
THE PSYCHOLOGY OF STOCK INVESTING
• Since 1926, stocks, as measured by the Standard & Poor's 500 Stock Index, have averaged an annual return of 9.8 percent. • Since 1926, stocks had positive gains in 63 years • Since 1926, stocks lost money in 25 years
