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Chapter 13 - Stock

• Purchase stock = buy part of company• Returns from dividends and capital

appreciation– Dividends – distribution of profits– Neither dividends nor appreciation guaranteed

• Why invest in stocks?– Over time, outperform other investments,

provide diversification, and are liquid

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Annual Rates of Return1926 to 2000

Avg Ann Stand RiskSecurity Returns Dev PremSmall Co Stocks 17.3% 33.4% 13.4%Common Stock 13.0 20.2 9.1L-T Corp Bonds 6.0 8.7 2.1L-T Govt Bonds 5.7 9.4 1.8Med-term Govt 5.5 5.8 1.6US T-Bills 3.9 3.2 0Inflation 3.2 4.4

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Terminology

• Limited liability – stockholder not liable for firm's debts

• Claim on income (after all expenses paid) but board decides to pay dividends

• Dividends – 75% pay, usually quarterly• Voting rights – shareholders elect directors

and approve changes in governing rules– Vote through proxies

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Proxy Statement

Proxy – gives instructions on how to vote your shares

Annual meeting – elect some directors, appoint auditors; sometimes approve option plans, new shares, merger, etc

Statement – discusses directors, executive comp, stock performance versus index

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Terminology II

Splits – new shares issued on pro rata basis– No economic impact

Share repurchases returns funds to shareholder; accomplishes other objectives

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Stock Indexes

• Measure general market performance– DJIA (30 companies), S&P 500 and others

• Bear market – falling prices; bull market rising prices

• Stock prices now decimalized; previously fractions of a dollar

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Classifications

• Blue-chips

• Growth stocks

• Speculative issues

• Cyclical stocks

• Defensive stocks

• Large caps

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Valuing Stocks

• Technical analysis – supply and demand; charts used to predict trends– Author: Little value, other strong believers

• Price/ earnings ratios– Price / EPS – forward and backward looking– Positive about prospects, have high P/E– Dividend yield – about 1.6%

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Top-Down Analysis

Economic Industry Fundamentals

Economic Analysis

Fiscal & Monetary, Other (inflation, etc)

Industry as a whole: Growing?

Competitive? Technology? Cyclical?

Company Fundamentals - Performance and position in industry, results

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Discounted Dividend Valuation

• Present values all future dividends– Dividends – an infinite stream– Assumed to grow at constant rate forever– Need to estimate future dividends and investors'

required rate

• Market value = Dividend Next Year Required rate less growth rate

• How can you value a non-dividend stock?

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Why Stocks Fluctuate

• Interest rate changes– Inverse relation between rate change and

price change– Rates rise, present value of dividend and

price both fall

• Risk – more risky, price falls

• Outlook for company and economy.

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Common Sense Advice

• Don'ts when stocks tumble:– Don't make impulsive decisions– Don't ignore taxes– Don't listen to pundits– Don't count you losses because they are

meaningless until you sell.

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Strategies

• Dollar cost averaging – buy fixed amount at regular intervals

• Buy and hold – Why?– Can't time the market, minimizes broker fees

• Dividend Reinvestment Plans (DRIP's)– Dividends automatically reinvested in the stock– Taxed on dividend even if get no cash

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Stocks and the 15 Principles

#1. Risk-return tradeoff – stocks on the upper end of the risk/return line

#3 Diversification reduces risk – find investments that don't move together

#4 Not all risk is equal – can reduce company specific risk but not market risk

#11 Time – long horizon, can take more risk. See Figure 13.7