Investing in Stocks. Consider THIS

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1 Chapter12 Ivestig i Stocks 12.1 Evaluatig Stocks 12.2 Buyig ad Sellig Stock Cosider THIS Jo worked durig the summer ad maaged to save $500 to ivest. He decided he wated to buy some stock ad see if he could double his moey i the ext year or two. I ve bee doig research about a medical research compay, ad I thik it s o the verge of somethig big, he said to a discout broker he met through his father. I ve bee readig about this compay ad I thik the stock price is low ow because the compay is t payig divideds. Istead, they are usig compay profits to develop ew products. Some of those products are o the cuttig edge of research. All the iformatio I ve gathered suggests that the compay is solid, growig, ad will be a leader i its idustry. I thik this compay s stock is worth the risk. Please buy me as may shares as my moey will purchase. Chapter 12 Ivestig i Stocks 261 Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

2 12.1 Evaluatig Stocks GOALS Describe features of stock ad types of stocks. Explai how to value a stock ad decide a fair price to pay for a stock purchase. TERMS stockholders, p. 262 divideds, p. 262 commo stock, p. 262 proxy, p. 263 preferred stock, p. 263 icome stocks, p. 263 growth stocks, p. 263 blue chip stocks, p. 264 par value, p. 265 market value, p. 265 OWNING STOCK Nearly 50 millio people i the Uited States ow stocks. There are more tha 34,000 public corporatios from which to choose. A public corporatio is a compay whose stock is traded opely o stock markets. People who ow shares of stock are called stockholders, or shareholders, of the corporatio. If the corporatio does well, stockholders will profit i two ways. Oe is through divideds. Divideds are moey paid to stockholders from the corporatio s earigs (profits). The other way stockholders profit is through capital gais. This is a icrease i the value of the stock over time. For example, if you bought stock for $5 per share ad the corporatio thrived, its stock price might go up to $10 per share. If it did, you could sell it for a substatial profit. Part of the risk i owig stock, however, is that the price could also go dow below the price iitially paid for it, resultig i a capital loss. Also, a capital gai becomes profit oly whe you sell the stock. Util the, it is a profit oly o paper. Stockholders ca also lose all of their ivestmet if the compay fails or goes out of busiess. However, oe advatage to owig stock is that stockholders ca lose o more tha their ivestmet i the stock. The ower of a small busiess, o the other had, ca also lose persoal assets if the busiess fails. Stocks are traded i roud lots or odd lots. A roud lot is 100 shares or multiples of 100 shares of a particular stock. A odd lot is fewer tha 100 shares of a particular stock. Brokerage firms usually charge higher pershare fees for tradig i odd lots. Odd lots are usually combied ito roud lots before they are traded. COMMON STOCK Commo stock represets a type of stock that pays a variable divided ad gives the holder votig rights. The board of directors, which guides the corporatio ad decides the amout of divideds to pay each year, is elected by the commo stockholders. Commo stockholders vote o major policy decisios, 262 Uit 3 Fiacial Security Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

3 such as whether to issue additioal stock, sell the compay, or chage the board of directors. Each share of commo stock has the same votig power, so the more shares a stockholder ows, the greater the power to ifluece corporate policy. Commo stockholders may vote i perso at the stockholders meetig or by proxy.a proxy is a stockholder s writte authorizatio to trasfer his or her votig rights to someoe else, usually a compay maager. Most commo stockholders vote by proxy rather tha by attedig the aual meetigs. PREFERRED STOCK Preferred stock represets a type of stock that pays a fixed divided but has o votig rights. Preferred stockholders ear the stated divided, regardless of how the compay is doig. Thus, preferred stock is less risky tha commo stock. I the evet the compay fails, the preferred stockholders would be paid ahead of commo stockholders. As with most ivestmets, however, the tradeoff for less risk is lower retur. Divideds o preferred stock may be lower tha commo stockholders would ear, if the compay is thrivig over time. TYPES OF STOCK INVESTMENTS Whe evaluatig stock ivestmets, ivestors ofte classify stocks ito differet categories. Categories of stocks iclude icome, growth, emergig, blue chip, defesive, ad cyclical. Some stocks may fall ito more tha oe category. Which category is best for you will deped o how much risk you are willig to assume for a chace to ear larger returs o your ivestmets. Also, most ivestors buy stocks i several of these categories to diversify their risk. Icome Stocks Corporatios ca use their profits i two ways. They ca distribute the profits to stockholders as divideds, or they ca reivest the profits i the busiess to help it grow. Stocks that have a cosistet history of payig high divideds are kow as icome stocks. Ivestors choose icome stocks i order to receive curret icome i the form of divideds. Preferred icome stocks pay the most certai ad predictable divideds ad are ofte the choice of retired people ad others eedig regular ad depedable sources of icome. Growth Stocks Growth stocks are stocks i corporatios that reivest their profits ito the busiess so that it ca grow. These corporatios may pay little or o divideds. Istead of curret icome, ivestors buy growth stocks for future capital gais. If the reivested profits do make the busiess grow, the stock will be worth substatially more i the future, whe the ivestor is ready to sell it. As a result, growth stocks are log-term ivestmets. They are ofte selected by youger Photodisc/Getty Images Why is owig stock risky? Chapter 12 Ivestig i Stocks 263 Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

4 May differet types of stocks are available, but ot all stocks are right for every ivestor. Access ad click o the lik for Chapter 12. Read about the differet kids of stocks o the Prudetial web site, ad the aswer these questios: What kid of stock would be a good choice durig a recessio? What would be a poor choice? If you wated to receive a icome i divideds, would a growth stock be a good choice? If you have little moey to ivest, should you avoid pey stocks? Why or why ot? people who have more time to let ivestmets grow. If the value of the stock icreases, stockholders must decide whether to sell it at the higher price ow or to cotiue to hold it, hopig that it will go up eve more. Whe stockholders decide to sell, the differece betwee their origial purchase price ad the sellig price they receive is their capital gai. Emergig Stocks Stocks i youg, ofte small corporatios that have higher overall risk tha stocks of compaies that have bee successful for may years are called emergig stocks. These youg compaies may be o their way to becomig highly profitable. Or, they may be amog the may small compaies that fail every year. Because the future of these compaies is so ucertai, their stocks are ofte iexpesive but risky Uit 3 Fiacial Security Blue Chip Stocks Blue chip stocks are stocks of large, well-established corporatios with a solid record of profitability. Most people have heard of these compaies because their products ad services have bee aroud for decades. They are compaies like IBM ad Coca-Cola. Blue chip stocks are a coservative ivestmet. Ivestors choose them for relatively safe, stable, but moderate returs. Defesive Stocks A defesive stock, oro-cyclical stock, is oe that remais stable ad pays divideds durig a ecoomic declie. Geerally, compaies i this category have a history of stable earigs. A defesive stock is ot affected as much by the ups ad dows of busiess cycles. Examples iclude utilities, pharmaceuticals, food, ad health care stocks. I other words, the demad for these products remais fairly cosistet regardless of ecoomic coditios. Therefore, stocks i these idustries protect the ivestor from sharp losses durig bad ecoomic times. Cyclical Stocks Cyclical stocks do well whe the ecoomy is stable or growig but ofte do poorly durig recessios, whe the ecoomy slows dow. Examples of cyclical stocks are travel-related compaies such as airlies ad resorts, maufacturig compaies such as auto makers, ad housig/costructio compaies. For example, durig a recessio, may people lose their jobs or ear less tha they would durig good ecoomic times. As a result, people have less moey for luxuries, such as leisure travel, causig reduced profits for travel-related compaies. I respose to this poor profit performace, the value of the stocks i these compaies will likely declie. Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

5 VALUING STOCK Whe you buy stock, you expect to hold it for a period of time ad the sell it, hopefully for a profit. Whether or ot you make a profit depeds o how much someoe else is willig to pay for it whe you are ready to sell. Whe you purchase stock, you may receive a stock certificate or have it held electroically. The certificate states the umber of shares you ow, the ame of the compay, the type of stock (commo or preferred), ad the par value. The par value is a assiged dollar value give to each share of stock. For commo stock, par value is ofte meaigless. Commo stock ca be issued without a par value (o-par value stock). However, for preferred stock, par value is used to calculate divided paymets. Par value has othig to do with a stock s market value, which is the price for which the stock is bought ad sold i the marketplace. The market value of a stock reflects the price ivestors are willig to pay for the stock. How a compay curretly is performig, its track record, ad how well it is expected to perform i the future determie market value. Some stocks perform very well, yet their market value seems too low or a real bargai. These udervalued stocks are worth more tha the price for which they are sellig. Stocks that are udervalued make good bargais for ivestors, while creatig a dagerous situatio for busiesses by leavig them vulerable to a takeover by a large ivestor or compay. Takeovers may be ufavorable for employees but ca be very favorable for stockholders, because the market value of the stock is likely to rise. O the other had, stocks ca be overvalued, which meas they are sellig at a price that is perceived to be too high. The price of the stock is ot justified by its earigs but is based o its superior growth potetial i the future. This situatio is very risky for the ivestor, because it is likely that the price of the stock will drop. The wider the price swigs, the riskier the stock. STOCK PRICE Several factors affect the price you will pay for a share of stock. These factors iclude the compay s fiacial situatio, curret iterest rates, the market for the compay s products or services, ad earigs per share. The Compay. Whe a compay is performig well (payig its curret debts ad earig a profit), the compay s stock is attractive. Ivestors cosider the compay s earig power (its ability to cotiue to make a strog profit), as well as its debt (how much the compay owes). If the compay seems to be i a good fiacial positio, the stock price will cotiue risig. Iterest Rates. Whe iterest rates are low, people who would ormally put moey i savigs accouts ad CDs look for more profitable places to ivest their moey. As iterest rates rise, however, people ted to move their moey to the safer ivestmets. Geerally, whe iterest rates fall below the curret rate of iflatio, people buy more stock, ad stock prices rise. The Market. The marketplace determies a compay s ability to sell its product or service ow ad i the future. If the compay is i a popular idustry ad its products or services are sellig well, its stock price will rise. For example, whe people are buyig computers, software, ad related items, compaies i the high-tech idustry are cosidered wise ivestmets. Chapter 12 Ivestig i Stocks 265 Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

6 If the demad for a particular product or service declies, the price of the stock will declie. Earigs per Share. Earigs per share are a corporatio s after-tax earigs divided by the umber of commo stock shares outstadig, that is, shares i the hads of ivestors. For example, assume that i a give year, XYZ Corporatio had after-tax earigs (et profit) of $1,000,000. It had 100,000 shares of commo stock outstadig. Therefore, its earigs per share at that time were $10 ($1,000,000/100,000). Stockholders use earigs per share as a measure of a compay s profitability. RETURN ON INVESTMENT Because you ca make moey o stocks from divideds ad from a icrease i the price of the stock (capital gai), you should cosider both whe computig the retur o your ivestmet. Figure 12.1 shows the formula for computig a stock s retur o ivestmet (ROI). Your profit is the differece betwee what you paid for the stock ad what you sold it for, plus ay divideds you eared. To compute the total costs, add ay commissio you paid to the stockbroker to the purchase price of the stock. STOCK INDEXES A stock idex is a bechmark that ivestors use to judge the performace of their ivestmets. Oe widely followed stock idex is the Dow Joes Idustrial Average. Ofte called simply the Dow, itisaaverageoftheprice movemets of 30 major stocks listed o the New York Stock Exchage. This average provides a geeral overview of how stock prices are doig i the stock market as a whole. Ivestors compare the price fluctuatios of their stocks agaist this average to judge how well their stocks are performig compared to the overall stock market. Idexes for judgig the performace of all kids of stocks are available olie ad i prit publicatios. Other commoly used idexes are the Stadard & Poor s 500 ad the NASDAQ Composite Idex. FIGURE 12.1 Computig Retur o Ivestmet Computig a Stock s Oe-Year ROI Curret Profit o Stock Retur o Ivestmet (ROI) Purchase Price Commissio Example: Sellig price (or curret stock price): $40/share Divideds received durig the year: $1/share Purchase price: $38/share Discout brokerage fee: $19 Number of shares owed: 100 Computatios: Curret profit: $40/share $38/share $2/share 100 $200 $100 divideds total profits of $300 $300 (100 $38) $19 $300 $3, % 266 Uit 3 Fiacial Security Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

7 Plaig a Career i... Educatio Probably the umber oe career for ispirig others is teachig. As a teacher, oe has the opportuity to touch, ifluece, ad chage more lives durig his or her career tha ay other type of job. Educatio careers occur at may levels, icludig pre-school, elemetary, secodary (middle ad high school), ad post-secodary (commuity college, juior college, ad four-year uiversity). Private idustry also has educators. They do corporate traiig ad help workers lear ew skills ad prepare them for higher positios withi the compay. Corporate educators have similar skills to those workig at colleges ad uiversities; they impart kowledge ad help studets reach their full potetial. Employmet Outlook l A average rate of employmet growth is expected. Job Titles l l l Teacher Professor Corporate traier Needed Skills l l l Bachelor s degree i subject matter; master s degree i educatio (teachig). Licesure i all 50 states for public educatio careers. Specialized kowledge ad skills for private idustry educators ad traiers. What's it like to work i... Educatio Mike uses his teachig skills to help prepare workers at a large ivestmet portfolio corporatio. With his degree i educatio, he uderstads adult learig strategies. He also has worked for several years i the idustry, so he has a good uderstadig of cliets eeds. Mike s compay is icorporatig a ew ivestmet plaig strategy to help cliets reach their ivestmet objectives. He has plaed a two-hour traiig sessio for the compay s fiacial advisers. He will use a combiatio of prit materials ad visual aids durig his presetatio to accommodate all learig styles. Mike has also prepared several learig tools, icludig a chart that lists a variety of ivestmet objectives ad the correlatig ew stock optios available to cliets. These tools are desiged to help advisers implemet the ew strategy more quickly ad efficietly. After the traiig sessio, Mike will coduct follow-up sessios with advisers to aswer questios ad address problems. He will coduct the traiig program for a ew group of workers every six moths. What About You? Do you ejoy traiig others to help them improve their performace? Would you like a job as a corporate traier? Chapter 12 Ivestig i Stocks 267 Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

8 12.1 Assessmet KEY TERMS REVIEW Match the terms with defiitios. Some terms may ot be used. 1. A class of stock that pays a fixed divided but has o votig rights 2. Price for which stock is bought ad sold i the marketplace 3. A assiged dollar value to each share of stock 4. A type of stock that has a history of payig high divideds 5. Moey paid to stockholders from earigs of a corporatio 6. A writte authorizatio to vote for a stockholder 7. Those who ow shares of stock 8. Stocks of large, well-established compaies a. blue chip stock b. commo stock c. divideds d. growth stock e. icome stock f. market value g. par value h. preferred stock i. proxy j. stockholders CHECK YOUR UNDERSTANDING 9. I what two ways ca you make moey from owig stock? 10. How is a icome stock differet from a growth stock? 11. Why do stockholders wat to kow a corporatio s earigs per share? APPLY YOUR KNOWLEDGE 12. Ivestig i blue chip stocks is said to be a coservative choice. Ca you list several well-kow stocks that are cosidered blue chip, besides the two metioed i the text? (Hit: Read through the listig of stocks i the fiacial pages or olie ad mark the stocks you recogize.) THINK CRITICALLY 13. If you had some moey to ivest, what stock would you choose? Why? Explai how you would make your stock choice(s). I other words, what criteria would you use to evaluate a potetial stock purchase? 14. Why should youg people (just startig their log-term ivestmet strategy) ivest i growth stocks rather tha icome stocks? Explai how these two types of stock are differet ad what that meas to you, as a youg perso. 268 Uit 3 Fiacial Security Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

9 12.2 Buyig ad Sellig Stock GOALS Describe the process of buyig ad sellig stocks. Describe short- ad log-term ivestmet strategies whe buyig ad sellig stocks. Explai how to read the stock listigs ad stock idexes. TERMS securities exchage, p. 269 bull market, p. 270 bear market, p. 270 leverage, p. 271 short sellig, p. 272 stock split, p. 273 direct ivestmet, p. 274 divided reivestmet, p. 274 THE SECURITIES MARKET The securities market cosists of the chaels through which you buy ad sell securities (stocks ad bods). To purchase commo or preferred stock, you eed a tradig aget. Your aget will buy or sell for you i a securities marketplace, which is either a securities exchage or the over-the-couter market. SECURITIES EXCHANGES A securities exchage is a marketplace where brokers who are represetig ivestors meet to buy ad sell securities. The largest orgaized exchage i the Uited States is the New York Stock Exchage (NYSE). The smaller America Stock Exchage (AMEX) is also i New York City. Regioal exchages are located throughout the coutry. To have a stock listed with the NYSE or AMEX, a compay must meet a miimum umber of public shares ad dollar market-value requiremets. I the NYSE buildig, the tradig floor (where stocks are bought ad sold) is about two-thirds the size of a football field. Aroud the edge of the tradig floor are booths with computer termials ad room iside for a doze or more floor brokers. Floor brokers buy ad sell stocks o the exchage. Oly brokers who are members of the exchage may do busiess there. Spaced at regular itervals aroud the tradig floor are tradig posts, which are horseshoeshaped couters, each occupyig about 100 square feet o the floor. Behid each couter are specialists the brokers to the Photodisc/Getty Images What does a floor broker do? Chapter 12 Ivestig i Stocks 269 Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

10 floor brokers. All buyig ad sellig is doe aroud tradig posts. About 90 differet stocks are assiged to each post. Post display uits above each couter show which stocks are sold i each sectio, the last price of that stock, ad whether that price represets a icrease or a decrease from the previous price. Orders received at a brokerage firm or discout brokerage are phoed or set by computer to that firm s booth at the exchage. A message is prited out ad is give to the floor broker to carry out. Whe the trasactio is completed, the brokers who bought ad sold the stock report back to their respective brokerage firms. The buyer ad seller ca the be advised that the trasactio has bee cocluded. The exchage is a form of auctio market where buyers ad sellers are brought together to trade securities. Stock tradig happes auctio-style because i every trasactio, stock is sold to the highest bidder (buyer) ad bought from the lowest offeror (seller). Securities listed with the NYSE are traded oly durig official tradig hours 9:30 a.m. to 4 p.m. New York time, Moday through Friday (except holidays). OVER-THE-COUNTER MARKET Whe securities are bought ad sold through brokers but ot through a stock exchage, the trasactio is over-the-couter (OTC). The OTC market is a etwork of brokers who buy ad sell the securities of corporatios that are ot listed o a securities exchage. Brokers i the OTC market do ot deal face-to-face with other brokers. Their marketplace is as large as the umber of brokers at work that day. Trades with other brokers are completed by telephoe, ad a computerized system displays curret price quotatios o a termial i a broker s office. Brokers operatig i the OTC market use a electroic quotatio system called NASDAQ. (The letters were origially a acroym for the Natioal Associatio of Securities Dealers Automated Quotatio System.) With early 3,200 compaies listed, NASDAQ has more tradig volume i a day tha ay other stock exchage i the world. BULL AND BEAR MARKET CONDITIONS The stock market goes through cycles. For a period of time, stocks go up i value. The the market corrects itself as people sell (to make a profit) ad stock prices decrease. A bull market is a prologed period of risig stock prices ad a geeral feelig of ivestor optimism. Cofidece i the coutry s ecoomy also serves to drive up stock prices. A bear market is a prologed period of fallig stock prices ad a geeral feelig of ivestor pessimism. It develops whe ivestors become egative about the overall ecoomy ad start to sell stocks. I bear markets, stock prices may fall 20 percet or more. Bear markets are usually short ad savage. The average bull market ofte lasts three to four times as log as a bear market. Whether the stock market i geeral is bullish (o a upward tred i prices) or bearish (o a dowward tred i prices) iflueces your decisios about whe to buy stocks ad which stocks to buy. To make a profit, you eed to buy stock whe the price is low ad sell whe the price is high. However, obody kows, icludig brokers, whe a stock is at its lowest price or whether or ot the price will rise. 270 Uit 3 Fiacial Security Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

11 INVESTING STRATEGIES You ca approach ivestig with either a short- or log-term strategy. Geerally, if you buy ad sell stock withi a short period of time, you are a speculator or day trader. If you hold your ivestmet for a log period of time (a year or more), you are a ivestor. SHORT-TERM TECHNIQUES Whe you buy ad sell stocks for quick profits, you are playig the stock market. The goal is to buy a stock that will soo icrease i value. The, whe the price rises, you sell the stock. May ivestors make short-term gais through processes called buyig o margi ad sellig short. Buy o Margi You ca borrow moey from your broker to buy stock if you ope a margi accout ad sig a cotract called a margi agreemet. To establish a margi accout, you must deposit a miimum of $2,000 i cash or eligible securities (securities your broker cosiders valuable collateral) with a broker. Let s assume you have $2,000 i your margi accout. You wat to buy 100 shares of XYZ Corporatio at $20 per share ($2,000). You could use $1,000 from your margi accout ad borrow $1,000, with iterest, from your broker. This strategy is called leverage the use of borrowed moey to buy securities. You use less of your ow moey ad therefore ca buy more stocks with less cash. You would still have $1,000 i your margi accout to use toward aother purchase o margi. With a margi purchase, you are bettig that the stock will icrease i value. If it does, you sell the stock, repay the loa with iterest ad commissio, ad take your short-term profit. Figure 12.2 shows how margi buyig works. FIGURE 12.2 Buyig o Margi Buyig o Margi Example: You buy $2,000 worth of stock with $1,000 of your ow moey ad $1,000 borrowed from your broker at 6% aual iterest. The stock icreases i value, ad you sell it after 60 days for $2,800. Your broker s commissio to buy ad sell is $200. Computig Profit: 60 days Iterest cost: $1,000 borrowed.06 aual iterest 360 days i a year $10 iterest o the 60-day loa Costs: $1,000 from margi accout $1,000 borrowed $10 iterest $200 commissio $2,210 total cost Profit: $2,800 sellig price $2,210 cost $590 total profit Computig Retur o Ivestmet: $590 profit $2,210 cost 26.7% ROI Chapter 12 Ivestig i Stocks 271 Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

12 Ufortuately, if the value of the stock does ot icrease, you will have to make up the differece. Whe the market value of a margied stock decreases to approximately oe-half of the origial purchase price, the ivestor will receive a margi call from the broker. This meas the ivestor must pledge additioal cash or securities to serve as collateral for the loa. Sell Short Short sellig is sellig stock borrowed from a broker that must be replaced at a later time. To sell short, you borrow a certai umber of shares from the broker. You the sell the borrowed stock, kowig that you must buy it back later ad retur it to the broker. You are bettig that the price will drop, so that you ca buy it back at a lower price tha you sold it for, thus makig a profit. However, if the stock price icreases, you will lose moey because you must replace the borrowed stock with stock purchased at a higher price. Figure 12.3 shows how sellig short works. There is usually o broker fee for sellig short. The broker receives a commissio whe the stock is bought ad sold. LONG-TERM TECHNIQUES As you may already suspect, ivestig i the stock market for short-term gais ca be extremely risky. You caot beat the market all of the time, but you ca make some healthy profits if you study ad follow the market carefully. However, most fiacial cosultats advise you to ivest for the log term. Records have show that, over a log time, stock ivestmets have cosistetly beate rates for savigs accouts, CDs, ad other coservative optios. FIGURE 12.3 Sellig Short Sellig Short Example: You borrow 100 shares of stock of XYZ Corporatio from your broker. You the sell 100 shares of XYZ at $28 per share ad pay a $100 commissio. Icome from sale: 100 shares $28 per share $100 commissio $2,700 iitial icome Two weeks later, the stock price drops to $22 per share. You buy 100 shares to retur to the stockbroker ad pay a $100 commissio. Cost of buyig back the shares: 100 shares $22 per share $100 commissio $2,300 cost Profit from sellig short: $2,700 icome $2,300 cost $400 profit Retur o Ivestmet: $ % ROI $2, Uit 3 Fiacial Security Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

13 Buy ad Hold Most ivestors cosider stock purchases as log-term ivestmets. All stocks go up ad dow, but over a umber of years, the overall tred of ospeculative stocks is moderately up. Remember, a profit or loss occurs oly whe you sell the stock. If you buy ad hold stocks for may years, you ca ride out the dow times. Whe you are ready to sell years later, most likely your stock will have gaied value. I additio, may stocks pay divideds, so you are earig icome while you hold the stock. A stock split ca also add to the value of the stock over time. A stock split is a icrease i the umber of outstadig shares of a compay s stock. Whe a compay icreases its umber of outstadig shares, it lowers the sellig price i direct proportio. For example, if there were 1,000 shares outstadig with a market value of $60, the a 2:1 (two for oe) stock split would result i 2,000 shares outstadig sellig for $30. You will otice that the stock is still worth a total of $60,000. A stock split lowers the sellig price of the stock, makig the shares more affordable ad ecouragig ivestors to buy more. As ivestors buy more stock at the lower price, the share price ofte rises. If you held the stock before the split, the this price icrease makes your stock worth more. Dollar-Cost Averagig The dollar-cost averagig techique ivolves the systematic purchase of a equal dollar amout of the same stock at regular itervals. The result is usually a lower average cost per share. To calculate the average cost per share, divide the total amout ivested by the total umber of shares purchased, as show i Figure I this figure, the ivestor purchased $100 worth of stock every quarter for oe year. Over that time, the average price of the stock was $8. However, by ivestig at regular itervals over the time period, the ivestor s average cost per share was lower: $7.41. Ivestors use this techique so they do t have to worry about timig their ivestmet purchases. A regular purchase over a year s time will usually average FIGURE 12.4 Dollar-Cost Averagig Dollar-Cost Averagig Quarterly Ivestmet Amout Share Price ($) Number of Shares $100 $100 $100 $100 $400 Total $ ivested $32 = 10 = = 20 = Total umber of shares Average share price = $8 $32 4 Your average cost per share = $7.41 Total $ ivested ($400) Total umber of shares (54) Edig value = $540 Last share price ($10) Number of shares (54) Chapter 12 Ivestig i Stocks 273 Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

14 GLOBAL View I May 2007, a Saudi Arabia compay bought a plastic maufacturer i Massachusetts; i November, a Frech compay bought a ew factory i Michiga (addig 189 automotive jobs); i December a British compay bought a New Jersey maker of cough syrup. Foreig ivestors buy busiesses i America whe the U.S. dollar is weak. At the same time, they make iroads to the world s largest market. I 2007, foreig ivestors poured $414 billio ito America compaies, factories, properties, ad publicly traded stock, up 90 percet from the previous year. I the first part of 2008, foreig busiesses ivested aother $22.6 billio. As the dollar cotiues to drop i value, more surge of foreig ivestmet is expected. The weak dollar has made it easier for foreig compaies to ivest i the Uited States. THINK CRITICALLY I November 2007, a Germa compay broke groud for a $3.7 billio stailess steel plat i Alabama based o the ability to reach millios of cosumers. They cited NAFTA, a trade agreemet which allows goods to flow ito Mexico ad Caada. How ca this type of ivestmet help America? out to a reasoable price per share. With dollar-cost averagig, the ivestor makes aprofit whe the sellig price per share is higher tha the average cost per share. Direct Ivestmet You ca save moey usig direct ivestmet, or buyig stock directly from a corporatio. By buyig directly, you avoid brokerage ad other purchasig fees. You may also be able to obtai shares at prices lower tha o ope exchages. Direct ivestmet is ofte available to existig stockholders who may have the privilege of buyig additioal shares at fixed prices that are at or below market value. Reivestig Divideds You ca also save moey by reivestig your divideds. Divided reivestmet meas usig divideds previously eared o the stock to buy more shares. Buyig stock this way avoids a broker fee ad other costs that apply, such as taxes, whe you receive cash divideds o the stock. READING THE STOCK LISTINGS To make wise ivestmets i the stock market, it is a good idea to track the progress of your chose ivestmets to see how they are performig. Whether you are readig The Wall Street Joural or followig your stocks olie, you should see a listig similar to Figure Follow alog i this figure as you read the followig explaatio of each colum. Colums 1 ad 2. These colums show the highest ad lowest price this stock sold for durig the year. For the ExeB stock i Figure 12.5, the high for the last 52 weeks was ad the low was This meas the stock sold for $57 a share at oe poit (high) ad $32 a share at aother (low), though it may have sold for may prices i betwee durig the year. 274 Uit 3 Fiacial Security Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

15 FIGURE 12.5 Readig the Stock Listigs Excerpt from stock exchage listigs: 52 wks High Low Stock Div Yld% P/E Ratio Sales 100s High Low Close Net Chage Eger Eg pf Etld Epsco Exlab ExeB z Colum 3. This colum lists stocks alphabetically by ame. You will otice that stock ames are abbreviated. This abbreviated ame is called the stock s ticker symbol. You may see additioal abbreviatios, such as pf (which meas preferred stock ), beside the ame of the stock. There will be a leged at the bottom of the page that explais what these abbreviatios mea. For example, a small s meas that the stock has recetly split. Whe a stock splits, each share owed is traded for additioal shares. A 2:1 split would double your shares. If you owed 10 shares worth $50 each, you would ow ow 20 shares worth $25 each. Colum 4. This colum shows the cash divided per share for the year, listed i dollars ad cets. For the ExeB stock, 2.50 meas that if you owed 100 shares of this compay, you would have received a divided of $250 for the year. Colum 5. Yld % stads for percet yield, or the percetage of the curret price the divideds represet. I other words, divide the amout of aual divideds (Colum 4) by the closig price (Colum 10). Colum 6. The P/E ratio (price/earigs ratio) is the price of a share of stock divided by the corporatio s earigs per share over the last 12 moths. For example, if XYZ Corporatio s stock is sellig for $50 per share ad XYZ s earigs per share are $10, the P/E ratio is 5 ($50/$10 ¼ $5). The price/ earigs ratio is a key factor that serious ivestors use to evaluate stock ivestmets. A low P/E may idicate a solid ivestmet, ad a high P/E may idicate higher risk. Colum 7. This colum shows sales i hudreds of shares from the previous day how may roud lots of stock were bought ad sold. Multiply the umber by 100 to get the umber of shares. Colums 8, 9, ad 10. These colums show the highest, lowest, ad closig price for this stock o the previous day. The closig price is the fial price at the ed of tradig for the day. Colum 11. This colum, called et chage, compares the closig price today with the closig price of the day before. A mius meas the price has goe dow. A plus meas the price has rise. Stocks that have a price chage of more tha 5 percet may be set i boldface i some fiacial listigs. Chapter 12 Ivestig i Stocks 275 Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

16 How ca you track your stock holdigs? Photodisc/Getty Images Keepig track of your stock portfolio (or stock holdigs) ca be as simple as checkig the closig prices periodically. Some people check their ivestmets oly oce a year to see if they should make chages to their portfolio. Ivestors might buy additioal shares, sell, or choose a differet type of stock after checkig their portfolios. The stocks show i Figure 12.6 have bee tracked for te days straight. As you ca see, some stocks have doe better tha others i terms of market value as of a certai date. But remember, this chart does ot take ito accout divideds received or the appreciatio i value sice a stock was purchased. The stock progress chart is merely a device for moitorig chages i the closig prices of stocks. May fiacial Iteret sites eable you to follow stock prices. Usig a stock s ticker symbol, you ca fid the stock s price up to the miute. If you wat stock quotes set to your computer automatically, you ca sig up for the service with your Iteret service provider. Most sites will allow you to specify the stocks you wat to follow. You ca eve buy ad sell stocks olie. Most major stockbrokers maitai web sites that allow olie trasactios. All you have to do is set up a accout, deposit some moey, ad you re o your way! FIGURE 12.6 Stock Progress Chart Stock Progress Chart Stock Names Closig Prices for 10 Days Total Chage (+ or ) 1. Eger Glast Karbr pf Maxl Totlmb Uit 3 Fiacial Security Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

17 ISSUES IN YOUR WORLD INFLATION: WHO GETS HURT? Iflatio is a icrease i the geeral level of prices. It is measured yearly to see how much prices are risig. The cosumer price idex (CPI) is the istrumet most ofte used as a measure of risig prices. The CPI measures price chages for a market basket of goods ad services typically purchased by cosumers. Iflatio is also evidet i risig iterest rates. Iterest rates reflect the cost of ledig ad borrowig moey. As prices icrease, iterest rates go up as well. Some people get hurt by rapidly risig prices ad iterest rates. People who are more likely to be impacted by iflatio iclude the followig: People o fixed icomes. May retired people live o a fixed mothly retiremet check. Whe prices rise, their fixed icome stays the same. Thus, they are uable to maitai the same stadard of livig i iflatioary times. People with a lot of debt. Durig iflatioary times, iterest rates charged for loas are risig. Thus, creditors (leders of moey) ca charge higher iterest rates. This makes it hard for people with a lot of debt to pay off their loas. More of each moth s paymet goes toward iterest rather tha payig off the debt. People who have to borrow. If you eed to borrow moey, you will pay higher iterest rates i times of iflatio. As a result, your mothly paymets will be higher or you will have to make paymets for a loger time to pay off the loa. People workig as employees. As a employee, you work for a salary or wage. Although you may get a yearly raise, it may ot be eough to keep up with price icreases, such as the risig cost of gasolie. Price icreases (iflatio) hit immediately, ad you must adapt by makig chages i your lifestyle. This lowers your stadard of livig as rapidly risig prices erode your purchasig power. To prepare for periods of iflatio, save so you will have resources durig hard times. The you ca be a leder rather tha a borrower. THINK CRITICALLY 1. Usig the keyword iflatio, coduct Iteret research ad compare iterest rates ad risig prices i the Uited States to those i other coutries, such as Brazil, Mexico, or Frace. Look at the rates over a three-year or five-year period of time. Report your fidigs. 2. Have you oticed goods or services you buy frequetly icreasig i price? How have prices of those goods or services affected your lifestyle? Chapter 12 Ivestig i Stocks 277 Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

18 12.2 Assessmet KEY TERMS REVIEW Match the terms with defiitios. 1. Buyig stock directly from a corporatio, avoidig costs of purchasig 2. A prologed period of fallig stock prices 3. Sellig borrowed stock that must be replaced at a later time 4. A marketplace where brokers meet to buy ad sell securities 5. The use of borrowed moey to buy securities 6. A prologed period of risig stock prices 7. A icrease i the umber of outstadig shares of stock 8. Usig eared divideds to buy more shares of stock a. bear market b. bull market c. direct ivestmet d. divided reivestmet e. leverage f. securities exchage g. short sellig h. stock split CHECK YOUR UNDERSTANDING 9. What are two kids of markets where securities are bought ad sold? 10. Why is buyig o margi risky? 11. How do you save moey by reivestig divideds? APPLY YOUR KNOWLEDGE 12. Search the Web for ivestmet advice. I o more tha oe page, summarize what the experts are sayig about which stocks are hot right ow ad which are ot. Do the experts seem to agree or disagree with each other? Some sites you might try iclude Forbes, MSN Moey, CNN Moey, Fortue, Kipliger, ad Barro s. THINK CRITICALLY 13. How ca you save moey by direct ivestmet? Is this a good idea for log-term ivestig? Why or why ot? 14. Use the Iteret or library resources to research the history of bull ad bear markets. List the years whe each type of market occurred durig the 1980s ad 1990s. Which type of market is evidet today? Why is it importat to uderstad bull ad bear market treds? 278 Uit 3 Fiacial Security Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

19 12 Chapter Assessmet SUMMARY 12.1 Stockholders profit through divideds ad capital gais. Because preferred stock pays a fixed divided, it is less risky tha a compay s commo stock, but geerally ears a lower retur. Corporatios that issue icome stocks pay profits to stockholders as divideds, while corporatios that issue growth stocks reivest profits i the busiess so it ca grow. Emergig stocks are issued by youg compaies ad have a higher overall risk. Blue chip stocks provide a relatively safe but moderate retur. Defesive (o-cyclical) stocks remai relatively stable durig good ad bad ecoomic times. Cyclical stocks do well whe the ecoomy is growig but do poorly durig recessios. The par value prited o the stock certificate has othig to do with the market value ivestors actually pay for the stock. Stock price depeds o compay performace, geeral level of iterest rates, the market for the compay s products, ad the compay s earigs per share. Both divideds ad capital gais are used to determie the ROI You ca buy ad sell securities through a securities exchage (physical place) or over-the-couter (by phoe or computer). Stock prices are risig durig a bull market ad fallig durig a bear market. Short-term ivestors are speculators who try to make a quick profit by buyig o margi or sellig short. Log-term ivestmet strategies are buy ad hold, dollar-cost averagig, direct ivestmet, ad reivestmet of divideds. You ca track your stock s progress by readig the stock listigs i prit publicatios ad olie. You ca fid iformatio, set up a accout, track your stocks, ad buy ad sell securities olie. Chapter 12 Ivestig i Stocks 279 Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

20 APPLY WHAT YOU KNOW 1. If you ow 100 shares of commo stock, which you purchased for $28 a share, ad the compay declares a cash divided of $.88 for the quarter, how much will you receive i divideds? 2. Assume a compay has issued the followig stock: 2,000 shares of 5 percet preferred stock at $50 per share ad 18,000 shares of commo stock at $22 per share. A cash divided of $1.30 per share is declared for commo stock, after preferred stockholders have received their 5 percet divided. Compute your total cash divideds for the year if you ow (a) 100 shares of preferred stock; (b) 100 shares of commo stock; (c) 50 shares of preferred stock ad 50 shares of commo stock. (Hit: To calculate preferred stock divideds, you must multiply 5 percet by the total cost of the umber of shares of stock owed.) 3. Suppose you purchased 100 shares of stock i Jauary for $48 a share. You received divideds of $1.25 per share o April 1 ad July 1 ad $.95 per share o September 1. You sold the stock i December for $50 a share. What would be the stock s retur o ivestmet for the year? Assume a broker commissio of 3 percet o the purchase ad 3 percet o the sale of the stock. (Hit: Use the formula i Figure 12.1.) 4. You have $2,500 i cash i a margi accout. You decide to buy stock o margi. You buy 50 shares of stock sellig at $100 per share. Assume that the stock rises i value, ad 30 days later you sell the stock for $110 a share. Iterest o the amout borrowed is 7 percet. The total commissio charged is $150. What is the total retur o ivestmet? Explai why buyig o margi is a risky practice. (Hit: Use the formula i Figure 12.2.) MAKE ACADEMIC CONNECTIONS 5. History The Securities ad Exchage Commissio (SEC) was formed i 1933 to protect ivestors from corporatios that would deceive them ito buyig stock. Visit the sec.gov web site ad write a report describig the role of the SEC i the past ad today. What do they do to protect ivestors? What kids of reports do corporatios file with the SEC that are made available to the public olie at the SEC web site? 6. Ecoomics Explai the relatioship of the ecoomy as a whole to the stock market. For example, stock prices are risig (bull market) whe the ecoomy is growig. Why is this true? Write a oe-page report explaiig how busiess cycles affect stock prices ad what it meas to you as a ivestor. 7. Math You wish to sell short. You arrage to borrow from your broker 100 shares of stock i XYZ Corporatio o Jauary 2. You immediately sell 100 shares of XYZ at $60 per share. O April 1, you istruct your broker to purchase 100 shares of XYZ at $53 per share. You retur 100 shares of XYZ stock to your broker. Assume the commissio was $200. What is your retur o ivestmet for this trasactio? (Hit: Use the formula i Figure 12.3.) 280 Uit 3 Fiacial Security Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.

21 SOLVE PROBLEMS AND EXPLORE ISSUES 8. Suppose you decided to buy stock usig dollar-cost averagig. You purchased $200 worth of stock every quarter for oe year. You paid the followig share prices. Quarter 1: $5; Quarter 2: $10; Quarter 3: $8; Quarter 4: $4. Usig Figure 12.4 as a guide, calculate these values: (a) average share price; (b) your average cost per share; (c) edig value. Did you beefit from dollar-cost averagig? Explai. 9. Your fried Jaice is cosiderig ivestig i stocks. She has a extra $5,000 that she wats to ivest. She wo t eed the moey for five years, whe she hopes to start medical school. Would you recommed commo or preferred stock? Explai why. 10. Mr. ad Mrs. Nelso are i their late fifties ad pla to retire withi the ext three to five years. They would like to put some of their moey ito the stock market because iterest rates o savigs accouts are low. Which of these optios would you recommed to them: Icome or growth? Emergig stocks or blue chip? Defesive or cyclical? Give a brief reaso for each choice. 11. Lucia ad Carlo are married ad are cosiderig buyig some stock to have a est egg for their future childre. Carlo prefers to buy stock i a local compay that is small ad just gettig started. Lucia prefers to buy the stock of a well-kow compay that is listed o a major exchage. Discuss with them the pros ad cos of each course of actio. 12. Choose three stocks to follow for a week: oe listed o the NYSE, oe o the AMEX, ad oe o the NASDAQ. Preted that you ivested $1,000 i each stock. O the Iteret, fid the closig price for these stocks o the day you purchased them ad at the ed of every day for oe week. At the ed of the week, prepare a stock progress chart (see Figure 12.6) showig the closig prices for each day for all three stocks. Aalyze your fidigs. Which stock price varied the most? Which had the highest high? The lowest low? Which had the most cosistet upward tred? If you sold the stocks at the ed of the last day, how much would you have gaied or lost o each oe? EXTEND YOUR LEARNING 13. Ethics ad Legal Issues I 2001, Ero Corporatio ad Arthur Aderse (accoutig firm) were ivolved i a massive stock fraud scheme. Ero s stock plummeted, ad it filed bakruptcy. Stockholders lost their etire ivestmet. Prepare a history of the Ero scadal. What ethics issues were ivolved? Discuss reforms that were put i place as a result of the Ero stock scadal, such as the Sarbaes-Oxley (SOX) Act of How does SOX ehace corporate resposibility ad protect you as a ivestor? For related activities ad liks, go to Chapter 12 Ivestig i Stocks 281 Copyright 2010 Cegage Learig, Ic. All Rights Reserved. May ot be copied, scaed, or duplicated, i whole or i part.