Chapter 12 Investing in Stocks Copyright © 2012 Pearson Canada Inc. 12-1.
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Transcript of Chapter 12 Investing in Stocks Copyright © 2012 Pearson Canada Inc. 12-1.
Chapter 12
Investing in Stocks
Copyright © 2012 Pearson Canada Inc. 12-1
Chapter Objectives
• Identify the functions of stock exchanges
• Describe how to interpret stock quotations
• Explain how to execute the purchase or sale of stocks
Copyright © 2012 Pearson Canada Inc. 12-2
Chapter Objectives (cont’d)
• Explain how to analyze a firm and its stock
• Explain how to value stocks
• Explain how to assess your stock portfolio’s performance
Copyright © 2012 Pearson Canada Inc. 12-3
Stock Exchanges• Stock exchanges: facilities that allow investors to purchase
or sell existing stocks• A stock must be listed on a stock exchange in order to be
traded there• Canadian stocks are traded on two markets:• Toronto Stock Exchange (TSX)• TSX Venture Exchange
Copyright © 2012 Pearson Canada Inc. 12-4
Stock Exchanges (cont’d)• To be listed on the TSX, a firm must meet
minimum listing requirements in areas such as:• revenue,
• cash flow,
• net tangible assets,
• working capital, and
• cash
Copyright © 2012 Pearson Canada Inc. 12-5
Stock Exchanges (cont’d)• Electronic Trading
• Major exchanges in Canada offer trading services electronically
• Liquidity is enhanced with the use of market makers
• Market makers: securities dealers who are required to trade actively in the market so that liquidity is maintained when natural market forces cannot provide sufficient liquidity
Copyright © 2012 Pearson Canada Inc. 12-6
Stock Exchanges (cont’d)• Over-the-Counter (OTC) Market• Over-the-counter (OTC) market: an electronic
communications network that allows investors to buy or sell securities
Copyright © 2012 Pearson Canada Inc. 12-7
Stock Quotations
• Where can you find stock quotes?
• Stockbrokers
• Financial newspapers (e.g. Globe & Mail)
• Business sections of local newspapers
• Financial news television networks (e.g. BNN)
• Financial websites
Copyright © 2012 Pearson Canada Inc. 12-8
Stock Quotations (cont’d)
• Example of a stock quotation:
Copyright © 2012 Pearson Canada Inc. 12-9
Purchasing or Selling Stocks
• How to selecting a Broker?• Analyst Recommendations
Copyright © 2012 Pearson Canada Inc. 12-10
Purchasing or Selling Stocks (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-11
• Focus on Ethics: Relying on Analyst Recommendations• Brokers and analysts tend to be overly
optimistic about stocks
Purchasing or Selling Stocks (cont’d)
• Brokerage Commissions• Discount brokerage firm: a brokerage firm that
execute transactions but does not offer investment advice
• Full-service brokerage firm: a brokerage firm that offers investment advice and executes transactions
Copyright © 2012 Pearson Canada Inc. 12-12
Purchasing or Selling Stocks (cont’d)
• Placing an Order• Must specify the following:
• Name and class of the stock,
• Buy or sell,
• Number of shares
• Market order or limit order
Copyright © 2012 Pearson Canada Inc. 12-13
Purchasing or Selling Stocks (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-14
• Name and Class of the Stock• Ticker symbol: the abbreviated term used to identify
a stock for trading purposes
• Buy or Sell
• Number of Shares• Board lot: shares bought or sold in multiples of
typically 100 shares. The size of the board lot depends on the price of the security
• Odd lot: less than a board lot of that particular stock
Purchasing or Selling Stocks (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-15
• Market Order or Limit Order• Market order: an order to buy or sell a stock at its
prevailing market price
• Limit order: an order to buy or sell a stock only if the price is within the limits that you specify
Purchasing or Selling Stocks (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-16
• Stop Orders
• On-stop order: an order to execute a transaction when the stock price reaches a specified level; a special form of limit order
• Buy stop order: an order to buy a stock when the price rises to a specified level
• Sell stop order: an order to sell a stock when the price falls to a specified level
Purchasing or Selling Stocks (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-17
• Buying Stock on Margin
• On margin: purchasing a stock with a small amount of personal funds and a portion of the funds borrowed from a brokerage firm
• Enable you to purchase stocks without having the full amount of cash necessary
Purchasing or Selling Stocks (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-18
• If the value of investments purchased on margin declines, you will receive a margin call
• Margin call: a request from a brokerage firm for the investor to increase the cash in the account in order to return the margin to the minimum level
Analysis of a Firm
Copyright © 2012 Pearson Canada Inc. 12-19
• Annual Report
• Includes a corporate profile, a message from the firm’s CEO, and a section summarizing recent performance and expected future performance
• Also contains financial statements
Analysis of a Firm (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-20
• Firm-Specific Characteristics
• Liquidity
• Shows the firm’s ability to cover expenses
• Current ratio: the ratio of a firm’s short-term assets to its short-term liabilities
Analysis of a Firm (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-21
• Financial Leverage• Used to determine a firm’s ability to make debt
payments
• Many firms prefer to borrow funds rather than issue stock
• Financial leverage: a firm’s reliance on debt to support its operations
• Debt ratio: a measure of financial leverage that calculates the proportion of total assets financed with debt
Analysis of a Firm (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-22
• Times interest earned ratio: a measure of financial leverage that indicates the ratio of the firm’s earnings before interest and taxes to its total interest payments
• Efficiency
• A firm that generates a relatively low level of sales and earnings with a large amount of assets is not using its assets efficiently
Analysis of a Firm (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-23
• Inventory turnover: a measure of how efficiently a firm manages its inventory; computed as the cost of goods sold divided by average daily inventory
• Average collection period: used to determine the average age of accounts receivable; computed as accounts receivable divided by average daily sales
• Asset turnover ratio: used to assess how efficiently a firm uses its assets; computed as sales divided by average total assets
Analysis of a Firm (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-24
• Profitability• Operating profit margin: a firm’s operating profit
divided by sales
• Net profit margin: a measure of profitability that measures net profit as a percentage of sales
• Return on assets: a measure of profitability; computed as net profit divided by total assets
• Return on equity: a measure of profitability; computed as net profit divided by the owners’ investment in the firm (shareholder’s equity)
Analysis of a Firm (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-25
Analysis of a Firm (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-26
• Information Provided by Value Line Investment Survey
Analysis of a Firm (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-27
• Focus on Ethics: Accounting Fraud• Motivation for Fraud
• Stock price helps determine manager compensation
• Leads to a short-tem focus
• Revenue-Inflating Techniques• Recognizing revenue before it is earned
• Recognizing revenue from orders that are likely to be cancelled
Analysis of a Firm (cont’d)
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• Preventing Future Accounting Fraud
• Auditor’s may not always be “independent”
• Sarbanes-Oxley Act was created in order to restore investor confidence in the markets and to prevent future occurrences of accounting fraud
Analysis of a Firm (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-29
• Economic Analysis of Stocks• Involves assessing any economic conditions
that can affect a firm’s stock price
• Economic Growth• Economic growth: the growth in a country’s
economy over a particular period; commonly measured by GDP
Analysis of a Firm (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-30
• Fiscal policy: how the government imposes taxes on individuals and corporations and how it spends tax revenues
Analysis of a Firm (cont’d)
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• Interest Rates
• Stocks perform better when interest rates are low
• The Bank of Canada uses monetary policy to influence interest rates
• Monetary policy: techniques used by the Bank of Canada to affect the economy of the country
Analysis of a Firm (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-32
Analysis of a Firm (cont’d)
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• Industry Analysis of Stocks
• Increased demand generally leads to higher stock prices
• Changes in competition also affect demand, earnings, and stock prices
Analysis of a Firm (cont’d)
Copyright © 2012 Pearson Canada Inc. 12-34
Analysis of a Firm (cont’d)• Integrating Your
Analyses
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Stock Valuation• Price of a stock is based on the demand for
that stock versus the supply of stock available for purchase
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Value a stock using technical or fundamental analysis
)• Technical analysis: the valuation of stocks based on historical price patterns using various charting techniques
• Fundamental analysis: the valuation of stocks based on an examination of fundamental characteristics such as revenue, earnings, and/or the sensitivity of the firm’s performance to economic conditions
Copyright © 2012 Pearson Canada Inc. 12-37
Stock Valuation (cont’d)
• Dividend Discount Model (DDM) Method
• Dividend discount model (DDM): a method of valuing stocks in which a firm’s future dividend payments are discounted at an appropriate rate of interest
• Works best for mature firms that pay a large stable dividend
Copyright © 2012 Pearson Canada Inc. 12-38
Stock Valuation (cont’d)
• Price-Earnings (P/E) Method
• Based on the value of the firm’s earnings
• Price-earnings (P/E) method: a method of valuing stocks in which a specific firm’s earnings per share are multiplied by the mean industry price-earnings (P/E) ratio
Copyright © 2012 Pearson Canada Inc. 12-39
Stock Valuation (cont’d)
• Stock Market Efficiency
• Efficient stock market: a market in which stock prices full reflect information that is available to investors
• Inefficient stock market: a market in which stock prices do not reflect all public information that is available to investors
Copyright © 2012 Pearson Canada Inc. 12-40