Balance Sheet Analysis

Introduction

In this section, we will look at some of the tools you can use in making an investment decision
from balance sheet information. If you are not familiar with balance sheets, you are advised to
first read the section entitled, "Understanding the Balance Sheet". It provides a good overview of
the functions of a balance sheet and its components. We will cover the following topics here:

• Why You Should Analyze a Balance Sheet

• Liquidity Ratios
• Leverage
• Bankruptcy
• Tying It All Together

A thorough analysis of a company's balance sheet is extremely important for both stock and bond
investors.

Why You Should Analyze a Balance Sheet

The analysis of a balance sheet can identify potential liquidity problems. These may signify the
company's inability to meet financial obligations. An investor could also spot the degree to which
a company is leveraged, or indebted. An overly leveraged company may have difficulties raising
future capital. Even more severe, they may be headed towards bankruptcy. These are just a few
of the danger signs that can be detected with careful analysis of a balance sheet.

Beyond liquidity and leverage, the following section will discuss other analysis such as working
capital and bankruptcy. As an investor, you will want to know if a company you are considering is
in danger of not being able to make its payments. After all, some of the company's obligations will
be to you if you choose to invest in it.

We will start with Liquidity Ratios, an important topic for all investors.

Liquidity Ratios

The following liquidity ratios are all designed to measure a company's ability to cover its short-
term obligations. Companies will generally pay their interest payments and other short-term debts
with current assets. Therefore, it is essential that a firm have an adequate surplus of current
assets in order to meet their current liabilities. If a company has only illiquid assets, it may not be
able to make payments on their debts. To measure a firm's ability to meet such short-term
obligations, various ratios have been developed.

You will study the following balance sheet ratios:

• Current Ratio
• Acid Test (or Quick Ratio)
• Working Capital
• Leverage
These tools will be invaluable in making wise investment decisions.

Current Ratio

The Current Ratio measures a firm's ability to pay their current obligations. The greater extent to
which current assets exceed current liabilities, the easier a company can meet its short-term
obligations.

Current Assets
Current Ratio = ---------------------------
Current Liabilities

After calculating the Current Ratio for a company, you should compare it with other companies in
the same industry. A ratio lower than that of the industry average suggests that the company may
have liquidity problems. However, a significantly higher ratio may suggest that the company is not
efficiently using its funds. A satisfactory Current Ratio for a company will be within close range of
the industry average.

Acid Test or Quick Ratio

The Acid Test Ratio or Quick Ratio is very similar to the Current Ratio except for the fact that it
excludes inventory. For this reason, it's also a more conservative ratio.

Current Assets – Inventory

Acid test = ---------------------------
Current Liabilities

Inventory is excluded in this ratio because, in many industries, inventory cannot be quickly
converted to cash. If this is the case, inventory should not be included as an asset that can be
used to pay off short-term obligations. Like the Current Ratio, to have an Acid Test Ratio within
close range to the industry average is desirable.

Working Capital

Working Capital is simply the amount that current assets exceed current liabilities. Here it is in the
form of the equation:

Working Capital = Current Assets - Current Liabilities

This formula is very similar to the current ratio. The only difference is that it gives you a dollar
amount rather than a ratio. It too is calculated to determine a firm's ability to pay its short-term
obligations. Working Capital can be viewed as somewhat of a security blanket. The greater the
amount of Working Capital, the more security an investor can have that they will be able to meet
their financial obligations.

You have just learned about liquidity and the ratios used to measure this. Many times a company
does not have enough liquidity. This is often the cause of being over leveraged.
Leverage\Debt to equity

Leverage is a ratio that measures a company's capital structure. In other words, it measures how
a company finances their assets. Do they rely strictly on equity? Or, do they use a combination of
equity and debt? The answers to these questions are of great importance to investors.

Long-term Debt
Leverage = ----------------------
Total Equity

A firm that finances its assets with a high percentage of debt is risking bankruptcy should it be
unable to make its debt payments. This may happen if the economy of the business does not
perform as well as expected. A firm with a lower percentage of debt has a bigger safety cushion
should times turn bad.

A related side effect of being highly leveraged is the unwillingness of lenders to provide more
debt financing. In this case, a firm that finds itself in a jam may have to issue stock on unfavorable
terms. All in all, being highly leveraged is generally viewed as being disadvantageous due to the
increased risk of bankruptcy, higher borrowing costs, and decreased financial flexibility.

On the other hand, using debt financing has advantages. Stockholder's potential return on their
investment is greater when a firm borrows more. Borrowing also has some tax advantages.

The optimal capital structure for a company you invest in depends on which type of investor you
are. A bondholder would prefer a company with very little debt financing because of the lower risk
inherent in this type of capital structure. A stockholder would probably opt for a higher percentage
of debt than the bondholder in a firm's capital structure. Yet, a company that is highly leveraged is
also very risky for a stockholder.

When a firm becomes over leveraged, bankruptcy can result.

Bankruptcy

Bankruptcy is a legal mechanism that allows creditors to assume control of a firm when it can no
longer meet its financial obligations. Bankruptcy is a result feared by both stock and bond
investors. Generally, the firm's assets are liquidated (sold) in order to pay off creditors to the
extent that is possible. When bankruptcy occurs, stockholders of a corporation can only lose the
amount they have invested in the bankrupt company. This is called Limited Liability. The
stockholders' liability to creditors is limited to the amount invested. Therefore, if a firm's liabilities
exceed the liquidation value of their assets, creditors also stand to lose money on their
investments.

When bankruptcy occurs, a federal court official steps in and handles the payments of assets to
creditors. The remaining funds are always distributed to creditors in a certain pecking order:

1. Unpaid taxes to the IRS and bankruptcy court fees

2. Unpaid wages
3. Secured bondholders
 4. General creditors and unsecured bonds
5. Subordinated debentures
6. Preferred Stockholders
7. Common Stockholders

Obviously, to hold secured bonds rather than unsecured bonds is more advantageous in the
event of a bankruptcy. This is where you must examine your risk/reward requirements. As you
move down this hierarchy, your risk of losing your investment increases. However, you are
"rewarded" for taking more risk with potentially higher investment returns.

How do you predict bankruptcy? Well, no one can do it perfectly. However, one popular method
called a Z-score (developed by Edward Altman) has a good track record. To learn more about "Z-
scores" go to your local library. We will recap a few of the most important points about learning to
analyze a company's balance sheet.

Tying It All Together

Analyzing a balance sheet is fundamental knowledge for anyone who wishes to carefully select
solid and profitable investments. The balance sheet is the basic report of a firm's possessions,
debts and capital. The composition of these three items will vary dramatically from firm to firm. As
an investor, you need to know how to examine and compare balance sheets of different
companies in order to select the investment that meets your needs.

After reading this section, you should have an understanding of liquidity, leverage and bankruptcy
and know how to apply basic ratios to measure each. These ratios should be compared to other
firms in the same industry in order for them to have relevance. Be careful, however, that the firms
are not fundamentally different even if they are in the same industry.

---------------X---------------
 ABOUT INCOME STATMENTS
A company's income statement is a record of its earnings or losses for a given period. It shows
all of the money a company earned (revenues) and all of the money a company spent (expenses)
during this period. It also accounts for the effects of some basic accounting principles such as
depreciation.

The income statement is important for investors because it's the basic measuring stick of
profitability. A company with little or no income has little or no money to pass on to its investors in
the form of dividends. If a company continues to record losses for a sustained period, it could go
bankrupt. In such a case, both bond and stock investors could lose some or all of their
investment. On the other hand, a company that realizes large profits will have more money to
pass on to its investors.

In this section, we will cover the following:

• Example of an Income Statement

• Gross Profit on Sales
• Operating Income
• Earnings Before Interest and Taxes
• Net Earnings (or Loss)
• Retained Earnings
• Income Statement Mnemonics
• The Importance of the Income Statement to Investors

Example of an Income Statement

The income statement shows revenues and expenditures for a specific period, usually the fiscal
year. Income statements differ by how much information they provide and the style in which they
provide the information. Here is an example of a hypothetical income statement, with revenues in
black and expenditures in red (and parentheses):

Wilma's Widgets Income Statements for the Years Ending

1998 and 1999
1998 1999
Sales $900,000 $990,000
Less Cost of Goods Sold (250,000) (262,500)
Gross Profit on Sales 650,000 727,500
Less General Operating Expenses (120,000) (127,500)
Less Depreciation Expense (30,000) (30,000)
Operating Income 500,000 570,000
Other Income 50,000 30,000
Earnings Before Interest and Tax 550,000 600,000
Less Interest Expense (30,000) (30,000)
Less Taxes (50,000) (54,500)
Net Earnings (Available Earnings for
470,000 515,500
Dividends)
Less Preferred and/or Common Dividends
(70,000) (80,000)
Paid
Retained Earnings 400,000 435,500

Now, as perplexing as those numbers might seem at first, you will become comfortable with them
very quickly once we explain what all this financial jargon really means. Let us start by looking at
the first term that was calculated - gross profit on sales.

Gross Profit on Sales

Gross profit on sales (also called gross margin) is the difference between all the revenue the
company earns and the sales of its products minus the cost of what it took to produce them. Let
us move on to clarify how to calculate this important number.

Gross Profit on Sales = Net Sales - Cost of Goods Sold

Simple, yes, but let's be sure we know what the terms sales and costs of goods sold means to the
accountants.

Net sales are the total revenue generated from the sale of all the company's products or services
minus an allowance for returns, rebates, etc. Sometimes on an income statement, you might see
the terms "gross sales" and "returns," "rebates" or "allowances." Gross sales are the total
revenue generated from the company's products or services before returns or rebates are
deducted. Net sales on the other hand have all these expenses deducted.

Cost of goods sold is what the company spent to make the things it sold. Cost of goods sold
includes the money the company spent to buy the raw materials needed to produce its products,
the money it spent on manufacturing its products and labor costs.

When you subtract all the money a company spent in the production of its goods and services
(cost of goods sold) from the money made from selling them (net sales), you have calculated their
gross profit on sales.

Gross profit on sales is important because it reveals the profitability of a company's core
business. A company with a high gross profit has more money left over to pump into research
and development of new products, a big marketing campaign, or better yet - to pass on to its
investors. Investors should also monitor changes in gross profit percentages. These changes
often indicate the causes of decreases or increases in a company's profitability. For instance, a
decrease in gross profit could be caused by an industry price war that has forced the company to
sell its products at a lower price. Poor management of costs could also lead to a decreased gross
profit.
Operating Income

Operating income is a company's earnings from its core operations after it has deducted its cost
of goods sold and its general operating expenses. Operating income does not include interest
expenses or other financing costs. Nor does it include income generated outside the normal
activities of the company, such as income on investments or foreign currency gains.

Operating income is particularly important because it is a measure of profitability based on a

company's operations. In other words, it assesses whether or not the foundation of a company is
profitable. It ignores income or losses outside of a company's normal domain. It also excludes
extraordinary events, such as lawsuits or natural disasters, which in a typical year would not
affect the company's bottom line.

An easy way to calculate operating income is as follows:

Operating Income = Gross profit - General Operating Expenses - Depreciation Expense

General operating expenses are normal expenses incurred in the day-to-day operation of
running a business. Typical items in this category include sales or marketing expenses, salaries,
rent, and research and development costs.

Depreciation is the gradual loss in value of equipment and other tangible assets over the course
of its useful life. Accountants use depreciation to allocate the initial purchase price of a long-term
asset to all of the periods for which the asset will be used.

Earnings before Interest and Taxes

Earnings before interest and taxes (EBIT) is the sum of operating and non-operating income.
This is typically referred to as "other income" and "extraordinary income" (or loss). As its name
indicates, it is a firm's income excluding interest expenses and income tax expenses. EBIT is
calculated as follows:

EBIT = Operating Income + (-) Other Income (Loss) + (-) Extraordinary Income (Loss)

Since we already know what operating income is, let's take a closer look at what other income
and extraordinary income mean.

Other income generally refers to income generated outside the normal scope of a company's
typical operations. It includes ancillary activities such as renting an idle facility or foreign currency
gains. This income may happen on an annual basis, but it is considered unrelated to the
company's typical operations.

Extraordinary income (or loss) occurs when money is gained (or lost) resulting from an event
that is deemed both unusual and infrequent in nature. Examples of such extraordinary
happenings could include damages from a natural disaster or the early repayment of debt.

Many companies may not have either other income or extraordinary income in a given year. If this
is the case, then earnings before income and taxes is the same as operating income. Regardless
of how it is calculated, EBIT is especially relevant to bondholders and other debtors who use this
figure to calculate a firm's ability to "cover" or pay its interest payments with its income for the
year.
Net Earnings (or Loss)

Net earnings or net income is the proverbial bottom line. It measures the amount of profit a
company makes after all of its income and all of its expenses. It also represents the total dollar
figure that may be distributed to its shareholders. Net earnings are also the typical benchmark of
success. Just a reminder, however, many companies report net losses rather than net earnings.

How do we calculate net earnings?

Net Earnings = Earnings before Interest and Taxes - Interest Expense - Income Taxes

Interest expense refers to the amount of interest a company has paid to its debtors in the current
year. Meanwhile, income taxes are federal and state taxes based upon the amount of income a
company generates. Often a company will defer its taxes and pay them in later years.

Net earnings are particularly important to equity investors because it is the money that is left over
after all other expenses and obligations have been paid. It is the key determinant of what funds
are available to be distributed to shareholders or invested back in the company to promote
growth.

Retained Earnings

Retained earnings are the amount of money that a company keeps for future use or investment.
Another way to look at it is as the earnings left over after dividends are paid out. Generally, a
company has a set policy regarding the amount of dividends it will pay out every year. In this
case, 70% of net earnings become retained earnings.

Calculation of retained earnings:

Retained Earnings = Net Earnings - Dividends

To better understand retained earnings, we need to explain the nature of dividends. Dividends
are cash payments made to the owners or stockholders of the company. A profitable year allows
them to make such payments, although there generally are no obligations to make dividend
payments. When a company has both common and preferred stockholders, the company has two
different types of dividends to pay.

Every publicly traded company has common stockholders. Dividend payments to common
stockholders are optional and up to each company to decide how (or if) it will make such
payments. A firm may decide to plow all of its earnings into new investments to promote future
growth. Preferred stockholders are in line before common stockholders if a dividend is declared.
However, not all companies have preferred stockholders.

As an investor, it is important to know what a company does with its net earnings. An investor
needs to know the company's dividend and retained earnings policies to decide whether the
company's objectives are in line with the investor's. If the company pays dividends it is income-
oriented. If it retains earnings for future expansion, it is growth-oriented.

Knowing the sources of income and expenses is necessary when reading an income statement.
Two helpful mnemonic devices have been created out of the major components of the income
statement.
Income Statement Mnemonics

Although these mnemonics may not account for every line on an income statement, these two will
help you remember the major parts, and the order in which they appear. The word "SONAR"
identifies the major sales and earnings. The word "EDIT" summarizes major expenditures.

As you look vertically down the first row of letters, you should discover the spelling of "SONAR."
The vertical set of letters in the second column spells out "EDIT."

S = Sales (gross)

E = Less expenses (general operating expenses and cost of goods sold)

D = Less depreciation

O = Operating income (before interest and taxes)

I = Less interest
T = Less taxes

N = Net earnings
A = Available earnings for common stock
R = Retained earnings

Let's conclude with a review of the importance of the income statement for investors.

The Importance of the Income Statement to Investors

The income statement provides the investor with much insight to the company's revenues and
expenses. You can identify where the company spends much of its income and compare that to
similar companies. You can also compare a company's performance with previous years. Most
importantly, the income statement tells an investor if the business is profitable. If the company
continually makes substantial profits, it indicates to bondholders that it is a stable company. The
savvy investor will compare income statements of similar companies.

---------------X---------------

===============================================================

Income Statement Analysis

Introduction

The income statement is a basic record for reporting a company's earnings. Since earnings are a
fundamental component in a firm's worth, it is essential for investors to know how to analyze
different elements of this important document.

This section is designed to teach you some basic methods for analyzing the income statement.
Analyzing income statements is an important tool to help investors appraise their investment
options. By analyzing an income statement properly, investors can begin to evaluate the
effectiveness of the management of operations in the companies in which they are interested in
investing. Proper income sheet analysis can help identify good investment opportunities. It can
also reduce the risk involved with choosing a poor investment choice.

In this section, we introduce you to the following ratios, tools and concepts to help you analyze
income statements:

• Interest Coverage
• Profitability Ratios
• Where Did All Those Expenses Come From?
• Depreciation Expense
• Basic Points about Calculating Depreciation
• Straight-Line Depreciation
• Accelerated Depreciation
• Selecting a Depreciation Method

Interest Coverage (a.k.a. Times Interest Earned)

Interest Coverage is the measurement of how many times interest payments could be made with
a firm's earnings before interest expenses and taxes are paid. From a bondholder's perspective,
interest coverage is a test to see whether a firm could have problems making their interest
payments. From an equity holder's perspective, this ratio helps to give some indication of the
short-term financial health of the company.

The following formula is used to determine the coverage of interest:

Earnings Before Interest and

Taxes (EBIT)
Interest Coverage Ratio = ----------------------------
Interest Expense

A higher ratio is typically better for bondholders and equity investors. For bondholders a high ratio
indicates a low probability that the firm will go bankrupt in the near term. A company with a high
interest coverage ratio can meet their interest obligations several times over. Stock investors
typically like companies with high interest coverage ratios too. A high ratio indicates a company
that is probably relatively solvent. Thus, all other things equal, an investor should be very careful
with firms that have a low Interest Coverage Ratio with respect to other companies in their
industry.

Since the fundamental purpose of the income statement is to report profits or losses,
understanding the various profitability ratios that follow is extremely helpful to your analysis of a
firm.
Profitability Ratios

Profitability is often measured in percentage terms in order to facilitate making comparisons of a

company's financial performance against past year's performance and against the performance of
other companies.

When profitability is expressed as a percentage (or ratio), the new figures are called profit
margins. The most common profit margins are all expressed as percentages of Net Sales.

Let's look at a few of the most commonly used profit margins that you can easily learn to use to
help you measure and compare firms:

Gross Margin is the resulting percentage when Gross Profit is divided by Net Sales. Remember
that Gross Profit is equal to Net Sales - Cost of Goods Sold. Therefore, Gross Margin represents
the percentage of revenue remaining after Cost of Goods Sold is deducted. Let us take a look at
a simple example.

Net Sales = $1,000

Cost of Goods Sold = - $400
Gross Profit = $600
Gross Profit
Gross Margin = --------------------------
Net Sales

In this example the Gross Margin = 600/1000 = .60 or 60%

Since this ratio only takes into account sales and variable costs (costs of goods sold), this ratio is
a good indicator of a firm's efficiency in producing and distributing its products. A firm with a ratio
superior to the industry average demonstrates superior efficiency in its production processes. The
higher the ratio, the higher the efficiency of the production process. Investors tend to favor
companies that are more efficient.

Operating Margin. As the name implies, operating margin is the resulting ratio when Operating
Income is divided by Net Sales.

Operating Income
Operating Margin = --------------------------
Net Sales

This ratio measures the quality of a firm's operations. A firm with a high operating margin in
relation to the industry average has operations that are more efficient. Typically, to achieve this
result, the company must have lower fixed costs, a better gross margin, or a combination of the
two. At any rate, companies that are more efficient than their competitors in their core operations
have a distinct advantage. Efficiency is good. Advantages are even better. Most investors will
tend to prefer a more efficient company.

Let's move on to the last profitability measure we will cover in this section.

Net Margin: As the name implies, Net Margin is a measure of profitability for the sum of a firm's
operations. It is equal to Net Profit divided by Net Sales:
 Net Profit
Net Margin = ---------------
Net Sales

As with the other ratios you will want to compare Net margin with other companies in the industry.
You can also track year-to-year changes in net margin to see if a company's competitive position
is improving, or getting worse.

The higher the net margin relative to the industry (or relative to past years), the better. Often a
high net margin indicates that the company you are looking at is an efficient producer in a
dominant position within its industry. However, as with all the previous profit margin
measurements, you need to always check past years of performance. You want to make sure
that good results are not a "fluke." Strong profit margins that are sustainable indicate that a
company has been able to consistently outperform their competitors.

The savvy investor uses profitability margins to help analyze income statements of prospective
investments. Companies with high interest coverage ratios, gross margins, operating margins and
net margins will always be very attractive to investors.

Where Did All Those Expenses Come From?

You have just finished learning about interest coverage and profitability ratios. Both of these
measures are simple and easy to understand. Interest coverage measures a company's ability to
make its loan payments. Profitability ratios measure the bottom line of the income statement -
earnings.

However, to calculate either ratio, you must be able to classify a company's expenses. The
interest coverage ratio concerns itself with a specific type of expense (interest expense).
Meanwhile, profitability ratios such as net profit margin consider the net effect of all the expenses
a company incurs.

Most of the expenses a company incur (raw materials, labor, rent, etc.) are straightforward items.
In general, companies want to minimize these sorts of expenditures to ensure improved
performance and profitability. For example, the less a company has to pay for the raw materials
of the products it produces, the more competitive that company can become.

Yet, there is one type of expense companies cannot eliminate. In fact, incurring this expense
actually helps save the company money. What is this mysterious expense?

Depreciation Expense

Depreciation is the process by which a company gradually records the loss in value of a fixed
asset. The purpose of recording depreciation as an expense over a period is to spread the initial
purchase price of the fixed asset over its useful life.

Each time a company prepares its financial statements, it records a depreciation expense to
allocate the loss in value of the machines, equipment or cars it has purchased. However, unlike
other expenses, depreciation expense is a "non-cash" charge. This simply means that no money
is actually paid at the time in which the expense is incurred.

Like all other expenses, depreciation expense reduces the taxable income of the company. Yet, a
business reporting a depreciation expense incurs no additional cash expenditure. Simply put,
depreciation allows businesses to reduce their taxable income without making the additional cash
expenditure typical of most other expenses.

While depreciation is an attractive way to reduce taxable income, specific regulations govern how
it is to be calculated and allocated. Let's take a moment to review a few important points about
how companies calculate depreciation.

Basic Points about Calculating Depreciation

When analyzing income statements, it is very important to understand how different accounting
methods for calculating depreciation affect the income statement. Sometimes the accounting
methods selected can materially alter the net result of this important statement.

Most businesses have the right to choose amongst a number of different depreciation schedules.
Typically, businesses elect a depreciation schedule to suit their specific needs or preferences. In
order to make comparisons of different companies, you will need to know the role that accounting
plays in the final composition of their respective income statements.

A company can choose from several methods (or depreciation schedules) to calculate its
depreciation expense. Read below to look at two of the most common methods.

Straight-Line Depreciation

Straight-line Depreciation is the simplest and most commonly used accounting method for
depreciation. Basically, the straight-line depreciation method calculates the amount of annual
depreciation expense that is to be recorded by dividing the value of the asset (as determined by
its purchased price) by its useful life. Often some adjustment is made for the anticipated "residual
value" that the asset may have at the end of its "useful life."

The IRS provides taxpayers with a depreciation schedule that defines what the useful life of
different types of assets (cars, computers, etc.) are to be. Thus, an item that has a relatively
short-lived useful life (such as a computer) may be able to be depreciated more quickly than an
asset (such as a building) that has a long and useful life expectancy ahead of it.

Using a straight-line depreciation schedule, businesses deduct the same amount of depreciation
each year until the assets has been fully depreciated.

However, straight-line depreciation is not the only method available. Let's look at another popular
option.

Accelerated Depreciation Methods

Accelerated Depreciation Methods are also a very common way for companies to allocate their
depreciation expenses. These methods are those methods that are utilized to write off
depreciation costs more rapidly than the straight-line method.

Various accelerated methods exist. Two popular methods of accelerated depreciation are Sum-
of-the-Years'-Digits and Double Declining Balance. These methods are more complex in nature
and we will not delve into their calculations at present.
However, the important thing to know is that each of these methods record depreciation expense
more heavily in the current years in comparison to the straight-line method. By recording more
expense in the early stages of an assets useful life, accelerated depreciation methods reduce the
taxable income for those years and thus reduce income taxes for those years. However, in later
years, accelerated depreciation methods will record less depreciation, leaving more income. The
company will therefore have to pay greater taxes.

Selecting a Depreciation Method

For the company, the choice of depreciation method will depend on a company's current financial
situation and/or its own preferences. Companies that wish to defer current taxable income may
elect accelerated depreciation methods to accomplish this goal. However, companies that need
to show large earnings in the current year may elect to forgo accelerated depreciation methods
and opt for a straight-line method. Both methods have their advantages and disadvantages.
Typically, a company is free to choose the method that best suits its preferences.

However, as an investor, you will likely not have the power to tell the company what method to
use. Instead you will need to know how each of these different methods can alter an income
statement. If you can do this, you will be able to evaluate how a company's depreciation schedule
impacts the value of the investment opportunity.

When making comparisons of different companies, you should always check to see if they use
the same accounting methods. If not, you will want to make an adjustment in order to effectively
compare these companies.

At first, comparing depreciation methods and accounting rules may seem daunting. However,
with a little practice you will be armed and ready to really understand the companies you are
interested in investing in.

Concluding Remarks

Now that you have completed this section, you should be familiar with some basic methods to
help you evaluate different investment options.

Using the analysis techniques that we have introduced, you have a good basis of knowledge from
which to make informed investment decisions. Remember that the main purpose of the income
statement is to report profitability. Because profitability is crucial in any investment decision,
knowing some basic techniques of how to analyze the income statement should be a very
important part in your development as an informed investor.

---------------X---------------

===============================================================
Calculating Profitability Ratios
Introduction

Corporate earnings are important to you as an investor. If you compare corporate earnings of
prospective investments, you will make wiser investment decisions. Profitability ratios provide you
with tools you can use to make these comparisons.

In this section you will learn:

• How Do I Use Fundamentals to Make an Investment Decision?

• What Is Ratio Analysis?
• What Can I Learn from Profitability Ratios?
• When Is an Increase in Earnings a Loss?
• How to Use Profitability Ratios to Make Investment Decisions
• Other Ratios to Consider

How Do I Use Fundamentals to Make an Investment Decision?

Fundamental analysis is a method used to evaluate the worth of a security by studying the
financial data of the issuer. Performing fundamental analysis will teach you a lot about a
company, but virtually nothing about how it will perform in the stock market. Apply this analysis on
two competing companies and it becomes clearer which is the better investment choice. In this
section, you will learn to use some of the tools of the fundamental analyst.

As an investor, you are interested in a corporation's earnings because earnings provide you with
potential dividends and growth. Companies with greater earnings pay higher dividends and have
greater growth potential. You can use profitability ratios to compare earnings for prospective
investments. Profitability ratios are measures of performance showing how much the firm is
earning compared to its sales, assets or equity.

You can quickly see the difference in profitability between two companies by comparing the
profitability ratios of each. Let us see how ratio analysis works.

What Is Ratio Analysis?

While a detailed explanation of ratio analysis is beyond the scope of this section, we will focus on
a technique, which is easy to use. It can provide you with a valuable investment analysis tool.

This technique is called cross-sectional analysis. Cross-sectional analysis compares financial

ratios of several companies from the same industry. Ratio analysis can provide valuable
information about a company's financial health. A financial ratio measures a company's
performance in a specific area. For example, you could use a ratio of a company's debt to its
equity to measure a company's leverage. By comparing the leverage ratios of two companies,
you can determine which company uses greater debt in the conduct of its business. A company
whose leverage ratio is higher than a competitor's has more debt per equity. You can use this
information to make a judgment as to which company is a better investment risk.
However, you must be careful not to place too much importance on one ratio. You obtain a better
indication of the direction in which a company is moving when several ratios are taken as a
group.

What Can I Learn from Profitability Ratios?

The profitability ratios include: operating profit margin, net profit margin, return on assets and
return on equity.

Profit margin measures how much a company earns relative to its sales. A company with a
higher profit margin than its competitor is more efficient. There are two profit margin ratios:
operating profit margin and net profit margin. Operating profit margin measures the earnings
before interest and taxes, and is calculated as follows:

Operating Profit Margin = Earnings Before Interest and Taxes

Sales

Net profit margin measures earnings after taxes and is calculated as follows:

Net Profit Margin = Earnings After Taxes

Sales

While it seems as if these both measure the same attribute, their results can be dramatically
different due to the impact of interest and tax expenses. Similarly, the next two ratios appear to
be similar but they tell different stories. As an investor, you are interested in getting a return on
your investment. So is a corporation.

Return on assets (ROA) tells how well management is performing on all the firm's resources.
However, it does not tell how well they are performing for the stockholders. It is calculated as
follows:

Return on Assets = Earnings After Taxes

Total Assets

Return on equity (ROE) measures how well management is doing for you, the investor, because
it tells how much earnings they are getting for each of your invested dollars. It is calculated as
follows:

Return on Equity = Earnings After Taxes

Equity

These ratios are easy to calculate and the information is readily available in a company's annual
report. All you need do is review the income statement and balance sheet to come up with the
data to plug into the formulas.

But, do not neglect other income statement information that can save you from making a costly
mistake.
When Is an Increase in Earnings a Loss?

Sometimes an increase in company earnings can disguise an operating loss. If a company's

operating expenses exceed its operating income, it has an operating loss. If it also has income
from investments and tax benefits, this income can offset the loss and show an increase in
earnings per share. However, if these other sources of non-operating income are not recurring,
the unsuspecting investor may come to an erroneous conclusion about the company's overall
financial health. The lesson to be learned here is to carefully scrutinize the financials especially
when operating income is negative.

How to Use Profitability Ratios to Make Investment Decisions?

When considering a company as a prospective investment you should review its financial
statements. Pay particular attention to the profitability ratios. If you can, calculate the ratios for the
same company over several successive years to see if the company earnings are consistent,
growing, or declining.

Compare your candidate's ratios to other companies in the same industry. This will help you
determine where your candidate stands in the industry.

Do not ignore other financial information on the income statement and balance sheet. Pay
particular attention to losses in income items.

For more information on financials, see the sections on Understanding Balance Sheets and
Understanding Income Statements.

Other Ratios to Consider:

Price to Earnings Ratio (P/E)

The price to earnings ratio, or P/E, is figured by dividing the stock price by the company's
earnings per share (EPS). The P/E is a performance benchmark that can be used as a
comparison against other companies or within the stock's own historical performance. For
instance, if a stock has historically run at a P/E of 35 and the current P/E is 12, you will want to
explore the reasons for the drastic change. If you believe that the ratio is too low, you may want
to buy the stock.

You will generally find a P/E ratio based on either the prior reporting year's earnings, or the
earnings of the prior four quarters added together. This latter number is referred to as LTM or
Latest Twelve Months. While this is useful for understanding the history of a company, most
analysts prefer to view a forward-looking P/E ratio. This ratio is calculated by dividing the stock
price by the analysts' earnings estimate for the next year or two.

One other note on P/E Ratios. Sometimes, when a company is not doing well, it will buy back
shares so that the EPS and P/E Ratio will appear better. This can be seen in the example below.
 Example 1 Example 2
Net Income $1,000,000 $1,000,000
Shares Outstanding 10,000,000 8,000,000
Earnings Per Share (EPS) $0.10 $0.125
Stock Price $3.00 $3.00

P/E Ratio 30 24

In the table above, the only change from Example 1 to Example 2 is in the number of shares
outstanding. The net income and stock price remain the same. However, by changing the shares
outstanding, the EPS has changed quite a bit. This means that the P/E ratio has also changed. At
first glance, if a stock's EPS has increased 25% and its P/E ratio has gone from 30 to 24 it might
look like a better buy. However, the truth is that nothing has changed but the number of shares.
The stock is not a better buy in Example 2 than it was in Example 1.

Where P/E Does Not Apply

When looking at newer companies such as Internet start-ups or bio-techs, there is often no net
income, so there are no earnings per share. In these cases the P/E ratio does not apply, forcing
analysts to turn to other measures. The most common alternative ratios include: revenues per
share, gross income per share or cash flow per share. All these ratios take the relevant number
from an income statement, divide them by the number of shares and then divide the stock price
by this number.

For example if XYZ Corp. has sales of $1 billion and 100 million shares outstanding, then the
revenue per share is $10. If the stock is trading at $90 per share, the price to revenue ratio is 9x.

There are flaws in taking these ratios, but in the absence of a meaningful P/E Ratio, they are a
good place to start.

Current Ratio

The current ratio provides an indication of how liquid a company may be in the coming year. To
calculate it, take the current assets and divide that number by the current liabilities. You will find
all of these figures on the balance sheet.

An answer of 1.0 or better is generally considered good. However this, like other ratios, can
depend on a company's current stage of growth. A start-up company should have a lower ratio
than an established company. If it does not, then you will want to ask yourself why and do further
research.

A current ratio can also be affected by how much long-term debt a company has in relation to its
short-term debt. Some companies prefer to use short-term debt and reissue it more often. Other
companies minimize their use of short-term debt. Most companies use a mix depending on what
is available to them, what is cheaper at the moment and how their economists project interest
rates for the future. Hence, this ratio also needs to be used to build a bigger picture rather than in
isolation.
Long-Term Debt to Equity

The long term debt to equity ratio can tell you how much debt a company is using to finance its
operations. If this number is too high it may signify future liquidity problems. If this number is too
low it can signify inefficient use of the financing alternatives available to a company.

This ratio is calculated by taking the long-term debt of a company and dividing it by the
shareholders' equity. Be sure to include the company's lease obligations (which can be found in
detail in the footnotes of an annual report) when calculating long-term debt.

Start up companies which have access to the debt markets, often have higher ratios than more
established companies. In addition, the amount of debt a company can safely issue varies by
industry. For example, companies with large manufacturing facilities often have more long-term
debt than companies that provide services or software. Therefore, it is useful to look at the ratios
of numerous companies in the same industry before drawing any conclusions.

Total Debt to Equity

Since companies can affect either the current ratio or the long-term debt to equity ratio by altering
their mix of short-term and long-term debt, this ratio can often be more useful than the other two.
This ratio is calculated by dividing all long-term debt, short-term debt and lease obligations by the
shareholders' equity.

---------------X---------------

======================================================
How Analysts Present Their Findings
The study of all this data is known on Wall Street as fundamental analysis. Most analysts would
view themselves as fundamental analysts, meaning they make investment decisions based on
the available information about a company.

After going through the history of the ratios above, other ratios not explained here and the non-
financial information available on a company (product, strategy, marketing, management, etc.),
the analysts build models that project what will happen to a company in the future. Based on
these models they issue two pieces of information.

The first piece of information you will likely see is an analyst's projected earnings per share (EPS)
for a company. Projections for many companies are available online, where you can see the
mean or average projection as well as the extreme projections and the recent movement in the
projections.

Since investors rely on analysts to filter the information provided, when analysts change these
projections, it will often affect the price of the stock. In other words, the analysts' projections act
as an information source in their own right. When an analyst lowers an earnings projection for a
company, people assume they have learned something negative about a company's future
performance. As a result, they believe a company is less valuable and sell their stock.
Conversely, when an analyst raises their earnings projection, people believe they have learned
something positive about the future of a company. In this case investors will view the company as
more valuable and proceed to buy the stock.

An analyst also makes their own buy or sell recommendation, often including a target stock price.
While many firms use synonyms for the following terms, these are the basic recommendation
levels:

Strong buy - Investors are strongly encouraged to buy a stock with this recommendation.

Buy - Buying a stock with this recommendation is suggested, but with a little less emphasis.

Accumulate - Investors are advised to buy a stock with this recommendation steadily over time.

Hold - Investors are advised neither to buy nor sell, but if you are a pessimist reading between
the lines, this might be construed as a signal to sell.

Sell - The analyst recommends that investors unload this stock.

When Is The Right Time To Buy?

Once you have found an investment idea, researched it thoroughly and have done a detailed
analysis, it will be time to make a decision. If an individual stock seems to have good prospects, if
it fits your portfolio and if the risk is acceptable, the time may be right to buy the stock.

The decision on when to buy is yours alone.

Dollar Cost Averaging
Introduction

Dollar cost averaging can give you an investment strategy that evens-out the fluctuations in the
price of an investment made over time. It works by purchasing the same dollar amount of shares
at regular intervals. It is most commonly used to purchase mutual fund shares on a regular basis.
We will cover the following in this section:

• What Is Dollar Cost Averaging?

• An Example of Dollar Cost Averaging
• A Helpful Formula for Calculating Average Price Per Share

What Is Dollar Cost Averaging?

Dollar cost averaging is the practice of purchasing the same dollar amount of shares of an
investment each period. When the price is up, you buy fewer shares. When the price is down, you
buy more shares. It is usually advised to make the payments on the same day each period.

This differs from buying the same number of shares each time. Let us explain this with some
examples. Imagine instead of dollar cost averaging that you choose to buy 100 shares on the
15th day of every month for four consecutive months. Assume the share prices were the following
on the 15ths of these months:

Date Price/Share Shares Cost

Jan 15 $30 100 $3000
Feb 15 $50 100 $5000
Mar 15 $100 100 $10,000
Apr 15 $40 100 $4000
Total 400 $22,000.00
Avg. Price Per Share $55

By dividing the total amount you paid ($22,000) by the number of shares you purchased (400)
you find that the average price is $55 per share.

Now let's examine what happens when you invest a set amount of dollars each month.

An Example of Dollar Cost Averaging

If you invest the same amount of money as the previous example over four months, you would
invest $5500 on the 15th of each month. You get the following:

Date Price/Share Shares Cost

Jan 15 $30 183.333 $5500
Feb 15 $50 110 $5500
Mar 15 $100 55 $5500
Apr 15 $40 137.5 $5500
Total 485.833 $22,000.00
 Avg. Price Per Share $45.28

You purchased 485.833 shares with your total investment of $22,000. By dividing $22,000 by
485.833, you arrive at an average price of $45.28 per share. This is a savings of $9.72 per share
from the $55 per share in the previous example. You purchased more shares for the same
investment.

You can see that when prices are low, you can buy more shares. Conversely, when prices are
high you will buy fewer shares. Thus, when it comes time to receive dividends, you will have more
shares on which you can earn dividends.

By using a little more math, you can see your savings in another way. Read below to find out
how.

Formula for Figuring Price per Share and Cost per Share

With the following handy formula, you can compare what you would have paid per share using
different investment strategies. In fact, this is the same simple formula we used in the previous
two examples to compare the results of buying a fixed number of shares per month compared
with purchasing a fixed dollar amount of shares per month.

You can determine your average price per share (what you paid) with this formula:

Average Price = Total Amount You Paid

Numbers of Shares Bought

As you should recall, using dollar cost averaging the average price per share was $45.28
compared with purchasing the same number of shares each month which resulted in an average
price per share of $55.

Dollar cost averaging gives you an advantage because it helps reduce the average price you pay.
This is true because the Dollar Cost Averaging method takes advantage of the fluctuation in
price.

Concluding Remarks

Dollar cost averaging is a simple and straightforward method of investing. It is often an attractive
option for the investor who wants to systematically contribute to their investment portfolio over
time. By electing to dollar cost average, you can help reduce some of the risk that poor timing and
potentially adverse price fluctuations will have on your investment decisions. Using the dollar cost
average method, it is not as likely that you will purchase too much of a particular security at a
time when it is priced relatively high in the market.

Introduction to Margin Accounts

In this section, you will learn the mechanics of margin accounts. You will learn about their
limitations and how to engage in margin transactions. You will also learn when to use a margin
account and the potential rewards and risks of using margin.
This section contains the following lessons:

• Why Use a Margin Account?

• How Do You Set Up a Margin Account?
• What Are the Limitations in Margin Accounts?
• What Is a Margin Call?
• How Do Margin Transactions Work?
• Is a Margin Account for You?

Why Use a Margin Account?

Let's begin with the terms.

Margin account. An account you establish at a brokerage firm that lets you borrow from your
broker to buy securities or for any other purpose.

Margin. The amount you must deposit when you use your broker's credit to buy securities.

A margin account lets you make a secured loan against your own portfolio. The advantage is that
you do not have to sell any of your portfolio to obtain the cash. Furthermore, you have no
repayment schedule. You are free to repay the loan at anytime, unless your collateral falls below
the required amount. While most investors use the borrowed cash to buy additional securities,
you can use it for any purpose. However, the wholly owned securities in your portfolio are
collateral for the loan. You will also need a margin account if you are engaging in short sales. See
the section on Selling Short for more information.

Interested? Let's see how to establish a margin account.

How Do You Set Up a Margin Account?

You have a choice of two types of brokerage accounts. You can open a cash account or a margin
account. A brokerage cash account is a simple account you may use to buy and sell securities.
You pay for transactions with cash. A margin account is a credit account. You pay a certain
percentage of the purchase price of your marginable securities and borrow the remainder from
the brokerage firm.

When opening a margin account you must sign a margin agreement form, which outlines the
rules for using your margin account. Once you have placed securities in your margin account, you
can borrow on margin anytime thereafter, without having to complete any other applications or
forms.

What Are the Limitations in Margin Accounts?

The Board of Governors of the Federal Reserve System regulations, as well as other regulatory
bodies, apply restrictions on margin lending practices. You may not borrow the full amount of your
portfolio. The Federal Reserve Board (FRB) regulates the amount of credit brokers can extend to
its customers. Currently, you can borrow up to 50% of the value of your marginable stocks to
make a new purchase. In the past, it has varied between 40 and 100 percent.

The "New York Stock Exchange minimum initial equity requirement" holds that your equity be at
least $2,000 whenever you enter into a new margin account transaction.
The "NYSE Minimum Maintenance Rule" requires that the equity in your account must be at least
25% of the current market value of margined securities.

All of these requirements are minimums and can be increased at any time by your brokerage firm
and/or by the regulatory agencies of the securities industry.

Not all securities are fully marginable. Your brokerage firm may have its own requirements and
your broker can tell you which ones would not apply.

Your broker will charge interest on the margin loan as long as it is not repaid. The rates vary but
generally will go down as the amount you borrow increases.

You cannot have shares registered in your name and sent out to you when you have purchased
these shares on margin. They must remain in the margin account in "the street name." You will
receive credit into your account for any dividends they pay. You may remove the shares from the
margin account only after you have repaid the amount you borrowed on margin to purchase these
shares.

If the value of your collateral rises, you can withdraw the amount over your minimum requirement
or use it for additional investments.

What Is a Margin Call?

A margin call is a demand by your broker for you to deposit cash or fully marginable securities
with your broker.

If the value of your collateral falls below the broker's minimum requirement (usually about 30% of
the loan), you will receive a margin call by letter, telephone, telegram, or other means, to request
additional collateral in the form of cash or fully marginable securities to meet the requirement.
However, only a percentage of a security's market value can be used to meet your margin call. If
you fail to meet the margin call, your broker is authorized (remember the margin agreement form)
to sell the margined securities and any other collateral needed to repay the loan plus interest and
commissions. You are responsible for any deficit that may remain after your assets are sold.

Let's see how a margin transaction works.

How Do Margin Transactions Work?

Margin accounts let you magnify your gains when you choose wisely. But, choose unwisely, they
also magnify your losses. You benefit from using margin only if the stocks you purchase rise in
price. If they stay the same, or worse, drop in price, you lose. You must pay interest on the
margin whether your stock rises or not. Here is an example:

Suppose you have an opportunity to purchase an Internet stock. It is selling for $11 a share. You
have about $ 5,500 to invest. So, you purchase 500 shares. A year later, you sell the stock at $33
per share. You receive about $16,300 before commissions on a $5,500 investment. Not bad.
However, instead you could use margin. Suppose you bought on margin 1,000 shares of an
Internet stock for $11 a share. You put up 50% of the stock's purchase price ($5,500) and
borrowed the other 50% from the brokerage firm. Next year, the stock is valued at $33 per share.
If you sell the stock and repay the broker, you are left with close to $27,000 after commissions
and interest charges. That is even better for a $5,500 investment.
However, what if your stock had dropped in price to $8 dollars? In the cash transaction, you
would receive about $4,000 back excluding commissions, from your original $5,000. In the margin
transaction, you would receive $8,000, repay the $5,500 you borrowed from your broker, and you
would be left with $2,500 of your original $5,500, excluding commissions and interest.

Is a Margin Account for You?

Before you decide to open a margin account, let us review the main points and the risks involved
in making margin transactions.

• A margin account is essentially a collateralized line of credit.

• You may use proceeds from a margin account for other investments and other purposes.

• You will pay interest on money borrowed from a margin account.

• If you use the margin to buy securities, you must meet certain minimum margin
requirements and maintain the appropriate amount of collateral. If the collateral level falls,
you can expect a margin call.

• Using margin to buy securities can magnify your gains. It can magnify your losses as
well.

• You can lose more funds than you deposit in the margin account. A decline in value of
securities that are purchased on margin may require you to provide additional funds to
your brokerage firm to avoid the forced sale of those securities or other securities in your
account.

• Your brokerage firm can force the sale of securities in your account. If the equity in your
account falls below the margin maintenance level required by the law, or below higher
"house" requirements, your brokerage firm can sell the securities in your account to cover
the margin deficiency. You will also be responsible for any shortfall in the account after
such a sale.

• Securities can be sold without contacting you prior to the sale. Some investors mistakenly
believe they must be contacted before a margin call becomes valid, and that the
securities in their accounts cannot be liquidated to meet the call, unless they have been
contacted first. This is not the case. Most firms will attempt to notify you of margin calls,
but are not required to do so. However, even if your firm has contacted you and provided
a specific date by which you can meet a margin call, they can still take the necessary
steps to protect their financial interests, including immediately selling the securities
without notice to you.

• You are not entitled to choose which securities in your margin account are liquidated or
sold to meet your margin call. Because the securities are collateral for the margin loan,
your brokerage firm has the right to decide which security to sell in order to protect its
interests.

• "House" maintenance requirements can be increased at any time and without advance
written notice. These changes in policy can take effect immediately and may result in the
issuance of a margin maintenance call. Your failure to satisfy this call may cause a forced
liquidation in your account.
 • You are not entitled to an extension of time on a margin call. While an extension of time
to meet margin requirements may be available to clients under certain conditions, a client
does not have a right to the extension.

---------------X---------------

=================================================
Buying on Margin
Introduction

In this section, we will cover the basics of using margins. We will discuss the following:

• Why Buy on Margin?

• Rules for Buying on Margin
• Which Securities Can Be Margined?
• Selling Short

Why Buy on Margin?

Let's begin with an example. Suppose you believe that a particular stock will rise in price. It is
currently trading at $10 per share and you believe it will soon hit $20. Currently you only have
$3,000 in cash to buy 300 shares. You can borrow $3,000 on margin and invest the total $6,000
for 600 shares. If the stock hits $20, your holdings will be worth $12,000 and you can then sell
them for that price. You pay back the $3,000 you borrowed, leaving you with your original
investment of $3,000 and a tidy gain of $6,000 (before commissions and interest). The chance to
magnify your earnings is what buying on margin is all about.

However, if the stock declined to $7 a share and you sell, you receive only $4,200. From this
amount, you must repay the $3,000 you borrowed. Thus, leaving you with $1,200 of your original
$3,000, before commissions and interest.

Buying on margin is a strategy for the short term, since holding on to borrowed money too long
could result in a loss. You are responsible to meet all margin calls promptly and you are
responsible to repay all funds borrowed on margin, even if this amount exceeds the value of your
account.

As with all investing, there is risk in buying on margin. One of the biggest reasons many people
lost lots of money in the stock market crash of 1929 was that they borrowed too much and could
not pay back their loans. The government stepped in soon after to create limits.

Rules for Buying on Margin

After the market crash of 1929, the government enacted laws to help prevent the practices that
led to the crash. Federal Reserve Board Regulation T sets margin requirements. Regulation T
requires that the customer put up a percentage of the total investment amount. The Federal
Reserve Board sets this percentage but changes it periodically to keep speculation under control.
Currently the margin requirement is 50%. However, some brokerages may require more than 50
percent. You may use fully marginable or partially marginable securities you already own as
collateral for the margin. Conversely, you may borrow up to 50 percent of the value of your
marginable portfolio. The broker-dealer holds the marginable shares as collateral. You pay the
broker interest and commissions on the transactions.

To buy on margin, you must have a margin account. You can put up your collateral in cash or
securities. You are allowed to add money or securities to your account.
The initial margin is the smallest amount that the investor must pledge at purchase. The bare
minimum that must stay in the account is the maintenance margin. When the balance falls
below this amount, if the margined securities drop in value, the investor will get a margin call,
which is a demand that the account be brought back up to the maintenance margin. If the
customer cannot meet the margin call, the broker may sell any and all of the customer's margined
securities and other assets to meet the call. The NASD requires maintenance margin on equities
of 25%. However, your broker may impose higher margin maintenance requirements. The
customer is responsible for any remaining deficit.

Which Securities Can Be Margined?

The Board of Governors of the Federal Reserve System publishes a list of marginable securities.
Most brokerages will extend margin on the following types of securities:

• Listed common and preferred stocks

• Municipal bonds
• Federal government bonds, notes and bills
• Nasdaq Securities
• Convertible bonds
• Corporate bonds

Always check with your brokerage firm to determine whether a security is, 1)marginable, and 2) if
a higher maintenance requirement is imposed on the security. Some securities are marginable
only up to a certain value of the security while still other securities are non-marginable all
together.

With an IPO, you must wait at least 30 days after a security has been traded in the secondary
market before the security may become marginable.

Mutual funds and certain options may not be bought on margin or used as collateral in a margin
account.

Buying on margin is usually simple, but it is risky. If you buy a security with it, and it nose-dives in
value, you cannot rescue it with more margin buying. Margining magnifies earnings, and it can
magnify losses as well.

Selling Short

Margin accounts are not just used for buying -- you can also use them to sell securities. This is
called selling short, or shorting. You can read more about selling short in the next section.
Selling Short
Introduction

Selling short involves borrowing securities you believe will decline in value and then selling them.
You are selling securities you do not own. Looked at another way, short selling is about selling
high and then buying low, just the opposite of regular trading. Once you have sold your securities,
you hope that the price falls, in which case you buy them back at a lower price. If the price rises,
you may be forced to buy the shares back at the higher price, losing money on the transaction.
Remember -- you have to buy them back because you must return them to the brokerage firm.

In this section about the short sale we will discuss the following:

• What Is a Short Sale?

• What Are the Potential Rewards of Selling Short?
• What Are the Potential Risks of Selling Short?
• What Kind of Brokerage Account Do I Need to Make a Short Sale?

What Is a Short Sale?

A short sale occurs when you "borrow" a security from your broker and sell it with the intent of re-
purchasing it in the future to repay the loan of the security. You might sell short if you believed the
price of a security was going to drop and you could re-purchase it at a price significantly below
the price for which you sold it.

You may have a "long" or "short" position in a security. When you have a "long" position in a
stock or bond, you actually own the security in your account. On the other hand, sometimes you
may want to take advantage of a price movement in a security you do not own. When you do this,
you may take a "short" position by borrowing the security.

Here is how selling short works:

1. You borrow a security from your broker.

2. You sell it at its current price.
3. You buy the security back when you believe the price has fallen sufficiently or the broker
calls for it (which ever comes first).
4. You return the security back to the broker.

As an example, let's say that you really believe that Chocolate Beer, Inc. (XYZ), which is currently
$10 per share, is going to fall very far and very fast. You borrow 100 shares of XYZ from your
broker and sell them for $1,000. Soon afterward, the stock drops to $4 a share, at which price you
buy the 100 shares back for $400. You come out $600 ahead (before commission and interest).

If Chocolate Beer, Inc. becomes a hit and its price rises, you will take a loss. Let's say it rises to
$15 by the time you must repay the shares. It will cost you $1,500 to buy those 100 shares back.
Thus, you must pay $1,500 to replace the shares you sold for $1,000. You must also pay
commission and interest costs as well.

Dividends or interest earned on the shorted security belong to the person from whom you
borrowed it. The broker can also demand that you return the shares at any time regardless of
whether the price is up or down.
Top

What Are the Potential Rewards of Selling Short?

Investors use short sales to make gains in a declining market or to hedge against losses in an
investment.

If you sell short, and buy back at a lower price, you stand to make larger gains than if you had a
long position in a security that declines in value. For example: you borrow 100 shares from a
corporation, which has a market price of $35. You sell the 100 shares for $3500. The price later
falls to $25. You buy back 100 shares for $2500. You have made a profit of $1000 ($3500-
$2500).

Top

What Are the Risks of Selling Short?

As with any investment strategy, there is a downside. If you are incorrect, you may have to re-
purchase the borrowed security at a price higher than you sold it. In our previous example, if the
price of the corporation increases from $35 to $40 and you have to buy the shares back, you
have to pay $4,000 and you lose $500. While you have a "short position" in a security, you are
responsible for paying any dividends or interest it distributed to the investor you borrowed it from
even though you did not receive it either. The security can be called at anytime by your broker
and you must return it immediately regardless of the market price.

A very important thing to remember when selling short is that you have only a limited amount of
money you can earn if you are correct. However, your potential to lose money has no limits. This
is true because the money you can make is restricted to the difference between the stock's
current market price and the floor price for all securities - $0.00. Whereas, a security can
hypothetically appreciate indefinitely. This means that when you sell short, your losses could
accrue indefinitely if you do not close out the position.

To take advantage of selling short you will need a special brokerage account. Read below to
learn more.

What Kind of Brokerage Account Do I Need to Make a Short Sale?

All orders to sell a security short must be placed in a short account. You must have margin
privileges with your brokerage firm in order to have a short account. Since selling short requires
that you borrow from your broker, you will need to establish credit with your broker and abide by
the rules for borrowing against your account. See the section Introduction to Margin Accounts for
more information about margin accounts.

Dividend Reinvestment Plans (DRIPs)

Introduction

Investing in stocks is not hard. While most investors elect to purchase shares directly from a
stockbroker, an interesting alternative exists - Dividend Reinvestment Plans. In this introductory
section we will explain:

• What Are Dividend Reinvestment Plans (DRIPs)?

• Two Types of Dividend Reinvestment Plans
• Benefits of Dividend Reinvestment Plans

What Is a Dividend Reinvestment Plan?

Some corporations offer their shareholders the option of reinvesting their dividends in additional
shares of stock. This allows shareholders to purchase additional shares of stock directly from the
company without having to use a brokerage service. This is known as a dividend reinvestment
plan (DRIP).

However, to be eligible for a dividend reinvestment plan, most corporations require that you
purchase your original shares from a brokerage house. Once you own some of the company's
stock, you then may be eligible to participate in a dividend reinvestment plan. Nonetheless, many
brokerage services can be very helpful in pointing out to investors (who ask) what companies
offer dividend reinvestment plans.

The obvious advantage to dividend reinvestment plans is the potential to save on brokerage
commissions through direct purchases. Nonetheless, there are other attractive features of these
plans that we will explore.

But before we look at all the potential benefits, let's begin by looking at the two dividend-
reinvestment plans available to investors.

Top

Types of Dividend Reinvestment Plans

There are two types of dividend reinvestment plans:

1. Plans that offers a shareholder stock that already exists, "old stock"
2. Plans that offers a shareholder "new stock"

The first type of DRIP has an outside trustee repurchase shares on the secondary market. These
shares are purchased to re-issue them to shareholders in the dividend reinvestment plan. The
shareholder will get the shares at market price. However, the corporation will often offer to cover
the commission and fees to encourage shareholders to participate in the plan.

In the second type of DRIP the shareholders receive newly issued shares directly from the
company. This implies that the company has the control on whether to provide an additional
discount or not. Some corporations will go as far as offering their stock at three to five percent
below the market price. Companies offer these discounts because they save the costs of going
through an investment banker to issue the new shares. The goal is usually to have shareholders
continuing to invest.

Read below to see how everyone benefits from these DRIPs.

Top

Benefits of Dividend Reinvestment Plans

Dividend reinvestment plans benefit both the investors and the corporations.

For investors: An investor will usually save brokerage fees or will be offered other discounts that
a corporation will provide in order to keep the investor. Furthermore, some investors may also
enjoy the benefits of the option to purchase more shares in a company they already know and
trust, rather than searching through the thousands of options available to them in the free market.

For the corporation: By offering the DRIP a corporation raises capital inexpensively. DRIPs can
also help provide stability for a company's stock price by offering perpetual demand for the
company's shares as new dividends are declared. Furthermore, the corporation may decrease or
increase the availability and the benefits of their dividend reinvestment plans based on how much
capital they need to raise.

Top

Conclusion

Today, about a thousand corporations (mainly the large ones) offer DRIPs. Only about 25% of the
shareholders actually choose to take advantage of them. Yet, corporations will continue to offer
discounts because DRIPs have proven themselves to be a good way to raise capital.
Furthermore, as more investors learn about the benefits of DRIPs, one might expect that more
investors will be drawn to the advantages offered by these programs.

Investing in IPOs
Introduction

The 1990s have witnessed many small start-up companies successfully placing large amounts of
stock in the primary market through well-publicized initial public offerings (IPOs). The possibility of
buying stock in a promising start-up company and finding the next success story has intrigued
many investors. Yet, is investing in an IPO right for you?

In this section, you will learn about some of the challenges, basic risks and potential rewards
associated with investing in an IPO. You will be able to answer the following questions:

• What Is an IPO?
• What Should I Look for When Choosing an IPO?
• What Are the Risks of Investing in an IPO?
• What Information Should I Get Before Investing?
• Where Can I Find Information about the Company?
Even if you never invest in an IPO, the lessons you learn here will prepare you to make a
decision about whether or not investing in an IPO is suitable for you.

What Is an IPO?

An initial public offering (IPO) is the first sale of a corporation's stock to outside investors. This
does not necessarily mean that a company is a new business. It simply means that the company
is offering shares of ownership to investors outside the corporate "family" for the first time.

Most businesses are privately owned. They do not have "outside" investors. A few people, who
may be management or employees and members of their respective families, own all the
outstanding stock. Such corporations are referred to as "closely held corporations." These
companies are usually small, but some are nationally recognized names such as AVIS Rent-a-
Car.

When a privately held corporation needs additional capital, it can borrow cash or sell stock to
raise needed funds. Often "going public" is the best choice for a growing business. Compared to
the costs of borrowing large sums of money for ten years or more, the costs of an initial public
offering are small. The capital raised never has to be repaid. When a company sells its stock
publicly, there is also the possibility for appreciation of the share price due to market factors not
directly related to the company.

If you are looking for a "diamond in the rough," an initial public offering may be for you.

What Should I Look for When Choosing an IPO?

As with any investment, you must do your homework carefully. Keep in mind that an initial public
offering is a cheap way to raise capital. Investing in an IPO is not always best for the investor.
Before signing that check, you must be clear about the benefits you hope to obtain from the
investment. Are you investing for income, long-term growth or short-term capital gains? The
offering's financials will tell the story.

• As an income investor, you need to examine the company's potential for profits and its
dividend policy. You are looking for steadily rising profits that will be distributed to
shareholders regularly.
• A growth investor evaluates the company's growth plan, earnings and potential for
retained earnings. You are looking for potential steady increase in profits that are
reinvested for further expansion.
• A speculator looks for short-term capital gains. As a speculator, you look for potential of
an early market breakthrough or discovery that will send the price up quickly with little
care about a rapid decline. You are not going to be in it that long. Companies that have
"fad" products often fit the bill.

This sounds simple, but what are the risks involved?

What Are the Risks of Investing in an IPO?

Slow down. It may sound easy, but it is risky. Before investing in an initial public offering, you
need to ask yourself some questions. How much do you really know about this company? A Wall
Street sage once said, "Never invest money in anything you don't understand." You may
understand all about how an IPO works, but what do you really know about the business of the
company in which you plan to invest? Before it went public, the only shareholders in a privately
held company were the management, employees and their families. They all know about the
business; they are in it. Before investing, you need to learn the fundamentals of the business.
What is their product or service? Who are their competitors? What is their share of the market for
their product? What is the likelihood they will succeed with their newfound capital? Ignorance is
your worst enemy.

You should concern yourself with three kinds of risk related to the company.

• Business Risk: Does this company have a sound business plan and management with
education, training, experience sufficient to execute the plan?
• Financial Risk: Is this company solvent with sufficient capital to weather short-term
business setbacks?
• Market Risk: Are other investors likely to buy this stock on the secondary market? Does
this company possess sufficient appeal to investors in the current market environment
(income, growth, or short-term capital gains)? How long is the attraction likely to last?

What Information Should I Get Before Investing?

The more information you have the better decision you will be able to make.

Keep in mind that the original stockholders are insiders. Among the information you will want to
know is:

• Business Operations: What is management like? Do the employees like to work there?
Is there a large turnover in the labor force? How do customers perceive the company?
How do Dunn and Bradstreet and the Better Business Bureau rate the company?
• Financial Operations: What is the company's credit history? Are they in default on any
debts? Have the owners invested sufficient capital to give them a financial stake in the
company's success? How does this company's expenses compare to their competition's?
• Marketability: Would you buy and use their product? Who would? Is their product a long-
term commodity or just a fad? Can you buy the IPO shares directly from the issuer?

A substantial advantage can be gained if you can purchase IPO shares directly from an issuer.
This could save you "mark-up" and commissions used to pay for marketing the offering.

By taking the time to answer each of the questions above, you gain valuable information that will
help you decide whether this IPO is a suitable investment for you.

Where Can I Find Information about the Company?

Unless you actively seek out IPOs, the first you hear about an IPO is likely to be that dreaded
dinnertime sales solicitation. Fortunately, all the information you need is readily available to you,
but you must take the time to read it. Forget about the sales pitch. If the "…deal is too good to
pass-up" and "… you must buy it tonight…" chances are you want to gain further information
before investing.

Federal law states that: ALL INITIAL PUBLIC OFFERINGS ARE REQUIRED TO BE
ACCOMPANIED OR PRECEDED BY A PROSPECTUS. The prospectus is the official offering
document that contains all material information about the company and its offering.

If you are looking for an IPO as an investment, you should be familiar with the following:
 • IPOs are often introduced in the financial press with a tombstone advertisement. This
contains the "bare bones" information, including the name of the stock, the issuer and
how to obtain a red herring.
• You may obtain a preliminary informational prospectus, red herring, to ascertain whether
or not you have any interest in the prospectus and offering when available.
• Information about the offering is available on the Securities and Exchange Commission's
Edgar database at www.sec.gov/edgarhp.htm.
• Today, many companies have their own web sites that provide information to their
customers and prospective investors.
• Barron's, the Wall Street Journal, Investor's Business Daily and other financial periodicals
report on companies going public.

IPOs are not for every investor. They may provide an opportunity for substantial gain for the
knowledgeable investor, but the unwary investor is just as likely to get burned.

What Are Stocks?

Stocks are ownership in a company, with each share of stock representing a tiny piece of
ownership. The more shares you own, the more of the company you own. The more shares you
own, the more dividends you earn when the company makes a profit. In the financial world,
ownership is called equity.

There are two primary classes of stock. The one you choose depends on what you want from a
stock. Preferred stock typically pays regular dividends and is favored by investors who want
income foremost from their stocks. Common stock represents ownership of a company and may
offer more rights and privileges than preferred stock.

Investors may purchase stock on the primary or secondary market. A company sells its stock to
the public on the primary market through its initial public offering. Investors may sell their shares
through brokers to other investors on the secondary market. The secondary market can be
structured as an auction market, like the New York Stock Exchange, or a dealer market, like the
NASDAQ. Stock prices (quotes) can be found in newspapers, on television and the Internet.

Types of Stocks
Introduction

In this section, we will explore what is meant by the many names given to stocks and the
corporations that issue them. Each of the following types refers to any of several different
qualities of stocks or companies. For example, a stock's classification may come from the size of
the company that issued it, or from the perceived investment objective it fulfills. You will be
introduced to the following stock types in this section:
 • Blue-Chip Stocks
• Penny Stocks
• Income Stocks
• Value Stocks
• Other Types of Stocks

Blue-Chip Stocks

The term "blue-chip" comes from poker, where the blue chips carry the highest value. Large,
established firms with a long record of profit growth, dividend payout and a reputation for quality
management, products and services are referred to as blue-chip companies. These firms are
generally leaders in their industries and are considered likely candidates for long-term growth.
Because blue-chip companies are held in such high esteem, they often set the standards by
which other companies in their fields are measured. Well-known blue-chips include IBM, Coca-
Cola, General Electric and McDonald's.

Blue-chip stocks are included in the Dow Jones Industrial Average, an index comprised of 30
companies that are all major players in their respective industries. Popular among individual and
institutional investors alike, the 30 stocks listed on the Dow account for about one fifth of the total
market value (over $8 trillion) of all U.S. stocks.

Investors who seek investments that pay moderate dividend yields and that also grow are
attracted to blue-chip stocks. These stocks are usually priced high because of their demand, have
relatively low volatility and deliver a steady stream of dividends. The main downside is that, since
they are so large, they have little room to appreciate, compared to smaller, up-and-coming
stocks.

Top

Penny Stocks

Penny stocks, over-the-counter bulletin board (OTCBB) or pink sheet securities are low-priced,
speculative stocks that are very risky and are not suitable for every investor. They are issued by
companies with a short or erratic history of revenues and earnings. Penny stocks sell for less
than $5 per share and their companies have under $2 million in net tangible assets. Therefore,
the companies do not qualify to trade on the New York Stock Exchange or on the NASDAQ.
Instead, the securities are traded by specially registered Dealers. Quotes for the securities are
frequently outdated or delayed and may not be firm. Trades for these securities are always
executed on a manual basis.

The appeal of penny stocks comes from their low price. Though the odds are against it, if the
company that issued them suddenly finds itself on a growth track, their share price can rise
rapidly. Investors who trade these securities are speculating as to the company's growth and are
willing to assume the entire loss of their investment.

Top

Income Stocks

Income stocks are those stocks that pay higher-than-average dividends over a sustained period.
These above average dividends tend to be paid by large, established companies with stable
earnings. Utilities and telephone company stocks are often classified as income stocks.
Income stocks are popular with investors who want steady income for a long time and who do not
need much growth in their stock's value (though some growth does occur). In this sense,
investors who choose them have something in common with bondholders. To maximize income,
some investors will even seek out companies that frequently raise their dividends and are not
saddled with debt.

Value Stocks

A value stock is a stock that is currently selling at a low price. Companies that have good
earnings and growth potential but whose stock prices do not reflect this are considered value
companies. Both the market and investors are largely ignoring their stocks. Investors who buy
value stocks believe that these stocks are only temporarily out of favor and will soon experience
great growth. Factors such as new management, a new product or operations that are more
efficient may make a value stock grow quickly.

Many companies alternate between value and growth as part of the business cycle. Value stocks
are attractive to investors who watch markets carefully for undervalued stocks they feel will move
upward.

Other Types of Stocks

Defensive stocks are those whose prices stay stable when the market declines and are issued
by industries that naturally do well during recessions. Food and utilities companies are defensive
stocks. Debt collection companies also tend to perform well when the market turns sour.

Cyclical stocks are stocks that move up or down in sync with the business cycle. Examples
include the housing industry and industrial equipment companies, because these companies
serve the needs of growing economies. Investors who do not mind buying and selling as the
market fluctuates tend to like cyclical stocks. Individuals who prefer to hold a stock for a long time
may not like them unless they can weather ups and downs in the stock's value.

Gold stocks are the stocks of gold-mining companies. Their value moves up or down with the
price of gold.

Treasury stocks are stocks that have been bought back by the company that issued them.
Companies may buy their stock back from investors when they believe it is underpriced on the
market. The company can then set aside the stock for future uses such as debt payment or the
awarding of stock options.

Small-, Mid- & Large-Cap Stocks

Introduction

You may have heard the terms "small-cap," "mid-cap" or "large-cap" in your reading about stocks
and the companies that issue them. This short section will discuss segments of the stock market.
It will cover the following topics:

• Market Capitalization
 • Small-Cap Stocks
• Mid-Cap Stocks
• Large-Cap Stocks

We will first read about market capitalization and what it means.

Market Capitalization

"Cap" is short for capitalization, which is the market value of a company's stock. Capitalization
gives a picture of a company's size. You can calculate a company's stock capitalization by
multiplying market price of its shares by the number of shares outstanding ("outstanding" means
in the hands of the public). For example, if ABC Corporation has one million shares outstanding,
and the price per share is $10, then ABC Corporation has a market capitalization of $10 million.

Corporate stock is often grouped by the company's capitalization. For example, one model would
group companies as follows:

Small-cap -- less than $500 million

Mid-cap -- between $500 million and $3 billion
Large-cap -- over $3 billion

These lower and upper limits will vary depending upon the model. However, the general
classification scheme remains true. You can see that stocks are grouped based on their issuer's
capitalization. That is where the terms small-cap, mid-cap and large-cap come in.

Small-Cap Stocks

The stock of small companies that have the potential to grow rapidly is classified as small-cap
stock. Many of these companies are relatively new. How they will behave in the market is often
difficult to predict. Because of their small size, growth spurts can affect their prices and earnings
dramatically. On the other hand, they tend to be volatile and may decline dramatically.

Most initial public offerings are for small-cap companies. Most small-cap stocks are oriented
toward growth. Growth and aggressive-growth mutual funds often look for small-cap companies
for their portfolios. Because they look to grow rapidly, small-cap stocks are likely to forego paying
dividends to investors so that profits can be reinvested for future growth of the company.

Small-cap stocks are popular among investors who are looking for growth, who do not need
current dividends, and who can tolerate price volatility. If successful, these investments can
generate significant gains.

Mid-Cap Stocks

Mid-cap stocks are typically stocks of medium-sized companies. Like small-cap stocks they offer
growth potential, but they also offer some of the stability of a larger company. Stocks of many
well-known companies that have been in business for decades are mid-cap stocks.
Baby blue-chips are mid-cap stocks that have steady growth and a good track record. They are
like blue-chip stocks (which are large-cap stocks) but lack the size of blue-chips. These stocks
tend to grow well over the long term.

Mid-cap stocks, like small-caps, emphasize growth but pay a relatively larger share of their
earnings as dividends.

Large-Cap Stocks

Stocks of the largest companies such as IBM or GE are classified as large-cap stocks. These are
large, established companies (many are blue-chips). They often keep large reserves of cash to
take advantage of new business opportunities. Together they make up over half of the value of
American stock.

Because of their large size, large-cap stocks are not expected to grow as rapidly as a smaller
capitalized company. Successful mid-caps and small-caps tend to outperform them over time.
Investors looking for dividends and preservation of capital with some growth potential choose
them. Large-cap stocks pay relatively more in dividends than small- and mid-cap stocks.

Investors who want their money to remain relatively safe over the long term are often attracted to
large-cap stocks.

Preferred Vs Common Stock

Introduction

Some corporations issue both common and preferred stock. Each provides unique benefits to
investors. Both common and preferred shareholders own a portion of the company, but they have
very different rights. Common stock confers voting and pre-emptive rights. Preferred stock may
trade voting and pre-emptive rights for dividends and a higher claim to liquidated company assets
than common stock. Regardless of whether you choose common or preferred stock you should
always read the prospectus before investing.

In this section, we will first explain shareholder rights and privileges, followed by common and
preferred stocks and their respective properties. For common stock, we will cover these topics:

• Shareholders' Rights and Privileges

• An Overview of Common Stock
• Types of Stock Dividends

For preferred stock will cover these areas:

• An Overview of Preferred Stock

• Types of Preferred Stock
• Features of Preferred Stock
Shareholders' Rights and Privileges

Shareholders may acquire the following rights and privileges when they purchase shares of a
company's common or preferred stock (although preferred shareholders may have theirs
restricted or applied only in certain situations).

Voting Rights

Owners of common stock have the right to vote on company matters. For example, they can vote
on whether to allow a stock split, or whether the objective of the company should be changed.
They cannot, however, vote on whether dividends should be distributed.

A shareholder has one vote for each share owned. To cast their votes, most shareholders use a
form of absentee ballot called a proxy.

Shareholders also elect the management of the corporation. There are two methods of voting.
The statutory method provides one vote per share for each vacant seat; this method benefits
those who hold many shares. The cumulative method allows those who do not own many shares
to have as many votes as there are seats to be filled. Shareholders can cast all their votes for one
candidate or distribute their votes among several. For example, if five directors were to be
elected, an owner of 30 shares of stock with the cumulative voting right would have 150 votes
that they could cast for one director or spread among the five directors.

Preemptive Rights

Preemptive rights may give shareholders the right to keep their proportionate ownership of the
company. If the company offers a new issue of stock to the public, shareholders are accorded the
right to buy new shares to keep their percentage of ownership the same. With preemptive rights,
they can maintain voting control, share of earnings and share of assets.

Preemptive rights let common shareholders buy new shares of stock before non-stockholders.
Thus, these rights assure the keeping of previous percentages of ownership. They must be
exercised within 45 days. If they are not, the company may sell the stock to non-shareholders.

Other Rights of Common Stockholders

Shareholders have the right to inspect the books and records of the company. They also have the
right to sue the management for any unauthorized activities. They have the privilege of receiving
dividends as cash, stock or property. The board of directors, however, is allowed to forego paying
dividends if it feels that doing so is against the best interests of the corporation.

Stockholders also have the right to receive distributions of any remaining assets should the
company go out of business. However, as stated before, they are last in line for the asset-
claiming privilege. Preferred shareholders are paid before common shareholders.

An Overview of Common Stock

Common stock represents ownership in a corporation.

Common stock dividends may be paid in cash, stock or property. The most common payment
method is a cash dividend. The board of directors determines whether or not to pay dividends to
common shareholders. Increases or reductions in dividend payments most frequently depend on
how well the company is performing. In a weak economy the company may even suspend
dividends until its balance sheet improves.

Should the corporation issuing the stock go bankrupt, it may have to liquidate its assets in order
to pay its creditors. Common stockholders will receive payment for their ownership interest only
after all other creditors, the bondholders, and preferred shareholders have been paid.

Types of Stock Dividends

Stock pays dividends in three forms: cash, stock and property. Let's take a look at each one.

Cash dividends are those that are paid out in cash form. They are treated as investment income
and are taxable in the year they are paid.

Stock dividends are dividends paid out in the form of additional stock shares in the corporation,
or shares of a subsidiary corporation. They are usually issued in proportion to shares owned. For
example, for every 100 shares of stock owned, a four percent stock dividend will yield four extra
shares. When the company distributes these new shares to investors, the price of each share
decreases to account for the new shares. This is a recalculation of cost basis. It means that the
stock dividends will not be taxed when distributed.

Stock dividends benefit the company by conserving its cash and they benefit the shareholder by
increasing his/her number of shares of the company.

Property dividends are paid with assets owned by the issuing company. Property dividends are
usually paid in the form of products or services that the corporation produces. Often the
corporation, when paying property dividends, will use securities of other companies owned by the
issuer.

This concludes our look at common stock. Read below to learn about preferred stock ownership.

An Overview of Preferred Stock

Preferred stock also represents ownership in a corporation.

Preferred stock promises guaranteed dividends and a claim on a company's assets that is above
that of common shareholders. The trade-off may be that preferred shareholders cannot vote or
share other specified rights. Preferred stock pays a fixed dividend that is specified and set down
in advance. Unless the stock is retired or called back, it will continue paying dividends forever.

Preferred stock is usually issued with a $100 par (face) value. The dividend payments are a fixed
percentage of the par. For example, if the par value of a stock share were $100 with a six percent
annual dividend rate, the annual dividend would be $6 on that share. In recent years, some
companies have also begun issuing preferred shares with variable rates tied to interest rates.

The par value is the most that the shareholder will receive if the company declares bankruptcy.
Preferred stock is generally issued at its par value.

Types of Preferred Stock

Preferred stock further divides into four types: cumulative, non-cumulative, participating and
convertible.

Cumulative preferred stock accords its owner a continuous claim to his or her dividends. Any
unpaid dividends accumulate until the corporation resumes paying them. Since the cumulative
preferred owner is entitled to all past and present dividends, he or she is paid before common
shareholders once payment is resumed. If the board of directors suspends dividends, the
shareholder still has a claim on them.

Non-cumulative (straight) preferred is the opposite of cumulative preferred: it doesn't confer a

steady claim on dividends in the event of a dividend suspension. Shareholders of this type may
not be paid any missed dividends prior to payments being made to the common shareholders.

Participating preferred shareholders receive extra dividends over their normal ones when the
company makes an extra profit and the board of directors declares dividends.

Convertible preferred stock may be converted to a certain number of shares of common stock.
Preferred investors who want the opportunity to share in the appreciation of the company's
common stock may find this option attractive.

Preferred stock has features other than fixed, steady dividends. The next section will explain
these features.

Features of Preferred Stock

Limited Voting Rights

Preferred stockholders may be limited to voting only in these situations:

• When the company wants to merge with another

• When the company wants to liquidate a large portion of its assets
• When the company wants to issue new bonds or preferred stock

Call Provisions

Preferred stock may carry a call provision. This means that the issuing company can repurchase
the stock from the shareholders. Though preferred stock is usually called at par value, some call
provisions actually tack on a premium.

Because of the steady dividends accorded to preferred shareholders, call provisions are not
usually advantageous to them, despite any premiums. However, a corporation may use calls as a
way to eliminate dividends, thus increasing earnings for common shareholders.