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Basics of Common Stocks
Basics of Common Stocks
Common Stock Basics
8. Dividend Payout Ratio: The percentage of earnings paid to
shareholders in dividends.
Calculated as:
The payout ratio provides an idea of how well earnings support the
dividend payments. More mature companies tend to have a
higher payout ratio.
Common Stock Basics
9. Capital Gain: Profit that results when the price of a security held
by a mutual fund rises above its purchase price and the security
is sold (realized gain). If the security continues to be held, the
gain is unrealized. A capital loss would occur when the opposite
takes place.
10. Growth Stock: A stock that experiences a continued period of
growth exceeding that of the economy. Generally, the duration is
over a year in length.
11. Income Stock: A stock that has a high, consistent, dividend
paid annually.
12. Speculative Stock: Stocks that offer the potential for substantial
price appreciation, usually because of some special situation
such as new management or the introduction of a promising new
product.
Common Stock Basics
13. Cyclical Stocks: these are stocks whose earnings and overall
market performance are closely linked to the general state of the
economy.
14. Defensive Stocks: these stocks tend to hold their own, and even
do well, when the economy starts to falter.
15. Mid-cap stocks: are medium-sized companies, generally with
market values of less than $4-$5 billion but more than $1 billion.
16. Small-cap stocks: are stocks that generally have market values
of less than $1 billion but can offer above-average returns.
Other Common Stock Values
17. Par Value: A dollar amount that is assigned to a security
when representing the value contributed for each share in cash
or goods.
18. Book Value: the value of the equity of the firm divided by the
number of shares outstanding.
19. Liquidation Value: the value obtained for selling all the
assets of the corporation on the auction block.
20. Market Value: the current market price of the stock times the
number of shares outstanding.
21. Investment (Intrinsic) Value: the value of the corporation
based on discounted cash flow analysis and the income
generating capacity of the firm.
Valuation of Common Stock
1. Dividend Valuation Model
A model for determining the intrinsic value of a stock, based on a future
series of dividends that grow at a constant rate. Given a dividend per
share that is payable in one year, and the assumption that the dividend
grows at a constant rate in perpetuity, the model solves for the present
value of the infinite series of future dividends.
Where:
D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)
Valuation of Common Stock
2. Capital Asset Pricing Model
A model that describes the relationship between risk and expected return and that is
used in the pricing of risky securities.
The CAPM says that the expected return of a security or a portfolio equals the rate on a
risk-free security plus a risk premium. If this expected return does not meet or beat
the required return, then the investment should not be undertaken. The security
market line plots the results of the CAPM for all different risks (betas).
Common Stock as an Inflation Hedge
- Protection Against Inflation
Over the last thirty years the S&P 500
has averaged approximately 12% annual
compound return.
- Inflation has averaged approximately
5.4% during the same time period.
Common Stock as an Inflation Hedge:
Source: Ibbotson and Sinquefield, “Stocks, Bonds, Bills and Inflation 2007
yearbook,” Chicago.
The Panic of 1987
Index arbitrage and portfolio insurance (programmed trading)
were the major cause. From Tuesday 10/13/87 to 10/19/87,
the DJIA fell 769 points or 31%. On 10/19/87 the DJIA
fell508 points or 22.6%. On 10/28/29 the DJIA fell 11.7%.
Columns 1 & 2: 52-Week High and Low - These are the highest and lowest prices at which
a stock has traded over the previous 52 weeks (one year). This typically does not include
the previous day's trading.
Column 3: Company Name & Type of Stock - This column lists the name of the company.
If there are no special symbols or letters following the name, it is common stock.
Different symbols imply different classes of shares. For example, "pf" means the shares
are preferred stock.
Column 4: Ticker Symbol - This is the unique alphabetic name which identifies the stock.
If you watch financial TV, you have seen the ticker tape move across the screen, quoting
the latest prices alongside this symbol. If you are looking for stock quotes online, you
always search for a company by the ticker symbol. If you don't know what a particular
company's ticker is you can search for it at: http://finance.yahoo.com/.
Stock Market Basics
Reading Stock Quotes
Column 5: Dividend Per Share - This indicates the annual dividend payment per share. If this space is
blank, the company does not currently pay out dividends.
Column 6: Dividend Yield - The percentage return on the dividend. Calculated as annual dividends per
share divided by price per share.
Column 7: Price/Earnings Ratio - This is calculated by dividing the current stock price by earnings per
share from the last four quarters. For more detail on how to interpret this, see our P/E Ratio tutorial.
Column 8: Trading Volume - This figure shows the total number of shares traded for the day, listed in
hundreds. To get the actual number traded, add "00" to the end of the number listed.
Column 9 & 10: Day High and Low - This indicates the price range at which the stock has traded at
throughout the day. In other words, these are the maximum and the minimum prices that people have
paid for the stock.
Stock Market Basics
Reading Stock Quotes
Column 12: Net Change - This is the dollar value change in the stock price
from the previous day's closing price. When you hear about a stock being
"up for the day," it means the net change was positive.
Stock Market Basics
Selling Short
Common Stock
Investments
A. Basic Characteristics
• 1. Equity Capital
• 2. Types
– a. Growth Stock
– b. Income Stock
– c. Speculative Stock
– d. Cyclical Stock
– e. Defensive Stock
Common Stock as an Inflation Hedge
• Protection Against Inflation
• Over the last thirty years the S&P 500
has averaged approximately 11%
annual compound return.
• Inflation has averaged approximately
5.4% during the same time period.
Types of Security Analysis
• 1. Fundamental Analysis
• 2. Technical Analysis
The Father of Fundamental Analysis:
Benjamin Graham
• Who was Benjamin Graham?
Fundamental Analysis: A method of evaluating a
security factors. Fundamental analysts attempt to study
everything that can affect the security's value, including
macroeconomic factors (like the overall economy and
industry conditions) and individually specific factors
(like the financial condition and management of
companies).
Sources: Security Analysis (Graham and Dodd); The Intelligent Investor (Graham)
Ben Graham and Mr. Market:
• Long ago Ben Graham described the mental attitude toward market
fluctuations that I believe to be most conducive to investment
success. He said that you should imagine market quotations coming
from a remarkably accommodating fellow named Mr. Market who is
your partner in a private business. Without fail, Mr. Market appears
daily and names a price at which he will either buy your interest or
sell you his. Even though the business that the two of you own may
have economic characteristics that are stable, Mr. Market’s
quotations will be anything but stable. For, it is sad to say, Mr.
Market is a fellow who has incurable emotional problems. At times
he falls euphoric and can see only the favorable factors effecting the
business. When in that mood, he names a very high buy-sell price
because he fears that you will snap up his interest and rob him of
imminent gains. At other times he is depressed and can see nothing
but trouble ahead for both the business and the world. On these
occasions he will name a very low price, since he is terrified that you
will unload your interest on him.
Ben Graham and Mr. Market
Continued:
• Mr. Market has another endearing characteristic: He doesn’t mind
being ignored. If his quotation is uninteresting to you today, he
will be back with a new one tomorrow. Transactions are strictly at
your option. Under these conditions, the more manic-depressive
his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or
everything will turn into pumpkins and mice: Mr. Market is there to
serve you, not to guide you. It is his pocketbook, not his wisdom,
that you will find useful. If he shows up someday in a particularly
foolish mood, you are free to either ignore him or to take
advantage of him, but it will be disastrous if you fall under his
influence. Indeed, if you aren’t certain that you understand and
can value your business far better than Mr. Market, you don’t
belong in the game. As they say in poker, “If you’ve been in the
game 30 minutes and you don’t know who the patsy is, you’re the
patsy.”
Graham’s Fundamental
Investment Rules
• 1. Adequate Size
• 2. Sufficient Strong Financial
Condition
• 3. Earnings Stability
• 4. Dividend Record
• 5. Earnings Growth
• 6. Moderate Price/Earnings Ratio
• 7. Moderate Ratio of Price to Assets
Terms
1. Net Current Assets (NCA)
– Defined as:
Current Assets
- Current Liabilities
- Long-Term Debt
- Preferred Stock
NCA Total
• 8. Total Debt
• 9. Equity
• 10. Growth
1/n
g = [ (1 + RP,-1)(1 + RP,-2) ... (1 + RP,-10)] -1
The Graham Model
• 1. Group A Criteria
#1: E/P > 2 (AAA Yield)(1 pt.)
E/P > 1.33 (AAA Yield) (1/2 pt.)
#2: P/E < .4 (Avg. P/E in last 3 yrs.) (1 pt.)
P/E < .4 (Avg. P/E in last 10 yrs.) (1/2 pt.)
#3: P/Bk < 2/3 (1 pt.)
P/Bk < 1 (1/2 pt.)
#4: D/P > .67 (AAA Yield) (1 pt.)
D/P > .50 (AAA Yield) (1/2 pt.)
#5: P/NCA < 1 (1 pt.)
P/NCA < 1.33 (1/2 pt.)
The Graham Model
2. Group B Criteria
#6: CR > 2 (1 pt.)
CR > 1.8 (1/2 pt.)
#7: TD/E < 1.0 (1 pt.)
TD/E < 1.2 (1/2 pt.)
#8: TD/NCA < 2 (1 pt.)
NCA > 0 (1/2 pt.)
#9: G10 > 7%/YR. (1 pt.)
G5 > 7%/YR. (1/2 pt.)
#10: No more than 2 declines in earnings of 5% each over the
last 10 years for one full point.
No more than 3 declines in earnings of 5% or more in last 10
years for one-half point.
Graham’s 14 Investment Points
Technical Analysis
A. Definition
Technical analysis really just studies supply and demand in a
market in an attempt to determine what direction, or trend,
will continue in the future. In other words, technical analysis
attempts to understand the emotions in the market by
studying the market itself, as opposed to its components. If
you understand the benefits and limitations of technical
analysis, it can give you a new set of tools or skills that will
enable you to be a better trader or investor.
H
C
Dollar L
Price of
Stock
Trading Days
Types of Technical Charts:
• Line Charts: a graph of successive day’s
closing prices
Closing
Prices
Trading Days
B. Approaches to
Technical Analysis
• 1. The Dow Theory
– The Dow theory views the movement of market
prices as occurring in three categories
1. Primary Movements: bull and bear markets
2.Secondary Movements: up and down
movements of stock prices that last for a few
months and are called corrections
3. Daily Movements: meaningless random daily
fluctuations
B. Approaches to Technical
Analysis (continued)
• 2. Trading Action
– a. Concentrates on minor trading
characteristics in the market
– b. Examples include:
• 1. Monday is the worst day to buy stocks,
Friday is the best.
• 2. If January is a good month for the
market then chances are good a good year
will occur.
B. Approaches to Technical
Analysis (continued)
• 3. Bellwether Stocks
– a. A few major stocks in the market are
consistently highly accurate in
reflecting the current state of the
market.
• IBM
• DuPont
• AT&T
• Exxon
• GM
Approaches to Technical
Analysis (Continued):
• 4. Relative Strength
– The basic idea behind relative strength
is that some securities will increase
more, relative to the market, in bull
markets and decline less, relative to
the market, in bear markets.
Technicians believe that by investing
in those securities that exhibit relative
strength higher returns can be earned.
B. Approaches to Technical
Analysis (continued)
• 5. Technical Indicators
– a. Market Volume -- a measure of investor
interest
• 1. STRONG when volume goes up in rising
market or drops during declining market
• 2. WEAK when volume goes up in declining
market or decreases during a rally
B. Approaches to Technical
Analysis (continued)
– Example
• On June 3, 2003
– Advances = 930
– Declines = 691
– Difference = + 239
• On June 11, 2003
– Advances = 651
– Declines = 920
– Difference = -269
– Conclusion: A weak market.
B. Approaches to Technical
Analysis (continued)
– b. Breadth of the Market
• 1. Considers the advances and
declines in the market.
• 2. As long as advances outnumber
declines a strong market exists.
• 3. The spread is used as an
indicator of market strength.
B. Approaches to Technical
Analysis (continued)
– c. Short Interest -- measures the number of stocks
sold short
• When the level of short interest is high, by historical
standards, then the situation is optimistic.
– d. Odd-Lot Trading: Theory of Contrary Opinion
• If the amount of odd-lot purchases start to exceed odd-lot
sales by a widening margin, it may suggest that
speculation is occurring among small investors. This is
the first signal of an upcoming bear market.
Review Questions: Section 3
• What are two theoretical ways to determine the value of
Common Stock?
• Net Current Asset in the Graham model is defined as?
• Why do we calculate geometric instead of linear growth
rates?
• The Graham model is a fundamental valuation model?
Explain.
• Define technical analysis.
• What are Bellweather stocks?
• Who was Peter Lynch and what is he primarily known for?
• What are Lynch’s 10 golden rules for investing?