Download Stocks - Bennie D. Waller, PhD Online Course Material

Personal Finance
Bennie Waller
[email protected]
434-395-2046
Longwood University
201 High Street
Farmville, VA 23901
Bennie D Waller, Longwood University
Stocks
Bennie D Waller, Longwood University
Stocks
Investing on the stock market is not without
risk
Investing on the stock market is all about risk
and return.
Sometimes, it’s all about making a fortune.
Bennie D Waller, Longwood University
Stocks
Shares of Stock Represent Pieces of a Business
 Owning stock in a company in essence indicates that you
are part-owner in the company.
 Generally each share of stock entitles the stockholder to be
have one vote toward the election of the Board of Director
(typically charged with the oversight of management).
 When organizations need to raise capital (money), they
typically have two broad options.
 One they can borrow the money (either from a bank or
issue debt (bonds) or
 they can give up partial ownership in the firm by selling
stock.
Bennie D Waller, Longwood University
Why Invest in Stocks?
• When you buy common stock, you purchase a part of the
company.
• Returns:
– Dividends—the company’s distribution of profits to
stockholders (paid at company’s discretion).
– Capital appreciation—the increase in the selling price of a
share of stock.
• Neither dividends nor capital appreciation is guaranteed.
• Over time, common stocks outperform all other investments.
• Stocks reduce risk through diversification and offer liquidity
Bennie D Waller, Longwood University
Stocks
Shares of Stock Represent Pieces of a Business
You start you own landscaping business. You decide that you
need $1,000 to get started. You divide the company into 10 pieces,
or "shares" of stock. You price each new share of stock at $100
which will garner the $1,000 you need to get started. If the
business earns $500 after taxes during its first year, each share of
stock would be entitled (not guaranteed) to 1/10th of the profit.
You'd take $500 and divide it by 10, resulting in $50.00 earnings
per share (EPS).
Source: http://beginnersinvest.about.com/od/stocksoptionswarrants/a/what-is-stock.htm
Bennie D Waller, Longwood University
Stocks
 Stock investors expect to earn a return (no guarantee).
 Capital Appreciation –
 Income - dividends
 Firm’s that pay dividends?
 Why firms may not pay a dividend
 Types of investors that invest in these firms
 Firm’s that don’t pay dividends, and why?
 Types of investors that invest in these firms and why
 Many/most firms pay some dividends as well as enjoy price
appreciation.
Bennie D Waller, Longwood University
Stocks
Bennie D Waller, Longwood University
Common Stock Language
 Limited Liability – only amount invested but unlimited potential
 Claim on Income - dividends
 Declaration date – date which BOD declares upcoming dividend
payment
 Ex-dividend date - date on which shareholders must own stock to be
eligible
 Claim on assets
 Voting Rights
 Proxy
 Stock splits – e.g. 2 for 1
 Reverse splits - 1 for 2
 Stock repurchases – why would a company choose to repurchase their
own stock?
Bennie D Waller, Longwood University
Income Statement
Bennie D Waller, Longwood University
STOCKS
Earnings Per Share (EPS) - measures the earnings of the firm on a per
share basis.
NI
50,000
Earnings Per Share (EPS) 

 $5
shares outstanding 10,000
Payout ratio (PO) - dictates what percent of earnings the firm will
payout to stockholders in the form of dividend. Conversely 1-PO
indicates what percent of net income the firm plans to retain. A
payout ratio of 60% illustrates that the firm is planning on paying
out 60% of the firm's net income and retaining 40 percent.
Payout (PO) 
DPS 3
  .60
EPS 5
Bennie D Waller, Longwood University
STOCKS
Dividend Per Share (DPS) - represents the dollar amount of
dividends that is paid to stockholders.
Dividend per share  EPS x PO  .60x5  $3/share
Price Earnings (PE)- is an earnings multiple. The P/E is
sometimes referred to as the "multiple", because it shows
how much investors are willing to pay per dollar of earnings.
If a company were currently trading at a multiple (P/E) of 10,
the interpretation is that an investor is willing to pay $10 for
$1 of current earnings.
Price Earning (PE) 
Price 50

 10
EPS
5
Bennie D Waller, Longwood University
Stocks
 Stock market indices – groups of stocks performance that
represent the market or segment of market
 DJIA
 S&P 500
 NASDAQ
 Bear market—characterized by falling prices.
 Bull market—characterized by rising prices
Bennie D Waller, Longwood University
Dow Jones Industrial Average (DJIA)
Bennie D Waller, Longwood University
How to Read Stock Quote
Bennie D Waller, Longwood University
Stocks
 Classification of stocks
 Blue-chip – large well known firms
 Growth – firms with growth above industry average
(many times these are new firms)
 Income –
 Speculative –
 Defensive – stocks that tend not to be affected in
economic swings
 Large caps - >$5 billion
 Small caps - <$1 billion
Bennie D Waller, Longwood University
How Stock is Valued
 Technical Analysis – charts/graphs/
 Uses mathematical and computer models used to predict
prices by looking for patterns and trends
 Price/Earnings Ratio – is an earnings multiple approach
 . Higher earnings growth, higher P/E ratio
Price Earning (PE) 
Price 50

 10
EPS
5
Bennie D Waller, Longwood University
How Stock is Valued
 Dividend Discount Model – stock price is based on present
value of future dividends.
 The value of any investment is the present value of the
benefits or returns received from the investment
 Value of a share of common stock = present value of the
infinite stream of future dividends
 Just another example of the importance of present value.
 More examples to follow
Bennie D Waller, Longwood University
Buy and Hold Stratgey
 Involves buying stock and holding it for a period of years.
 Avoids timing the market.
 Minimizes brokerage fees, transaction costs.
 Postpones capital gains taxes.
 Gains taxed as long-term capital gains.
Bennie D Waller, Longwood University
Risk of Investing in Stocks
 Risk and return go hand in hand.
 Principle 8—can eliminate risk associated with common stock
by diversifying.
 Only systematic risk remains.
 Measure systematic risk using Beta.
 Beta—measure of how responsive a stock or portfolio is to
changes in the market portfolio.
 Beta benchmark for market = 1
 Beta > 1—stock moves up and down more than market
 Beta <1—stock moves up and more less
Bennie D Waller, Longwood University
 Researchers have shown that the best measure of the risk of a
security in a large portfolio is the beta (b)of the security.
 Beta measures the responsiveness of a security to movements
in the market portfolio (i.e., systematic risk).
i 
Cov( Ri , RM )
 ( RM )
2
Bennie D Waller, Longwood University
Risk/Return Trade-off
Bennie D Waller, Longwood University
Risks of Common Stocks
Short-term investments in stocks are very risky
Holding stocks longer reduces variability of
average annual return.
Investors can afford to take on more risk as
investment time horizons increase—they have
more opportunities to adjust saving,
consumption, and work habits.
Bennie D Waller, Longwood University
Stock valuation
 Dividend Growth Model – used to value stocks that pay
dividends
 Taking present value of future cash flows
 As you go further out into the future, the impact of the cash
flows decrease
𝐷1
𝐷2
𝐷3
𝐷𝑛
𝑃0 =
+
+
+⋯
2
3
(1 + 𝑘) (1 + 𝑘)
(1 + 𝑘)
(1 + 𝑘)𝑛
Bennie D Waller, Longwood University
Stock Valuation
Stock Valuation assuming constant growth - Constant Growth
Model – used to determine 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.
Stock Value = 𝑷𝟎 =
𝑫𝟏
𝒌−𝒈
Because the model assumes a constant growth rate, it is generally
only used for mature companies (or broad market indices) with low
to moderate growth rates.
Bennie D Waller, Longwood University
Stock Valuation Example
A share of common stock has just paid a dividend of $2.00. If the
expected long-run growth rate for this stock is 15 percent, and if
investors require a 19 percent rate of return, what is the price of the
stock?
Stock Value = 𝑷𝟎 =
𝑫𝟏
𝒌−𝒈
Bennie D Waller, Longwood University
Stock valuation
Stock Valuation assuming abnormal growth – firms with high
growth or emerging areas such as technology or pharmaceutical
are likely to experience periods of abnormal or super-abnormal
growth.
𝐷3
𝐷1
𝐷2
(𝑘 − 𝑔)
𝑃0 =
+
+
2
(1 + 𝑘) (1 + 𝑘)
(1 + 𝑘)2
Bennie D Waller, Longwood University
Stock valuation
Stock Valuation assuming abnormal growth – firms with high
growth or emerging areas such as technology or pharmaceutical
are likely to experience periods of abnormal or super-abnormal
growth.
 Assume that a biotech firm discovers a cure for a terminal
disease. The firm is expected to have growth rates of 30%, 25%
and 20% over the next three years at which time, growth is
expected to level off and remain constant at 10% for the
foreseeable future. The current required rate of return is 12%
for investors (k=.12) and the last dividend paid was $2.00
(D0=2.00).
• Since the growth will become constant in year 4, we can then
apply the constant growth formula.
Bennie D Waller, Longwood University
Stock Valuation
•
•
•
•
•
•
g1=.30 – expected growth in year 1
g2 =.25 – expected growth in year 2
g3 =.20 – expected growth in year 3
G4+=.10 – expected growth in year 4 and thereafter
D0=2.00 – last dividend paid
k=.12 –required rate of return (rate firm must pay to encourage investment in firm)
•
Since the growth will become constant in year 4, we can then apply the constant
growth formula using the formula below.
𝐷4
𝐷1
𝐷2
𝐷3
(𝑘 − 𝑔)
𝑃0 =
+
+
+
2
3
(1 + 𝑘) (1 + 𝑘)
(1 + 𝑘)
(1 + 𝑘)3
We need to calculate the dividends for each of the next 4 years
D1=D0(1+g1) = 2(1.30) =2.60
D2=D1(1+g2) = 2.60(1.25) =3.25
D3=D2(1+g3) = 3.25(1.20) = 3.90
D4=D3(1+g4) = 3.90(1.10) = 4.29
Bennie D Waller, Longwood University
Stock Valuation
We need to calculate the dividends for each of the next 4 years
D1=D0(1+g1) = 2(1.30) =2.60
D2=D1(1+g2) = 2.60(1.25) =3.25
D3=D2(1+g3) = 3.25(1.20) = 3.90
D4=D3(1+g4) = 3.90(1.10) = 4.29
𝐷4
𝐷1
𝐷2
𝐷3
(𝑘 − 𝑔)
𝑃0 =
+
+
+
2
3
(1 + 𝑘) (1 + 𝑘)
(1 + 𝑘)
(1 + 𝑘)3
4.29
2.60
3.25
3.90
(.12 − .10)
𝑃0 =
+
+
+
2
3
(1 + .12) (1 + .12)
(1 + .12)
(1 + .12)3
Bennie D Waller, Longwood University
Stock Valuation
We need to calculate the dividends for each of the next 4 years
D1=D0(1+g1) = 2(1.30) =2.60
D2=D1(1+g2) = 2.60(1.25) =3.25
D3=D2(1+g3) = 3.25(1.20) = 3.90
D4=D3(1+g4) = 3.90(1.10) = 4.29
𝑃0 =2.32 + 2.59 + 2.78 +
214.50
(1+.12)3
= $160.37
So how do we interpret this estimated price?
Bennie D Waller, Longwood University
STOCKS
The last dividend paid by Klein Company was $1.00. Klein’s
growth rate is expected to be a constant 5 percent for 2 years, after
which dividends are expected to grow at a rate of 10 percent
forever. Klein’s required rate of return on equity (ks) is 12
percent.
How much should a prudent investor be willing to pay for this
stock based on the above assumptions?
𝐷3
𝐷1
𝐷2
(𝑘 − 𝑔)
𝑃0 =
+
+
2
(1 + 𝑘) (1 + 𝑘)
(1 + 𝑘)2
Bennie D Waller, Longwood University
STOCKS
•
•
•
•
•
g1=.05 – expected growth in year 1
g2 =.05 – expected growth in year 2
g3+ =.10 – expected growth in year 3 and thereafter
D0=1.00 – last dividend paid
k=.12 –required rate of return (rate firm must pay to encourage investment in firm)
𝐷3
𝐷1
𝐷2
(𝑘 − 𝑔)
𝑃0 =
+
+
2
(1 + 𝑘) (1 + 𝑘)
(1 + 𝑘)2
Bennie D Waller, Longwood University
STOCKS
Assume that you plan to buy a share of XYZ stock today and to hold it for 2 years. Your
expectations are that you will not receive a dividend at the end of Year 1, but you will
receive a dividend of $9.25 at the end of Year 2. In addition, you expect to sell the stock
for $150 at the end of Year 2. If your expected rate of return is 16 percent, how much
should you be willing to pay for this stock today?
Bennie D Waller, Longwood University
STOCKS
Womack Toy Company’s stock is currently trading at $25 per share. The stock’s
dividend is projected to increase at a constant rate of 7 percent per year. The
required rate of return on the stock, ks, is 10 percent. What is the expected price of
the stock 4 years from today?
Bennie D Waller, Longwood University
STOCKS
Capital Asset Pricing Model or CAPM –describes the relationship
between risk and expected return and is commonly used in the pricing of risky
securities.
The idea behind CAPM is that investors need to be compensated in two ways:
time value of money and risk.
 The time value of money is represented by the risk-free (𝑅𝑓 ) rate in the
formula and compensates the investors for placing money in any investment
over a period of time.
 The other half of the formula represents risk and calculates the amount of
compensation the investor needs for taking on additional risk. This risk
measure (β) that compares the returns of the asset to the market over a period
of time and to the market premium (𝑅𝑚 − 𝑅𝑓 ). Beta measure the systematic
or business risk.
𝐶𝐴𝑃𝑀: 𝑅𝑎 = 𝑅𝑓 + 𝛽𝑎 (𝑅𝑚 − 𝑅𝑓 )
Bennie D Waller, Longwood University
STOCKS
 The CAPM says that the expected return of a security or a portfolio should
equal the risk-free rate plus a risk premium.
 Using the CAPM model and the following assumptions, we can compute the
expected return of a stock.
 Risk-free rate is 3%, the stock’s beta (risk measure) is 2 and the expected
market return over the period is 10%,
 The expected return on the stock is 17% (3%+2(10%-3%)).
𝐶𝐴𝑃𝑀: 𝑅𝑎 = 𝑅𝑓 + 𝛽𝑎 (𝑅𝑚 − 𝑅𝑓 )
𝐶𝐴𝑃𝑀: 𝑅𝑎 = .03 + 2 .10 − .03 = .17
The security market line plots the results of the CAPM for all
different risks (betas).
SML illustrated
Bennie D Waller, Longwood University
Security Market Line (SML)
The security market line plots the results of the CAPM for all different risks (betas).
Return
Rm
Rf
β=0
β=1
Bennie D Waller, Longwood University
β
STOCKS
The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5
percent and the market risk premium (kM - kRF) is 6 percent. Assume the firm will
be able to use retained earnings to fund the equity portion of its capital budget.
What is the company’s cost of retained earnings, ks?
𝐶𝐴𝑃𝑀: 𝑅𝑎 = .05 + 1.2 .06 = .122
𝐻𝑃𝑅 =
𝑃1 −𝑃0
𝑃0
=
10−8.91
8.91
= .122
Bennie D Waller, Longwood University
STOCKS
Security Market Line (SML)
Return
.122
Overpriced stocks will fall
below the SML In the previous
example, if the stock was
currently trading at $9.00/share,
the expected return would only
be 11%, which is well below
the required return of 12.2%
Rm
Rf
β=0
β=1
β=1.2
Bennie D Waller, Longwood University
β
Derivative Securities
 Derivative securities – a security whose value is dependent
upon the value of some underlying asset, e.g., MBS
Bennie D Waller, Longwood University
Options/Futures
 Options – a security (financial instrument) that gives the owner
the right to buy or sell an asset (typically common stock) for a
specified price over a specified period of time.
 Call option – gives the owner the right to purchase an asset
at a given price (strike price) before the expiration of the
option. e.g., if you believe that a stock will increase in price,
you could purchase a call option. If the stock goes above the
strike price, the option could be exercised and the underlying
stock purchased.
Bennie D Waller, Longwood University
Call Option Example
Suppose the stock of XYZ company is trading at $40. A call option contract with a
strike price of $40 expiring in a month's time is being priced at $2. You strongly believe
that XYZ stock will rise sharply in the coming weeks after their earnings report. So you
paid $200 to purchase a single $40 XYZ call option covering 100 shares.
 Assume the price of XYZ stock rallies to $50 after reported earnings. With this sharp
rise in the underlying stock price, your call buying strategy will net you a profit of
$800.
 If you were to exercise your call option after the earnings report, you invoke your
right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in
the open market for $50 a share. This gives you a profit of $10 per share. As each call
option contract covers 100 shares, the total amount you will receive from the exercise
is $1000.
Source: www.theoptionguide.com
Bennie D Waller, Longwood University
Call Option Example
Source: www.theoptionguide.com
Bennie D Waller, Longwood University
Put Option
 Put option – give the owner the right to sell an asset at a given
price before the expiration of the option.
 Suppose the stock of XYZ company is trading at $40. A put
option contract with a strike price of $40 expiring in a month's
time is being priced at $2. You strongly believe that XYZ stock
will drop sharply in the coming weeks after their earnings
report. So you paid $200 to purchase a single $40 XYZ put
option covering 100 shares.
 If you are right and the price of XYZ stock plunges to $30 after
the company reported earnings. With this crash in the underlying
stock price, your put buying strategy will result in a profit of
$800.
Bennie D Waller, Longwood University
Put Option
 If you were to exercise your put option after earnings, you
invoke your right to sell 100 shares of XYZ stock at $40 each.
 Although you don't own any share of XYZ company at this
time, you can easily go to the open market to buy 100 shares at
only $30 a share and sell them immediately for $40 per share.
 This gives you a profit of $10 per share. Since each put option
contract covers 100 shares, the total amount you will receive
from the exercise is $1000. As you had paid $200 to purchase
this put option, your net profit for the entire trade is $800
Bennie D Waller, Longwood University
Put Option
Bennie D Waller, Longwood University
Thank You
Bennie D Waller, Longwood University
Bennie D Waller, Longwood University
Learning Objectives
1. Invest in stocks.
2. Read stock quotes online or in the newspaper.
3. Classify common stock according to basic market terminology.
4. Determine the value stocks.
5. Employ different investment strategies.
6. Understand the risks associated with investing in common stock.
Bennie D Waller, Longwood University
Summary
• Common stocks over time outperform all other
investments.
• Stock indexes such as the Dow and S&P 500
show health of stock market.
• Common stocks can be blue-chip, growth,
income, speculative, defensive, large- to smallcap stocks.
Bennie D Waller, Longwood University
Summary
• A number of methods can be used to determine
the value of stock—but interest rates, risk, and
expected future growth determine the value of
common stock.
• Use one or more investment strategies such as
dollar-cost average, buy-and-hold, and DRIPs.
• Stocks are riskier but diversification and
watching beta values can help.
Bennie D Waller, Longwood University