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ECONOMICS What Does It Mean To Me? The Financial System STOCKS, BONDS, MUTUAL FUNDS & OPTIONS CONTENT Introduction to Stocks a) Terminology b) Shorting a stock Bonds & Other Financial Markets a) Terminology b) Who Issues Bonds? c) Reading stock indexes c) Bond Ratings d) Stock Exchanges d) Options e) Dow Jones Average e) Mutual Funds f) Stock Market Crashes g) World Stock Markets f) Financial Intermediaries Considerations/Selecting a Stock a)Analysis Terms b) Firm Numbers c) Industry Considerations d) The Economy The Financial System The financial system consists of the group of institutions in the economy that help to match one person’s saving with another person’s investment. It moves the economy’s scarce resources from savers to borrowers. FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY The financial system is made up of financial institutions that coordinate the actions of savers and borrowers. Financial institutions can be grouped into two different categories: financial markets and financial intermediaries. FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY Financial Markets Stock Market Bond Market Financial Intermediaries Banks Mutual Funds FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY Financial markets are the institutions through which savers can directly provide funds to borrowers. Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. Corporation: A legal entity that can conduct business in its own name in the same way that an individual does and that is owned by stockholders. Financial Markets The Stock Market Stock represents a claim to partial ownership in a firm and a claim to the profits that the firm makes. The sale of stock to raise money is called equity financing. Compared to bonds, stocks offer both higher risk and potentially higher returns. The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ. Share of stock- represents ownership in a corporation or a claim on the assets of a corporation. Dividends -optional payments of annual profits to stockholders. Growth Stock -stock where the dividends are reinvested into the stock. Initial Public Offering (IPO) --when stock is initially offered to the public. ADVANTAGES OF A CORPORATION •Stockholders are not personally liable for the debts of the corporation; they have limited liability. •Corporations continue to exist even if one or more owners of the corporation sell their shares or die. •Corporations are usually able to raise large sums of money by selling stock. DISADVANTAGES OF CORPORATIONS •Corporations are subject to double taxation. (corporate income tax and personal income tax) •Corporations are difficult to set up. What do the following companies have in common? Kraft Foods Lender’s Bagels County Line Tang Cool Whip Oscar Mayer Jell-O Minute Rice Stove Top Breyers Ice Cream Breakstone Sour Cream Philadelphia Cream Cheese Cracker Barrel Maxwell House Crystal Light Caprice Tombstone Pizza Toasties Del Monte Light-n-Lively Sanka Kool-Aid Raisin Bran Louis Rich Miracle Whip Log Cabin Lowenbrau Miller Beer Shake-n-Bake ANSWER: ALTRIA (PHILIP MORRIS) Stock Symbol: MO More than 10% of the food items that tumble down the world’s supermarket check-out lines carry the Philip Morris seal. Formally, Philip Morris is a holding company whose principal wholly owned subsidiaries are: Philip Morris USA, Philip Morris International, Kraft Foods, Miller Brewing, and Philip Morris Capital. CABLE HOLDINGS OF THE BIG NETWORKS VIACOM <VIA> (CBS) MTV VH1 BET Nickelodeon TV Land DISNEY <DIS> (ABC) ESPN ESPN2 ESPN Classic Disney Channel Family Channel Showtime Movie Channel Country Music TV Comedy Central (50%) UPN Soapnet Toon Disney TimeWarner <TWX> Liberty Media <L> Cox Commun. <COX> DSC Animal Planet DSC Health Travel Channel DSC Kids BBC America TLC USA TNT CNN HBO TBS America Online WB GE <GE> (NBC) CNBC MSNBC (50%) A & E (partial) History Channel National Geographic (partial) Bravo Liberty Media (part) NEWS CORP <NWS> (FOX) Fox Movie Channel Fox News Fox Sports FX National Geographic (partial) STAR FUEL DirectTV Stock split -- when a stock’s high price is discouraging new investors, the company splits the stock to a lower price; thus creating more shares at a lower price. For example: 100 shares at $50 per share equals 200 shares at $25 per share Would you invest in this company? Microsoft Corporation 1978 History of Microsoft Stock Splits Symbol: MSFT IPO: March 13, 1986 Last updated: August 18, 1998 First Sep 21, 1987 2 for 1 Second Apr 16, 1990 2 for 1 Third Jun 27,1991 3 for 2 Fourth Jun 15, 1992 3 for 2 Fifth May 23, 1994 2 for 1 Sixth Dec 9, 1996 2 for 1 Seventh Feb 23, 1998 2 for 1 Sep 18 = 114.50 Sep 21 = 53.50 Apr 12 = 120.75 Apr 16 = 60.75 Jun 26 = 100.75 Jun 27 = 68.00 Jun 12 = 112.50 Jun 15 = 75.75 May 20 = 97.75 May 23 = 50.63 Dec 6 = 152.875 Dec 9 = 81.75 Feb 20 = 155.13 Feb 23 = 81.63 History of Microsoft Stock Splits IPO: March 13, 1986 First Last updated: Sep 21, 1987 2 for 1 Second Apr 16, 1990 2 for 1 Third Jun 27,1991 3 for 2 Fourth Jun 15, 1992 3 for 2 Fifth May 23, 1994 2 for 1 Sixth Dec 9, 1996 2 for 1 SeventhFeb 23, 1998 2 for 1 Symbol: MSFT August 18, 1998 Sep 18 = 114.50 Sep 21 = 53.50 Apr 12 = 120.75 Apr 16 = 60.75 Jun 26 = 100.75 Jun 27 = 68.00 Jun 12 = 112.50 Jun 15 = 75.75 May 20 = 97.75 May 23 = 50.63 Dec 6 = 152.875 Dec 9 = 81.75 Feb 20 = 155.13 Feb 23 = 81.63 2 shares = $107.00 4 shares = $243.00 6 shares = $408.00 9 shares = $681.75 18 shares = $910.74 36 shares = $2943.00 72 shares = $5877.36 What does it mean to SHORT the stock? Shorting stocks is a method of gambling on a stock whose price you think will decline. Instead of purchasing shares of a stock you think is going up in price, you instead borrow shares, sell them immediately, wait for the price to go down, and then buy them back at the lower price and return the shares to the broker. The advantage of shorting stocks is that you can make a profit without an initial cash investment. For example, suppose you think the price of NOPE stock is going down from its current price of $32. You tell your broker that you want to short 200 shares of NOPE stock. (You must have a margin account to short stocks.) Your broker then borrows 200 shares of NOPE and sells them for you, depositing $6400 in your account. Now you hope the price goes down because eventually, you need to return the 200 borrowed shares to your broker. Suppose the price goes down to $25. You can now buy the 200 shares of NOPE for $5000, return the 200 shares to your broker, and pocket the $1400 profit. ($6400 - $5000) minus the commission. You have now made money without an initial cash investment. However, shorting stocks is considered riskier than buying stocks because the price of the stock could go UP an unlimited amount, resulting in unlimited losses. At some point you need to buy the shares you borrowed to short the stock. For example, if the price of NOPE goes up to $40, you would have to pay $8000 to buy the 200 shares owed to your broker. In this case, you would lose $1600 ($8000 - $6400) plus the commission Buying your shares back and returning them to the broker is called covering a short. When an investor sells a stock for profit, it is called a CAPITAL GAIN. A capital gain is the difference between an asset’s purchase price and its’ selling price when the amount is positive. Because shorting stocks involves unlimited risk, the SEC has special regulations requiring brokers to issue a margin call when an investor’s losses reach a certain point. MARGIN is the amount of money a customer deposits with a broker when borrowing from the broker for securities. Example: If a broker has a 50% margin requirement and the customer sells short 100 shares of XYZ at $50 a share, how much equity must be maintained in the margin account? ANSWER: $2500 Reading Stock Indexes Originally, prices were read in fraction form per share of stock: Historical Note: The Spanish practice of dividing the silver dollar into eighths was largely responsible for the prevalence of fractions when describing stock values. 1/64= .0156 1/32 = .03 1/16 = .06 1/8 = .125 1/4 = .25 3/8 = .38 1/2 = .50 5/8 = .63 3/4 = .75 7/8 = .88 However, since September 2000, all stock exchanges converted stock prices to decimal format. The stocks listed are common stocks unless indicated otherwise. For example “pf” indicates a preferred stock. The numbers to the left of the name of the corporation show the highest and lowest price at which the stock has traded during the previous 52 weeks. The symbol column lists the stock’s ticker symbol. The dividend column shows the current level of dividends that will be paid over one year to the owner of one share of stock. A dividend is the annual payment per share of a stock designated by a company for its stockholders. The dividend yield shows the dividend as a percentage of stock closing price. The PE column lists the price/earnings ratio, which is the price of a share of stock divided by the company’s earnings (profits) per share of stock for the last 12-month period. The column marked volume lists the number of shares traded (in hundreds) during that day. The hi, lo, and close columns show the range of prices at which the stock traded during the day. The closing price is the price for the last transaction of the day. The net change column shows the change between this closing price and the closing price the previous trading day. STOCK EXCHANGES Three U.S. stock exchanges are: 1) NYSE --The New York Stock Exchange. Started with “Buttonwood Agreement” in 1792 Founded in 1817 Home to Dow Jones Industrial Average 2) AMEX --The American Exchange. Founded in 1920s 3) NASDAQ --National Assn. Of Security Dealers Automated Quotation •Founded in 1976 •Completely computerized quotations--no exchange floor Regional Stock Exchanges San Francisco Los Angeles Chicago * Cincinnati Boston Philadelphia * The term "seat" is now synonymous with a membership on the NYSE. NYSE memberships can be purchased and sold. The all time high price paid for an NYSE membership was $2,650,000 on August 23, 1999. The lowest price ever paid was $4,000 in 1876 and again in 1878. What is the origin of the term "Blue Chip Stock"? This phrase first dates back to 1904 and has its origin from the blue, i.e., highest denomination chips used in gambling. Today, Blue Chip stocks are thought of as being the most stable and safe investments available. However, when the expression was first used, investors were evidently aware of the similarities between gambling and investing. The Dow Jones Average was started by Charles H. Dow and Edward Jones at a time when the stock market was not highly regarded. He began testing his Average in 1884 with 11 stocks, most of them railroads, which were the first great national corporations. In the spring of 1896, he introduced the 12-stock average to the nation. Charles Dow 1852-1902 The original 12 stocks on the Dow Jones Average were: American Cotton Oil American Sugar American Tobacco Chicago Gas Distilling & Cattle Feeding General Electric Laclede Gas National Lead North American Tennessee Coal & Iron US Leather preferred US Rubber In the autumn of 1896, he dropped the last non-railroad stock from the original average and made the 20-stock railroad average. Today, this is called the TRANSPORTATION AVERAGE. In 1916, the Dow Jones industrial average was increased to 20 stocks and on October 1, 1928, it was expanded to 30--the number of stocks comprising the average ever since. Currently, the 30 stocks on the Dow Jones Industrial Average are: 3M Exxon/Mobil Alcoa General Electric Altria (MO) General Motors Merck & Co. American Express Hewlett Packard Microsoft Corp American Int’l Group Home Depot Pfizer Proctor & Gamble Boeing Honeywell International Caterpillar IBM Citigroup Intel Verizon Communications Coca-Cola Johnson & Johnson Wal Mart Disney JP Morgan Chase Dupont McDonalds AT & T United Technologies 11000 10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 1884 The Dow Jones Industrial Average opened at 40 in the year 1884 By 1920, the index had reached 100 11000 10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 11000 10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 On September 3, 1929, the index reached a high of 381. 11000 10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 October 28, 1929, the Dow fell 38 points (down 12.8%) and on October 29, 1929, it fell 30 points (down 11.7%) to close at 230. This was a 2-day percentage loss of 24.5% By July 8, 1932, the Dow closed at 41. So………….. 11000 10000 9000 How long did it take the Dow to reclaim it’s all time high of 381 ?? 8000 7000 6000 5000 The answer : 1954 (22 years) 4000 3000 2000 1000 WHY? What year did it reach 1000? 11000 10000 9000 8000 The answer : 1972 (18 years) 7000 6000 5000 4000 3000 2000 1000 WHY? By January of 1987, the Dow reached 2000. 11000 10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 Then on October 19, 1987, the Dow went from 2240 to 1738. It lost 507 points in its largest EVER one day percentage loss of 22.6%. In 1991, the Dow reached 3000. 11000 10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 In 1995, it hit 4000 in February and 5000 in November. 11000 10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 In 1996, the Dow reached 6000. In 1997, it hit 7000 in February and 8000 in July. In 1998, the Dow reached 9000. In 1999, it hit 10000 in March and 11000 in May. 11000 10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 It finally reached a high of 11,722 in January 2000. 11000 10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 Can you see why Alan Greenspan called the ninties a period of “irrational exuberance?” 11000 10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 The following is a chart of the Dow (1900-present) as compared to the inflation adjusted Dow (1925-present). A prolonged period of rising stock prices is called a BULL MARKET. A prolonged period of falling stock prices is called a BEAR MARKET. How many stock market crashes have there been? The largest single day market sell-off occurred on October 19, 1987 (Black Monday) when the Dow Jones Industrial Average fell 22.6%. The 1929 market crash actually occurred over a two-day period, when the Dow Jones Industrial Average fell 12.8% on October 28, 1929 and 11.7% on October 29, 1929. The largest one-day point drop occurred on October 27, 1997 when the Dow lost 554.26 points (7.18%). A BEAR MARKET is defined as a prolonged decline in stock prices, e.g., greater than a 30% decline over a 50-day trading period. There were 30 bear markets in the 20th century. The worst ran from September 3, 1929 to July 8, 1932, when the Dow lost 89.1%. It took over 20 years for the Dow to trade above its pre-crash levels. The worst bear market in the 21st century ran from March 10, 2000 to October 9, 2002. During this period, the Nasdaq Composite Index lost 77.9%. At current levels, the Nasdaq Composite is trading 70% below its all-time high. THE GREAT CRASH: What Happened? 1925: value of all stocks= $27b 1929: value of all stocks= $87b (rising $11.4b in 1928 alone) *relatively small number of companies and people held much of the nation’s wealth **farmers and workers were suffering ***ordinary people went into debt buying consumer goods such as refrigerators and radios on credit. ****industries were producing more goods than consumers could buy, developing large surpluses. (ie, Autos) Additionally, investors were going into debt investing in the stock market. The incredible climb of the stock market encouraged SPECULATION, the practice of borrowing money to invest in high-risk investments hoping for a big return. Small investors began using life savings to buy stocks. To encourage the less-wealthy, stockbrokers invented the practice of BUYING ON MARGIN, which allowed people to buy stocks for a fraction of the cost and borrow the rest from the brokerage. *On September 3, 1929, the Dow reached an all time high of 381. After the prices began to fall, some brokers demanded repayment of loans. *When the market opened on October 23, 1929, the Dow had dropped 21 points in an hour. *Worried investors began to sell and prices fell further. *By Monday, October 28, 1929, stocks were selling for a fraction of what people had paid for them. *On October 29, 1929, known as BLACK TUESDAY, a record 16.4 million shares were sold. The GREAT CRASH had begun. . . . . . In 1932, President Roosevelt created reform measures in response to the crash of 1929. He formed the SECURITIES AND EXCHANGE COMMISSION to regulate the stock market. In charge of the SEC, he placed Joseph Patrick Kennedy, the father of President John F. Kennedy. WORLD STOCK MARKETS World Stock Markets Stock trading goes on around the world, around the clock, in an electronic global marketplace. Indexes --major stock exchanges around the globe express stock performance as indexes, which are statistical composits. U.S. Dow Jones Industrial Average Tokyo Average London FT 30-share Frankfurt FAZ Paris Cac-40 BONDS and other FINANCIAL MARKETS Financial Markets The Bond Market A bond is a certificate of indebtedness that IOU specifies obligations of the borrower to the holder of the bond. Characteristics of a Bond Term: The length of time until the bond matures. Credit Risk: The probability that the borrower will fail to pay some of the interest or principal. Tax Treatment: The way in which the tax laws treat the interest on the bond. Municipal bonds are federal tax exempt. Bonds Investor loans money to a government, municipality or corporation (borrower gets needed cash and lender earns interest) Bonds allow expansion and help create jobs. Maturity -- time when loan expires or is due. Coupon Rate -- percentage of par value paid in interest to bondholder on a regular basis. Par Value -- amount that an investor pays to purchase the bond and that will be replaced to the investor at maturity. WHO ISSUES BONDS? Who issues bonds? Corporations -- to raise money for expansion and operations. Who issues bonds? Municipalities and local governments -- for schools, highways, stadiums, etc. Who issues bonds? Government agencies -- for home mortgage associations, Federal Housing Administration (FHA) Who issues bonds? Foreign governments and corporations -- as a primary way to raise capital. Who issues bonds? Federal Government -in the form of SAVINGS BONDS, which are lowdenomination bonds in amounts of $50 to $10,000. Who issues bonds? and the United States Treasury Department -- for federally funded programs. These are issued in the form of Treasury Bills, Treasury Notes, and Treasury Bonds. What is the difference between the Treasury Bill, Treasury Bond and Treasury Note? Treasury Bond Treasury Note Term long-term intermediate Maturity 10 to 30 years 2 to 10 years Liquidity & Safety safe safe Minimum purchase $1,000 $1,000 Denomination $1,000 $1,000 Treasury Bill short-term 3, 6, or 12 months liquid & safe $1,000 $1,000 BOND RATINGS B o n d R a t i n g s Moody’s Aaa Aa A Baa Ba B Caa Ca Standard & Poors AAA AA A BBB BB B CCC CC C C __ D Meaning Best qualit y, with the smallest risk, issuers are exceptionally stable and dependable. High qualit y, with a sligh tly higher degree of long-term ri sk. High-to-medium qualit y, with many strong attributes but somewhat vulnerable to changing economic con ditions Medium qualit y, currently adequate but perhaps unrelia ble over the long term. INVESTMENT GRADE BONDS Some speculative element with moderate security, but not well safeguarded. Able to pay now but at ris k of default in t he fu ture. Poo r quality, clear danger of default . Highly speculative qualit y, often in default. Lowest rated, poor prospect of repayment, though m ay still be paying. In default. JUNK BONDS B O N D S NOTE: Junk Bonds have been known to have interest rates as high as 12% at a time when government bonds were only 8%. BUYING BONDS AT A DISCOUNT Suppose Al buys a $1000 bond with a coupon rate of 5 percent. The person who buys the bond (Al) is called the “holder,” while the seller of the bond is called the “issuer.” Interest rates go up to 6 percent, and Al needs to sell the bond. (noone wants to buy a 5 percent bond when the interest rate is 6 percent) Al offers to sell the bond to Patsy “at a discount” for $950--taking $50 off the $1000 value of the bond. Patsy now owns a par value $1000 bond for $950. FINANCIAL MARKETS Markets in which money is lent for periods longer than one year are called CAPITAL MARKETS. When money is lent for less than one year, it is called a MONEY MARKET. Money market investments are NOT insured by FDIC (Federal Deposit Insurance Corporation). FINANCIAL MARKETS Financial assets that can only be redeemed by the original holder are sold on a PRIMARY MARKET. (ex: savings bonds, small CDs) Financial assets that can be resold are sold on SECONDARY MARKET. This option for resale provides liquidity to investors. **For example: if the mortgage on a house does not meet the banks’ criteria for sale on the secondary market, the borrower may have to pay a higher interest rate for their mortgage. MUTUAL FUNDS What Is A Mutual Fund? Company “A” $ $ Company “B” Company “C” A mutual fund is a professionally managed pool of money. Mutual Funds – A collection of stocks, bonds, or other securities bought by a group of investors and managed by a professional investment company. Why Own One? •Money is Professionally Managed. •Diversified. •Flexible. •Marketable. •You Have Control. Open-end funds –(most common) the fund will sell as many shares as investors want. Cannot trade in stock market, only buy or sell through mutual fund company. Closed-end funds -- have a limited number of shares for trading on an exchange or OTC. Load funds -- includes a sales charge (usually 5%), + fees. Purchased through a broker. No-load funds -- charge a management fee, not a commission. Net Asset Value (NAV) – The total value of the fund’s holdings divided by the number of shares. (= price per share) A Hypothetical Example Investing $100 per month with different rates of return $1,188,240 12% 10% 8% $637,680 $351,430 $200,140 6% 10 years 20 years 30 years 40 years $100 Investment Per Month Assumed Rates 6% 8% 10% 12% 10 Years $16,470 $18,420 $20,660 $23,230 20 Years $46,440 $59,290 $76,570 $99,910 30 Years $100,950 $150,030 $227,930 $352,990 40 Years $200,140 $351,430 $637,680 $1,188,240 The hypothetical illustration and the 6%, 8%, 10% and 12% nominal rates compounded monthly, are not guaranteed or intended to demonstrate the performance of any actual investment and assumes $100/month investment. Assumes payments are made at the beginning of the compounding period and are rounded to the nearest $10. When You Become Financially Independent Depends on How Much Money You Can Invest. At age 65, could you live on $140,000 / Year? To do that, you need to accumulate $1,400,000 @ 12% Average Rate of Return 40 Year Plan -- Invest $120/Mo. • 30 Year Plan -- Invest $400/Mo. • 20 Year Plan -- Invest $1,400/Mo. • 10 Year Plan -- Invest $6,025/Mo. The High Cost of Waiting Saving $100 per month at 10% return Begin Saving Now In One Year In Five Years Total in 40 Years $637,680 $576,090 $382,830 Cost to Wait $ 61,590 $254,850 Don’t Procrastinate! Cost to wait includes monthly contributions. This hypothetical example demonstrates compounding at specified rate and not the performance of any actual program. No allowance for taxes, applicable fees or inflation. Rate of return is nominal, compounded monthly. The Best IRA Option for you Contributions Traditional IRA Roth IRA Up to $4,000 Tax Deductible Up to $4,000 Non-deductible No age limit Contribution 70 1/2 /Distribution age limit Earnings Tax-deferred Tax-deferred Taxes before 59 1/2 Money taken will be taxable w/10% penalty Earnings tax-free if Roth IRA account has been open at least 5 years Withdrawals after age 591/2 All of the money will be taxable upon withdrawal TAX FREE MONEY no matter how much is withdrawn! Comparing IRA Income Participation Limits Full Eligibility Roth IRA Traditional IRA Full eligibility income limits for retirement plan participants Married Single 2006 $80,000 $50,000 Full eligibility income limits (regardless of retirement plan participation) Married Single 2006 and on $150,000 $95,000 OPTIONS Options The right, but not the obligation, to buy or sell a stock for a specified price on or before a specific date. Options Strike price -- selling price Expiration date -- deadline to exercise the right to buy or sell. This occurs on the THIRD FRIDAY of each month. Call: normally represents 100 shares of underlying stock. Buy -- right to buy a stock at a fixed price in the future. The buyer of an equity call option has purchased the right to buy 100 shares of the underlying stock at the stated exercised price. Thus, the buyer of one XYZ June 110 call option has the right to purchase 100 shares of XYZ stock at $110 up until the June expiration (the third Friday in June). Therefore, if XYZ stock increases in price to $120 per share, the value would increase $10 per share x 100 shares or $1000, minus the premium. Put: normally represents 100 shares of underlying stock. Buy -- right to sell a stock at a fixed price in the future. The buyer of a put option has purchased the right to sell 100 shares of underlying stock at the contracted exercise price. Thus, the buyer of one ZXY June 50 put option has the right to sell 100 shares of ZYX at $50 any time prior to the third Friday in June. Therefore, if the price of ZXY decreases to $40 per share, the value would increase $10 per share x 100 shares, or $1000, minus the premium. The largest exchange for trading options is the CBOE, the Chicago Board of Options Exchange. FINANCIAL INTERMEDIARIES Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. Financial Intermediaries Banks take deposits from people who want to save and use the deposits to make loans to people who want to borrow. pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. Financial Intermediaries Banks Banks help create a medium of exchange by allowing people to write checks against their deposits. A medium of exchanges is an item that people can easily use to engage in transactions. This facilitates the purchases of goods and services. Financial Intermediaries Mutual Funds A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a portfolio, of various types of stocks, bonds, or both. They allow people with small amounts of money to easily diversify. Financial Intermediaries Other Financial Institutions Credit unions Pension funds Insurance companies Loan sharks CONSIDERATIONS FOR SELECTING A STOCK ANALYSIS TERMS MARKET CAPITALIZATION Value of a corporation valued by the market price of its issued and outstanding stock. price of stock x outstanding shares = market cap EARNINGS PER SHARE Portion of a company’s profit allocated to each share Actual earnings / outstanding shares = EPS BOOK VALUE Value at which an asset is carried on a Balance Sheet. (also called net asset value when applied per bond or per share) cost of asset - depreciation = BV DEBT TO EQUITY RATIO This shows to what extent owner’s equity can cushion creditor’s claims in the event of liquidation. Total liabilities / total shareholders equity = d/e ratio Over the Counter (OTC) -- an electronic marketplace regulated by the NASD (National Association of Securities Dealers). NASDAQ -- where OTC companies are listed (National Association of Securities Dealers Automated Quotation) FIRM NUMBERS PRICE/EARNINGS RATIO (PE): A calculation that evaluates a stock’s relative performance and value. •Higher PE multiples suggest that investors are more optimistic about a stock’s prospects than comparable lower PE stocks. •Reason for high/low PE ratios also include the company’s growth outlook, the company’s industry, the company’s accounting policies, and whether the company is a start-up firm or more established. PE is calculated by dividing the stock’s price by the company’s earnings per share (EPS) for the most recent 4 quarters. Stock price compared to “company’s earnings” (EPS) reported in ratio. This would indicate that a LOW PE = better return on investment Example: Stock A Stock B Price $10 $20 EPS $2.00 $2.00 PE Ratio 5 10 Which is a better investment? The answer is Stock A. Stock B is more expensive than Stock A in terms of earnings. For Stock B, you must pay $20 to earn $2, but for Stock A, you pay only $10 to earn $2. The ratio is the number of times greater the stock price is as compared to the corporate earnings. P $1.00 = 1 PE 10 PE E $1.00 P $1.00 = E .10 When a market tends toward rapid and extreme fluctuations, it is said to be VOLATILE. BETA: refers to risk management or volatility of a stock (I.e. the percentage change for the stock’s return compared to the change in the return of the market) If the returns are the same, the ratio is 1.0. A beta of 1.00 means that the stock has the same percentage of change as the market. Thus, if you want to perform better than the market, a beta greater than 1.0 would be desired. A high beta # would indicate more volatility than the current market. A high beta # would indicate more volatility than the current market. When market indicators shift, the high beta stock will move more in the direction that the stock is presently headed. For example, if a stock has a beta of 1.35 and the market has changed 10%, how much has the stock changed in return? 1.35 = X/10 percent X = 13.5 percent * the 13.5% stock return change indicates that this stock has a greater risk of change than the market. DIVIDEND: indicates the annual payment per share of a stock designated by the company for stockholders. COMMON shares dividends vary with the business condition of the company and are evaluated regularly by a firm’s directors. PREFERRED stockholders are the first to get paid. %YIELD: represents the dividend return an investor can expect on each share of stock purchased. It is calculated by dividing the dividend that each share pays by its current market value, expressed as a percentage. $1 dividend / $10 price = 10% yield $1 dividend / $5 price = 20% yield NEWS: Strikes/scandals, accidents/hazards, research & development, safety issues, new technology, management/labor, takeover bids, et. al. can all lead to the price of a stock going up or down. TRADING VOLUME: shows the total number of shares traded for the day (listed in hundreds); thus 363 would mean 36,300. When a “z” precedes the volume number, it refers to the actual number. For example, “z20” means 20 shares not 2000. CURRENT DEBT RATIO: A BALANCE SHEET sets forth the various types of assets and liabilities of the firm. An excess of current assets (cash, inventory, accounts receivable) over current liabilities (accounts payable, shortterm debt, etc.) is viewed as favorable. This information is expressed in a ratio. A ratio of 1.0 means that assets are equal to liabilities. A ratio greater than 1.0 means that assets are greater than liabilities. A ratio less than 1.0 means that assets are less than liabilities. BROKER RECOMMENDATION: Financial ideas or suggestions are offered by brokerage firms or brokers who act as intermediaries between a buyer and a seller. FACTORS OF PRODUCTION: what a firm uses as resources to produce their goods should be considered when investing in a company. BOOK VALUE/OVERPRICED?: The difference between the firm’s assets and liabilities which determines what the stockholder owns after all debts are paid. To calculate book value use the following equation: P = PE x EPS P = 15 x 3 P = $45 If the current price of the stock is over $45 per share, it is overpriced. INDUSTRY CONSIDERATIONS INDUSTRY TYPE: A group of companies that produce or sell the same kind of product or service is called an industry. GROWTH PROSPECTS: A common stock that has increased in earnings, year-after-year, would indicate that the company is growing. One hopes that the company will continue to grow so that the earnings will increase. GOVERNMENT POLICIES AND REGULATIONS: these may encourage or discourage corporate expansion and growth. For example: if the government decides to spend money on defense items, those companies that produce defense-related goods are guaranteed work and usually long-term profits. LIFE CYCLE: The firm may be young, growing, maturing or failing. Management may use a merger, acquisition, new technology, human resource development and diversification to revive and renew the firm if it is in a mature or failing state. THE ECONOMY INTEREST RATE: the amount paid for borrowing someone else’s money. It is usually expressed as an Annual Percentage Rate (APR) INFLATION (CPI): an increase in the amount of money in circulation that lowers the value of money. Inflation results in higher prices paid for goods and services. The CONSUMER PRICE INDEX (CPI) is used to measure the current inflation rate. UNEMPLOYMENT: Failure of the economy to fully employ its labor force. The unemployed are people in the civilian labor force who do not have jobs but are actively seeking work. It is important to note whether unemployment is cyclical, frictional or structural. BUSINESS CYCLE (GDP): the business cycle is divided into four phases of the economy (peak, recession, trough, recovery). The GROSS DOMESTIC PRODUCT (GDP) is a good reference of measurement. MONETARY POLICY: considers whether the current monetary policy favors contraction or expansion of the money supply. A CONTRACTIONARY policy is when the discount rate goes up, when the reserve requirement goes up, or the Fed sells government securities. An EXPANSIONARY policy is when the discount rate goes down, when the reserve requirement goes down, or the Fed buys government securities. FISCAL POLICY: consider whether the current fiscal policy favors contraction or expansion. A CONTRACTIONARY policy is when tax rate goes up and/or federal government spending goes down. An EXPANSIONARY policy is when tax rates go up and/or federal government spending goes up. THE END Compiled by: Virginia Meachum, Economics Teacher Coral Springs High School Broward County, Florida