💳Principles of Finance Unit 11 – Stocks and Stock Valuation

What Are Stocks?

• Stocks represent ownership in a company and entitle the holder to a portion of the company's assets and earnings
• When you buy a stock, you become a shareholder and own a small piece of the company
• Stocks are issued by companies to raise capital for various purposes such as expanding operations, investing in new projects, or paying off debt
• Companies sell stocks to the public through an initial public offering (IPO) and then the stocks can be traded on stock exchanges
• The price of a stock fluctuates based on supply and demand in the market, which is influenced by various factors such as company performance, market conditions, and investor sentiment
• Stockholders have the potential to earn returns through capital appreciation (increase in stock price) and dividends (portion of company's profits distributed to shareholders)
• The two main types of stocks are common stock and preferred stock, each with different rights and privileges

Types of Stocks

• Common stock represents the most basic form of ownership in a company and entitles the holder to voting rights and a share of the company's profits through dividends
  • Common stockholders have the right to elect the company's board of directors and vote on major corporate decisions
  • However, common stockholders have the lowest priority in the event of a company's liquidation and are paid after bondholders and preferred stockholders
• Preferred stock provides a higher claim on a company's assets and earnings than common stock, but typically does not carry voting rights
  • Preferred stockholders receive fixed dividends that are paid out before any dividends are distributed to common stockholders
  • In the event of a company's liquidation, preferred stockholders have a higher priority than common stockholders but a lower priority than bondholders
• Blue-chip stocks are shares of well-established, financially stable companies with a history of consistent growth and dividend payments (Coca-Cola, Johnson & Johnson)
• Growth stocks are shares of companies expected to grow at a faster rate than the overall market, often in emerging industries (Amazon, Tesla)
• Value stocks are shares of companies that are believed to be undervalued by the market and have the potential for price appreciation (Berkshire Hathaway, JPMorgan Chase)
• Income stocks are shares of companies that pay consistent, high dividends and are often in mature industries with stable cash flows (AT&T, Procter & Gamble)
• Cyclical stocks are shares of companies whose performance is closely tied to the overall economy and tend to rise and fall with economic cycles (General Motors, Caterpillar)

Stock Markets and Exchanges

• Stock markets are platforms where stocks are bought and sold, enabling companies to raise capital and investors to buy and sell shares
• Stock exchanges are organized markets that facilitate the trading of stocks and other securities, providing a regulated and transparent environment for transactions
• The two largest stock exchanges in the United States are the New York Stock Exchange (NYSE) and the NASDAQ
  • The NYSE is the largest stock exchange in the world by market capitalization and is known for its trading floor where transactions are executed through a combination of electronic and human interaction
  • The NASDAQ is the second-largest exchange in the world and is known for its fully electronic trading system and its focus on technology companies
• Other major stock exchanges around the world include the Tokyo Stock Exchange, London Stock Exchange, and Shanghai Stock Exchange
• Stock exchanges have listing requirements that companies must meet to have their stocks traded on the exchange, such as minimum market capitalization, financial transparency, and corporate governance standards
• Trading on stock exchanges occurs through brokers who execute buy and sell orders on behalf of investors
• Stock markets operate during specific hours, which vary by exchange, and trades are settled within a few days after the transaction occurs

Factors Affecting Stock Prices

• Company performance is a key factor affecting stock prices, as investors assess a company's financial health, growth prospects, and competitive position in its industry
  • Positive earnings reports, strong revenue growth, and expanding market share can drive stock prices higher
  • Conversely, disappointing financial results, declining sales, or loss of market share can lead to a decrease in stock prices
• Economic conditions, such as GDP growth, inflation, interest rates, and employment levels, can impact stock prices across the market
  • A growing economy with low inflation and interest rates generally supports higher stock prices, while a slowing economy or rising inflation and interest rates can lead to lower stock prices
• Industry trends and competitive dynamics can affect stock prices within specific sectors
  • Technological advancements, changing consumer preferences, or regulatory changes can create opportunities or challenges for companies in a particular industry
• Investor sentiment and market psychology play a significant role in short-term stock price movements
  • Positive investor sentiment, driven by factors such as optimism about the economy or a company's prospects, can lead to higher stock prices
  • Negative sentiment, fueled by uncertainty, fear, or pessimism, can result in lower stock prices
• Global events, such as political instability, natural disasters, or public health crises, can impact stock prices by affecting investor sentiment and economic conditions
• Company-specific events, such as mergers and acquisitions, management changes, product launches, or legal issues, can also influence stock prices

Stock Valuation Methods

• Price-to-Earnings (P/E) Ratio compares a company's stock price to its earnings per share (EPS), indicating how much investors are willing to pay for each dollar of earnings
  • The P/E ratio is calculated as: $\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{Earnings per Share}}$
  • A higher P/E ratio suggests that investors expect higher growth in the future, while a lower P/E ratio may indicate that a stock is undervalued or that investors have lower growth expectations
• Dividend Discount Model (DDM) estimates the intrinsic value of a stock based on the present value of its expected future dividend payments
  • The DDM is calculated as: $\text{Stock Value} = \frac{\text{Expected Dividend}}{\text{Required Rate of Return - Dividend Growth Rate}}$
  • This model assumes that a stock's value is equal to the sum of all its future dividend payments, discounted back to their present value
• Price-to-Book (P/B) Ratio compares a company's stock price to its book value per share, which represents the value of the company's assets minus its liabilities
  • The P/B ratio is calculated as: $\text{P/B Ratio} = \frac{\text{Market Price per Share}}{\text{Book Value per Share}}$
  • A lower P/B ratio may suggest that a stock is undervalued, while a higher P/B ratio may indicate that a company's assets are overvalued or that investors expect higher growth
• Discounted Cash Flow (DCF) Analysis estimates the intrinsic value of a stock by discounting its expected future cash flows to their present value
  • The DCF model is calculated as: $\text{Stock Value} = \sum_{t=1}^{\infty} \frac{\text{Expected Cash Flow}_t}{(1 + \text{Required Rate of Return})^t}$
  • This method considers a company's future cash generation potential and accounts for the time value of money
• Relative Valuation compares a company's valuation multiples, such as P/E or P/B ratios, to those of its peers or industry averages to determine if a stock is overvalued or undervalued
  • For example, if a company's P/E ratio is significantly lower than the average P/E ratio of its industry peers, it may suggest that the stock is undervalued relative to its competitors

Reading Stock Information

• Stock symbols are unique identifiers assigned to each publicly traded company, typically consisting of one to four letters (AAPL for Apple Inc., MSFT for Microsoft Corporation)
• Stock price represents the current market value of a single share of a company's stock, which fluctuates throughout the trading day based on supply and demand
• Volume indicates the total number of shares traded during a given period, providing insight into the level of market activity and liquidity for a particular stock
• Bid price is the highest price a buyer is willing to pay for a stock, while the ask price is the lowest price a seller is willing to accept
  • The difference between the bid and ask prices is called the bid-ask spread, which represents the cost of trading and the potential profit for market makers
• Market capitalization (market cap) is the total value of a company's outstanding shares, calculated by multiplying the current stock price by the number of shares outstanding
  • Market cap is used to classify companies as small-cap, mid-cap, or large-cap, which can help investors assess a company's size and potential risk-return profile
• Dividend yield represents the annual dividend payment as a percentage of the current stock price, indicating the potential income an investor can earn from owning the stock
• Earnings per share (EPS) is a company's net income divided by the number of outstanding shares, measuring the profitability of a company on a per-share basis
• Price-to-earnings (P/E) ratio compares a company's stock price to its EPS, providing insight into how expensive a stock is relative to its earnings

Trading Strategies

• Buy and hold is a long-term investment strategy where investors purchase stocks and hold them for an extended period, regardless of short-term market fluctuations
  • This strategy is based on the belief that the stock market tends to rise over time, and that trying to time the market is difficult and often counterproductive
  • Investors using this strategy often focus on fundamentally strong companies with a history of consistent growth and stable dividends
• Value investing involves identifying and investing in stocks that are believed to be undervalued by the market, with the expectation that their prices will eventually rise to reflect their intrinsic value
  • Value investors look for stocks with low valuation multiples (such as P/E or P/B ratios) relative to their peers or the broader market
  • This strategy requires thorough research and analysis to determine a stock's intrinsic value and to assess whether the market has mispriced it
• Growth investing focuses on companies with strong earnings growth potential, often in emerging industries or with innovative products or services
  • Growth investors prioritize a company's future earnings prospects over its current valuation and are willing to pay a premium for stocks with high expected growth rates
  • This strategy often involves investing in smaller, younger companies that are rapidly expanding, but may also carry higher risk due to their unproven track records
• Momentum investing involves buying stocks that have recently outperformed the market, with the expectation that their positive performance will continue in the near term
  • Momentum investors look for stocks with strong price appreciation, high trading volume, and positive investor sentiment
  • This strategy is based on the belief that stocks that have performed well in the recent past are more likely to continue performing well in the near future
• Contrarian investing involves going against prevailing market sentiment and investing in stocks that are out of favor or overlooked by the majority of investors
  • Contrarian investors look for stocks that have been oversold due to temporary setbacks, negative news, or market overreactions, believing that these stocks will eventually rebound
  • This strategy requires a strong conviction in one's analysis and the ability to withstand short-term market pressure and volatility
• Dollar-cost averaging is a strategy where investors invest a fixed amount of money into a stock or portfolio at regular intervals, regardless of the stock price
  • By investing a consistent amount over time, investors can reduce the impact of market volatility on their portfolios and avoid the risk of investing a large sum at a market peak
  • This strategy can be particularly useful for investors who are risk-averse or have a long-term investment horizon

Risks and Returns

• Market risk, also known as systematic risk, refers to the potential for losses due to factors that affect the overall stock market, such as economic downturns, political events, or changes in interest rates
  • Market risk cannot be eliminated through diversification, as it impacts all stocks to varying degrees
  • Investors can manage market risk by adjusting their asset allocation, hedging their portfolios, or using stop-loss orders to limit potential losses
• Company-specific risk, also known as unsystematic risk, refers to the potential for losses due to factors unique to a particular company, such as management issues, product failures, or legal problems
  • Company-specific risk can be reduced through diversification, as the impact of any single company's performance is limited in a well-diversified portfolio
  • Investors can manage company-specific risk by thoroughly researching companies before investing and by monitoring their investments regularly
• Liquidity risk refers to the potential difficulty in buying or selling a stock without significantly affecting its price, particularly for stocks with low trading volume or during market downturns
  • Liquidity risk can be managed by investing in stocks with high trading volume and by maintaining a well-diversified portfolio to avoid overexposure to illiquid stocks
• Volatility risk refers to the potential for a stock's price to fluctuate significantly over short periods, which can lead to substantial losses if an investor needs to sell during a downturn
  • Volatility risk can be managed by having a long-term investment horizon, using dollar-cost averaging to invest consistently over time, and by maintaining a well-diversified portfolio
• Inflation risk refers to the potential for the purchasing power of an investment to decline over time due to rising prices in the economy
  • Inflation risk can be managed by investing in stocks of companies with strong pricing power, or by including inflation-protected securities (such as TIPS) in a portfolio
• Return on investment (ROI) measures the profitability of an investment by comparing the gain or loss from the investment to its initial cost
  • ROI is calculated as: $\text{ROI} = \frac{\text{Gain from Investment - Cost of Investment}}{\text{Cost of Investment}} \times 100\%$
  • A higher ROI indicates a more profitable investment, while a negative ROI indicates a loss
• Risk-return tradeoff refers to the principle that higher potential returns are associated with higher levels of risk, and vice versa
  • Investors must assess their risk tolerance and investment goals to determine an appropriate balance between risk and return in their portfolios
  • Diversification can help optimize the risk-return tradeoff by spreading risk across multiple investments while still allowing for potential returns