Q.
Why should I buy (invest in) common stocks?
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A.
The short answer is that you can
often make more money than you can make from other savings and investment
alternatives. You may make money owning common stocks by:
- Receiving
dividends.
- Through
capital appreciation.
The
payment of dividends is a way for a corporation to share part
of its profits with its owners. Many corporations have a history of
regularly increasing the dividends they pay their owners
(stockholders). By increasing dividends, the corporation increases
the return to owners as its profits increase. Increasing dividends
serves as an inflation hedge for the corporation's stock
owners.
Another
way of making a profit on common stocks is through capital appreciation,
an increase in the price of the stock over a period of time. If you
bought a common stock at $50 a share ten years ago and it is now selling
at $100,, you would have capital appreciation of $50 a share, or a
100 percent increase in the value of your invested money over ten
years.
To
properly compare the returns on different investments held for different
periods of time, you need to know the annual return. A 100 percent
increase over ten years provides an average annual return of 10 percent
per year. It also provides a compound annual return of 7.18 percent
per year. If the value of a stock you purchased at $50 a share increased
by 7.18 percent each year, the value at the end of ten years would
be $100.
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Q.
What is the price-earnings ratio?
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A.
The price-earnings ratio,
often referred to as the P/E ratio, is the price of a stock divided
by the company's earnings per share.
Example: If a stock's price is $60 and the earnings per
share are $4.00, the price-earnings ratio is 15 (60 divided by 4 =
15). If the price is $40, the P/E ratio is 10 (40 divided by 4 = 10).
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Q.
Why is the price-earnings ratio important to me?
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A.
The price-earnings ratio can be a good
measure of whether a stock is a bargain or overvalued.
- If
the P/E ratio of the corporation you are reviewing is lower than
that of similar corporations, you may want to investigate why it
is lower. The stock may be a bargain.
- Conversely,
if the P/E ratio of the corporation you are reviewing is higher
than that of similar corporations, you may want to investigate why
it is higher. The stock may be overvalued.
Illustration:
Ten-Year History of the Average Annual P/E
Ratio of PepsiCo Common Stock
Year
Average Annual P/E Ratio
- 11.8
- 12.6
- 16.3
- 15.5
- 12.6
- 15.7
- 17.8
- 20.4
- 22.8
- 20.0
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Q.
What are warrants?
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A.
Warrants
are rights to buy shares of a corporation's
securities, usually common stock, at a specified price for a limited
period of time. Warrants are primarily issued as a marketing technique
to help make other types of securities of a corporation more attractive
to investors. Many warrants have a market value and a trading market
for buying and selling. If warrants are exercised, they are a potential
source of additional shares of common stocks.
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Q.
What are stock options?
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A.
Options, in a discussion of potential dilution,
are rights to buy a fixed number of shares at a fixed price for a
fixed period of time. Options are issued to a corporation's officers
based on the company's performance or for other reasons. The options
usually require that an officer remain employed for a certain period
of time. Options are a potential source of additional shares of common
stock.
When you see a
corporation report primary earnings per share, this means earnings
per share based on current shares outstanding.
When you see a
corporation report fully diluted earnings per share, this means the
earnings per share if all possible shares were issued. It does not
mean that all the potential additional share will be issued. The warrants,
convertible securities, or options are only possible sources of additional
shares
Click
here for further information on other types of options.
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Q. What
happens if I buy a stock before the ex-dividend date, but the records
of the corporation cannot be updated in time for proper dividend credit?
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A.
If the buyer is entitled to a dividend, but the ownership has not
been transferred on the corporation's books in time for the dividend
to be paid to the buyer, the brokerage firm executing the transaction
is responsible for claiming the dividend from the seller and making
certain that the payment is made to the buyer. This is referred to
as a dividend claim.
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Q.
What is the current yield on a stock?
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A.
The
current yield is the anticipated annual dividend divided
by the current price of the stock.
Example: If you purchase a share of PepsiCo at $40
and the anticipated annual dividend is $0.64 per share, your
current yield is 1.6 percent ($0.64 divided by $40 = 1.6 percent).
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Q.
Why do stock prices go up and down?
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A.
The
current price of a stock is the price investors will pay for that
stock at that moment. The price represents the present value of the
expected future cash to be received from that stock, either from dividends
or through capital appreciation. When you buy a stock for its appreciation
potential, you believe that expectations about the corporation will
improve and investors will pay higher prices for the stock. Since
the price depends on investors' expectations, the price will rise
or fall as new developments occur, such as:
- Company
developments. The corporation's own operations will sometimes
exceed or fall short of investors' expectations. For example, IBM's
internal troubles from 1991 to 1993 caused its stock to fall even
as the stocks of other computer companies continued to rise.
- Industry/group
developments. The industry of which the corporation is a part
will experience better or worse prospects from time to time, such
as the banking industry during the credit crisis in the 1989-1991
period.
- Market
developments. The entire stock market environment can change,
pulling a stock's price along with it regardless of how well the corporation
is doing. The bull market that began in 1982 elevated the price level
for stocks in general, and the market crash of October 1987 pulled
most down temporarily.
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Q.
What is a bull market?
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A.
A
bull market is a period during which the general level of stock prices
are rising.
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Q.
What is a bear market?
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A.
A bear market is a period during
which the general level of stock prices are falling.
- Economic/political
developments. Good or bad reports on the economy and political
events such as elections or new laws can affect expectations about
a corporation, an industry, or the entire stock market. As a historic
example, the Arab oil embargo of 1973-1974 affected not just oil stocks,
but the stock market and the economy as a whole.
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Q.
What is the total return on my stock?
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A. Total
return is dividend yield plus appreciation.
Example: You bought a stock paying s 50 cents per
share dividend one year ago for $10 a share (5 percent yield).
Today, the stock is worth $12 a share ($2 per share appreciation
or 20 percent). Your total return is 25 percent: the dividend
yield of 5 percent plus appreciation of 20 percent. If you had
owned the stock for five years, your total dividends would be
$2.50 (50 cents per year for five years), or 25 percent ($2.50
dividend by 10). Add the appreciation of 20 percent and your
total return is 45 percent over five years. This translates
into an average annual return of 9 percent, or a compound annual
return of 7.7 percent.
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Q.
What is my stock portfolio?
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A.
Your
stock portfolio is your entire holdings of stocks. As your investment
strategy develops and changes, you should regularly review your portfolio
to make sure it continues to meet your objectives and requirements.
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Q.
How do I diversify my stock portfolio?
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A.
You
diversify your stock portfolio by owning several different types of
stocks. You should not put all your eggs in one basket by investing
all your money in one security. Diversification into different types
of stock will reduce risk. Often a difficult period for one type of
corporation or industry will be offset by good relative performance
of the rest of the portfolio. You may diversify in several different
ways, including:
- Company
size
- Industry
group
- Market
behavior
- Investment
objective
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Q.
How do I diversify by industry groups or sectors?
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A.
Companies
operate in many different industries, and those industries are grouped
into industry sectors. The major industry sectors and
some industries within those sectors are the following:
- Basic
Industry, Chemicals, Metals, Paper.
- Capital
Goods, Machinery, Computers, Electrical Equipment, Telephone-Long
Distance, Pollution Control, Aerospace / Defense.
- Consumer
Durable, Appliances, Autos, Building, Photography.
- Consumer,
Nondurables / services, Foods and Beverages, Drugs / Health, Retail,
Publishing, Tobacco, Household, Entertainment / Leisure.
- Energy,
Oil Service / Drilling, Oil-Domestic, Oil-International.
- Financial,
Banks, Other Finance, Insurance.
- Transportation,
Air, Rail, Truck.
- Utilities,
Electric, Gas, Telephone.
- Miscellaneous.
Investing
in a broad variety of industry groups usually allows you, the investor,
representation in the different sectors of the economy. Companies
in an industry sector will be affected by the same industry developments,
but companies in other sectors often will be affected by different
factors and circumstances. Diversifying a portfolio among industry
sectors usually reduces the risk from down cycles in any one sector.
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Q.
How do I diversify by market behavior?
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A.
Classifying
stocks by their historic price behavior in various market environments
is another way of seeking diversification. In addition to size and
industry groupings, stocks also may be classified by how their price
reacts to various cycles within the stock market and the economy.
At the start of an economic upturn, for instance, cyclical stocks
(those tied most closely to the economy's health, like steel or machinery
stocks) will usually perform well. The reverse is also true: as the
economy turns down, defensive stocks (those of companies
making staple goods, such as foods and beverages) will resist the
downturn better than others.
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Q.
How do I diversify by investment objective?
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A.
Stocks
may also be classified by which investment objective, such as growth
or income, they most closely fulfill.
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Q.
What are growth stocks?
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A.
Growth
stocks are those of corporations, such as computer makers, that are
growing rapidly and that reinvest the majority of their earnings in
this growth rather than paying them out as dividends. Growth stocks
have a long-term record of superior appreciation tied to growth of
the company's earnings. Since the shareholder's total return and accumulation
of wealth often depends on this growth, the stocks tend to be more
volatile than stocks with higher dividends.
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Q.
What are income-oriented stocks?
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A.
Income-oriented
stocks generally provide a high income and often a steady growth of
income, but do not hold as much promise for growth and appreciation.
Examples include utility stocks or real estate investment trusts.
Such stocks are usually steadier in price behavior because investors
are not demanding dynamic appreciation potential. Generally, the higher
the yield of a stock, the less opportunity there is for capital appreciation.
In general the following is true: the prices of income stocks will
decline if interest rates increase; their prices will rise if interest
rates decrease.
Note
of Caution:
If a stock is yielding a great deal more than
similar stocks, you may want to investigate whether its dividend is
in jeopardy.
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Q.
Can I diversify by investing in foreign stocks?
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A.
As
the world becomes smaller and stock markets develop abroad, many investors
are seeking opportunities in foreign stocks. You can invest in foreign
stocks either directly or through American Depository
Receipts (ADRs). Generally, an American investor will
not purchase the stock of foreign corporations directly. He or she
will invest in American Depository Receipts.
Shares
of many of the larger foreign corporations, such as British Petroleum,
Sony, and Honda, are traded in US markets via ADRs. Even though ADR
certificates look like stock certificates, they actually represent
shares of a foreign corporation that are held by an American bank,
which issues the ADR. ADRs are a popular way for Americans to invest
in foreign corporations because of the ease of transfer and sale.
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Q.
What are some of the risks of investing in foreign securities?
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A.
If
you invest in foreign stocks, your investments may be subject to currency
adjustments, special taxes, or transfer difficulties. Currency adjustments
mean that the dollar value of your foreign stocks may fluctuate because
of a change in the value of the foreign currency relative to the US
dollar rather than because of any corporate event or news. Rules and
regulations and reporting requirements for foreign markets are often
different from those for domestic corporations. Foreign stocks that
are traded in US markets must conform to US reporting requirements.
Note of Caution:
Before
investing in ADRs or foreign securities, you should look into
potential problems and see if you are willing to assume the additional
risk.
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Q.
Is there a possible tax consequence in owning foreign securities?
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A.
When
you own ADRs or own shares of a foreign corporation directly, the
country in which the foreign corporation is located will often withhold
income tax from the dividends you receive. Generally, you may credit
such withholdings against your US income taxes. For precise information
on the taxation of the dividends or distributions from foreign corporations,
you should consult your broker or tax advisor.
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Q.
Every day I hear quotes for the Dow Jones Industrial Average and the
S&P 500. What do these quotes mean to me?
|
A.
Indexes
reflect the general direction of the stock market or specific segments
of the stock market. When news commentators want to indicate the direction
of stock prices, they quote the movements of one or more stock indexes.
Indexes
are published daily to give investors the general direction of stock
prices. The indexes are commonly reported by the news media as part
of regular coverage. When large movements occur in stock prices, the
change in the indexes often makes headlines.
Different
indexes are formulated to measure different sectors of the market.
The Dow Industrials includes only 30 large-capitalization stocks,
whereas the S&P 500 measures the broader market, covering 500
stocks.
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Q.
What are some of the most popular indexes and averages?
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Q.
How do I go about buying and selling stocks?
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A.
Your
first step is to establish your general investment objectives and
the role stocks should play in your strategy to achieve those objectives.
For assistance in establishing your investment objectives, you may
turn to a professional at a brokerage house, bank, or other advisory
firm.
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Q.
How do I choose stocks that meet my investment objectives?
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Q.
What are the major US stock exchanges?
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A.
The major US stock exchanges include:
- New
York Stock Exchange.
- American
Stock Exchange.
- Pacific
Stock Exchange.
- Philadelphia
Stock Exchange.
- Midwest
Stock Exchange.
There
are also stock exchanges in many foreign countries.
When
you buy or sell a stock that trades over-the-counter
(OTC), your order is not sent to New York or Philadelphia
or any other exchange location. Your broker's own trading desk makes
direct contact with another firm's traders. They negotiate price and
execute the transaction themselves, reporting the trade to you and
to the networks of OTC trading firms around the country. The major
OTC reporting network is called the National Association of
Securities Dealers Automated Quotations (NASDAQ) system. Another
OTC reporting service called the "Pink Sheets" is published
by the National Quotation Bureau Inc. and reports trading in smaller
stocks. Daily trading in many OTC stocks is reported in major newspapers.
The format is the same as that used for exchange listed stocks.
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Q.
What are some of the over-the-counter market terms I should know?
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A.
Some over-the-counter market terms you
should understand are:
- Bid
price.
- Asked
price.
- Spread.
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Q.
What is the bid price?
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A.
The
bid price is the price a dealer would pay a seller for
shares.
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Q.
What is the asked price?
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A.
The
asked price is the price a dealer would charge a buyer
for shares.
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Q.
What is the spread?
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A.
The
spread is the difference between the bid and asked prices,
which the dealer keeps as compensation for the trader who executed
the transaction. Your broker may also charge you a commission.
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Q.
If my account is coded to hold in customer name, what does this mean?
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A.
If
your account is coded to hold in customer name, a certificate
will be registered in your name but held at the brokerage firm for
safekeeping. All dividends and corporate information will be mailed
directly to you at your address of record.
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Q.
If my account is coded to hold in street name, what does this mean?
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A.
If
your account is coded to hold in street name, securities are
registered in the name of the broker/dealer for the benefit of you,
the owner. This method facilitates transfer, collection of dividends,
identification, and notification of major corporate events. All dividends
and corporate information are mailed to the broker/dealer and forwarded
to the investor. The investor may instruct the broker to hold dividends
for future investment.
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Q.
What are some of the different orders I can enter?
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A.
Once
the account is open, you may enter an order to purchase or sell stock.
Again, you may state your preference on a number of factors, including
price and time.
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Q.
What is a short sale?
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A.
Sometimes
investors sell a stock that they do not own with the intention of
repurchasing it at a lower price. This transaction is known as a short
sale. If the short sale is successful, the difference between
the sale price and the purchase price is the investor's profit.
Example:
An investor decides that IBM common stock is
overvalued at $100 per share and sells the stock which she does not
own. Six months later, IBM is selling for $50 a share, and the investor
purchases stock to close the position. Her profit is $50 per share.
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Q.
Are there any special rules when entering a short sale order?
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A.
Yes.
You must disclose to your broker that you are selling short (selling
stock you do not own), because the broker must make arrangements to
borrow the number of shares you are selling to make delivery.
The buyer of the stock you are selling must receive the shares for
the stock he or she is buying.
Short
sales must be executed in a short account. In order to execute a short
sale, you must also have a margin account. On most major exchanges,
short sales can only be executed when the price of the order is higher
than the last trade. This is referred to as the uptick rule.
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Q.
What is the risk in entering into a short sale?
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A.
When
you invest in a stock, you are risking only the money you invested.
In a short sale, in theory, your risk is unlimited-that is, the price
of the stock you short could continue to rise indefinitely.
In
the IBM example, if the price of IBM stock rose to $300 and the investor
decided to repurchase at that price, her loss would be $200 a share
($300, the price at which she purchased the stock, less $100, the
price at which she sold the stock).
Note of Caution:
If the price of a stock you shorted increases,
you may receive a margin call for a portion of the rise in value.
In some instances, you may not be able to enter a short sale
because your broker cannot borrow a certificate to make delivery.
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Q.
After I buy a stock, how do I follow my stock's progress?
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A.
It
is important that you keep current on your stock's activity, the underlying
company, and general market conditions. By checking your stock regularly,
you can determine if there is an upward or downward trend in its price
movement and if its trading volume is above or below average. Volume
trends can reinforce or contradict the trend you see in price movement.
For
instance, if your stock's price is rising and its trading volume is
heavier than usual, this may indicate not only that investors are
willing to pay higher prices, but also that there is increased demand
at the higher price levels. On the other hand, if the price has been
falling, but the volume is getting very light, there may not be many
more sellers willing to accept the lower prices, and the price decline
may be ending.
News
on corporate developments will affect the price of your stock. By
reviewing the company's quarterly and annual reports on sales and
earnings, and any news releases the company may issue, you will notice
the effect good or bad news can have on your stock's price. You should
also watch general news, since broader developments in the market
and the economy can also affect your stock, regardless of how well
the particular corporation is doing. One-time events may not have
a major effect on your long-term investment. But if such events become
a trend in the corporation's operations, the nature of your investment
will change, and you might want to decide whether to hold, buy more,
or sell your stock.
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Q.
How will dividend changes effect the price of my stock?
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A.
Dividend
payments are one of the most direct contributors to your investment
return. Once you know the quarterly dividend payment dates and the
amount of the dividend the stock has been paying, you can record the
upcoming dates in your calendar and anticipate these payments. From
time to time, corporations will increase or decrease the dividend.
One indication that a stock is a good investment is a record of steady
increases in its dividend.
If
you own a stock and the corporation announces a dividend increase,
you may see the stock price appreciate as investors react to the good
news. A dividend increase is a message that the board of directors
has a positive expectation for the corporation's future.
The
reverse is also true. If your corporation is having difficulties and
announces a reduction or elimination of its dividend, this is generally
a negative signal on the corporation's outlook.
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Q.
What is a stock split?
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A.
A
stock split is a proportional division of a corporation's
outstanding shares. A shareholder will receive a proportional number
of additional shares, and the par value and market price of the stock
will decrease proportionately.
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Q.
What is a stock dividend?
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A.
A
stock dividend is a distribution of additional shares
to current shareholders in addition to or in lieu of a cash dividend.
As in a stock split, your shares will increase in number, but your
overall ownership and value remain the same.
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Q.
How do stock dividends and stock splits affect the value of my investment?
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A.
In
theory, stock splits and stock dividends do not affect the value of
your investment. In both cases, the corporation issues more shares
and the stock's market price is automatically adjusted proportionately
so that the value of your total investment stays the same. For instance,
if you own 100 shares of a stock priced at $60 (a $6,000 value) that
splits or declares a stock dividend, the math will change, but the
value will not:
Pre-split
100 at $60 = $6,000 value
2-for-1
split 200 at $30 = $6,000 value
100%
stock dividend 200 at $30 = $6,000 value
3-for-2
split 150 at $40 = $6,000 value
50%
stock dividend 150 at $40 = $6,000 value
Like
cash dividends, stock splits and stock dividends will have a declaration
date, a record date, and a payment date. If the payment date has passed
and you have not received your new shares, you may follow the same
procedures outlined for cash dividend payment problems-
Note:
Par value
is a nominal dollar value per share set by the corporation's charter
when the stock was originally issued. Currently, par value has
little significance except for bookkeeping purposes within the
corporation.
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Q.
What is a reverse split?
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A.
Corporations
whose stocks have very low prices, say under $1 per share, may declare
a reverse split to adjust the price upward to what investors
may perceive as a more mainstream price level. For example, a holder
of 1,000 shares of a $0.75 stock declaring a 1-for-10 reverse split
would receive a replacement certificate for 100 shares, and the price
would adjust to $7.50.
Note of Caution:
A
reverse split will substantially reduce the number of shares you
own. If you own a stock selling at under $1.00 per share and you
suddenly see the price quoted several times higher, you should
inquire whether an event such as a reverse split has affected
your holdings. If you sell stock that you do not own, you may
be obligated to purchase additional shares to make delivery, even
if the result is a loss.
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Source:
Money & Investing Victor L. Harper., Arthur S. Brinkley.,
with Sarah E. Dale
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