CH 3

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LESSON 3: Investing in Stocks

Rules to Follow Before Considering Individual Stocks

While it's tempting to buy stock in the companies we like, the only reason to buy a
stock is if it relates and contributes to your risk and return goals. Owning stock is not
an emotional investment, and you should only consider it to be a source of income.
Remembering this fact will help you to keep your perspective so that you can focus
solely on your financial goals. In addition to distancing yourself from the corporation
emotionally, below you'll find a few more rules that will prove useful for you:

 A portfolio of individual stocks should consist of at least nine stocks from a wide
array of industries.

 Stocks should be purchased in 100-share lots (called round lots).

 At an average price of $35 per share of individual stock, you'll need more than
$3,500 before you can start investing.

 If you're just starting to invest or if you don't have at least $50,000 to invest in
individual stocks and bonds, invest in mutual funds (mutual funds will be discussed in
detail in Lesson 5).

 Ignore the hot tips you hear on the street and thoroughly research the companies
you're interested in before making any investment decisions.

 Be careful with the news you find in the paper and on TV. By the time you read the
headlines, professional traders have most likely already reaped the benefits, and the
stock price will probably reflect the changes already.

 Apply common sense. If it sounds too good to be true, then it probably is.

 Start with a detailed investment plan and stick to it.

 Evaluate your plan at least quarterly.

 Minimize costs by avoiding excessive turnover of stock.

As the remaining lessons in of the course unfold, the applicability and importance of
these rules will become apparent.

Fundamental vs. Technical Analysis

Fundamental analysis seeks a discrepancy between intrinsic and market value -- that
is, trying to buy stock that is being sold for less than it is worth. Intrinsic value is the
actual value that you believe a stock to have, regardless of what it is being bought and
sold for on the market. Individuals who are more comfortable with fundamental
strategies use a wide array of economic, industry and corporate information to
calculate the corporation's "intrinsic value." If you determine that the intrinsic value of
the corporation's stock is more than its market value, it is said that a buy opportunity
has presented itself.

While fundamental analysis places importance on some of the factors underlying the
price of stocks, technical analysis tends to focus on outcome data, such as the stock
price itself and stock trading volume. Technical analysts believe that the stock price
and other measures such as volume behave in patterns that can then be used to
anticipate future price directions. Technical analysis seeks to detect patterns and
discrepancies in the way the market functions in order to be able to make educated
guesses about certain stocks. Technical analysts hope to "predict" market moves in
order to take advantage of them quickly.

While neither approach has proved to be superior, if you apply a consistent strategy,
you will attain your goal more often than if you had no strategy at all. In other words,
a necessary element for investment success is a consistent strategy based on sound
principles. For more insight on shaping a strategy that suits you, start reading "Picking
Individual Stocks," Chapter 5 of Investing 101.

Mining Annual Reports and Financial Statements for Information

 The annual report is a convenient way for the corporation to put its best foot
forward. If you want to learn more about a company, this is a very good place to start.
But if you've tracked the company for a while and already understand what it does and
what it plans to do, you can skip all of the flashy public relations sections and go to
the back of the annual report, which is where the financial statements appear.

 The balance sheet is a snapshot of a company's assets and liabilities. It helps you
answer such questions as how much cash the company has available, how much debt
it has assumed and how much the corporation's net worth is.

 The income statement reports revenue, expense and net income for a defined
period of time. It provides answers to questions regarding the company's net income
and will explain how this will affect the budget.

 The cash flow statement, in conjunction with the income statement, tells you if the
company is making money. Net losses on the income statement aren't necessarily bad.
Net cash outflow on the cash flow statement isn't necessarily bad. A combination of
the two for an extended period of time, however, spells doom for any company.

 The analysis of financial statements relies on accounting data.


Accounting Data and Ratios: Measuring the Corporate Pulse

How can you use the information from the financial statements to help you invest
wisely? By comparing numbers to each other by means of ratios. These ratios can help
you compare the company with its competitors or with its own performance in prior
years. All measures should be compared with five to 10 years of historic data and with
industry averages to detect if any trends to the information are present.

Profitability

 After-Tax Net Income and Net Income Per Share (after-tax net income/number of
common stock shares outstanding): For corporations with seasonal business -- a
predictable ebb and flow in revenues that's tied to changes in climate, holidays and
vacations -- be sure to compare the same quarters across the years.

 Return On Assets (after-tax net operating income/total assets): Operating income is


income earned from doing business, not the sale of assets or investment returns. This
ratio is directly related to the productivity of assets, and a low ratio suggests that the
company's assets have not been well managed.

 Asset Turnover (revenue/total assets): This ratio is the amount of assets the
company needed in order to generate a dollar of sales.

Liquidity

 Debt to Equity (long-term debt/total equity -- current liabilities): This measures


whether the corporation can satisfy its obligations to its creditors. Long-term debt
shouldn't include accruals or accounts payable. It should only be IOUs that the
company owes a bank, or has issued publicly to investors. Long-term debt will usually
be labeled "Long Term Debt." Equity should be total stockholders' equity. The higher
this ratio, the more this company relies on debt. A higher number isn't necessarily bad,
but should be able to be rationally explained. If the replacement will help the company
make a profit in the future, then the debt isn't so bad.

 Current Ratio (current assets/current liabilities): This ratio measures the


corporation's ability to fund its current liabilities, such as day-to-day operating
expenses and short-term debt. Companies with dependable cash flows can more safely
maintain lower current ratios than companies without.

 Quick Ratio (cash + marketable securities + accounts receivable / current


liabilities): Marketable securities are simply investments that the company has made
in other companies. Marketable securities must be easily marketed, or converted into
cash. So this ratio lets you evaluate at a glance how a company would fare if sales
stopped. It compares cash and cash equivalents -- such as investments and sales that
have been made but not converted to cash -- to current liabilities in order to measure
the company's capacity to pay its current obligations and to fund its day-to-day
operations. A rule of thumb commonly used to evaluate the acid test states that the
quick ratio should be at least one (1).

To find official public corporation reports that include financial statements as well as
other critical corporate information, go to www.sec.gov, select "Edgar Database" and
then "Search the EDGAR Archives."

For more insight on how to read and interpret this data, read pages 95-97 of Investing
101.

Evaluating Stock Performance

Plans with hard and fast target allocations and buy-sell rules govern most stock
performance evaluations. It pays to evaluate and assess your success at making
investment decisions periodically. Even if you're following your plan, do your
decisions yield acceptable results? If not, you may want to re-script your buy-and-sell
rules. You can evaluate your investment performance by comparing stocks in your
portfolio with appropriate indices, baskets of stocks that represent a certain category
of stocks. For example, the Dow Jones Industrial Average represents established,
high-dividend stocks.

The S&P 500 index is composed of 500 large, well-established U.S. companies. Other
indices represent industries and segments. You can find indices for small-
capitalization stocks (stocks issued by small companies), precious metals stocks,
Internet stocks, even funeral company stocks.

When you buy a stock, assign it to an index. Then, once every year or so, lump the
performance of all the stocks you assigned to the same index and compare your group
with the index. Assume for a minute that you assigned two stocks to the same index.
You bought 100 shares of each stock and on a preset date, one closed the trading day
at $5 and the other at $10 per share. This group was worth $1,500. On the same day,
the selected index closed at 10,000. One year later, you owned the same number of
shares in both stocks and had added no more stocks to the group. Their combined
value including dividends was $1,600 and the index closed at 10,050. Your stock
value rose (1,600 - 1,500) / 1,500 =) 6.7 percent while the index rose only ((10,050 -
10,000) / 10,000 =) 0.5 percent. In this instance, you're either lucky or doing
something right. Repeat this process for all groups and corresponding indices.

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