Chapter 11 – Investing in

Stocks
LO 1. Identifying the functions of stock exchanges
Stock exchanges are facilities that allow investors to purchase or sell existing
stocks
- They facilitate trading in the secondary market
- A stock must be listed on the stock exchange to be traded there.

Canadian Stock Markets:

1. Toronto Stock Exchange (TSX)
a. To be listed on the TSX, a firm must meet minimum listing
requirements in areas like revenue, cash flow, working capital, cash…
2. TSX Venture Exchange – Public venture capital
a. Venture capital  Investors’ funds destined for risky, generally new
businesses with tremendous growth potential.
3. Montreal Exchange
a. This is a derivatives exchange
b. Investors interested in trading options and futures would use the
services of the Montreal Exchange.
Over The Counter (OTC) market
- An electronic communications network that allows investors to buy or sell
securities.
- Not a transparent market
- Less rules and regulations
- Business is transacted with one person, principal to principal, at their price.
- Designed for companies that do not meet the listing requirements of the TSX
or the TSX Venture Exchange.
Electronic Trading
- Bid Price  The price at which a purchaser would like to purchase a stock.
- Ask Price  The price at which a seller would like to sell a stock
- Characteristics of a high-quality stock exchange include:
o Small difference between bid price and ask price
o Market liquidity where there is a large volume of shares being
offered for purchase or sale with each trade request
o Market depth where a large volume of traders are making requests.

New York Stock Exchange

 - Demutualization  The transformation of a firm from a member-owned
organization to a publicly owned, for profit organization

LO 2. How to Interpret Stock Quotations

LO 3. How to Execute the Purchase or Sale of
Stocks
Full-service broker can provide you with investment advice. Recommendations from
brokers and analysts have limitations.
Different Brokerage Firms
1. Discount Brokerage Firm  Executes transactions but does not offer
investment advice
2. Full-Service Brokerage Firm  Offers investment advice and executes
transactions
a. Charges higher fees for their services than discount brokerage firms.

Step 1: Placing an Order

- Name and class of the stock
- Buy or sell
- Number of shares
o Board Lot  shares bought or sold in multiples of typically 100
shares.
o Odd lot  less than a board lot of that particular stock
- Market order or limit order
o Market Order  an order to buy or sell a stock at its prevailing
market price.
o Limit Order  an order to buy or sell a stock only if the price is within
the limits that you specify
 On-Stop Order  an order to execute a transaction when the
stock price reaches a specified level.
 Buy-Stop Order  an order to buy a stock when the price rises
to a specified level.
 Sell-Stop Order  an order to sell a stock when the price falls
to a specified level.

Step 2: Buying Stock on Margin

Buying on margin means the amount of your own cash that you must use to
purchase stock

Margin Call  A request from a brokerage firm for the investor to increase
the cash in their account in order to return the margin to the minimum level.
Step 3: Short Selling Stock
Short Selling  The process by which investors sell a stock that they do not
own.
- Stock is overvalued
- Borrow the stock from the brokerage firm
- Purchase the stock at a future point in time

LO 4. How to Analyze a Stock

Analyzing a Firm’s Financial Condition
Impact of a Strong Firm Performance on Stock Price of Firm
1. Strong sales and profit of firm
2. Investors are confident that the firm will perform well
3. Investors demand for stock of firm increases
4. Supply of stock for sale by investors decreases
5. Therefore, price of firm’s stock increases.

Impact of Weak Firm Performance on Stock Price of Firm

1. Weak sales performance
2. Investors expect the firm will perform poorly
3. Investor demand for stock of firm decreases
4. Supply of stock for sale by investors increases
5. Therefore, price of firm’s stock decreases

Economic Analysis of Stocks

1. Economic Growth  The growth in a country’s economy over a particular
period
a. Measured by GDP
b. Fiscal Policy  How the government taxes on individuals and
corporations and how it spends tax revenues.
2. Interest Rates  When rates are low:
a. Stocks perform better
b. Firms tend to be more willing to expand
c. Enables more consumers to afford cars or homes
d. Monetary Policy  Techniques used by the Bank of Canada to affect
the economy of the country by influencing interest rates.
 3. Inflation  The increase in the general level of prices of products and
services over a specific period.
a. Consumer Price Index (CPI)  Represents the increase in the prices
of consumer products over time.

Factors that Increase and Decrease a Stock’s Price

Increase a firm’s stock price
1. Investors expect firm to do well based on:
a. Strong economic growth
b. Low interest rates
c. Low inflation
d. Strong industry conditions
e. Proper decisions by the firm
2. Strong demand for firm’s stock; low supply of firm’s shares for sale
3. Increase in firm’s stock price

Decrease a firm’s stock price

1. Investors expect firm to perform poorly based on:
a. Weak economy
b. High interest rates
c. High inflation
d. Weak industry conditions
e. Improper decisions by the firm
2. Weak demand for firm’s stock; large supply of firm’s shares for sale
3. Decrease in firm’s stock price

Technical Analysis  The valuation of stocks based on historical price patterns.

Fundamental Analysis  The valuation of stocks based on an examination of
fundamental characteristics like revenue or earnings.

Analyzing a Firm’s Financial Condition

- Balance sheet : Indicates a firm’s sources of funds and how it has invested
those funds at a particular point in time.
o Assets  How it has invested its funds and what it owns.
o Liabilities and Equity  How the firm has obtained its funds.
- Income Statement: Measure a firm’s revenues, expenses, and earnings
over a period of time.
Firm-Specific Characteristics
- Liquidity
- Efficiency
- Financial leverage
- Profitability

Or NET
PROFIT
LO 5. How to Value a Stock
Intrinsic Valuation Model:
- This model attempts to find the value of an investment by focusing on:
o the amount of future cash flows generated by the investment
o the timing of these cash flows
o and the rate of return required on the investment.
- The value of an investment equals the present, or discounted, value of all of
its expected future cash flows.

Relative Valuation Model:

- Attempts to find the value of an investment by comparing it to other similar
investments.

Dividend Discount Model (DDM):

- A firm’s future dividend payments are discounted at an appropriate rate of
interest.
o Zero growth model
o Constand growth model
o Variable growth model
- This method of valuing stocks works best for mature firms that pay a large
stable dividend.
- Limitations of this model
o Dividend payments may not be stable over time. Valuation of
stocks may be unreliable
o Dividends may not accurately reflect the cash flows available to
shareholders.

Price-Earnings (P/E) Method:

- Values a stock based on the value of the firm’s earnings.
- Price/earnings analysis is a stock valuation technique that values a firm using
comparable industry or firm earnings multiples.

Efficient Stock Market

 - A market in which stock prices fully reflect information that is available to
investors
- Not be able to identify stocks that are undervalued.
Inefficient Stock Market
- A market in which stock prices do not reflect all public information that is
available to investors.

Digital Study Module Notes

When the Bank of Canada acts to lower interest rates, it is an example of
MONETARY POLICY.
Monetary policy, or the policies of the Bank of Canada, focuses on manipulating
interest rates to achieve some economic objective
Lowering interest rates stimulates consumption and growth while raising interest
rates has the opposite impact.
The government’s use of taxation and spending designed to achieve some
economic objective is known as fiscal policy. Higher taxes on individuals and firms
can reduce consumption and profits respectively and have a negative impact on
stock price.

Fundamental Analysis vs. Technical Analysis

A fundamental analyst is more likely to use an income statement. Fundamental
analysts focus on the fundamental characteristics of the firm. They use the firm’s
financial statements in many different ways to determine a firm’s intrinsic value.
Fundamental analysis is the process of determining a stock’s value by looking
at a firm’s expected future cash flows and the timing of those cash flows,
level of risk and overall economic and market conditions. Fundamental
analysts believe that a firm’s value is the present value of all future cash flows
discounted back to the present using a discount rate that reflects the firm’s level of
risk
In contrast, a technical analyst is more likely to use price charts. Technical
analysts are sometimes called chartists. They believe a stock can be valued by
looking at historical price patterns so they make extensive use of charts in order
to identify patterns or trends.
Technical analysis uses price and volume data to identify patterns or trends
that may identify underlying supply and demand factors leading to
changes in stock price. Technical analysts are sometimes called chartists given
their predominate use of charts and graphs to identify stock price patterns.
Round Lot  A round lot of stocks usually equals 100 shares or a multiple of 100
shares.

Buying on Margin  When you borrow a portion of the funds from your broker to
buy stocks.