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Determining The Stock Option Values

DIVIDEND REINVESTMENT PLANS

Municipal Bond Funds

How to find information about mutual funds

Types of Taxable Bond Funds

How to find information about stocks

How market capitalization affects stock value

How to minimize your stock investing risk

How to fund your stock program

Stock Option Plans

Tips on how to choose growth stocks

Advantages and Disadvantages in the Granting of Stock Options

Setting your sights on your financial goals

The Discount Rate Used by Venture Capital Fund

Stocks represent ownership in a company. They are traded publicly on stock exchanges throughout the world. Shareholders have the right to vote at shareholders’ meetings and review the books of the company. Generally, I don’t recommend holding more than five percent of an investor’s portfolio in individual stock due to the risk factor associated with stocks. There are two types of stock we discuss: common and preferred.

Common Stock

Common stock can help you accumulate wealth in two ways. First, they provide income through dividends, which are distributed to shareholders from corporate earnings. Second, the stocks can appreciate in value. This is generally the result of successful company management and products, or the prospect of future successes. Common stocks allow the stockholder, as part owner of the company, to participate in the firm’s profits.

It is important to remember that the stock value may depreciate as well. A number of reasons may go into why a stock depreciates instead of appreciating. It varies from stock to stock and industry to industry. For instance, Lucent Technologies was trading at around five to six dollars per share during the summer of 2001. This doesn’t mean that it’s a bad company, or even a poor investment. Depending on your risk tolerance and your outlook, you might think purchasing some shares of Lucent right now is a good investment decision that will pay off in the future.

Stocks traded publicly are easily converted into cash. Because of this, they are considered readily marketable investments. They aren’t considered liquid, though, because the sale of the stock could result in a loss of principle. Nonpublicly traded stocks are neither liquid nor readily marketable because they are difficult to sell and the selling price is uncertain.

Publicly traded stocks are exchanged on stock exchanges around the world. The largest exchanges in the United States are the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX). Both of these exchanges are located in New York City, but the NYSE is the largest. The NASDAQ (National Association of Securities Dealers and Automated Quotations) is an automated information system that provides stockbrokers and dealers with price quotes for over-the-counter stocks. There are other American exchanges, such as the Philadelphia Exchange and the Pacific Exchange.

Common stocks can be segregated into many different categories, and some stocks may fall into more than one category. While it may not always be easy to pigeonhole stocks, here are a few ways to categorize them. BLUE CHIP STOCKS. These are stocks of companies that have the highest overall quality. Because of the blue chips’ high quality, many investors are drawn to them. These companies are known for being financially stable and distributing dividends in both good and bad years. They are usually leaders in their industries or industry segments. All 30 companies that make up the Dow Jones Industrials are classified as blue chip stocks, as well as other utility companies and large, consistently successful companies.

Special note: A lot of emphasis is put on watching what the market does every day. It’s important to remember that the Dow Jones Industrial Average (DJIA) only comprises 30 companies. The NASDAQ Composite Indes and the S&P 500 are much more representational of what the market is doing because of their size. The S&P is made up of 400 industrial, 40 utility, 40 financial, and 20 transportation stocks, whereas the NASDAQ contains 5000 companies.

The DJIA, as well as the other Dow Jones averages, are priceweighted indices. Throughout every trading day, and at the end of each day, the averages are computed by adding the prices of the included stocks and dividing that number by a specified divisor. This divisor changes all the time, usually daily. No one stock will have a greater influence on the index than another.

The NASDAQ Composite and the S&P 500 are both valueweighted. The value of a given stock will affect the index in proportion to its value.

VALUE STOCKS. Companies whose stock is considered undervalued (trading at a price lower than expected) fall under this heading. The stock may be undervalued because of inner company strife (management change, etc.), business operations restructuring, or perhaps that particular industry is currently unpopular. Generally, value stocks have a lower price-per-earnings ratio than growth stocks do, and thus, their price per share is lower.

Many times a value stock may be reclassified as a growth stock. Although growth stocks have dramatically outperformed value stocks in certain years, over time, the returns of value stocks have surpassed those of growth stocks.

GROWTH STOCKS. These are companies that are expected to have dramatic growth rates in business and/or earnings. Generally, stock of companies that are emerging or very young would be considered growth stocks. These companies tend to reinvest their earnings, rather than distributing them to stockholders, to help them increase their business. Therefore, the only income stockholders would see from growth stocks would come in the form of stock appreciation at the time of sale. Growth stocks are also a riskier investment than blue chip or value stocks. Their share prices usually increases much faster than those of blue chips or value stocks, making their potential for appreciation very great. However, the share prices are just as likely to decrease very quickly. Growth stocks also tend to do poorly in down market times.

Depending on your risk tolerance, objectives, and time frame, growth stocks may not be appropriate for your portfolio. If you are willing to assume the risk associated with growth stocks and are investing for long-term potential growth and appreciation, then growth stocks may be a good fit for you.

INCOME STOCKS. Companies that consistently distribute high dividends fall under this heading. Income stock companies are those that are in mature, stable industries. While their dividends are generally a high percentage of corporate earnings, the tendency for their share prices is to hold fairly steady. This is due to the fact they distribute, rather than reinvest, their earnings.

Income stocks are best held by people who look for their investments to provide cash flow. Those investors seeking growth and share price appreciation are typically disappointed with the performance of income stocks. However, if you were to participate in dividend reinvestment programs (DRPs), over time there would be a large capital appreciation of your shares. DRPs are discussed later. GROWTH AND INCOME STOCKS. This group is really just a combination of the two previous groups. These are stocks that not only pay a reasonable dividend, but also offer the potential for appreciation over time.

CYCLICAL STOCKS. Cyclical stocks generally follow the business cycle. The housing sector is an example of a cyclical sector because as the economy does well, more people are likely to purchase or build houses. Likewise, when the economy is in a recession or depression, people generally don’t build or purchase new homes. Investing in cyclical stocks is not without risk. Investors who want to make money from cyclical stocks aim to purchase the shares before a market upswing and sell them prior to a market downturn.

DEFENSIVE STOCKS. In essence, defensive stocks are the opposite of cyclical stocks. They tend to perform better when the market is down and, comparatively, worse when the market is doing well. Defensive stocks are used to help balance the risk in a portfolio because of this. These are companies that produce goods that are still in demand when the economy is not doing well. Food and beverage companies are good examples of defensive stocks.

SMALL TO MIDSIZED COMPANY STOCKS. Small-cap or mid-cap stocks are those from companies that have a smaller market share than their large-cap counterparts. These companies have shown, in the past, to have a better overall performance than the larger companies, but they have also proven to be more volatile.

SPECULATIVE STOCKS. Stocks that present a greater risk to the investor than common stocks in general are speculative. Typically, hot new issues and penny stocks are speculative. While some stocks may be easily qualified as speculative, others may not be so easy. Over the past few years, we’ve seen many small companies, particularly dot.coms, release new issues of their companies or take them public for the first time. These offerings found a highly competitive marketplace, thus driving their share prices skyward.

Unfortunately for investors, the market for these stocks usually drops just as fast as it rises, sometimes even resulting in the companies going bankrupt.

FOREIGN STOCKS. Although the easiest way for investors to hold foreign stock is through different types of mutual funds, Americans can buy stocks in individual foreign companies through American Depositary Receipts (ADR). These receipts are listed on U.S. stock exchanges and are an alternative to direct investing. Asset allocation usually recommends that a portion of an investor’s portfolio be held in foreign stocks.

Stocks may sound like the perfect investment choice for you, but remember, not everything is as great as it seems. Until the year 2000, the United States was experiencing unprecedented economic growth. While the stock market, on the whole, soared to new record heights, there were some low points. Throughout the first six months of 1987, the market gained almost 30 percent. However, on October 19, 1987, the stock market suffered its worst crash to date. The Dow Jones Industrial Average dropped 508 points. That day a few new records were set: largest point drop, largest one-day volume of shares traded, and the largest percentage drop. The Dow dropped 23 percent, which was nearly double the previous record. Ten years later, on October 27, 1997, the market dropped precipitously again. This time, it fell 554 points, a new record. However, the percentage drop wasn’t as bad due to the value of the Dow at the time. It fell a mere 12 percent. However, within two weeks, the market had regained all its losses of October 27. It took the market nearly two and a half years to recover from the October 19, 1987 crash.

This isn’t designed to scare you when it comes to investing in common stocks. It’s just a reminder of what can happen in the market. In the past decade, this country has seen such unbridled enthusiasm for investing in individual stocks, with ever-increasing returns, it’s easy to forget what has happened in the past. When it comes to common stocks, there is no such things as either a safe investment, or a guaranteed thing. This is why I generally don’t like my clients to hold more than five percent in an individual stock.

Market capitalization—The price per share of a company multiplied by the number of outstanding shares.

Large-capitalization stocks—The stock of a company with market capitalization of more than $5 billion.

Mid-capitalization stocks—The stock of a company with market capitalization between $1 billion and $5 billion.

Small-capitalization stocks—The stock of a company with market capitalization of less than $1 billion.

Preferred Stock

Just like common stock owners, preferred stock owners own a part of the company. However, there are more rights that come with preferred stock that aren’t associated with common stock. First, preferred stock holders hold the right to be paid their dividends before they are distributed to common shareholders. Second, should the company have to liquidate, preferred shareholders hold the right to receive the par value of their stock before there is any distribution to common shareholders.

Dividends on preferred stock are fixed, much like the interest rates on bonds are. The price of preferred stock also differs from that of common stock, and is affected by interest rate changes. They almost always have a higher dividend yield than common stock does, but preferred stock doesn’t have the growth and price appreciation potential that common stock does because preferred stock doesn’t participate in the corporate earnings growth of the company.

Other features of preferred stock include more voting rights than common shareholders (either more total votes or the ability to elect more directors), the right to receive more than the stated dividend amount in certain conditions, the right to exchange preferred shares for a fixed number of common shares, and the right to cumulation of dividends. Cumulation of dividends may happen if any preferred dividends have been missed. If this has happened, all prior and current preferred dividends must be paid out before common shareholders receive their dividends.