[SOLVED] Ji Wu of Troy, New York, has $

Ji Wu of Troy, New York, has $5,000 that he wants to invest in the stock market. Ji is in college on a scholarship and does not plan to use the $5,000 or any dividend income for another five years, when he plans to buy a home. He is currently considering a small company stock selling for $25 per share with an EPS of $1.25. Last year, the company earned $900,000, of which $250,000 was paid out in dividends. Required: (a) Review Table 14-1 and explain which classification of common stock would you recommend to Ji? Why? Table 14-1:

(b) Calculate the P/E ratio and the dividend payout ratio for this stock. Given this information and your recommendation, would this stock be an appropriate purchase for Ji? Why or why not? (c) Identify the components of the total return Ji might expect, and estimate how much he might expect annually from each component. (d) Review the section titled â€œEvaluate Stocks Using Corporate Earningsâ€ on pages 430â€“432 and select two that you think Ji would utilize to evaluate when investing in stocks. Explain why. Evaluate Stocks Using Corporate Earnings:

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Table 14-1 Characteristics of Stocks Type of Stock Characteristics Income Stock Company that pays a cash dividend higher than that offered by most companies. Stocks issued by telephone, electric, and gas utility companies; beta often less than 1.0. Growth Stock Corporations that are leaders in their fields, that dominate their markets, and that have several consecutive years of above- industry-average earnings; pays some dividends. Investor awareness of such corporations is widespread, and expectations for continued growth are high. The P/E ratio is high; betas of 1.5 or more. Blue-Chip Stock A company that has been around for a long time, has a well- regarded reputation, dominates its industry (often with annual revenues of $1 billion or more), and is known for being a solid, relatively safe investment; betas are usually around 1.0. Countercyclical A company whose profits are greatly influenced by changes in the economic business cycle in consumer-dependent industries, like automobiles, housing, airlines, retailing, and heavy machinery; betas of about 1.0. A stock with a beta that is less than 1.0 is called a countercyclical (or defensive) because it exhibits price changes contrary to movements in the business cycle, thus prices remain steady during economic downturns. Examples are cigarette manufacturers, movies, soft drinks, cat and dog food, electric utilities, and groceries. Stock Value Stock A company that grows with the economy and tends to trade at a low price relative to its company fundamentals (dividends, earnings, sales, and so on) and thus is considered under-priced by a value investor; beta 1.0 to 2.0. Large-Cap, Small-Cap, and Mid-Cap stocks A company's size classification in the stock market is based on market capitalization. Large caps are those firms valued at or more than $10 billion. Mid-caps are $2 billion to $10 billion. Small caps is $300 million to $2 billion. Tech Stock A company in the technology sector that offer technology-based products and services, biotechnology, Internet services, network services, wireless communications, and more. Speculative Stock A company that has a potential for substantial earnings at some time in the future but those earnings may never be realized; betas above 2.0. Examples: computer graphics firms, Internet applications firms, small oil exploration businesses, genetic engineering firms, and some pharmaceutical manufacturers. 14.2d Evaluate Stocks Using Corporate Earnings Those who use fundamental analysis use several numerical measures to evaluate stock performance. These numbers are readily available to investors on the Internet that will help you assess future stock prices. Corporate Earnings Corporate earnings are the profits a company makes during a specific time period. Corporate earnings are at the core of fundamental analysis. The investor must study past market data, primarily price and sales volume to learn about an investment's corporate earnings. If a company cannot generate earnings now or in the future, stock market analysts and investors are not going to be impressed. As people reach this conclusion, there quickly will be more sellers than buyers of the company's common stock, and that will depress the stock's market price. Earnings Per Share A company's earnings per share (EPS) is annual profit di- vided by the number of outstanding shares. It indicates the income that a company has available, on a per-share basis, to pay dividends and reinvest as retained earnings. The EPS is a measure of the firm's profitability on a common-stock-per-share basis, and it is helpful because investors can use it to compare financial conditions of many companies. The EPS is reported in the business section of many newspapers as well as online. In our example, assume that next year, after payment of $9,000 in dividends to pre- ferred stockholders, Running Paws had a net profit of $32,000. With 20,000 shares of stock, the company's EPS would be $1.60 ($32,000 + 20,000). Price/Earnings Ratio The price/earnings ratio (P/E ratio) (or multiple) is the current market price of a stock divided by earnings per share (EPS) over the past four quarters. This ratio is the primary means of valuing a stock. It demonstrates how expensive the stock is versus the company's recently reported earnings, by revealing how much you are paying for each $1 of earnings. For example, if the market price of a share of Running Paws stock is currently $25 and the company's EPS is $1.60, the P/E ratio will be 16 ($25 + $1.60 = 15.6, which rounds to 16). This value can also be called a 16-to-1 ratio or multiple, or a P/E ratio of 16. The P/E ratios of many corpo- rations are widely reported on the Internet and in the financial section of newspapers. To assess a company's financial status, you could compare that firm's P/E ratio with the P/E ratios for other similar stocks. The P/E ratios for corporations typically range from 5 to 25. The historical average P/E ratio for stocks is 15, although it varies for different industries. Financially successful companies with a P/E ratio ranging from 7 to 10 tend 1.44% 100 705 200 190.1 51.05 +2.79 +1.49% 30.83 12.229 +22 +.71% 199 31.7 13.00 26.87 12.49 26.83 -261 -2.09% 26.27 300 +56 30.58 29.80 +2.13% 300 +.78 +2.62% 91.63 91.14 5000 30.77 36.76 +49 +.54% 35.57 800 92.18 +1.19 38.26 38.72 +3.35% 542 37.00 88.71 -46 -1.19% 88.24 100 39.31 +47 +53% UNCH 100 89.60 35.84 36.53 0% - 69 -1.89% UNCH 350 36.76. 190.14 34.91 0% 157.15 +32.99 33 20 Being invested in the stock market is an excellent way to create wealth. Mkeflppoutertock.com to have higher dividend yields, ks risk, lower prices, and slower camings growth. Rapidly carnings yield growing companies would likely have a much higher P/E ratio-13 to 20. Speculative The earnings per share of a stock companies might have P/E ratios of 25 or 50 or even higher because they have kow carn- divided by its price; an inversian ings now but anticipate much higher carnings in the future. Inverting a P/E ratio of 12, for example, reveals that stocks have an earnings yield investars mare ciearly see investment of 8.5 percent. In other words, each $100 of stocks is backed by S8.50 in expected expectations. carnings. During times of low interest rates, an 8.5 percent yield on stocks looks terrific. trailing P/E ratio of the pricelearnings ratio; helps Cakulated using recently reported Trailing and Projected Price/Earnings Ratios The standard P/E ratio is, in fact, called a trailing P/E ratio measure because it is calculated using recently reported eamings, usualy from the previous carnings, usually from the previous four quarters. Investors also need to focus on future prospects when analyzing the value of a stock. A projected P/E or forward price/ projected P/E ratio (forward carnings ratio divides price by projected carnings over the coming four quartens, an pricelearnings ratio) estimate available via online stock quote providers. The earnings yield, which is the Because investors need to look to the inverse of the P/E ratio (Running Paws' carnings yield is 6.4 percent [S1.60 + $25]), future rather than the past, this mea- helps investors think more cdearly about expectations for investments. four quarters. Sure divides price by projected eamings over the coming four quarters. Aso PEG Ratio Critics of price-carnings ratio argue that those firms with high levels of known as forward pricel eamings ratio. growth should not be penalized for having high P/E ratios. PEG ratio, or price- PEG ratio (price-carnings carnings growth, is a way to adjust for this. Divide the P/E ratio by the company's growth) projected growth rate. Going back to Running Paws, divide the firm's P/E ratio of 16 A way to rationalize buying a stock by its projected growth rate of 15 percent (16/15 - 1.07). Investors think a PEG ratio that has high growth is to cakulate by of 1 is fairly priced while a value of 2 or more is too high. Price/Sales Ratio The price/sales ratio (P/S ratio) indicates the number of dollars s projected growth rate. it takes to buy a dollar's worth of a company's annual revenues. The P/S is obtained by price/sales ratio (P/S ratio) dividing a company's total market capitalization by its sales for the past four quarters. Tells the number of dollars it takes to For example, if Running Paws Cat Food Company's common stock currently sells for buy a dollar's worth of a company's S25 per share and 20,000 shares of the company's stock are outstanding, its total capi annual revenues cakulated by dividing talization is $500,000. If company revenues (sales of dog and cat food) were $750,000 company's total market capitalization over the past year, the stock's P/S would be 0.67 (S500,000 + $750,000). Stock an- by its sales for the past four quarters. alysts suggest investors avoid companies with a P/S greater than 1.5 and favor those having a P/S of less than 0.75. Many investors ignore the P/S, but it works better than the highly acclaimed P/E ratio in predicting which companies provide the best return, as explained in James P. O'Shaughnessy's Wiet Works on Wall Street. dividing the PE ratio by the compa- Cash Dividends Stocks usually pay dividends. Cash dividends are distributions made in cash to holders of stock. They are the current income that you receive while you own shares in the company. The firm's board of directors usually declares a dividend on a quarterly basis (four times per corporate year), typically at the end of March, June, September, and December. Dividends are ordinarily paid out of current earnings, but in the event of unprofitable times (low carnings or none), the money might come from cash reserves held by the company. Occasionally, a company will borrow to pay the dividend so as to maintain its reputation of consistently paying dividends. Later profits can be used to repay any funds borrowed for this purpose. COMMON SENSE Get Dividends If You Want Investment Income Cash dividends have accounted for more than 40 percent of the S&P's total return for 100 years. If you want regular investment income, put some money into dividend-paying stocks and stock mutual funds. You might earn 2 percent in cash dividends plus price appreciation that results in earning 4 or 5 percent- age points more than from Treasuries. You may reinvest the income distributions so your returns compound over time. Betas are usually 1.0 or less. Dividends per Share The dividends per share measure translates the total cash dividends paid out by a company to common stockholders into a per-share figure. For example, Running Paws might elect to declare a total cash dividend of $8,000 for the year to common stockholders. In that case, cash dividends per share would amount to $0.40 (S8,000 - 20,000 shares). Dividend Payout Ratio The dividend payout ratio is the dividends per share divided by EPS. It helps you judge the likelihood of future divi- dends. For example, imagine that Running Paws Cat Food Company earmed $32,000 (after paying preferred stockholders), paid out a cash dividend of S8,000 to company stockholders, and retained the remaining $24,000 to facilitate growth of the company. In this case, the dividend payout ratio equals 0.25 (S8,000 - $32,000). For that year, Running Paws paid a divi- dend equal to 25 percent of carnings. Newer companies usually retain most, if not all, of their profits to facili- tate growth. An investor interested in growth woukd, therefore, seek a com- pany with a low payout ratio. The lower the payout ratio the greater the likelihood that the company will grow, which results in later capital gains for investors. Examples of companies that historically have a high payout ratio are AT&T (T), Chevron (CVX), Exelon (EXC), Home Depot (HD), Intel (INTC), Merck (MRK), Pfizer (PFE), and Verizon (Vvz). DID YOU KNOW About Employee Stock Options Many employers give stock options to attract and retain senior employees. dividend yield The dividend yield is the cash dividend paid to an in- An employee stock option (ESO) is a gift, like a bonus, from an employer to an employee that allows them to benefit from the appreciation of their employer's stock price with or without putting any money down. The company gives them the right and opportunity to exercise the option by buying the stock sometime in the future at an "exercise" or "striking price established when the option was given. If the company prospers, by the time the employee eventually decides to exercise the options, the current share price may be much higher than the exer- cise price, thus allowing the employee to buy the shares at a considerable discount. vestor expressed as a percentage of the current market price of a security. For example, the $0.40 cash dividend of Running Paws divided by the cur- rent $25 market price for its stock reveals a dividend yicld of 1.6 percent (50.40/525). Growth and speculative companies typically pay little or no cash dividends, so they have limited dividend yields. Such companies may be attractive to investors who are interested in capital gains. Book Value Book Value (also known as sharcholder's equity) is the net worth of a company, which is determined by subtracting the compa- ny's total liabilitics from its assets. It theoretically indicates a company's worth if its assets were sold, its debts were paid off, and the net proceeds were distributed to the investors who own the outstanding shares of com- mon stock. Book Value per Share The book value per share reflects the book value of a company divided by the number of shares of common stock out- standing. Running Paws has a net worth of $230,000, which, when divided by 20,000 shares, gives a book value per share of $11.50. Often little relationship exists between the book value of a company and its carnings or the market price of its stock. A stock's price usually exceeds its book value per share. The reason is that stockholders bid up the stock price because they anticipate carnings and dividends in the future and expect the market price to rise even more. When the book value per share exceeds the price per share, the stock may truly DO IT IN CLASS be underpriced. book value (sharecholder's equity) Net worth of a company determined by subtracting total liabilities from Price-to-Book Ratio The price-to-book ratio (P/B ratio), also called the market- to-book ratio, identifies firms that are asset rich, such as many banks, brokerage firms, and insurance companies. The P/B ratio is the current stock price divided by the per- share net value of the company's plant, equipment, and other assets (book value). It tells sets. you the premium that you are paying for the net assets of the company. In the Running Paws example, the book value per share of $11.50 would be divided into the recent price at which the stock was sold (S25 in this case); thus, the P/B ratio for Running Paws is 2.17. The current P/B ratio for most stocks lies between 2.1 and book value per share Reflects the book value of a company divided by the number of shares of common stock outstanding price-to-book ratio (P/B ratio) Current stock price divided by the pershare net value of a firm's plant, equipment and other assets (book 1.0. The lower the ratio, the less highly a company's assets have been valued, indicating that the stock may be currently under-priced. If the ratio is less than 1, the assets may be utilized ineffectively. In such cases, an under-performing and undervalued company may become a target of a corporate takcover; where the company may be broken up and sold.

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Question: Ji Wu of Troy, New York, has $

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