Question

Pete and​ Jessica, on the advice of their​ next-door neighbor, recently purchased 600 shares of a​ small-capitalization Internet​ stock, trading at $ 78.91 per share. Their neighbor told them that the stock was a​ "real money​ maker" because it recently had a​ two-for-one stock split and would probably split again soon. Even​ better, according to the​ neighbor, the company was expected to earn $ 1.49 per share and pay a $ 0.27 dividend next year. Pete and Jessica have so far been less than impressed with the​ stock's performancelong dashthe stock has underperformed the​ S&P 500 Index this year. Pete and Jessica have come to you for some independent advice. Questions 1. Assuming that the stock actually splits two for​ one, how many shares will Pete and Jessica​ own? What will be the market value of their stock after the​ split? How will the split affect the value of their​ holdings? Was their neighbor correct in thinking that the stock split made the stock a​ "real money​ maker"? 2. Using the information​ provided, calculate the​ stock's P/E ratio. Would you classify this investment as a growth or value​ stock? 3. Since​ Pete, in​ particular, is worried about the price of the​ stock, explain to him how and why corporate earnings are so important in the valuation of common stocks. 4. Should Pete and Jessica be using the​ S&P 500 Index as a benchmark for this​ stock? Why or why​ not? What benchmark recommendation would you​ make? 5. Yesterday they received a cold call from a stockbroker wanting to sell them an initial public offering in a cable television company. Jessica was worried because the broker promised a​ "no-lose guarantee." Should they invest with this type of​ broker? 6. Name at least five things Pete and Jessica need to look out for when making stock investments.

1. Assuming that the stock actually splits two for​ one, how many shares will Pete and Jessica​ own?

After the​ two-for-one split, they will own

nothing

shares.  ​(Round to the nearest​ integer.)

What will be the market value of their stock after the​ split?

The shares will be valued at

​$nothing.

​(Round to the nearest​ dollar.)

How will the split affect the value of their​ holdings?  ​(Select the best choice​ below.)

A.

The market value will double after the stock split since this is a​ two-for-one split.

B.

The market value will remain the same before and after the stock split.

C.

The market value will be cut in half after the stock split since this is a​ two-for-one split.

D.

None of the above.

Was their​ next-door neighbor correct in thinking that the stock split made the stock a​ "real money​ maker"?  ​(Select from the​ drop-down menu.)

Their neighbor was

▼

correct

incorrect

in thinking that a stock split will automatically increase the value of the stock.

2. Using the information​ provided, calculate the​ stock's P/E ratio.

The​ stock's P/E ratio is

nothing.

​(Round to two decimal​ places.)

Would you classify this investment as a growth or value​ stock?  ​(Select from the​ drop-down menu.)

By all measures​ (both dividend payout and​ P/E Ratio) this is a

▼

value stock

growth stock

.

3. Since​ Pete, in​ particular, is worried about the price of the​ stock, explain to him how and why corporate earnings are so important in the valuation of common stocks.  ​(Select all the choices that​ apply.)

A.

The​ long-term value of any stock is most closely aligned with a​ firm's earnings. The faster a firm can compound​ earnings, the greater the​ long-term value of the​firm's stock.

B.

Corporate earnings are important because analysts use earnings as a proxy for a​ company's ability to pay dividends in the future.​ Thus, Pete should pay close attention to the earnings outlook for the stock.

C.

The​ short-term value of any stock is most closely aligned with a​ firm's earnings. The faster a firm can compound​ earnings, the greater the​ long-term value of the​ firm's stock.

D.

Corporate earnings are important because analysts use earnings as proxy for a​ company's ability to pay its bills in the future.​ Thus, Pete should pay close attention to the earnings outlook for the stock.

4. Should Pete and Jessica be using the​ S&P 500 Index as a benchmark for this​ stock? Why or why​ not? What benchmark recommendation would you​ make?  ​(Select all the choices that​ apply.)

A.

The​ S&P 500 index is an inappropriate benchmark for Pete and Jessica because the​ make-up of the index does not include any Internet company.

B.

Pete and Jessica should consider tracking the performance of their stock to an index comprised of other Internet companies​ (e.g., NASDAQ​ index)

C.

The​ S&P 500 index is an inappropriate benchmark for Pete and Jessica because the​ make-up of the index does not represent the type of company they own.

D.

Pete and Jessica should consider tracking the performance of their stock to an index comprised of other Internet companies​ (e.g., FTSE 100​ index)

5. Yesterday they received a cold call from a stockbroker wanting to sell them an initial public offering in a cable television company. Jessica was worried because the broker promised a​ "no-lose guarantee." Should they invest with this type of​ broker?  ​(Select the best choice​ below.)

A.

They should definitely not invest with this or any other broker who makes cold calls promising unlimited returns or guarantees against losses for an​ investment, unless they can put the​ "no-lose guarantee" in writing.

B.

They should definitely not invest with this or any other broker who makes cold calls promising unlimited returns or guarantees against losses for an​ investment, unless the investment opportunities involve initial public offerings.

C.

They should definitely not invest with this or any other broker who makes cold calls promising unlimited returns or guarantees against losses for an investment.

D.

They should definitely invest with this or any other broker who makes cold calls promising unlimited returns or guarantees against losses for an investment. These opportunities​ don't come around very often.

6. Name at least five things Pete and Jessica need to look out for when making stock investments.

Before making any stock​ investment, Pete and Jessica need​ to:  ​(Select all that​ apply.)

A.

be prepared for the risks involved with broker​ "churning" when they employ an investment strategy and asset allocation model that meets or exceeds their risk beta.

B.

be aware of​ misrepresentation, telephone sales​ pitches, or recommendations based on​ "inside information" or other tips.

C.

be aware of​ "hot tips" and​ "insider information" that will help them choose the best stocks.

D.

be aware of psychological impacts on investment decisions.

E.

understand the types and potential impacts of the various risks they would be exposed to.

F.

understand the concept of beta and how the beta of a stock tells how much and in what direction an individual stock price has moved relative to the market. High beta stocks have much more volatile price swings than low beta stocks.

G.

be aware of excessive transactions undertaken by broker​ "churning", if they use a broker.

H.

be prepared for losses and be wary of claims for easy profit or​ "hot tips", if they use an online account.

I.

employ an appropriate investment strategy and asset allocaion model that meets their risk tolerance

Answer 1

The answer to the questions are as follows:-

1) (i) As per the values provided to us, Pete & Jessica are buying 600 shares.

Ratio of stock split = 2:1

Therefore, the total number of shares that Pete & Jessica will own after the stock split =

Therefore, the total number of shares held by Pete & Jessica = 1200

(ii) The market value before stock split =

Therefore, the market value will be = $47,346.

The market value per share after the stock split =

The market value per share after the split = $39.455

Therefore, the market value after the split = = $47,346.

(iii) Therefore, from the above, we can see that the market value of the stock will remain same even after the stock split. Hence, option (B) is correct.

(iv) From the above calculations we can see that the contenntion of the neighbour is not correct. Hence option (B) is correct.

2) The information provided to us for calculaton of Price-to-Earning Ratio is as follows:-

Price per share (after stock split) = $39.455

Earnings per share = $1.49

  

3) By the calculations provided above, we can see that the P/E Ratio is 26 times (approx). Further, the company has an EPS of $1.49 out of which it declares a dividend of $0.27. This means that the company growth opportunities and hence, it is a growth stock and not a value stock. Therefore, Option (B) is correct.

4) The​ long-term value of any stock is most closely aligned with a​ firm's earnings. The faster a firm can compound​ earnings, the greater the​ long-term value of the​firm's stock. Hence, option (A) is correct.