Evaluating Popular
Investments
Lesson 2
Corporate Categorization
Investing in Stocks vs Bonds
Aim:
 What can we learn from comparing and
contrasting different companies?
Do Now:
 Explain why a company that sells
cereal is different from one that sells
luxury watches.
Investing in Stocks vs Bonds
 Do Now answer:
 Consumers need to eat and cereal is
an affordable meal. No one needs a
luxury watch.
Categorization by Size
1.
Market Capitalization - Total market value of
all of a company’s outstanding shares
Market Cap = Shares Outstanding x Share Price
 Large-cap: Companies that have a market
capitalization value of more than $10 billion
WMT
MSFT
GE
 Mid-cap: Companies that have a market
capitalization between $2 and $10 billion
 Small-cap: Companies that have a market
capitalization between $300 million and $2 billion
Categorization by Size
1.
Market Capitalization example:
Market Cap = Shares Outstanding x Share Price
 Example:
 Company ABC has a share price of $15 per share
and has 20,000 shares outstanding. The market
capitalization is 20,000 x $15 = $300,000,000.
 Therefore, Company ABC is considered a small
cap company.
 Generally, the larger and more established a
company is, the safer it is.
The Business Cycle
2.
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The Business Cycle - The business cycle describes
different stages of growth and decline in an economy
Peak: Economic activity is growing rapidly and
production facilities are operating at full capacity
Contraction: Economy begins to slow down,
unemployment rises, consumer spending declines, and
sales decline
Trough: Economy is at the lowest point on the
business cycle
Recovery: Employment levels and sales start to
increase again
Expansion: A period when business activity surges
and the GDP expands until it reaches a peak (also
known as an economic recovery)
The Business Cycle
2.
Company’s Sensitivity to the Business Cycle
 Describes different stages of growth and decline
in an economy
Recession
Recovery
Expansion
GDP Growth
5%
Peak
Previous Peak Broken
0%
-5%
Trough
Business Cycle
What determines a Company’s
Sensitivity to the Business Cycle?
1. The types of products and services the
company offers
2. How it has set up its:
 Operations (known as operating leverage)
 Finances (known as financial leverage)
Business Cycle
1.
Defensive vs. Cyclical Stocks
 Defensive Stock: not greatly affected by the
business cycle. This is because defensive
stocks are in industries such as food, utilities,
and other consumer goods that are considered
“necessities”. Defensive stocks do not increase
in price significantly when the market surges or
suffer big declines when it falters.
 Example: ConAgra Foods
Business Cycle
1.
Defensive vs. Cyclical Stocks (cont)
 Cyclical Stocks: largely affected by the business cycle.
Cyclical stocks will decrease when the market is weak
and increase when the market is favorable.
 Examples: Auto Makers (Ford), Airlines (Jet Blue)
What are some reasons airlines and automakers are cyclical companies?
Business Cycle
2. Operating Leverage
 Measures the amount of operating risk
associated with a company’s level of fixed costs
compared to its variable costs.
 The greater the percentage of fixed costs to total
expenses, the higher a company’s degree of
operating leverage.
 Higher operating leverage means there are
more costs that not easy to cut in bad times.
Therefore, the higher the operating leverage, the
higher the sensitivity to the business cycle.
Business Cycle
2.
Operating Leverage (continued)
Fixed Costs: Costs that do not change with the level
of production. Examples of fixed operating costs
include salaries, insurance expenses, and rent
because regardless of how much you produce, these
costs will not change.
Variable Costs: Costs that change with the level of
production. Examples include the costs of goods sold
or sales commission. Generally the larger the
production, the less each individual product costs to
make because of “economies of scale”.
Business Cycle
2. Operating Leverage (continued)
We should recognize that while:
• some expenses are almost always going to be
fixed (eg: rent, insurance), and
• others almost always variable (eg: heat and
electricity, which vary by month),
• with regard to operations, it can have a choice.
Business can take on fixed costs in order to lower
variable costs.
Business Cycle
2.
Operating Leverage (continued)
Scenario: You walk into Factory A and see rows of
people sitting at tables assembling a SuperToys. It
sells them to Toys R’ Us for $10 each. The cost to
make them is $7.
You go into Factory B that makes the same
SuperToy. It’s a less crowded space with robots
here and there turning every which way. This highly
automated factory can make a SuperToy for just $5
each.
Business Cycle
2.
Operating Leverage (continued)
Fixed Costs vs. Variable Costs:
• Factory A has chosen to employ more people. The
lack of automation raises the cost to make each unit.
• Factory B has chosen to invest heavily in robotics so
that there is a low cost to make each unit. But the
robots cost $50,000 per month to lease on a 5 year
contract!
• Factory B has traded variable costs (ie: workers) for
fixed costs (ie: robots that it has leased for a
substantial monthly expense).
Business Cycle
2. Operating Leverage (continued)
• If business booms, Factory A will certainly make
money, but Factory B’s profits will soar. Its robots
ensure the cost of making each unit is as low as
possible, resulting big profit per unit and overall.
• If business falters, Factory A can lay off the
employees it has, lowering this variable cost. But
Factory B, which has committed to a long-term
lease on the robots, will be in big trouble. It will be
stuck with high fixed costs!
Business Cycle
2. Operating Leverage (continued)
• If business booms, Factory A will certainly make
money, but Factory B’s profits will soar. Its robots
ensure the cost of making each unit is as low as
possible, resulting big profit per unit.
• If business falters, Factory A can lay off the
employees it has, lowering this variable cost. But
Factory B, which has committed to a long-term
lease on the robots, will be in big trouble. It will be
stuck with high fixed costs!
Business Cycle
2. Operating Leverage (continued)
• We see that with regard to their operations,
companies are able to automate more (thereby
raising their fixed costs) in order to cut variable
costs.
• The more highly automated, the higher the fixed
costs, the higher the operating leverage!
• Companies with high operating leverage are more
sensitive to the business cycle. They soar in good
times and can suffer mightily in bad times.
Business Cycle
3.
Financial Leverage
 It is a way for a company to gain large returns
without requiring a lot of shareholder investment.
You may have figured out that companies do this by
borrowing any additional money they need.
 As we’ve mentioned earlier, there are two ways to
raise money, sell stock (ie: equity) or sell bonds (ie:
debt). Leverage compares them. It is calculated:
 Leverage = Debt/Equity
 Firms with a high degree of financial leverage are
more sensitive to the business cycle
Lesson Summary 1 of 2
1. What do we call the measure of a company’s
size?
2. Generally speaking, are smaller or larger
companies safer to invest in, and why?
3. What to we call the recurring periods of
expansion and contraction that economies
experience?
4. What is the very bottom of this cycle called?
5. Identify one defensive stock and one cyclical
stock, explaining why.
Lesson Summary 2 of 2
6. What do we call the comparison of a
company’s fixed costs to its variable costs?
7. What do we call the amount of a company’s
borrowing compared to the money it has
raised from shareholders?
8. With regard to both of these types of
leverage, what is the rule regarding
sensitivity to the business cycle?
9. What can we learn from comparing and
contrasting different companies?
Web Challenge #1
Q: The latest categorization of what constitutes a
“large cap” company is one with a market cap in
excess of $10 billion. Are there companies whose
market caps are much bigger than this?
•
A: Yes, there are several with market
caps in the hundreds of billions!
•
Challenge: Find and list five companies with
a market cap over $100 billion. What name
would you suggest giving to this group of
behemoths? “__________ cap”
Web Challenge #2
We saw earlier that food may be the ultimate
defensive industry because we all need to eat!
However, there’s another industry that consists
of products we consume all the time by using,
not eating them! Think of toothpaste and soap.
This the “consumer staples” industry.
Challenge: Research three consumer staples
companies and for each identify three to five of
their brands that are household names.
Web Challenge #3
The Great Recession was the most devastating
economic event since the Great Depression.
Important lessons can be learned from it.
 Challenge: Research the Great Recession.
Document the month and year of its peak,
contraction, trough, recovery and
expansion.