Chapter 14
Investing in
Stocks and Bonds
Learning Objectives
1. Explain how stocks and bonds are used as investments.
2. Classify common stocks according to their major
characteristics.
3. Describe fundamental and numerical ways to evaluate stock
values.
4. Use the internet to evaluate common stocks in which to
invest.
5. Summarize how stocks are bought and sold.
6. Describe how to invest in bonds.
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Introduction
When you invest in stocks and bonds, you can
increase returns significantly while increasing
risk only slightly.
Stocks and bonds provide opportunities for
conservative, moderate, and aggressive
investors alike.
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The Role of Stocks and Bonds in
Investments
• Corporation – Individual investors provide the money
corporations use to create sales and earn profits. The
investors share in those profits.
• Public Corporation – Issues stock which is ownership
purchased by the general public and traded on stock
markets such as the New York Stock Exchange.
• Privately Held Corporation – Owned by a relatively
small number of people and is not traded on a public
stock exchange.
• Startup Capital – Funds initially invested in a business
enterprise supplied by a bank or venture capital
investors.
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Common Stock
• Stocks are shares of ownership in a business
corporation’s assets and earnings.
• Cash Dividends – When income exceeds
expenses, a corporation may pay cash in the
form of a dividend payment to its shareholder
owners in the firm.
• Market Price – The current price of a share of
stock that a buyer is willing to pay a willing
seller.
• Shareholder (or Stockholder) – Each person
who owns a share of a company’s stock holds
a proportionate interest in a firm’s assets and
income.
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Common Stock
• Residual Claim – The right to share in the
income and assets of a corporation after higher
priority claims are satisfied
• Limited Liability – Risk of loss is limited to
investment
• Voting Rights – Authority to express an opinion
or choice in matters affecting the company
• Board of Directors – Sets policy and names the
offers of the company management
• Management – Responsible
for daily operations of the firm
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Preferred Stock
• Cumulative Preferred Stock – Future payment
of previously skipped dividend payments must
be paid before distribution is made to common
shareholders.
• Noncumulative Preferred Stock –
Shareholders do not have a claim on previously
skipped dividend payments before common
shareholders are paid a dividend.
• Convertible Preferred Stock – Option to
exchange preferred shares for common shares.
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The Major Characteristics
of Common Stocks
• Match your investment choices using P/E ratio and Beta.
• Price/Earnings (or P/E) Ratio:
– Trailing P/E Ratio – A measure of price/share to
earnings/share with earnings from previous 4
quarters
– Projected P/E (or Forward P/E) Ratio – A measure
of future growth estimated for 4 quarters also known
as the forward price/earnings ratio Ex: Current P/E
ratio for S&P 500 is 14.5x.
– Earnings Yield – Helps investors more clearly see
future investment expectations
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The Major Characteristics
of Common Stocks
• Use Beta to Compare a Stock to Similar
Investments
– Beta (or Beta Value or Beta Coefficient):
Measure of stock volatility. In essence, it
measures how much the stock price varies
relative to the rest of the market.
– 1.0b = stock movement that
has the same volatility as
market
the
– 2.0b = stock movement that
has twice the volatility as
the market.
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The Major Characteristics
of Common Stocks
• Income Stocks – A stock that may not grow too quickly but year
after year pays a cash dividend higher than offered by most
companies
• Growth Stocks – A stock that offers the promise of much higher
profits tomorrow in exchange for lower income or dividend
payments.
– Well-known growth stocks – Awareness of firm is widespread
and expectations for future growth are high. Coca-Cola, Intel,
Nike, Microsoft
– Lesser-known growth stocks – Awareness of firm is not well
known but has strong earnings in the industry. Longs Drug
Store, Urban Outfitters, Quality Systems
• Value Stocks – A stock that trades at a low price relative to its sales
or earnings and is considered undervalued due to bad news
reported such as earnings, legal issues and bad press, etc. General
Motors, AT&T, Citigroup, General Electric
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The Major Characteristics
of Common Stocks
• Speculative Stocks – A stock with the potential for substantial
earnings at some time in the future. New stock issues are good
examples
• Tech Stocks – Technology firms such as Microsoft, Cisco, Intel and
Yahoo
• Blue-Chip Stocks – Well established firms which often dominate
their industry and known for being a solid, relatively safe investment.
Exxon, Coca-Cola, Wal-Mart, etc.
• Capitalization: The total market value of the firms stock
–
Large-capitalization = $3-4 Billion in Market Value
–
Mid-capitalization = $750 Million to $3 Billion in Market Value
–
Small-capitalization = Less than $750 Million in Market Value
–
Microcapitalization Stocks – Less than $100 Million in Market Value
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How to Evaluate Stock Values
• Use fundamental analysis to evaluate stocks.
– Fundamental Analysis – A market analysis
that assumes each stock has an value based
on expected stream of future earnings
– Technical Analysis – An analysis which
uses statistics generated by market activity
such as past price and volume over time to
determine when to buy and sell stock.
• Corporate earnings are most important ! !
– Operating earnings (profit) drives the market and
share prices adjust above or below current level
depending upon expectations !
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Numerical Measures to Evaluate Stock Prices
– Earnings per share – A firm’s total profit divided by the
number of outstanding shares.
– Price/Sales ratio – The number of dollars it takes to buy a
dollar’s worth of a company’s annual revenues. Ex: $500,000
market capitalization/$750,000 sales = 0.67 P/S Ratio. A ratio
of 0.75 or less is suggested as a good investment.
– Cash Dividends – Distributions made in cash to holders of
common and preferred stock.
– Dividends Per Share – Total cash dividends paid by a
company to stockholders on a per-share basis.
– Dividend Payout Ratio – Dividends paid per share divided by
earnings per share. Ex: $1.00 dividend/$4.00 earnings per
share has a 25% payout ratio.
– Dividend Yield – Cash dividend paid to an investor
expressed as a percentage of the current market price of a
security. Ex: $1.00 Dividend/$25 stock price = 4% yield.
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Numerical Measures to Evaluate
Stock Prices
– Book Value – The net worth of a company as determined by
subtracting net liabilities from net assets. It determines a
company’s worth if its assets are sold and debts paid off with
the net proceeds distributed to owners of the firm’s stock
– 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 – Identifies firms that are asset rich such
as banks, brokerage firms and insurance companies. It is
determined by dividing the current stock price by the per-share
net value of a firm’s plant, equipment and other assets at book
value. It tells you the premium paid for the net assets of the
firm. The current P/B ratio is between 2.1 and 1.0.
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Calculating a Stock’s Potential Rate of Return
• Alpha statistic – The difference between expected
return and actual return given its risk. A positive alpha
means the company did better than expected while a
negative alpha indicates poor performance.
• Beta – Used to estimate the risk of the investment
relative to overall market risk.
• Market risk (or systematic risk)- Risk associated with
the effects of the overall economy on securities prices.
Ex: 8% return is historic market risk for U.S. stocks.
• Required rate of return – Determined by multiplying
Beta times the market risk such as 8% and adding the
treasury bill rate. Ex: A firm with a 1.5 beta and 8%
market risk with a 2% treasury bill rate would have a
required return on an investment of (8% x 1.5) + 2% =
14%.
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Calculate the Stock’s Potential
Rate of Return
• Add up projected income and price appreciation.
– Potential Rate of Return - Approximate
Compound Yield (or ACY)
Assume: $1.02/share annual average dividend (forecasted), Current
Stock Price = $30, Projected Stock Price (5 years) = $60.38 with
investment period of 5 years. The approximate compound yield is equal
to:
$60.38 - $30.00
=
=
$1.02 + __5 years_______
$60.38 + $30.00
2
15.7% potential rate of return
• Compare the 14% required rate of return with the
15.7% potential rate of return on the investment.
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Use the Internet to Evaluate and Select
Stocks
• Set criteria for your stock investments. Ex: investment
goals, philosophy, time horizon, etc.
• Find investment information at the following
websites:
– fool.com
– morningstar.com
– kiplinger.com/personalfinance/
– money.cnn.com/pf/indes.html
• Use Stock-Screening Tools:
– www.kiplinger.com/tools/stockscreener/index.html
– http://screen.morningstar.com/StockSelector.html
• Stock History
• Company Website
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How To Use the Internet to
Evaluate and Select Stocks
• Security analysts’ research reports
• The two most popular firms that offer stock
advisory research services:
– Morningstar
(http://www.morningstar.com)
– Value Line
(http://www.valueline.com)
– Omaha Public Library, Reference
Dept.,2nd floor, 13th Street & Douglas
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How To Use the Internet to
Evaluate and Select Stocks
• Track economic data such as:
–
–
–
–
–
–
Stage in the business cycle
Inflation rates
Interest rates
Expected changes in these indicators
http://www.conference-board.org/data/
Use other online sources such as Yahoo!,
Google, Wall Street Journal, Money Magazine,
USA Today
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Use the Internet to Evaluate and Select Stocks
• Securities market indexes:
–
–
–
–
–
–
New York Stock Exchange (Euronext) – The largest organized exchange by
volume (4.3 million trades per day valued at $39.1 Billion) of publicly traded
firms. http://nyse.com
Dow Jones Industrial Average – The most widely reported of all stock
market indexes that tracks prices of only 30 actively traded “blue chip” stocks
such as American Express, IBM, AT&T, Coca-Cola, & Walmart.
http://dowjones.com
Standard & Poor’s 500 Index – Reports price movements of 500 stocks of
large, established publicly traded firms. http://standardandpoors.com
NASDAQ Composite Index – over the counter market exchange which uses
an electronic and automated quotation system (1.2 million trades per day
valued at $8.1 Billion) http://nasdaq.com
Russell 2000 Index – A small capitalized stock market index of small
companies which measures the overall performance of small to mid-capitalized
company shares http://russell2000.com
Wilshire 5000 Index – Represents the total market value of virtually all
publicly traded stocks in only the U.S. (Currently $14.5 Billion)
http://web.wilshire.com/Indexes/Broad/Wilshire5000/
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Buying and Selling Stocks
• Stockbroker – Licensed to buy and sell securities on behalf
of the brokerage firm’s clients.
• Security’s street name – Securities kept in the brokerage
firm’s name instead of the name of the individual investor for
convenience purposes and to facilitate resale.
• Discount, online, and general (or full-service) brokers –
Discount brokers offer fewer services and charge less
commissions (30%-80%) than full service brokers. Discount
and online brokers include Fidelity, TD Ameritrade, Vanguard,
Scott Trade, E*Trade, etc.
• Broker commissions and fees based upon:
– Round Lots – Standard units of trade such as 100
shares of stock or $1,000 or $5,000 par value bonds.
– Odd Lot – An amount of a security less than normal such
as less than 100 shares of stock.
– Differential: The odd-lot portion of the transaction which
may be subject to 12.5 cents per share on the odd-lot.
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Buying and Selling Stocks
•
•
How to order stock transactions:
– The process of trading stocks involves a floor broker and a
specialist.
– Securities prices are either matched between buyer and seller or
negotiated between the bid (highest price a brokerage firm is
willing to pay for a security) and ask price (lowest price that another
brokerage firm is willing to sell the security.
Types of stock orders (executing an order):
– Market order – Instructs the stockbroker to execute an order at the
current selling price of the stock.
– Limit order – Instructs the stockbroker to buy or sell a stock at a
specific price. May include instructions to buy up to a specified
price limit or not sell below a specified price limit.
– Stop order (or stop-loss order) – Instructs a stockbroker to sell
shares of stock at the market price if a stock declines to or goes
below a specified price.
– Time limits: fill-or-kill order, day order, open order – Order to
buy or sell immediately or cancel (fill-or-kill) the order. A day order
is valid only for the trading day while an open order remains valid
until executed by the stockbroker or cancelled by the investor.
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Bonds
• Bonds - interest-bearing, negotiable certificates
of long-term debt.
• Principal – an interest bearing negotiable
certificate of long term debt issued by a
corporation or government organization.
• Maturity Date – Date upon which the principal
or amount loaned is returned to the bondholder.
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Investing In Bonds
• Investment-Grade Bonds – Offer investors a
reasonable certainty of regularly receiving
periodic income and a return of the original
investment
• Par (or Face) Value – A multiple of $1,000
printed on the bond when issued
• Speculative Grade (or Junk) Bonds – High risk
bonds issued by companies with poor or no
credit ratings.
• Default Rate – Percent of bonds that do not
repay principal at maturity and may cease
interest payments.
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Investing In Bonds
• Corporate, U.S. government, and municipal
bonds are examples of interest bearing
certificates of long-term debt issued.
– Bond rating – An impartial opinion of the
quality or creditworthiness of the issuing
organization in terms of risk of default.
– Default (or Credit) risk – Uncertainty
associated with not receiving the promised
periodic interest and principal repayment
when due.
• U.S. government bills, notes, and bonds – short
term securities with maturities of less than 1 year
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Investing In Bonds
• Treasury bills (t-bills), notes, and bonds
– Discount yield, I-bonds – the difference between bond value at
maturity and price paid. I bonds pay a fixed rate set when
purchased and a variable rate indexed to inflation.
(http://www.treasurydirect.gov)
– TIPS (or Treasury Inflation-Protected Securities) Treasury
inflation Protected Securities – Principal increases/decreases
with inflation and sold in increments of $1K ranging from 5-30
years in maturity.
– U.S. Government savings bonds – U.S. Treasury bonds that
pay interest and are non-marketable
– Series EE savings bonds – similar to zero coupon bonds
which pay no interest but are purchased at a deep discount.
– Municipal Bonds – Long-term debts issued by local
governments and their agencies. Proceeds are used for public
improvement projects such as parks, roads and bridges and the
interest earned from them is exempt from federal taxes as well
as state and local taxes if the investor lives in the same state
where the bond was issued.
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Investing In Bonds
• Unique characteristics of bond investing:
– Coupon rate (or coupon, coupon yield,
or stated interest rate) – Interest rate printed on
certificate when the bond is issued
– Serial or sinking fund – A bond that is retired
numerically in order of issue. Sinking fund is money
reserved each year to repay the principal portion at
maturity
– Secured bond or unsecured bond (debenture) –
The pledge of assets as collateral or has principal
and interest guaranteed by another corporation or
government agency. Unsecured bond is backed only
by the good faith and reputation of issuing agency.
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Evaluating Bond Prices and Returns
• Interest rate risk results in variable value.
– Market interest rates – Changes in rates affect the bond
value based upon future inflation expectations. Higher
inflation results in higher interest rates which lowers bond
values.
– Interest rate risk – The risk that interest rates will rise
and bond prices will fall, thereby lowering the prices on
older bond issues.
– Fixed yield versus variable value – Interest income
payment remains the same each period but the bond’s
value or market price changes when interest rates
change.
– Premiums and discounts – A sum of money paid in
addition to a regular price. Ex: A bond with a $1,000 face
value sells for $1,200 (premium) vs. $800 (discount).
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Evaluating Bond Prices and Returns
• Present value of a bond – the current amount of future interest
payments and the repayment of the face amount at maturity
discounted at the required rate of return. Ex: An 8% coupon
rate, 10 year bond with 5 years to maturity and a $1,000 face
value has a 6% required rate of return and a present value of:
$80 x 4.2124 (PVIFA, 6%, 5 yrs) = $ 336.99 – 8% Coupon
$1,000 x 0.7473 (PVIF, 6%, 5 yrs) = $ 747.30 – Bond Face Value
Total Bond (Present) Value $1,084.29
• The bond above is trading at a premium (above) its $1,000 Face
Value.
• Current yield – Equals the bond’s fixed annual interest payment
divided by its bond price. Ex: $80 annual interest/$1,084 current
price = 7.38% yield.
• Yield to maturity – The annual effective rate of return earned by
the bondholder if the bond is held to maturity. Ex: The bond
shown above has a 6% YTM assuming the security is held for
five years.
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Summary of Bond Ratings
Ratings are measures of default risk to principal and interest
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The Top 3 Financial Missteps
of Investing in Stocks and Bonds
People experience challenges with investing in
stocks and bonds when they do the following:
1. Seek to invest in just one stock that promises
to make them a lot of money.
2. Neglect to carefully research investment
choices.
3. Hold onto a lousy investment too long instead
of cutting losses by selling it.
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Good Money Habits in
Investing in Stocks and Bonds
• Include stocks and bond or mutual funds that
own stocks and bonds in your investment
portfolio.
• Use fundamental analysis to determine a
company’s basic value before investing in a
stock.
• Resist putting money into so-called hot stocks.
• Invest part of the conservative portion of your
portfolio in TIPS to beat inflation.
• Use zero-coupon bonds to help fund a child’s
education and your retirement.
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