#12
Investing in
Stocks and Bonds
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Learning Goals
Describe types of risk and sources of return
•
Research an acceptable investment in risk, return, and yield
Discuss merits of common stock, distinguish among types of
stocks
Become familiar with performance measures, use them in
placing value on stocks
Describe characteristics of bonds and how they are used
Distinguish between types of bonds, understand bond prices,
compute yield
The Risks Of Investing
Business
Financial
Market
Purchasing Power
Interest Rate
Liquidity
Event
Returns from Investing
Current income -- bond interest,
stock dividends, rent on real estate
Capital gains -- increase in market
value
Interest-on-interest -- returns must be
reinvested for compounding
Elements of Return 8%, 20 Year
Bond
The Risk-Return Trade-Off
If you want greater return you will most
likely have to accept greater risk
Amount of risk is directly
related to expected return
The Risk-Return Relationship
What Makes A Good Investment?
Future return
Approximate yield
Desired rate of return
Approximate Yield
Investing in Common Stock
Each share represents equity or part
ownership in the company
Investor participates in firm’s profits
Stock ownership is residual
Firm’s obligations paid first
Exhibit 12.3 DJIA and NASDAQ
April 2001 through April 2011
Voting Rights
Common stockholders
usually receive one vote
per share
Most small shareholders
assign their votes to a
proxy
Basic Tax Considerations
Cash dividends and long-term
capital gains are both taxed at
maximum 15%
5% if in 10 and 15% tax brackets
Gains are not taxed until realized
Dividends
Determined by firm’s
board of directors
Cash dividends usually
paid quarterly
Can be paid even if
company shows a loss
Dividends
Cash dividends - most common and most desirable
Stock dividends - new shares given to shareholders
Dividend Yield =
Annual dividend per share
Market price per share
Key Measures of Performance
Book Value - stockholder’s equity in a firm
Good when:
book value steadily increases
market value exceeds book value
Book Value =
Total assets – (liabilities + preferred stock)
Key Measures of Performance
Net Profit Margin - one of the most
widely used measures of corporate
performance
Relates net profit to sales
The more money the company
earns, the higher the net profit
Stable or increasing net profit
margins are a good sign
Key Measures of Performance
Return on Equity – shows firm’s overall
profitability from stockholders perspective
Ratio of net income to common
equity
Reflects company’s management of
assets, operations, and debt
Better ROE = better financial condition
and competitive position of firm
Key Measures of Performance
Earnings per Share (EPS) - amount of
net income earned by a share of
common stock
EPS =
Net profit after taxes – Preferred dividends paid
Number of shares outstanding
Key Measures of Performance
• Price/Earnings Ratio (PE ratio) –
indicator of investor confidence and
expectations
• Shows how aggressively the stock
is priced in the market
Key Measures of Performance
βeta – indicates stock’s price
volatility relative to the market
• The market, as a performance
benchmark, is assigned a βeta = 1
• If βeta < 1 then stock less volatile
• If βeta > 1 then more volatile
Types of Common Stock
Blue-Chip - large, well established
companies
Usually pay dividends which
lends price stability
Returns are considered more
dependable and less risky
Types of Common Stock
Growth
• above average growth
rates in operations and
earnings
• Usually low or no
dividends
• May experience more
price volatility
Tech
• companies in
technology sector
• Mostly growth or
speculative stocks
– Some are
blue-chip stocks
Types of Common Stock
Income
• fairly stable
earnings stream
• pay high dividends
• attractive to those
seeking current
income
Speculative
• high risk companies
• company, products, or
industry may be new
or unproven
• stock prices may be
highly volatile
Types of Common Stock
Cyclical
• stock prices move in
same direction as
business cycle
• often found in basic
industries
• have a positive βeta
Defensive
• stock prices are
stable in economic
downturns
• provide basic needs,
consumer goods
• βetas are low or
negative
Types of Common Stock
Large-Cap
Mid-Cap
• market caps
• market caps of
over $10
$2-10 billion
billion
• greater returns
than larger
firms and less
volatile than
small caps
Small-Caps
• market caps
of $2 billion or
less
• prices can be
volatile due to
high risk
exposure
Market Globalization and Foreign
Stock
Foreign stock - issued by
firms in other countries
Provide portfolio diversity
International mutual funds and American
Depositary Receipts (ADRs) are convenient
ways to invest in foreign securities
Currency exchange rates can impact returns
Investing in Common Stock
Advantages
• Potential returns
• Actively traded
and highly liquid
• Involve no direct
management
Disadvantages
• Risk
• Timing of sales
and purchases
• Uncertainty of
dividends
Making the Investment Decision
Putting a value on stock
Plow back earnings
Dividend Reinvestment
Plan (DRP)
Cash or Reinvested Dividends
Investing in Bonds
Fixed income security
Interest rates and bond prices
move in opposite directions
Versatile
Preservation and long-term
accumulation of capital
Lower risk and return than stock
Exhibit 12.6 Comparative Performance
of Stocks and Bonds: 1991-2011
Bond Issue Characteristics
Like a loan - bondholder lends money to issuer
Interest - usually paid every 6 months
Coupon - annual interest rate paid by issuer
Maturity date - when loan ends issuer repays
principal to bondholder
Bond Issue Characteristics
• Par value – principal amount repaid at maturity
– usually $1000 on a corporate bond
regardless of purchase price
• Selling before maturity
may generate capital
gains or losses
Discount bond = market price < par
Premium bond = market price > par
Bond Issue Characteristics
Collateral
• Senior or Secured Bonds - backed by a legal
claim on specific property
– Liquidated to pay bondholders if issuer defaults
– Mortgage bonds, Equipment trust certificates
• Junior or Unsecured Bonds - backed only by
issuer’s promise
– Debentures
Bond Issue Characteristics
Sinking Fund
• Annual
repayment
schedule
detailing used
to pay off the
issue
Call Feature
• Bond provisions
must state if bond
can be called prior to
maturity
– Freely callable
– Noncallable
– Deferred call
The Bond Market
Treasury Bonds
Agency and Mortgage-Backed Bonds
Municipal Bonds
Corporate Bonds
Convertible Bonds
The Bond Market
• Treasury Bonds – 20 or 30 year maturities
• Treasury Notes – 2, 3, 5, 10 year maturities
• TIPS – Treasury security with principal
payments adjusted for inflation
Note: Exempt from state
and local taxes
The Bond Market
• Agency Bonds
– Issued by subdivisions of the
government
• Not obligations of US Treasury
– Yields above Treasuries
• Mortgage-backed Securities include
Fannie Mae and Freddie Mac
The Bond Market
Municipal Bonds
Issued by state and local governments
Considered “tax-free bonds” since interest
usually free from federal income tax
The Bond Market
Municipal
bonds
Serial obligations
– different
maturities and coupon rates
Revenue bonds – serviced from
income generated by specific
project
General obligation bonds – backed
by full faith and credit of issuer
The Bond Market
Corporate Bond segments
Industrials
Public utilities
Rail and transportation
Financial issues
The Bond Market
Convertible Bond - Debenture that
may be converted into a certain number
of company’s common stock
Conversion privilege
Conversion ratio
Conversion value
Conversion premiums
Bond Ratings
• Letter grade designates quality
the lower
the rating
the greater the
risk of default
the higher the
coupon rate
which must be
offered
Moody’s and S&P’s Bond
Ratings
Bond Prices and Yields
Bond price is a function of its coupon,
length of maturity, and movement of
market interest rates
Inverse relationship between
price and interest rates
Premium bond > $1,000
Discount bond < $1,000
Bond Prices
Bond Yields
• Yield is rate of return earned if bond is
held the bond for stated time period
• Most common bond yields are
– current yield
– yield to maturity
Current Yield
• Amount of annual interest income
the bond provides relative to
current market price
Yield to Maturity (YTM)
• Annual rate of return if bond is held until
maturity
• Measures
– annual interest income
– recovery of principal
Yield to Maturity (YTM)
If bond is purchased at face value
YTM = coupon rate
If bond purchased at a discount
YTM > coupon rate
If bond purchased at a premium
YTM < coupon rate
