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Investing in Stocks and Bonds
#12
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
whereCI = average annual current income FP = expected future price of investmentCP = current market price of investmentN = investment period
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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
The Dow and the NASDAQ, 1999-mid 2009
• Common stockholders usually receive one vote per share
• Most small shareholders assign their votes to a proxy
• assign stockholder’s voting rights to another
Voting Rights
• Cash dividends and long-term capital gains are both taxed at maximum 15%
• 5% if in 10 and 15% tax bracket5
• Gains are not taxed until realized
Basic Tax Considerations
• 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 current shareholders
Dividend Yield =Annual dividend per share
Market price per share
Dividends
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Key Measures of Performance
Book Value - amount of stockholder’s equity in a firm
• Good when– book value steadily increases– market value exceeds book value
Book Value = Total assets – (liabilities + preferred stock)
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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
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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
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EPS =
Net profit after taxes – Preferred dividends paid
Number of shares outstanding
Earnings per Share (EPS) - amount of net income earned by a share of common stock
Key Measures of Performance
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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
Key Measures of Performance
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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
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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
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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
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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
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Types of Common Stock
Mid-Cap
• market caps of $2-10 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
Large-Cap • market caps
over $10 billion
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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
Market Globalization and Foreign Stock
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
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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
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Bonds v. Stocks
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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
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• 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 < parPremium 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
Bond Issue Characteristics
The Bond Market
• Treasury Bonds
• Agency and Mortgage-Backed Bonds
• Municipal Bonds
• Corporate Bonds
• Convertible Bonds
The Bond Market
U.S. Treasury long term debt pays semi-annual interest, sold via auctions
• Notes: 2, 3, 5, 10 year maturities
• Bonds: 20, 30 year maturities
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
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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
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Bond Ratings
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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 > $1,000Discount bond < $1,000
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Bond Prices
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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
• Amount of annual interest income the bond provides relative to current market price
Current Yield
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Yield to Maturity (YTM)
• Annual rate of return if bond is held until maturity
• Measures– annual interest income – recovery of principal
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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