© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 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 where CI = average annual current income FP = expected future price of investment CP = current market price of investment N = investment period

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 bracket 5 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

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)

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

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

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

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 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

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

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

Bonds v. Stocks

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

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 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

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

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

Amount of annual interest income the bond provides relative to current market price Current Yield

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