CHAPTER 12: INVESTING IN STOCKS AND BONDS

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CHAPTER 12 INVESTING IN STOCKS AND BONDS
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The Risk-Return Trade-OffA Fundamental
Investing Concept

• If you want
• GREATER RETURN,
• you will most likely have to accept
• GREATER RISK!

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The Risk-Return Relationship
Commodities and Financial Futures
Precious Metals
Options
R e t u r n
Real Estate
Common Stock
Bonds
3-yr Treasury Notes
U.S. Treasury Bills
Risk
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• Example
• Buy an 8, 1,000 Treasury bond that matures in
  20 years.

• Scenario 1 Spend the income
• Every year you receive 1000 X 8 80 in
  interest.
• After 20 years, you have received 1,600 in total
  interest.

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After 20 years you receive
2,600 total
3,000
2,000
Interest 1,600
Original 1,000 investment capital
1,000
0 5 10 15 20
Years
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After 20 years you receive
4,661 total
5,000
4,000
Interest on interest 2,061
3,000
2,000
Interest 1,600
1,000
Original 1,000 investment capital
0 5 10 15 20
Years
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Features of Common Stock

• Each share represents equity or part ownership in
  the company.
• Stock ownership allows the investor to
  participate in the profits of the firm.
• Stock ownership is a residual other obligations
  of company must be paid first.

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• Cash dividends are most common and most desirable.

• Stock dividends are paid in new shares given to
  current shareholders. Does not represent an
  increase of ownership because all stockholders
  receive same percentage.

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Key Measures of Performance

• Book Value amount of stockholder funds used to
  finance the company.

• Subtract liabilities and preferred stock from
  total assets.
• Good if book value steadily increases.
• Good if market value exceeds book value.

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• Net Profit Margin one of the most widely used
  measures of performance.

• Relates net profit to sales.
• The higher the net profit, the more money the
  company earns.
• Stable or increasing net profit margins are good
  signs.

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• Return on Equity the ratio of net income to
  common equity.

• Reflects the companys management of its assets,
  operations, and debt.
• The better the ROE, the better the financial
  condition and competitive position of the company.

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• Earnings per Share amount of net income earned
  by one share of common stock.

• EPS
• (Net profit after taxes
• Dividends paid on preferred stock)
• Number of shares outstanding

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• Price/Earnings Ratio shows amount investors are
  willing to pay for 1 of earnings.

• High P/E ratio may indicate a stock is overpriced!

• P/E
• Market price of the stock
• Annual earnings per share

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• Beta indicator of a stocks price volatility
  relative to the market.

• The market is used as a benchmark of performance
  and is assigned a beta of 1.
• Stocks with betas lt 1 are relatively less
  volatile in price swings.
• Stocks with betas gt 1 are relatively more
  volatile in price swings.

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Types of Common Stock

• Blue-Chip issued by large, well established
  companies.
• Usually pay dividends, which lends price
  stability.
• Returns are considered more dependable and less
  risky.

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• Growth issued by companies expected to have
  above average rates of growth in operations and
  earnings.

• Usually pay low or no dividends.
• Typically experience more price volatility.
• Tech issued by companies in the technology
  sector.
• Most are either growth or speculative stocks.
• Some are blue-chip stocks.

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• Income issued by companies which have a fairly
  stable stream of earnings.

• Pay relatively high dividends.
• Attractive to people who seek current income.
• Speculative issued by companies which are
  considered to have higher risk.
• The company, its products, or the industry may be
  new or unproven.
• Stock prices may be highly volatile.

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• Cyclical issued by companies whose stock prices
  move in same direction as the business cycle.

• Most are found in basic industries.
• Always have a positive beta.
• Defensive issued by companies whose stock
  prices usually remain stable during economic
  downturns.
• Companies usually provide basic needs, such as
  consumer goods.
• Betas are usually low or even negative.

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• Mid-Cap issued by companies with market
  capitalization of 15 billion.

• Usually offer greater returns than larger
  companies.
• Stock prices tend to be less volatile than small
  caps.
• Small Cap issued by companies with market
  capitalization of 1 billion or less.
• Offer possibility of high returns.
• Prices can be very volatile due to high risk
  exposure.

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Fundamentals of Bonds

• A bond is loanthe bondholder is lending money to
  the bond issuer.
• Generally, interest is paid to the bondholder
  every 6 months.
• The coupon rate is the annual interest rate paid
  by the bond issuer.
• The maturity date is when the loan ends and the
  bond issuer repays the principal to the
  bondholder.

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• The par value is the amount of principal that
  must be repaid to the bondholder usually 1000
  on a corporate bond.

• Regardless of the market price paid for the bond,
  the bondholder will receive the par value at
  maturity.
• Bonds offer current income during the time the
  bonds are held.
• If sold before maturity, bonds can also generate
  capital gains (losses).

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Types of Bonds

• Treasury Securities
• Agency Bonds
• Municipal Bonds
• Corporate Bonds
• Zero Coupon Bonds

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Bond Ratings

• A letter grade is assigned to new bond issues to
  designate investment quality.
• The lower the rating, the greater the risk of
  default and the higher the coupon rate which must
  be offered.
• Outstanding bonds are also reviewed regularly to
  ensure that their ratings are still valid.

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Bond Yields

• The yield on a bond is the rate of return you
  would earn if you held the bond for a stated
  period of time.
• The two most commonly cited bond yields are
  current yield and yield to maturity.

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Preferred Stocks Convertible Bonds

• Hybrid securities
• with features of both
• stocks and bonds.

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Preferred Stock

• Behaves like a bond in that a fixed amount is
  paid per year.
• Classified as an equity security because
• No maturity date.
• Dividend payments are not a legally binding
  obligation and do not have to be paid unless
  dividends are declared.
• Called "preferred" because if dividends are
  declared, preferred shareholders are paid first.
  Common stockholders divvy up whats left.

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Convertible Bonds

• Debentures which may be converted into a given
  number of shares of common stock of the same
  company within a given time period.
• Bondholder will convert when stock price makes it
  more advantageous to hold stock.

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THE END