CHAPTER 12 INVESTING IN STOCKS AND BONDS 12

CHAPTER 12: INVESTING IN STOCKS AND BONDS

12 -2 RISKS of Investing! Business Financial Market Purchasing Power Interest Rate Liquidity Event

12 -3 Returns from Investing Current Return—income while you hold the security + Future Return or Capital Gain— gain on the sale of the investment = Total Return on the investment

12 -4 Interest-on-Interest: An Important Element of Return i. Investment returns must be reinvested in order for compounding to take place!!! i. Utilizes the time value of money concepts presented earlier.

12 -5 Example: Buy an 8%, $1, 000 Treasury bond that matures in 20 years. Scenario 1: Spend the income i. Every year you receive $1000 X 8% = $80 in interest. i. After 20 years, you have received $1, 600 in total interest.

12 -6 After 20 years you receive: $3, 000 $2, 600 total $2, 000 Interest= $1, 600 $1, 000 0 5 10 Years 15 20 Original $1, 000 investment capital

12 -7 Use your calculator to calculate your compounded annual return: Set on 1 P/YR and END mode: 1000+/2600 20 I/YR PV FV N 4. 9%

12 -8 Scenario 2: Reinvest the income Use your calculator to find what you would end up with if you indeed earned an 8% compounded annual return: 1000+/PV 8 I/YR 20

After 20 years you receive: $5, 000 12 -9 $4, 661 total Interest on interest = $2, 061 $4, 000 $3, 000 $2, 600 $2, 000 Interest= $1, 600 $1, 000 0 5 10 Years 15 20 Original $1, 000 investment capital

12 -10 The Risk-Return Trade-Off: A Fundamental Investing Concept If you want GREATER RETURN, you will most likely have to accept GREATER RISK!

The Risk-Return Relationship: Commodities and Financial Futures R e t u r n Real Estate Common Stock Bonds 3 -yr Treasury Notes U. S. Treasury Bills Risk Options 12 -11 Precious Metals

12 -12 What makes a good investment? i Know your desired level of risk. i Consider potential investments. i Compare their returns with those of like investment types. i Do the returns on the investments you are considering meet or exceed the returns expected for this type of investment?

12 -13 Investing in Common Stock i Each share represents equity or part ownership in the company. i Stock ownership allows the investor to participate in the profits of the firm. i Stock ownership is a residual; other obligations of company must be paid first.

12 -14 i. Voting Rights – Usually one share = one vote. – Most small shareholders assign their votes to a proxy, another party who will vote for them. – Voting rights are not particularly important to small shareholders.

12 -15 i. Basic Tax Considerations: – Short-term capital gains (sale of securities held less than one year) are taxed at regular income tax rates, which go up to over 30%. – Cash dividends and long-term capital gains (sale of securities held longer than one year) are taxed at a maximum rate of 15%. – Gains are not taxed until realized.

12 -16 i. Dividends – Usually paid quarterly. – Can be paid even when company shows a loss. – Paid either in cash or in additional shares of stock.

12 -17 – 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.

i. Assessing Dividends: 12 -18 – Dividend Yield measures dividends received relative to market price of stock. – Compare stocks based on dividend yield rather than dollars received if you are investing for current income. Dividend Yield = Annual dividends per share Market price per share

12 -19 Key Measures of Performance i. 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.

12 -20 i. 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.

12 -21 i. Return on Equity — the ratio of net income to common equity. – Reflects the company’s management of its assets, operations, and debt. – The better the ROE, the better the financial condition and competitive position of the company.

12 -22 i. Earnings per Share — amount of net income earned by one share of common stock. EPS = (Net profits after taxes – Preferred stock dividends paid) Number of shares outstanding

12 -23 i. 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

12 -24 i. Beta — indicator of a stock’s 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 < 1 are relatively less volatile in price swings. – Stocks with betas > 1 are relatively more volatile in price swings.

12 -25 Types of Common Stock i. Blue-Chip — issued by large, well established companies. – Usually pay dividends, which lends price stability. – Returns are considered more dependable and less risky.

12 -26 i 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.

12 -27 i Income — issued by companies which have a fairly stable stream of earnings. – Pay relatively high dividends. – Attractive to people who seek current income. i 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.

12 -28 i 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. i 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.

i Mid-Cap — issued by companies with market capitalization of $1– 5 billion. 12 -29 – Usually offer greater returns than larger companies. – Stock prices tend to be less volatile than small caps. i 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.

i Foreign — issued by companies from other countries in the world. 12 -30 – Offer investors greater portfolio diversity. – Major markets in Japan, United Kingdom, Germany, France, and Canada. – Other emerging markets around the world. – International mutual funds and American Depositary Receipts (ADRs) provide convenient ways to invest in foreign securities. – Currency exchange rates can impact returns on investments.

12 -31 Investing in Bonds i A bond is loan—the bondholder is lending money to the bond issuer. i Generally, interest is paid to the bondholder every 6 months. i The coupon rate is the annual interest rate paid by the bond issuer. i The maturity date is when the loan ends and the bond issuer repays the principal to the bondholder.

12 -32 i The par value is the amount of principal that must be repaid to the bondholder —usually $1000 on a corporate bond. i Regardless of the market price paid for the bond, the bondholder will receive the par value at maturity. i Bonds offer current income during the time the bonds are held. i If sold before maturity, bonds can also generate capital gains (losses).

Bond Issue Characteristics: 12 -33 i Collateral – Senior or Secured Bonds are backed by a legal claim on specific property which could be liquidated and used to pay the bondholders if the issuer defaults. – Junior or Unsecured Bonds are backed only by the promise of the issuer. Debentures are a form of unsecured debt.

12 -34 i Sinking Fund – Some bond provisions stipulate a repayment schedule detailing how the issuer is to set aside money to repay the principal. i Call Feature – Bond provisions must state if the bond can be called prior to maturity, and if so, under what conditions.

12 -35 Types of Bonds i. Treasury Securities i. Agency Bonds i. Municipal Bonds i. Corporate Bonds i. Zero Coupon Bonds i. Convertible Bonds

12 -36 Bond Ratings i A letter grade is assigned to new bond issues to designate investment quality. i The lower the rating, the greater the risk of default and the higher the coupon rate which must be offered. i Outstanding bonds are also reviewed regularly to ensure that their ratings are still valid.

Below Investment Grade Bond Ratings: 12 -37

12 -38 Reading a Bond Quote: XYZ Corp. 7½ 15 Close 101 i XYZ Corporation is the bond issuer. i 7½% is the coupon or annual interest rate paid on this bond. i The amount of annual interest is 7½% of the par value, or. 075 x $1000 = $75

12 -39 i The bondholder should receive half of the interest every 6 months, or $75 2 = $37. 50 i This bond matures in 2015, so the last payment to the bondholder should consist of the last interest payment plus the principal amount, or $37. 50 + $1000 = $1, 037. 50

12 -40 Reading a Bond Quote (con't): XYZ Corp. 7½ 15 Close 101 i Bond prices are not quoted in dollars but as a percent of par. i This bond's closing price (or last price) was 101% of par, or 1. 01 x $1000 = $1, 010

12 -41 Bond Prices i The price of a bond is a function of its coupon, length of maturity, and the movement of market interest rates. Remember: INTEREST RATES AND BOND PRICES MOVE IN OPPOSITE DIRECTIONS!!!

12 -42 Example: You bought a 1 -year, $1000 bond at 8%. How does a change in the interest rates affect your bond?

Scenario A: 12 -43 Interest rates RISE and comparable new bonds are now issued at 9%. i. If you wish to sell your bond, no one would pay $1000 for your 8% bond because it pays less interest than the new 9% bond. i. You must decrease the price of your bond (sell it at a discount) in order to attract a buyer.

Scenario B: 12 -44 Interest rates FALL and comparable new bonds are now issued at 7%. i. If you wish to sell, your 8% bond is now very attractive because it pays higher interest than new 7% bonds. i. You would be able to increase the price of your bond (sell it at a premium).

12 -45 Bond Yields i. The yield on a bond is the rate of return you would earn if you held the bond for a stated period of time. i. The two most commonly cited bond yields are current yield and yield to maturity.

i. Current Yield: 12 -46 – Amount of annual interest income relative to the current market price of the bond. – All else being equal, the higher the current yield, the more attractive the bond. – Essentially the same calculation as the dividend yield on stocks.

12 -47 h. Yield to Maturity (YTM): – Annual rate of return if bond is held until maturity. – Measures both annual interest income and recovery of principal.

12 -48 – 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.

THE END!