© 2012 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

Learning Goals Describe types of risk and sources of returnResearch 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 BusinessFinancialMarketPurchasing PowerInterest RateLiquidityEvent

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 returnApproximate yieldDesired rate of return

Approximate Yield

Investing in Common Stock Each share represents equity or part ownership in the company Investor participates in firm’s profitsStock ownership is residualFirm’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 bracketsGains are not taxed until realized

Dividends Can be paid even if company shows a loss Determined by firm’s board of directors Cash dividends usually paid quarterly

Dividend Yield = Annual dividend per share Market price per share Cash dividends - most common and most desirableStock dividends - new shares given to shareholders Dividends

Key Measures of Performance Book Value = Total assets – (liabilities + preferred stock) Book Value - stockholder’s equity in a firm Good when: book value steadily increases market value exceeds book value

Net Profit Margin - one of the most widely used measures of corporate performance Key Measures of 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

Return on Equity – shows firm’s overall profitability from stockholders perspective Key Measures of Performance 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 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 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

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 stockPlow 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:

Bond Issue Characteristics Like a loan - bondholder lends money to issuerInterest - usually paid every 6 monthsCoupon - 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

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 BondsAgency and Mortgage-Backed Bonds Municipal BondsCorporate BondsConvertible 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 IndustrialsPublic utilitiesRail and transportationFinancial issues

The Bond Market Convertible Bond - Debenture that may be converted into a certain number of company’s common stock Conversion privilegeConversion ratioConversion valueConversion 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