Slides by Pamela L. Hall Western Washington University 1 Buying and Selling Securities Chapter 13

2 Classifying Today’s Investment Alternatives  Direct investing You actually own the investment Types of direct investments  Fixed-income securities  Stocks  Real estate  Exotic investments (options, futures, real assets, collectibles)  Indirect investing You own shares in an investment company (typically a mutual fund) that actually owns the investment

3 Fixed-Income Securities  You are lending money to the issuer of the security (can be a corporation, the government, etc.)  Characteristics You would buy the fixed-income security because the issuer promises to pay you a fixed amount of interest income every period The security will mature at some point and you will receive par, or face value, at that point If the issuer fails to make interest or principal payments when due, you have certain legal rights as a lender  Known as default risk

4 Money-Market Instruments  Mature within one year of issuance  Typically sold at a discount  Low risk (in terms of default)  Large face values ($100,000 to $1 mil) Probably never buy a money market security directly T-bills have small face values ($10,000)

5 Bonds (Long-Term, Fixed- Income Securities)  Up to a 30-year maturity date  Most bonds pay a periodic, fixed amount of interest (income to you)  Most bonds are callable Gives issuer right to buy back the bonds  Bonds vary widely in terms of default risk  How much default risk a bond has depends on the issuer U.S. government, municipality, corporation

6 Bonds (Long-Term, Fixed- Income Securities)  Treasury Notes and Bonds Issued by U.S. Treasury Maturities range from 2 to 30 years Fixed coupon rates No default risk Interest is exempt from state (not federal) income taxes

7 Bonds (Long-Term, Fixed- Income Securities)  Municipal Bonds Issued by state and local government units Used for public projects such as building a new school, repairing highways Types of munis  Revenue—only the revenue generated from the project for which bonds were issued is used to pay income on bond  General obligation bond—backed by the “full faith and credit” of the state Interest income is exempt from federal income taxes Many are rated by bond rating companies  Standard & Poors  Moodys

8 Bonds (Long-Term, Fixed- Income Securities)  Corporate bonds Issued by corporations to finance expansion, etc. Vary widely in terms of collateral and repayment provisions Vary widely in terms of default risk Interest income is subject to federal and state taxes

9 What Determines Bond Prices?  Price of bond is present value of future expected cash flows The higher the discount rate used to find the present value, the lower the present value, and vice versa  It is possible for a bond to sell at a price above or below face value Depends on the interest rate used to discount the bond’s future cash payments  Known as yield to maturity  A bond’s yield to maturity changes as market interest rates change

10 Stock Investing  As a stockholder, you actually own a portion of a company  You have voting rights (vote for members of the Board of Directors who oversee management who run the company)  Why invest in common stock? As a bondholder you are promised a fixed income (interest) regardless of how well or poorly the firm performs As a stockholder, as the firm profits, you profit through either dividends or stock price increase (or both)

11 Stock Investing  Dividends represent cash payments from a firm to its stockholders Not guaranteed Can be eliminated, increased, decreased Some firms pay dividends, some don’t  As a stockholder, you want to see a firm’s stock price rise, as you would benefit when you sold the stock  Most of a stockholder’s return comes in the form of an increase in stock price

12 Types of Common Stock  Blue chip: companies with a long record of stable earnings and dividend growth, financially strong  Growth Stocks: firms experiencing rapid sales and earnings growth (& this growth is expected to continue)  Income stocks: stocks that produce most of the return to stockholders in the form of dividends, rather than price appreciation (utility companies)  Speculative stocks: risky as they may do quite well, or quite poorly  Cyclical vs Defensive stocks: stocks that move with, or against (or have little relationship with) the market

13 Valuing Common Stocks  How much should you be willing to pay for this stock?  If you own it already, at what price should you sell it?  Subjective component: Stock A is currently selling for $46  To some, this is a good purchase price  To others, it is not…  Different people use different valuation techniques Technicians vs fundamentalists

14 Valuing Common Stocks  In general, the following factors affect a stock’s price Company earnings Company dividends Expected growth rate in company’s future earnings and dividends Uncertainty over above growth rate Interest rates

15 Web Links  Lots of information available on web:

16 Some Important Numbers  Return on Equity—aftertax profits ÷ stockholder equity Measures return to stockholders An ROE of 15 is considered average  Earnings per share—aftertax profits ÷ number of outstanding shares  Price-to-earnings ratio—current stock price ÷ company’s earnings Some people dislike stocks with above average P/E ratios  Beta—measures how risky a stock is relative to the overall market Betas > (<) 1.0 are considered more (less) risky than overall market

17 Choosing the Right Stock for You  Does the stock fit into your overall investment plan in terms of Goals Risk tolerance  Don’t forget to diversify

18 Understanding Financial Markets  U.S. financial markets are fair, open and orderly Trades occur in full view of all market participants Information is available as to the number of buyers and sellers (important because supply and demand determine market prices) Assuming no new pertinent information, one can place a trade at or near the last trade price Transaction costs are low (commissions) All participants have equal access to the market Prices adjust quickly to new public information

19 Types of Financial Markets  Primary vs Secondary  Where trading takes place Physical location—trading floor Via computers (over-the-counter markets)  Examples of Financial Markets NYSE  Trading floor NASDAQ  Computer-based network

20 Selecting a Brokerage Firm and a Broker  Do you want full service? Offer investment advice Record keeping Access to analysts’ reports Provide list of recommended securities Normally deal with a specific person who is your broker (and paid on commission)  Do you want discount service? Mainly provides order execution & record keeping Most provide information from independent sources (for a fee) Broker works via salary, you deal with no specific person  Do you want deep discount service? Provide order execution and record keeping and little else

21 Selecting a Brokerage Firm and a Broker  The main difference is in the area of advice and how much you pay Are you an inexperienced investor AND Do you think an experienced investment professional can consistently earn you more than if you invested in the stock market in general?

22 Selecting a Stockbroker  Remember, with a full service firm, the stockbroker is paid on commission (and receives a higher commission on some items compared to others) Before you select a broker, set your financial goals, time horizon, and your tolerance for risk Interview several brokers at several firms  Ask about their experience, educational background, typical client Check the broker’s background and licenses Make certain that the broker clearly explains the commission he’ll receive for specific products Don’t submit to pressure! Be wary of unsolicited calls (cold calls)  NEVER buy a security from a cold call—ALWAYS ask for written information about the investment and check that investment via other sources.

23 Types of Orders and Trades  Market Order Order to trade at the best possible price for you  Lowest (highest) if you are buying (selling) Most are filled within 1 minute of the time you place the order  Limit Orders Establishes a floor (as a seller) or ceiling (as a buyer) for stock price

24 Investment Record Keeping  Extremely important Taxes  Dividends  Capital gains/losses  Commissions are tax deductible, but you need to have the records for proof Track your performance Update records at least quarterly Will receive monthly statements from broker