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CHAPTER 12: INVESTING IN STOCKS AND BONDS

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Compare stocks based on dividend yield rather than dollars received if you are ... Stocks with betas – PowerPoint PPT presentation

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Title: CHAPTER 12: INVESTING IN STOCKS AND BONDS


1
CHAPTER 12 INVESTING IN STOCKS AND BONDS
2
RISKS of Investing!
Business Financial Market Purchasing Power Int
erest Rate
Liquidity Event
3
Returns from Investing
  • Current Returnincome while you hold the
    security
  • Future Return or Capital Gain gain on the sale
    of the investment
  • Total Return on the investment

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

5
Example Buy an 8, 1,000 Treasury bond that m
atures 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.

6
After 20 years you receive
3,000
2,600 total
2,000
Interest 1,600
Original 1,000 investment capital
1,000
0 5 10 15 20
Years
7
Use your calculator to calculate your compounded
annual return
  • Set on 1 P/YR
  • and END mode
  • 1000/- PV
  • 2600 FV
  • 20 N
  • I/YR 4.9

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 N
  • FV 4,661

9
After 20 years you receive
5,000
4,661 total
4,000
Interest on interest 2,061
3,000
2,600
2,000
Interest 1,600
1,000
Original 1,000 investment capital
0 5 10 15 20
Years
10
The Risk-Return Trade-OffA Fundamental
Investing Concept
  • If you want
  • GREATER RETURN,
  • you will most likely have to accept
  • GREATER RISK!

11
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
12
What makes a good investment?
  • Know your desired level of risk.
  • Consider potential investments.
  • Compare their returns with those of like
    investment types.
  • Do the returns on the investments you are
    considering meet or exceed the returns expected
    for this type of investment?

13
Investing in 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.

14
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.

15
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.

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

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.

18
Assessing Dividends
  • 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 Ma
rket price per share
19
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.

20
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.

21
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.

22
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

23
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

24
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 volatile in price swings.
  • Stocks with betas 1 are relatively more
    volatile in price swings.

25
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.

26
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.

27
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.

28
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.

29
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.

30
Foreign issued by companies from other
countries in the world.
  • 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.

31
Investing in 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.

32
The par value is the amount of principal that
must be repaid to the bondholderusually 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).

33
Bond Issue Characteristics
  • 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.

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

35
Types of Bonds
  • Treasury Securities
  • Agency Bonds
  • Municipal Bonds
  • Corporate Bonds
  • Zero Coupon Bonds
  • Convertible Bonds

36
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.

37
Bond Ratings
Investment Grade
Below Investment Grade
38
Reading a Bond QuoteXYZ Corp. 7½15 Close 101
  • XYZ Corporation is the bond issuer.
  • 7½ is the coupon or annual interest rate paid on
    this bond.
  • The amount of annual interest is 7½ of the par
    value, or
  • .075 x 1000 75

39
The bondholder should receive half of the
interest every 6 months, or
  • 75 ? 2 37.50
  • 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

40
Reading a Bond Quote (con't)XYZ Corp. 7½15
Close 101
  • Bond prices are not quoted in dollars but as a
    percent of par.
  • This bond's closing price (or last price) was
    101 of par, or
  • 1.01 x 1000 1,010

41
Bond Prices
  • 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!!!

42
Example You bought a 1-year, 1000 bond at
8. How does a change in the interest rates
affect your bond?
43
Scenario A Interest rates RISE and comparable
new bonds are now issued at 9.
  • 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.
  • You must decrease the price of your bond (sell it
    at a discount) in order to attract a buyer.

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

45
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.

46
Current Yield
  • 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.

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

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 rate.

49

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