chapter 14: investing in stocks and bonds

Chapter Fourteen

Investing in Stocks and Bonds

Learning Objectives

1. Describe how stocks and bonds are used.

2. List key numeric measures of stock performance that influence investment decisions.

3. Distinguish among the classifications of stocks.

4. Identify major characteristics of bonds and differentiate among corporate, U.S. government, and municipal bonds.

5. Evaluate bond prices and returns and summarize the decisions that bond investors must make.

Stocks and Bonds: How They Are Used

• Corporation – state-chartered legal entity that can conduct business operations in its own name.

• Startup Capital – funds initially invested in a business enterprise.

• Securities – negotiable instruments of ownership or debt:– Common stock.– Preferred stock.– Bonds.

Common Stock

• Stocks – shares of ownership in the assets and earnings of a business corporation.

• Common Stock – the most basic form of ownership of a corporation.

• Shareholder – the owner of a stock.

• Voting Rights – proportionate authority to express a choice in matters affecting the company.

• Proxy – written authorization given by shareholder to someone else to represent him or her and vote his or her shares at a stockholder’s meeting.

Common Stock (Continued)

People who own stocks typically have two expectations:

– The corporation will be profitable enough that income will exceed expenses, allowing the firm to pay cash dividends.

• Cash Dividends – a share of profits distributed in cash.

– The market price of a share of stock will increase.

Common Stock (Continued)

Revenues are used to pay

– expenses

– interest to bondholders

– taxes

– cash dividends to preferred stockholders and

– cash dividends to common stockholders.

• Retained Earnings – the remainder, left to accumulate and finance the company’s goals.

Preferred Stock

• Preferred Stock – a type of fixed-income ownership security in a corporation.

– Owners receive a fixed dividend BEFORE common stock holders and have NO voting privileges

• Cumulative Preferred Stock – when the board of directors skips making a cash dividend, that dividend must be paid before any future dividends are distributed to common stockholders.

• Noncumulative Preferred Stock – the preferred stockholders have no claim to previously skipped dividends.

• Bond – interest-bearing certificate of long-term debt issued by a corporation, a municipality, or the U.S. federal government.

• Principal – the amount of money lent to the issuer by the initial purchaser.

• Maturity Date – the future point when the issuer must repay the investor’s principal.

• Secondary Market (or Aftermarket) – where existing securities that have already been sold to the public are bought and sold.

Stock Dividends and Stock Splits

• Stock Dividend – a dividend paid in the form of securities instead of cash.

– Has no effect on price; owners retain proportional shares

• Stock Split – occurs when the shares of stock owned by existing shareholders are divided into a larger number of shares; done to change price

– Example: 2:1- twice as many shares worth half as much

• A reverse stock split results in a smaller number of shares.

– Example: 1:2- half as many shares worth twice as much

Book Value

• The net worth of a company determined by subtracting the company’s total liabilities from its assets.

• Also known as shareholder’s equity

Book Value Per Share

• Book value divided by # of outstanding shares

• The market price for a company’s common stock usually exceeds its book value per share

– This is because stockholders anticipate earnings and dividends in the future and expect the market price to rise.

– When the book value per share exceeds the price per share, the stock may truly be under-priced.

Earnings Per Share (EPS)

• Amount of profit divided by the number of outstanding shares.

• Indicates the income that a company has available, on a per-share basis, to pay dividends and reinvest as retained earnings.

Price/Earnings (P/E) Ratio

• Current market price of a stock divided by earnings per share over the past four quarters.

– A.K.A., a stock’s “multiple”

– Primary method of valuing stocks

– Tells how expensive stock is versus recent company earnings

– Indicates cost per $1 of earnings

• Example: $25 stock price/1.60 EPS = 16 P/E

Beta Value (or Beta Coefficient) – a measure of an investment’s volatility compared with a broad market index for similar investments.

– Benchmark for all stocks is +1.0

– < 0 to .9, means stock is less sensitive to market moves

– > 1.0, means stock is more sensitive to market moves

Classifications of Stocks

• Income Stock – may not grow too quickly, but pays a cash dividend higher than that offered by most companies year after year (e.g., utility companies)

• Growth Stock – company offers the promise of higher profits tomorrow and has a consistent record of relatively rapid growth in earnings in all economic conditions (e.g., Microsoft, Intel)

Classifications of Stocks (Continued)

• Speculative Stock – company that has a potential for substantial earnings at some time in the future.

• Blue-Chip Stocks – company that has been around for a long time, has a well-regarded reputation, dominates its industry, and is known for being a solid, relatively safe investment.

• Value Stock – company that may sell for less than the true worth of its assets.

Other Characterizations for Common Stocks (Continued)

• Cyclical Stocks – company whose profits are greatly influenced by changes in the economic business cycle.

– Examples?

• Countercyclical (or Defensive) Stocks – perform well even in an environment characterized by weak economic activity and sliding interest rates.

– Examples?

Capitalization Size

Multiply share price by number of outstanding shares

• Large-Cap Stocks

• Mid-Cap Stocks

• Small-Cap Stocks

• Micro-Cap Stocks

Characteristics of Bonds• Par Value (or Face Value) – amount

specified on the bond certificate.– $1,000 for most Treasury and corporate bonds

(or multiples thereof)

• Coupon Rate (or Coupon, Coupon Yield, or Stated Interest Rate) – interest rate printed on the certificate when a bond is issued.

Bonds are Either Secured or Unsecured

• Secured Bond – pledges specific assets as collateral or has the principal and interest guaranteed by another corporation or a government agency.

– Examples: buildings, airplanes, equipment

• Unsecured Bond (Debenture) – does not name collateral as security and is backed only by the good faith and reputation of the issuing agency.

Bonds Are Callable

Callable – bonds and preferred stocks can be bought back from an investor before the maturity date, if the issuer desires.

When would this happen?

Corporate, U.S. Government, and Municipal Bonds

• Corporate Bonds – interest-bearing certificates of long-term debt of a company.

• U.S. Government Bills, Notes, and Bonds

– “Treasury Securities” – treasury bills, notes, and bonds, collectively; different maturities

• Municipal Government Bonds (or Munies) – long-term debt issued by local governments and their agencies.

I Bonds

U.S. savings bonds backed by the U.S. Government that pay an earnings rate that is a combination of two rates:

– A fixed interest rate that is set when the investor buys the bond.

– A semi-annual variable interest rate tied to inflation that protects the investor’s purchasing power.

U.S. Government Securities (Continued)

• Treasury Inflation-Protection Securities (TIPS) – Treasury securities whose value increases as inflation occurs.

Interest-Rate Risk

• Market Interest Rates – current long- and short-term interest rates paid on various corporate and government debts that carry similar levels of risk.

• Interest-Rate Risk – risk that interest rates will rise and bond prices will fall, thereby lowering the value of your bond investments.

Figure 14.1: Price Changes for Bonds

Premiums and Discounts

When a bond is first issued, it is sold in one of three ways:

– at its face value

– at a discount below its face value or

– at a premium above its face value.

Decisions Bond Investors Must Make

• Decide on risk level.

– Investment grade bonds: top 4 grades (BBB, A, AA, AAA)

– Junk bonds (a.k.a., high yield bonds): lower rated and higher risk

• Decide on maturity.

– Match to financial goals

• Determine the after-tax return.

– Taxable versus tax-exempt

Golden Rules of Investing in Stocks and Bonds

1. Include stocks and/or stock mutual funds in a diversified investment portfolio.

2. Consider investing the conservative part of your money in TIPS (Treasury Inflation-Protected Securities) to beat inflation.

3. Instead of investing in individual corporate bonds, minimize financial and interest-rate risks by investing in bond mutual funds.

For Further Information About Investing

www.investing.rutgers.edu

chapter 14: investing in stocks and bonds

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