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Personal Finance: An Integrated Planning Approach

Personal Finance: An Integrated Planning Approach. Winger and Frasca Chapter 11 Stocks and Bonds: Your Most Common Investment. Introduction. Stocks are an important investment choice for individuals. Understanding the characteristics, risks, and potential returns is crucial.

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Personal Finance: An Integrated Planning Approach

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  1. Personal Finance:An Integrated Planning Approach Winger and Frasca Chapter 11 Stocks and Bonds: Your Most Common Investment

  2. Introduction • Stocks are an important investment choice for individuals. Understanding the characteristics, risks, and potential returns is crucial. • Bonds are also an investment choice for individuals. • Stocks and bonds have different risk and therefore different potential returns. • A savvy investor needs to understand when investments in stocks and bonds are warranted. • Also, an investor needs to understand their rights when they invest in stocks and bonds.

  3. Chapter Objectives • To identify basic shareholder rights and the means by which corporations make distributions to shareholders • To recognize the investment opportunities in various types of stocks, such as growth stocks or income stocks • To understand how to determine the investment appeal of a stock using various valuation techniques and the price-to-earnings approach • To understand corporate bondholders’ rights and the payment characteristics of corporate bonds

  4. Chapter Objectives (Continued) • To identify different types and payment characteristics of U.S. Treasury securities, U.S. agency securities, and municipal bonds • To know how to calculate a bond’s current yield, yield to maturity, and present value • To understand default risk and interest rate risk associated with bond investments • To become familiar with preferred stock, recognizing its characteristics and investment quality

  5. Topic Outline • An Overview of Common Stocks • Fundamental Analysis of Common Stocks • Corporate-Issued Bonds • Government-Issued Bonds • Return and Risk Characteristics of Bonds • Preferred Stock

  6. Characteristics of Common Stock • Shareholders’ Rights • Distributions to Shareholders • Opportunities in Common Stocks • Stock Quotations

  7. Shareholders’ Rights • The right to vote: Usually, you receive one vote for each common share that you own. • Proxy: You can assign your voting rights to someone else. • Preemptive right: Your right to maintain your proportionate investment in a company • Right to share in earnings or asset distributions: Shareholders are owners of the corporation. Therefore, they have the right to any distribution of earnings or assets

  8. Shareholders Come Last • Common shareholders have a residual claim on assets and earnings. This means that all other claims must be paid before shareholders can receive any distribution. • Other claims have fixed payments so: • If the company has good earnings, common shareholders benefit considerably. • If the company has poor earnings, common shareholders might receive nothing.

  9. Earnings of only $9,000 (Poor) $5,000 interest to bondholders $3,000 in dividends to preferred stockholders $1,000 in dividends to common stockholders (the balance) Earnings of $20,000 (Good) $5,000 interest to bondholders $3,000 in dividends to preferred stockholders $12,000 to common stockholders (the balance) Earnings Distribution Example

  10. Common Stock Distributions Corporations are not required to make distributions—it is at the discretion of the board of directors. • Cash distributions • Regular (Quarterly) dividends • Special or one-time dividends due to unusual circumstances • Periodic share repurchases • Noncash distributions • Stock dividend • Stock split

  11. Noncash Distributions:Stock Dividends and Splits • Although favored by some shareholders, stock dividends and splits do not increase shareholder wealth. • Stock dividends and splits simply provide shareholders with a greater number of shares. • Although the price of the shares falls, the total market value remains the same.

  12. Opportunities in Common Stocks • Growth Companies: Earnings are expected to grow significantly more than other companies • Income Stocks: Companies who pay a good dividend return • Blue Chips: High-quality stocks; low-risk stocks with a good rate of return • Cyclical Stocks: Very responsive to changes in the economy • Special Situations: Potentially profitable opportunities such as a takeover

  13. Example of a Stock Quotation High Low Stock Div Yld P-E % Ratio 40 30 ABC .40 1.0 17 Sales High Low Close Net 100s Chg 243 41 39 40 +0.75 Quote Continued

  14. Fundamental Analysis of Common Stocks • Application of the CAPM • Price-to-Earnings Analysis • The PEG Ratio • Fundamental Value and Book Value

  15. Determining Expected Return • A stock’s expected total return (TR) consists of: • Expected current return (CR) and • Expected future return (FR) • Current return is the expected dividend yield for the upcoming year. • Future return is the expected annual growth in dividends in the future. • TR = CR + FR

  16. Calculating Expected Total Return • Data for ABC Company: • Current stock price = $20/share • Expected dividend next year = $1.20 • Current return (CR) = $1.20/$20 = 0.06 • Expected annual growth in dividends in the foreseeable future (FR) = 0.08 • Total return = current return + future return • TR = CR + FR • TR = 0.06 + 0.08 = 0.14 or 14%

  17. Review of CAPM • This method provides a pertinent view of a company’s risk – its Beta value. • It brings a company’s risk into the picture through the required return equation, which expresses how much return you should earn on the stock. • Comparing this return to what you expect the company to earn provides a clear decision signal – the alpha value • Alpha = expected return – required return

  18. Mead’s Required Rate of Return versus its Expected Rate of Return, 2004 Required Rate of Return Expected Rate of Return

  19. Comparing Mead’s Required Return with its Expected Return • Expected rate of return = 10.3% • Required rate of return = 10.0% • Alpha = + 0.3%  BUY since alpha is positive

  20. Price-to-Earnings Analysis • A stock’s P/E ratio is the ratio of a stock’s price (P) to its earnings per share (EPS). • P/E = P/EPS • Example: If P = $50.00 and EPS = $2.50, • then P/E = $50.00/$2.50 = 20.0. • Investors are willing to pay $20 for each $1.00 of the company’s earnings.

  21. Finding P/E Ratios To calculate the P/E, we need to use future EPS but this information can only be estimated. • There are three methods for determining P/E ratios: • Use the current P/E ratio. • Use the average P/E ratios over previous time periods. • Use the company’s expected dividend growth rate (ignore % sign). • These three methods can lead to quite different values so we must use judgment.

  22. The PEG Ratio • This ratio shows the relationship between the P/E ratio and the long-term growth rate of earnings per share. • PEG = (P/E)/Growth • All other things being equal, low numbers are desirable because it shows that you are buying growth at a low price (bargain).

  23. Using Book Value • Book value is simply a company’s net worth (assets – liabilities) divided by the number of shares outstanding. • Book value may not provide a realistic estimate of the true value because: • Assets may have replacement costs much higher than book value. • Some assets may not appear on the company’s books. For example, the Coca-Cola trademark is quite valuable but it is not valued on the company’s balance sheet.

  24. The Market-to-Book Ratio • Despite the limitations of the book value number, some analysts use it in the market-to-book ratio. • This ratio divides the stock price (market value) by its book value to assess a relative value. • Example: If the price of a stock is $40/share and the book value is $10/share, then the market-to-book ratio is 4 ($40/$10) • All other things being equal, analysts prefer low values for this ratio.

  25. Fixed-Income Securities • Corporate-Issued Bonds • Government-Issued Bonds • Return and Risk Characteristics of Bonds • Preferred Stock

  26. What Is a Bond? • A bond is simply a loan. It is a marketable IOU. • Bond parties • The issuer who is borrowing money • The investor who lends the money • The loan • Specifies interest payments • Has a maturity, such as 20 years • The bond certificate • Is a small part of the overall loan • Is easily traded in the bond market

  27. Your Rights as a Bondholder • Bondholders are creditors. They have rights comparable to the rights of other creditors. • A bond indenture is the contract between the issuer and the bondholders that spells out the rights of the bondholders. • It is similar to a loan agreement that you sign when you borrow money. • Protective covenants are restrictions on the issuer. These are included in the indenture and they are intended to strengthen the bondholders’ position.

  28. Payment Characteristics of Bonds • Face value: The amount the issuer pays to redeem the bond • It is usually $1,000 for corporate bonds. • Semiannual interest payments: • Most bonds have a fixed rate of return, which are the interest payments that are made every 6 months. • The amount of the payment is determined by multiplying the bond’s coupon rate by the face value of $1,000. • Example: An 8% bond pays $80 in interest per year (0.08 × $1,000) divided into two payments of $40 semiannually.

  29. Zero Coupon Bonds • Zero coupon bonds do not pay interest during the life of the bond. • Interest is earned by paying less than the face value of $1,000 to buy the bond. • Example: you pay $500 today to buy a bond that will be redeemed in eights years for $1,000 • A savings bond is an example of a zero coupon bond. You buy it for $50 and it is redeemed for $100 in the future.

  30. Retirement Methods • Redeemed at maturity • Earlier redemption due to a “call” • Interest rates have declined and the issuer wants to refinance. They call the existing bonds and issue new bonds at a lower interest rate. This is similar to refinancing a home mortgage. • Sinking funds involve a plan to retire a portion of the outstanding bonds each year rather than retiring all of the bonds at the maturity date. • Bonds that can be converted into common stock

  31. Convertible Bonds • These bonds can be converted into common stock. • The conversion rate is the number of shares of stock acquired by converting 1 bond; e.g., 40 shares per bond. • Conversion value of the bond • This is the bond value if it was converted into common stock. • It is determined by multiplying the stock price by the conversion rate. • For example: Stock price = $30; the conversion rate is 40 shares per bond; conversion value = $30 × 40 = $1,200

  32. Investing in Corporate Bonds • Trading costs can be high • Commission cost • The bid-ask spread • Callable bonds are bonds that can be called prior to maturity. • No interest is paid after the call date • Mutual funds may be the best way for individual investors to invest in bonds.

  33. Government-Issued Bonds • U.S. Treasury Securities • U.S. Agency Bonds • Conventional • Mortgage-backed • Municipal Bonds • General obligation (GO) bonds • Revenue bonds

  34. U.S. Treasury Bonds • The characteristics are the same as corporate bonds: • Face value of $1,000 • A maturity date such as 10 years • Semiannual coupon payments • Investors can buy these directly from the Federal Reserve Bank • Free of default risk • May be subject to price risk but the degree depends on the time to maturity

  35. Special Types of U.S. Treasury Bonds • U.S. Treasury Strips • Created by brokerage firms • Issued in zero coupon form • Interest payments and face value are each sold separately. • Inflation-Indexed Bonds • Intended to lessen price risk of bonds • The coupon rate is not changed. • The redemption value is adjusted periodically to reflect inflation. Example: If annual inflation is 3%, the redemption value is increased to $1,030.

  36. U.S. Agency Bonds • Conventional bonds have the same characteristics as U.S. Treasury Bonds • Mortgage-Backed Bonds: • Issued by agencies such as Fannie Mae • Agency buys mortgages from local lenders • Creates a pool of similar mortgages and issued bonds backed by these pools of mortgages • Mortgage payments are “passed through” to the bond buyers • Due to the complexities of these bonds, it is best to invest through a mutual fund.

  37. Municipal Bonds (Munis) • Issued by cities, counties, or states to fund projects • General obligation (GO) bonds • These are backed by the full taxing authority of the issuer. • Revenue bonds • Backed only by the revenues of the project that the bonds are financing • These bonds are considered more risky since they are dependent upon the revenues from a project. • Most municipal bonds are free of federal income tax and may be free of state income tax.

  38. Munis’ Income Tax Advantage • Calculate pre-tax equivalent yield (PTEY) PTEY = Muni Yield/(1.00 – MTR) where MTR = marginal tax rate • Example: Muni Yield = 5.91% and MTR = 28% (0.28) PTEY = 5.91/(1.00 – 0.28) = 5.91/0.72 = 8.21% • Compare to yields on taxable bonds and choose the bond with the highest yield.

  39. Expected Return from Bonds • Current yield (CY): annual interest divided by current price • Example: • Bond price (P) = $900 • Annual coupon interest (I) = $120 • The current yield calculation: • CY = I/P = $120/$900 = 0.1333 or 13.3% • The advantage of this calculation is that it is easy. • The disadvantage is that ignores maturity.

  40. Yield to Maturity (YTM) • Formula (approximation) YTM = [ I + (1,000 – P)/N]/ [(P + 1,000)/2] • Example: I = 120, P = 900, N = 5 YTM = [120+(1,000 – 900)/5]/ [(900 + 1,000)/2] = [120 + 20]/ [950] = 140/950 = 0.1474 or 14.74%

  41. Present Value of a Coupon Bond • A coupon bond’s present value (PV) has two components: • Present value of the coupon interest payments • Present value of the future redemption value (usually $1,000) • But these payments are all in the future • The future cash flows are discounted using the bond’s yield to maturity (not the coupon rate) to determine the present value of the bond.

  42. Present Value of a Coupon Bond: An Example • Data: YTM = 15%; coupon rate = 12% ($120 a Year); Redemption Value = $1,000; 5 Years to Maturity • Using present value tables (appendix), find: • PV of $1 for 15%, 5 Years = 0.4972 • PV of $1 Annuity for 15%, 5 years = 3.3522 • Present Value: • = (0.4972 × $1,000) + (3.3522 × $120) • = $497.20 + $402.26 = $899.46

  43. Present Value of a Zero Coupon Bond • There is only one cash inflow with a zero coupon bond – the future redemption value. • To find the present value, use the present value of $1 table in the appendix. • Example: Find the PV of a zero coupon bond that matures in 10 years with a YTM of 8%. • PV of $1 = 0.3855. • PV of the bond = 0.3855 × $1,000 = $385.50.

  44. Present Value and YTM • A bond’s present value is actually its market price. • We can say that a bond’s YTM determines its market price, as we assumed in the previous examples. • We can also say that the bond’s price determines its YTM – the higher the price, the lower its YTM. • And vice versa. It is simply a matter of perspective. • There is an inverse relationship between bond prices and their YTM.

  45. Default Risk • Default risk is the possibility that the issuer will not make the interest payments and/or redeem the bonds at maturity. • This is not a problem with U.S. Treasury bonds and most agency issues. • It may be a problem with municipal bonds. • It is a very serious problem with corporate bonds. • Investors can use credit-rating services such as Moody’s to assess the default risk with bonds.

  46. Interest Rate Risk • Interest rate risk is the price volatility of a bond in relationship to the changes in market rates of interest. • As interest rates increase, the YTM of a previously-issued bond must also increase. • As the YTM increases, the bond price decreases. • If you own this bond, this results in a loss in your investment. • The flip side is true if interest rates fall. Then bond prices increase and you have a gain on your investment.

  47. Price and YTM: 12% Coupon Rate and Maturities as Shown YTM 1-Year 5-Year 20-Year Maturity Maturity Maturity _________________________________ 9% $1,028 $1,117 $1,274 12% 1,000 1,000 1,000 15% 974 900 812 Least Price Most Price Variation Variation

  48. Preferred Stock • Hybrid security: Preferred stock has some characteristics of both bonds and stocks • Form of equity ownership – similar to common stock • Pays a fixed return – similar to bonds • Stockholders’ rights • Are provided in the offering agreement • This agreement is similar to a bond indenture but is weaker. • Preferred stock usually does not vote.

  49. Preferred Stock Features • $100 par value is common but other par values can also be used. • Cumulative dividend (frequently used): • If a dividend is not paid in a particular year, it is carried forward and must be paid before any dividend can be paid to common stockholders. • Participating dividends (rarely used): • Extra dividends due to income sharing • Convertibility (sometimes used): Preferred stock may be exchanged for common stock. This is new.

  50. Expected Return from Preferred Stock • Similar to common stock, most preferred stock does not have a maturity • The expected return is simply the preferred stock’s current return (CR): • CR = Dividend/Stock Price • Example: If the dividend = $2 and the price = $8, then CR = $2/$8 = 0.1111 or 11.11%.

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