CHAPTER 12: INVESTING IN STOCKS AND BONDS

1. CHAPTER 12: INVESTING IN STOCKS AND BONDS

2. The Risks and Rewards of Investing • You cannot consider the return of an investment without also looking at its risk. • Generally speaking, the riskier the investment, the higher the level of return.

3. Returns from Investing Current Return—income 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-Interest:An 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 matures 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. Scenario 2:Reinvest the income

8. 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

9. Fully Compounded Rate of Return • The idea of earning interest on interest. • This principle applies to any type of long-term investment.

10. The Risk-Return Trade-Off:A 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? • Expected future return • Approximate yield – see page 379 in book for formula • Desired rate of return

13. Desired Rate of Return • The minimum rate of return an investor feels should be earned in compensation for the amount of risk assumed. NOTE: An investment should be considered acceptable only if it’s expected to generate a rate of return that meets (or exceeds) your desired rate of return.

14. Why Invest in Stocks? • To use the stock as a warehouse of value—storage of value is important to all investors • To accumulate capital (build wealth) —generally important to individuals with long-term investment horizons. • To provide a source of income—a dependable flow of dividends

15. 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.

16. Public Offering The corporation, working with its underwriter, offers the investing public a certain number of shares of its stock at a certain price.

17. 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.

18. 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 generally not taxed until realized (when the stock is actually sold).

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

20. Cash dividends are most common and most desirable. • Stock dividendsare paid in new shares given to current shareholders. Does not represent an increase of ownership because all stockholders receive same percentage.

21. 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. Book Value per Share— book value divided by number of shares outstanding.

22. 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.

23. Return on Equity— the ratio of net income to common equity. • Reflects the company’s management of its assets, operations, and debt. • The better the ROE, the better the financial condition and competitive position of the company.

24. 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

25. Price/Earnings Ratio— shows amount investors are willing to pay for $1 of earnings. P/E = Market price of the stock Annual earnings per share • High P/E ratio may indicate a stock is overpriced!

26. Beta— indicator of a stock’s 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 < 1 are relatively less volatile in price swings. • Stocks with betas > 1 are relatively more volatile in price swings. • Example: Stock with a beta of 0.8 means it should rise (or fall) only 80 percent as fast as the market

27. 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. • Often relatively high priced.

28. 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. • Earnings and price increase over time at a rate well above average Tech — issued by companies in the technology sector. • Most are either growth or speculative stocks. • Some are blue-chip stocks.

29. Income — issued by companies which have a fairly stable stream of earnings. • Pay relatively high dividends which can be expected to increase over time. • 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. • Purchased with the hope that its price per share will increase

30. Cyclical — issued by companies whose stock prices move in same direction as the business cycle. • Most are found in basic industries (automobiles, steel, lumber). • Always have a positive beta. Defensive (countercyclical) — issued by companies whose stock prices usually remain stable during economic downturns. • Companies usually provide basic needs, such as consumer goods, certain public utilities, gold mines. • Betas are usually low or even negative.

31. . Large-Cap — issued by companies with market capitalization of more than $10billion. Mid-Cap — issued by companies with market capitalization of $2–10 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 $2 billion or less. • Offer possibility of high returns. • Prices can be very volatile due to high risk exposure. Cap Value is found by multiplying stock’s market price by number of shares outstanding.

32. 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.

33. Investing in Common Stock • Advantages • Potential returns • Actively traded and highly liquid • Involves no direct management • Disadvantages • Risk • Timing of purchases and sales • Uncertainty of dividends

34. Investing in Common Stock • The first step in investing in knowing where to put your money—matching your risk and return objectives with the available investment vehicles. • The second step is knowing when to make your moves. • You should expect to earn more than what you can get from T-bills or high-grade corporate bonds because stocks are riskier.

35. Selecting a Stock • Find a company that you like • Take a look at how it has performed over the past 3 to 5 years. • Find out what kind of growth rate (in sales) it has experienced • Find out if it has a strong ROE and if it has been able to maintain or improve its profit margin • Find out how much it has been paying out in dividends. • Looking at the past is only the beginning; what’s really important is the Future!

36. Financial Press - Market Data What is the Dow Jones (DJIA)? 30 Stocks in the Dow Current stock prices in the Dow

37. Online Investment Information • Google Finance • Yahoo Finance • MSN Money • Daily Finance (AOL) • Reuters

38. Expected Future Performance of a Stock • Using a 3-year investment horizon, forecast annual dividends per share for each of the next 3 years plus the future price of the stock at the end of the 3-year holding period. (You can try to generate these forecasts yourself or you can look to a publication like Value Line.) • Use this information in the approximate yield equation, you can determine the expected return from the investment.

39. The Investment Club Approach • People form a club, pool money, and make investments. • BetterInvesting – functions as clearninghouse for thousands of investment clubs; provides sound investment information, education, & support to investment clubs • Investment Clubs - Bloomberg

40. Timing Your Investments • As long as the prospects for the market and the economy are positive, the time may be right to invest in stocks • Don’t invest in stocks if • You feel very strongly that the market is headed down • You feel uncomfortable with the general tone of the market—it lacks direction or there is too much price volatility to suit you.

41. Online Brokers • Setting up an online account • E-trade

42. Plow Back Your Earnings • Plow back your earnings • Dividend reinvestment plan (DRP)

43. Dividend Reinvestment Plan • Shareholders sign up to have their cash dividends automatically reinvested in additional shares of the company’s common stock. • The idea is to put your money to work by building up your investment in the stock. • Additional stock is usually acquired free of any brokerage commissions • Most plans allow partial participation—portion of dividend goes to reinvestment; remainder goes to shareholder as cash • Reinvested dividends are taxable in year they’re received.

44. Investing in Bonds • A bond is loan—the 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.

45. The par value is the amount of principal that must be repaid to the bondholder—usually $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).

46. Why Invest in Bonds? • They provide a generous amount of current income (in the form of interest). • They can generate substantial amounts of capital gains because interest rates and bond prices move in opposite directions. When interest rates rise, bond prices fall; and when they drop, bond prices rise. • They are highly versatile—can be used conservatively to seek high current income or aggressively to seek capital gains. • They can be used for preservation and long-term accumulation of capital.

47. Bonds vs. Stocks • Relative to stocks, there’s a big sacrifice in returns when investing in bonds which is the price you pay for the even bigger reduction in risk. • Bond returns are far more stable than stock returns. • Bond possess excellent portfolio diversification properties.

48. Types of Issues • Senior Bonds – secured obligations because they are backed by a legal claim on some specific property of the issuer that acts as collateral • Mortgage Bonds – secured by real estate • Equipment Trust Certificates – backed by certain types of equipment; popular with airlines and railroads. • Junior Bonds – unsecured obligations because they are backed only with a promise by the issuer to pay interest and principal on timely basis. • Debenture – most popular; issued as either note (maturities of 2-10 years) or bond (maturities of more than 10 years.

49. Sinking Fund • Specifies the annual repayment schedule that will be used to pay off the issue and indicates how much principal will be retired each year. • Repayment generally begins 1 to 5 years after date of issue. • Any amount not repaid by maturity is retired with a single balloon payment.

50. Call Feature • Stipulates whether a bond can be called (retired) prior to its regularly scheduled maturity date and under what conditions. • Normally used to replace an issue with one that carries a lower coupon; issuer benefits by being able to realize a reduction in annual interest cost. • Call premium (usually equal to about a half to one year’s interest) is tacked on to par value and is paid to investors at time bond is called.