Chapter 14

1. Chapter 14 Investing inStocks and Bonds

2. Learning Objectives • Explain how stocks and bonds are used as investments. • Classify common stocks according to their major characteristics. • Describe fundamental and numerical ways to evaluate stock values. • Use the internet to evaluate common stocks in which to invest. • Summarize how stocks are bought and sold. • Describe how to invest in bonds.

3. Introduction When you invest in stocks and bonds, you can increase returns significantly while increasing risk only slightly. Stocks and bonds provide opportunities for conservative, moderate, and aggressive investors alike.

4. The Role of Stocks and Bonds in Investments Corporation – Individual investors provide the money corporations use to create sales and earn profits. The investors share in those profits. Public Corporation – Issues stock which is ownership purchased by the general public and traded on stock markets such as the New York Stock Exchange. Privately Held Corporation – Owned by a relatively small number of people and is not traded on a public stock exchange. Startup Capital – Funds initially invested in a business enterprise supplied by a bank or venture capital investors.

5. Common Stock Stocks are shares of ownership in a business corporation’s assets and earnings. Cash Dividends – When income exceeds expenses, a corporation may pay cash in the form of a dividend payment to its shareholder owners in the firm. Market Price – The current price of a share of stock that a buyer is willing to pay a willing seller. Shareholder (or Stockholder) – Each person who owns a share of a company’s stock holds a proportionate interest in a firm’s assets and income.

6. Common Stock • Residual Claim – The right to share in the income and assets of a corporation after higher priority claims are satisfied • Limited Liability – Risk of loss is limited to investment • Voting Rights – Authority to express an opinion or choice in matters affecting the company • Board of Directors – Sets policy and names the offers of the company management • Management – Responsible for daily operations of the firm

7. Preferred Stock • Cumulative Preferred Stock – Future payment of previously skipped dividend payments must be paid before distribution is made to common shareholders. • Noncumulative Preferred Stock – Shareholders do not have a claim on previously skipped dividend payments before common shareholders are paid a dividend. • Convertible Preferred Stock – Option to exchange preferred shares for common shares.

8. The Major Characteristicsof Common Stocks • Match your investment choices using P/E ratio and Beta. • Price/Earnings (or P/E) Ratio: • Trailing P/E Ratio – A measure of price/share to earnings/share with earnings from previous 4 quarters • Projected P/E (or Forward P/E) Ratio – A measure of future growth estimated for 4 quarters also known as the forward price/earnings ratio Ex: Current P/E ratio for S&P 500 is 14.5x. • Earnings Yield – Helps investors more clearly see future investment expectations

9. The Major Characteristicsof Common Stocks • Use Beta to Compare a Stock to Similar Investments • Beta (or Beta Value or Beta Coefficient): Measure of stock volatility. In essence, it measures how much the stock price varies relative to the rest of the market. • 1.0b = stock movement that has the same volatility as the market • 2.0b = stock movement that has twice the volatility as the market.

10. The Major Characteristicsof Common Stocks • Income Stocks – A stock that may not grow too quickly but year after year pays a cash dividend higher than offered by most companies • Growth Stocks – A stock that offers the promise of much higher profits tomorrow in exchange for lower income or dividend payments. • Well-known growth stocks – Awareness of firm is widespread and expectations for future growth are high. Coca-Cola, Intel, Nike, Microsoft • Lesser-known growth stocks – Awareness of firm is not well known but has strong earnings in the industry. Longs Drug Store, Urban Outfitters, Quality Systems • Value Stocks – A stock that trades at a low price relative to its sales or earnings and is considered undervalued due to bad news reported such as earnings, legal issues and bad press, etc. General Motors, AT&T, Citigroup, General Electric

11. The Major Characteristicsof Common Stocks • Speculative Stocks – A stock with the potential for substantial earnings at some time in the future. New stock issues are good examples • Tech Stocks – Technology firms such as Microsoft, Cisco, Intel and Yahoo • Blue-Chip Stocks – Well established firms which often dominate their industry and known for being a solid, relatively safe investment. Exxon, Coca-Cola, Wal-Mart, etc. • Capitalization: The total market value of the firms stock • Large-capitalization = $3-4 Billion in Market Value • Mid-capitalization = $750 Million to $3 Billion in Market Value • Small-capitalization = Less than $750 Million in Market Value • Microcapitalization Stocks – Less than $100 Million in Market Value

12. How to Evaluate Stock Values • Use fundamental analysis to evaluate stocks. • Fundamental Analysis – A market analysis that assumes each stock has an value based on expected stream of future earnings • Technical Analysis – An analysis which uses statistics generated by market activity such as past price and volume over time to determine when to buy and sell stock. • Corporate earnings are most important ! ! • Operating earnings (profit) drives the market and share prices adjust above or below current level depending upon expectations !

13. Numerical Measures to Evaluate Stock Prices Earnings per share – A firm’s total profit divided by the number of outstanding shares. Price/Sales ratio – The number of dollars it takes to buy a dollar’s worth of a company’s annual revenues. Ex: $500,000 market capitalization/$750,000 sales = 0.67 P/S Ratio. A ratio of 0.75 or less is suggested as a good investment. Cash Dividends – Distributions made in cash to holders of common and preferred stock. Dividends Per Share – Total cash dividends paid by a company to stockholders on a per-share basis. Dividend Payout Ratio – Dividends paid per share divided by earnings per share. Ex: $1.00 dividend/$4.00 earnings per share has a 25% payout ratio. Dividend Yield – Cash dividend paid to an investor expressed as a percentage of the current market price of a security. Ex: $1.00 Dividend/$25 stock price = 4% yield.

14. Numerical Measures to Evaluate Stock Prices Book Value – The net worth of a company as determined by subtracting net liabilities from net assets. It determines a company’s worth if its assets are sold and debts paid off with the net proceeds distributed to owners of the firm’s stock Book Value Per Share – Reflects the book value of a company divided by the number of shares of common stock outstanding Price-to-Book Ratio – Identifies firms that are asset rich such as banks, brokerage firms and insurance companies. It is determined by dividing the current stock price by the per-share net value of a firm’s plant, equipment and other assets at book value. It tells you the premium paid for the net assets of the firm. The current P/B ratio is between 2.1 and 1.0.

15. Calculating a Stock’s Potential Rate of Return Alpha statistic – The difference between expected return and actual return given its risk. A positive alpha means the company did better than expected while a negative alpha indicates poor performance. Beta – Usedto estimate the risk of the investment relative to overall market risk. Market risk (or systematic risk)- Risk associated with the effects of the overall economy on securities prices. Ex: 8% return is historic market risk for U.S. stocks. Required rate of return– Determined by multiplying Beta times the market risk such as 8% and adding the treasury bill rate. Ex: A firm with a 1.5 beta and 8% market risk with a 2% treasury bill rate would have a required return on an investment of (8% x 1.5) + 2% = 14%.

16. Calculate the Stock’s Potential Rate of Return Add up projected income and price appreciation. Potential Rate of Return - Approximate Compound Yield (or ACY) Assume: $1.02/share annual average dividend (forecasted), Current Stock Price = $30, Projected Stock Price (5 years) = $60.38 with investment period of 5 years. The approximate compound yield is equal to: $60.38 - $30.00 = $1.02 + __5 years_______ $60.38 + $30.00 2 = 15.7% potential rate of return Compare the 14% required rate of return with the 15.7% potential rate of return on the investment.

17. Use the Internet to Evaluate and Select Stocks Setcriteria for your stock investments. Ex: investment goals, philosophy, time horizon, etc. Find investment information at the following websites: fool.com morningstar.com kiplinger.com/personalfinance/ money.cnn.com/pf/indes.html Use Stock-Screening Tools: www.kiplinger.com/tools/stockscreener/index.html http://screen.morningstar.com/StockSelector.html Stock History Company Website

18. How To Use the Internet to Evaluate and Select Stocks Security analysts’ research reports The two most popular firms that offer stock advisory research services: Morningstar (http://www.morningstar.com) Value Line (http://www.valueline.com) Omaha Public Library, Reference Dept.,2nd floor, 13th Street & Douglas

19. How To Use the Internet to Evaluate and Select Stocks Track economic data such as: Stage in the business cycle Inflation rates Interest rates Expected changes in these indicators http://www.conference-board.org/data/ Use other online sources such as Yahoo!, Google, Wall Street Journal, Money Magazine, USA Today

20. Use the Internet to Evaluate and Select Stocks Securities market indexes: New York Stock Exchange (Euronext)– The largest organized exchange by volume (4.3 million trades per day valued at $39.1 Billion) of publicly traded firms. http://nyse.com Dow Jones Industrial Average – The most widely reported of all stock market indexes that tracks prices of only 30 actively traded “blue chip” stocks such as American Express, IBM, AT&T, Coca-Cola, & Walmart. http://dowjones.com Standard & Poor’s 500 Index – Reports price movements of 500 stocks of large, established publicly traded firms. http://standardandpoors.com NASDAQ Composite Index – over the counter market exchange which uses an electronic and automated quotation system (1.2 million trades per day valued at $8.1 Billion) http://nasdaq.com Russell 2000 Index – A small capitalized stock market index of small companies which measures the overall performance of small to mid-capitalized company shares http://russell2000.com Wilshire 5000 Index – Represents the total market value of virtually all publicly traded stocks in only the U.S. (Currently $14.5 Billion) http://web.wilshire.com/Indexes/Broad/Wilshire5000/

21. Buying and Selling Stocks Stockbroker– Licensed to buy and sell securities on behalf of the brokerage firm’s clients. Security’s street name – Securities kept in the brokerage firm’s name instead of the name of the individual investor for convenience purposes and to facilitate resale. Discount, online, and general (or full-service) brokers – Discount brokers offer fewer services and charge less commissions (30%-80%) than full service brokers. Discount and online brokers include Fidelity, TD Ameritrade, Vanguard, Scott Trade, E*Trade, etc. Broker commissions and fees based upon: Round Lots – Standard units of trade such as 100 shares of stock or $1,000 or $5,000 par value bonds. Odd Lot – An amount of a security less than normal such as less than 100 shares of stock. Differential: The odd-lot portion of the transaction which may be subject to 12.5 cents per share on the odd-lot.

22. Buying and Selling Stocks How to order stock transactions: The process of trading stocks involves a floor broker and a specialist. Securities prices are either matchedbetween buyer and seller or negotiatedbetween the bid (highest price a brokerage firm is willing to pay for a security) and ask price (lowest price that another brokerage firm is willing to sell the security. Types of stock orders (executing an order): Market order – Instructs the stockbroker to execute an order at the current selling price of the stock. Limit order – Instructs the stockbroker to buy or sell a stock at a specific price. May include instructions to buy up to a specified price limit or not sell below a specified price limit. Stop order (or stop-loss order) – Instructs a stockbroker to sell shares of stock at the market price if a stock declines to or goes below a specified price. Time limits: fill-or-kill order, day order, open order – Order to buy or sell immediately or cancel (fill-or-kill) the order. A day order is valid only for the trading day while an open order remains valid until executed by the stockbroker or cancelled by the investor.

23. Bonds • Bonds - interest-bearing, negotiable certificates of long-term debt. • Principal– an interest bearing negotiable certificate of long term debt issued by a corporation or government organization. • Maturity Date – Date upon which the principal or amount loaned is returned to the bondholder.

24. Investing In Bonds • Investment-Grade Bonds – Offer investors a reasonable certainty of regularly receiving periodic income and a return of the original investment • Par (or Face) Value – A multiple of $1,000 printed on the bond when issued • Speculative Grade (or Junk) Bonds – High risk bonds issued by companies with poor or no credit ratings. • Default Rate – Percent of bonds that do not repay principal at maturity and may cease interest payments.

25. Investing In Bonds • Corporate, U.S. government, and municipal bonds are examples of interest bearing certificates of long-term debt issued. • Bond rating – An impartial opinion of the quality or creditworthiness of the issuing organization in terms of risk of default. • Default (or Credit) risk – Uncertainty associated with not receiving the promised periodic interest and principal repayment when due. • U.S. government bills, notes, and bonds – short term securities with maturities of less than 1 year

26. Investing In Bonds • Treasury bills (t-bills), notes, and bonds • Discount yield, I-bonds – the difference between bond value at maturity and price paid. I bonds pay a fixed rate set when purchased and a variable rate indexed to inflation. (http://www.treasurydirect.gov) • TIPS (or Treasury Inflation-Protected Securities) Treasury inflation Protected Securities – Principal increases/decreases with inflation and sold in increments of $1K ranging from 5-30 years in maturity. • U.S. Government savings bonds – U.S. Treasury bonds that pay interest and are non-marketable • Series EE savings bonds – similar to zero coupon bonds which pay no interest but are purchased at a deep discount. • Municipal Bonds – Long-term debts issued by local governments and their agencies. Proceeds are used for public improvement projects such as parks, roads and bridges and the interest earned from them is exempt from federal taxes as well as state and local taxes if the investor lives in the same state where the bond was issued.

27. Investing In Bonds • Unique characteristics of bond investing: • Coupon rate (or coupon, coupon yield,or stated interest rate) – Interest rate printed on certificate when the bond is issued • Serial or sinking fund – A bond that is retired numerically in order of issue. Sinking fund is money reserved each year to repay the principal portion at maturity • Secured bond or unsecured bond (debenture) – The pledge of assets as collateral or has principal and interest guaranteed by another corporation or government agency. Unsecured bond is backed only by the good faith and reputation of issuing agency.

28. Evaluating Bond Prices and Returns Interest rate risk results in variable value. Market interest rates – Changes in rates affect the bond value based upon future inflation expectations. Higher inflation results in higher interest rates which lowers bond values. Interest rate risk – The risk that interest rates will rise and bond prices will fall, thereby lowering the prices on older bond issues. Fixed yield versus variable value – Interest income payment remains the same each period but the bond’s value or market price changes when interest rates change. Premiums anddiscounts – A sum of money paid in addition to a regular price. Ex: A bond with a $1,000 face value sells for $1,200 (premium) vs. $800 (discount).

29. Evaluating Bond Prices and Returns Present value of a bond – the current amount of future interest payments and the repayment of the face amount at maturity discounted at the required rate of return. Ex: An 8% coupon rate, 10 year bond with 5 years to maturity and a $1,000 face value has a 6% required rate of return and a present value of: $80 x 4.2124 (PVIFA, 6%, 5 yrs) = $ 336.99 – 8% Coupon $1,000 x 0.7473 (PVIF, 6%, 5 yrs) = $ 747.30 – Bond Face Value Total Bond (Present) Value $1,084.29 The bond above is trading at a premium (above) its $1,000 Face Value. Current yield – Equals the bond’s fixed annual interest payment divided by its bond price. Ex: $80 annual interest/$1,084 current price = 7.38% yield. Yield to maturity – The annual effective rate of return earned by the bondholder if the bond is held to maturity. Ex: The bond shown above has a 6% YTM assuming the security is held for five years.

30. Summary of Bond Ratings Ratings are measures of default risk to principal and interest

31. TheTop 3 Financial Misstepsof Investing in Stocks and Bonds People experience challenges with investing in stocks and bonds when they do the following: • Seek to invest in just one stock that promises to make them a lot of money. • Neglect to carefully research investment choices. • Hold onto a lousy investment too long instead of cutting losses by selling it.

32. Good Money Habits inInvesting in Stocks and Bonds • Include stocks and bond or mutual funds that own stocks and bonds in your investment portfolio. • Use fundamental analysis to determine a company’s basic value before investing in a stock. • Resist putting money into so-called hot stocks. • Invest part of the conservative portion of your portfolio in TIPS to beat inflation. • Use zero-coupon bonds to help fund a child’s education and your retirement.