Garman/Forgue

Personal FinanceNinth Edition

Chapter 14Investing in

Stocks & Bonds

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Learning Objectives

1. Explain how stocks and bonds are used as investments

2. Classify common stocks according to their major characteristics

3. Describe fundamental and numerical ways to evaluate stock values

4. Use the Internet to evaluate common stocks

5. Summarize how stocks are bought and sold

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The Role of Stocks & Bonds in Investments

Why Do Corporations Issue Stock?• Stock is a form of EQUITY financing

– Corporations sell stock to raise money for various activities (start-up costs, expansions, ongoing business expenses)

– Each stockholder has a proportionate interest in the company– Investors share in the future profits of the company

• Stock dividends are NOT MANDATORY

– May be paid to stockholders out of profits– May be reduced or omitted

• Stock ownership gives shareholders VOTING RIGHTS

– Proportionate authority to elect board members

Stocks and Bonds are the basic securities used in the world of investing.

They allow us to earn a larger return than offered by conservative investments… but we must accept more risk.

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What are Bonds?• Bonds are a form of DEBT financing (IOUs)

– Corporations, governments, municipalities issue bonds to raise $ (ex: to finance construction projects, buy equipment)

– Investors lend their money with the expectation that

1. They will receive regular fixed-interest payments

2. They will receive their principal upon maturity

• Desirable for those who seek a reliable stream of income

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How do Investors Benefit?

Investing in stock:1. Income: from dividends

2. Capital Gains: appreciation of stock value

Investing in bonds:1. Income: from interest

COMPARING corporate stocks vs. corporate bonds:– As a bondholder you are promised a fixed income

regardless of how the firm performs

– As a stockholder you MAY profit through either dividends or stock price increases (or both, if the firm profits)

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Stock Splits

• How do stock splits work?

• How can they benefit shareholders?

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The Major Characteristics of Common Stocks

Methods of evaluating potential investments:

• Earnings per share (EPS)– Annual profit ÷ # of outstanding shares of stock

– A measure of company profitability: shows the income a company has available (on a per-share-basis) to pay dividends and reinvest

– An increase in earnings is generally a healthy sign

• Price-earnings (PE) ratio– Key factor used to evaluate how expensive a stock is

– How much you are paying for each $1 of earnings?

– Price per share ÷ EPS

– Average = 18; Low P/E ratio => good investment, less risk

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• Beta– Measures an investment’s volatility compared to the

overall market– Average for all stocks is 1.0 (benchmark)– Higher beta = higher risk

• Earnings estimates

– Based on analysts research

• Current yield – Dividend per share ÷ price per share

– An increasing current yield is considered a healthy sign

• % Total return

– Total return ÷ original purchase price

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Example of Total Return

You bought stock 1year ago at a price of $50 per share

You sold it a year later for $55 per share

During that time you received dividends of $1 per share

Calculate the total return from your investment:

Total Return = Dividends plus capital gains

$1 + $5 = $6% Total return =

Total return ÷ original purchase price

[ $1 + $5 ] $50 = 12%

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Classifications of Stock Income stocks

Pays higher dividends, little price appreciation; less risky (ex: utility companies)

Growth stocks Companies with a consistent record of rapid growth and earnings (potential to earn above average profits)

Value Stocks Trades at a low price relative to its company characteristics (earnings, etc.): considered undervalued

Blue chip stocks

Financially strong, reputable companies with a long history of stable earnings and dividend growth (Solid, semi-safe investment for conservative investors)

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• Stocks categorized by CAPITALIZATION

– The TOTAL DOLLAR WORTH of stock outstanding

– Large-cap stocks

• 10+ billion (Ex: Microsoft, Time Warner)

– Midcap stocks

• 2-10 billion (Ex: Wendy’s, Starbucks)

– Small-cap stocks

• 300 million – 2 billion

– Microcap stocks

• 50 - 300 million

• Speculative stocks– New or erratic companies whose stock performance is uncertain

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How to Evaluate Stock Values

• Use of Fundamental Analysis to evaluate stocks:

– The idea: analyze financial statements to determine the value of a company’s stock

– The presumption: each stock has a true value based on its expected future earnings

– The goal: find stocks that are underpriced

• Use of Technical Analysis to evaluate stocks:

– The idea: use charts, graphs, software programs to identify the general direction in which a security or market is headed.

– The goal: to identify patterns (trends) that can suggest future activity (price movements)

When is the right time to buy or sell?Ideal situation: BUY LOW => SELL HIGH

The methods used to analyze securities and make investment decisions fall into two broad categories: fundamental analysis and technical analysis. Fundamental analysis involves analyzing

the characteristics of a company in order to estimate its value. Technical analysis takes a completely different approach; it doesn't care one bit about the "value" of a company. Technicians

(sometimes called chartists) are only interested in the price movements in the market.

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Using the Internet to Evaluate & Select Stocks

Your job is to interpret the info provided!

• Basic investment information, sites pg. 425

• Stock screening tools

– Sort through databases to find companies that meet your investment objectives based on given criteria

• Advisory services for more detailed research

– www.standardpoor.com

• Corporate news on company website

• Prospectus

• Stock research firms (often a paid subscription)

– Value Line, Morningstar

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• Stock market data – Reports on market indexes are reported around the clock

– Index = an indicator of market performance

– A sample reflecting the behavior of a more general market

Dow Jones Industrial Average

Standard & Poor’s 500 Index

• Securities exchanges– A place where brokers (who represent investors) meet to buy and sell

securities (NYSE, AMEX)

• Over-the-Counter (OTC) market– Buyers and sellers negotiate transactions via a computerized

telecommunications network (NASDAQ)

A committee selects the companies in the S&P 500 so they are representative of the

industries in the United States

economy

index of the market value of all stocks traded in the US. Currently, the index

contains over 6,307 components. The index is

used to measure the performance of most

publicly traded companies in the US

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% change in price (year-to-date) 52-week high / low price Name of company and ticker symbol Dividend Yield P/E ratio Number of shares traded that day Closing price Net change in price from previous day

You can use portfolio

tracking to monitor your investments

Reading stock quotes is easy!

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Buying and Selling Stocks

• Stockbroker

– A “middleman” licensed to buy and sell securities

• Discount Brokers

– Low commissions; fewer services

• Full-Service Brokerage Firms

– High commissions; many services

• Brokerage fees and commissions

– Can range from $25 to 3% of the transaction value

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How to Order Stock TransactionsStockbrokers execute buy/sell orders according to

prescribed instructions

Types of Stock Order “Instructions”

• Market order: Execute the order at the current market price

• Limit order: Execute the order at a specified price: offers protection, but may miss out on opportunities

• Stop order (stop-loss order)

• Execute a sell order if the stock price goes below a specified price; a form of protection (stops a loss)

• Execute a sell order if the stock climbs to a certain price (to protect, or lock-in, your profit

Time Limits: fill-or-kill, day order, week/month order, open order (GTC)

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Investing in BondsInvesting in Bonds

• Just as people need money, so do companies and governments!

• A company needs funds to expand into new markets; governments need money to fund infrastructure, social programs, etc.

• The problem: they typically need far more money than the average bank can provide.

• The solution: is to raise money by issuing bonds.• Thousands of investors then each lend a portion

of the capital needed.

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Corporate Bonds• A written promise to pay back a specific amount of money at a

certain date in the future.

• In the interim, bondholders receive interest payments at fixed rates on specified dates.

• Holders can sell bonds to someone else before they are due.

• Corporations benefit by issuing bonds because the interest rates they must pay investors are generally lower than rates for most other types of borrowing and because interest paid on bonds is considered to be a tax-deductible business expense.

• However, corporations must make interest payments even when they are not showing profits.

• If investors doubt a company's ability to meet its interest obligations, they either will refuse to buy its bonds or will demand a higher rate of interest to compensate them for their increased risk. For this reason, smaller corporations can seldom raise much capital by issuing bonds.

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Bond RatingsBond Ratings

• Investment-Grade Bonds

– Relatively low risk (less than 1% default rate)

– Receive regular interest income and face value at maturity

• Speculative Grade (or Junk) Bonds

– Issued by companies with poor or no credit rating

– High risk; high interest rate

– Carry a high default rate (8%-24%)

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Summary of Bond Ratings

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What is the risk in buying a corporate bond?

• Chance of DEFAULT• If you sell bond before maturity, price can change

If interest rates have RISEN, the price of your bond

If interest rates have FALLEN, the price of your bond

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Price Changes for Corporate BondsPrice Changes for Corporate BondsInterest rates and bond prices move in opposite directionsInterest rates and bond prices move in opposite directions

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

Treasury Securities: world’s safest investments!• Sold to obtain money to finance the national debt, and the

ongoing costs of governmentTreasury Bills (t-bills)– Matures in 1 year or less– Sold at a discount from face (par) value– Interest is exempt from state taxes

Treasury Notes & Bonds– Notes: 2 -10 year maturities and Bonds: 10+ year maturities– Fixed-interest-rate paid every six months – Higher rate than t-bill since lending rate is longer– Interest is exempt from state taxes

• Municipal Bonds (Muni’s)– Long-term debt issued by local governments– Use funds to build major projects (schools, airports, bridges)

Treasury Bills 0.135%

  Treasury Notes

1.962%

  Treasury Bonds

5.331%

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•Series EE Bonds As of 2005, EEs are fixed-rate bondsfixed-rate bonds For new bond purchases, rates are adjusted every six months (the rate on previously issued bonds always remains the same)

A good buy when interest rates are high and a bad deal when rates are low!

• Series I Bonds An inflation-indexed bondinflation-indexed bond: has a fixed-rate of return plus an inflation premium The inflation premium is adjusted every May and November … But the fixed rate assigned at purchase remains same The inflation premium ensures that you do not lose the purchasing power of your investment over time.

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US Savings BondsUS Savings Bonds

• Virtually risk-free: backed by the US Govt

• Payable only to the person to whom they are registered (you can't resell them although you can cash them in) NON-MARKETABLENON-MARKETABLE

• Can earn interest for up to 30 years

• Able to be redeemed after 1 year (min holding period

• If redeem before 5 years => 3-month interest penalty

• Interest-rates on bonds are fixed: coupon rate

• Interest is exempt from state taxes (and federal if used for education)