Download Investing in Stocks Chapter Sixteen

Investing in Stocks and Bonds
Objectives
 Describe stocks and bonds and how they
are used by corporations and investors.
 Define everyday terms in the language of
stock investing.
 Classify stock according to their basic
descriptive categories.
Objectives
 Describe the major characteristics of
bonds.
 Differentiate among the four general types
of bonds.
Objectives
 Describe what the investor should
consider before investing in bonds,
particularly the current yield and yield to
maturity.
 List the advantages and disadvantages of
investing in bonds.
Stocks and Bonds and How They are
Used
 Common stock
 Preferred stock
 Bonds
Investing in Stocks
 Why do corporations issue common
stock?
 To raise money to start or expand a
business
 To help pay for ongoing business
expenses
 They don’t have to repay the money
 Dividends are not mandatory
 Stockholders have voting rights
Why Do Investors Purchase Stock?
Income from dividends
Dollar appreciation
of stock value
Increased value from
stock splits
Common vs. Preferred Stock
 Common stock
 get dividends depending on profit the
company makes
 Preferred stock
 receive cash dividends before common
stock holders
 pre-determined dividend rate
 most preferred stock is callable
Calculating Total Return
100 shares of common stock purchased December 21,
2008, sold December 21, 2009; total dividedts of $2.60
per share for the investment period.
Cost when purchased:
100 Shares @ $71
$7,100
Commissions
+55
Total investment
$7,155
Transaction Summary:
Total Return
Minus Total Investment
Profit from Stock Sale
Plus Dividends
Total Return for the transaction
Return when sold:
100 shares @ $89
Commissions
Total Return
$8,830
7,155
$1,675
+260
$1,935
$8,900
- 70
$8,830
Features of Preferred Stock
 Cumulative preferred stock
 unpaid cash dividends accumulate and are
paid before cash dividends to common stock
holders
 Participation feature
 rare form of investment
 can share in earnings beyond stated dividend
amount
 Conversion feature
 can be traded for shares of common stock
How to Evaluate a Stock
 Read stock quotes in a newspaper, such as the
Wall Street Journal
 52 week high and low
 stock abbreviation and symbol
 dividends per share in the last 12 months
 percent yield
 price earnings ratio
 volume
 high and low for the day
 closing price and net change
Language of Stock Investing
 Earnings per share (EPS)
 Price/earnings ratio (P/E ratio)
 Dividend payout ratio
 Market price
 Book value
Language of Stock Investing
 Market-to-book ratio
 Par value
 Total return
Language of Stock Investing
 Preemptive rights
 Stock dividends
 Stock splits
 Voting rights
Classifications of Common Stock
 Income stocks
 Growth stocks
 Speculative stocks
 Other characterizations
Types of Stock Investments
 Blue chip stock
 low risk
 consistent dividends
 ex. AT&T, Kellogg's, General Electric
 Income stock
 higher than average dividends
 ex. utility stock
Types of Stock Investments
(continued)
 Growth stock  earns above average profits
 low or no dividends
 Profits reinvested in
company, so...
 Stock price
should go up
 ex. Microsoft or Intel
Types of Stock Investments
(continued)
 Cyclical stock
 follows business cycles of advance
and declines in the economy
 ex. new construction, cars, timber
 Defensive stock
 remains stable even if the economy is
declining
 ex. food and utility stocks
Numeric Measures to Consider
When Evaluating a Stock
 Look at book value of one share
 net worth of company divided by the
number of outstanding shares
 if a share costs more than the book value
the company may be overextended or it
may have a lot of money in research and
development
Numeric Measures to Consider
When Evaluating a Stock (continued)
 Look at the price earnings ratio
 also called the P-E
 price of one share of stock divided by the
earnings per share of stock over the last 12
months
 a low number means could be a good time to
buy it, however many technology stocks have
high P-Es
 Look at the beta for the stock
 stock with a beta >1.0 means more volatility
Long-Term and Short Term
Investment Strategies
Buy-and Hold Technique
Dollar Cost Averaging
Direct Investment and Dividend Reinvestment Plan (DRIP)
Long-Term and Short Term
Investment Strategies
Day Trading
Buying Stocks on Margin
Selling Short
Trading in options
Make a Decision to
Sell Stocks
 1. Stock reaches target price.
 2. Favorable development temporarily push up
price.
 3. Good profits unlikely to continue.
 4. Stock lags behind others in industry group.
 5. Company profits begin to fall short of
projections.
 6. Industry/company prospects are deteriorating.
 7. Losses are moderate.
 8. Stock’s price/earnings ratio appears too high.
Language of Bond Investing
 Corporate bond
 Face value
 Maturity date
 Bond indenture
 Debenture
 Mortgage bond
 Trustee
 Secured and unsecured
 Senior and subordinated
Language of Bond Investing
 Registered and bearer
 Callable
 Convertibility
 Bond Ladder
Types of Bonds
 Corporate bonds
 U.S. government securities
 Treasury bills, notes, and bonds
 Federal agency issues
 Municipal Bonds
Tax Equivalent Yield
Taxable equivalent yield = Tax exempt yield
1.0 – tax rate
The taxable equivalent yield on a 5% taxexempt municipal bond for a person in the 28%
tax bracket is 6.94%
.05
1.0-.28 = .0694 = 6.94%
Considerations Before Investing in
Bonds
 Susceptibility to certain risks
 Credit
 Callability
 Inflation
 Interest rate
Considerations Before Investing in
Bonds
 Premiums and discounts
 Current yield
 Yield to maturity
 Tax-equivalent yields
 When to sell
Approximate Market Value of a
Bond
Example: Shawn purchased a corporate bond that pays 4.5% interest based on
a face value of $1,000. Comparable new corporate bond issues are paying 7%.
How much is Shawn’s bond worth?
Formula:Dollar Amount of Annual Interest = Approximate Market
Interest Rate of Comparable Bonds
Value
A. Find the dollar amount of annual interest.
Face Value of Bond x Annual Interest Rate = Dollar Amount of Annual Interest
$1,000 x 4.5% = $45
B. Solve for approximate market value.
Dollar Amount of Annual Interest = Approximate Market
Interest Rate of Comparable Bonds
Value
$45 = $642.86
7%
Current Yield
Assume you own a $1,000 corporate bond that pays 7%
interest annually and matures on July 15, 2013. This
means you will receive $70.00 annually. Also assume the
market price is $940. The current yield is calculated:
Yield to Maturity
Corporate Bond Transaction
Assume that on March 15, 1998, you purchased a 9.2% corporate
bond. Your cost for the bond was $920 plus a $10 commission
charge. Also assume that you held the bonds until March 15, 2008,
when you sold them for the current value of $1,040.
Bond Ratings
Advantages of Investing in Bonds
 Pay higher interest rates than savings
 Offer safe return of principle
 Have less volatility than stocks
 Offer regular income
 Require smaller initial investment
Disadvantages of Investing in Bonds
 No hedge against inflation
 Can be quite volatile
 Compounding is almost impossible
 Subject to investors tax rate
 Poor marketability