Stock Market Investing

Wednesday, September 19th,2018

 Last week
• We learned there are only 3 financial investment types
– Cash, Stocks and Bonds
• We know what cash is
• Stocks represent part ownership of a business
– If the business does well, you will do well
– If the business doesn’t, you won’t either
• We will look at two common methods for comparing stocks
– Dividend Yield
– PE ratio
 Comparing Shares
• There are many different approaches to analysing and
comparing shares, for purposes of investing.
• Fundamental investing is based on analysing the actual
business of the company
• If you were buying a small business, what would you look at ?
– Profitability (Does the business make money)
– Growth prospects
– Competition
– Debt
– Value of the assets etc
 Comparing Shares
• A large business is evaluated the same way, it’s just bigger and
more complex
• Most individuals, including most Financial advisors, aren’t
qualified to analyse financial statements. They rely on
published reports from professional analysts and researchers
and the company itself.
• Instead of in depth analysis, there are a number of “standard”
measurements that are used. There are two very common
ones.
– Dividend Yield
– PE ratio
 Comparing Shares – Dividend yield
Formula is Annual dividend amount x 100 = Yield
What the share cost you
Eg You get $1.50 per share annual dividend
You paid $35 for each share

Your dividend yield is $1.50 x 100 = 4.28%

$35

This is identical to how you calculate the interest you get on a GIC

The Dividend Yield is a very commonly reported figure. Generally,

higher is better. Too high is a warning flag
Dividend Yield example
 Dividend Yield example
• Formula is
Annual dividend amount x 100
How much the share cost
$3.76 x 100 = 4.51%
$83.23
• The yield is reported using the current
dividend amount, and todays stock price
– This means that the yield changes as the
stock price changes
• . The yield you actually get will depend
on what the stock cost you originally
 Dividend yield example
• In the previous example, assume you had paid $70, instead
of $83.23 for the stock.
• The calculation would be
Dividend amount = $3.76 x 100 = 5.37%
The share cost you = $70
Your dividend yield would be 5.37%
Whenever the dividend amount, or the cost of the share
changes, the effective yield changes.
Dividend Yield example
 Dividend Yield example

• CIBC from March 12 • CIBC from April 2

• Dividend yield = 4.51% • Dividend yield = 4.66%

$3.76 x 100 = 4.51% $3.76 x 100 = 4.66%

$83.23 $80.55
 Price/Earnings ratio (PE)
• The most commonly used measurement
• Formula is
Cost of a share = PE ratio
Profit (Earnings) per share

(Profit (earnings) per share is simply the total profit divided by the
number of shares)
PE example
 Price/Earnings example (PE)
From the chart
Cost of a share $80.55 = 10.29 times
Earnings per share $7.83
• The profit per share comes from the
most recent quarterly financial
statements
• The lower the PE ratio, the better.
PE example RBC
 PE example RBC
Formula is Cost of a share
Earnings per share

From the chart $62.22 = 12.15 times

$5.12
CIBC vs RBC
 CIBC vs RBC
CIBC RBC
• Share price $80.55 • Share price $62.22
• Profit per share $7.83 • Profit per share $5.12
• PE ratio 10.29 • PE ratio 12.15
• Dividend amount $3.76 • Dividend amount $2.52
• Dividend Yield 4.66% • Dividend yield 4.05%

Based purely on PE and Dividend yield, CIBC scores higher

 CIBC vs RBC
• Why doesn’t everybody buy CIBC and sell RBC ?
• Nobody knows, but it could be
– Investors think that CIBC will get worse, or RBC will get better
– There may be tax implications
– Investors already own shares in both banks
– Investors don’t want to own any bank shares
– There could be negative public sentiment about RBC vs CIBC
– They don’t believe the numbers
• The market is generally forward looking, not backward
• We will cover additional assessment methods later
 Comparing shares - summary
• PE and dividend yield are two (out of many) mechanisms
for comparing shares to each other
• They are based on accounting information which can be 3
or 4 months old.
• While broadly reported, they are not very sophisticated or
precise. They should not be used as the sole means of
selecting shares. They simply give a flavour of the kind of
analysis that can be done
• We will look at more detailed analysis later in the course
Bonds (Fixed Income)
 Bonds (Fixed Income)
• Bonds are simply a loan. When you buy a bond, you are lending
money to somebody. A bond is an IOU.
• Unlike shares, bonds do not represent ownership of the
organisation you are lending the money to.
• The return from a bond is interest paid by the borrowing
organisation.
• The simplest form of bond is a GIC or Term Deposit.
– You “loan” the bank $1,000, and it pays you interest
– At some future point (the maturity date), you get the $1,000 back
– You can’t sell these types of bonds to anybody else.
 Bonds (Fixed Income)
• You can buy bonds (lend money to) from many organisations,
domestic and international
– Federal/provincial governments
– Business Corporations
– Utilities
• They all pay interest, and promise to give your original money
back at maturity. This promise is only as good as the
organisation that makes it.
– A Canada government bond has zero repayment risk
– A Greek government bond has huge repayment risk
– A Corporate Bond has varying levels of repayment risk.
 Bonds (Fixed income)
• The riskier a bond is, the higher the interest rate it pays. In
Canada, Federal Government bonds are the least risky,
and pay the lowest interest.
– Federal 5 year bonds 2.32% 10 year bonds 2.54%
– Provincial 5 year bonds 2.46%
– 5 year Corporate bonds 2.5% - ???
• These are example rates. Rates change daily
• The longer the term, generally the higher the interest rate
• These types of bond can either be held to maturity, or sold
to someone else, like a stock.
• If sold before maturity, there may be a capital gain or loss
from the original purchase price.
– There is a huge bond market, much bigger than the stock market
 Bonds (Fixed income)
• A bond is an IOU that obligates the issuer of the bond to
pay the holder of the bond:
– A fixed sum of money (called the principal, par value, or face
value) at the bond’s maturity date, and usually
– Fixed periodic interest payments (called coupons) during the life
of the bond – usually semi annually
• Some bonds have a feature that allow the issuer to repay
the principal on a specified date prior to the maturity date.
This is known as the call date.
 Bond components
• The components of any bond are
– The Face Value
– The Coupon Rate
– The Maturity date
• Any special features such as call date/call premium
• From these basic features a number of elements are
calculated
– The current yield
– The Yield to maturity/call
– The current price of the bond
– The duration (not the same as maturity date)
• We will look at each of these
 Bond issuance
• Bonds are initially issued in very large amounts.
– A typical bond issue might be for $100 million +
– The original issue has a par value ($100 million), maturity date
and a coupon rate.
• These bonds are marketed by dealers (Banks, investment
companies etc), who make an agreement with the issuer up front
• The bond is then broken up and sold to individuals in small
amounts.
• The smaller pieces have the same maturity date and coupon rate.
– The par value will be whatever size amount you buy
• You can hold the bond to maturity, or you can sell it again
 Bonds (Fixed income)
• The coupon rate is the original interest rate when the bond was
first issued.
• The par value is the amount of principal to be repaid to the
bondholder on maturity. The coupon amount and par value
never changes.
• Two basic yield measures for a bond are its coupon rate and its
current yield.
• The current yield will change, based on the bond price (which
may be different than the original par value)

Annual coupon Annual coupon

Coupon rate  Current yield 
Par value Bond price
 Bonds (Fixed income)
• Suppose a bond with a par value of $1,000 pays a
semiannual coupon of $45 and is currently priced at $960.
• What is the coupon rate? What is the current yield?
Annual coupon Annual coupon
Coupon rate  Current yield 
Par value Bond price

Coupon Rate = $45 x 2 = 9%

$1,000 The yield
Current Yield = $45 x 2 = 9.375% changes based
$960 on the price paid
 Bond market/pricing
• Like the stock market, there is a bond market where you can
buy and sell bonds
• The bond market is huge – much bigger than the stock market,
but not as transparent
• Unlike stocks, bond prices are mostly based on math, not
simply demand and supply
• If you hold a bond to maturity, you do not have to worry about
the price of the bond fluctuating. You will receive the par value
on maturity
• If you buy or sell a bond before maturity, the price you
pay/receive may be significantly different than the par value
 Bond Price
• The price of a bond is calculated by adding together the present
value of the bond’s stream of coupon payments and the present
value of the bond’s face value.
• What is present value ?
• If I owed you $100, would you rather receive the $100 now, or in 1
years time ?
• Why now ?
• Assume interest rates are 10%.
• With interest rates at 10%, if you had the $100 now you could
invest it and make $10 interest, so that in 1 year you would have
$110.
• Money now is more valuable than money in the future
 Bond Price
• Assuming interest rates are 10%, Which would you rather have,
$90.91 now or $100 in 1 year ?
• They are identical, so it doesn’t matter financially whether you
have $90.91 now, or $100 in 1 year. $90.91 invested at 10% for 1
year will give you $100 at the end.
• If interest rates were only 5%, you would need $95.24 now to give
you $100 in 1 year.
• $90.91 and $95.24 are known as the present value of $100 in 1
year at interest rates of 10% and 5%
• This is exactly how bond prices are calculated
 Bond Price
• The price of a bond is calculated by adding together the
present value of the bond’s stream of coupon payments and
the present value of the bond’s face value.
– The math involved is complex, but there are many simple online
calculators that can do this.
$50 interest
$1,000 1 year
$1,000 principle

• This represents a bond with a par value of $1,000, a 5% interest

rate (coupon), and 1 year left to maturity.
• Assuming current rates are 5% for 1 year bonds, what is the
current price of the bond ?
 Bond Price Formula
• The formula for calculating the price of a bond is

PV of Coupons PV of Face value

• Where C = Coupon Amount, r is current interest rate,
t = Maturity in years, and F = Face Value
• From the example, the coupon is $50, the current interest rate is 5%,
and the Face value is 1,000
• Doing the math, the bond price is 1,000 and is trading at par value
 Bond price
• If current interest rates change, using the same bond as an
example
1 year $50 interest
$1,000 $1,000 principle

• This represents a bond you own, with a face value of $1,000, a

5% interest rate, and 1 year left to maturity
• If new 1 year bonds are now paying 10%, could you sell this
bond to someone for $1,000 ?
 Bond price
• No. Nobody will pay $1,000 for an existing 1 year bond
paying 5%, when they can buy a new bond that is paying
10%
• Therefore, they will pay less than $1,000. The exact amount
less is based on a calculation that will end up giving them a
10% return – as if they had bought a new bond. They want
10%
• Instead of paying $1,000, they will only pay $954.54
• How was $954.54 arrived at ?
 Bond Price
• The formula for calculating the price of a bond is

• From the example, the coupon is $50, the current interest

rate is 10% and the Face value is 1,000
 Solving equation manually
1
1 − 1.10 1000
= 50 𝑥 +
.10 1.10
.091
= 50 𝑥 + 909.09
.10

= 45.5 + 909.09

= 954.54

However, you don’t need to do this calculation manually

Bond price using calculator
 Bond price using calculator

https://www.easycalculation.com/finance/bond-price-calculator.php
 Bond price
• Price of the 5% bond if current interest rates are now 10%
$954.54 1 year $50 interest
$1,000 principle

• If you wanted to sell this bond, you would only get $954.54
• The bond is selling at a discount to par
• This illustrates how bond prices are affected by current
interest rates
 Bond price
• Suppose current interest rates on bonds are now only 2%,
and you own this 5% bond
$1,000 1 year

$50 interest
$1,000 principle

• Would you sell this bond for $1,000 ?

• No. You know that new bonds are only paying 2%. This
bond is worth more than that. You could sell this bond for
$1,029.64
 Bond price
• Using the formula for calculating the price of a bond

• From the example, the coupon is $50, the current interest rate
is 2% and the Face value is 1,000
• Doing the math, the bond price is $1,029.41 and is trading at a
premium to par value
Bond price using calculator
 Bond prices
• The bonds shown so far are simple bonds, with 1 year left to
go, and 1 annual coupon payment
• Most bonds you will buy usually have more than 1 year left to
go, and coupon payments are semi annual
• The price calculation uses the same approach. The present
value of each coupon payment is summed, and added to the
present value of the par value to give the price.
• Lets assume you have a $1,000 face value bond, with 3 years to
go, a coupon rate of 5% paid semi annually, and current interest
rates of 10%
• You could still do the calculation by hand, but ….
 Bond prices using calculator
Face value $1000
Coupon rate of 5%,
paid semi annually
Todays interest rate
of 10%
3 years to maturity
 Bond prices
• The calculations have shown the correct value of the bond
• The price you pay to actually buy the bond from a broker will be
higher
• The difference is mostly the commission that the broker charges
• There is not much transparency or disclosure on commissions, but
you can calculate the correct price using the calculator, and find out
the commission that way.
• You may get different commissions from different brokers
• You can also only buy the bonds that the broker has in inventory
 Bond price
• When buying and selling a bond, you likely will pay a premium or a
discount to par value, unless interest rates haven’t changed
• The size of the premium or discount is based on whether current interest
rates are less than or greater than the interest rate attached to the bond
when it was originally issued
– If current interest rates are higher the bond will sell at a discount to
par
– If current interest rates are lower, the bond will sell at a premium.
• Par value is the amount that is paid back at maturity
– If you paid a premium to par you will have a loss at maturity
– If you paid a discount to par, you will have a gain at maturity
• This affects your total yield from owning the bond
 Bond Prices
• The Yield to maturity (YTM) of a bond is the yield that
takes into account the value of all remaining future cash
flows of the bond, including the face value return
• It is essential that the YTM is used when evaluating
bonds, not the current yield. The current yield does not
take into account the return of the face value amount.
 Bond Prices current yield vs YTM
• Consider a bond with a par value of $1,000, an annual coupon of $90, 1 year left
to maturity, and currently priced at $1,050.
• According to the formula, the current yield would be $90 = 8.57%
$1,050
• However, in 1 years time, you will get $1,000 back, not $1,050. You paid out
$1,050, and received $90 in coupon, and $1,000 in face value. The $50 loss on the
face value must be deducted from the $90 in coupon.
• The actual yield you received is
$40 = 3.81%
$1,050
• This is the Yield to Maturity, and is the figure that matters. This is the single most
important Bond concept
 Yield to maturity calculation
• Uses same formula for calculating price, solving for r instead
• Can be done manually, but on line calculator makes it simple

Par value $1000

Coupon rate of 9%,
paid annually
1 year left to maturity
Current price $1,050

http://www.investinganswers.com/calculators/yield/yield-maturity-ytm-calculator-2081
 Bond yield if callable
• Some bonds are callable. This means that the issuer can redeem – at
their option - the bond at par value, prior to the maturity date
• The call date is specified as part of the bond features
• If interest rates have fallen since the bond was originally issued, and the
bond is callable, it will almost certainly be redeemed by the issuer
• For example, assume a bond was issued in 2010, at an interest rate of
5%, maturity date of 2020, and a call date of 2017. Assume todays
interest rates are 2%. The issuer will redeem the bond in 2017, and issue
a new one at 2%
• For a callable bond you must use the Yield to Call calculation, instead of
the Yield to Maturity
 Yield to call calculation – first the price
• $1,000 face value
• Coupon rate of 5%
• Matures in 5 years
• Current interest rate 2%
• Callable in 2 years
• Price is $1141.40
 Yield to call calculation
• $1,000 face value
• Coupon rate of 5%
• Matures in 5 years
• Current interest rate 2%
• Callable in 2 years
• Price is $1141.40
 Same bond – tale of 3 yields
Current yield Yield to maturity Yield to call

$50 x 100
$1141.40

= 4%
 Bond duration
• Duration is a complicated concept. It is defined as the average
weighted time when the investor will get back the amount he paid for
the bond, and is expressed in years
• It is the duration that governs the impact of interest rates on Bond
prices, not the maturity date
• The rule of thumb is that for every 1% change in interest rates, the
value of the bond changes by its duration eg a 25 year duration
bond would change by 25%, a 4 year duration bond by 4%
• Short duration means you get your cash back sooner, and we know
with Present Value analysis cash now is more valuable than cash in
the future
 Bond duration
Duration of a normal bond with
coupon payments is always less
than the maturity period
The formula to calculate duration
is extremely complex, and is
affected by the size of the coupon
rate, the YTM and the term of the
bond.
It is usually quoted.
There are also online calculators
that will do it
 Bond duration formula
n = number of cash flows
t = time to maturity
C = cash flow
i = required yield
M = maturity (par) value

Fortunately, there are calculators on line

 Bond duration calculator

http://www.investopedia.com/calculator/bonddurcdate.aspx
 Other types of Bonds
• Most bonds are regular bonds, with interest coupons and face
value return at maturity.
• There is another type of bond called a strip bond, (sometimes a
zero coupon bond), that pays no interest during the term. It
only pays the face value at maturity.
• The yield (return) on this bond is based on buying the bond at a
discount.
• The same formula (or calculator) is used to calculate the price,
simply leaving out the coupon calculation component.
• These bonds are affected the most by interest rate swings
 Strip Bond duration
• Because there are no coupon payments, the duration of a
strip bond is the same as the maturity
 Bonds – Credit Quality
• Bond prices are also very affected by the credit quality of the
issuing organisation
• Credit Quality is assessed by various rating agencies, such as
Standard & Poors eg.
– AAA and AA: High credit-quality investment grade
AA and BBB: Medium credit-quality investment grade
BB, B, CCC, CC, C: Low credit-quality (non-investment grade), or "junk
bonds"
D: Bonds in default for non-payment of principal and/or interest
• Generally, all bonds with the same credit rating will have the
same credit premium
 Buying and selling Bonds
• There is no need to understand the math. When you buy or sell
a bond from a broker, the price quoted reflects the calculation.
– If current interest rates are higher, the bond will sell at a discount
– If current interest rates are lower, the bond will sell at a premium
• Key points to understand if interest rates change
– The bigger the change in interest rates, the more the value of your
bond is affected, up or down
– The longer the duration of the bond, the more the value of your bond
is affected, up or down
• The changes in value can be very significant
• This only matters if you sell the bond before it matures
 Bonds - summary
• Bonds are simply a loan, with interest payments
• If held to maturity, the principle is returned (assuming the
issuer is not bankrupt)
• Many bonds can be sold prior to maturity, resulting in possible
capital gains or losses
• The major factors affecting the price of a bond are.
– Current Interest rates
– Credit quality of the issuer (borrower)
• The longer the term, the higher the interest rate you get, and
the more the value is affected by interest rate fluctuations
• The lower the quality, the higher the risk and return
 Bonds Conclusions
• Interest rates are at an all time low. They can not go much
lower, only higher
• When interest rates start to rise (and they have started to),
bond prices will fall, possibly significantly
• Long term bonds (over 5 years) will suffer the most.
• The optimum way to invest in bonds is by using a ladder.
• Failing that, bonds of duration less than 3 – 5 years will
offer the most protection.
 Bonds Conclusions
Canada 3 -5 year bond yields Canada 3-5 year bond prices
 Bond Ladder
• Tried and tested way of owning bonds,
but requires a larger investment
• Buy bonds (or GICs) with equal $
amounts, but a staggered maturity date
– Eg maturing in 1 year, 2 years, 3 years
etc, up to 5 or 7 years
• As each bond matures and returns the
principle, buy another bond at the far
end of the ladder
• This strategy is highly effective when
interest rates are rising.
• As each bond matures annually, it is
reinvested at the current higher rate
 Comparative returns
Compounded Annual Average Real Return on Investment through June 22, 2011

Corporate
Since Stocks T-Bills Gold
Bonds
1926 6.8% 2.9% 0.5% 1.8%
1940 6.7% 1.9% 0.0% 1.1%
1960 5.6% 3.4% 1.0% 2.9%
1980 7.8% 6.1% 1.6% -0.2%
1990 6.2% 5.5% 0.6% 2.4%
2000 0.2% 5.6% -0.4% 9.1%
2003 5.6% 4.2% -0.6% 10.9%
2008 2.1% 6.3% -1.5% 6.4%
2009 13.7% 5.8% -1.2% 7.0%
2010 11.2% 7.4% -1.2% 3.1%
2011 10.3% 6.1% -0.5% -5.6%