CHAPTER 12:

INVESTING IN
STOCKS AND BONDS
 12-2

RISKS of Investing!
Business
Financial
Market
Purchasing Power
Interest Rate
Liquidity
Event
 12-3

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
 12-4

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.
 12-5

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.
 12-6

After 20 years you receive:

$3,000
$2,600 total
$2,000
Interest= $1,600
$1,000
Original $1,000
investment capital
0 5 10 15 20

Years
 12-7

Use your calculator to calculate

your compounded annual return:
Set on 1 P/YR
and END mode:

1000+/- PV
2600 FV
20 N
I/YR 4.9%
 12-8

Scenario 2: Reinvest the income

Use your calculator to find what you
would end up with if you indeed earned
an 8% compounded annual return:

1000+/- PV
8 I/YR
20 N
FV $4,661
 12-9
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
 12-10

The Risk-Return Trade-Off:

A Fundamental Investing
Concept
If you want
GREATER RETURN,
you will most likely have to accept
GREATER RISK!
 12-11
The Risk-Return Relationship:
Commodities and Precious
Financial Futures Metals

R Options
Real Estate
e
Common Stock
t
u
Bonds
r
n 3-yr Treasury Notes
U.S. Treasury Bills

Risk
 12-12

What makes a good investment?

 Know your desired level of risk.
 Consider potential investments.
 Compare their returns with those of
like investment types.
 Do the returns on the investments you
are considering meet or exceed the
returns expected for this type of
investment?
 12-13

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.
 12-14

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.
 12-15
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 not taxed until realized.
 12-16

Dividends
– Usually paid quarterly.
– Can be paid even when company
shows a loss.
– Paid either in cash or in additional
shares of stock.
 12-17

– Cash dividends are most common

and most desirable.
– Stock dividends are paid in new
shares given to current
shareholders. Does not represent
an increase of ownership because
all stockholders receive same
percentage.
 12-18
Assessing Dividends:
– Dividend Yield measures dividends
received relative to market price of
stock.
– Compare stocks based on dividend
yield rather than dollars received if
you are investing for current income.

Dividend Yield =
Annual dividends per share
Market price per share
 12-19

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.
 12-20
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.
 12-21

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.
 12-22

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
 12-23

Price/Earnings Ratio — shows

amount investors are willing to
pay for $1 of earnings.
– High P/E ratio may indicate a
stock is overpriced!
P/E =
Market price of the stock
Annual earnings per share
 12-24

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.
 12-25

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.
 12-26
 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.
Tech — issued by companies in the
technology sector.
– Most are either growth or speculative
stocks.
– Some are blue-chip stocks.
 12-27
 Income — issued by companies which
have a fairly stable stream of earnings.
– Pay relatively high dividends.
– 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.
 12-28
 Cyclical — issued by companies whose
stock prices move in same direction as
the business cycle.
– Most are found in basic industries.
– Always have a positive beta.
 Defensive — issued by companies
whose stock prices usually remain
stable during economic downturns.
– Companies usually provide basic
needs, such as consumer goods.
– Betas are usually low or even negative.
 12-29
 Mid-Cap — issued by companies with
market capitalization of $1–5 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 $1 billion or
less.
– Offer possibility of high returns.
– Prices can be very volatile due to high
risk exposure.
 12-30
 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.
 12-31

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.
 12-32
 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).
 12-33
Bond Issue Characteristics:
 Collateral
– Senior or Secured Bonds are backed
by a legal claim on specific property
which could be liquidated and used
to pay the bondholders if the issuer
defaults.
– Junior or Unsecured Bonds are
backed only by the promise of the
issuer. Debentures are a form of
unsecured debt.
 12-34

 Sinking Fund
– Some bond provisions stipulate a
repayment schedule detailing how
the issuer is to set aside money to
repay the principal.
 Call Feature
– Bond provisions must state if the
bond can be called prior to maturity,
and if so, under what conditions.
 12-35

Types of Bonds

Treasury Securities
Agency Bonds
Municipal Bonds
Corporate Bonds
Zero Coupon Bonds
Convertible Bonds
 12-36

Bond Ratings
 A letter grade is assigned to new bond
issues to designate investment quality.
 The lower the rating, the greater the
risk of default and the higher the
coupon rate which must be offered.
 Outstanding bonds are also reviewed
regularly to ensure that their ratings
are still valid.
 12-37
Bond Ratings:
Moody’s S&Ps Description
Investment Grade

Aaa AAA Highest rating

AaA AA High-grade
A A
Baa BBB Medium-grade—lowest of the
investment grade bonds
Ba BB Junk bonds—highly
Below Investment Grade

B B speculative
Caa CCC Poor-quality—in default or
Ca CC very close to it
C C
D
 12-38

Reading a Bond Quote:

XYZ Corp. 7½15 Close 101
 XYZ Corporation is the bond issuer.
 7½% is the coupon or annual
interest rate paid on this bond.
 The amount of annual interest is
7½% of the par value, or
.075 x $1000 = $75
 12-39

 The bondholder should receive half

of the interest every 6 months, or

$75  2 = $37.50
 This bond matures in 2015, so the
last payment to the bondholder
should consist of the last interest
payment plus the principal amount,
or
$37.50 + $1000 = $1,037.50
 12-40

Reading a Bond Quote (con't):

XYZ Corp. 7½15 Close 101

 Bond prices are not quoted in

dollars but as a percent of par.
 This bond's closing price (or last
price) was 101% of par, or
1.01 x $1000 = $1,010
 12-41

Bond Prices
 The price of a bond is a function of its
coupon, length of maturity, and the
movement of market interest rates.
Remember:
INTEREST RATES AND BOND PRICES
MOVE IN OPPOSITE DIRECTIONS!!!
 12-42

Example:

You bought a 1-year, $1000

bond at 8%. How does a
change in the interest rates
affect your bond?
 12-43
Scenario A:
Interest rates RISE and comparable
new bonds are now issued at 9%.
If you wish to sell your bond, no
one would pay $1000 for your 8%
bond because it pays less
interest than the new 9% bond.
You must decrease the price of
your bond (sell it at a discount) in
order to attract a buyer.
 12-44
Scenario B:
Interest rates FALL and comparable
new bonds are now issued at 7%.
If you wish to sell, your 8% bond
is now very attractive because it
pays higher interest than new 7%
bonds.
You would be able to increase the
price of your bond (sell it at a
premium).
 12-45

Bond Yields
The yield on a bond is the rate of
return you would earn if you held
the bond for a stated period of
time.
The two most commonly cited
bond yields are current yield and
yield to maturity.
 12-46
Current Yield:
– Amount of annual interest income
relative to the current market price of
the bond.
– All else being equal, the higher the
current yield, the more attractive the
bond.
– Essentially the same calculation as
the dividend yield on stocks.
 12-47

Yield to Maturity (YTM):

–Annual rate of return if bond is
held until maturity.
–Measures both annual interest
income and recovery of
principal.
 12-48

–If bond is purchased at face

value, YTM = coupon rate.
–If bond purchased at a discount,
YTM > coupon rate.
–If bond purchased at a premium,
YTM < coupon rate.
THE END!