Investing in Stocks and Bonds

Investing in Stocks & Bonds

Investment Risks

  • Business Risk: Firm may not maintain profitability.

  • Financial Risk: Ability to meet debt obligations.

  • Market Risk: Price volatility of a security.

  • Purchasing Power Risk: Impact of inflation.

  • Interest Rate Risk: Changes in interest rates affect investment value.

  • Liquidity Risk: Difficulty of converting assets to cash.

  • Event Risk: Unexpected events impact financial position.

Types of Return

  • Income: Dividends, interest, and rent.

  • Capital Gains: Realized gain upon sale of investment.

  • Compounding: Reinvestment of income at the same rate.

  • Risk-Return Tradeoff: Higher risk typically means higher potential returns.

What Makes a Good Investment?

  • Future return estimation requires:

    • Expected dividends

    • Expected appreciation rate

  • Expected Return Formula:

    • [ \text{Expected Return} = \frac{\text{Future Price of Investment} - \text{Current Price of Investment}}{\text{Number of Years in Investment Period}} + \frac{\text{Average Annual Current Income}}{\text{Current Price of Investment}} ]

Expected Return Example

  • Example scenario:

    • Current income from dividends: $2.15

    • Current stock price: $60

    • Future stock price: $95

    • Investment period: 3 years

  • Required Rate of Return: Minimum return required to offset risk.

Investing in Common Stock

  • Benefits of investing in common stock:

    • Price appreciation.

  • Historical Performance (1929 - 2019):

    • S&P 500 down 25 times (27%), up 73%.

Taxation of Common Stock Investments

  • Non-Qualified Dividends: Taxed as ordinary income (up to 37%).

  • Qualified Dividends & Long-Term Capital Gains: Taxed at 0%, 15%, 18.8%, or 23.8%.

  • Dividends determined by Board of Directors and often paid quarterly.

Performance Measures

  • Book Value: Assets - Liabilities - Preferred Stock.

  • Net Profit Margin: Profit / Sales.

  • Return on Equity (ROE): Income / Shareholder’s Equity.

  • Earnings per Share (EPS): [ \text{EPS} = \frac{\text{Net Profit After Taxes} - \text{Preferred Dividends Paid}}{\text{Number of Shares of Common Stock Outstanding}} ]

  • Price to Earnings Ratio (P/E): Indicator of investor confidence and expectations.

Beta

  • Measure of price volatility relative to the market:

    • Beta = 1: Volatility equals the market.

    • Beta < 1: Volatility less than the market.

    • Beta > 1: Volatility greater than the market.

Types of Common Stock

  • Blue-Chip Stocks: High quality, stable earnings.

  • Growth Stocks: High growth rate (15-20%).

  • Income Stocks: Focus on dividend stream.

  • Speculative Stocks: High volatility, often small companies.

  • Cyclical Stocks: Follow business cycle trends.

  • Defensive Stocks: Stable during economic downturns.

Types of Common Stock by Market Capitalization

  • Large Cap: More than $10 billion.

  • Mid-Cap: $2 billion to $10 billion.

  • Small-Cap: Less than $2 billion.

  • Micro-Cap: Typically below $250 million.

Why Invest in Common Stock?

  • Accumulate capital and provide a source of income.

  • Advantages:

    • Return potential (dividends and capital gains).

    • Liquidity.

    • No direct management required.

  • Disadvantages:

    • Risk and timing concerns.

Common Stock Investment Decision

  • Purchase if expected return > required rate of return.

  • Research 3-5 years performance history before buying.

  • Consider dollar cost averaging to manage investment risk.

Investing in Bonds

  • Reasons to Invest:

    • Provide current income and capital gains.

    • Preservation of capital and portfolio diversification.

Bond Issue Characteristics

  • Long-term debt instruments that typically pay interest semi-annually.

  • Types:

    • Senior (Secured) Bonds: Mortgages, equipment trust certificates.

    • Junior Bonds: Promise to pay - debentures.

  • Sinking Fund: Specifies annual repayment schedule.

The Bond Market

  • Types of Bonds:

    • Treasury Bonds: Risk-free, 20-30 year maturities.

    • Municipal Bonds: Interest exempt from federal income tax.

    • Corporate Bonds: Can have a sinking fund.

    • Zero Coupon Bonds: Sold at a deep discount.

Bond Pricing

  • Priced as a percent of par value;

    • Clean price = quoted price.

    • Dirty price = quoted price + accrued interest.

Current Yield and Yield to Maturity

  • Current Yield: Comparable to dividend yield on a stock.

  • Yield to Maturity: Annual rate of return if the bond is held to maturity.

    • [ \text{Annual Interest Income} = \frac{ ext{Current Yield}}{ ext{Market Price of Bond}} ]

    • If bond is purchased at face value, YTM = Coupon Rate.