Ch. 14 Investments (Study Guide)

Unique Characteristics of Bonds

1. Coupon Rate 2. Serial or Sinking Fund 3. Secured or Unsecured 4. Registered and Issued 5. Book Entry 6. Callable See Table 14-5 pg 445 (attached)

4 Decisions for Bond Investors

1. Decide on Credit Quality: T-bills, Govt bonds, Muni Bonds, Corp Bonds, above and below grade bonds 2. Decide on Maturity: balance with your investment needs 3. Determine after tax return 4. Select highest yield to Maturity (YTM)

Five Steps: A. Use Beta to estimate risk of the investment

- Can do for all types of investments - Betas available online ex: Beta of stock = 1.5, if all stocks rise 20% over time, price of your stock rises 30% over time (1.5 beta x 20%). If all stocks drops 10% over time, price of your stock might drop 15% (1.5 beta x 10%)

Tax Consequences of Investing in Stocks and Bonds

1. Dividends: must pay income tax; due in year you got the dividend, max tax=15% or 0% for low income. 2. Capital Gains/Losses: low taxes; don't pay on gains until security is sold; gain is based on: (purchase price+commissions+fees) - (sales price+commissions+fees). Short Term Gains: held less than 1 yr; regular income tax rate Long Term Gains: Held < 1 yr.; 0% if in 10-15% marginal tax bracket 15% if in 25, 28, 33, 35% tax bracket 20% if in 39.6% tax bracket. Capital losses can offset capital gains.

Securities Market Indexes

1. Dow Jones 2. S&P 500 3. NASDAQ Good indicators of market performance and changes in market conditions.

Places to go to get information about a Company?

1. EDGAR database (sec.gov) 2. Morningstar (morningstar.com) 3. Bloomberg (bloomberg.com) 4. Annual Reports 5. Prospectus's 6. 10Q report (SEC filing report)

How to evaluate Common Stocks?

1. Evaluate. Stock Price 2. Calculate Stock's potential rate of return Characteristics of Stocks See table 14-1, pg. 424 (attached)

Buying and Selling Stocks

1. Open a brokerage account (etrade); a. 3 types: general, discount, online discount b. Broker commissions and fees c. Check broker background (finra.org), 7% of brokers have misconduct charges.

Regulations to protect against investment fraud

1. SEC 2. FINRA (Financial Industry Regulatory Authority) 3. Brokerage Firms 4. SIPC - Security Investors Protection Corporation 5. FSOC - Financial Services Oversight Council

How To Evaluate Stocks

1. Use Beta to compare a stock to similar investments. 2. Use Fundamental Analysis 3. Use Technical Analysis 4. Use Corporate Earnings

FIVE STEPs of Calculating Stocks Potential Rate of Return

1. Use Beta to estimate risk of the investment 2. Estimate market risk 3. Calculate your required rate of return 4. Calculate the Stock's potential return 5. Compare "required" rate of return with "potential" rate of return on investment

How to Order Stock Transactions

2 types: BUY and SELL It's called executing an order

Value Stock

A stock that tends to trade at a lower price relative to it's fundamentals (dividends, earnings, sales, etc.) and thus considered undervalued by a value investor.

NASDAQ

American market for OTC securities Measure of companies not so popular, lots of tech companies like Cisco, Intel, Microsoft. Dow Jones Wilshire 5000 Index: All stocks traded in US Russell 200 Index: small cap index Exchanges in London, Sydney, Tokyo, Toronto, Frankfurt, Mumbai, Hong Kong, Shanghai, etc.

Discount Brokers

Charge commissions to execute trades that are often 30 to 80 percent less than the fees charged by full-service brokers, but also offer fewer services. ex: Fidelity, TD Ameritrade, Charles Schwab, Vanbguard

Yields on Bonds

AAA = 1/2 to 1% AA = 1.5% A = 3% BBB = 10% See Table 14-6, pg 446 (attached)

Why do Bonds and Interest Rates have Inverse Relationship?

All else being equal, if new bonds are issued with a higher interest rate than those currently on the market, the price of existing bonds will decline as demand for those bonds falls. If Interest Rates UP, Bond prices DOWN

speculative grade bonds

Long-term, high-risk, high-interest-rate corporate (or municipal) IOUs issued by companies (or municipalities) with poor or no credit ratings. Also called junk bonds or high-yield bonds.

Standard & Poor's 500 (S&P 500)

An index based on the stock prices of 500 of the largest firms by market value. 400 industrial firms, 40. financial institution, 40 public utilities, 20 transportaiton companies. Companies with highest market v alues greatly influence index.

Technical Analysis for Stock Analysis

Analyzes stats through study of past market data, primarily price and volume. Does not measure intrinsic value Uses charts, graphs, math and software to identify and predict future price movements. NOT THAT VALUABLE a tool.

Projected P/E ratio (forward price/earnings ratio)

Because investors need to look to the future rather than the past, this measure divides price by projected earnings over the coming four quarters. Also known as forward price/earnings ratio. Formula: STOCK PRICE / PROJECT EARNINGS FOR FUTRE 4 QUARTERS Earnings Yield: Inverse ratio. Helps investors think about expectations.

Beta Analysis for stock analysis

Beta is a Number widely used by investors to predict future stock prices Average for all stocks in market is BETA of +1.0, moves in concert with S&P 500. If beta is > 1.0, stock is more volatile ex: Assumed risk for stocks in 8% over time; when overall stock market increases by 8% a stock with a beta=1.0 is likely to increase the same amount. If stock beta=1.2, the stock will move 20% more up or down in value than the S&P index. Most stocks have positive between 0.5 - 2.0 If beta is (0.0-0.9), the stock price is "less" sensitive to the market. If beta is (+1.0-+2.0 or higher), means greater risk and price is "more" sensitive to the market. If Beta=0, it;s independent of market, like a risk free US treasury security.

Registered Bond

Bondholder's name is recorded so that checks or electronic funds transfers for payment of interest and principal can be safely forwarded when due

Buying Long

Buying a security (especially on margin) with the hope that the stock price will rise.

Margin buying

Buying stock on credit Margin buy/selling is risky; it can increase returns. Margin rate (currently 50%) is set by FED. 50% of each dollar invested must be investor's. Rest can be borrowed.

Dividend Yield

Cash dividend paid to an investor as a % of current market price of a security. RATIO: $25 current market price, $.40 Dividend Price Share (.40/25=1.6%)

Bonds

Certificates of debt that carry a promise to buy back the bonds at a higher price. It's an IOU. Typically used to finance large, expensive construction projects, buy expensive equipment, etc. Issued by companies, US govt or municipalities (county, city, state). Ex: Paw Cat Food Company (pg. 422)

Add-up Projected Income and Projected Appreciation

Called Approximate Compound Yield; annualized compound growth of any long term investment stated as a percentage. Tells you whether one stock or the other is good. Ratio: (SEE ATTACHED), Equation 14.2, pg 430

Corporate v. US Govt v. Muni Bonds?

Corp Bonds: A corporate bond is a debt instrument issued by a company to raise capital; corporate bond interest is always taxed. Higher risk and higher return. US Govt Bonds: Tbills, reasury bonds to provide funds to operate the federal government and to cover the federal debt; federal taxes but no state/local. Most secure - no risk of default as secured by US government. Muni Bonds: a municipal bond is a bond issued by a city, town, or state to raise money for public projects; interest carries certain tax exemptions - federal taxes, but no state/local or only some. Medium risk of default and medium returns.

How Do public corporations use stocks and bonds?

Corporations issue bonds and stocks to raise operating capital and to fund financial transactions. There are advantages to issuing bonds over stocks. The main one being that you're not diluting the ownership of the company with bonds. The difference between stocks and bonds is that stocks are shares in the ownership of a business, while bonds are a form of debt that the issuing entity promises to repay at some point in the future. This means that stocks are a riskier investment than bonds.

investment grade bonds

offer investors a reasonable certainty of regularly receiving periodic income (interest) and retrieving the amount originally invested (principal)

Secured Bond

pledges specific assets as collateral in indenture or has the principal and interest guaranteed by another corporation or government agency

5 STEPS: #4: Calculate Stock's Potential

Determined by adding anticipated income (dividends, interest, rents, other sources) to the future value of an investment then subtracting investment's original cost. (Anticipated Income + Future Value of Investment) - Original Investment

Dividend Payout Ratio

Dividends per share / Earnings per share Helps judge future likelihood of future dividends.

5 Steps: #5: Compare Required Rate of Return with Potential Rate of Return

EX: Required ROR=12.5%, Potential ROR=15.7%. At stocks selling price, it's a good buy.

current yield

Equals the bond's fixed annual interest payment divided by its bond price Equation: current annual income / current market price Can find these available online

Distinguish between investment and speculative grade bonds?

Investment Grade Bonds: Lower risk, higher credit rating, lower return but more stable over the long run; (BAA1 thru BBB-) Speculate Grade Bonds: Higher risk, lower credit rating, higher return but less stable over long run (BA1 - BB-)

Treasuries

securities issued by the U.S. government, including notes, bills and bonds

Where to lookup a stock price?

Google, Yahoo!Finance, MSN Money, Reuter's, MarketWatch 1. YTD% Change 2. 52 Week High and Low 3. Stock and Symbol 4. Dividend 5. YLD% - yield as a % of income; calculated by estimated dividend / current stock price 6. PE Ratio 7. Vol 100s - total trading activity 8. Last - price of last trade of the day 9. Net Change (difference between closing price today and yesterday as %)

Evaluating Bond Prices and Returns

Interest Rates Premiums Discounts Current Yield Yield to Maturity Price also varies due to fluctuations in market interest rates. Economy, supply and demand for credit affect market interest rates. These are current ST/LT interest rates paid on corporate and government debts (bonds).

Role of Stocks and Bonds in Investments

Investors by buying stocks, bonds, etc. provide $$ companies or govt needs to create sales and earn profits or do public projects (Think about school bonds). Companies are selling shares of ownership in their business. Start with start-up capital, may get other loans, if they go public (IPO) may issues securities (common stock, preferred stock) or bonds.

Difference between I-bonds and TIPS bonds?

Like I-Bonds, Treasury Inflation-Protected Securities include an element of inflation protection. An important distinction, however, is that TIPS' principal values are adjusted to incorporate the current inflation rate, whereas I-Bonds receive an adjustment in their interest rates to reflect inflation.

Municipal Government Bonds (munis)

Long-term debts (bonds) issued by local governments (cities, states, and various districts and political subdivisions) and their agencies.

zero coupon bond

Municipal, corporate, and Treasure bonds that are issued at a sharp discount from face value and pay no annual interest but are redeemed at full face value upon maturity.

5 STEPS: #2 Estimate Market Risk

Need to QUANTIFY market risk 8% is a realistic estimate of market risk for US stocks. It's high in turbulent times.

Book Value

Net worth of a company; also called shareholders equity. TOTAL ASSETS - TOTAL LIABILITIES Stock price usually exceeds book value because investors anticipate earnings and dividends IN THE FUTURE. If book value is GREATER than share price, stock may be "undervalued"

Earnings Per Share (EPS)

PROFIT / # OUTSTANDING SHARES Income company has available on a per share basis to pay dividends and reinvest as retained earnings. Used to compare financial conditions of companies. EX: net profit of $32,000 and 20,000 shares EPS=32000 / 20000 = $1.60

fundamental analysis

School of thought in market analysis that assumes each stock has an intrinsic (or true) value based on its expected stream of future earnings

Characteristics of Stocks

See Table 14-1, pg 424 (attached) 1. Income AStock 2. Growth Stock 3. Blue Chip Stock 4. Countercyclical Stock 5. Value Stock 6. Tech Stock 7. Speculative Stock 8. Large Cap, Small Cap, Mid Cap stocks

Do some of the math problesm

See pg. 454

Online Discount Brokers

Such brokers, also called internet or electronic discount brokers, have reduced the cost of executing a trade to perhaps $20 or even $10 because their primary business is online trading. EX: TD Ameritrade, E-Trade, Fidelity, Scott Trade

price/sales ratio (P/S ratio)

Tells the number of dollars it takes to buy a dollar's worth of a company's annual revenues; calculated by dividing company's total market capitalization by its sales for the past four quarters RATIO: total market cap / sales 4 past quarters Avoid if P/S > 1.5 and likes if P/S < .75 Lots of investors ignore P/S but actually works better than common P/E ratio

Dow Jones Industrial Average (DJIA)

The most widely reported of all stock market indexes that tracks prices of only 30 actively traded blue-chip stocks, including well-known companies such as American Express and AT&T - transportation average of 20 stocks - utility average of 15 stocks - composite average base on all 65 industrial, transportation, and utility stocks

market price

The current price that a buyer is willing to pay

Corporate Earnings for Stock Analysis

The profits a company makes during a specific time period that indicate to many analysts whether to buy or sell a stock; Core of fundamental analysis Earnings to Evaluate: 1. Corporate Earnings 2. Earnings Per Share 3. Price/Earnings Ratio 4. Trailing and Projected Price/Earnings Ratio 5. PEG Ratio 6. Price/Sales Ratio 7. Cash Dividends 8. Dividends per Share 9. Dividend Payout Ratio 10. Divident yeld 11. Book Value 12. Book Value Per Share 13. Price to Book Ratio

Dividends Per Share

Total cash paid to common stockholders per share. EX: $8000 dividend, 20,000 shares 8000/20000 = $.40 per share

Government Securities

Two Groups: (all are Treasuries) 1. Treasury bills, notes, and bonds. 2. Federal Agency issue notes, bonds abnd certificates.

5 Steps: #3: Calculate Required Rate of Return

Use the T-Bill yield (rate) as a base number to provide a zero percent real rate of return - zero return after taxes and inflation. T-bills usually hover above inflation rate, currently around 1 percent so not much room for investor gains. Suggests to investors the return required to put their money at risk. t-bill rate + (beta x market risk) ex: t-bill rate=0.5%, beta=1.5, market risk=8% [0.5% + (1.5 x 8.0)] = 12.5%

How to Price a Bond in Today's Market

Value of a Bond Formula See Equation 14.3, pg 449 (Attached) Calculates Present value of interest payments and repayment lump sum. Interest Rate Risk: risk that interest rates rise and bond prices fall Bond Premium: sum of $$ paid in addition to regular price. KEY: Bond yields and prices move in opposite direction. KEY: Bond Prices and interest races have inverse relationship. Over time, 90% of returns on bonds comes from interest income and only 10% from price changes. Premiums/Discounts: Bonds are sold 3 ways. Remember, market value rate changes and impacts which one to do: 1. Face value 2. Discount below face value 3. Premium above face value

How to Calculate YTM?

Yield to maturity (YTM) = 1+[(face value-current value)/yrs to maturity divided by (face value + current value)/2 If the YTM is less than the bond's coupon rate, then the market value of the bond is greater than par value ( premium bond). EX: For example, say an investor currently holds a bond whose par value is $100. The bond is currently priced at a discount of $95.92, matures in 30 months, and pays a semi-annual coupon of 5%. 1+(100-95.92)/2.5yrs / (100-95.92)/2 = 2.632 / 2.04 = 1.29%

beta value (beta coefficient)

a measure of stock volatility; that is, how much the stock price varies relative to the rest of the market

over-the-counter (OTC) market

a network of dealers who buy and sell the stocks of corporations that are not listed on a securities exchange

income stock

a stock that may not grow too quickly, but year after year pays a cash dividend higher than that offered by most companies

PEG Ratio

a way to rationalize buying a stock that has high growth is to calculate by dividing the P/E ratio by the company's projected growth rate Divide the P/E ratio by company's projected growth rate. RATIO: P/E RATIO / PROJECTED GROWTH Investors thing PEG=1 is fairly priced while a value >=2 is too high.

Bond Rating

an impartial outsider's opinion of the quality of the issuing organization

portfolio tracking

automatically updates the value of your portfolio after you enter the symbols of the stocks you own and the number of shares held

Sinking Fund

bond feature through which money is set aside with a trustee each year for repayment of the principal portion of the debt at maturity

Trailing P/E ratio

calculated using recently reported earnings, usually from the previous four quarters

cash dividends

cash profits that a firm distributes to stockholders

residual claim

common stockholders have a right to share in the income and assets of a corporation after higher-priority claims are satisfied

market interest rates

current long and short term interest rates paid on various types of corporate and government debts that carry similar levels of risk

Price-to-Book-Ratio

current stock price divided by the per-share net value of a firm's plant, equipment, and other assets Identifies firms that are "asset rich" like banks, brokerage firms, insurance companies. RATIO: current stock price / per share net value of company's plant, equipment, other assets (book value). Most stocks = 1.0 - 2.1, lower value means lower value of assets. If < 1, assets not utilized effectively.

maturity date

date upon which the principal is returned to the bondholder

Cash Dividends

distribution from earnings paid in the form of cash. Current income you receive while you won shares in a company. Sometimes will borrow to pay dividends and pay back later when profits.

Fundamental Analysis for Stock Analysis

each stokc has an intrinsic (true) value base on expected stream of future earnings. you can identify some stocks that will outperform others given the satate of economy. Assumes stocks basic value is largely determine by current and future earnings trends, assets, debts, products competition, managements expertise to assess growth potential. key: seek out stocks priced below what they out to be. you invest in stocks because you havbe a good reason related to earnings and profitability.

Online - Stock Screening Tools

enable you to quickly sift through vast databases of hundreds of companies to find those that best suit your investment objectives. You can input P/E ratios, GROWTH PROJECtions, etc. Ex: Kiplingers, MSN Money, Marketwatch

principal

face amount of a bond

Prospectus

highly legalistic information presented by a firm to the SEC and to the public with any new issue of stock

Corporate Bonds

interest-bearing certificates of long-term debt issued by a corporation

annual report

legally required yearly report about financial performance, activities, and prospects sent to major stockholders and made available to the general public

TBills v. Notes v. Bonds

major difference among them is the time you need to wait to collect your principal: Treasury bills have maturities of a year or less. Treasury notes are issued with maturities from two to ten years. Treasury bonds are long-term investments that have maturities of 10 to 30 years from their issue date.

Securities Exchange

market where agents of buyers and sellers can find each other easily by providing an orderly, open plan to trade securities NYSE: Big Board, NY stock exchange American Stock Exchange

securities

negotiable instruments of ownership or debt, including common stock, preferred stock, and bonds

General (full-service) brokerage firms

offer a full range of services to customers, including investment advice and research. ex: Edward jones, UBS, Morgan Stanley, Wells Fargo Advisors

Investing in Bonds

offer a lower return than stocks; offers steady income; reduces market risk Issued at PAR VALUE (face value) of $1000 Pay interest semi-annually=COUPON RATE Types: 1. Investment Grade (AAA grade) 2. Zero-Coupon bonds (AA grade) 3.Speculative-Grade Bonds (BBB grade)

Selling Short

selling stocks borrowed from broker the process of selling stock that an investor does not actually own but has borrowed from a brokerage firm and will repay at a later date. They hope to buy same stock at a later date on their own at a lower price and make money on the spread. HOW IT GOES WRONG? Investor has funds tied up in the margin account; often times earning no interest; if your can't buy back securities at a LOWER cost (days or weeks later), you've lost money along with having your funds tied up.

Stocks

shares of ownership in a company's assets and earnings. 1. Common Stock 2. Preferred Stock 3. Convertible Preferred Stock 4. Non-Negotiable Preferred Stock

Call Option

stipulation in some indentures that allows issuer to repurchase the bond at par value or by paying a premium, often one years worth of interest

blue-chip stock

stocks that have been around for a long time, well regarded reputations, dominate its industry, known for being solid, relatively safe investments.

Price to Earnings Ratio (P/E)

the current market price of a stock divided EPS over the past four quarters. used as a primary means of valuing a stock EX: market price=$25, EPS=$1.60 EPS ($25 / $1.60 = 15.6 or 16). Called a 16:1 ratio or multiple or P/E ratio of 16. Typical range is from 5-25. Historical average is usually 15. Financial successful companies are in 7-10 range with higher dividends. Rapidly growing companies have P/E of 13-20, less dividend. Speculative companies have P/E of 25-50 because of low earnings. Inverting P/E gives you earnings yield. If PE=12, earnings yield is 8.5%. Means each $100 of stock is backed by $8.50 expected earnings. NOTE: If low interest rates, 8.5% is a good yield.

Coupon Rate

the interest rate that a bond issuer will pay to a bondholder

Common Stock

the most basic form of ownership, including voting rights on major issues, in a company. Investor (Shareholder) Expectations: 1. Company will make profits and pay cash dividends. Has residual claim to dividends as a owner of company. 2. Market price of stock will increase over time 3. Expect returns of 8-9% over time 4. Has limited liabiility. Their claims come after creditors if company fails. EX: Paw Cat Food Company (pg. 422)

10Q Report

the quarterly unaudited financial statements of corporate issuers that are filed with the SEC, and which are a public record. Included in the 10Q are the corporation's balance sheet; income statement; retained earnings statement; and sources and uses of cash statement.

pre-emptive right

the right of common stockholders to maintain their proportional ownership if the company offers more shares of stock

growth stock

the stock of a company that offers the promise of much higher profits tomorrow and has a consistent record of relatively rapid growth in earnings in all economic conditions

Countercyclical Stock

the stock of a company whose profits are less influenced by changes in the economic business cycle

Yield to Maturity

total annual effective rate of return earned by a bondholder on a bond if the security is held to maturity. Takes into consideration both the price at which the bond sold and the coupon interest rate to arrive at effective rate of return. It's the internal rate of return on cash flows of a bond. 3 Generalizations: 1. Face Value Bond, YTM = coupon rate printed on certificate 2. Premium, YTM=lower than coupon rate 3. Discount, YTM=higher than coupon rate FORMULA: See formula 14.5, pg 451

Preferred Stock

type of fixed-income ownership security in a corporation that pays fixed dividends Owners received "fixed dividend" per share. MUST get paid before common stock dividend. Non-comulative preferred stockholders have no previous claims to unpaid dividends.

default risk

uncertainty associated with not receiving the promised periodic interest payments and the principal amount when it becomes due at maturity

margin call

using a margin account to buy securities; allows the investor to apply leverage that magnifies returns or losses

Indenture

written, legal agreement between bondholders and debtor that describes terms of the debt by setting forth the maturity date, interest rate, and other details