Bond rating
14 Investing in Stocks and Bonds
YOU MUST BE KIDDING, RIGHT?
Brothers Michael and Christopher Morton differ in investment philosophies—Michael is a conservative investor and Christopher holds a moderate investing outlook. Their father left each of them $100,000 when he died ten years ago, and Christopher invested in common stocks while Michael invested in corporate bonds. After ten years, how much more money is Christopher likely to have in his account than Michael?
A. $12,000
B. $21,000
C. $148,000
D. $179,000
The answer is B, $21,000. One could expect in today's times to obtain a long-term average annual return of perhaps 6 percent on U.S. common stocks compared with about 4 percent on corporate bonds. A $100,000 common stock portfolio that returned 6 percent annually would accumulate to $179,000 in ten years while a bond portfolio earning 4 percent annually over the same time period would grow to $148,000. Christopher's willingness to accept more risk by investing in common stocks may provide him with a balance bigger than his brother's by a whopping $31,000 or 21 percent ($31,000/$148,000)!
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
Explain how stocks and bonds are used as investments.
Describe ways to evaluate stock prices, and calculate a stock's potential rate of return.
Use the Internet to evaluate common stocks in which to invest.
Summarize how to buy and sell stocks, as well as the techniques of margin buying and selling short.
Describe how to invest in bonds.
WHAT DO YOU RECOMMEND?
Ashley Diaz, age 42, is a senior Web designer for a communications company in Lansing, Michigan. She earns $92,000 annually. From her salary, Ashley contributes $200 per month to her 401(k) retirement account, matched by her employer, through which she invests in the company's stock. Ashley is divorced and has custody of her three children, 10-year-old twins and a 6-year-old. Her ex-husband pays $1500 per month in child support. Ashley and her former spouse contribute $3000 each annually to a college fund for their children. Over the past 15 years, Ashley has built a $300,000 portfolio of investments after starting by investing the proceeds of a $50,000 life insurance policy following the death of her first husband. Currently, her portfolio is allocated 40 percent into preferred stocks (paying 4.5 percent); 30 percent into cyclical, blue-chip common stocks (P/E ratio of 14); 10 percent into Treasury bonds (paying 2.2 percent); 10 percent into municipal bonds (paying 1.7 percent); and 10 percent into AAA corporate bonds (paying 4.6 percent). Ashley's total return in recent years has been about 6 percent annually. Her investment goals are to have sufficient cash to pay for her children's education and to retire in about 18 years.
What do you recommend to Ashley on the subject of stocks and bonds regarding:
1. Investing for retirement in 18 years?
2. Owning blue-chip common stocks and preferred stocks rather than other common stocks given Ashley's investment time horizon?
3. The wisdom of owning municipal bonds rather than corporate bonds?
4. The likely selling price of her corporate bonds, if sold today?
5. Investments that might be appropriate to fund her children's education?
YOUR NEXT FIVE YEARS
In the next five years, you can start achieving financial success by doing the following related to investing in stocks and bonds:
1. Don't be afraid of investing in the stock market so include stocks and bonds or stock mutual funds in your investment portfolio.
2. Use fundamental analysis to determine a company's basic value before investing in any stock, bond, or stock mutual fund.
3. Resist putting money into so-called hot stocks.
4. Invest part of the conservative portion of your portfolio in TIPS (Treasury Inflation-Protected Securities) to beat inflation.
5. When you have children, use zero-coupon bonds to help save for their education.
LEARNING OBJECTIVE 1
Explain how stocks and bonds are used as investments.
To earn a larger return than offered by conservative investments, you must accept more risk. Historically, common stocks, for example, have earned substantially more than bonds, often twice as much. When you invest in stocks, you can increase returns significantly while increasing risk only slightly. These investments belong in everyone's investment portfolio because they provide opportunities for moderate and aggressive investors alike. Your task when selecting stocks is to find the right balance between safety and risk.
The principles of long-term investing remain valid because over time turbulent stock and bond markets calm down and provide investors fairly predictable returns. In fact, a good time to invest is when the share prices of high-quality firms have been beaten down to affordable levels. When the stock markets are down that means that stocks are “on sale,” as prices are lower than usual.
You should welcome the fact that economic slumps always spark a powerful market recovery. The typical post-recession rally in prices on the stock market is a 50 percent increase over the following 18 months. In fact, the Great Recession stock market that started in October 2007 saw stock prices decline 55 percent by March 2009, and the subsequent bull market more than doubled prices in less than four years. Investing is an act of faith and confidence in the future of the U.S. and global economies. History argues that by the time students in college are ready to retire, stock market prices will have tripled or quadrupled.
14.1 THE ROLE OF STOCKS AND BONDS IN INVESTMENTS
Individual investors provide the money corporations use to create sales and earn profits. The investor shares in those profits. A corporation is a state-chartered legal entity that can conduct business operations in its own name. A public corporation is one that issues stock purchased by the general public and traded on stock markets such as the New York Stock Exchange. In contrast, the stock of a privately held corporation is held by a relatively small number of people and is not traded on a public stock exchange. The ability to sell shares of ownership to investors offers a corporation the opportunity to develop into a firm of considerable size. It can continue to exist even as ownership of its shares changes hands. For example, the owners of AT&T are the holders of its more than 5.38 million shares of stock.
A corporation's financial needs will vary over time. To begin its operations, a new corporation needs start-up capital (funds initially invested in a business enterprise). During its life, a corporation may need additional money to grow. To raise capital and finance its goals, it may issue three types of securities (negotiable instruments of ownership or debt): common stock, preferred stock, and bonds.
securities Negotiable instruments of ownership or debt, including common stock, preferred stock, and bonds.
Stocks are shares of ownership in the assets and earnings of a business corporation. Each stock investor is a part owner in a corporation. Common stock is the most basic form of ownership of a corporation. For the investor, stocks represent potential income because the investor owns a piece of the future profits of the company. Investors usually have two expectations: (1) the corporation will be profitable enough that income will exceed expenses, thereby allowing the firm to pay cash dividends (a share of profits distributed in cash); and (2) the market price of a share of stock, which is the current price that a buyer is willing to pay a willing seller, will increase over time.
stocks Shares of ownership in a business corporation's assets and earnings.
common stock Most basic form of ownership of a corporation.
cash dividends Cash profits that a firm distributes to stockholders.
market price The current price of a share of stock that a buyer is willing to pay a willing seller.
Stocks usually require a low minimum investment. Investors expect to earn annual returns of 6 percent or higher on average over time from the combination of dividends and capital gains.
Each person who owns a share of stock—called a shareholder or stockholder —has a proportionate interest in the ownership (usually a very small slice) and, therefore, in the assets and income of the corporation. This residual claim means that common stockholders have a right to share in the income and assets of a corporation only after higher-priority claims are satisfied. These higher-priority claims include interest payments to those who own company bonds and preferred stocks.
shareholder (stockholder) Each person who owns a share of a company's stock holds a proportionate interest in firm ownership and, therefore, in the assets and income of the corporation.
residual claim Common stockholders have a right to share in the income and assets of a corporation after higher-priority claims are satisfied.
Stockholders have a limited liability, as their responsibility for business losses is limited to the amount invested in the shares of stock owned. These amounts may be small or large, but the most the shareholder can lose is the original amount invested. If the corporation becomes bankrupt, the common stockholder's ownership value consists of the amount left per share after the claims of all creditors are satisfied first. Each common stockholder has voting rights : the proportionate authority to express an opinion or choice in matters affecting the company. Stockholders vote to elect the company's board of directors. This group of individuals sets policy and names the principal officers of the company—management—who run the firm's day-to-day operations. The number of votes cast by each shareholder depends on the number of shares he or she owns. Stockholders attend an annual meeting or vote by proxy—shareholders' written authorization to someone else to represent them and to vote their shares at a stockholder's meeting.
voting rights Proportionate authority to express an opinion or choice in matters affecting the company.
Preferred stock is a type of fixed-income ownership security in a corporation. Owners of a preferred stock receive a fixed dividend per share that corporations are required to distribute before any dividends are paid out to common stockholders. They receive no extra income from the stock other than their fixed dividend, even when the firm is highly profitable. The regular dividend payments appeal to those who desire a reliable stream of income, such as retired investors. While the income stream may be consistent, the market price of preferred stock is sensitive to changes in interest rates. Preferred stockholders rarely have voting privileges.
preferred stock Type of fixed-income ownership security in a corporation that pays fixed dividends.
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Sometimes a corporation decides not to pay dividends to preferred stockholders because it lacks profits or simply because it wants to retain and reinvest all of its earnings. When the board of directors votes to skip (pass) making a cash dividend to preferred stockholders, holders of cumulative preferred stock must be paid that dividend before any future dividends are distributed to the common stockholders. For example, assume that a company passes on the first two quarterly dividends of $2.25 each to preferred stockholders, who expect to receive $9 each year ($2.25 × 4 quarters).
cumulative preferred stock Preferred stock for which dividends must be paid, including any skipped dividends, before dividends go to common stockholders.
If the company prospers and wants to give a cash dividend to its common stockholders in the third quarter, it must first pay the passed $4.50 to the cumulative preferred stockholders. Furthermore, the usual third-quarter cash dividend of $2.25 has to be made to the preferred stockholders before the common stockholders can receive any dividends. In the case of noncumulative preferred stock, the preferred stockholders would have no claim to previously skipped dividends. Convertible preferred stock , a unique security occasionally sold by companies, can be exchanged at the option of the stockholder for a specified number of shares of common stock.
convertible preferred stock Can be exchanged at the option of the stockholder for a specified number of shares of common stock.
Individuals who want to invest by loaning their money can do so by buying bonds and becoming a creditor of the business (again a very small one). A bond is an interest-bearing negotiable certificate of long-term debt issued by a corporation, the U.S. government, or a municipality (such as a city or state). Bonds are basically IOUs. Corporations and governments often use the proceeds from bonds to finance expensive construction projects and to purchase costly equipment.
With bonds, investors lend the issuer a certain amount of money—the principal —with two expectations: (1) they will receive regular interest payments at a fixed rate of return for many years, and (2) they will get their principal returned at some point in the future, called the maturity date . The regular pattern of interest appeals to those who desire a reliable stream of income, again retired investors. The market price of bonds is sensitive to changes in interest rates.
principal Face amount of a bond.
maturity date Date upon which the principal is returned to the bondholder.
Don't Get Scared Out of Buying Stocks and Stock Mutual Funds
Investment expert Peter Lynch says, “The real key to making money in stocks and stock mutual funds is not to get scared out of them.” Investing based on the recent past is like driving a car while focused on the rear view mirror: it is stupid and dangerous. Therefore, remain optimistic about stocks and look for gains of 4 to 6 percent annually for the next 10 or 20 years.
14.1d An Illustration of Stocks and Bonds: Running Paws Cat Food Company
To better understand how a corporation finances its goals by issuing common and preferred stock while also paying returns for stockholders, consider the example of Running Paws Cat Food Company. When reading through the example, imagine that the numbers have many more zeros to better visualize a company the size of Google or Microsoft.
Running Paws Is Born Running Paws began as a small family business in Lincoln, Nebraska, started by Linda Webtek. She developed a wonderful recipe for cat food that contained no corn, corn meal, or corn gluten meal and sold the product through a local grocery store. As sales increased, Linda decided to incorporate the business, expand its operations and share ownership of the company with the public by asking people to invest in the company's future. Running Paws issued 10,000 shares of common stock at $10 per share. Three friends each bought 2500 shares, and Linda signed over the cat food recipe and equipment to the corporation itself in exchange for the remaining 2500 shares. At that point, Running Paws had $75,000 in working capital (7500 shares sold at $10 each), equipment, a great recipe, and a four-person board of directors. Each of the directors worked for the firm, although they paid themselves very low salaries.
Running Paws Begins to Grow The sales revenues of a corporation like Running Paws are used to pay (1) expenses, (2) interest to bondholders, (3) taxes, (4) cash dividends to preferred stockholders, and (5) cash dividends to common stockholders, in that order. If money is left over after items 1 and 2 are paid, the corporation has earned a profit . If funds are available after item 3 is paid, the company has an after-tax profit . The average corporation pays out 40 to 60 percent of its after-tax profit in cash dividends to stockholders. The remainder, called retained earnings , is left to accumulate and finance the company's goals—often expansion and growth. In its early years, Running Paws retained all of its profits and distributed no dividends.
profit Money left over after a firm pays all expenses and interest to bondholders.
after-tax profit Money left over after a firm has paid expenses, bondholder interest, and taxes.
retained earnings Money left over after a firm has paid expenses, bondholder interest, taxes, preferred stockholder dividends, and common stockholder dividends.
Common stockholders, such as the stockholders of Running Paws Cat Food Company, are not guaranteed dividends. However, most profitable companies do pay common stockholders a small dividend on a quarterly basis until increased earnings justify paying out a higher amount.
Assume Your Investment Portfolio Will Earn 5 Percent to 6 Percent
When planning for long-term financial goals, assume your investments will conservatively earn 3 percent after inflation or at least 5 percent to 6 percent a year. Your investment returns could be higher.
Given that Running Paws retained all its earnings, you might wonder why people would invest in such a company. Two reasons explain the attraction. First, as a company becomes more efficient and profitable, cash dividends to common stockholders may not only begin but also become significant. Second, the market price of the stock may increase sharply as more investors become interested in the future profitability of a growing company. Common stock constitutes a share of ownership; thus as the company grows, the price of its common stock follows suit.
Increasing sales meant more production for Running Paws. Soon more orders were coming in from Chicago than the firm could handle. After three years, the owners of Running Paws decided to expand once again. They wanted to borrow an additional $100,000, but their business was so new and its future so uncertain that lenders demanded an extremely high interest rate. To raise the needed funds, the owners decided to issue 5000 shares of preferred stock at $20 per share, promising to pay a cash dividend of $1.80 per share annually, providing a 9 percent yield to investors. The preferred stock was sold to outside investors, but the original investors retained control of the company through their common stock.
Running Paws Becomes a National Company Following its pattern of expanding into new markets, Running Paws soon developed additional lines of cat food that sold well. With the proceeds from the sale of preferred stock, and after a new plant in Brooklyn, New York, opened, the income of the four-year-old business finally exceeded expenses, and it had a profit of $13,000. The board of directors declared the promised preferred stock dividend of $9000 (5000 preferred shares × $1.80) but no dividend for common stockholders. In the following year, net profits after taxes amounted to $28,000. Once again the board paid the $9000 dividend to preferred stockholders but retained the remainder of the profits to finance continued expansion and improved efficiency.
Then one of the original partners wanted to exit the business and needed to sell her 2500 shares of stock, for which she had originally paid $25,000. Because Running Paws was beginning to show some profits, two other private investors recommended by a local stockbroker made offers to purchase her shares. The shares were sold at $16 per share, with 1500 shares going to one investor and 1000 shares to another investor. Thus, this original investor gained $15,000 in price appreciation ($16 × 2500 = $40,000; $40,000 − $25,000 = $15,000) when she sold out. (Running Paws did not profit from this transaction.) Now five owners of the common stock, including the two new ones, voted for the board of directors, with each share representing one vote.
During the sixth year, the company's sales again increased and its earnings totaled $39,000. This time the board voted $9000 for the preferred stockholders and $5000 ($0.50 per share) for the common stockholders but retained the remaining $25,000. With the $5000 distribution, the common stockholders finally began to receive cash dividends.
Even with its success, Running Paws faced another decision. To distribute its products nationally would require another $400,000 to $500,000 for expansion costs. After much discussion, the board voted to sell additional shares of stock and issue some bonds. The company planned to sell 10,000 shares of common stock at $25 per share. This would dilute the owners' proportion of ownership by half. Common stockholders, however, have a pre-emptive right to purchase additional shares before new shares are offered to the public. Thus, each current stockholder retained the legal right to maintain proportionate ownership by being allowed to purchase more shares.
pre-emptive right Right of common stockholders to purchase additional shares before a firm offers new shares to the public.
Bonds were sold, too. * Running Paws issued two hundred $1000 bonds with a coupon rate of 8 percent. After several months, all of the new stock and bond shares were sold. After brokerage expenses, the company netted more than $190,000 from the bonds to help finance the expansion. On the stock sales, various local stockbrokers took selling commissions totaling $16,000, leaving $234,000 available for the company to use for expansion. These and other investors will follow the progress of Running Paws and buy and sell shares accordingly. The company will not benefit from this trading. Running Paws and its shareholders will benefit from a rising stock price because ownership in a growing company becomes increasingly valuable. If Running Paws continues to prosper, its board of directors might work toward having its stock listed on a regional stock exchange (discussed later in this chapter) to facilitate trading of shares and to further enhance the company's image.
Money Websites Investing in Stocks
Informative websites for investing in stocks and bonds, including online screens to compare stocks are:
AOL Money Basics ( www.dailyfinance.com/?icid=navbar_Finance )
BloombergBusinessWeek ( www.businessweek.com/markets-and-finance )
CNN Money ( www.money.cnn.com/magazines/moneymag/money101/ )
Kiplinger's Personal Finance ( www.kiplinger.com/fronts/channels/investing/ )
MarketWatch ( www.marketwatch.com/personal-finance?showsmscrim=true )
Morningstar ( www.morningstar.com )
Motley Fool ( www.fool.com )
NASDAQ ( www.nasdaq.com )
Yahoo! Finance on stocks ( www.finance.yahoo.com/marketupdate?u )
Zacks Investment Research ( www.zacks.com )
CONCEPT CHECK 14.1
1. Distinguish between common stocks and bonds.
2. How do public corporations use stocks and bonds?
3. Why do individuals invest in stocks?
LEARNING OBJECTIVE 2
Describe ways to evaluate stock prices, and calculate a stock's potential rate of return.
14.2 HOW TO EVALUATE COMMON STOCKS
When thinking about investing in a stock it is helpful to begin by reviewing Table 14-1 , which shows the types of stocks and their characteristics.
14.2a Use Beta to Compare a Stock to Similar Investments
Beta is a number widely used by investors to predict future stock prices. The beta value ) (or beta coefficient) is a measure of an investment's volatility compared with a broad market index for similar investments over time. For large-company stocks, the S&P 500 Stock Index often serves as a benchmark. The average for all stocks in the market is a beta of 11.0, thus a stock with a beta of + 1.0 typically moves in lockstep with the S&P and a beta greater than 1.0 indicates higher-than-market volatility. Recall from Chapter 13 that market risk is assumed to be 8 percent; thus when the overall stock market increases 8 percent a stock with a 1.0 beta is likely to increase the same amount. A stock with a beta of 1.2 will move 20 percent high and lower than the index.
beta value (beta coefficient) A measure of stock volatility; that is, how much the stock price varies relative to the rest of the market.
Most stocks have positive betas between 0.5 and 2.0. A beta of less than 1.0 (0.0 to 0.9) indicates that the stock price is less sensitive to the market. This is because the price moves in the same direction as the general market, but not to the same degree. A beta of more than +1.0 to +2.0 (or higher) indicates that the price of the security is more sensitive to the market because its price moves in the same direction as the market but by a greater percentage. Higher betas mean greater risk relative to the market. A beta of zero suggests that the price of the stock is independent of the market, much like that of a risk-free U.S. Treasury security. You may look up betas for stocks (just input the stock's symbol) at Calculator Edge ( www.calculatoredge.com/finance/betas.htm ) or Yahoo! Finance ( screener.finance.yahoo.com/stocks.xhtml ). Stocks with a negative beta move in the opposite direction of the market.
Reasons to Invest in Dividend-Paying Stocks
When you invest in companies that pay dividends, odds are that they will continue to pay the dividend even when the company is not doing well financially. Dividend-paying companies typically outperform other firms and provide a greater total return than the return on the S&P 500 index. Firms that pay dividends typically boost them about 3.2 percent annually. When inflation is low a dividend of 2 to 4 percent is an excellent return. Finally, dividend-paying companies are less volatile than other stocks often with a beta of 1.0 or less.
14.2b Most Use Fundamental Analysis to Evaluate Stocks
The theory underlying fundamental analysis is that each stock has an intrinsic (or true) value based on its expected stream of future earnings. Most professional stock analysts and investors take this approach to investing as they research corporate and industry financial reports. Fundamental analysis suggests that you can identify some stocks that will outperform others given the state of the economy. The fundamental approach presumes that a stock's basic value is largely determined by its current and future earnings trends, assets and debts, products, competition, and management's expertise to assess its growth potential. The aim is to seek out sound stocks—perhaps even unfashionable ones—that are priced below what they ought to be.
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.
Fundamental analysis suggests that you should consider investing only in companies that will likely be industry leaders—not necessarily the largest firms and fastest-growing industries, but the pacesetters in terms of profitability. You should invest in a stock because you have good reasons related to earnings and profitability, such as a new division in a firm that soon is expected to be quite profitable, a firm is starting to outsell its competitors, product research looks promising, or the firm is a leader in an industry that will be a future driver of profits in the economy. Several numerical measures are used to evaluate stock performance, and these are readily available to investors on the Internet to help you assess future stock prices.
Table 14-1 Characteristics of Stocks
|
Type of Stock |
Characteristics |
|
Company that pays a cash dividend higher than that offered by most companies. Stocks issued by telephone, electric, and gas utility companies; beta often less than 1.0. |
|
|
Corporations that are leaders in their fields, that dominate their markets, and that have several consecutive years of above-industry-average earnings are considered; pays some dividends. Investor awareness of such corporations is widespread, and expectations for continued growth are high. The P/E ratio is high; betas of 1.5 or more. |
|
|
A company that has been around for a long time, has a well-regarded reputation, dominates its industry (often with annual revenues of $1 billion or more), and is known for being a solid, relatively safe investment; betas are usually around 1.0. |
|
|
A company whose profits are greatly influenced by changes in the economic business cycle in consumer-dependent industries, like automobiles, housing, airlines, retailing, and heavy machinery; betas of about 1.0. A stock with a beta that is less than 1.0 is called a countercyclical (or defensive) because it exhibits price changes contrary to movements in the business cycle, thus prices remain steady during economic downturns. Examples are cigarette manufacturers, movies, soft drinks, cat and dog food, electric utilities, and groceries. |
|
|
A company that grows with the economy and tends to trade at a low price relative to its company fundamentals (dividends, earnings, sales, and so on) and thus is considered under-priced by a value investor; beta 1.0 to 2.0. |
|
|
Large-Cap, Small-Cap, and Mid-Cap stocks |
A company's size classification in the stock market is based on market capitalization. Large caps are those firms valued at or more than $10 billion. Mid-caps are $2 billion to $10 billion. Small caps is $300 million to $2 billion. |
|
Tech Stock |
A company in the technology sector that offer technology-based products and services, biotechnology, Internet services, network services, wireless communications, and more. |
|
Speculative Stock |
A company that has a potential for substantial earnings at some time in the future but those earnings may never be realized; betas above 2.0. Examples: computer graphics firms, Internet applications firms, small oil exploration businesses, genetic engineering firms, and some pharmaceutical manufacturers. |
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.
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.
blue-chip stocks Stocks that have been around for a long time, have a well-regarded reputation, dominate its industry, and are known for being solid, relatively safe investments.
Countercyclical Stock The stock of a company whose profits are greatly influenced by changes in the economic business cycle.
value stock A stock that tends to trade at a low price relative to its company fundamentals (dividends, earnings, sales, and so on) and thus is considered undervalued by a value investor.
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14.2c Some Investors Use Technical Analysis to Evaluate Stocks
An opposing and minority theory on valuing common stocks is advocated by proponents of technical analysis , often investment newsletter authors. This method of evaluating securities analyzes statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value but instead use charts, graphs, mathematics, and software programs to identify and predict future price movements. Technical analysis has proved to be of little value, although some investors find technical analysts' logic appealing.
technical analysis Method of evaluating securities that uses statistics generated by market activity, such as past prices and volume, over time to determine when to buy or sell a stock.
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14.2d You Should Use Corporate Earnings and Other Measures
Those who use fundamental analysis use several numerical measures to evaluate stock performance. These numbers are readily available to investors on the Internet that will help you assess future stock prices.
Corporate Earnings Corporate earnings are the profits a company makes during a specific time period. If a company cannot generate earnings now or in the future, stock market analysts and investors are not going to be impressed. As people reach this conclusion, there quickly will be more sellers than buyers of the company's common stock, and that will depress the stock's market price. Corporate earnings are at the core of fundamental analysis.
corporate earnings The profits a company makes during a specific time period that indicate to many analysts whether to buy or sell a stock.
Earnings Per Share A company's earnings per share (EPS) is annual profit divided by the number of outstanding shares. It indicates the income that a company has available, on a per-share basis, to pay dividends and reinvest as retained earnings. The EPS is a measure of the firm's profitability on a common-stock-per-share basis, and it is helpful because investors can use it to compare financial conditions of many companies. The EPS is reported in the business section of many newspapers as well as online.
earnings per share (EPS) A firm's profit divided by the number of outstanding shares.
In our example, assume that next year, after payment of $9000 in dividends to preferred stockholders, Running Paws had a net profit of $32,000. With 20,000 shares of stock, the company's EPS would be $1.60 ($32,000 ÷ 20,000).
Price/Earnings Ratio The price/earnings ratio (P/E ratio) (or multiple ) is the current market price of a stock divided by earnings per share (EPS) over the past four quarters. This ratio is the primary means of valuing a stock. It demonstrates how expensive the stock is versus the company's recently reported earnings, by revealing how much you are paying for each $1 of earnings. For example, if the market price of a share of Running Paws stock is currently $25 and the company's EPS is $1.60, the P/E ratio will be 16 ($25 ÷ $1.60 = 15.6, which rounds to 16). This value can also be called a 16-to-1 ratio or multiple, or a P/E ratio of 16. The P/E ratios of many corporations are widely reported on the Internet and in the financial section of newspapers. Stocks with low P/E ratios tend to have higher dividend yields, less risk, lower prices, and slower earnings growth.
price/earnings (P/E ratio) (or multiple) The current market price of a stock divided by earnings per share (EPS) over the past four quarters; used as the primary means of valuing a stock.
To assess a company's financial status, you could compare that firm's P/E ratio with the P/E ratios for other similar stocks. The P/E ratios for corporations typically range from 5 to 25.
The historical average P/E ratio for stocks is 15, although it varies for different industries. Financially successful companies that have been paying good dividends through the years might have a P/E ratio ranging from 7 to 10. Rapidly growing companies would likely have a much higher P/E ratio—13 to 20. Speculative companies might have P/E ratios of 25 or 50 or even higher because they have low earnings now but anticipate much higher earnings in the future. Firms that are expected to have strong earnings growth generally have a high stock price and a correspondingly high P/E ratio.
Inverting a P/E ratio of 12 reveals that stocks have an earnings yield of 8.5 percent. In other words, each $100 of stocks is backed by $8.50 in expected earnings. During times of low interest rates, an 8.5 percent yield on stocks looks terrific.
earnings yield The earnings per share of a stock divided by its price; an inversion of the price/earnings ratio; helps investors more clearly see investment expectations.
Trailing and Projected Price/Earnings Ratios The standard P/E ratio is, in fact, called a trailing P/E ratio measure because it is calculated using recently reported earnings, usually from the previous four quarters.
trailing P/E ratio Calculated using recently reported earnings, usually from the previous four quarters.
Investors need to focus on future prospects when analyzing the value of a stock. A projected P/E or forward price/earnings ratio divides price by projected earnings over the coming four quarters, an estimate available via online stock quote providers. The earnings yield, which is the inverse of the P/E ratio (Running Paws' earnings yield is 6.4 percent [$1.60 ÷ $25]), helps investors think more clearly about expectations for investments.
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.
Being invested in the stock market is an excellent way to create wealth.
PEG Ratio Critics of the price-earnings ratio argue that because of fundamentals sometimes they should pay more for a stock. Those firms with high levels of growth should not be penalized for having high P/E ratios. PEG ratio , or price-earnings growth, is a way to adjust for this. Divide the P/E ratio by the company's projected growth rate. Going back to Running Paws, divide the firm's P/E ratio of 16 by its projected growth rate of 15 percent (16/15 = 1.07). Investors think a PEG ratio of 1 is fairly priced while a value of 2 or more is too high.
PEG ratio (price-earnings growth) 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.
Price/Sales Ratio The price/sales ratio (P/S ratio) indicates the number of dollars it takes to buy a dollar's worth of a company's annual revenues. The P/S is obtained by dividing a company's total market capitalization by its sales for the past four quarters. For example, if Running Paws Cat Food Company's common stock currently sells for $25 per share and 20,000 shares of the company's stock are outstanding, its total capitalization is $500,000. If company revenues (sales of dog and cat food) were $750,000 over the past year, the stock's P/S would be 0.67 ($500,000 ÷ $750,000). Stock analysts suggest investors avoid companies with a P/S greater than 1.5 and favor those having a P/S of less than 0.75. Many investors ignore the P/S, but it works better than the highly acclaimed P/E ratio in predicting which companies provide the best return, as explained in James P. O'shaughnessy's What Works on Wall Street.
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.
Cash Dividends Stocks usually pay dividends. Cash dividends are distributions made in cash to holders of stock. They are the current income that you receive while you own shares in the company. The firm's board of directors usually declares a dividend on a quarterly basis (four times per corporate year), typically at the end of March, June, September, and December. Dividends are ordinarily paid out of current earnings, but in the event of unprofitable times (low earnings or none), the money might come from cash reserves held by the company. Occasionally, a company will borrow to pay the dividend so as to maintain its reputation of consistently paying dividends. Later profits can be used to repay any funds borrowed for this purpose.
Dividends per Share The dividends per share measure translates the total cash dividends paid out by a company to common stockholders into a per-share figure. For example, Running Paws might elect to declare a total cash dividend of $8000 for the year to common stockholders. In that case, cash dividends per share would amount to $0.40 ($8000 ÷ 20,000 shares).
dividends per share Translates the total cash dividends paid out by a company to common stockholders into a per-share figure.
Dividend Payout Ratio The dividend payout ratio is the dividends per share divided by EPS. It helps you judge the likelihood of future dividends. For example, imagine that Running Paws Cat Food Company earned $32,000 (after paying preferred stockholders), paid out a cash dividend of $8000 to company stockholders, and retained the remaining $24,000 to facilitate growth of the company. In this case, the dividend payout ratio equals 0.25 ($8000 ÷ $32,000). For that year, Running Paws paid a dividend equal to 25 percent of earnings.
dividend payout ratio Dividends per share divided by earnings per share (EPS); helps judge the likelihood of future dividends.
Newer companies usually retain most, if not all, of their profits to facilitate growth. An investor interested in growth would, therefore, seek a company with a low payout ratio. The lower the payout ratio the greater the likelihood that the company will grow, which results in later capital gains for investors. Examples of companies that historically have a high payout ratio are AT&T (T), Chevron (CVX), Exelon (EXC), Home Depot (HD), Intel (INTC), Merck (MRK), Pfizer (PFE), and Verizon (VZ).
Dividend Yield The dividend yield is the cash dividend paid to an investor expressed as a percentage of the current market price of a security. For example, the $0.40 cash dividend of Running Paws divided by the current $25 market price for its stock reveals a dividend yield of 1.6 percent ($0.40 ÷ $25). Growth and speculative companies typically pay little or no cash dividends, so they have limited dividend yields. Such companies are attractive to investors who are interested in capital gains.
dividend yield Cash dividend to an investor expressed as a percentage of the current market price of a security.
Book Value Book value (also known as shareholder's equity) is the net worth of a company, which is determined by subtracting the company's total liabilities from its assets. It theoretically indicates a company's worth if its assets were sold, its debts were paid off, and the net proceeds were distributed to the investors who own the outstanding shares of common stock.
book value (shareholder's equity) Net worth of a company, determined by subtracting total liabilities from assets.
Book Value per Share The book value per share reflects the book value of a company divided by the number of shares of common stock outstanding. Running Paws has a net worth of $230,000, which, when divided by 20,000 shares, gives a book value per share of $11.50.
book value per share Reflects the book value of a company divided by the number of shares of common stock outstanding.
Often little relationship exists between the book value of a company and its earnings or the market price of its stock. A stock's price usually exceeds its book value per share. The reason is that stockholders bid up the stock price because they anticipate earnings and dividends in the future and expect the market price to rise even more. When the book value per share exceeds the price per share, the stock may truly be underpriced.
Price-to-Book Ratio The price-to-book ratio (P/B ratio) , also called the market-to-book ratio , identifies firms that are asset rich, such as many banks, brokerage firms, and insurance companies. The P/B ratio is the current stock price divided by the per-share net value of the company's plant, equipment, and other assets (book value). It tells you the premium that you are paying for the net assets of the company.
price-to-book ratio (P/B ratio) Current stock price divided by the per-share net value of a firm's plant, equipment, and other assets (book value).
In the Running Paws example, the book value per share of $11.50 would be divided into the recent price at which the stock was sold ($25 in this case); thus, the P/B ratio for Running Paws is 2.17. The current P/B ratio for most stocks lies between 2.1 and 1.0. The lower the ratio, the less highly a company's assets have been valued, indicating that the stock may be currently under-priced. If the ratio is less than 1, the assets may be utilized ineffectively. In such cases, an under-performing and undervalued company may become a target of a corporate takeover; where the company may be broken up and sold.
Bias toward Following the Bandwagon
People engaged in investing in stocks and bonds have a bias toward certain behaviors that can be harmful, such as a tendency toward getting on the “bandwagon” when investments are headed down. What to do? Remember that markets that go down will definitely come up again, so stay in the market and continue to invest or you will miss the big upswing that sure will follow.
14.2e Calculating a Stock's Potential Rate of Return Takes Five Steps
There is but a single reason to make an investment: to obtain a positive return. Although you cannot know the exact performance of any investment in advance, you certainly will want to pay no more than the “right price” for the investment given its potential rate of return. Calculating returns on a potential investment involves five steps. Armed with these data, you will be better positioned to make informed decisions:
1. Use beta to estimate the level of risk of the investment.
2. Estimate the market risk.
3. Calculate the required rate of return.
4. Calculate the potential rate of return on the investment.
5. Compare the required rate of return with the potential rate of return on the investment.
1. Use Beta to Estimate the Risk of the Investment Beta is a useful piece of information when you want to estimate the rate of return you require on an investment in a stock, bond, or mutual fund before putting your money at risk. Betas for individual stocks, mutual funds, and other investments are available online from brokerage firms, advisory services, and investment magazines.
The following example illustrates how to use beta to estimate the amount of risk in an investment portfolio. Assume you are willing to accept more risk than the general investor and that you buy a stock with a beta of 1.5. If the average price of all stocks rises by 20 percent over time, the price of the stock you chose might rise by 30 percent, which is the beta of 1.5 multiplied by the increase in the market (1.5 × 20%). If the average price of all stocks drops in value by 10 percent, the price of the stock you chose might drop by 15 percent (1.5 × 10%).
2. Estimate the Market Risk To estimate the required rate of return on an investment, you need to quantify the market risk. market risk, also known as systematic risk, which we discussed in Chapter 13 , is the risk associated with the effects of the overall economy on securities markets. It often causes the market price of a particular stock or bond to change, even though nothing has changed in the fundamental values underlying that security. Historical records indicate that 8 percent represents a realistic estimate of market risk for U.S. stocks. Market risk is high during turbulent times in stock markets, and in the near term, it remains elevated.
About Employee Stock Options
Many employers give stock options to attract and retain senior employees. An employee stock option (ESO) is a gift, like a bonus, from an employer to a senior employee that allows them to benefit from the appreciation of their employer's stock with or without putting any money down. The company gives them the right and opportunity to “exercise” the option by buying the stock sometime in the future at an “exercise” or “striking” price established when the option was given. If the company prospers, when the employee eventually decides to exercise the options, the current share price may be much higher than the exercise price, thus allowing the employee to buy the shares at a considerable discount.
DO IT IN CLASS
How to Use Online Stock Calculators
You can perform almost any kind of mathematical calculation necessary in investing by using one of the online investment websites. For example, by using DailyFinance.com ( www.dailyfinance.com/calculators/stocks/ ), you can get answers to these questions:
• What is the return on my stock if I sell now?
• Should I wait a year to sell my stock?
• Should I sell my stock now and invest the money elsewhere?
• What stock price achieves my target rate of return?
• What is my current yield from dividends?
• How much do fees affect my stock's rate of return?
• Which is better: income or growth stock?
• How do exchange rates affect my foreign stock?
• When will I recover my stock costs?
3. Calculate Your Required Rate of Return The return on short-term U.S. Treasury bills has historically exceeded the rate of inflation by a slight degree (but not always as sometimes it is lower). Thus, when T-bills pay 2 percent interest, the inflation rate might hover around 1.7 percent. (The various interest rates in this chapter are chosen to be instructive. Note that the government's real T-bill rate is currently much lower than 1 percent.) This circumstance provides almost no gain for the investor because the combination of inflation and income taxes reduce the return to about zero. For this reason, investors often use the yield on Treasury bills as a base number that provides a zero real rate of return—that is, a zero return on investment after inflation and income taxes.
To calculate your required rate of return on an investment, multiply the beta value of an investment by the estimated market risk and then add the risk-free T-bill rate, as shown in Equation (14.1) . For recent T-bill rates, see www.treasurydirect.gov/indiv/research/indepth/tbills/res_tbill_rates.htm . Use Equation (14.1) to determine an estimate of the required rate of return on an investment .
estimate of the required rate of return on an investment A calculation that multiplies the beta value of an investment by the estimated market risk and adds the risk-free T-bill rate that suggests to investors the return required to put their money at risk.
For example, assume you are considering investing in Running Paws Cat Food Company, which has a beta of 1.5. If you assume a market risk of 8 percent and the current T-bill rate is 2.0 percent, the total rate of return you will require on this investment is 14.0 percent [2.0 1 (1.5 × 8.0)]. Investors need the promise of a return higher than 14 percent to put their money at risk in this investment.
4. Calculate the Stock's Potential Return The potential return for any investment over a period of years can be determined by adding anticipated income (from dividends, interest, rents, or other sources) to the future value of the investment and then subtracting the investment's original cost. The investor using fundamental analysis can obtain the figures needed to construct the expected stream of future earnings for a company from a variety of sources. For example, you can use estimates for earnings and dividends gathered from large investment data firms such as Value Line, Standard & Poor's, MarketWatch, or Reuters, and then obtain an individual stock analyst's projections or you can create your own numbers.
potential return Determined by adding anticipated income (from dividends, interest, rents, or other sources) to the future value of investment and then subtracting the investment's original cost.
Add Up Projected Income and Price Appreciation Table 14-2 illustrates how to sum up the projected income (dividend income) and price appreciation (earnings). You can convert these figures into a potential rate of return by calculating the approximate compound yield, as shown in Equation (14.2) . This figure can then be compared with returns on other investments.
Table 14-2 One Investor's Projections of the Earnings and Dividends for Running Paws Cat Food Company
|
End of Year |
Earnings |
Dividend Income |
|
1 |
$2.76 |
$0.76 |
|
2 |
3.17 |
0.87 |
|
3 |
3.65 |
1.00 |
|
4 |
4.20 |
1.15 |
|
5 |
4.83 |
1.33 |
|
Total dividends |
|
$5.11 |
|
Average annual dividend ($5.11 ÷ 5) |
|
$1.02 |
Get Dividends if You Want Investment Income
If you want regular investment income, put some of your money into dividend-paying stocks and mutual funds. Everything is liquid and priced daily, and most pay quarterly. Including price appreciation you might earn 4 or 5 percentage points more than from Treasuries. If instead of cashing the checks, you may reinvest the income distributions so your returns will compound over time. Some high-dividend paying stocks include American Electric Power (AEP) and AT&T (T). Some appropriate mutual funds include Artio Global High Income (BJBHX) and DoubleLine Total Return Bond N (DLTNX).
Example: Running Paws Cat Food Company Based on a recommendation from his stockbroker, Izzle Stevens, who lives in Seattle, is considering Running Paws Cat Food Company as a potential investment. Izzle figures that the company's stock might provide a better return than inflation and income taxes for about five years. He has determined the following information about this stock investment: It is currently priced at $30 per share, its most recent 12-month earnings amounted to $2.40 per share, and the cash dividend for the same period was $0.66 per share.
Izzle began the task of projecting the future value of one share of the stock by using the EPS information. He first calculated the P/E ratio to be 12.5 ($30 ÷ $2.40). Next, as illustrated in Table 14-2 , Izzle applied a 15 percent rate of growth estimate (the same rate that occurred in previous years, according to Running Paws' annual report) for the EPS for each year ($2.40 × 1.15 = $2.76; $2.76 × 1.15 = $3.17; and so forth). Using a P/E ratio of 12.5 (the same as the current ratio), Izzle estimated the market price at the end of the fifth year to be $60.38 (12.5 × $4.83). This calculation gives a projected net appreciation in stock price over five years of $30.38 ($60.38 minus the current price of $30).
To project the future income of the investment in Running Paws—the anticipated cash dividends— Table 14-2 shows that Izzle estimated a 15 percent growth rate in the cash dividend ($0.66 × 1.15 = $0.76; $0.76 × 1.15 = $0.87; and so forth). Adding the projected cash dividends over five years gives a total of $5.11. Izzle obtained the potential return for one share of Running Paws over five years by adding anticipated dividend income ($5.11) to the future value of the investment ($60.38) less its original cost ($30.00), for a result of $35.49 ($5.11 + $30.38). Thus, Izzle has projected that $30 invested in one share of Running Paws will earn a potential total return of $35.49 in five years.
What is the ACY? The question now becomes, what is the percentage yield for this dollar return? The approximate compound yield (ACY) provides a measure of the annualized compound growth of any long-term investment. You can determine this value by using Equation (14.2) . The calculation requires use of an annual average dividend rather than the specific projected dividends. In this example, the annual average dividend of $1.02 is computed by dividing the $5.11 in dividend income by five years. Substituting the data from Table 14-2 into Equation (14.2) and using the average annual dividend figure results in an approximate compound yield of 15.7 percent on the potential investment in one share of Running Paws stock for five years. (This formula can be found on the Garman/Forgue companion website.)
approximate compound yield (ACY) A measure of the annualized compound growth of any long-term investment stated as a percentage.
5. Compare the Required Rate of Return with the Potential Rate of Return on the Investment Now the moment of decision making is at hand. You compare the estimated required rate of return on an investment (given its risk) with the investment's potential projected rate of return. In our example involving Running Paws Cat Food Company, the risk suggested a required rate of return of 14.0 percent. The investment's potential rate of return was projected to be 15.7 percent, which suggests that Running Paws is a good buy for Izzle at the current selling price of $30—that is, the stock is under priced. Once armed with projected rate of return information for an investment, you can compare it with other investments.
Seven Questions Every Investor Needs to Answer
Before investing, investors ought to have written down responses to the following questions:
1. My investment experience?
2. My investment philosophy (conservative, moderate, or aggressive)?
3. My investment goals?
4. My age and family responsibilities?
5. My net worth?
6. My income?
7. My investment time horizon?
DO IT IN CLASS
CONCEPT CHECK 14.2
1. Distinguish between the terms income stocks and growth stocks.
2. Explain how a stock with a beta of 1.0 differs from ones with a beta of 1.2 and 2.5
3. What is the focus of fundamental analysis?
4. Summarize the meanings of the terms trailing and projected price/earnings ratio.
5. List the five steps to calculate a stock's potential rate of return.
LEARNING OBJECTIVE 3
Use the Internet to evaluate common stocks in which to invest.
14.3 USE THE INTERNET TO EVALUATE AND SELECT STOCKS
An overwhelming amount of information is available on stock investments. With about 5000 U.S. public companies to choose from and another 33,000 stocks in other countries, stock selection takes time. Hundreds of investment resources exist, including television and radio shows, books, websites, blogs, and newsletters. What approach should you take? Use the Internet because everything you need is online.
14.3a Begin by Setting Criteria for Your Stock Investments
The process of setting criteria for a stock investment starts with a review of your investment plan, as discussed in Chapter 13 and illustrated in Figure 13-7 on page 405. To make informed selections of the stock investments that match your investment goals, philosophy, and time horizon, begin by making decisions on criteria for your stock investments:
• What classifications of stocks are best suited for your goals?
• What market capitalization size company meets your desires?
• What specific numeric measures do you require on beta, sales, profitability, P/E ratio, dividends, payout ratio, and market price?
• What projected EPS growth do you require?
• Do you want to invest in an industry leader?
Phone Apps for Investing
Vanguard's Phone app users can access their stock brokerage accounts and mutual fund accounts, read market news, listen to podcasts, and watch videos. Scores of apps for investing are available including those from Bloomberg, Chase, CNBC Real-Time, EFFdb, Mint, Morningstar, Fidelity, Forbes, Charles Schwab, StockTwits, Wikinvest Portfolio Manager, and Yahoo! Finance.
14.3b Investor Education Is Widely Available Online
Comprehensive investment websites provide updated news headlines; market overviews; market statistics; industry statistics; industry trends; corporate stock symbols; current stock market prices; specific company profiles, history, financials, prices, and outlook for the future; tips on how to build a portfolio; and stock-screening tools with search capabilities. Following are some popular websites on investor education:
• The Investor's Clearinghouse ( investoreducation.org/release032013.cfm )
• FINRA Investor Education Clearinghouse ( www.finrafoundation.org/resources/education/modules/ )
• US Securities and Exchange Commission ( investor.gov/ )
• The Motley Fool ( www.fool.com/how-to-invest/index.aspx?source=ifltnvpnv0000001 )
14.3c Set Up Your Portfolio Online
You can set up a portfolio through an online brokerage account or by using any of several websites. For example, see WikiHow at www.wikihow.com/Build-a-Stock-Portfolio and JP Morgan at www.jpmorganfunds.com/cm/Satellite?pagename=jpmfVanityWrapper&UserFriendlyURL=buildyourportfolio . Both let you insert the number of shares you own and at what price. The sites then track stock quotes to update the value of your holdings.
14.3d Use Stock Screening Tools
You can research stocks, bonds, and mutual funds by using stock-screening tools available on the Internet. Screening enables you to quickly sift through vast databases of numerous companies to find those that best suit your investment objectives. For example, you can use the Kiplinger screening tool to filter thousands of stocks using 27 search criteria, and you can use Kiplinger's or another company's tools to identify dividend-paying stocks, small companies, and growth companies. You simply set the standard for screening, such as high P/E ratios, and the program sorts out the investment choices, including five-year EPS growth projections by professional stock analysts. You may be surprised to find how easy it is to screen stocks. The following websites offer stock-screening tools:
stock-screening tools Enable you to quickly sift through vast databases of hundreds of companies to find those that best suit your investment objectives.
• Kiplinger ( www.kiplinger.com/tools/stockscreener/index.xhtml )
• MSN Money ( investing.money.msn.com/investments/stockscouter-top-rated-stocks?sco=10 )
• MarketWatch ( www.marketwatch.com/tools/stockresearch/screener// )
14.3e Get a Sense of the History of a Stock
You can study the price of stock movements over different time frames, including bull and bear markets, as well as make comparisons to various benchmarks such as the S&P 500 Index. See Market Watch ( bigcharts.marketwatch.com/historical// ).
14.3f Go to the Source for Company Information
Corporate filings required by the Securities and Exchange Commission are available on the Internet from the Electronic Data Gathering and Retrieval (EDGAR) project ( www.sec.gov/edgar/searchedgar/webusers.htm#.U2p5IaJn34g ). Top online sources for stock, bond, and mutual fund information include Morningstar ( www.morningstar.com ) and Bloomberg ( www.bloomberg.com ). Each public company has its own website that offers insights from management about the future of the firm, and it is easy to request a company's annual report.
Every company registered with the Securities and Exchange Commission (SEC) is required to file once each year to ensure public availability of accurate current information about the firm. The company summarizes its financial activities for the year. The 10-Q report includes the financial results for the quarter, a discussion from management, a list of material events and other risk factors that have occurred (such as legal problems and loss of a large customer), a forecast of the company's future, and any significant changes or events in the quarter. A similar 10-K report is filed annually. You can obtain both 10-Q and 10-K reports from the SEC online ( www.sec.gov ). You can find executive compensation details on Form DEF 14A.
10-Q report A report required by the SEC prepared by the company showing its financial results for the quarter, a discussion from management, a list of material events and other risk factors that have occurred, forecasts of the company's future, and notes of any significant changes or events in the quarter.
There are numerous websites that offer fundamental and technical analysis of stocks. The Motley Fool does so with humor.
The company's annual report is mostly a numbers-free publication that looks like a slick marketing magazine. While annual reports do contain some summarized financial information, they serve more as promotional corporate brochures.
annual report Legally required yearly report about financial performance, activities, and prospects sent to major stockholders and made available to the general public.
When a company issues any new security, it files a prospectus with the SEC. This disclosure describes the experience of the corporation's management, the company's financial status, any anticipated legal matters that could affect the company, and potential risks of investing in the firm. The language is legalistic and full of technical jargon, but the interested investor may find it useful to sift through the details.
prospectus Highly legalistic information presented by a firm to the SEC and to the public with any new issue of stock.
14.3g Use Stock Analysts' Research Reports
Stock analysts working for independent stock advisory firms or stock brokerages write research reports on companies and industries, as illustrated in Figure 14-1 with a report from Standard & Poor's. Reports based on fundamental analysis are quite informative. The quality of advice is uneven, ranging from brilliant to pedestrian as analysts have a tendency to run with the herd and make similar recommendations. They often recommend buying certain stocks and rarely suggest selling. The prudent investor interprets “hold” recommendations as a signal to sell.
14.3h Read Research Newsletters
The most popular firms that offer stock advisory research services on a subscription basis to individual investors are Morningstar ( www.morningstar.com ), Value Line ( www.valueline.com ), MarketWatch ( www.marketwatch.com ), and Reuters ( reuters.com/finance/markets ). The cost for some of these services is in the hundreds of dollars per year. A Google search for “stock advisory newsletters” will reveal several dozen firms that offer guidance on stock selections, market updates, and investment advice. You may wish to avoid those that offer suggestions based on a “technical” or “chartist” approach to analyzing stocks; instead select one that uses a mainstream approach emphasizing fundamental research.
Figure 14-1 Illustrative Stock Analyst's Report
Investment Blogs
There is a vast array of investment blogs. Many are rubbish; some seem useful. Some favorites include those from Listly's Lists (list.ly/list/1 HO-top-100-investment -blogs) and Swing-Trade-Stocks.com( www.swing-trade-stocks.com/recommended-blogs.xhtml )
14.3i Be Aware of Economic Trends
You need to know the stage of the business cycle (recession or prosperity) and the current interest and inflation rates. You also need to understand how economic conditions are likely to change over the next 12 to 18 months. (These topics were examined in Chapter 1 .) Economic information is available through almost all media:
• Search engines: Yahoo!, Google, and Momma
• Big newspapers: USA Today, Los Angeles Times, The Wall Street Journal
• Business news: Business Week Fortune, Forbes Financial World
• Personal finance: Money magazine and Kiplinger's Personal Finance
• Investment sources: The Wall Street Journal, Barron's, Investor's Business Daily, Market Watch, Reuter's
• News magazines: U.S. News & World Report, Time
14.3j Pay Attention to Securities Market Indexes
Reports on securities market indexes are provided around the clock in almost every media. “The Dow went up 80 points today.” “The S&P 500 rose 68 points.” When it is reported that “the Dow rose 80 points today in heavy trading,” realize that these “points” are changes in the index, not actual dollar changes in the value of the stocks. A securities market index is an indicator of market performance. It measures the average value of a number of securities chosen as a sample to reflect the behavior of a more general market. Popular indexes include the following.
securities market index Measures the average value of a number of securities chosen as a sample to reflect the behavior of a more general market.
Dow Jones Industrial Averages The Dow Jones Industrial Average (DJIA) is the most widely reported of all indexes. The most popular DJIA industrial average, also called the “Dow,” follows prices of only 30 actively traded blue-chip stocks, including well-known companies such as American Express, AT&T, Caterpillar, Coca-Cola, Nike, Visa, Walmart, and Walt Disney. The average is calculated by adding the closing prices of the 30 stocks and dividing by a number adjusted for splits, spin-offs, and dividends. * The DJIA also produces a transportation average based on 20 stocks, a utility average based on 15 stocks, and a composite average based on all 65 industrial, transportation, and utility stocks.
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.
Standard & Poor's 500 Index The popular Standard & Poor's (S&P) 500 Index reports price movements of 500 stocks of large, established, publicly traded firms. It includes stocks of 400 industrial firms, 40 financial institutions, 40 public utilities, and 20 transportation companies. Companies with the highest market values influence the index the greatest.
NASDAQ Composite Index The NASDAQ Composite Index takes into account virtually all U.S. stocks (about 3700) traded in the over-the-counter market in the automated quotations system operated by the National Association of Securities Dealers. It provides a measure of companies not as popular or as large as those traded on the popular exchanges, including price behavior of many smaller, more speculative companies, although some big companies (such as Cisco Systems, Intel, Microsoft, and Staples) are listed as well. It is often used as a benchmark for the performance of high-tech stocks.
Dow Jones Wilshire 5000 Index The Dow Jones Wilshire 5000 Index represents the total market value of all the publically traded stocks in the United States, about 3776. One point in the index is worth $1 billion; thus when the index is 20,200, that translates into a U.S. stock market valued at over $20 trillion.
Russell 2000 Index The Russell 2000 Index is a small-cap stock market index of relatively small capitalized companies and is the most widely quoted measure of the overall performance of the small-cap to midcap company shares.
Foreign Stock Exchanges Stock exchanges are located in major cities throughout the world, including London, Sydney, Tokyo, Toronto, Frankfort, Mumbai, Hong Kong, Shenzhen, Shanghai, and Kuala Lumpur. U.S. investors often check the stock exchanges throughout the night to gain a hint of what might happen that day in the U.S. stock market.
14.3k Securities Exchanges (Stock Markets)
A securities exchange (also called a stock market ) is a market where agents of buyers and sellers can find each other easily by providing an orderly, open plan to trade securities. Each exchange has its own rules, is subject to government regulation, and provides constant supervision and self-regulation.
securities exchange (stock market) Market where agents of buyers and sellers can find each other easily by providing an orderly, open plan to trade securities.
The transactions were historically performed in an organized physical location, such as the New York Stock Exchange (known officially as NYSE Euronext and listed as NYX), and also known as the “Big Board”) as well as the American Stock Exchange (known officially as NYSE MKT LLC and also owned by NYSE Euronext) Both are in New York City. You may visualize a bustling exchange that ends the trading day with a bell. However, today most stock trading occurs in a fragmented collection of 50 trading platforms, and almost all transactions are performed electronically. The market capitalization of the NYSE Euronext's over 8000 listed companies is over $16 trillion. As many as 100 billion shares trade daily on the New York Stock Exchange.
Regional stock exchanges are places where equity in publicly-held companies (often regionally located firms) is traded, and these firms do not meet the strict listing requirements of national stock exchanges. Examples are located in Boston, Chicago, Philadelphia, and San Francisco. Newer exchanges also exist like Direct Edge, in New Jersey, and BATS Exchange in Kansas; each handles about 10 percent of trades in the U.S.
OTC or Over-the-Counter Trading Over-the-counter (OTC) or off-exchange trading is done directly between two parties, without any supervision of an exchange. The electronic telecommunications network facilitates the buying and selling of securities that usually are not listed on the major exchanges through market makers.
Over-the-counter (OTC) (off-exchange trading) trading is done directly between two parties, without any supervision of an exchange.
Amateurs Have an Advantage over Big Stock Research Firms
Three to five years before analysts really start to follow such developments, local investors can be among the first to see the company in which they work start to really succeed. They also may see nearby new retailers in shopping malls with bright futures.
14.3l Looking Up a Stock Price
What affects the price of a stock the most is supply and demand. When more people want to buy, the price goes up. When more people want to sell, the price goes down. If you know the company's stock symbol (search Google for “stock symbols”), the current price of any stock may be obtained by inputting the company symbol into Google or any of the other popular investment websites, such as Yahoo! Finance, MSN Money, Reuter's, and MarketWatch.
Crowd Funding for Startup Companies
Congress passed a law approving crowd funding as a way for companies to raise capital. Startup companies now may use web portals overseen by federal regulators to solicit up to $1 million annually in small amounts from lots of people, rather than solicit from a few large investors as securities laws have required. Those with an annual income of less than $100,000 will only be allowed to invest $2000 or 5 percent of their assets, whichever is greater. Kickstarter.com is the most well known. This opens up a badly needed source of funds. However, crowd funding could turn into “crowd fleecing” if investors cannot tell the difference between a legitimate opportunity and a scam.
The millions of daily buying and selling transactions involving stocks, bonds, and mutual funds are summarized in The Wall Street Journal, the most widely read financial newspaper in the United States. Many daily newspapers publish abbreviated information, and security prices are quoted and traded to two decimal points. Stock quotations that might appear in The Wall Street Journal for Walmart, a retailer, are illustrated in Figure 14-2 .
Column 1: YTD % Change. The numbers in this column report the “year to date (YTD) as a percentage” change in the price (18.6%) of Walmart stock since January 1 of the current calendar year.
Columns 2 and 3: 52 Weeks, High and Low. This column shows that Walmart stock traded at a high price of $63.08 and a low price of $41.50 during the previous 52 weeks, not including the previous trading day.
Figure 14.2 How Stocks Are Quoted
Column 4: Stock and Sym. This column gives the name of the stock (Walmart in this example) and its abbreviated trading symbol (WMT).
Column 5: Div. The dividend amount is based on the last quarterly declaration by the company. For example, Walmart last paid a quarterly dividend that, when converted to an annual basis, amounts to an estimated $0.28 annual dividend.
Column 6: Yld %. The figure in this column represents the yield as a percentage of dividend income, calculated by dividing the current price of the stock into the recent estimated dividend. The yield of the Walmart stock is 0.4 percent.
Column 7: PE. This figure provides the P/E ratio based on the current price. The earnings figure used to calculate the price is not published in the newspaper but is the latest available. When Walmart's “last” or closing price of $62.52 is divided by earnings, it gives a P/E ratio of 42.
Column 8: vol 100s. This figure indicates the total volume of trading activity for the stock measured in hundreds of shares. Thus, 10,457,200 shares of Walmart were traded on that day.
Column 9: Last. The price of the last trade of the day before the market closed for Wal-Mart was $62.52.
Column 10: Net Cng. The net change, +0.82%, represents the difference between the closing price (last) on this day and the closing price of the previous trading day. Today's Walmart closing (last) price of $62.52 was up $0.82 from the previous closing price, which must have been $61.70.
Bias toward Short-term Emotions
People engaged in investing through mutual funds have a bias toward certain behaviors that can be harmful, such as a tendency toward paying too much attention to our short-term emotions when making long-term decisions. When markets are calm, investors think they will stand pat; when they start declining they bail out, often at the worst possible moment. What to do? Set short-term goals to accomplish long-term goals you are comfortable with and stay the course, or hire an investment professional to do it for you.
14.3m Using Portfolio Tracking to Watch Your Investments
Watching your investments requires record keeping, particularly for income tax purposes, although when you sell any securities your brokerage firm will provide you with sufficient details. Recordkeeping tasks can be performed easily using the Internet. 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. Online portfolio tracking services also alert you to events that may affect your stocks. Tracking helps you stay on top of your holdings so you know which stocks are performing well, which are underperforming, and which might need to be sold. For programs type in “portfolio tracker” on Google.
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.
CONCEPT CHECK 14.3
1. Give three examples of the types of website resources available to investors on the Internet.
2. List five places where you can obtain investment information on a specific stock.
3. Distinguish between the Dow Jones Industrial Average and the S&P 500.
4. Where can you go to look up stock symbols and prices?
LEARNING OBJECTIVE 4
Summarize how to buy and sell stocks, as well as the techniques of margin buying and selling short.
14.4 BUYING AND SELLING STOCKS
Securities transactions require the use of a licensed broker serving as a middleman between the seller and the buyer and collecting a fee on each purchase or sale of securities. A stockbroker (also known as an account executive) is licensed to buy and sell securities on behalf of the brokerage firm's clients. You can buy or sell securities through an online or human stockbroker who works for a brokerage firm that has access to the securities markets. Brokerage firms often provide investors with investment advice.
stockbroker (account executive) Professional who is licensed to buy and sell securities on behalf of the brokerage firm's clients.
As a matter of convenience and to facilitate resale, investors prefer to leave securities certificates in the name of their brokerage firm rather than take physical possession themselves. Securities certificates kept in the brokerage firm's name instead of the name of the individual investor are known as the security's street name . Brokers have a duty to assess each client's suitability for particular investments. Table 14-3 shows the different types of stock brokerage firms.
security's street name Securities certificates kept in the brokerage firm's name instead of the name of the individual investor.
14.4a Opening a Brokerage Account
To trade securities, you will need a brokerage firm to act as your agent. You can open an account at a full-service general brokerage firm or a discount brokerage firm. The firm charges a commission for any trading it conducts on your behalf. You should make clear to the brokerage firm, in writing, your investment objectives and your desired level of risk. A cash account is a brokerage account that requires an initial deposit (perhaps as little as $1000) and specifies that full settlement is due to the brokerage firm within three business days after a buy or sell order has been given. After each transaction, your account is debited or credited, and written confirmation is immediately forwarded.
cash account A brokerage account that requires an initial deposit (perhaps as little as $1000) and specifies that full settlement is due to the brokerage firm within three business days after a buy or sell order has been given.
14.4b Broker Commissions and Fees
Brokerage firms receive a commission on each securities transaction to cover the direct expenses of executing the transaction and other overhead expenses. They have established fee schedules that they use when dealing with any except the largest investors. The fees reflect a commission rate that declines as the total value of the transaction increases. For example, in lieu of a minimum commission charge of $25, a brokerage firm might charge 2.8 percent on a transaction amounting to less than $800, 1.8 percent on transactions between $800 and $2500, 1.6 percent on amounts between $2500 and $5000, and 1.2 percent on amounts exceeding $5000.
Table 14-3 Types of Brokerage Firms
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Offers a full range of services, including investment information and advice; research reports on companies, industries, general economic trends, and world events; an investment newsletter; recommendations to buy, sell, or hold stocks; execution of securities transactions by live brokers and online; and margin loans. Commissions and fees are higher than other firms. See Edward Jones, Raymond James, UBS, Morgan Stanley Smith Barney, and Wells Fargo Advisors. |
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They charge commissions to execute trades that are often 30 to 80 percent less than the fees charged by full-service brokers. Most offer excellent research and investment tools. See Fidelity, TD Ameritrade, Charles Schwab, USAA Brokerage Services, and Vanguard. |
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Online discount 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. All the discount brokers noted are also online brokers. Additional highly rated online brokers are TD Ameritrade, E*Trade, Fidelity, Scott Trade, and Vanguard. |
general (full-service) brokerage firms Offer a full range of services to customers, including investment advice and research.
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.
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.
About Online Day Trading
Online day trading occurs when an investor buys and sells stocks quickly throughout the day with the hope that the price will move enough to cover transaction costs and earn some profits. Day traders rarely own stocks overnight. Transactions are executed online because they can be done quickly with low commissions. Day trading is a risky practice. One of billionaire Warren Buffett's commandments for getting ahead in personal finance states, “You will lose money if you trade stocks actively.”
day trading Occurs when an investor buys and sells stocks quickly throughout a day with the hope that prices will move enough to cover transaction costs and earn some profits.
How to Check the Background of Your Stockbroker or Investment Advisor
You can check the background of a stockbroker (440,000) or a brokerage firm (45,000) via the Financial Industry Regulatory Authority (FINRA) ( www.finra.org/investors/toolscalculators/brokercheck/ ). Also check the disciplinary record of most any financial adviser who manages more than $110 million in assets at the Securities and Exchange Commission at www.adviserinfo.sec.gov . Too often the investor receives poor advice. Don't let it happen to you!
Transaction costs are based on sales of round lots, which are standard units of trading of 100 shares of stock and $1000 or $5000 par value for bonds. An odd lot is an amount of a security that is less than the normal unit of trading for that particular security; for stocks, any transaction less than 100 shares is usually considered to be an odd lot. When brokerage firms buy or sell shares in odd lots, they may charge a fee of 12.5 cents (called an eighth) per share on the odd-lot portion of the transaction, which is called the differential.
The payment of commissions can quickly reduce the return on any investment. A purchase commission of 2 percent is added to a sales commission of another 2 percent, for example, means that the investor has to earn a 4 percent return just to pay the transaction costs. Brokerage commissions typically range from $25 to 3 percent of the value of the transaction. The easiest way to hold down investing costs is to find a brokerage firm that charges low commissions, and that usually means using a discount or online broker.
14.4c How to Order Stock Transactions
Hundreds of millions of shares of securities are traded daily on the stock markets in the United States. Every trade brings together a buyer and a seller to complete the transaction at a given price.
Types of Stock Orders Basically, there are only two types of orders—buy and sell. The stockbroker will buy or sell securities according to prescribed instructions in a process called executing an order. Those instructions can place constraints on the prices at which those orders are carried out. Table 14-4 shows the instructions that accompany stock orders.
Regulations Help Protect against Investment Fraud
Public trust is vital to the success of the securities industry; without it, consumers will not invest. Regulation of securities markets aims to provide investors with accurate and reliable information about securities, maintain ethical standards, and prevent fraud against investors. This regulation occurs at five levels:
1. Securities and Exchange Commission (SEC) . The SEC is a federal government agency that focuses on ensuring disclosure of information about securities to the investing public and on approving the rules and regulations employed by the organized securities exchanges. The SEC requires registration of listed securities with appropriate and updated information. It also prohibits manipulative practices, such as using insider information for illegal personal gain or causing the price of a security to rise or fall for false reasons. All states require registration of securities sold within their states, and they, too, regulate the securities industry.
2. Self-Regulatory Agencies . The Financial Industry Regulatory Authority (FINRA) and other self-regulatory organizations, such as the New York Stock Exchange, enforce standards of conduct for their members and their member organizations. They dictate rules for listing and for trading securities.
3. Brokerage Firms . Individual brokerage firms have established standards of conduct for brokers that govern how they deal with investors.
4. Security Investors Protection Corporation (SIPC) . The SIPC is a limited insurance program to protect the investing public when an SEC-registered brokerage firm fails. Although investment losses due to fraud, misrepresentation or bad investment decisions are not covered, the SIPC protects each of an investor's accounts at a brokerage firm against financial loss as a result of unreturned securities and cash up to a total of $500,000, but no more than $100,000 in cash.
5. Financial Services Oversight Council (FSOC). The mission of the FSOC is to identify and monitor excessive risks to the U.S. financial system arising from the distress or failure of large, interconnected bank holding companies or non-bank financial companies and from risks that could arise outside the financial system. The idea is to eliminate expectations that any American financial firm is “too big to fail” and to respond to emerging threats to U.S. financial stability.
Table 14-4 Instructions Accompanying Stock Transaction
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Instruction |
Process |
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Market |
Buy or sell at current prevailing price |
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Fill-or-Kill |
Immediately buy or sell at current market price or cancel |
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Matched |
Held for minutes, hours or days until executed or cancelled |
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Negotiated |
Buyer “bids” for best price and negotiates until accepted or cancelled |
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Good-til-Cancelled |
Remains valid until executed or cancelled by the investor |
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Limit |
Buy at best possible price “but not above” a specified limit or to sell at a certain price “but not below” a specified price |
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Stop (or Stop-Loss) |
Sell at the market price if it goes below a specified price |
The Tax Consequences of Investing in Stocks and Bonds
The government encourages investing through tax policies that favor investors.
Dividends and Interest
Taxes are low on dividend income. Funds put into regular investment accounts represent after-tax money (you earn an income on which you pay taxes, and then you invest some of the remaining money). Taxes are due on any interest, dividends, and capital gains in the year in which the income is received. The IRS considers as interest income any increase in the par value on bonds, including TIPS bonds. Interest is taxable at the investor's marginal tax rate. Dividend income is taxed at a maximum rate of 15 percent for most people; a zero percent rate applies to lower-income taxpayers.
Capital Gains and Losses
Capital gains taxes are low. No tax liability is incurred for any capital gains until the stock, bond, mutual fund, real estate, or other investment is sold. When you sell an investment, such as a stock, the gain or loss is calculated by analyzing what you paid for the investment plus broker commissions and loads minus the selling price minus commissions or redemption fees. Short-term gains (for investments held one year or less) are taxed at the same rates as ordinary income. Long-term gains (for investments held at least a year and a day) are taxed at special rates: The long-term capital gains rate for taxpayers below the 25 percent bracket is zero percent, the rate is 15 percent for those in the 25 percent bracket and above, and it is 20 percent for those subject to the 39.6 tax rate. Long-term capital gain rates for collectibles such as stamps and coins are 28 percent. Capital losses can be used to offset capital gains or even your regular income. See Chapter 4 .
14.4d Margin Buying and Selling Short Are Risky Trading Techniques
For investors interested in taking on additional risk, there are two advanced trading techniques, and both involve using credit: (1) buying stocks on margin and (2) selling short.
Margin Trading Is Buying Stocks on Credit Some investors open a margin account with a brokerage firm in addition to their cash account so they can buy securities using credit. Opening a margin account requires making a substantial deposit of cash or securities ($2000 or more) and permits the purchase of other securities using credit granted by the brokerage firm. Both brokerage firms and the Federal Reserve Board regulate the use of margin buying , which is using a margin account to buy securities. It allows the investor to apply leverage that magnifies returns or losses.
margin account Account at a brokerage firm that requires a substantial deposit of cash or securities and permits the purchase of other securities using credit granted by the brokerage firm.
margin buying Using a margin account to buy securities; allows the investor to apply leverage that magnifies returns—or losses.
The margin rate is the percentage of the value (or equity) in an investment that is not borrowed. The current requirement is 50 percent for common stock. Thus at least 50 percent of each dollar invested must be the investor's. The remainder may be borrowed from the broker. The securities purchased, as well as other assets in the margin account, are used as collateral.
margin rate Set by the Fed, percentage of the value (or equity) in an investment that is not borrowed—recently 25 to 50 percent.
Buying on margin also can increase returns. Those with an aggressive investment philosophy might buy on margin because it gives them the opportunity to obtain a higher rate of return. Let's say you buy a stock for $50 and the price of the stock rises to $75. If you bought the stock in a cash account and paid for it in full, you'll earn a 50 percent return on your investment ($75 − $50 = $25/50). But if you bought the stock on margin—paying $25 in cash and borrowing $25 from your broker—you'll earn a 100 percent return on the money you invested ($25/$25). Of course, you have to repay your broker $25 plus interest.
The downside to using margin is that if the stock price decreases, substantial losses can occur. Let's say the stock you bought for $50 falls to $25. If you fully paid for the stock, you'll lose 50 percent of your money. But if you bought on margin, you'll lose 100 percent, and you still must come up with the interest you owe on the loan.
The Investment That Is Best for You May Not Be Best for Your Financial Advisor
Ninety percent of financial advisors sell you what is best for them and is “suitable for you”. Here is how the Securities and Exchange Commission defines the suitability standard. When your broker recommends that you buy or sell a particular security or she must have a reasonable basis for believing that recommendation is suitable for you. In making this assessment, your broker must consider your income and net worth, investment objectives, risk tolerance, and other security holdings.
In other words, a bond portfolio might be suitable for an older investor seeking income; a portfolio of penny stocks would not. The same bond portfolio would be unsuitable, however, for a young investor seeking growth. The suitability standard also does not preclude conflicts of interest. What is best for you may not be best for the financial advisor. There could be two investments that could qualify as suitable for you, but one would pay your advisor a 1 percent commission and the other 6 percent. Which do you think he or she might recommend?
A fiduciary standard means that the broker must always act in the best interest of the client regardless of how it might affect the advisor. Only an investment advisor who is a registered investment advisor (RIA) is legally required to act as a fiduciary. Be sure to ask.
The Department of Labor is drafting a rule requiring that all financial advisors abide by fiduciary standards. The industry is fighting against the proposal.
Your Worst Financial Blunders in Investing in Stocks and Bonds
Based on others' financial woes, you will make mistakes in personal finance when you:
1. Invest in stocks that do not match your investment philosophy.
2. Fail to use fundamental analysis when making stock investments.
3. Buy stocks on margin or sell stocks short.
Here a representative of the firm will tell the investor to immediately either put up more collateral (money or other stocks) or face having the investment sold. This procedure is known as a margin call. If the investor fails to put up the additional cash or securities to maintain a required level of equity in the margin account, the broker will sell the securities at the market price, resulting in an even sharper financial loss to the investor. The investor is required to repay the broker for any losses.
Selling Short Is Selling Stocks Borrowed from Your Broker Buying a security with the hope that it will go up in value—the goal of most investors—is called buying long . You might suspect, however, that the price of a security will drop. You can earn profits when the price of a security declines by selling short . In this trading technique, investors sell securities they do not own (borrowing them from a broker) and after so many days or weeks plan to buy the same number of shares of the security at a lower price (returning them to the broker). Thus, the investor earns a profit on the transaction.
buying long Buying a security (especially on margin) with the hope that the stock price will rise.
selling short Investors selling securities they do not own (borrowing them from a broker) and later buying the same number of shares of the security at a lower price (returning them to the broker).
Brokerage firms require an investor to maintain a margin account when selling short because it provides some assurance that the investor can repay the firm for the borrowed stock, if necessary. As a result, some or all of an investor's funds deposited in a margin account are effectively tied up during a short sale. Many brokers hold the proceeds of a short sale, without paying interest, until the customer covers the position by buying it back for delivery to the broker.
Only a small proportion of investors sell stocks short because this approach is so risky. Selling short and buying on margin are techniques to be used only by sophisticated investors.
CONCEPT CHECK 14.4
1. Summarize the differences among discount, online, and full-service brokers.
2. Summarize the differences among types of stock orders: market, limit, and stop order.
3. Explain what selling short is and how it can go wrong for an investor.
LEARNING OBJECTIVE 5
Describe how to invest in bonds.
You should consider investing in bonds if you wish to receive periodic income from a portion of your investments. While bonds usually offer a lower return to investors than stocks, there are good reasons to include bonds in one's portfolio. The primary one is to reduce market risk. Others include obtaining a regular source of predictable although low income, likelihood of profiting from possible future increases in the value of bonds, and matching some of one's assets to one's investment time horizon.
A variety of bonds are available to the investor. High quality bonds are called investment-grade bonds and they offer investors a reasonable certainty of regularly receiving the periodic income (interest) and retrieving the amount originally invested (principal). Only about 8 percent of the 23,000 largest U.S. companies that issue bonds meet the highest investment-grade rating standards. Bonds are usually issued at a par value (also known as face value) of $1000.
investment-grade bonds Offer investors a reasonable certainty of regularly receiving periodic income (interest) and retrieving the amount originally invested (principal).
An investor typically earns a low to moderate return on bond investments, an appropriate yield when compared with the higher total returns earned on riskier stocks and stock mutual funds. Owning some bonds (or bond mutual funds) along with stocks and cash diversifies an investment portfolio.
Speculative-grade bonds pay a high interest rate. These are often derisively called junk bonds, and they are long-term, high-risk, high-interest-rate corporate (or municipal) IOUs issued by companies (or municipalities) with poor or no credit ratings. The interest rates paid investors on junk bonds are 3.5 to 8 percentage points more than those of Treasury bonds.
speculative-grade bonds Long-term, high-risk, high-interest-rate corporate (or municipal) lOUs issued by companies (or municipalities) with poor or no credit ratings. Also called junk bonds or high-yield bonds.
Also more elegantly called high-yield bonds, they carry investment ratings that are below traditional investment grade and carry a higher risk of default (not repaying the bond investors). Keep in mind that higher returns require greater risk. The default rate on investment grade AAA-rated bonds is ½ of 1 percent. It is 1.5% on AA bonds; 3% on A bonds; and 10% on BBB bonds. The rate is over 4% for munis. For more information, see Bond Pickers ( www.bondpickers.com ) or www.defaultrisk.com or search Google using “high-yield bonds.”
Individual investors usually avoid buying individual junk bonds because of the substantial financial risk involved with owning too few investments. Instead, they reduce risk by diversifying their investments through a “high-yield income” bond mutual fund (see Chapter 15 ) that has junk bonds in its portfolio.
14.5a Corporate, U.S. Government, and Municipal Bonds
Three types of bonds are available: corporate bonds, U.S. government securities, and municipal government bonds.
Corporate Bonds Pay Reasonable Returns Corporate bonds are interest-bearing certificates of long-term debt issued by a corporation. They represent a needed source of funds for corporations. The dollar value of newly issued bonds is three times the dollar value of newly issued stocks. Because of tax regulations, corporations often finance major projects by issuing long-term bonds instead of selling stocks. One reason they do so is that payments of dividends to common and preferred stockholders are not tax deductible for corporations, unlike interest paid to bondholders. State laws require corporations to make bond interest payments on time. Therefore, companies in financial difficulty are required to pay bondholders before paying any short-term creditors.
corporate bonds lnterest-bearing certificates of long-term debt issued by a corporation.
Money Websites for Investing in Bonds
Informative websites for investing in bonds, including the latest bond prices are:
Financial Industry Regulatory Authority ( www.finra.org/ )
JW Korth Shop-4-Bonds ( www.shop4bonds.com )
Municipal Securities Rulemaking Board ( emma.msrb.org/home )
Securities Industry and Financial Markets Association ( www.investinginbonds.com )
Yahoo! Finance on bonds ( finance.yahoo.com/bonds )
Wikipedia ( en.wikipedia.org/wiki/Bond_(finance) )
Figure 14-3 Higher Returns on Bonds Requires Greater Risk
The default risk varies with the issuer. To help you in appraising the risks and potential rewards of bond investments, independent advisory services, such as Moody's Investors Service, Standard & Poor's, and Fitch, grade bonds for credit risk. These firms publish what they describe as unbiased ratings of the financial conditions of corporations and municipalities that issue bonds.
A bond rating represents the opinion of an outsider on the quality—or creditworthiness—of the issuing organization. It reflects the likelihood that the issuing organization will be able to repay its debt. Ratings for each bond issue are continually re-evaluated, and they often change after the original security has been sold to the public. Investors have access to measures of the default risk (or credit risk), which is the uncertainty associated with not receiving the promised periodic interest payments as well as the principal amount when it becomes due at maturity.
bond rating An impartial outsider's opinion of the quality—or creditworthiness—of the issuing organization.
default risk (credit risk) Uncertainty associated with not receiving the promised periodic interest payments and the principal amount when it becomes due at maturity.
Table 14-5 shows the bond ratings used by Moody's, Standard & Poor's and Fitch, all well known rating services. The higher the rating, the greater the probable safety of the bond and the lower the default risk. The lower the rating of the bond the higher the stated, or effective interest rate. When bonds are reduced in price from their face amount, more risk is involved. Higher ratings denote confidence that the issuer will not default and, if necessary, that the bond can readily be sold before its maturity date. Investment-grade corporate bonds may provide returns as much as 2.5 percentage points higher than the returns available on comparable U.S. Treasury securities.
U.S. Government Securities Represent Quality and Safety U.S. Treasury securities are the world's safest investment because the government has never intentionally defaulted on its debt. U.S. Treasury securities are backed by the “full faith, credit, and taxing power of the U.S. government,” and this all but guarantees the timely payment of principal and interest. The debt is held by a variety of investors, including the governments of Japan and China, the largest U.S. creditors. U.S. debt is denominated in dollars and is the cornerstone of the global financial system.
U.S. government securities are classified into two groups: (1) Treasury bills, notes, and bonds and (2) federal agency issue notes, bonds, and certificates. Treasury bills, notes, and bonds are collectively known as Treasury securities , or Treasuries. The federal government uses these debt instruments to finance the public national debt.
Treasury securities (Treasuries) Known as Treasuries, securities issued by the U.S. government, including bills, notes, and bonds.
Treasury securities have excellent liquidity and are simple to acquire and sell. Previously issued marketable Treasury securities are bought and sold in securities markets through brokers. New issues can be purchased online using the Treasury Direct Plan ( www.publicdebt.treas.gov ), where they are stored electronically. Individuals may buy Treasury securities in amounts as small as $100.
Table 14-5 Summary of Bond Ratings
The interest rates on federal government securities are lower than those on corporate bonds because they are virtually risk free. The possibility of default is near zero. Individuals with a conservative investment philosophy and overseas investors and governments are often attracted to the certainty offered by U.S. government securities. Investors can purchase these directly from the Treasury. Although interest income is subject to federal income taxes, interest earned on Treasury securities is exempt from state and local income taxes.
Treasury Bills, Notes, and Bonds Treasury bills , or T-bills, are short-term government securities with maturities ranging from a few days to just less than one year. Bills are sold at a discount from their face value (par). The difference between the original purchase price and what the Treasury pays you at maturity, the gain or par, is interest. This interest is exempt from state and local income taxes but is reported as interest income on your federal tax return in the year the Treasury bill matures.
Treasury bills Known as T-bills, U.S. government securities with maturities of less than one year.
Stated as an interest rate, the return on such investments is called a discount yield . For example, if you buy a $10,000 26-week Treasury bill for $9925 and hold it until maturity, your interest will be $75 for an annual return of approximately 1.5 percent. An investor can hold a bill until maturity or sell it before it is due. When a bill matures, the proceeds can be reinvested into another bill or redeemed and the principal will be deposited into the investor's checking or savings account. The minimum purchase of T-bills is $100.
discount yield Difference between the original purchase price of a T-bill and what the Treasury pays you at maturity.
A Treasury note or bond is a fixed-principal, fixed-interest-rate government security issued for an intermediate or long term. Notes are issued for two, three, five, or ten years, and pay interest every six months. Treasury bonds have a maturity of 10 to 30 years. Notes and bonds exist only as electronic entries in accounts. The interest rate on notes and bonds is typically higher than the rates for T-bills because the lending period is longer. Interest payments are to be reported as interest income on one's federal tax return in the year received. When the security matures, the investor is repaid the principal. Investors can hold a note or bond until maturity or sell it.
Treasury note (bond) Fixed-principal, fixed-interest-rate government security issued for an intermediate term or long term. Notes mature in ten years or less; bonds mature in more than ten years.
Floating-rate notes are the Treasury's newest security. Their interest rates change weekly over the two-year time period, paying investors more when market rates rise and less when they fall, and they make quarterly interest payments. Interest rates are pegged to the yield on 3-month Treasury bills. Floating-rate notes may be purchased at auction or via Treasury Direct with a $100 minimum investment.
I bonds are nonmarketable savings bonds backed by the U.S. government that pay an earnings rate that is a combination of two rates: (1) a fixed interest rate that is set when the investor buys the bond and (2) a semiannual variable interest rate tied to inflation that protects the investor's purchasing power. They are sold at face value, such as $25 for a $25 bond. Interest stops accruing 30 years after issue, and I bonds pay off only when redeemed. If you redeem a I bond within the first five years, you will forfeit the three most recent months' interest; after five years, you will not be penalized. All earnings on savings bonds are exempt from both state and local income taxes, while federal taxes can be deferred until the bonds are either redeemed or reach final maturity. I bonds cashed in to pay education expenses are exempt from federal income taxes.
I bonds Nonmarketable savings bonds backed by the U.S. government that pay an earnings rate that combines two rates: a fixed interest rate set when the investor buys the bond and a semiannual variable interest rate tied to inflation that protects the investor's purchasing power.
Treasury Inflation-Protected Securities (TIPS) are marketable Treasury securities whose principal increases with changes in the Consumer Price Index (CPI). These inflation-indexed bonds are the only investment that guarantees that the investor's return will outpace inflation. TIPS bonds are sold in terms of 5, 10, and 30 years, and interest is paid to TIPS owners every six months until they mature. The interest rate is set when the security is purchased, and the rate never changes. The principal is adjusted every six months according to the rise and fall of the CPI; if inflation occurs and the CPI rises, the principal increases. The government sends the interest payment on the new principal to the investor's account. The fixed interest rate on TIPS is applied to the inflation-adjusted principal; so if inflation occurs throughout the life of a TIPS security, every interest payment will be greater than the one before it. The amount of each interest payment is determined by multiplying the inflation-adjusted principal by one-half the interest rate.
Treasury Inflation-Protected Securities (TIPS) Marketable Treasury bonds whose value increases with inflation. These inflation-indexed $1000 bonds are the only investment that guarantees that the investor's return will outpace inflation.
The inflation-adjusted amount added to the principal on a TIPS bond every six months is taxable, even though the investor does not receive the money until the bond matures. Thus, TIPS bonds pay “phantom taxable interest income,” like zero-coupon bonds (zeros or deep discount bonds) (described in the Advice From a Professional box, so the investor pays federal income taxes on the interest earned each year. The investor must use other funds to pay the taxes on that income. If the TIPS are owned in a retirement account, the returns are not taxable until withdrawn.
zero-coupon bonds (zeros or deep discount bonds) Municipal, corporate, and Treasury 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.
Zero-Coupon Bonds Pay Phantom Interest
Zero-coupon bonds (also called zeros or deep discount bonds) are municipal, corporate, and Treasury bonds that pay no annual interest. They are sold to investors at sharp discounts from their face value and may be redeemed at full value upon maturity. For example, a 4 percent, $1000 zero-coupon bond to be redeemed in the year 2024 might sell today for $457. Zeros pay no current income to investors, so investors do not have to be concerned about where to reinvest interest payments. The semiannual interest accumulates within the bond itself, and the return to the investor comes from redeeming the bond at its stated face value at the maturity date. In this manner, zeros operate much like Series EE savings bonds and T-bills. The maturity date for a zero could range from a few months to as long as 30 years.
Parents often invest in zero-coupon bonds to help pay for their children's college education, and they wisely establish ownership of the zeros in the child's name. The phantom income “paid” to the child is generally so small that little, if any, income taxes are due.
People planning for retirement often buy zeros because they know exactly how much will be received at maturity. Even though the investor receives no interest money until maturity, the investor still pays income taxes every year on the interest that accumulates within the bond. Investors can avoid income taxes altogether by buying zeros in a qualified tax-sheltered retirement plan account.
Anne Ranczuch
Monroe Community College, Rochester, New York
When TIPS mature, the federal government pays the inflation-adjusted principal (or the original principal if it is greater). Investors can hold a TIPS bond until it matures or sell it before it matures. The interest on TIPS bonds can be excluded from federal income tax when the bond owner pays tuition and fees for higher education in the year the bonds are redeemed.
U.S. government savings bonds are nonmarketable, interest-bearing bonds issued by the federal government and sold at face value. They are considered a low-risk savings product that earns interest while protecting one from inflation and market risk calamities.
U.S. government savings bonds Nonmarketable, interest-bearing bonds issued by the U.S. Treasury.
Series EE/E savings bonds are a secure savings product issued by the federal government that pays a fixed rate of interest for up to 30 years. The maximum amount of savings bonds you can buy in a single year is $10,000. Electronic EE savings bonds are sold at face value in TreasuryDirect. Paper bonds are no longer available. EE savings bonds are sold at one-half of the face value and pay no annual interest, and they may be redeemed at full value upon maturity. For example, a $100 EE savings bond might be purchased for half of its face amount, $50. The interest, compounded semi-annually, accumulates within the bond itself, and the return to the investor comes from redeeming the bond at its stated face value at the maturity date. Interest on Series EE bonds is exempt from state and local taxes. There is no federal income tax liability on the interest at redemption if the proceeds are used to fund the child's college education. (Series HH savings bonds [no longer sold] were originally issued at par and acquired only by exchanging Series EE bonds. Interest on Series HH bonds is exempt from state and local taxes.)
Series EE/E savings bonds Nonmarketable, interest-bearing bonds issued by the federal government that are issued at a sharp discount from face value and pay no annual interest, and that may be redeemed at full value upon maturity.
Agency Bonds Pay Slightly Better Returns than Treasuries More than 100 different bonds, notes, and certificates of debt are issued by various federal agencies that are government-sponsored enterprises but stockholder owned; these are agency bonds . Well-known examples of these agencies are Fannie Mae (Federal National Mortgage Association), Freddie Mac (Federal Home Loan Mortgage Corporation), and Sallie Mae (Student Loan Marketing Association). Together these make up about 40 percent of the outstanding investment-grade bonds. The first two are the government-chartered agencies responsible in part for the housing and credit debacle that went bankrupt and today are substantially owned by the federal government. Fannie and Freddie service continue to sell bonds, buy mortgages, and package home loans into securities.
agency bonds Bonds, notes, and certificates of debt issued by various federal agencies that are government-sponsored enterprises but stockholder owned, such as the Federal National Mortgage Association.
Other government-chartered agencies that issue bonds include the Tennessee Valley Authority, Federal Farm Credit Banks, Federal Home Loan Banks, and Government National Mortgage Association (Ginnie Mae). Each security represents interest in a pool of loans that are sold to institutions and investors in units of $25,000, although they can also be purchased in smaller units through a mutual fund.
The assets and resources of the issuing agency back these bonds. Although the federal government does not guarantee the debt issued by such agencies, it did provide billions of dollars when Fannie Mae and Freddie Mac faced default. Agency bonds are not as widely publicized as Treasury securities, yet they pay a yield two-tenths to one full percentage point higher than the yield for comparable-term Treasury securities.
Municipal Government Bonds Municipal government bonds (also called munis ) are long-term debts issued by local governments (cities, states, and various districts and political subdivisions) and their agencies. Their proceeds are used to finance public improvement projects, such as roads, bridges, and parks, or to pay ongoing expenses. Moody's Bond Record rates some 20,000 munis, and twice as many unrated securities exist. Bonds range in quality from AAA-rated state highway bonds to unrated securities issued by local governmental parking authorities.
municipal government bonds (munis) Long-term debts (bonds) issued by local governments (cities, states, and various districts and political subdivisions) and their agencies.
The investor's interest income on municipal bonds is not subject to federal income taxes. This is because the U.S. Constitution requires that municipal bond interest be exempt from federal income tax. Because the interest income is tax free, municipal bonds are also known as tax-free bonds or tax-exempt bonds. Interest income on munis also is exempt from state and local income taxes when the investor lives in the state that issued the bond.
Check Bond Performance Online
The bond section of the FINRA website highlights all the key questions one might have about investing in bonds ( www.finra.org/Investors/InvestmentChoices/Bonds/SmartBondInvesting/Introduction/ ). Municipal bond prices and information is available at the Municipal Securities Rulemaking Board ( emma.msrb.org/home ).
Sean's Success Story
Sean's success in investing through the years pushed the value of his portfolio to $140,000. His old portfolio matched his aggressive investment philosophy: cash (10%), bonds (10%), and equities (80%). However, his investments took a terrible hit during the bear market crash of 2007–2009. Because of defaults, his bond values dropped from $14,000 to $11,000. The equity portion of his portfolio, which was mostly hightech, small-cap and microcap stocks and stock mutual funds, dropped 50 percent from $112,000 to $56,000.
The first thing Sean did to try and keep his net worth figure from dropping even further was to spend less money on eating out, music, and electronics. He was scared but resisted the urge to sell low and get out of the market completely; therefore, he stayed invested throughout those two long years, which was depressing for almost all investors. Within 4 years the equities in his portfolio rose well over 60 percent to $130,000. Even though these were still shaky economic times, Sean stayed in the market, and he will continue to invest regularly as the stock markets recovers in the coming years with the slowly growing world economies. Thus by remaining invested as the market recovered, Sean recovered all of his losses, and his portfolio is up from its old high.
Municipal bonds offer a lower stated return than other bonds. However, if your marginal tax rate is higher than 25 percent, it generally makes economic sense to invest in municipal bonds because the after-tax return on a muni might be higher than that of a corporate bond. To compare the after-tax returns of investments, see page 129.
Capital gains on the sale of munis are taxable. Such gains may be realized when bonds are bought at a discount and then sold at a higher price or redeemed for full value at maturity. Bonds bought at a premium also may appreciate to produce a gain.
14.5b Evaluating Bond Prices and Returns
Investors can utilize the standard factors to evaluate bond prices and potential returns: interest rates, premiums and discounts, current yield, and yield to maturity.
Interest Rate Risk Results in Variable Value A bond's price, or its value on any given day, is affected by a host of factors. These include its type, coupon rate, and availability in the marketplace; demand for the bond; prices for similar bonds; the underlying credit quality of the issuer; and the number of years before it matures.
Most important, the price also varies because of fluctuations in current market interest rates in the general economy. The state of the economy and the supply and demand for credit affect market interest rates. These are the current long- and short-term interest rates paid on various types of corporate and government debts that carry similar levels of risk.
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.
Long-Term Interest Rates Set by Investors Plus Occasional Fed Interventions Long-term rates are largely set by bond investors' buying and selling decisions, primarily based on their expectations of future inflation. Short-term interest rates are manipulated by the Federal Reserve Board, which is popularly known as the “Fed.” When inflation rises, the Fed often raises interest rates to discourage borrowing, which reduces consumer and business spending. When the economy slows, the Fed often lowers the interest rates on short-term Treasury issues in an attempt to stimulate economic activity by making it cheaper for companies to borrow and expand. On occasion, the Fed buys long-term mortgage securities and Treasury bonds and notes and related debt for autos and credit cards, again to stimulate the economy.
DO IT IN CLASS
Table 14-6 Unique Characteristics of Bonds
|
Coupon Rate |
The bond's coupon rate (also known as the coupon, coupon yield, or stated interest rate) is the interest rate printed on the certificate when the bond is issued. It reflects the total annual fixed rate of interest that will be paid. |
|
Serial or Sinking Fund |
Occasionally bonds are retired serially. That is, each bond is numbered consecutively and matures according to a prenumbered schedule at stated intervals. These investments are known as serial bonds. Many bonds include a sinking fund through which money is set aside with a trustee each year for repayment of the principal portion of the debt. |
|
Secured or Unsecured |
A corporation issuing a secured bond pledges specific assets as collateral in the indenture (written legal agreement between debtor and lenders) the principal and interest guaranteed by another corporation or a government agency. An unsecured bond (or debenture) does not name collateral as security for the debt and is backed only by the good faith and reputation of the issuing agency. |
|
Registered and Issued |
By law, all bonds issued now are registered bonds . This provides for the recording of the bondholder's name so that checks or electronic funds transfers for payment of interest and principal can be safely forwarded when due. |
|
Book Entry |
All bonds today are issued in book-entry form, which means that certificates are not issued. Instead, an account is set up in the name of the issuing organization or the brokerage firm that sold the bond, and interest is paid into this account when due. |
|
Callable |
An issuer might desire to exercise a call option when interest rates drop substantially. For example, assume a company issues bonds paying a $60 annual dividend (6 percent coupon rate). When interest rates drop perhaps to 4 percent, the 6 percent bonds may represent too high a cost for borrowing to the corporation. If the bonds have a callable feature, the issuer can redeem the bonds before the maturity date. The issuer repurchases the bond at par value or by paying a premium, often a partial year's worth of interest. Approximately 80 percent of long-term bonds are classified as callable. |
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.
secured bond Pledges specific assets as collateral in indenture or has the principal and interest guaranteed by another corporation or government agency.
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.
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.
call option Stipulation in some indentures that allows issuer to repurchase the bond at par value or by paying a premium, often one year's worth of interest.
14.5c Pricing a Bond in Today's Market
As we noted in Chapter 13 , interest rate risk is the risk that interest rates will increase and bond prices will fall, thereby lowering the prices on older bond issues. This decline in value ensures that an older bond and a newly issued bond will offer potential investors approximately the same yield. Bonds generally have a fixed yield (the interest income payment remains the same) but a variable value.
interest rate risk Risk that interest rates will rise and bond prices will fall, thereby lowering the prices on older bond issues.
For example, assume you own a 30-year bond with a face value of $1000 paying a semiannual coupon interest rate of 6 percent that has 20 years remaining until maturity. If interest rates in the general economy jump to 8 percent after one year, no one will want to buy your 6 percent bond for $1000 because it pays only $60 per year. If you want to sell it, the price of the bond will have to be lowered, perhaps to $802.80.
The value of bond (or bond selling price) formula, Equation (14.3) , shows the calculation involved. If rates on similar bonds are now at 8 percent, then the discount rate is 8 percent (or 4 percent twice a year for 40 payments). The task is to calculate the present value of the interest payments and the repayment lump sum. To do so, use Appendix A.2 and Appendix A.4 and look across the interest rows to 4% and down to 40 “n” periods.
where
Conversely, if interest rates on newly issued bonds slip to 4 percent, the price of your 6 percent bond will increase sharply, perhaps to $1273.55. Thus, investors might be willing to pay a bond premium of $273.55 ($1273.55 − $1000), which is a sum of money paid in excess of the bond's face amount, to buy your $1000 bond paying 6 percent when other rates are only 4 percent. Remember that bond yields and prices move in opposite directions— as one goes up, the other goes down.
bond premium A sum of money paid in addition to a regular price.
DO IT IN CLASS
Premiums and Discounts When a bond is first issued, it is sold in one of three ways: (1) at its face value (the value of the bond stated on the certificate and the amount the investor will receive when the bond matures), (2) at a discount below its face value, or (3) at a premium above its face value. After a bond is issued its market price changes in order to provide a competitive effective rate of return for anyone interested in purchasing it from the original bondholder.
As an example, assume that Running Paws Cat Food Company decided to issue 20-year bonds at 8.8 percent. While the bonds were being printed and prepared for sale, the market interest rate on comparable high-risk bonds rose to 9 percent. In this instance, Running Paws would sell the bonds at a slight discount to provide a competitive return. Discounts and premiums on bonds reflect changing interest rates in the economy and the number of years to maturity.
Current Yield The current yield equals the bond's fixed annual interest payment divided by its bond price. It is a measure of the current annual income (the total of both semiannual interest payments in dollars) expressed as a percentage when divided by the bond's current market price. When you buy a bond at par, its current yield equals its coupon yield. For example, a bond with a 5.5 percent coupon yield purchased at par for $1000 has a current yield of 5.5 percent. As bond prices fluctuate because of interest rate changes and other factors, the current yield also changes. For example, if Sarah Jones of Denver, Colorado paid $940 for a $1000 bond paying $55 per year, the bond's current yield is 5.85 percent, as shown by the current yield formula, Equation (14.4) .
current yield Equals the bond's fixed annual interest payment divided by its bond price.
The current yields for many bonds based on that day's market prices are available online and are published in the financial section of many newspapers.
The total return on a bond investment consists of the same components as the return on any investment: current income and capital gains. In Sarah's case, she will receive $1000 at the maturity date (20 years from now), even though she paid only $940 for the bond; therefore, her anticipated total return (or effective yield) will be higher than the 5.85 percent current yield. How much higher is accurately revealed by the yield to maturity formula (discussed next).
Yield to Maturity Yield to maturity (YTM) is the total annual effective rate of return earned by a bondholder on a bond if the security is held to maturity. The YTM is the internal rate of return on cash flows of a fixed-income security. The YTM reflects both the current income and any difference if the bond was purchased at a price other than its face value spread over the life of the bond. The market price of a bond equals the present value of its future interest payments and the present value of its face value when the bond matures.
yield to maturity (YTM) 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.
Three generalizations can be made about the yield to maturity:
1. If a bond is purchased for exactly its face value, the YTM is the same as the coupon rate printed on the certificate.
2. If a bond is purchased at a premium, the YTM will be lower than the coupon rate.
3. If a bond is purchased at a discount, the YTM will be higher than the coupon rate.
For example, because Sarah bought her 20-year bond with a coupon rate of 5.5 percent at a discount for $940, her yield to maturity must be greater than the coupon rate because she will receive $60 more than she paid for the bond when she receives the $1000 at maturity. Exactly how much greater can be determined by calculating an approximate yield to maturity when contemplating a bond purchase because bonds that seem comparable may have different YTMs.
The yield to maturity (YTM) formula, Equation (14.5) , which is duplicated on the Garman/Forgue companion website, factors in the approximate appreciation when a bond is bought at a discount or at a premium:
where
I = Interest paid annually in dollars
FV = Face value
CV = Current value (price)
N = Number of years until maturity
If Sarah paid $940 for a 20-year bond with a 5.5 percent coupon rate, the YTM is calculated as follows:
If you plan to buy and hold a bond until its maturity, you should compare YTMs instead of current yields when considering a purchase because YTMs fairly represent all factors. The current yield on a bond is not an effective measure of the total annual return to the investor; in fact, the fewer years until maturity, the worse an indicator it becomes. As just calculated, Sarah's 20-year bond with a coupon rate of 5.5 percent and a current yield of 5.85 percent has a YTM of 5.98 percent. If the same bond had been purchased with only ten years until maturity, the YTM would be 6.29 percent; with five years until maturity, the YTM would be 6.90 percent; and with two years until maturity, the YTM would be 8.76 percent. Exact YTMs are online and listed in detailed bond tables available at large libraries and at brokers' offices.
Turn Bad Habits into Good Ones
Do You Do This?
Invest only in certificates of deposit
Listen to tips and invest in hot stocks
Invest in speculative stocks
Invest in fewer than five stocks
Ignore big changes in interest rates
Accept broker's advice on stock choices
Utilize full-service brokers exclusively
Buy on margin and sell short
Avoid bonds as investments
Do This Instead!
Invest in common stocks, bonds and mutual funds
Invest only in stocks with good fundamentals
Utilize no more than 5 to 10 percent for speculative stocks
Invest in more than five, or buy stock mutual funds
Invest in bonds on interest rate shifts (but not when rates are rising)
Use the Internet to research stocks and bonds
Buy and sell online to save on commissions
Never buy on margin and sell short, as it is too risky
Buy some TIPS bonds
DO IT NOW!
You know more about personal finance after reading this chapter, so get started right now by:
1. Identifying three types of stocks (See Table 14-1 on page 417) that are appropriate for your investment goals and selecting an example of each.
2. Following the price fluctuations of those stocks for two months online or via newspapers.
3. Considering a bond investment of a corporate bond by selecting one, and researching its price, and bond rating.
Six Decisions for Bond Investors Individuals interested in investing in bonds can review resources on the website of the Securities Industry and Financial Markets Association ( www.investinginbonds.com ). It offers a free, searchable database of the latest corporate, government, municipal, and mortgage-backed bond issues and prices. Bond investors must make six decisions:
1. Decide on credit quality. Consider Treasury/agency, investment-grade corporate and municipal, and below investment-grade corporate and municipal.
2. Decide on maturity. Consider the time schedule of your financial needs: short, medium, or long term. Bonds with a short maturity have the lowest current yield but excellent price stability. Medium maturity bonds pay close to the higher rates earned on long-term bonds and enjoy much greater price stability.
3. Determine the after-tax return. Assuming equivalent risk, choose the bond that provides the better after-tax return because tax-exempt securities may offer a higher after-tax return than taxable alternatives. To compare the after-tax return of investments, see page 129 in chapter 4 .
4. Select the highest yield to maturity. Given similar bond securities with comparable risk, maturity, and tax equivalency, investors are wise to choose the one that offers the highest yield to maturity, as calculated by Equation (14.5) .
5. Instead, think about investing in bond mutual funds. Consider whether it is smarter to invest in bond mutual funds rather than individual bonds. This topic is examined in Chapter 15 .
6. Consider selling bonds or bond mutual funds. Consider selling when interest rates have dropped or are expected to rise substantially in the near future, the bond rating has seriously declined, and because you can profit when rate declines push up the value of your bond.
CONCEPT CHECK 14.5
1. Distinguish between investment- and speculative-grade bonds.
2. Give some reasons why individuals often invest in corporate bonds rather than Treasuries.
3. Summarize the differences among Treasury bonds, I bonds, and TIPS bonds.
4. Give a math example of how to calculate a bond's yield to maturity that is different than the one in the book.
WHAT DO YOU RECOMMEND NOW?
Now that you have read the chapter on stocks and bonds, what do you recommend to Ashley Diaz in the case at the beginning of the chapter regarding:
1. Investing for retirement in 18 years?
2. Owning blue-chip common stocks and preferred stocks rather than other common stocks given Ashley's investment time horizon?
3. The wisdom of owning municipal bonds rather than corporate bonds?
4. The likely selling price of her corporate bonds, if sold today?
5. Investments that might be appropriate to fund her children's education?
BIG PICTURE SUMMARY OF LEARNING OBJECTIYES
LO1 Explain how stocks and bonds are used as investments.
Individual investors provide the money corporations use to create sales and earn profits. The investor shares in those profits by investing in corporations' common stock, preferred stock, and bonds.
LO2 Describe ways to evaluate stock prices and calculate a stock's potential rate of return.
Common stocks may be broadly classified as either income or growth stocks. The investor studies certain fundamental factors, such as the company's sales, assets, earnings, products or services, markets, and management, to determine a company's basic value. To do so, investors examine several revealing ratios such as price/earnings (P/E), price/sales (P/S), and dividend payout, as well as revealing numbers such as book value per share. Individuals also estimate the value of a company by using beta to compare its history and expected future profitability with those of competing stocks.
LO3 Use the Internet to evaluate common stocks in which to invest.
Individuals begin evaluating stocks by setting criteria for a stock investment. This may involve using stock-screening software; obtaining security analysts' research reports, annual reports, 10-Q and 10-K reports, and prospectuses; acquiring economic and stock market data; and using portfolio-tracking services.
LO4 Summarize how to buy and sell stocks, as well as the techniques of margin buying and selling short.
Securities transactions require the use of a licensed broker serving as a middleman between the seller and the buyer. You can buy or sell securities online or through a live stockbroker who works for a brokerage firm that has access to the securities markets. Many individuals use discount and online brokers rather than full-service brokers. Types of stock orders include market, limit, and stop orders. Buying on margin and selling short are risky trading techniques.
LO5 Describe how to invest in bonds.
Investment-grade bonds offer a reasonable certainty of regularly receiving the periodic income (interest) and retrieving the amount originally invested (principal). Junk bonds are available, too. Corporate bonds usually pay higher returns than government bonds. Interest rate risk results in variable value on bond investments.
LET's TALK ABOUT IT
1. Investing Today. What counsel can you offer long-term investors who are hesitant to invest in stocks and bonds in today's economy?
2. Common or Preferred Stock. Make a list of the plusses and minuses of investing in either common stock or preferred stock, and give your conclusion as to which is better for you.
3. Three Good Companies. Make a list of three products and services that you buy on a weekly or monthly basis and the companies that sell them. Offer your initial views on whether each company would be a good place to invest money.
4. Two Useful Measures. The text introduced a variety of ways to measure stock performance. Name two of those measures that you might use in your own decision making. Offer reasons for selecting those measures.
5. Would You Buy? You have just heard that Microsoft's stock price dropped $5. If you had the money, would you buy 100 shares? Give three reasons why or why not.
6. Interesting Stock. Review the classifications of common stock. Based on your personal comfort level for risk, which one type of stock would be of interest to you? Give three reasons why.
7. Sources of Information. If you had an investment portfolio of stocks worth $20,000, identify three sources for information that you would likely use to keep abreast of current information affecting your investments.
8. Potential Rate of Return. Do you think anyone really calculates the potential rate of return on a particular investment? Should they? If so, offer a reason why.
9. Invest Using Credit. Buying on margin and selling short both involve using credit. Would you invest this way? Give two reasons why or why not.
10. Interest in Bonds. Do bonds interest you as an investment? Why or why not?
DO THE MATH
DO IT IN CLASS PAGE 418
1. Numerical Measures. A stock sells at $15 per share.
(a) What is the EPS for the company if it has a P/E ratio of 20?
(b) If the company's dividend yield is 3 percent, what is its dividend per share?
(c) What is the book value of the company if the price-to-book ratio is 1.5 and it has 100,000 shares of stock outstanding?
2. Bond Selling Price. What is the market price of a $1000, 8 percent bond if comparable market interest rates drop to 6 percent and the bond matures in 15 years?
3. Market Price. What is the market price of a $1000, 8 percent bond if comparable market interest rates rise to 10 percent and the bond matures in 14 years?
DO IT IN CLASS PAGE 131
4. Equivalent Taxable Yield. For a municipal bond paying 3.4 percent for a taxpayer in the 25 percent tax bracket, what is the equivalent taxable yield? (Hint: See page 129.)
5. Equivalent Taxable Yield. For a municipal bond paying 3.7 percent for a taxpayer in the 33 percent tax bracket, what is the equivalent taxable yield? (Hint: See page 129.)
6. Yield, Price, and YTM. A corporate bond maturing in 15 years with a coupon rate of 9.9 percent was purchased for $980.
(a) What is its current yield?
(b) What will be its selling price in two years if comparable market interest rates drop 1.9 percentage points?
(c) Calculate the bond's YTM using Equation (14.6) or the Garman/Forgue companion website.
7. Yield, Price, and YTM. A corporate bond maturing in 20 years with a coupon rate of 8.2 percent was purchased for $1100.
DO IT IN CLASS PAGE 441
(a) What is its current yield?
(b) What will the bond's selling price be if comparable market interest rates rise 1.8 percentage points in two years?
(c) Calculate the bond's YTM using Equation (14.6) or the Garman/Forgue companion website.
8. Beta Calculations. Michael Margolis is a single parent and motivational training consultant from Reno, Arizona. He is wondering about potential returns on investments given certain amounts of risk. Michael invested a total of $6000 in three stocks ($2000 in each) with different betas: stock A with a beta of 0.8, stock B with a beta of 1.7, and stock C with a beta of 2.5.
DO IT IN CLASS PAGE 442
(a) If the stock market rises 7 percent over the next year, what will be the likely value of each investment?
(b) If the stock market declines 8 percent over the next year, what will be the likely value of each of Michael's investments?
9. Investment Calculations. Xiao and Shiao Jing-jian, newly weds from Rockville, Maryland, have decided to begin investing for the future. Xiao is a 7-Eleven store manager, and Shiao is a high-school math teacher. The couple intends to take $3000 out of their savings for investment purposes and then continue to invest an additional $200 to $400 per month. Both have a moderate investment philosophy and seek some cash dividends as well as price appreciation.
Calculate the five-year return on the investment choices in the table below. Put your calculations in tabular form like that shown in Table 14-2 . (Hint: When making your calculations you should assume at the end of the first year. At the end of the first year the EPS for Running Paws will be $2.40 with a dividend of $0.66, and the EPS for Eagle Packaging will be $2.76 with a projected dividend of $0.86.)
(a) Using the appropriate P/E ratios, what are the estimated market prices of the Running Paws and Eagle Packaging stocks after five years?
(b) Show your calculations in determining the projected price appreciations for the two stocks over the five years.
(c) Add the projected price appreciation of each stock to its projected cash dividends, and show the total five-year percentage returns for the two stocks.
(d) Determine the average annual dividend for each stock, and use these figures in calculating the approximate compound yields for each.
(e) Assume that the beta is 2.5 for Running Paws and 2.8 for Eagle Packaging. If the market went up 20 percent during the year, what would be the likely stock prices for Running Paws and Eagle Packaging?
(f) Assume that inflation is approximately 4 percent and the return on high-quality, long-term corporate bonds is 8 percent. Given the Jing-jians' investment philosophy, explain why you would recommend (1) Running Paws, (2) Eagle Packaging, or (3) a high-quality, long-term corporate bond as a growth investment. Support your answer by calculating the potential rate of return using the information on pages 421–424 to; or by using the Garman/Forgue website. The Jing-jians are in the 25 percent marginal tax bracket.
|
|
Running Paws |
Eagle Packaging |
|
Current price |
$30.00 |
$48.00 |
|
Current earnings per share (EPS) |
$ 2.00 |
$ 2.30 |
|
Current quarterly cash dividend |
$ 0.15 |
$ 0.18 |
|
Current P/E ratio |
15 |
21 |
|
Projected earnings annual growth rate |
20% |
20% |
|
Projected cash dividend growth rate |
10% |
10% |
FINANCIAL PLANNING CASES
CASE 1
The Johnsons Want Greater Yields on Investments
The investments of Harry and Belinda have done well through the years. While the cash portion of their portfolio has risen to $16,000, it is earning a minuscule 1 percent in a money market account; thus they are seeking greater yields with bond investments. Examine the following table, which identifies eight investment alternatives, and then respond to the questions that follow. The coupon rates vary because the issue dates range widely, and market prices are above par because older bonds paid higher interest than today's issues.
(a) What is the current yield of each investment alternative? Use Equation (14.5) or visit the Garman/Forgue companion website. (Write your responses in the proper column in the table.)
(b) What is the yield to maturity for each investment alternative? (Write your responses in the proper column in the table.) You may calculate the YTMs by using Equation (14.6) or by visiting the Garman/Forgue companion website.
(c) Knowing that the Johnsons follow a moderate investment philosophy, which one of the six corporate bonds would you recommend? Why?
(d) Given that the Johnsons are in the 25 percent federal marginal tax rate, what is the equivalent taxable yield for the municipal bond choice? Should they invest in your recommendation in part (c) or in the municipal bond? Why? You may calculate the equivalent taxable yield using the information on page 129.
(e) Which three of the eight alternatives would you recommend as a group so that the Johnsons would have some diversification protection for their $16,000? Why do you suggest that combination?
CASE 2
DO IT IN CLASS PAGE 413 AND 416
Victor and Maria Hernandez Wonder About Investing
Victor and Maria have decided to increase their contribution to their investment portfolio since Victor is now age 59 and thinking about retiring in five years. For years, they have followed a moderate-risk investment philosophy and put their money in suitable stocks, bonds, and mutual funds. The value of their portfolio is now $320,000, and this is in addition to their paid-for rental property, which is worth $200,000. They plan to invest about $9000 every year for the next five years.
(a) Why should Victor and Maria consider buying common stock as an investment with the additional money?
(b) If Victor and Maria bought a stock with a market price of $50 and a beta value of 1.8, what would be the likely price of an $8000 investment after one year if the general market for stocks rose 6 percent?
(c) What would the same investment be worth if the general market for stocks dropped 8 percent?
(d) Review the types of stocks in Table 14-1 on page 417 and select 2 that you think Victor and Maria might prefer as investments. Explain why.
(e) Discuss the positives and negatives of preferred stock for Victor or Maria.
CASE 3
Julia Price Seeks Rewards in the Bond Market
Julia's investments survived the Great Recession-related bear stock market declines because she was well diversified and was investing more heavily in bonds in the years preceding the decline. When it seemed like the coming recession was starting to look like a reality, Julia cashed out of some equities and moved most of that money into corporate bonds and Treasuries. As a result, over the past four years, the bond portion of her portfolio rose over 20 percent due to low inflation and declining interest rates, which pushed up the value of her bonds. Now she thinks inflation and bond prices will rise so she is selling all her bonds and investing the proceeds into equities. But the stock market prices seem too high already, so she is hesitating. Offer your opinions about her thinking.
CASE 4
An Aggressive Investor Seeks Rewards in the Bond Market
Jessica Varcoe works as a drug manufacturer's representative based in Murfreesboro, Tennessee. She has an aggressive investment philosophy and believes that interest rates will drop over the next year or two because of an expected economic slowdown. Jessica, who is in the 25 percent marginal tax rate, wants to profit in the bond market by buying and selling during the next several months. She has asked your advice on how to invest her $15,000.
(a) If Jessica buys corporate or municipal bonds, what rating should her selections have? Why?
(b) Jessica has a choice between two $1000 bonds: a corporate bond with a coupon rate of 5.1 percent and a municipal bond with a coupon rate of 3.2 percent. Which bond provides the better after-tax return? (Hint: See Equation [4.1] on page 129.)
(c) If Jessica buys fifteen, 30-year, $1000 corporate bonds with a 5.1 percent coupon rate for $960 each, what is her current yield? (Hint: Use Equation [4.1].)
(d) If market interest rates for comparable corporate bonds drop 1 percent over the next 12 months (from 5.1 percent to 4.1 percent), what will be the approximate selling price of Jessica's corporate bonds in (c)? (Hint: Use the Garman/Forgue companion website.)
(e) Assuming market interest rates drop 1 percent in 12 months, how much is Jessica's capital gain on the $15,000 investment if she sells? How much was her current return for the two semiannual interest payments? How much was her total return, both in dollars and as an annual yield? (Ignore transaction costs.)
(f) If Jessica is wrong in her projections and interest rates go up 1 percent over the year, what would be the probable selling price of her corporate bonds? (Hint: Use the Garman/Forgue companion website.) Explain why you would advise her to sell or not to sell.
CASE 5
Two Brothers' Attitudes Toward Investments
Kyle Broflovski, a guidance counselor in South Park, Colorado, has purchased several corporate and government bonds over the years, and his total bond investment now exceeds $40,000. He prefers investments with some inflation protection. His kid brother Ike, a highly paid physician, has more than $150,000 invested in various blue-chip income stocks in a variety of industries.
(a) Justify Kyle's attitude toward bond investments.
(b) Justify Ike's attitude toward stock investments.
Explain why both brothers might be happy investing some of their money in TIPS bonds.
CASE 6
A College Student Ponders Investing in the Stock Market
Ji Wu of Jefferson City, Tennessee, has $5000 that he wants to invest in the stock market. Ji is in college on a scholarship and does not plan to use the $5000 or any dividend income for another five years, when he plans to buy a home. He is currently considering a small company stock selling for $25 per share with an EPS of $1.25. Last year, the company earned $900,000, of which $250,000 was paid out in dividends.
(a) What classification of common stock would you recommend to Ji? Why?
(b) Calculate the P/E ratio and the dividend payout ratio for this stock. Given this information and your recommendation, would this stock be an appropriate purchase for Ji? Why or why not?
(c) Identify the components of the total return Ji might expect, and estimate how much he might expect annually from each component.
(d) Review the section titled “You Should Use Corporate Earnings and Other Measures” on pages 418–420 and select two that you think Ji would utilize to evaluate when investing in stocks. Explain why.
BE YOUR OWN PERSONAL FINANCIAL MANAGER
1. Your Stock Preferences. Complete Worksheet 54: My Preferences Among Stocks from “My Personal Financial Planner” by identifying, for each of the seven types of stock, those that are of interest to you, what you do or do not like about them, and those in which you might invest during your own investing life.
2. Compare Different Stocks as Investments. Learn about the stocks of three publically traded companies of interest to you, perhaps General Motors, Ford Motor Company, and Google, by visiting the website for Kiplinger at www.kiplinger.com . Then complete Worksheet 55: Comparing Stocks as Investments from “My Personal Financial Planner” by recording for each company each of the several performance variables.
3. Preference Among Types of Bond. Complete Worksheet 56: My Preference Among Bonds from “My Personal Financial Planner” by marking for each of the nine types one characteristic you do or do not like about each and which might be of interest to you as an investor.
4. Taxable Versus Tax-Free Income. Complete Worksheet 57: Comparing Taxable and Tax-Free Income from “My Personal Financial Planner” by inserting a realistic rate of investment return and tax rate and then performing the appropriate calculations.
5. Current Yield on a Bond. Complete Worksheet 58: The Current Yield on My Bond Investment from “My Personal Financial Planner” by inserting realistic different current market prices on two existing bonds (perhaps $980 and $910) and different annual interest payments (perhaps $70 and $80) for two bonds and calculating the current yields.
6. Current Value of a Bond. Complete Worksheet 59: The Current Value on My Bond Investment from “My Personal Financial Planner” by going online to find the current market prices of two existing bonds, perhaps individual issues of General Motors and Ford Motor Company, and then inserting the following information in the places provided: annual interest payment and years to maturity. Look online elsewhere for a current market interest rate on comparable securities, or perhaps use 7%, and complete the calculations required.
7. Yield to Maturity on a Bond. Complete Worksheet 60: The Yield to Maturity on My Bond from “My Personal Financial Planner” by going online to find the following information about two bonds: current market price, face value, number of years until maturity, and annual interest in dollars.
ON THE NET
Go to the Web pages indicated to complete these exercises.
1. Latest Financial Information. Go to Kiplinger.com and determine the top three news items that you think are related to personal investing. Note how you can use that information in making a good investment decision.
2. Stock Quotes. Visit the website for Kiplinger at www.kiplinger.com , where you can find stock quotes for most publicly traded companies. Type in the symbols for the following companies: Coca-Cola (KO), Google (GOOG), Microsoft (MSFT), and Disney (DIS). Evaluate these four firms on the basis of EPS, dividend yield, and P/E ratio. What do these data suggest to you about the relative attractiveness of these companies for investors?
3. Stock Screener. Visit the website for Yahoo! Finance, where you can find a stock-screener utility at www.screener.finance.yahoo.com/stocks.xhtml . Search among the S&P 500 stocks for companies with a $50 minimum share price. How many companies meet this criterion? Select again using a P/E ratio from 0 to 20. How many companies meet this new criterion? Why is this list longer? Do you recognize any of the companies on either list?
4. Recent Treasury Prices. Visit the website for the U.S. Treasury Department at www.treasurydirect.gov and enter its Institutional section, where you will find the results of recent auctions for Treasury notes and bonds. What do the results of the auctions over the past year tell you about market expectations for movement of interest rates in the future? (Hint: Compare auction rates for bonds and notes with similar maturity periods.)
5. Find Bond Ratings. Visit the Standard and Poor's website at www.standardandpoors.com and look up the current bond ratings for General Motors and Ford Motor Company. Summarize your findings.
6. Bond Calculator. Go to Investopedia's Bond Calculator to input illustrative pricing data on bonds ( www.investopedia.com/calculator/BondPrice.aspx ). Write what you think of this tool.
7. Beta Values. Go to Calculator Edge ( www.calculatoredge.com/finance/betas.htm ) and input basic information on any stock to calculate its beta. Use 2 percent or a lower figure as the risk-free interest rate.
ACTION INVOLVEMENT PROJECTS
DO IT IN CLASS PAGE 424
1. Answer Seven Questions. Review the box “Did You Know? Seven Questions Every Investor Needs to Answer” on page 424 and write down your responses to each question.
2. Latest Stock Market Values. Using a resource like The Wall Street Journal or the Internet in general, find the latest values for the following market indexes and indicate how each has performed over the past 12 months: DJIA, S&P 500, NASDAQ Composite, and Dow Jones Wilshire 5000 Index.
3. Prices of Popular Stocks. Find the latest values for the following stocks and indicate how each has performed over the past 12 months: American Express, AT&T, Caterpillar, Coca-Cola, Dell, Merck, Walmart, and Walt Disney.
4. Characteristics of Bonds. Review the section “Unique Characteristics of Bonds” on pages 443, select 2 that would be critically important to you as a bond investor. Explain why.
Visit the Garman/Forgue companion website at www.cengagebrain.com .
* Companies that need capital to begin or expand their operations sell new issues of stocks, bonds, or both to the investing public. New issues of stock are referred to as initial public offerings (IPOs). Investment banking firms serve as intermediaries between companies issuing new stocks and bonds and the investing public.
* A stock split occurs when the shares of a stock owned by existing shareholders are divided into a larger number of shares. This may be an indicator that management expects better profits in the years ahead. Many companies provide a cash dividend to stockholders, and sometimes companies declare a noncash dividend in the form of a stock dividend. Here the shareholder receives additional shares of the company's stock.