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Financial Assets I: Stocks and Bonds

VIEWS: 82 PAGES: 39

									Financial Assets I:
Stocks and Bonds
      Chapter 12
  Review of Investment Basics


• Risk/return trade-off

• Intrinsic value = Present value of all cash
  flows
   – Bonds: interest and return of principal
   – Stocks: dividends and potential growth
• Not all risk is equal
   – Systematic risk is important
      • Estimated by Capital Asset Pricing Model
Investing in Stocks

       Ownership and potential gain
Characteristics of Stocks

• Residual ownership
• Two forms of return
  – Dividends
  – Capital gain
• No guarantees!
  – For dividend

  – For capital gain
What kind of stock?

•   Blue chip stocks
•   Growth stocks
•   Income stocks
•   Speculative stocks
•   Cyclical stocks
•   Defensive stocks
•   Large caps, mid caps, small caps
•   Penny stocks
How do I decide?

• Value
  –   Macroeconomic and mega trends
  –   Quality of management
  –   Quality of Product
  –   Investing in the stock is investing in the company


• Growth
  – Opportunities
  – Competitive environment
Methods of Choosing Stocks

• Technical analysis   • Valuation
  – Charting             – P/E ratio
  – Based on price       – PEG ratio
    movement             – Discounted
                           dividends valuation
                           model
                         – Free cash flow
                           model
Technical analysis

• Market sentiment measures
  – Volume trading
  – Advance/decline ratio
  – Put/call ratio
• Charting
  – Trend lined
  – Head and shoulders, saucers…
  – Breaking through the average
What do the recommendations
mean?

• Go to www.finra.org
  – Investors
     • Smart investing
        – Understanding security analysts‟ recommendations
Why are stocks so hard to predict?

• Changes based on         • Changes based on
  “value”                    psychology
  – Interest rate change     – Trend investing
  – Business risk            – Herd behavior
  – Market risk change          • Bubbles
                                • Crashes
Strategies in stock investing

• Pick and choose
  – Market timing

• Dollar cost averaging
  – Avoids perception bias


• Buy and hold

• Dividend reinvestment plans
One more thing for the notebooks


• Go to the SEC website
  – www.sec.gov
     • Go to investor information
         – Go to online publications
            » Go to “T”
            » Get “Trade executions: what every investor should
               know”
     • Look at the EDGAR tutorial
         – When you start investing, you may want to use this source
What do I need to know about
buying a stock?

• Recordkeeping
   – Basis
• All that stuff in the mail
   –   Annual reports
   –   Proxy statements
   –   Dividends
   –   Notices
Valueline
The basic numbers



•   Description of the business
•   Exchange listed and symbol
•   Price/earnings
•   Beta
•   Recent price
•   High/low price
•   Volume
Valueline Rankings
1 (high) to 5 (low)



• Timeliness
   – Price performance in next 6 - 12 months
• Safety
   – Based on financial strength and price stability
   – Important to conservative investors
• Technical
   – Predictor of short term movement (3 - 6 month)
Valueline
Detailed information


• Analyst‟s report
• Historical values and estimates
  – Sales, cash flow, earnings, ROE, ROA
• Annual growth rates
• Target price
• Effect of a recession
     Capital Asset Pricing Model
     CAPM




               ki  krf   km  krf 
     • Risk free rate estimated by Treasuries
     • Market premium estimated by historical returns over risk-free



                        
              ki  krf   km  krf               
                    Alpha is a measure of the return
                    beyond what was expected
                 Positive Alpha means returned
                 better than expected

Investment Calculations

• Estimating price on P/E ratio
  – P/E x estimated earnings
  – Can use P/CF and estimated cash flows
Investment Calculations

• Dollar cost averaging
   – Investing $1000 per month
   – 1000/Share price = shares bought
• Average cost
   – Total cost/Total shares
• Profit/loss
   – (Total share x current price) - total cost
Investment Club
Groups of four




• Compare stocks
   – Which will be least risky in a fully diversified
     portfolio?
   – Which is least affected by an economic downturn?
   – Which has the best prospects for price
     improvement over the next 6 – 12 months?
   – Which would be „best‟ for conservative investors?
Notebook Assignment

•   Building your “portfolio”
    –   Discuss the risk profile of your group members
    –   Review the Valueline information of your 4 stocks
    –   Go to an Bloomberg, get price history and comparison graph on
        the stocks
        www.bloomberg.com
•   Build a portfolio from the 4 stocks you have
    –   Begin with your investment plan, choose your portfolio
        – Total invested $40,000
        – Decide how much to invest in each stock
            • Between $1,000 and $37,000
    –   Explain how your allocation supports your investment plan and
        investing profile
Investing in Bonds

      Corporate
     Government
 Bonds

• A promissory note
  – Pays interest, called the coupon rate
  – Is redeemed for face value on the maturity date
• Pays a fixed income stream for a fixed period
• Indenture (contract)
• Other characteristics
  – Call provision
  – Convertibility
  – Sinking fund
How interest is paid

                            Reinvestment risk
• Current income
  – Most corporate bonds
  – Cash on a regular basis
• Accrual basis                  Opportunity risk
  – Interest is awarded and accrued to the bond
  – CDs, some US savings bonds
• Discount basis                Taxed on the
                                implied interest
  – Interest is interpolated from capital gain
  – OIDs, short-term Treasuries
Bonds - Coupon rates


• Investment grade
  – BB and above
  – Very low risk of default
• Junk or High Yield
  – Never for your core investment
• Zero-coupon (Original Issue Discount Bonds)
  – Helpful for timing of cash flows
Bonds - Issuers

• Corporate bonds
• Government bonds
  – Muni‟s
     • Pre-tax equivalent yield
  – General obligation bonds
  – Revenue bonds
  – US EE savings bonds
Bonds - Types

• Corporate
  – Secured
     • Secured by a particular asset
         – Mortgage bonds
  – Debentures
     • Secured against the total assets of the company
         – Senior and subordinate

• Government
  – Federal
  – Muni‟s
     – General obligation bonds
     – Revenue bond
Buying a Bond

• From a broker
  – Fee around $25
  – Spread
• Accrued interest settlement
  – Interest pays semi annually
  – Owners get interest on a pro rata basis
• Duration
  – A measurement of interest rate sensitivity
Bonds and Interest Rates

• Bonds pay a fixed income regardless of what
  market interest rates are
  – Reinvestment risk
• Market value of bonds
  – Interest rate risk (price risk)
     • Rises when interest rates fall
     • Falls when interest rates rise
• Return to par value when maturity is reached
Bond Essentials

• Coupon rate
  – The rate that determines the amount of the
    periodic payment
• Par value, Face value
  – The amount for which the bond will be redeemed
    at maturity
• Maturity date
  – The time when the bond will be „bought back‟
Is this investment worth it?

• What you think it is worth
   – Insert the Investor’s Required Rate of Return
   – Get the “intrinsic value”
   – Compare to the current market price
• What you think it is getting you
   – Insert the current market price
   – Get the Yield to Maturity
   – Compare to your required rate of return
Is this investment worth it?

• To compute intrinsic value:
   –   FV = Par value
   –   PMT = coupon rate x par x I/2
   –   N = number of years to maturity x 2
   –   I = investor‟s required rate of return
   –   Compute PV
• To compute yield to maturity:
   –   FV = Par value
   –   PMT = coupon rate x par x I/2
   –   N = number of years to maturity x 2
   –   PV = market price
   –   Compute i
Bond Portfolio Strategies

• Timing of cash flows
  – Bonds to mature at educational cash flow needs
• Laddering
  – Bonds maturing at year or two year intervals
  – Each year replaced by new bond
• Barbell
  – Balancing price risk with reinvestment risk
US Government Bonds

• Bills, notes and bonds
  – Time to maturity
  – Method of interest payment
     • Discount
     • Accrual
     • Current income
  – Tax consequences
US Government Bonds

• TIPS
  – Treasury Inflation Protected Securities
     • Principal is adjusted for CPI

     • Interest rate stays same
         – Interest amount may vary
         – Interest and increase in principal taxable when accrued
US Government Bonds

• STRIPS
  – Separate Trading of Registered Interest and
    Principal of Securities
     • Management of cash flows
     • Bought through brokers
Notebooks


• Go to the US public debt website and
  complete the handout
  – www.treasurydirect.gov
• Complete the computation handout
• Do Case 10.1 and 10.2
                   Maturity        The date the issuer agrees
                                   to redeem the bond for its face value



                    1/1/2020

                       RELIABLE CORP.
                   $1000               5% annually


  Face value
  or Par value                                    Coupon Rate
How much the bond will                         Annual interest paid =
be redeemed for on its maturity date           coupon rate x face value
Review of Investment Basics

• Risk/return trade-off

• Intrinsic value = Present value of all cash
  flows
   – Bonds: interest and return of principal
   – Stocks: dividends and potential growth
• Not all risk is equal
   – Systematic risk is important
      • Estimated by Capital Asset Pricing Model

								
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