Investing in Stocks (and Bonds)
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Why Stocks and Bonds?
Risk-return tradeoff
- To earn higher returns than conservative investments, you must accept more risk.
- Over the long term, stock values tend to rise (but fluctuate along the way).
Corporations and capital
- Corporation: government-chartered legal entity that operates in its own name.
- Public corporation: issues stock traded to the general public.
- To raise capital, firms may issue:
- Common stock
- Preferred stock
- Bonds
Common Stock
What it is
- Shares of ownership in a corporation’s assets and earnings.
Two main expectations for investors
- The company earns profits and pays cash dividends.
- The market price of shares rises over time (capital gains).
Residual claim + limited liability
- Residual claim: common shareholders get paid after higher-priority claimants (bondholders, preferred).
- Limited liability: you can lose what you invested, but you can’t lose more (stock price can’t go negative).
Voting rights
- Common shareholders typically vote for the board of directors (policy and officer selection).
- Votes are proportional to shares owned.
Preferred Stock
What it is
- Fixed-income ownership security with fixed dividends per share.
- Preferred dividends must be paid before common dividends.
Key features
- Often attractive to investors who want steady income.
- Typically no voting rights.
Cumulative preferred stock
- If dividends are skipped, missed dividends must be paid before common dividends can resume.
Convertible preferred stock
- Can be exchanged (at holder’s option) for a specified number of common shares.
Bonds (Lending to the Issuer)
What a bond investor expects
- Regular interest payments at a fixed rate (current income)
- Return of principal at the maturity date
Stock Characteristics and Classifications
Price/Earnings (P/E) ratio
P/E ratio = Market price per share ÷ Earnings per share (EPS)
Interpretation (lecture patterns):
- Lower P/E often correlates with higher dividend yield, less risk, slower growth.
- Compare to peers/industry for context.
Beta (volatility vs. the market)
- Beta = 1.0: average market sensitivity
- Beta < 1.0: less sensitive (defensive/countercyclical tendencies)
- Beta > 1.0: more sensitive (higher relative risk)
Cyclical vs. countercyclical (defensive)
- Cyclical: profits strongly influenced by business cycle (autos, housing, airlines, retailing)
- Countercyclical/defensive: tends to hold up in weak economy; often lower beta
Income stocks
- Pay relatively high cash dividends consistently
- Often lower beta (utilities-type profile in lecture)
Growth stocks
- Rapid earnings growth; returns mainly from price increases
- Rarely pay dividends
- Often high P/E and high beta
Value stocks
- Trade at low price relative to fundamentals (dividends/earnings/sales)
- Often higher dividend yield and lower P/E
Blue-chip stocks
- Long-established, reputable, industry leaders
- Consistent dividends and “steady” earnings growth (not spectacular)
Fundamental Analysis (Evaluating Stocks)
Big idea
- Stocks have an intrinsic value based on expected future earnings.
- Look for sound companies priced below what they “should” be.
Measuring Expected Stock Returns (Key Metrics)
Earnings per share (EPS)
EPS = Annual profit (after preferred) ÷ Common shares outstanding
Price/Sales (P/S) ratio
Lecture definition structure:
- P/S ratio compares market capitalization to annual sales.
P/S ratio = Market capitalization ÷ Annual sales
Lecture rule of thumb:
- Avoid firms with (P/S > 1.5)
- (P/S < 0.75) is “good” in the lecture framing
Dividends per share
Dividends per share = Total cash dividends ÷ Shares outstanding
Dividend payout ratio
Dividends per share ÷ EPS (or total dividends ÷ total earnings).
Payout ratio = Dividends ÷ Earnings
Interpretation:
- Lower payout ratio can imply more retained earnings for growth (potential capital gains).
Dividend yield
Dividend yield = Annual dividend per share ÷ Market price per share
Book value and book value per share
- Book value: assets − liabilities (shareholders’ equity).
Book value per share = Shareholders’ equity ÷ Shares outstanding
Lecture signal:
- If book value per share exceeds market price per share, the stock may be underpriced.
Key Terms & Definitions
| Term | Definition |
|---|---|
| Common stock | Basic ownership claim; residual claim |
| Preferred stock | Fixed dividend ownership security; priority over common dividends |
| Bond | Debt security; investor lends principal for interest + repayment at maturity |
| Dividend | Portion of earnings paid to shareholders |
| Market price | Current price buyers/sellers agree on |
| Residual claim | Paid after higher-priority claims |
| Limited liability | Loss limited to amount invested |
| P/E ratio | Price per share ÷ EPS |
| Beta | Volatility vs. broad market index |
| EPS | Earnings per share |
| P/S ratio | Market cap ÷ annual sales |
| Dividend yield | Dividend ÷ current price |
| Book value | Assets − liabilities |
Exam Tips
- ✅ Be able to distinguish common vs preferred vs bonds (ownership vs lending; priority; dividends vs interest).
- ✅ Know what beta communicates (relative volatility).
- ✅ Be able to compute P/E, EPS, dividend yield, payout ratio quickly.
- ✅ Know which stock type matches goals (income vs growth vs value vs blue-chip).
Common Mistakes to Avoid
- ❌ Confusing dividends (equity income) with bond interest (debt income).
- ❌ Interpreting beta backwards (higher beta = more market sensitivity).
- ❌ Using dividend yield as “total return” (it’s only the current income component).
Practice Problems
Problem 1: P/E ratio
Market price = 25. EPS = 1.60.
Find: P/E
Solution: 25 ÷ 1.60 = 15.625 ≈ 16.
Problem 2: EPS
Net profit after preferred = 32,000. Shares = 20,000.
Find: EPS
Solution: 32,000 ÷ 20,000 = 1.60.
Problem 3: Dividend yield
Dividend per share = 0.40. Market price = 25.
Find: dividend yield
Solution: 0.40 ÷ 25 = 0.016 = 1.6%.
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