Basic Concepts of Stocks and Bonds PDF

SH1902 Basic Concepts of Stocks and Bonds Stocks and Bonds Stocks and bonds are financial assets but they differ from each other. A stock is a share in the ownership of a company, representing a claim on the company's assets and earnings. A stockholder is a person who...

SH1902 Basic Concepts of Stocks and Bonds Stocks and Bonds Stocks and bonds are financial assets but they differ from each other. A stock is a share in the ownership of a company, representing a claim on the company's assets and earnings. A stockholder is a person who holds a company's stock, and this means that person is one of the many owners or shareholders of the company. A stockholder's return on his/her investment is called dividend. S/he may have voting rights to some important company decisions, but only depending on the privileges the company attaches to stock s/he holds. A stockholder’s ownership stake in the company becomes greater when s/he buys more stocks. A stock certificate is a proof of ownership, which represents a stock. Stocks are bought and sold in a stock exchange, also called the stock market. The Philippine Stock Exchange (PSE) regulates the stock market in the country. The original price set by a company for stocks when they are first issued is called par value. The market value is the highest estimated price a buyer would pay, and a seller would accept for a stock in an open and competitive market. The true value of a share of stock is how much an investor is willing to pay for it. Many stocks are issued with little or no par value. These are some important features of stocks: 1. Issuing stocks does not require the company to pay interest. 2. Liability is limited. A stockholder is not personally liable if the company is not able to pay its debts. 3. The more shares a stockholder owns, the larger the portion of the profits s/he gets. A bond is bought to grant credit to a company. When a person buys bonds from a company, s/he becomes a lender to that company instead of a part-owner. The company would now be obliged to pay him/her back its "loan." Bonds may be bought and sold at any time. The term "bond" also refers to the written contract between the issuer of the bond (borrower) and the investor (lender, or the buyer of the bond) that specifies the following: 1. the face value or denomination of the bond on the front of the bond; 2. the redemption date or maturity date on which the loan will be repaid; 3. the bond rate or coupon rate which the bond pays on its face value at regular time intervals until the maturity date; and 4. the redemption value which is the amount promised to be paid on the redemption date. Stocks and bonds are traded through brokers in exchanges either online or in traditional transaction. Brokerage firms can set their own commission charge for bond transactions. 08 Handout 1 *Property of STI  [email protected] Page 1 of 7  SH1902 Kinds of Stocks and Their Dividends Common stock gives the owner the right to share in the profits and to vote on company policy. The share of the profits will vary from year to year, depending on how much profit the company makes and how much is distributed to the stockholders. Preferred stock pays the owner a fixed percentage of the stock's par value each year. Dividends for preferred stocks must be paid before any dividend can be distributed to owners of common stock. However, preferred stock owners generally do not have voting rights in the company. A preferred stock can be cumulative (cumulative preferred stock), that is, a company has the option not to distribute it for a period of time, and the dividends accumulate until they are finally distributed by the company. Example: Consider a stock report of a certain company below. Type of Stock Number of Shares Par Value Stock Dividend Value Cumulative Preferred 10,000 ₱100 9% of par value Common 145,000 ₱10 ₱3.50 How much would stockholders of each kind receive? Solution: Stockholders with cumulative preferred stocks would receive 9% of par value, that is ₱9. 9% × ₱100 = ₱9 Stockholders with common stocks would receive dividends of ₱3.50 per share. The total amount for each stock is as follows. For preferred stock: ₱9 × 10,000 shares = ₱90,000 For common stock: ₱3.50 × 145,000 shares = ₱507,500 Retained earnings is the remaining amount of profit of the company after stock dividends are subtracted. Example: Suppose the company in the previous example had net income of ₱825,000 in one year. How much is the retained earnings that year? Solution: Total dividends distributed is ₱90,000 + ₱507,500 = ₱597,500. Thus, the retained earnings is ₱825,000 − ₱597,500 = ₱227,500. Market indices are indicators of the value of a certain stock used to quantify and compare relative values of stocks and bonds. 08 Handout 1 *Property of STI  [email protected] Page 2 of 7  SH1902 Market Indices for Stocks Stock Yields (percent yield) – Ratio of annual dividend to price per share Annual dividend Percent yield = Price per share Current Yield – Ratio of annual dividend to current price Annual dividend Current yield = Price per share Earnings per Share (EPS) – Ratio of net income to number of outstanding shares Net income EPS = Number of outstanding shares Price-Earnings Ratio (PE ratio) – Ratio of price per share to annual earnings per share Price per share PE ratio = Annual earnings per share The PE ratio measures how expensive a stock is. Rate of Return on a Stock Investment – Ratio of total gains to total cost Total gains Rate of return = Total cost Consider these examples of illustrating ways of quantifying relative values of stocks. Example: Ms. Bautista bought shares from a company at ₱90. If she receives ₱3 annual dividend, what percent yield did she have on her investment? Solution: Annual dividend Percent yield = Price per share ₱3 = ₱90 = 3.33% Example: A company sells stocks at ₱85 and paying ₱2.50 annual dividend. What would be the current yield? 08 Handout 1 *Property of STI  [email protected] Page 3 of 7  SH1902 Solution: Annual dividend Current yield = Current price ₱2.50 = ₱85 = 2.94% Example: A company reported net income of ₱870,000 and had 40,000 outstanding shares of stocks. If the current price is ₱75, what are the EPS and the PE ratio of the stock? Solution: Net income Price per share EPS = PE ratio = Number of outstanding shares Annual earnings per share ₱870,000 ₱75 = = 40,000 ₱21.75 = ₱21.75 = 3.45 Example: With the help of stockbroker Phebe, Timothy purchased 525 shares at ₱18 and received his dividends for that year. He sold his shares the next year at ₱21 per share, again with Phebe’s help. If Phebe charges 3% broker commissions and the current dividend is ₱1 per share, what is the company’s rate of return? Solution: Consider the table that summarizes the situation above. Expenses Gains 525 × ₱18 = ₱9,450 525 × ₱21 = ₱11,025 Broker’s Commission Broker’s Commission 3% × ₱9,450 = ₱283.50 3% × ₱11,025 = ₱330.75 Total Cost Total Received ₱9,450 + ₱283.50 = ₱9,733.50 ₱11,025 + ₱330.75 = ₱11,355.75 Net gain = Total received − Total cost = ₱11,355.75 − ₱9,733.50 = ₱1,622.25 Total gain = Net gain + Dividends (₱1 per share) = ₱1,622.25 + ₱525 = ₱2,147.25 Thus, Total gains Rate of return = Total cost ₱2,147.25 = ₱9733.50 = 22.06%. 08 Handout 1 *Property of STI  [email protected] Page 4 of 7  SH1902 Market Indices for Bonds Bond Yields (percent yield) – Ratio of annual dividend to price per share Annual dividend Percent yield = Price per share Current Yield – Ratio of annual dividend to current price Annual dividend Current yield = Current price Approximate Yield to Maturity 2(𝑛𝑛𝑛𝑛 + 𝑃𝑃 − 𝐶𝐶) Approximate Yield to Maturity = 𝑛𝑛(𝑃𝑃 + 𝐶𝐶) 𝐼𝐼 is the amount of annual interest 𝑃𝑃 is the par value of bond 𝐶𝐶 is the cost or current price 𝑛𝑛 is the number of years to maturity Example: A ₱7,000 bond bears 6% interest. Find the percent yield under the conditions below. a. The bond is bought at 95. b. The bond is bought at 105. c. The face value (₱7,000) is paid. Solution: Annual dividend is 6% × ₱7,000 = ₱420. Price per share varies for each condition. a. Since the bond is bought at 95, then Price per share = 95% × ₱7,000 = ₱6,650. Therefore, Annual dividend Percent yield = Price per share ₱420 = ₱6,650 = 6.32%. b. Since the bond is bought at 105, then Price per share = 105% × ₱7,000 = ₱7,350. Therefore, 08 Handout 1 *Property of STI  [email protected] Page 5 of 7  SH1902 Annual dividend Percent yield = Price per share ₱420 = ₱7,350 = 5.71%. c. Since face value is paid, then the price per share is 100% of ₱7,000, that is, Price per share = ₱7,000. Therefore, Annual dividend Percent yield = Price per share ₱420 = ₱7,000 = 6% Example: Consider the same bond in the previous example, that is, ₱7,000 bond bearing 6% interest. Find the current yield under the conditions below. a. The bond is priced at 92. b. The bond is priced at 104. Solution: a. Since bond is priced at 92, then Current price = 92% × ₱7,000 = ₱6,440. Therefore, Annual dividend Current yield = Current price ₱420 = ₱6,440 = 6.52%. b. Since bond is priced at 104, then Current price = 104% × ₱7,000 = ₱7,280. Therefore, Annual dividend Current yield = Current price ₱420 = ₱7,280 = 5.77%. Example: What is the approximate yield to maturity of a ₱6,000 bond bearing 5% interest, bought at 108, with 10 years left to maturity? 08 Handout 1 *Property of STI  [email protected] Page 6 of 7  SH1902 Solution: Given 𝐼𝐼 = 5% × ₱6,000 = ₱300 𝑃𝑃 = ₱6,000 𝐶𝐶 = 108% × ₱6,000 = ₱6,480 𝑛𝑛 = 10 Therefore, 2(𝑛𝑛𝑛𝑛 + 𝑃𝑃 − 𝐶𝐶) Approximate Yield to Maturity = 𝑛𝑛(𝑃𝑃 + 𝐶𝐶) 2(10(₱300) + ₱6,000 − ₱6,480) = 10(₱6,000 + ₱6,480) = 4.04%. Theory of Efficient Markets The Theory of Efficient Markets holds that stocks are already accurately priced and they reflect all available information about companies. Hence, there is no way to predict future stock prices and the only way to earn higher returns is by purchasing higher risk investments. Given how broad the original theory was, Eugene Fama divided the theory into three (3) sub-theories: The weak form assumes that current stock prices fully reflect all historical information, including past returns. Thus investors would gain little from technical analysis, or the practice of studying a stock's price chart in an attempt to determine where the stock price is going to go in the future. The semi-strong form assumes that stock prices fully reflect all historical information and all current publicly available information. Thus, investors gain little from fundamental analysis, or the practice of examining a company's financial statements and recent developments. The strong-form states that prices reflect not just historical and current publicly available information, but insider information, too. Investors therefore can't benefit from technical analysis, fundamental analysis, or insider information References: Chua, R., Ubarro, A., & Wu, Z. (2016). Soaring 21st century mathematics (general mathematics). Quezon City: Phoenix Publishing House. Fernando, O. (2016) Next century mathematics (general mathematics). Quezon City: Phoenix Publishing House. Lim, Y., Nocon E., Nocon, R., & Ruivivar L. (2016). Math for engaged learning (general mathematics). Quezon City: Sibs Publishing House. Melosantos, L. (2016). Math connections in the digital age (general mathematics). Quezon City: Sibs Publishing House. Regacho, C., Benjamin, M., & Oryan, S. (2017). Mathematics skills for life. Quezon City: Abiva Publishing House, Inc. Zorilla, R. (2016). General mathematics for senior high school. Malabon City: Mutya Publishing House. 08 Handout 1 *Property of STI  [email protected] Page 7 of 7