Equities: Stocks, Derivatives, Bonds

Investing in the stock market can be financially rewarding. It can also be risky. A basic understanding of stocks is vital if an individual hopes to successfully navigate the complexities of investing.

Equities: Stocks, Derivatives, Bonds

Corporations and Individual Stocks

Corporations are really artificial entities with authority to operate as a “person” when given that power by the state or federal government. Although a corporation may be owned by a single person, most are owned by large groups of individuals. One of the many advantages of the corporate form is its ability to raise large amounts of capital by attracting investors who then become owners.

Those owners are issued a piece of paper, called a stock certificate, which attests to their position. These shares of stock also entitle the owner to receive any dividends declared, sell the stock, or gift it to family members. As an owner, the investor can vote his or her shares of stock but most of the time small holders do not travel to annual meetings or pass on their votes to management by proxy, although both are viable options.

The stock certificate routinely shows:  (A) the name of the corporation, (B) its address, (C) the name of the stockholder, (D) the number of units of ownership, i.e., number of shares owned, (E) signatures of the Treasurer and President, (F) value of the certificate, and (G) Committee of Uniform Securities Identification [CUSIP], as shown below.

Investors can either keep shares in their possession or allow them to be kept at the broker’s office, also called keeping them in the “street name.” This second option allows for easier selling of the shares and avoids the risk of loss of the physical documents.

One of the basic privileges of owners, known as the preemptive right, is the ability to buy new stock when the corporation issues it and thus maintain their proportionate ownership without the company diluting that ownership by a stock issuance. Conversely, there may be restrictions on the ability to transfer shares to anyone else if the corporate bylaws require the stock to be offered back to the company first. This restriction is typically more common in smaller companies. This is a tactic to prevent hostile takeovers: an acquisition by an individual or corporate entity desiring only to siphon off cash and shut down the original issuing business.

There are two types of stocks – common and preferred. Common is usually the voting stock; preferred has the first right to any dividends declared and first claim on any cash if the corporation is liquidated. Preferred stock dividends are a fixed amount expressed in dollars if the stock is no-par. Otherwise it is a percentage if there is a par value.

For example, General Electric (GE) may issue preferred for $8.00 per share with a dividend, or it may be expressed as 8%, if the stock has a par value of $100 per share. Usually preferred stock does not fluctuate as much in price as common stock, due to its right to receive dividends first: preferred is much more stable than common.

Corporations which offer preferred stock usually attach a cumulative feature which means that if dividends are not paid in any year, they will have to be paid at some future date and before common shareholders receive anything. It is an attractive feature to preferred shareholders but unattractive to the common investor. As a result it may be offered with a call provision, which means the corporation can redeem the preferred stock at a call premium.

When the stock is called, any dividends in arrears at that time would have to be paid. For example, if the company declared but did not issue any cash dividends during the three preceding years, those dividends would have to be paid at the time the stock is called before holders of common stock are paid.

Corporations may also issue preferred stock with a convertible feature which allows the shareholders to change their preferred shares for common share at some fixed ratio. For example, you might be able to convert one preferred share into four common shares. This is irreversible, but means that if the company becomes more profitable, the investor could cash in on the more valuable common stock.

If a company hopes to grow without issuing new stock – thereby diluting ownership and earnings – it may declare a stock dividend. This may be in the form of additional shares but doesn’t give the investor any extra income. In fact, the Internal Revenue Service treats most stock dividends as nontaxable only if there is no option to take either cash or stock: nothing is received and the holder has no value except that he or she now has more shares, more paper certificates. If a corporation wishes to maintain a history of dividends but elects not to pay out cash, it will declare a stock dividend.

The accounting profession requires that the company debit Retained Earnings2 equal to the fair market value of the shares if the stock dividend is considered small: say 20% to 25% of the number of shares outstanding. If it is considered larger than this, the debit should be equal only to the legal value which is par or the stated value of no par stock, an arbitrary value assigned to this stock but not shown on the certificate.

Large stock dividends are more like stock splits because the stock prices decrease. For example, a 2-for-1 stock split typically will result in the market price dropping 50%. Instead of the 100 shares you owned worth $20 each, you now own 200 shares worth $10 each. Stock dividends have favorable tax advantages because they turn ordinary income into long-term capital gains (LTCG): because stocks are always held for more than one year, a long term. As of 2012, LTCG will be taxed at 0%, if the taxpayer’s rate on their federal return is 15% or lower, or at 15%, if that rate is 16% or higher.

An investor should not try to time the market. It is nearly impossible to know when a stock price high or low has been reached based on price alone. Financial advisors usually tell their clients to stay in for the long haul. There is nothing wrong in trying to cash in on your profits by selling some of your shares because you’re not playing with your own money. It is similar to being at a casino and gambling only with your winnings.

However, a better strategy is to use the fundamental tools of statement analysis to determine which company to invest in. Such tools are well known among accounting and financial analysts. They include Earnings per Share (EPS) which is measured by taking the bottom line net earnings and dividing that number by the outstanding shares. To the investment community that represents one of the most useful tools in evaluating a corporation’s financial performance.

It is comparable to adding up all the income of a household and then dividing that number by the total number of persons in the household. It gives you a clear picture of how much income each person would have a share in.

A related measure used by financial advisors is the Price Earnings Ratio. This represents the market view of the future profitability of the corporation. The higher the multiple, the most optimistic the market is about this company. In the “dot.com” era, multiple was twenty or thirty times earnings, and for companies with a loss it was infinity because in this case the numerator was a negative number. That was a high risk time and the bursting “bubble” spelled trouble for many people. In contrast today a multiple of 15 would be relatively reasonable, but this could change as it did in the late 1990s.

Many people who invest in the market are often interested in a corporation’s current income. They are looking for dividends and are concerned with the dividend payout ratio, the amount of earnings distributed to the shareholders rather than being reinvested in the company. In companies that finance their growth internally, you would find a low dividend payout ratio.

Another related measure is the dividend yield which is computed by dividing the dividend paid by the current market price. Here a result of 6% to 7% would be fairly high. One more measure is the book value per share. This represents the stockholder’s equity minus the preferred stock plus any dividends in arrears divided by the total number of shares outstanding. It is not a very meaningful value because it represents what a stockholder would receive if the company sold all of its assets at exactly book value and paid all of its liabilities. Perhaps in an entity like an investment club it would have some meaning, but not in general.

There are other measured used by lenders that anyone can study to gauge the performance of a company. These include the current ratio, debt to equity, accounts receivable and inventory turnovers, the rate of return, and the number of times the interest is being met. These ratios are also useful in evaluating credit risk. Here is an example of a hypothetical corporation, Fantasy Inc. It was formed in 2010.

Their financial statements include the following:

• income statement
• balance sheet
• retained earnings statement
• statement of stockholders equity

There are short-term current liquidity measures. They include the current ratio which is measured by dividing current assets by current liabilities. For Fantasy Inc, this is $135,000/30,000 which equals $4.5:1. This means that Fantasy has $4.50 of current assets for each $1 of current liabilities.

There is a rule of thumb that $2:1 is the maximum any company should have, but I have seen companies with smaller numbers that are in better current liquidity position, and other companies with higher ratios in worse conditions. What is important is to make comparisons with prior periods for the company as well as other companies in the same industry.

Another related measure often used to measure short-term liquidity is the “acid test” or “quick” ratio. It includes only cash, marketable securities, and short-term receivables, excluding inventories and prepaids. For Fantasy this is $50,000/30,000 which equals $1.7:1. It tells that the company has $1.70 of quick assets for each $1 of current liabilities. Here the “rule of thumb” is $1. Again, comparisons are important.

Another thing to be aware of is the opportunity to manipulate date by entering transactions at or near the end of statement date. For example, if Fantasy paid off $15,000 of its accounts payable, its current ratio of 120,000/15,000 would increase from $4.5:1 to $8:l without any real economic difference. You must be careful in using ratios. Again, it is best practice to make comparisons with prior periods and other companies in your industry. Places to look for industry comparisons include Robert Morris Associates, Standard and Poor, or other financial publications.

Ratios on long-term liquidity could include the total debt to total assets. For Fantasy Inc. this would be $105,000/400,000 which equals 26%. This is a fairly low ratio. Still another measure of long-term liquidity is long-term debt to total debt. For Fantasy Inc., this is $75,000/105,000 which equals 71%. This is a fairly high percentage.

An additional measure of this type of liquidity is the debt to equity ratio. For Fantasy Inc, this is $105,000/295,000 which equals 36%. This is a fairly low number.

A measure of safety is the number of times the interest charge is being met. You divide the net income before interest expense and income taxes by the interest expense. For Fantasy Inc., this is $84,000/5,000 which equals 17 times. This means the company’s net income could decrease by 17 times before the creditors – including stockholders – would be unlikely to be paid.

Ratios involving the measure of the company’s ability to collect its receivables involve the accounts receivable turnover. That is measured by dividing credit sales by average receivables. An acceptable way to measure average receivable quickly is to add the current receivables to prior period receivables and divide by two (2).

For Fantasy Inc, this is ($500,000/25,000) + 30,000/2 which equals 18. This means that on average, receivable turn into cash about 18 times a year. A related measure easier to visualize is the number of days’ sales in receivable. It is calculated by dividing 365 by the turnover ratio. For Fantasy Inc., this is 365/18 which equals 20. This means that they on average collect their receivables in 20 days. If their credit terms are n/30, their customers are paying very fast which means they are probably extending credit to very wealthy people.

Still another measure of liquidity is the inventory turnover. It is calculated by dividing cost of goods sold by the average inventory. For Fantasy Inc., this is $240,000/85,000 + 80,000/2 which equals 2.9.

This is a very low number. Grocery stores have a high number while jewelry stores or land development companies have a very low number. A related measure is the number of days the inventory is around. For Fantasy Inc., this is 365/2.9 which equals 126 days. This should be compared to prior periods and other companies in their industry.

A profitability measure used by financial analysts that you see on the cable channel CNBC is Earnings per Share. It is measured by dividing net income after preferred dividends from the net earnings ($2.50 × 2,000 shares) $63,000 – 5,000 which equals $58,000/20,000 which equals $2.90. This means that if the corporation paid out all of its earnings, each shareholder would receive $2.90 for each share owned. A related measure used by investors and analysts is the price earnings ratio which is measured by dividing the market price by EPS. For Fantasy Inc. this is $30/2.9 which equals 10 times.

Other measures of profitability could include rate of return which is measured by dividing net earnings by average assets. For Fantasy Inc., this is $63,000/295,000 + 330,000/2 which equals 20%, a relatively high percentage.

A measure useful to common stockholders is the return on common stockholders’ equity. It is calculated by dividing net earnings minus the preferred dividends by the average common stockholders’ equity.

For Fantasy Inc. this is $63,000 – 5,000/295,000 + 330,000/2 which equals 19%. Confusing? Could be. Does it require a mathematics genius to figure it all out? Not really. In fact there are even more measures used by investors and analysts to predict the company’s ability to pay its billsand be profitable. These are the very basics of evaluation and well worth the time to master, if an investor hopes to be successful in the market.

Values of Individual Stocks

There are several values associated with stock. There is par value which is an arbitrarily assigned legal value, technically the face value of thestock certificate. It is often a very low number to avoid possible later assessments to shareholders if issued below the value.

Most stocks today have a no-par value. But the true value for a stock would be its current fair market value. This is the price a buyer would pay and a seller would sell for. Most stocks today have a no-par value. But the true value for a stock would be its current fair market value. If stock is valued at $100 but sells for $90, the investor could be responsible for the $10 difference. This is the price a buyer would pay and a seller would sell for. In publically held companies it is an easy value to determine because the stock is actively traded and prices are readily available.

However in closely-held corporations – usually a small firm with only a small number of stockholders – it requires a valuation using techniques like capitalizing earnings or cash flow by a cost of capital or some other acceptable measure of value.

Stock prices fluctuate daily or even hourly as economic conditions change. They sometimes move in strange ways that cannot be explained by financial or economic factors. For example, during the 1970s, the stock market as a whole took a deep plunge when then-President Gerald Ford fell while deplaning from Air Force 1 and hit his head on the exit door. The only explanation for such a downward movement is uncertainly due to the possibility of a new president if Mr. Ford were to become incapacitated.

The measure of stock volatility is call beta. This is a statistic used to measure how much a particular stock moves in relation to the total market. A positive “1” means that a stock changes exactly, and in the same direction, as the overall market. A negative “1” means that it moves in the opposite direction, going up in price when the market is generally declining. A “0” would means that this stock is completely independent of market movement.

Some investors purchase “penny” stocks, available only on the Over the Counter (OTC) market. These are shares that are sold for less than $1.00 and are very risky. However, if they move upward they can be very profitable. Most wise investors avoid the “penny” stocks and invest only in “blue chip” stocks issued by corporations that are well established and have a history of steady earnings and growth. Penny stocks are usually shares in new companies or in those which may go into bankruptcy. There are no Securities and Exchange Commission (SEC) oversight or compliance issues in this specific OTC market. Companies that trade there sometimes pay for publicity to increase the value of their stocks.

Derivatives

Derivatives are used widely in financial markets, but they are not always understood. We’ll cover the basics in this chapter. This will give you a fundamental understanding of what derivatives are and how they work.

Many investors are familiar with the term “spot market”. A spot market is simply a market where you pay cash and get something in return. Sometimes spot markets are referred to as cash markets. The stock market is an example of a spot market. You pay cash and in return receive a stock. There are also spot markets for commodities like gold, oil, and corn. You pay cash and receive a bar of gold, a barrel of oil, or a bushel of corn.

In addition to spot markets there are derivatives markets. What is a derivative? A derivative is a financial

instrument whose value is derived from the value of some other asset. This other asset is called the underlying asset. The two main classes of derivatives are commodities and financial derivatives. The price of a commodities derivative is based on movements in the price of commodities like gold, oil, and corn. The price of a financial derivative is based on the movements in price of a financial asset, such as a stock.

In the financial news we often hear of executives being compensated with stock options. Options are an example of a derivative. There are two main types of stock options – put options and call options. Stated simply, a put option gives you the right to sell something at a designated price. A call option gives you the right to buy something at a designated price. Executives are generally given call options.

Let’s look at an example: Suppose the stock of Apex Company is trading at $20 per share on January 1st. At this time, the CEO of Apex Company is given call options. These call options allow the CEO to purchase Apex stock at the designated price of $20 per share at any time during the next year. You can see that the CEO now has an incentive to manage Apex in such a way that Apex’s stock price will go up.

If by June 1, the price of Apex is at, say, $30 the executive would surely be interested in exercising his or her options to buy Apex stock for $20. It’s an immediate $10 per share profit! This is one way executives are given incentives to effectively manage their companies.

You might be asking, “What if the price of Apex stock had gone down by June 1?” If at June 1, the stock of Apex was at $15, the executive would not be interested in exercising the option to buy at $20. In fact, no one would. In this case the call option is worthless.

In our example, the executive was given the right to purchase stock at $20. The designated price of $20 is referred to as the strike price. Our example showed that when the market price of the Apex stock was below the strike price of the call option, it effectively made the call option worthless. When the market price was above the strike price of the call option, it definitely had value to the CEO. Wouldn’t you like to be able to purchase something for $20 that you could immediately sell for $30?

The value of the call option in our example was entirely derived from the movement in the price of another asset. In this case, Apex stock. This brings us back to our definition of a derivative. A derivative is a financial instrument whose value is derived from the value of something other asset. The value of stock options is derived from the price of the underlying stock. Stock options are derivatives.

Other common derivatives are futures contracts and forward contracts. Futures and forwards are an agreement to buy or sell some underlying asset in the future. In the spot, or cash, market you buy a bushel of corn to be used immediately. In the futures and forwards markets you enter an agreement to buy or sell a bushel of corn at some point in the future.

There are differences between futures and forwards contracts, but their fundamental principles are the same – they are agreements about a transaction that will occur in the future. For our discussion, we will focus on futures contracts. Futures are traded on a futures exchange.

Now let’s look at some basic features of futures contracts. All futures contracts are based on the value of some underlying asset. This underlying asset could be a commodity like corn, gold, or oil. All futures contracts have an expiration, or settlement, date. Settlement can either be in cash or in delivery of the underlying asset. All futures contracts specify an exact measure of the underlying asset. For example, 100,000 barrels of oil, or 100 ounces of gold, or 20 bushels of corn.

Suppose you purchase a futures contract that agrees to purchase 20 bushels of corn three months from now at a price of $12 per bushel. This most likely would be speculative. You will be hoping that the spot, i.e., cash., price of corn in three months is higher than $12. If the spot price for corn is $15 in three months, you will buy the corn for $12 per bushel, as stated on your futures contract, and then immediately sell it in the spot market for $15 – an automatic $3 per bushel profit. If however, the spot price of corn is lower than $12 in three months, say, $10, then you will be losing money on that futures contract. You will have to buy the corn for $12 per bushel, and sell it in the spot market for only $10.

You will lose $2 per bushel.

Derivatives are complex and very risky financial instruments, and generally only seasoned and well funded investors should endeavor to trade them. Also, the processors of commodities, such as farmers, would hedge rather than speculate.

Most individual investors never purchase derivative instruments directly. They rely on professional money managers who are well-educated in finance and financial markets to manage the trading of derivatives. If you own mutual funds, it is possible that a small portion of the portfolio is made up of derivative instruments. Money managers often use derivatives to hedge market risks.

Some wealthy investors can put their money in so-called hedge funds. These funds trade heavily with derivatives. These investors would enter into an opposite transaction than investors in derivatives: they attempt to exploit inefficiencies in the markets by taking risky positions involving derivatives and non derivatives rather than protecting price declines for farmers and increases for producers.

While we’ve talked about just a couple examples of derivatives, it is worth noting that there are many, many derivative securities.

Bonds

Bonds are really investments in debt. They are actually loans which represent an asset to the investor (who is the buyer) and a liability to the borrower (the issuer). These can include government-issued instruments such as Series EE or H bonds, but usually have corporate issuers. They have a maturity date of 20 to 30 years for corporate bonds and the interest rate is typically fixed at 4% or 5%. This rate is known as the contract or stated rate.

To compute the amount of interest, this rate is multiplied by the face or principal value. It also represents the maturity value which the holder receives on the maturity date, if the company does not default. Bonds are issued in various denominations, but the usual face value or principal is $1,000. That figure also represents the maturity value, the money received by the investor at the maturity date.

For example, a General Electric bond issued at 5% with a fixed value of $1,000 would entitle the holder to receive $50 per year ($1,00, × 5%) and a return of $1,000 at maturity.

From the date of issue to the date of maturity, the price or fair market value will change daily because the real or effective rate is constantly changing due to different economic conditions, in the same way that the stock market changes. The bond will either sell at a premium, that is a price above par, or at a discount, a price below par. Because the stated rate and the face amount are fixed, the only change that can be made is to adjust the market price.

For the investor, the premium price reduces the income earned because these debt instruments were bought at a lower-than-face value, so the investor would not actually recoup the price they paid if the bonds are held to maturity.

The discount price, on the other hand, increases the amount of interest earned if held to maturity because the purchase price was less than face value but they are being redeemed at the higher price. For tax and accounting purposes, the discount is amortized by what is known as effective interest method. This is a complicated mathematical formula that is best computed by a finance or accounting professional.

When bonds are issued with a security backing in the form of collateral, they are called mortgage bonds, as opposed to bonds issued with no security backing. It can be mistakenly assumed that mortgage bonds are safer than non-mortgage bonds.

This would be true only if the mortgage and unsecured bonds were from the same entity because mortgage bonds have the security of property and other assets behind them. The debtor responsibilities are spelled out in a legal document call the indenture.

These include, among others, the stated rate of interest, interest payment dates, covenants required, and security. Today the interest and principal most bonds are registered in a company’s records. In days past bonds were called “bearer bonds” which meant whoever turned in the document would receive the money.

The debtor – the issuing entity – can call in the bonds at a date before the stated maturity. This is done when the market rate of interest is declining in relation to the contract or stated rate. In this case the borrower or issuer sees a chance to save money by redeeming bonds with a higher rate of interest than the current market rate and issuing new bonds at a lower rate.

This is the same as people who refinance their mortgages when real estate rates are declining, especially if that obligation has several years to maturity. However, the closing and other costs of refinancing have to be weighed against the annual savings generated by the lower rate of interest, and figured as part of the budget.

In the case of bonds, there is a risk to the investor/buyer. They will have cash available because of the payout from the issuer if they do not choose to reinvest, but any new bonds will probably be at a lower rate of interest.

Issuers may offer the investor a convertible feature, meaning there will be a number of shares of stock that the investor will receive on conversion. Once agreed to, this transaction is irreversible and the investor would probably only do the conversion when stock prices have increased. The convertible feature allows the company to pay a lower interest rate because the stock is being reinvested in a product that is worth something, like stock.

For example, a General Electric convertible bond may be converted to 50 shares of GE stock. If that stock is selling above $10, it would be an advantage to investors to convert their $1,000 GE bond for GE stock.

Companies may offer warrants with bonds, which are options to buy stock at below current market prices. This feature will result in a lower interest rate.

Bond yields are an expression of the real rate of interest that the company pays. This is a complicated formula that is best computed by a professional tax or financial advisor.

Risk and Rate of Return

There is a direct relationship between risk and rate of return. They move together: The higher the risk, greater will be the rate of return. There is a classic way to represent this, a pyramid which reflects the proportion of assets you should allocate to each level of risk. At the apex of the pyramid where you have the highest risk, you should allocate the least amount of investment. This would include future contracts and collectibles.

As the pyramid widens, you would increase your investments with medium risk. At the top of this second level, identified as aggressive growth, you would include so-called junk bonds, stocks, and growth mutual funds. At a lower level of medium risk investments you would include real estate (the actual properties) or Real Estate Investment Trusts (REIT’s). At the very bottom of the medium level would be blue chip stocks and income producing mutual funds.

The very bottom of the pyramid is low risk investments. At the top of this low risk would be life insurance and government securities, such as treasury bills, U.S and municipal bonds, and mutual funds which primarily invest in government bonds and government agencies. At the very bottom of the pyramid, the lowest of the low risk, would be FDIC-insured savings accounts, Certificates of Deposits, and money market mutual funds.

Following the pyramid concept of investing is a prudent strategy and staying will probably result in an overall decent return on your assets.