Equities: Stocks, Derivatives, Bonds

Investing in the stock market offers tremendous potential for financial growth, but it also carries inherent risks. To navigate these complexities successfully, investors must develop a fundamental understanding of stocks, bonds, and derivatives. This comprehensive guide explores the essential concepts that can help both novice and experienced investors make more informed decisions.

Understanding Stocks and Corporate Ownership

Corporations are legally recognized entities that operate as "persons" when granted authority by state or federal governments. While some corporations have single owners, most are owned by large groups of individuals who become owners by investing capital. This investment is acknowledged through stock certificates, which serve as proof of ownership.

Stock Certificates and Ownership Rights

A stock certificate typically includes:

The corporation's name and address
The stockholder's name
Number of shares owned
Signatures from company executives (usually the Treasurer and President)
Certificate value
Committee of Uniform Securities Identification (CUSIP) number

Investors can either keep physical stock certificates in their possession or allow them to be kept at the broker's office (known as keeping them in the "street name"). The second option facilitates easier selling and avoids the risk of losing physical documents.

As a shareholder, you're entitled to several privileges, including:

Receiving declared dividends
Selling or gifting your shares
Voting rights proportional to your ownership
Preemptive rights to maintain your ownership percentage when new stock is issued
Attending annual meetings or voting by proxy

Small shareholders typically don't attend annual meetings but may pass their votes to management by proxy. Some corporate bylaws may restrict the ability to transfer shares, requiring the stock to be offered back to the company first—a tactic often used in smaller companies to prevent hostile takeovers.

Common vs. Preferred Stock

The two primary types of stock are:

Common Stock:

Usually carries voting rights
Higher potential for price fluctuation and growth
Receives dividends after preferred shareholders
No guarantee of dividends
Unlimited upside potential if company performs well
Greater risk if company performs poorly
Most widely traded type of stock

Preferred Stock:

First claim on dividends and liquidation proceeds
More stable price than common stock
Often includes a fixed dividend amount (e.g., $8.00 per share or 8% of par value)
Typically has limited or no voting rights
May include features like:
- Cumulative dividends (unpaid dividends accumulate and must be paid before common shareholders receive anything)
- Call provisions (company can redeem shares at a premium)
- Convertibility to common stock at a fixed ratio (e.g., one preferred share for four common shares)

Stock Dividends and Splits

When companies want to grow without issuing new stock and diluting ownership, they may declare a stock dividend. Unlike cash dividends, stock dividends provide shareholders with additional shares rather than income. Stock dividends are generally non-taxable if there's no option to take cash instead.

For accounting purposes:

Small stock dividends (20-25% of outstanding shares): Company debits Retained Earnings equal to the fair market value of shares
Large stock dividends: Company debits only the legal value (par or stated value)

Large stock dividends function similarly to stock splits, as they typically result in a proportional decrease in stock price. For example, a 2-for-1 stock split usually results in the market price dropping by 50%—if you owned 100 shares worth $20 each, you'd now own 200 shares worth $10 each.

Stock dividends offer favorable tax advantages because they convert ordinary income into long-term capital gains, which are typically taxed at lower rates.

Evaluating Stock Performance

Essential Financial Ratios

Understanding financial ratios is crucial for evaluating a company's performance:

Earnings Per Share (EPS):

Calculated as: Net Earnings ÷ Outstanding Shares
Represents the portion of company profit allocated to each share
One of the most important indicators of financial performance

Price-Earnings Ratio (P/E):

Calculated as: Market Price ÷ EPS
Reflects market expectations about future company growth
Higher multiples indicate greater market optimism
A P/E ratio around 15 is generally considered reasonable

Dividend Payout Ratio:

Portion of earnings distributed to shareholders rather than reinvested
Lower ratios suggest the company is financing growth internally

Dividend Yield:

Calculated as: Dividend Paid ÷ Current Market Price
A yield of 6-7% is considered relatively high

Book Value Per Share:

Represents what shareholders would theoretically receive if the company sold all assets at book value and paid all liabilities

Liquidity and Profitability Measures

Current Ratio:

Calculated as: Current Assets ÷ Current Liabilities
Measures short-term liquidity
Traditional benchmark is 2:1

Quick Ratio (Acid Test):

Calculated as: (Cash + Marketable Securities + Short-term Receivables) ÷ Current Liabilities
Excludes inventory and prepaid expenses
Traditional benchmark is 1:1

Debt-to-Equity Ratio:

Calculated as: Total Debt ÷ Total Equity
Measures long-term liquidity and financial leverage
Lower percentages indicate stronger financial positions

Interest Coverage Ratio:

Calculated as: (Net Income + Interest Expense + Income Taxes) ÷ Interest Expense
Indicates how many times the company can cover its interest payments

Accounts Receivable Turnover:

Calculated as: Credit Sales ÷ Average Receivables
Measures how efficiently a company collects its receivables

Inventory Turnover:

Calculated as: Cost of Goods Sold ÷ Average Inventory
Reflects how quickly inventory is sold
Varies significantly by industry (e.g., high for groceries, low for jewelry)

Return on Assets (ROA):

Calculated as: Net Earnings ÷ Average Assets
Measures how efficiently a company uses its assets to generate profit

Return on Equity (ROE):

Calculated as: (Net Earnings - Preferred Dividends) ÷ Average Common Stockholders' Equity
Important measure for common shareholders

Understanding Stock Values and Volatility

Stock Valuation

Stocks have several associated values:

Par Value: An arbitrary legal value assigned to the stock (face value)
Market Value: The current price at which the stock trades (true value)
Book Value: The accounting value based on the company's balance sheet

Stock Price Fluctuations

Stock prices change regularly due to various factors:

Economic conditions
Company performance
Market sentiment
Unexpected events

Beta is a statistical measure of stock volatility relative to the market:

Beta of 1: Stock moves exactly with the market
Beta less than 1: Stock is less volatile than the market
Beta greater than 1: Stock is more volatile than the market
Negative beta: Stock moves in the opposite direction of the market

Investment Categories

Blue Chip Stocks: Shares in well-established companies with steady earnings
Penny Stocks: Shares trading below $1, usually on the Over-the-Counter (OTC) market
- Higher risk but potentially higher reward
- Less regulatory oversight
- Often subject to price manipulation

Understanding Derivatives

Derivatives are financial instruments whose value derives from an underlying asset. Unlike spot (or cash) markets where you pay cash and immediately receive something in return, derivatives represent agreements about future transactions or the right to execute transactions.

Types of Derivatives Markets

Derivatives can be classified into two main categories:

Commodities Derivatives:

Value based on movements in commodities prices (gold, oil, corn, etc.)
Used by producers and consumers to hedge against price fluctuations
Allow farmers, miners, and manufacturers to lock in prices

Financial Derivatives:

Value based on movements in financial assets (stocks, bonds, currencies, etc.)
Used for speculation, hedging, and risk management
Include options, futures, forwards, and swaps

Options

Options are contracts giving the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price (strike price) within a specific time period.

Call Options:

Give the holder the right to buy an asset at the strike price
Valuable when market price exceeds strike price
Often used in executive compensation to align interests with shareholders
Example: If a CEO receives call options to purchase company stock at $20 per share, and the stock rises to $30, the CEO can exercise the options for an immediate $10 per share profit

Put Options:

Give the holder the right to sell an asset at the strike price
Valuable when market price falls below strike price
Often used as insurance against price declines
Example: An investor holding stock at $50 per share might buy put options with a $45 strike price as protection against significant losses

Option Characteristics:

Premium: The price paid to acquire the option
Expiration date: When the option contract ends
Exercise style: American (exercisable any time until expiration) or European (exercisable only at expiration)
Intrinsic value: The actual value if exercised immediately (market price minus strike price for calls; strike price minus market price for puts)
Time value: The additional value based on potential for favorable price movement before expiration

Futures and Forward Contracts

Futures Contracts:

Standardized agreements to buy or sell an underlying asset at a predetermined price on a specific future date
Traded on regulated exchanges with standardized terms
Require margin deposits and daily settlement of gains/losses
Example: A corn futures contract might specify delivery of 5,000 bushels of corn three months from now at $4 per bushel

Forward Contracts:

Similar to futures but customized between parties rather than standardized
Traded over-the-counter (OTC) rather than on exchanges
No daily settlement—settlement occurs only at maturity
Greater counterparty risk (risk that the other party defaults)

Key Characteristics of Futures:

Settlement date: When the contract expires and delivery occurs
Contract specifications: Exact measure of the underlying asset (e.g., 100,000 barrels of oil, 100 ounces of gold)
Settlement method: Cash settlement or physical delivery
Margin requirements: Initial deposit and maintenance margin

Uses of Derivatives:

Hedging: Protecting against adverse price movements (e.g., farmers locking in crop prices)
Speculation: Betting on price movements to generate profit
Arbitrage: Exploiting price differences between markets
Risk management: Transferring specific risks to those willing to accept them

While derivatives offer sophisticated risk management tools, they're extremely complex and risky financial instruments generally best handled by professional money managers. Most individual investors encounter derivatives indirectly through mutual funds or hedge funds rather than trading them directly.

Understanding Bonds

Bonds represent investments in debt, functioning as:

Assets to investors (buyers) who provide the capital
Liabilities to borrowers (issuers) who must repay the debt

Unlike stocks that represent ownership, bonds represent loans with a promise of repayment and regular interest payments. They can be issued by governments (federal, state, municipal) or corporations.

Bond Characteristics and Terminology

Maturity Date: When the principal is returned (typically 20-30 years for corporate bonds)
Interest Rate (Coupon Rate): Fixed percentage of face value (contract or stated rate)
Face Value (Par Value): Principal amount (usually $1,000) and the amount returned at maturity
Market Price: Changes based on prevailing interest rates
- Sold at premium (above par) when market rates are lower than stated rate
- Sold at discount (below par) when market rates are higher than stated rate
Indenture: Legal document detailing the issuer's responsibilities, including interest rate, payment dates, and covenants
Yield: The effective interest rate, taking into account the bond's current price
Bond Rating: Assessment of creditworthiness by rating agencies (e.g., AAA, AA, A, BBB)

How Bond Pricing Works

The inverse relationship between interest rates and bond prices is fundamental to bond investing:

When market interest rates rise, existing bond prices fall
When market interest rates fall, existing bond prices rise

This occurs because the fixed interest payment (coupon) becomes more or less attractive relative to new bonds being issued at current rates.

Example: A General Electric bond issued at 5% with a face value of $1,000 entitles the holder to receive:

$50 per year in interest ($1,000 × 5%)
$1,000 at maturity

If market interest rates rise to 6%, new bonds would pay $60 annually on a $1,000 investment. The existing 5% bond becomes less attractive and its market price would fall below $1,000 (to a discount) to compensate for the lower interest rate.

Types of Bonds

By Issuer:

Government Bonds: Treasury bonds, bills, and notes issued by federal governments
Municipal Bonds: Issued by state and local governments, often tax-exempt
Corporate Bonds: Issued by corporations to fund operations or expansions
Agency Bonds: Issued by government-sponsored enterprises

By Security:

Mortgage Bonds: Backed by specific collateral (property or assets)
Debentures: Unsecured bonds backed only by the issuer's creditworthiness
Revenue Bonds: Repaid from a specific revenue source (e.g., toll road)

By Risk/Return Profile:

Investment-Grade Bonds: Higher credit ratings (BBB- and above), lower risk and yield
High-Yield ("Junk") Bonds: Lower credit ratings (BB+ and below), higher risk and yield
Sovereign Bonds: Issued by national governments, risk varies by country

Special Features:

Callable Bonds: Issuer can redeem before maturity (usually when interest rates decline)
- Includes a call premium to compensate investors
- Similar to mortgage refinancing when rates fall
- Creates reinvestment risk for the investor
Convertible Bonds: Can be converted to a specified number of stock shares
- Example: A GE convertible bond might be convertible to 50 shares of GE stock
- If GE stock rises above $20 per share, conversion becomes advantageous
- Allows issuers to offer lower interest rates due to the conversion feature
Bonds with Warrants: Include options to buy stock at below-market prices
- Enhances bond attractiveness while enabling lower interest rates
Zero-Coupon Bonds: Sold at deep discounts with no regular interest payments; full face value paid at maturity

Bond Registration and Ownership

Modern bonds are typically registered in the issuing company's records, linking the bond to the owner. This contrasts with historical "bearer bonds," where whoever possessed the physical document could claim payment.

Tax Implications

Bond interest is generally taxable as ordinary income, with some exceptions:

Municipal bond interest is typically exempt from federal taxes and sometimes state taxes
Zero-coupon bonds generate "phantom income" taxed annually despite no cash payment until maturity
Capital gains/losses apply when bonds are sold before maturity

Risk and Return Relationship

There's a direct correlation between risk and potential return. A classic investment pyramid helps visualize appropriate asset allocation:

High Risk (Apex of Pyramid - Smallest Allocation)

Futures contracts
Collectibles

Medium Risk (Middle of Pyramid)

Junk bonds
Growth stocks and mutual funds
Real estate investments
Blue chip stocks
Income-producing mutual funds

Low Risk (Base of Pyramid - Largest Allocation)

Life insurance
Government securities (Treasury bills, U.S. bonds)
Municipal bonds
Government bond mutual funds
FDIC-insured savings accounts
Certificates of Deposit
Money market funds

Frequently Asked Questions (FAQ)

What's the difference between common and preferred stock?

Common stock typically carries voting rights but receives dividends after preferred shareholders. Preferred stock has priority for dividends and liquidation proceeds but usually lacks voting rights. Preferred stock tends to have more stable prices compared to common stock.

How do I evaluate if a stock is worth investing in?

Examine key financial ratios like Earnings Per Share (EPS), Price-Earnings Ratio (P/E), dividend yield, and debt-to-equity ratio. Compare these metrics to the company's historical performance, industry averages, and competitors. Also consider the company's business model, management team, and growth prospects.

What are derivatives and should I invest in them?

Derivatives are financial instruments whose value derives from an underlying asset, such as options and futures contracts. They're complex and generally riskier than direct investments. Most individual investors should avoid trading derivatives directly unless they have substantial financial knowledge or professional guidance.

How do bonds work as investments?

Bonds are essentially loans to corporations or governments. You receive fixed interest payments (typically semi-annually) and the return of principal at maturity. Bond prices fluctuate inversely with interest rates—when rates rise, bond prices fall, and vice versa. They generally offer lower risk and lower returns than stocks.

What's the relationship between risk and return?

Higher risk investments typically offer higher potential returns to compensate investors for taking on additional uncertainty. Lower risk investments generally provide more modest but more consistent returns. A well-balanced portfolio includes investments across the risk spectrum, with allocation proportions based on your financial goals and risk tolerance.

Should I try to time the market with my investments?

Timing the market consistently is nearly impossible, even for professionals. A better strategy is long-term investing based on fundamental analysis and diversification. Financial advisors generally recommend staying invested through market cycles rather than attempting to predict market highs and lows.

What's a stock dividend and how does it differ from a cash dividend?

A stock dividend distributes additional shares to existing shareholders rather than cash. It doesn't provide immediate income but increases your ownership stake. Stock dividends are generally not taxable until the shares are sold, whereas cash dividends are typically taxable in the year received.

How can I assess a company's financial health before investing?

Review the company's financial statements (balance sheet, income statement, cash flow statement) and analyze key ratios like current ratio, debt-to-equity ratio, and profit margins. Also examine trends in revenue, earnings growth, and dividend history. A company with strong fundamentals typically has consistent earnings, manageable debt, and positive cash flow.

Conclusion

Successful stock market investing requires a balanced approach that considers your financial goals, risk tolerance, and market knowledge. By understanding the fundamentals of stocks, bonds, and derivatives, and by applying analytical tools to evaluate company performance, you can make more informed investment decisions and build a diversified portfolio aligned with your objectives.

Remember that while higher-risk investments may offer greater potential returns, they should constitute a smaller portion of your overall investment strategy. Following the pyramid concept of investing often results in a prudent strategy with decent overall returns.