A Quick Intro to Stocks And Bonds

Some of the important qualities of Stocks include:

• A stock is valued, partially, on the value of Owners’ Equity, which comes from the Balance Sheet. The balance sheet is based on this relationship: Assets – Liabilities = Owners’ Equity.
  • Assets: Things a company owns, like cash or a building.
  • Liabilities: Things that are owed, like a repaying a mortgage or work on a contract.
  • Owners’ Equity: The value of the company, which will be positive if Assets > Liabilities. Owners’ Equity is also called Book Value and is used in the Price to Book Value ratio.
• Stocks are sometimes called “equity”. It is common to hear people say they trade equities when referring to stocks.
• A stock is also valued based on how much the company is expected to earn in the future (if earnings growth is high, investors expect the company to make lots of money).
• Stocks are issued by the company, who raises money during an IPO in exchange for the new shareholders having an ownership stake in the company
• Stocks can go up and down in price because investors estimate the future value of the company and buy or sell shares when they believe the future value is higher or lower than the current value.
• A company may pay a dividend to shareholders. This dividend usually comes from the company’s earnings and the dividend yield is calculated as the (12 month dividend)/(current stock price).
• If a company declares bankruptcy, the stock is expected to be worthless. Ownership is risky.

Some of the important qualities of Bonds include:

1. Bonds may be issued by the US Treasury, other sovereign governments, and corporations.
2. Bonds do not represent ownership in the company. On the balance sheet, they show up as a liability!
3. A bondholder will expect to receive certain cash flows in the future. They expect to receive the coupon payments (like your monthly mortgage bill) and a repayment of the loan when the bond matures. The repayment amount is usually the bond’s face value and is often $1000 per bond. 
4. A bond is a contract between the company/issuer and the bondholder. The contract specifies how much the company will pay and with what frequency. In other words, how much income will the bond generate. Therefore, bonds are considered part of the asset class called Fixed Income.
5. Bonds can go up and down in price, just like a stock. However, bonds are valued based on cash flows and the probability of the cash flows being paid as specified in the contract.
   1. If a strong company like Apple announces great earnings, the stock will probably go up in value because the company is assumed to be growing more quickly. The bond price will not go up. Instead the bond becomes a little less risky because the bond’s cash flows are more likely to be paid.
   2. If a very weak company, like Hertz, announces great earnings, its bonds may increase in price. A company like Hertz, which is in bankruptcy proceedings, might default on its bonds, leaving investors with worthless paper. Therefore, the bonds are trading below their face value. If the company begins to grow its earnings, they will be less likely to default, which increases the value of the bonds.
6. If a company does default on its bonds, bondholders may get proceeds from the sale of the company’s assets. In fact, bondholders come before stockholders when the proceeds are being doled out. We say that bondholders have a higher claim on the company’s assets.