Stocks and Bonds

A share of stock represents a fractional ownership in the business.  A bond represents a debt owed to the bond holder.  You would own the company’s stock if you want to participate in the future earnings of the business.  You would own a bond if you wanted predictable earnings in the form of interest payments.

Stocks and bonds represent two primary ways for a business to raise capital.  Stock is referred to as equity since it represents a share of the business.  Bonds are referred to as debt since they are an obligation or liability of the business to the bond holder.  Bonds are also part of a larger universe referred to as “fixed income investments”.  A bond holder does not directly participate in the growth of the business but wants to know that the business will have the ability to make the interest payments over the term of the bond.  Bonds are issued for a fixed term, generally between 5 and 20 years and may be “callable” meaning the bond issuer may choose to redeem the bond before its maturity date.  Bonds can be traded during their life.  Bonds are also issued by governments.  Bonds issued by city and state governments are referred to as municipal bonds, those issued by the US government are referred to variously as Savings Bonds, Treasury securities, T-Bills and Treasury Bonds.

How do you make money from owning stock?  By an increase in the share price, through dividends and through stock buy back.  (These will be covered later.)  Of course, the stock price can also go down.  How do you make money from owning bonds?  The primary means is by collecting the interest payments, also referred to as the coupon.  Also, if market interest rates go down, the market value of the bond will go up and can be sold for a profit.

What causes the value of the stock to go up or down?  Factors related directly to the business, such a new products, higher earnings, etc. as well as factors related to the overall economy such as recession, growth or just uncertainty in the economy.  When a company does well through increased profits, new products, opening additional stores, more people want to own it which will tend to drive up the share price.  In the long term, the share price will reflect the earnings and prospects for continued growth in the company’s earnings.  This is essentially the reason you want to own the stock.  It is a claim on the future earnings of the business.  After accounting for all of the costs to produce their products and the expenses to run the business and the taxes, the result is the net profit or earnings (or net loss).  This will be expressed as the earnings per share or EPS.  Investors will look at the EPS and want to see that it is increasing from year to year.   The total value of all outstanding shares of the company is referred to as the “market capitalization” or market cap.

What causes the value of the bond to go up or down?  The primary factor is any changes in overall interest rates.  Generally, when interest rates go up, the value of existing bonds go down and vice versa.

How are stocks and bonds traded?  There are “exchanges” whose function is to provide a market place for buying and selling stocks and bonds.  Essentially, they match the parties that want to sell with parties who want to buy.  They will adjust the share price to a level that satisfies both buyers and sellers.  The most recognizable exchanges are the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX) and the Nasdaq.

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