WHAT IS A STOCK?
A stock (or share) is a share in the ownership of a company, which means that every shareholder has ownership of the company in proportion to his share.
If the company is a listed company, its shares are sold in the stock market. The stock market is the place where shares of public companies are bought and sold by retail and institutional investors.
If you have shares of a corporation, you can participate to shareholders meetings and vote, receive dividends (if the company distributes them), and you can sell the shares to somebody else.
Stocks change their value over time, and this is caused not only by the company’s performance, but also from other factors such as global market trends, central bank decisions on interest rates, wars, crises…
WHAT IS A BOND?
A bond in finance is a loan that you make to a borrower, that is usually either a company or a nation. Bonds are issued by companies and governments to borrow money from many individual investors, that can decide to keep the bond to maturity or to sell it when they want.
Bondholders have the right, at the end of the contract, to receive their original money plus interests.
Bonds can be purchased either in the primary market, when they are first offered to the public, or in the secondary market, from whoever has bought them and wants to sell them.
Bonds can pay their coupons (interests periodically paid to the bondholder in percentage of the bond value) in two ways:
– Fixed rate, which guarantees a predetermined amount of interest periodically;
– Variable-rate, where the paid interest depends on financial indices (such as Euribor), inflation rate, or currency exchange rates.
WHAT IS THE DIFFERENCE BETWEEN STOCKS AND BONDS?
The main difference between stocks and bonds is that if you own a stock, you are a company shareholder. If you hold a bond, you don’t have any ownerships’ rights, you only have a creditor position with respect of the issuer and the right to receive periodic interest through coupons.
In terms of risks, stocks are riskier than bonds for various reasons:
– Bonds have a guaranteed yield to maturity (if the issuing entity does not default), but stocks do not;
– Stocks are more volatile, meaning that they can results in higher profits and losses than bonds;
– Bonds are usually considered as a long-term investment due to their low volatility whereas stocks, thanks to trading, can result in profits in the short term.
BOND YIELDS AND HOW THEY AFFECT THE STOCK MARKET
Bond yields represent one of the most relevant factors that must be taken into account when investing in this security. When describing yields, it is vital to distinguish them from the “Coupon Rate”, also known as “Nominal yield”. The latest is calculated dividing the coupon payment the investor periodically receives through the investment in the bond by the face value of the asset. In this case, the denominator remains constant. On the other hand, the calculation method for the bond yield is quite different from the previous one and takes into account estimates of the true yield. The main estimate is represented by the “Current yield”, where the numerator is the same used for the coupon rate, while the denominator is the current market price of the bond. Obviously, this price is subject to a lot of changes during the course of the trading days. Another important type of yield is the so-called “Yield to maturity”, that represents the discount rate at which the sum of the present values of all the coupons paid to the investor on that bond is equal to its current market price. We can easily see that there’s a negative relation between yield and market price. In fact, a rise in the yield implies a drop in the bond price and vice versa, so as the yield increases the investor becomes more willing to pay for the bond, considering that there will be a greater return on the investment and a lower price to pay for it. Focusing on how bond yields affect the stock market, as yields rise, the bond market becomes more attractive for the investors than the stock one due to the fact that investing in virtually riskless securities represented by bonds becomes increasingly more profitable than opting for stocks, which are, instead, very risky assets. In fact, dividends may not be paid to shareholders, while coupon payment is almost certain. So, there’ll be a decrease in demand and consequently price of stocks. The latter effect is produced also when we use bond yields as discount rates in the DCF model and they tend to increase.
MARKET CAP
Market cap represents the total market value of a company’s outstanding shares of stock, and it is often used to determine a company’s size:
– large-cap: > $10 billion,
– mid-cap $2 billion to $10 billion,
– small-cap $300 million to $2 billion.
Market cap shows how much the company is worth for the market and it is calculated by multiplying the share price by the number of outstanding shares.
Large-cap companies are often a safer investment because they are solid, well-established and can usually guarantee a consistent increase in share value and dividends. For their low-risk level, they do not usually have a high volatility in the short period.
On the other hand, small-caps are most likely to have high volatility and they are considered a higher-risk investment.
REVENUES AND EBITDA
Revenues are the money brought into a company by its business operations, and they are calculated by multiplying the average sales price by the number of units sold. To determine the net income, you need to subtract from revenues costs, and it is very important for a company that costs do not exceed revenues.
EBITDA (earnings before interests, taxes, depreciation, and amortization) represents the profit generated by the company’s operations and it is calculated by adding interests, taxes, depreciation, and amortization to net income. It is a measure of core corporate profitability.
Amortization and depreciation are two methods of calculating the value for business assets over time: amortization consists in spreading the cost of an intangible asset (patents, copyrights…) over its useful life, while depreciation diminishes the value of a tangible asset(buildings, vehicles…) over its useful life.
Amortization and depreciation are usually calculated with the straight-line method, that consists in spreading the asset’s cost equally year-by-year over its useful life.
Depreciation aims to reflect that an asset is no longer worth the previous carrying cost reflected on the financial statements, and amortization instead aims to allocate costs over a specific period of time.
Depreciation and amortization differ also for their formulas because the depreciable base of a tangible asset is reduced by the salvage value. Salvage value is the estimated value of the asset at the end of its useful life.
Talking again about EBITDA and revenues, the difference between these two is that EBITDA is a company’s total income minus operating expenses, while revenues are the gross profit, so without deducting any expenses. Both EBITDA and revenues are key metrics used to calculate business performance.
INDICES IN THE STOCK MARKET
Stock indices are one of the main features of the stock markets. An index is made of multiple stocks related to specific companies that can be both financial or not and its value corresponds to an average of the stocks’ prices considered in the index. Various types of weighting procedures can be used: equal weighting (each stock has a weight of 1/n, where n is the total number of stocks considered in the index), value weighting (the weight assigned to each stock depends on its market-cap, which is equal to the number of outstanding shares of the company multiplied by their market price in that specific moment), sustainability weighting (in this case, each stock has a weight that depends on how well the company performs with respect to social-environmental indices), etc.. Some of the main indices worldwide are the: Dow Jones, S&P 500, Nasdaq, DAX 40, Nikkei 225, FTSE MIB, etc..Indices like the ones cited before are characterized by the fact that each one of them is composed of multiple stocks related to different and specific companies. For example, S&P 500 only considers the 500 US companies with the highest market capitalizations. Similarly, FTSE MIB, the main Italian stock market index, takes into account the 40 Italian companies that show the highest values with respect to 3 main factors: market capitalization, number of company’s floating shares that can be traded on the secondary market and liquidity. An important aspect to consider is that stock indices are often used as performance benchmarks in Portfolio Management and portfolios are sometimes built by replicating the exact composition of stock indices.
Authors: Piero Foberti and Filippo Ferrero