Earny Asks: How Is a Stock Different From a Bond?

Summer is in full swing, and I know that many of you have more important things on your mind than investing. So, read on, and I’ll tell you an embarrassing story from when I was a professional trader.

Also, since it’s summer, I’m going to keep this question short and sweet. It’ll even be a bit basic, too, so if you’re new to investing, I think you’ll find this one to be helpful.

Earny wants to know:

Which of the statements below are true about stocks and bonds?

Stockholders have ownership in the company. Bondholders do not.
Different stock issuers include corporations and the US Treasury. Bonds are issued only by the US Treasury.
Stocks may pay dividends in order to generate a yield. Bonds pay coupons and also have a yield.
Stocks go up and down in value. Bonds, because of the coupon payment, only go up.
Stocks fall into the asset class of Equity while Bonds are Fixed Income.

Answer:

Let’s start that embarrassing story I mentioned. Perhaps you have your own.

I used to be a trader at a Wall Street firm. It was a fun job. I worked in close quarters with some great people who had big personalities. I also got to think about the stocks I was trading and make decisions as to whether or not I should make a trade. Basically, I would research them and then buy the stocks I thought would do well and sell the ones I thought would do poorly.

Mostly, it worked for me.

In early 2001, however, I decided that the brokerage firm Merrill Lynch was worth buying. I liked it so much that I paid something like $80 per share for my stake. Nobody had ever paid that much for a share of Merrill. I set a new all-time high when I bought those shares and I was comfortable with that. I thought that stock was going to the moon.

The thing is, I was wrong and it would be another six years before the stock surpassed that price again. It's not that I held the shares for that long. I was a trader and took my loss quickly.

For every buyer, there has to be a seller, and to the smart trader who sold me those shares, you’re welcome.

The point is, we all make mistakes. In investing, as in anything else, it’s about doing your best and managing your risk.

With that said, let’s get to this week’s answer.

Which of the statements above are true about stocks and bonds?

Statements 1, 3, and 5.

Here’s what you should know:

Some of the important qualities of Stocks include:

Stocks go up AND down in price. See my embarrassing story above.
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 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” because of quality #2.
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, which 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:

Bonds may be issued by the US Treasury, other sovereign governments, and corporations.
Bonds do not represent ownership in the company. On the balance sheet, they show up as a liability!
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.
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.
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.

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.
If a very weak company, like Rite Aid, announced great earnings, its bonds may increase in price. Rite Aid is in bankruptcy proceedings and is at risk of not making payments on its bonds, leaving investors with worthless paper. That’s called a default. 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. (Note that I’m speaking generally. Rite Aid is closing stores and selling assets. It’s unlikely to remain as an ongoing business.)

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.

Those are some of the important things you need to know about stocks and bonds. This could be a good article to bookmark and refer back to in the future.

Have a great weekend.