Securities For Beginners

Monday, January 30, 2006

Bond types explained (Overview)

Convertible Bonds:

Convertible Bonds are corporate bonds that can be converted into common stock of the issuing company. As a result, convertible bonds are usually offered with a lower yield. Investors may like convertible bonds because of the mixture of a bond's constant income stream combined with the chance to participate in a rising share price. On the other hand, there's always the chance that the share price takes a downturn and the bond's holder is stuck with the low coupon rate, because it's unattractive to convert the bond into shares.

Zero-Coupon Bonds:

Zero-Coupon bonds come with no interest rates to be paid by the company. Sounds strange? Well, here's the clue: They're sold with a considerable discount to par value, but in the end the whole par value is paid to the bond owner.

Coupon: 0
Par Value: $1000
Years to maturity: 5
Bond's price: $800
In this example you pay $800 now and will receive $1000 in five years, but won't receive any interest payments in the meantime.

Callable Bonds:

Issuing callable bonds allows the company to redeem the bonds before maturity. In return a premium is paid to the bond holders when the company uses the call option to compensate the future interesting rates that won't be paid due to the call. The call option is often used when interest rates decline and therefore the company has the opportunity to restructure its debts to better (i.e. "cheaper") conditions.

Bonds with floating interest rates:

Some bonds come with flexible interest rates. The actual interest rate paid by the issuer depends on some index, for example the short-term Treasury bills or the EURIBOR in Europe. Usually the prices of normal bonds decline when market interest rates raise, but due to the constant adjustment of the interest rates the volatiliy of bonds with floating interest rates is lower compared to normal bonds.

Related Post: on Bonds

Friday, January 27, 2006

Terms Explained - Price/Earnings Growth (PEG) Ratio

After I already explained the P/E ratio, this time I want to explain another ratio that is directly linked to the P/E ratio: The Price/Earnings Growth ratio (PEG).

Many investors consider the P/E ratio to be inaccurate to judge wether a stock is overvalued by the market. The problem with the P/E ratio is that it shows you the premium investors are willing to pay in return to an expected growth of the company and its stock's price. It doesn't show you wether this premium is (too?) high or low compared to other companies in the same sector. To get this information you will need to take a look at the PEG ratio.

The PEG is based on the P/E ratio and the expected growth of a company's earnings and is calculated by dividing the P/E ratio by the expected growth:
PEG = P/E ratio / Expected Growth

Company X
P/E ratio: 20
Expected growth: 10%
Company X's PEG = 20 / 10 = 2

Like with the P/E the companies with lower PEG ratios are supposed to be more attractive than those with higher PEG ratios and there are also differences in the PEG levels depending on the industrie you are looking at.

Although the PEG is a great way to judge a stock's value, it has its own traps you need to consider when using it. The main problem is the expected growth you need to know in order to calculate the PEG. And there it is: It's an expectation, not a given fact that the company will achieve this growth rate. But a lower actual growth rate means a higher PEG and in consequence a less attractive stock - unfortunately you will see this after you bought the stock, i.e. when it's too late to change your decision. For this reason investors are sometimes advised to shave 15% from any growth estimates issued by the analysts to create some kind of protection against analysts' errors.

Further information: Move Over P/E, Make Way For The PEG
Yahoo! Finance: Price/Earnings Growth ratio

Wednesday, January 04, 2006

Terms Explained - Cash Flow

The cash flow statement in a company's financial statement shows you the inflow and outflow of money. The difference between cash flow and income is that the net income is heavily influenced by depreciation, amortization and other non-cash items. Sometimes a company announces a loss although they earned a lot of money throughout the year. Investors now wonder wether buying the stock was a fault or the loss is the result of one-time effects that only affect the financial statement without affecting the company's economical health in general.

To answer this question you can take a look at the cash flow statement. The change of cash flow compared to the last year tells you wether the situation remained (nearly) unchanged, became better or worse. The higher the cash flow the better, beacause it means the company earned a lot of money! Since a company needs cash to pay its bills, employees and so on it's in great danger of bankruptcy when it's unable to generate enough cash throughout the year. To show the real amount of money earned the cash flow is calculated by adding depreciation and amortization to the net income (this is the most simple type of cash flow, there are other types that require more items to be included).

Due to the many ways a company can change its economic appearance by using the various accounting instruments the net income doesn't tell you that much - except you want to know wether there is a chance to get a dividend this year. The cash flow however can't be manipulated by accounting tricks, so it is much more important for the investor. Don't get fooled by the income - it's worth nothing without cash. As you can see, there isn't that much to say about cash flow (at least at the beginning), you just have to know the difference between cash flow and net income and the importance of this figures.

Investopedia: The Essentials Of Cash Flow
Investopedia: Operating Cash Flow: Better Than Net Income?

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