This is a series of study notes I took while taking PurdueX PN-17.2.

Financial Ratios

P/E (Price and Earning) Ratio

Defined as the current stock price/earnings per share. The denominator is the critical component here, we can use the past 52 weeks earning or the expected earning for the next 52 weeks. So when you’re comparing P/E ratios from different companies, be sure to use the same.

Dividend Yield

Defined as dollar dividend/current stock price. Here, the dividend can be the expected dividend or past dividend. Be sure to use the same when comparing companies.

Price to Book Ratio

Defined as stock price/(company assets-liabilities), the denominator is called the book value.

Peg Ratio

Defined as the P/E ratio/earnings growth (Annual earning per share growth %). This factors in a company’s growth.

How to Use These Ratios

If the PEG ratio is significantly > 1, then it suggests the company might be over-valued. If the opposite, then the company would be under-valued, which suggests that it might be a good buying option.

For P/E ratio, if it’s very high, then it can signal market optimism.

But it’s critical to remember that these ratios are just part of the puzzle.

Exchange Traded Funds (ETFs)

One biggest complaint of the traditional mutual funds: They are priced once a day: it means that if you put in order to buy or sell shares, the order won’t get executed until after the markets close for that day. This is because the price of a mutual fund share is calculated based on the component stock (stock in a mutual fund) prices. And those prices are calculated once after the market closes.

This is why ETFs were invented:

1. Traded and priced throughout the day
2. High liquidity makes them more like stocks than MFs.
3. ETFs also focus on specific industry segments
   1. They are index funds that target very specific micro areas
4. Purchase on margin/Short sell:
   1. Purchase on margin: Buying an asset by paying only a percentage of its price and borrow the rest from a bank or broker. See ref[2] for more information.
   2. Short selling: Borrow a certain quantity of security and sell them. Then later buy and return the same quantity back. If the price happens to decrease between the sale and buy back, then you can profit from this short selling. See ref[3] for more details.
5. Tax advantage: “The overwhelming majority of ETFs only sell holdings when the elements that compose their underlying index change. A significantly lower portfolio turnover rate means significantly fewer taxable gain incidents.” See ref[4] for more details.

Stock Market Indices & Companies DJIA

An index represents an overall state of the market. Again, this value is not absolute but comparative.

DJIA

When DJIA (Dow Jones Industrial Average) first started, it used the closing prices of the 12 important companies and average them. Nowadays, the DJIA is based on 30 representative companies of the stock market.

This index is price-weighted: sum of N stock prices/N. It doesn’t account for the size of the companies. This means that if the stock price of any company goes up by 5%, then the index will reflect that regardless of the size of the company.

S&P 500 (Standard & Poor’s 500 Index)

500 stocks that are considered to represent the market. S&P 500 is basically the average of these stock prices. This is the most important index today and should be more representative of the U.S stock market compared to DJIA.

This index is value-weighted: The price movement of the individual stock in that index is weighted by the relative size of that company.

Stock Analysis

Stock analysts perform research on specific industry groups. They declare recommendation on whether to BUY/SELL/HOLD a stock(s).

However, in 2001, fewer than 2% of stocks were rated as “sell” or “strong sell”. This might due to the fact that the real money that these brokerage firms earn come from investment banking activities (from later explanation, it sounds like the investment banks give money to the brokerage firms to invest), sometimes with the same firms that their analysts are researching on.

Although some effort and money has been spent on dealing with these types of conflict of interest and things have been cleared up a little. There’s always gonna be some conflict of interest.

Put simply, don’t bet everything based on a single analyst recommendation.

Bonds

When you borrow money, you’re essentially selling bonds to the lender. Most banks can not afford the amount of money that companies/government/countries want to borrow, so these entities go to the capital market to “borrow money”.

One important distinction is that bond holders are creditor of a company but not owners. So they don’t have voting rights to tell the board how to run the company.

On the other hand, if a company can’t pay the interest of its bond, then it can be taken to the bankruptcy court right away.

Local governments sell bonds (in the form of municipals) to raise money for certain projects.

Bonds usually are considered safer investment compared to stocks.

Bond Pricing and Bond Rating

How do you price a particular bond certificate? Easier to price compared to stock because it has finite maturity date (on the other hand, the stock is there as long as the company exists), so the value of the bond is predetermined by:

1. the coupon payment the bond is gonna pay over the lifetime
2. the face value at maturity.

**Bond Ratings: **Represents the quality of the bonds. The best is AAA, which means the bankruptcy risk is pretty much 0%. The worst is BB or lower, which are called speculative/junk bonds (high risk). When a bond’s rating goes worse, the borrowing cost goes up.

There are 3 major rating agencies: Standard&Poor’s, Fitch, Moody’s.

How to Make Money “Holding” Bonds

First thing to remember is bond prices are inversely related to the prevailing borrowing rates in the economy [6]. That is, borrowing rates go up, bond prices go down and vice versa.

LAddering

It also depends on whether you use your bonds for long-term or short-term goals. For example, shorter maturity bonds.

However, there’s a way to use short-term bonds to achieve long-term goals called “laddering”, which means that you buy similar bonds that have short maturities, but sequential maturity years. This takes away the year to year fluctuations that you normally would have and make it an average (i.e. “smoother”) yield over time. And it’s considered to be a very reliable, longer term strategy.

Ways to Buy or Sell Stocks

Common Stock Orders

Market order: An order to sell/buy certain amount of stock without specifying the price (it’s determined when the order is actually executed). The execution of the order is guaranteed.

Limit order: An order to sell/buy certain amount of stock at certain price. It’ll be the ceiling if it’s a buy order (because you’re ok with buying at a lower price) and floor if it’s a sell order (because you’re ok with selling at a higher price). Note that there’s a risk that this order will not execute due to the specified price. That’s why we have 2 main types of limit order: GTC (good til cancelled) and good-for-the-day.

Stop Loss order: When the price reaches certain point on your investment, sell it. An example:

Let’s say you’ve bought shares of Company X at $25 a share. It is now currently trading at $28 a few months later. And you are really worried that one bad day in the market can wipe out all the $3 share paper gains that you’re holding on your investment. One way to allay your fears or reduce your fears and tensions somewhat, is for you to go in there and place a stop loss order say at $27 a share.

In a limit sell order, you can accidentally sell too soon as the price of your investment goes up. However, if you use a stop loss order, it won’t get executed.

Margin Buying & Short Selling

For more serious investors, there are 2 other ways to buy/sell stocks.

**Buying on margin**: Borrow money for an asset and only put in a certain percentage of the full price. Under the current laws, you can finance up to 50% of the price. This is popular because you can control a lot more of the market with a lot less of your own money (which sadly was also one of the main causes of the 1929 stock market crash).

Short selling: Selling something you don’t actually own. Basically, you borrow stocks (instead of money), sell them, buy back the stock and finally return them. If the initial sale prices happens to be higher than the buy-back back price. You earn the difference. For this, you’ll have to go through a process similar to borrowing money from a bank, such as credit check, etc.

Options

Options [7] are actually very common in real life. For example, coupons:

Any kind of a deal that has a price that entitles you or give you certain conditions that entitle you to transact that particular item.

One key difference of stock options is that they do not come for free. That is, they have intrinsic value associated with them and the price goes up/down depending on the underlying stock (this is why Options are also know as derivative securities). In the U.S, Options market is much larger than the stock markets and has a much larger trading volume compared to the stock market.

There are 2 types of options and you can buy/sell them. Buying sells/puts is relatively safer than selling calls/puts.

Call options: It is a financial contract meant to give you the option to buy a certain number of shares. Usually one contract is equivalent to 100 shares of that particular company’s shares at a predetermined price within a predetermined period. You have the right but not obligation to use this option.

Put options: give you the right but not the obligation to sell specific amounts of that company’s shares at a predetermined price within a period, a predetermined period,

Reference

1. PEG ratio
2. Buying on margin
3. Short selling
4. ETFs tax efficiency
5. Coupon payment
6. Why do interest rates have an inverse relationship with bond prices?
7. Stock Options
   1. What happens when options expire? A: short answer, you lose them.