When it comes to your own personal finances there are no dumb questions; however, many people are intimidated by the industry jargon, or things they don’t know much about, and thus are very self-conscious to not ask questions for the fear they may come off as unintelligent. I’ve made it my mission to make my company as inviting as possible because I understand how complicated many of these topics can be. So, today’s post is about one of the fundamental building blocks for personal finance. To make this as simple as possible, this post is part dictionary, part examples. The concept is the difference between a stock and a bond. These are the basics:
Owning a stock means you have ownership in a company. If there are 1,000,000 total shares of the company and you own 10,000 shares, then you own 1% of the company. You own the revenue, expenses, profits, assets, liabilities, trademarks, copyrights, etc. Ownership is also known as equity.
Stocks are priced on a per share basis. The price reflects a combination of current earnings, future earnings, dividends, opportunities, and threats. For example, if the price of the stock is $50 and there are 1,000,000 shares, the company has a market cap (the total value of the company) of $50,000,000.
A dividend is a profit the company earned that is paid back to owners of stock, i.e. shareholders. Think of it as a “bonus” for owning the stock. However, not all companies pay dividends. Companies that do not pay back dividends reinvest profits in the company in the hopes of developing new products and grow revenue.
Stocks are traded on a stock market exchange. An initial public offering (IPO) is when a private company goes public and the stock is first offered to the general public on a stock market exchange. Companies will do this to bring cash into the company to either reinvest and/or pay initial investors.
Stocks are generally riskier than bonds.
A bond is debt and owning it does not traditionally provide any ownership in a company. It is like if a friend went to a bank for a loan; but in this scenario, you are the bank and your friend is a company. A company can take on debt for many reasons, some of them being: to develop new products, to pay for cash flow, or to fund purchases of other companies. I would rather see a company use debt to grow (develop products and buy other companies) rather than maintain operations (pay for cash flow).
A bond is a promise by the company to pay you back the original amount, plus interest. Many times, a bond is priced at $100 or $1,000. The interest rate, i.e. coupon rate, is usually fixed and doesn’t change over time. This interest rate determines the payment. Interest/coupon payments are typically paid on a semi-annual (2x per year - every 6 months) basis.
For example, let’s assume there is a bond with a par value (the amount paid back to the owner of the bond) of $1,000 and has 4% interest. The term of the bond is 10 years. The initial face value is priced at a premium of $1,180. In exchange for this $1,180, the owner of the bond will receive $40 annually ($20 semi-annually) from the company for 10 years. At the end of 10 years, the owner of the bond receives $1,000. In total, the bondholder will receive $220 profit ($40 per year x 10 years + $1,000 final payment) for an initial $1,180 investment . Bonds are generally regarded as a safer investment than stocks but offer less in potential gains. Bonds do have risk associated with changes in market interest rates and the ability for the debtor to pay their debts.
The following entities offer bonds: Federal Government (Treasury), Local/State Governments (Municipal), Companies. Local/State Governments will generally offer bonds to finance public projects. Companies will generally offer bonds to finance new projects, refinance existing debt, or maintain the operations of the company. They will take on debt rather than dilute ownership percentages by selling more company stock.
I hope this helps paint a picture of the main differences between stocks and bonds. These investments each have their time and place in a well-diversified portfolio because of how different they are. That difference can be confusing at times and I aim to educate my clients so they can make better decisions with their finances. If you would like to learn more or have additional questions on how stocks and bonds work, you can contact me here.
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