Evaluating Popular

InvestmentsLesson 2

Corporate Categorization

Investing in Stocks vs Bonds

Aim: What can we learn from comparing and

contrasting different companies?

Do Now: Explain why a company that sells

cereal is different from one that sells luxury watches.

Do Now answer: Consumers need to eat and cereal is

an affordable meal. No one needs a luxury watch.

Investing in Stocks vs Bonds

Categorization by Size1. Market Capitalization - Total market value of

all of a company’s outstanding shares

Large-cap: Companies that have a market capitalization value of more than $10 billion

Mid-cap: Companies that have a market capitalization between $2 and $10 billion

Small-cap: Companies that have a market capitalization between $300 million and $2 billion

WMT MSFT GE

Market Cap Shares Outstanding Share Pricex=

Categorization by Size1. Market Capitalization example:

Example:

Company ABC has a share price of $15 per share and has 20,000 shares outstanding. The market capitalization is 20,000 x $15 = $300,000,000.

Therefore, Company ABC is considered a small cap company.

Generally, the larger and more established a company is, the safer it is.

Market Cap Shares Outstanding Share Pricex=

The Business Cycle2. The Business Cycle - The business cycle describes

different stages of growth and decline in an economy Peak: Economic activity is growing rapidly and production

facilities are operating at full capacity Contraction: Economy begins to slow down, unemployment

rises, consumer spending declines, and sales decline Trough: Economy is at the lowest point on the business

cycle Recovery: Employment levels and sales start to increase

again Expansion: A period when business activity surges and the

GDP expands until it reaches a peak (also known as an economic recovery)

Recession Recovery Expansion

The Business Cycle

Peak

0%

5%

-5%

GD

P G

row

th

Trough

Previous Peak Broken

2. Company’s Sensitivity to the Business Cycle Describes different stages of growth and decline in an

economy

Business Cycle

What determines a Company’s Sensitivity to the Business Cycle?

1. The types of products and services the company offers

2. How it has set up its: Operations (known as operating leverage) Finances (known as financial leverage)

Business Cycle1. Defensive vs. Cyclical Stocks

Defensive Stock: not greatly affected by the business cycle. This is because defensive stocks are in industries such as food, utilities, and other consumer goods that are considered “necessities”. Defensive stocks do not increase in price significantly when the market surges or suffer big declines when it falters. Example: ConAgra Foods

Business Cycle1. Defensive vs. Cyclical Stocks (cont) Cyclical Stocks: largely affected by the business cycle.

Cyclical stocks will decrease when the market is weak and increase when the market is favorable. Examples: Auto Makers (Ford), Airlines (Jet Blue)

What are some reasons airlines and auto-makers are cyclical companies?

Business Cycle2. Operating Leverage Measures the amount of operating risk associated

with a company’s level of fixed costs compared to its variable costs.

The greater the percentage of fixed costs to total expenses, the higher a company’s degree of operating leverage.

Higher operating leverage means there are more costs that not easy to cut in bad times. Therefore, the higher the operating leverage, the higher the sensitivity to the business cycle.

Business Cycle2. Operating Leverage (continued)

Fixed Costs: Costs that do not change with the level of production. Examples of fixed operating costs include salaries, insurance expenses, and rent because regardless of how much you produce, these costs will not change.

Variable Costs: Costs that change with the level of production. Examples include the costs of goods sold or sales commission. Generally the larger the production, the less each individual product costs to make because of “economies of scale”.

Business Cycle2. Operating Leverage (continued)

We should recognize that while:

• some expenses are almost always going to be fixed (eg: rent, insurance), and

• others almost always variable (eg: heat and electricity, which vary by month),

• with regard to operations, it can have a choice. Business can take on fixed costs in order to lower variable costs.

Business Cycle2. Operating Leverage (continued)

Scenario: You walk into Factory A and see rows of people sitting at tables assembling a SuperToys. It sells them to Toys R’ Us for $10 each. The cost to make them is $7.

You go into Factory B that makes the same SuperToy. It’s a less crowded space with robots here and there turning every which way. This highly automated factory can make a SuperToy for just $5 each.

Business Cycle2. Operating Leverage (continued)Fixed Costs vs. Variable Costs:

• Factory A has chosen to employ more people. The lack of automation raises the cost to make each unit.

• Factory B has chosen to invest heavily in robotics so that there is a low cost to make each unit. But the robots cost $50,000 per month to lease on a 5 year contract!

• Factory B has traded variable costs (ie: workers) for fixed costs (ie: robots that it has leased for a substantial monthly expense).

Business Cycle2. Operating Leverage (continued)• If business booms, Factory A will certainly make

money, but Factory B’s profits will soar. Its robots ensure the cost of making each unit is as low as possible, resulting big profit per unit and overall.

• If business falters, Factory A can lay off the employees it has, lowering this variable cost. But Factory B, which has committed to a long-term lease on the robots, will be in big trouble. It will be stuck with high fixed costs!

Business Cycle2. Operating Leverage (continued)• If business booms, Factory A will certainly make

money, but Factory B’s profits will soar. Its robots ensure the cost of making each unit is as low as possible, resulting big profit per unit.

• If business falters, Factory A can lay off the employees it has, lowering this variable cost. But Factory B, which has committed to a long-term lease on the robots, will be in big trouble. It will be stuck with high fixed costs!

Business Cycle2. Operating Leverage (continued)• We see that with regard to their operations,

companies are able to automate more (thereby raising their fixed costs) in order to cut variable costs.

• The more highly automated, the higher the fixed costs, the higher the operating leverage!

• Companies with high operating leverage are more sensitive to the business cycle. They soar in good times and can suffer mightily in bad times.

Business Cycle3. Financial Leverage It is a way for a company to gain large returns

without requiring a lot of shareholder investment. You may have figured out that companies do this by borrowing any additional money they need.

As we’ve mentioned earlier, there are two ways to raise money, sell stock (ie: equity) or sell bonds (ie: debt). Leverage compares them. It is calculated:

Leverage = Debt/Equity Firms with a high degree of financial leverage are

more sensitive to the business cycle

Lesson Summary 1 of 21. What do we call the measure of a

company’s size?

2. Generally speaking, are smaller or larger companies safer to invest in, and why?

3. What to we call the recurring periods of expansion and contraction that economies experience?

4. What is the very bottom of this cycle called?

5. Identify one defensive stock and one cyclical stock, explaining why.

Lesson Summary 2 of 26. What do we call the comparison of a

company’s fixed costs to its variable costs?

7. What do we call the amount of a company’s borrowing compared to the money it has raised from shareholders?

8. With regard to both of these types of leverage, what is the rule regarding sensitivity to the business cycle?

9. What can we learn from comparing and contrasting different companies?

Web Challenge #1Q: The latest categorization of what constitutes a “large cap” company is one with a market cap in excess of $10 billion. Are there companies whose market caps are much bigger than this?

• A: Yes, there are several with market caps in the hundreds of billions!

• Challenge: Find and list five companies with a market cap over $100 billion. What name would you suggest giving to this group of behemoths? “__________ cap”

Web Challenge #2We saw earlier that food may be the ultimate defensive industry because we all need to eat! However, there’s another industry that consists of products we consume all the time by using, not eating them! Think of toothpaste and soap. This the “consumer staples” industry.

Challenge: Research three consumer staples companies and for each identify three to five of their brands that are household names.

Web Challenge #3The Great Recession was the most devastating economic event since the Great Depression. Important lessons can be learned from it. Challenge: Research the Great Recession.

Document the month and year of its peak, contraction, trough, recovery and expansion.