The interpretation of financial statements is a crucial step for effective decision-making among investors and shareholders. The financial statements provide key evidence of the entity's financial health, and, in this case, proper analysis of such statements is needed to provide a useful insight into the entity's performance, operations, and overall conditions. Consequently, the investor can decide whether to invest their money in the company or exploit other investment opportunities. Making an informed decision allows the investor to have peace of mind and increases their chances of making a high return on their investment in either stock or bonds. Bonds and stocks are easily available, given that corporations use them to raise capital. It is essential for an investor to be fully aware of what they are investing in, how much returns they can expect, and the risks involved. An individual can invest in bonds, stocks, or both depending on many variables, including their experience, investment strategy, and level of risk and expected return. Investment in such securities is not limited to individuals, given that both institutions and corporations can make such a decision. However, before making a decision regarding their type of investment, the investor, whether an institution, individual or corporation, must carry out stock and bond valuation to determine the intrinsic value of each investment. The valuation of such investment types involves the interpretation of financial statements.
The valuation of stock through the absolute and relative methods entails the interpretation of financial statement items. Absolute stock valuation is based on the entity’s fundamental information. It entails the assessment of financial information obtained from the company’s financial statements. The techniques used in absolute stock valuation require the interpretation of the entity’s cash flows and dividends. The Dividend Discount Model, a key absolute stock valuation technique, assumes that the entity’s dividends represent its cash flow to stockholders. An individual must interpret the income statement section, specifically the part highlighting the dividends paid by the entity. The interpretation of this part will enable the potential investor to value the entity's stock and, in effect, determine whether it is worth their investment. The Discounted Cash Flow model, another absolute stock valuation technique, requires the potential investor to analyze the entity's cash flow statement. In this case, they can identify the cash flow amount to be discounted to the present value to determine the intrinsic worth of a stock. Relative stock valuation, an alternative to absolute stock valuation, entails the comparison of the specific investment with similar entities. It uses financial ratios to make comparisons among similar companies. Such ratios are computed by using income statement and balance sheet items. The individual must be aware of what each ratio means to ensure they reach an accurate conclusion after performing a comparative analysis. Bond valuation also requires proper interpretation of the entity's income statement. Corporations issue bonds to raise money from investors. The issue of such securities creates a liability for the entity, and, in this case, the non-current liabilities of the entity are increased. In the balance sheet, the bond's coupon and market discount rate are listed together with the bond's total value. The analysis and interpretation of such information assist the investor to carry out bond valuation. Bond and stock valuation are necessary tools for reducing investment risks. The decision regarding whether to carry out bond or stock valuation depends on whether the investor wants to purchase stock or bonds. In the interpretation of financial statements, bond valuation should be prioritized over stock valuation given that bonds have greater benefits than stocks, including low volatility, high liquidity and a steady income stream.
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Analysis/Critical Evaluation
The article highlights strategies that can assist investors in managing their investment risk. An increase in the investment risk is unfavorable since it means an increase in the potential for loss of returns. According to the article, one of the ways of lowering profitability is reducing portfolio volatility through buying bonds ("6 Investment Risk," 2020). In this case, the author has taken a position favoring bonds over stocks. Bond valuation is prioritized over stock valuation in diminishing portfolio volatility. A key strength in the author's argument is the investor's preference for stock. According to the article, an investor's portfolio mix may be skewing to a greater extent towards stocks than they think. The author makes a valid point given that people prefer high returns and, in this case, are likely to increase their stock investments in their portfolio mix. Historically, stocks have delivered greater returns than bonds since there is a higher risk that, if the entity fails, all the shareholders' investments will be lost. Regardless, the stock's price will also increase despite this risk when the entity performs well. The greater volatility and potential for loss means that stocks have greater long-term returns than bonds. Since the 1930s, S&P 500 stocks have had a yearly return of nearly 10%, while US 5-year government bonds have had returns amounting to around 5% ("This is Why," 2020). The greater stock returns are the investors’ compensation for bearing their high risks of stocks. The high returns are likely to motivate investors to increase their stock investments rather than their bond investments. Consequently, the individual portfolio is likely to skew towards a higher proportion of stock in the portfolio mix leading to an increase in volatility.
Another strength relates to the steady income associated with bonds. The article provides a compelling reason why investors should buy bonds to decrease their portfolio volatility. Bonds can be purchased by the investor to provide a steady income stream that can be used for reinvestment or meeting living expenses (Hawawini & Viallet, 2010). Bonds are typically known as fixed-income securities. Investors typically purchase bonds with the aim of holding them until maturity to benefit from the interest they earn. The investor owning the bond receives interest payments, otherwise known as coupon, throughout the bond's life. The interest rate is typically determined when the bond is issued. The interest payments normally made twice per year provide the investor with a steady income stream until the bond matures. The investor can use such income for reinvestment purposes.
A key weakness of the author's supporting arguments is related to the point regarding market volatility. According to the author, investors concerned about their market volatility should rebuild the bond portion of their portfolio ("6 Investment Risk," 2020). This argument is weak since it does not prove why the bond market enjoys less volatility compared to the stock market. In the bond market, bonds may be purchased by corporations or the government, with the investor becoming a creditor. When the company collapses, the general rule is that it must repay its debts before paying the shareholders (Amihud, Mendelson, & Pedersen, 2013). In this respect, the creditors are paid first while the shareholders are paid last. The bondholder is paid before the stockholder. Based on this scenario, it becomes riskier to own a stock compared to a bond. The high risk associated with stocks means that their prices are more responsive than those of bonds to economic changes. Since the 1930s, the volatility of stocks has been four times greater than that of bonds ("This is Why," 2020). The investor should increase the proportion of bonds in their portfolio since the bond market has low volatility compared to the stock market.
Conclusion
Given the views in the article and other research conducted, investors should have a higher proportion of bonds than stocks in their portfolio. Individual investors and corporations should focus on purchasing bonds rather than stock. A key advantage of bonds lies in the fact that they are often liquid (Hawawini & Viallet, 2010). In this case, an entity can easily sell a significant quantity of bonds without influencing the price much. The same does not apply to stocks. When the entity cannot meet its interest payments to the bondholders, it can easily sell the bonds, such as US Treasury bonds, since they are highly liquid. On the other hand, stocks are less liquid, and, in this respect, it takes time to sell them, meaning that the stockholder may realize a large loss on their returns if the price of the stock is dropping quickly. The attractiveness of bonds also lies in their high level of security. Bonds such as US Treasury bonds are backed by the complete faith and credit of the US government. Resultantly, the bondholder is guaranteed to earn a return in the form of regular interest payments twice a year and a lump sum payment at maturity. Such lump-sum payments allow bondholders to preserve their capital while investing. If the individual investor or corporation buys corporate bonds, they are guaranteed to earn back their investments in case the corporation fails. Creditors, including bondholders, enjoy the right of being paid before shareholders when the corporation is under liquidation. The security enjoyed by bondholders minimizes their investment risk considerably.
Individual investors and corporations should purchase bonds rather than stocks since they come with indentures and covenants. The bond indenture is a valid document that specifies the bond issue parameters, including the par value, security pledge, coupon amount, and rights of the bondholder (Amihud, Mendelson, & Pedersen, 2013). When purchasing a bond, the individual investor or corporation can review the issuer's credit risk and the bond's security rankings. The covenants specify the duty of the issues, including the actions that they must perform or are prohibited from performing. The indentures and covenants promote accountability among the bond sellers. The increase in accountability enhances the security of bonds.
Purchasing bonds is beneficial to corporations since it increases their amount of liquid assets. Assets are a key component of the balance sheet since they depict the type of amount of resources the entity possesses and which it can use to generate cash. When the entity purchases bonds from another corporation, it records the bond amount as an asset (Shim, Siegel, Shim, & Shim, 2012). The purchase of the bonds is a valuable investment since it guarantees the entity semi-annual interest payments and a principal payment when the bond matures. The investment in bonds allows the entity to increase its cash revenues, given that it will receive an amount greater than the principal amount due to the interest payments. The increase in the entity's cash reserves is beneficial since it increases the entity's attractiveness as an investment option. The entity can also finance projects when other sources of capital, for instance, loans, become too costly. The increase in bonds through purchase also means an increase in the entity's liquidity level. A high liquidity level is favorable to the company since it means that it can easily meet its debt obligations in the short run (Amihud, Mendelson, & Pedersen, 2013). When the entity repays its debts, it decreases its chances of collapsing. In this regard, the going concern status of the entity is preserved. If an entity purchases stock rather than bonds in another company, it reduces its level of liquidity, given that bonds are more liquid than stocks. A reduction in liquidity does not bode well for the entity since it means that it may fail to meet its obligations in the short run.
Valuation of bonds should be prioritized over stock valuation by the individual investor or corporation, given that purchasing bonds has more benefits than purchasing stock. Bonds have lower volatility, higher liquidity, and offer a steadier supply of returns than stocks (Shim, Siegel, Shim, & Shim, 2012). Investors have limited cash assets which they can use to carry out investments. Such assets should be allocated wisely to ensure a maximum return for the investor. Bond valuation is necessary since it allows the investor to determine the value of a bond. The information regarding bond value can be used by the investor to determine the bond’s fair price. In this case, the investor does not waste their limited cash resources by overpaying for the bond. In addition, there are different types of bonds, and, in effect, determining the value of each bond allows the investor to make the right decision. The main types of bonds include corporate, investment-grade, high-yield, municipal and US Treasury bonds. Corporate bonds include those issued by corporations, while counties, cities, or states issue municipal bonds. The US federal government issues US Treasury bonds. The valuation of such securities is necessary to determine which bond has the potential of earning a high return. Investors can know what returns they can expect from every type of bond and, in effect, they can make an informed decision.
References
6 investment risk management strategies. (2020). SOFI . Retrieved from www.sofi.com/learn/content/investment-risk-management/
Amihud, Y., Mendelson, H., & Pedersen, L. H. (2013). Market liquidity: Asset pricing, risk, and crises . Cambridge: Cambridge University Press.
Hawawini, G., & Viallet, C. (2010). Finance for executives: Managing for value creation . Nelson Education.
Shim, J. K., Siegel, J. G., Shim, A. I., & Shim, J. K. (2012). CFO fundamentals: Your quick guide to internal controls, financial reporting, IFRS, Web 2.0, cloud computing, and more . Hoboken, New Jersey: Wiley.
This is why stocks have higher returns than bonds. (2020). MD Wealth Management . Retrieved from mdwmllc.com/why-stocks-have-higher-returns-than-bonds/
