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Stocks versus Bonds

Stocks versus Bonds
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So let us try to understand stocks a little bit better. I give you an overall context about them. So let's get going. We know what bonds are. How is a stock different from a bond? And the one characteristic that's very different is a bond is a contract and a stock is not. In other words, remember when we did the bond it was like a loan, that's another name. You never get a loan if you go to raise money, whether it is you personally or it's a corporation, or the government, or name it. You will never go get a loan unless you say, commit to how much will you pay back in the future.
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And we saw last time that paying back in the future's determined first before you can even figure out the value of the loan. So, it's pretty straight forward. But between a stock and a bond, when you go raising money. Stock is not contract. So which comes first? Typically it's always bonds come first when you're about to pay them. In other words when you have raised money from bonds and stocks the person who gets paid first are the bond holders. And in some senses they are less interesting people but when you initially start a firm, if you don't have any equity or any stocks in the firm, no money, nobody's going to give it.
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So, for example, when you raise money against a house, it's called the down payment. You have to have some stake. So therefore, you start off with equity, you then borrow money, and let's assume a realistic world where you have both, and you are an entity. So there, bonds get paid first, after you've constructed. So after you've taken the loan and equity. Equity always comes last in the line in terms of payment. And therefore, what I like about it is, everything else is a contract in a firm and equity gets paid the crumbs at the end. Right? The trouble though, is sometimes, what happens is that stockholders are the people.
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Who either run the firm, like if you're the owner, original owner. And, private companies are run like that still. All you hire, if you become very big, you hire professional managers. But they are working on your behalf. It is their obligation legal to pay bond holders first. But because they run the company no more there are now unfortunately many instances in which there's a conflict of interest between the bond holder payment and the stockholder. This is very interesting stuff that I wanted, you to know. So when a bond gets paid, we know how it gets paid. It gets paid in the form of interest. Or coupon, or right?
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Or, if you repay it which you do slowly, then are the second component is, the Principal repayment. We went through it multiple times, right? How does the stock get paid. Well, after you paid off bond holders think of them as all contracted payments that you make for financing your project or your firm. You then pay stockholders. And the stockholders are paid something called dividends. And dividends are payment per share. Remember stocks are per share, we get into all of that. So if the company's worth one million dollars and suppose that is half a million dollars worth of debt, and other half of million is stocks. There won't be one stock, there'll be a bunch of shares of the stock.
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So it's divided up among what's called shares and each share gets a small payment. And as we do examples later I'll have a lot of decimals floating around so I'll go very carefully. I don't want to create a problem that's so unrealistic. That's got big numbers per share. That happens sometimes but that's not frequent. Does a firm have to pay dividend? Now this is the key difference, right? Between a bond and a stock. So bond is a contract. If you cannot pay the promised payment every six months you had agree to pay the bond holders or the bank or whatever. You're in default effectively.
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Now, you may renegotiate and you may make it possible for you to restructure the loan, so that you don't have to pay the interest today, but you are technically in default. What about dividend? Well, turns out the stock never promised to pay you anything. And that's what I find so, I'm so enamored by it. All my research is in stock pricing because there's nothing promised, however, you do expect something. So the dividend is paid. At the end after everybody else is paid off. But it doesn't have to pay dividend, right. Even then, even if you have money you don't have to pay it out. And the reason is you'll see later and you must be guessing right now.
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You may choose to, you the firm put some of that money back into the firm in form of new ideas. And many very famous firms haven't paid dividends. And the reason is they're famous because they're very successful, and we do not, as shareholders, want them to pay us dividends. Because a sad part about life is rich people hold stocks, right? This is true about the world. They do not hold stocks, so that they can finance the consumption, our food and so on. They have money, so the problem of getting dividends paid is one, you have to pay taxes but second, what do you do with it, right? You have to reinvest it in something typically.
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Not always, but typically that's what you do. So one reinvestment is have the firm reinvest it for you and do very well. Does equity have a life? Again, I'm highlighting everything that's distinct from bonds. Does equity have a life? Bonds always have lives except very rarely like a console issued in UK. Which last forever, one pound, one pound, one pound. Another key distinction between stocks and bond, is stocks last forever or want to. I know of no one who starts a firm and says, you know what, I need money but I'm only going to last for five years. That nobody's gonna give you that money.
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Mostly money comes to you because you want to last forever, and so it's not a contract, and it's kind of goes on in perpetuity. So one of the things I always want you to think about is stock really an IOU?
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It's not an IOU in the technical legal sense it's an IOU in an expectation sense. So can't legally suit yourself for not paying yourself because in hell a promise to yourself anything, right? You may have an expectation again very, very fascinating. Final thought before we take a little break, is think about what is riskier, a stock or a bond? At the background I've always said there'll always be risk and I'm gonna push down a little bit stocks because there's no such thing as a risk free stock. I mean, You gotta create one. [LAUGH] So, which is riskier, stock or a bond?
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And if you think about it, if every company that has a loan has to pay the loan first, before they get to pay the shareholders, or if you're the owner as a shareholder. It's gotta be the case that a contract is less risky, right? That doesn't mean it's risk less, right? Remember zero coupon bonds? We think they are risk less, but there too, if you sell them before maturity you have price risk. Of course coupon bonds, default risk. So there is risk, but stocks of a company in the long run should have more risk and therefore should bear higher rate of return on average.
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