In this article we will discuss about the factors determining yields on stock of a firm. Also learn about the computation of yields on stock.
Factors Determining Yields:
The general level of yields on stocks is determined by a complex of factors.
I. Level of Interest Rates:
A change in interest rates will affect security prices and yields as follows:
a. A fall in interest rates brings about a rise in the price of fixed interest securities and a fall in yields.
b. A rise in interest rates has the opposite effect.
II. Borrower’s Financial Standing:
The Government offers absolute security for its debts so that yields on gilt-edged are the finest in the market and establish a standard for other yields. Since the standing of other borrowers is lower, investors expect higher yields. This difference is known as ‘yield differential’ or ‘yield gap’.
III. Duration of Loan:
The element of risk increases with the duration of the loan so that, investors expect higher yields on long-term bonds than for short, by way of compensation.
IV. General Outlook of Economy:
A bullish outlook for industry or the prospect of inflation and high rates of interest will cause investors to switch to equities to depress the prices of gilts and to raise their yields.
V. Political Events:
Prices and yields are also influenced by political events, e.g., changes of Government, industrial unrest, publication of trade figures, international crises or any events likely to effect business confidence etc.
Computation of Yield on Stocks:
The prospective purchaser of gilt-edged stocks will compare the return or yield of the investment with its opportunity cost, i.e., what it could earn elsewhere at current interest rates.
Problem:
An investment produces annual returns of 12% in the first year, 7% in the second year and 10% in the third year. What is the annualized return over the three years?
Solution:
Annualized return over the 3 years = (1.12 x 1.07x 1.10) 1/3 -1 = 1.096477- 1 = 0.096477 or 9.65%
Two yields may be calculated as follows:
Flat Yield:
This is the annual return on the investment. It is appropriate for irredeemable stocks.
Suppose 14 per cent undated bonds of Rs.100 are quoted at Rs.80. Then:
Redemption Yield:
The true return on dated stocks must include the rate of interest and any capital gain which results from differences between their cost and redemption price. Suppose 12 per cent conversion bonds redeemable at par in 2016 were quoted at Rs.84 in 2015 then:
In addition, the investor will make a capital gain of Rs.16 over six years since the bond was redeemable for Rs.100 in 2016. Capital gain may be expressed as an annual yield for the period.
In practice this is found in actuarial tables, which allow for compounding, but it may be estimated as follows:
Redemption yield = Flat yield p.a. + Capital gain p.a. = 14.29% + 2.66% = 16.95%