Monday, 26 December 2016

A Dividends-and-Earnings (D&E) Approach - Finding the Value of Non-Dividend-Paying Stocks

What about the value of a stock that does not pay dividends and is not expected to do so for the foreseeable future?

The D&E approach can be used.

Value of a share of stock
= Present value of future dividends + Present value of the price of the stock at the date of sale.

Using the above equation, simply set all dividend to 0.  

The computed value of the stock would come solely from its projected future price.

The value of the stock will equal the present value of its price at the end of the holding period.


Stock XYZ pays no dividends.
Investment period 2 year holding period.
Estimates this stock to trade at around $70 a share at end of this period.
Required rate of return 15%.

Using a 15% required rate of return, this stock would have a present value of
= $70 / (1.15^2)
= $52.93

This value is the intrinsic value or justified price of the stock.

So long as it is trading for around $53 or less, it would be a worthwhile investment candidate.

A Dividends-and-Earnings (D&E) approach to Stock Valuation

A Dividend-and-Earnings approach

One valuation procedure that is popular with many investors is the so-called dividends-and-earnings (D&E) approach, which directly uses future dividends and the future selling price of the stock as the relevant cash flows.

The value of a share of stock is a function of the amount and timing of future cash flows and the level of risk that must be taken on to generate that return.

The D&E approach (also known as the discounted cash flow or DCF approach) conveniently captures the essential elements of expected risk and return and does so in a present value context.

Value of a share of stock
= Present value of future dividends + Present value of the price of the stock at the date of sale.

The D&E estimates the future stock stock price by multiplying future earnings times a P/E ratio.

Because the D&E calculation does not require a long-run estimate of a stock's dividend stream, it works just as well with companies that pay little or nothing in dividends as it does with stocks that pay out a lot of dividends.

Finding a viable P/E multiple is critical in the D&E approach

Using the D&E valuation approach, we focus on projecting 

  • future dividends and 
  • share price behaviour 
over a defined, finite investment horizon.

Especially important in the D&E approach is finding a viable P/E multiple that you can use to project the future price of the stock.

This is a critical part of this valuation process because of the major role that capital gains (and therefore the estimated price of the stock at its date of sale) play in defining the level of security returns.

Using market or industry P/E ratios as benchmarks, you should establish a multiple that you feel the stock will trade at in the future.

The P/E multiple is the most important (and most difficult) variable to project in the D&E approach.

Estimates required

Estimate its future dividends
Estimate its future earnings per share
Estimate a viable P/E multiple
Estimate its future price ( = P/E multiple x future earnings per share)
Estimate your required rate of return

Using the above estimates, this present value based model generates a justified price based on estimated returns.

You want to generate a return that is equal to or greater than your required rate of return.


Company ABC
Our investment horizon - 3 years
Forecasted annual dividends  Yr 1 $0.18       Yr 2 $0.24      Yr 3  $0.28
Forecasted annual EPS           Yr 1 $3.08       Yr 2  3.95       Yr 3  $4.66
Forecasted P/E ratio                Yr 1 20.0         Yr 2 20.0        Yr 3  20.0
Share price at year end of        Yr 1 $61.60     Yr 2 $75.06    Yr 3  $93.20

Given the forecasted annual dividends and share price, along with a required rate of return of 18%, the value of Company ABC stock is:

Value of a share of stock
= Present value of future dividends + Present value of the price of the stock at the date of sale.

= {[$0.18/(1.18)] + [$0.24/(1.18^2)] + [(0.28/(1.18)^3]}    +     [$93.20/(1/18^3)]
= {$0.15 + $0.17 + $0.17}    +    $56.72
= $57.22

According to the D&E approach, Company ABC's stock should be valued at about $57 a share.

Comments on the above example:

1.  Assuming our projections hold up and given that we have confidence in the projections, the present value figure computed here means that we would realize our desired rate of return of 18% so long as we can buy the stock at no more than $57 a share.

2.  If Company ABC is currently trading around $41, we can conclude that the stock at present price is an attractive investment.  Because we can buy the stock at less than its computed intrinsic value, we will earn our required rate of return and then more.

3.  Note:  Company ABC would be considered a highly risky investment, if for no other reason than the fact that nearly all the return is derived from capital gains.  Its dividends alone account for less than 1% of the value of the stock.  That is only 49 cents of the $57.22 comes from dividends.

4.  If we are wrong about EPS or the P/E multiple, the future price of the stock would be way off the mark and so too, would our projected return.

A little COMMON SENSE goes a long way to Improve Investment Results! The mistakes of some investors may be the profit opportunities for others.

Investors' decisions are affected by a number of psychological biases that lead investors to make systematic, predictable mistakes in certain decision-making situations.

These mistakes, in turn, may lead to predictable patterns in asset prices that create opportunities for other investors to earn abnormally high profits without accepting abnormally high risk.

Here are some of the behavioural factors that might influence the actions of investors:

1.  Overconfidence and Self-Attribution Bias
2.  Loss Aversion
3.  Representativeness
4.  Narrow Framing
5.  Belief Perseverance
6.  Familiarity Bias

Using Behaviour Finance to Improve Investment Results

Studies have documented a number of behavioural factors that appear to influence investors' decisions and adversely affect their returns.

By following some simple guidelines, you can avoid making mistakes and improve your portfolio's performance.

A little common sense goes a long way in the financial markets!

1.  Don't hesitate to sell a losing stock.

If you buy a stock at $20 and its price drops to $10, ask yourself whether you would buy that same stock if you came into the market today with $10 in cash.  

If the answer is yes, then hang onto it.

If not, sell the stock and buy something else.

2.  Don't chase performance.

The evidence suggests that there are no "hot hands" in investment management.

Don't buy last year's hottest mutual fund if it doesn't make sense for you.

Always keep your personal investment objectives and constraints in mind.

3.  Be humble and open-minded.

Many investment professionals, some of whom are extremely well paid, are frequently wrong in their predictions.

Admit your mistakes and don't be afraid to take corrective action.

The fact is, reviewing your mistakes can be a very rewarding exercise - all investors make mistakes, but the smart ones learn from them.

Winning in the market is often about not losing, and one way to avoid loss is to learn from your mistakes.

4.  Review the performance of your investments on a periodic basis.

Remember the old saying, "Out of sight, out of mind."

Don't be afraid to face the music and to make changes as your situation changes.

Nothing runs on "autopilot" forever - including investment portfolios.

5.  Don't trade too much

Investment returns are uncertain, but transaction costs are guaranteed.

Considerable evidence indicates that investors who trade frequently perform poorly.

Implications of Behavioural Finance for Security Analysis

Behavioural finance can play an important role in investing.

The contribution of behavioural finance is 

  • to identify particular psychological factors that can lead investors to make systematic mistakes, and 
  • to determine whether those mistakes may contribute to predictable patterns in stock prices.

If that is the case, the mistakes of some investors may be the profit opportunities for others.

See the above 5 common sense rules on how to keep your own mistakes to a minimum.

Sunday, 25 December 2016

Valuing companies with little or no earnings or with very volatile and highly unpredictable earnings.

Companies with no earnings or very volatile and highly unpredictable earnings

Some companies, like high tech startups, have little, if any, earnings.

If they do have earnings, they tend to be quite volatile and therefore highly unpredictable.

In these cases, valuation procedures based on earnings (and even cash flows) are not much  help.

Price to Sales ratio or Price to Book Value ratio

Investors turn to other procedures - those based on sales or book value.

While companies may not have much in the way of profits, they almost always have sales and, ideally, some book value.

Investor Mistakes (Short-lived Growth)

So called value stocks are stocks that have low price to book ratios, and growth stocks are stocks that have relatively high price to book ratios.

Many studies demonstrate that value stocks outperform growth stocks, perhaps because investors overestimate the odds that a firm that has grown rapidly in the past will continue to do so (Short-lived Growth).

Price to Sales ratio

Price to Sales ratio

P/S = Market price of common stock / Sales per share

Sales per share equals net annual sales (or revenues) divided by the number of common shares outstanding.

Many bargain hunting investors look for stocks with P/S ratios of 2.0 or less.

They believe that these securities offer the most potential for future price appreciation.

Very low P/S multiples of 1.0 or less are especially attractive

Especially attractive to these investors are very low P/S multiples of 1.0 or less.

Think about it:  With P/S ratio of, say, 0/9, you can buy $1 in sales for only 90 cents!

So long as the company isn't a basket case, such low P/S multiples may well be worth pursuing.

High P/S aren't necessarily bad.

While the emphasis may be on low multiples, high P/S ratios aren't necessarily bad.

To determine if a high multiple - more than 3.0 or 4.0, for example - is justified, look at the company's net profit margin.

Companies that can consistently generate high net profit margins often have high P/S ratios.

Valuation rule to remember:

High profit margins should go hand in hand with high P/S multiples.

That make sense because a company with a high profit margin brings more of its sales down to the bottom line in the form of profits.

Price to Book Value Ratio

Price to Book Ratio

P/BV ratio
= Market price of common stock / Book Value per share

Unless the market becomes grossly overvalued (1999 and 2000), most stocks are likely to trade at multiples of less than 3 to 5 times their book value.

There is usually little justification for abnormally high price to book value ratios - except perhaps for firms that have abnormally low levels of equity in their capital structures.

Other than that, high P/BV multiples are almost always caused by "excess exuberance."

As a rule, when stocks start trading at 7 or 8 times their book values, or more, they are becoming overvalued.

Investor Mistakes (Short-lived Growth)

So called value stocks are stocks that have low price to book ratios, and growth stocks are stocks that have relatively high price to book ratios.

Many studies demonstrate that value stocks outperform growth stocks, perhaps because investors overestimate the odds that a firm that has grown rapidly in the past will continue to do so (Short-lived Growth).

Friday, 23 December 2016

The Market as a Leading Indicator

Investors use the economic outlook

  • to get a handle on the market and 
  • to identify developing industry sectors.

It is important to note that changes in stock prices 

  • normally occur before the actual forecasted changes become apparent in the economy.

Indeed, the current trend of stock prices 

  • is frequently used to help predict the course of the economy itself.

Investors in the stock market tend to look into the future to justify the purchase or sale of stock.

If their perception of the future is changing, stock prices are also likely to be changing.

Therefore, watching the course of stock prices as well as the course of the general economy can make for more accurate investment forecasting.

Thursday, 22 December 2016

Fundamental Analysis Advocates versus Efficient Market Advocates

Fundamental Analysis Advocates

The concept of security analysis in general, and fundamental analysis in particular, is based on the assumption that at least some investors are capable of identifying stocks whose intrinsic values differ from their market values.

Fundamental analysis operates on the broad premise that some securities may be mispriced in the marketplace at least some of the time.

Fundamental analysis may be a worthwhile and profitable pursuit:

  • if securities are occasionally mispriced, and 
  • if investors can identify mispriced securities.

To many, those two premises seem reasonable.

Efficient Market Advocates

However, there are others who do not accept the assumptions of fundamental analysis.

These so-called efficient market advocates believe

  • that the market is so efficient in processing new information that securities trade very close to or at their correct values at all times. and 
  • that even when securities are mispriced, it is nearly impossible for investors to determine which stocks are overvalued and which are undervalued.

Thus, they argue, it is virtually impossible to consistently outperform the market.

In its strongest form, the efficient market hypothesis asserts the following:

1.  Securities are rarely, if ever, substantially mispriced in the marketplace.
2.  No security analysis, however detailed, is capable of identifying mispriced securities with a frequency greater than that which might be expected by random chance alone.

In recent years, stock markets have been extremely volatile in the U.S. and around the world.

October 2007 to March 2009

From October 2007 to March 2009, U.S. stocks lost more than half their value, and in many markets around the world, the results were even worse

Those declining stock values mirrored the state of the world economy, as country after country slipped into a deep recession.

U.S. firms responded by cutting dividends.  Standard &Poor's reported that a record number of firms cut their duvidend payment in the first quarter of 2009, and a record low number announced plans to increase their dividends.

March 2009 to April 2011

From March 2009 low, the U.S. stock market nearly doubled ovee the next 2 years, hitting a post-recession peak in April 2011.   The run up in stock prices coincided with an increase in dividend payouts.

Of the 500 firms included in the S&P 500 stock index, 154 increased their dividend payment in 2010 or 2011, compared to just 3 firms which cut payments over the same period.

April of 2011 to April 2012

The good news for stocks didn't last very long.  In the spring of 2011, concern about a looming economic crisis in Europe sent U.S. stocks lower again.   The S&P 500 Index fell by more than 17% from April to August in 2011.  The market largely recovered its losses over the next year.

Dividend Aristocrats

Throughout this volatile period, some companies managed to increase their dividends each year.   Standard and Poor's tracks the performance of a portfolio of firms that it calls "dividend aristocrats" because these firms have managed to increase their dividends for at least 25 consecutive years.

Including household names such as Johnson & Johnson, Exxon Mobil and AFLAC, the dividend aristocrat index displays ups and downs that mirror those of the overall market, but at least investors in these firms have enjoyed consistently rising dividends.

Future Value is an Extension of Compounding

A simple concept.

It is never too early to begin saving for retirement.

If you placed $2,000 per year for the next 8 years into an account that earned 10% and left those funds on deposit, in 40 years the $16,000 that you deposited would grow to more than $480,000.  When investing, time is your biggest ally.

Time is on your side.

Monday, 19 December 2016

Why understanding fundamental analysis is important for investing in stocks?

Fundamental analysis:

Why understanding FA is important? 

FA cannot offer you the magic keys to sudden or instant wealth. If that were true, the Professors of Finance will all be fabulously rich! What FA can do is to provide sound principles for formulating a successful long-range investment program. FA are proven methods that have been used by millions of successful investors.

The motivation for investing in stocks is obvious. It is to watch your money grow.

Why then, for every story of great success in the market, there are dozens more that don't end so well!!!!

More often than not, most of those investment flops can be traced to:

1. Bad timing
2. Poor planning
3. Failure to use common sense in making investment decisions.

Intrinsic Value

The entire concept of stock valuation is based on the idea that all securities possess an intrinsic value that their market value will approach over time.

Security analysis consists of gathering information, organizing it into a logical framework, and then using the information to determine the intrinsic value of common stock.

Given a rate of return that's compatible with the amount of risk involved in a proposed transaction, intrinsic value provides a measure of the underlying worth of a share of stock. It provides a standard for helping you judge whether a particular stock is undervalued, fairly priced or overvalued.

Main message

The aims of fundamental analysis are to determine the asset's intrinsic value and its future growth potential.

Income Stocks

Income Stocks

Income stocks are appealing simply because of the dividends they pay.

These issues have a long history of regularly paying higher than average dividends.

Income stocks are ideal for those who seek a relatively safe and high level of current income from their investment capital.

Growing dividends protect from effects of Inflation

Holders of income stocks (unlike bonds and preferred stocks) can expect the dividends they receive to increase regularly over time.

Thus, a company that paid, say, $1.00 a share in dividends in 1997 would be paying just over $1.80 a share in 2012, if dividends had been growing at around 4% per year.

Dividends that grow over time provide investors with some protection from the effects of inflation.

Major Disadvantage: some have Limited Growth Potential

The major disadvantage of income stocks is that some of them may be paying high dividends because of limited growth potential.

Indeed, it is not unusual for income securities to exhibit relatively low earnings growth.

This does not mean that such firms are unprofitable or lack future prospects.

Quite the contrary:   Most firms whose share qualify as income stocks are highly profitable organizations with excellent prospects.

A number of income stocks are among the giants of U.S. industry, and many are also classified as quality blue chips.


By their nature, income stocks are not exposed to a great deal of business and market risk.

They are, however, subject to a fair amount of interest rate risk.


Many public utilities are in this group, such as:

  • American Electric Power,
  • Duke Energy,
  • Oneok,
  • Scana,
  • DTE Energy, and 
  • Southern Company.
Also in this group are selected industrial and financial issues like:
  • Conagra Foods,
  • General Mills, and
  • Altria Group.

Blue-Chip Stocks

"Blue chips are companies that pay a dividend and increase it over time."

Blue Chips

Blue chips are the cream of the common stock crop.

They are stocks issued by companies that have a long track record of earning profits and paying dividends.  

Blue-chip stocks are issued by large, well-established firms that have impeccable financial credentials.

These companies are often the leaders in their industries.

Not all blue chips are alike.

Some provide consistently high dividend yields; others are more growth oriented.

While blue-chip stocks are not immune from bear markets, they are less risky than most stocks.

They tend to appeal to investors who are looking for quality, dividend-paying investments with some growth potential.

Blue chips appeal to investors who want to earn higher returns than bonds typically offer without taking a great deal of risk.


Good examples of blue chip growth stocks are:

  • Nike,
  • Procter & Gamble,
  • Home Depot,
  • Walgreen's,
  • Lowe's Companies, and 
  • United Parcel Service.

Examples of high-yielding blue chips include such companies as:

  • AT&T,
  • Chevron,
  • Merck,
  • Johnson & Johnson,
  • McDonald's, and 
  • Pfizer.

Sunday, 18 December 2016

The Advantages of Stock Ownership

1.  Possibility for substantial returns

One reason stocks are so appealing is the possibility for substantial returns that they offer.

Stocks generally provide relatively high returns over the long haul.

Common stock returns compare very favourably to other investments such as long-term corporate bonds and U.S. Treasury securities.

Over the last century, high-grade corporate bonds earned annual returns that were about half as large as the returns on common stocks.

Although long term bonds outperform stocks in some years, the opposite is true more often than not.

Stocks typically outperform bonds, and usually by a wide margin.

Stocks also provide protection from inflation because over time their returns exceed the inflation rate.

In other words, by purchasing stocks, you gradually increase your purchasing power.

2.  Ease of buying and selling

Stocks are easy to buy and sell, and the costs associated with trading stocks are modest.

3.  Information easily available

Information about stock prices and the stock market is widely disseminated in the news and financial media.

4.  Cost to own stocks is low.

The unit cost of a share of common stock is typically fairly low.    

Unlike bonds, which normally carry minimum denominations of at least $1,000 and some mutual funds that have fairly hefty minimum investments, common stocks don't have such minimums.

Most stocks are priced less than $50 a share and you can buy any number of shares that you want.

Additional notes:

Investors own stocks for all sorts of reasons:
1.  the potential for capital gains,
2.  their current income, or
3.  perhaps the high degree of market liquidity.

The Disadvantages of Stock Ownership

There are some disadvantages of common stock ownership.

1.  Risk

Risk is perhaps the most significant.

Stocks are subject to various types of risk, including:

  • business and financial risk,
  • purchasing power risk,
  • market risk and 
  • event risk.
All of these can adversely affect 
  • a stock's earnings and dividends, 
  • its price appreciation and 
  • of course, the rate of return that you earn.

Even the best of stocks possess elements of risk that are difficult to eliminate because company earnings are subject to many factors, including:
  • government control and regulation,
  • foreign competition and
  • the state of the economy.
Because such factors affect sales and profits, they also affect stock prices and (to a lesser degree) dividend payments.

2. Price & Returns Volatility

All of this leads to another disadvantage: stock returns are highly volatile and very hard to predict, so it is difficult to consistently select top performers.

The stock selection process is complex because so many elements affect how a company will perform.

In addition, the price of a company's stock today reflects investors' expectations about how the company will perform.

In other words, identifying a stock that will earn high returns requires that you not only identify a company that will exhibit strong future financial performance (in terms of sales and earnings) but also that you can spot that opportunity before other investors do and bid up the stock price.

3. Current income

A final disadvantage is that stocks generally distribute less current income than some other investments.

Several types of investments - bond, for instance - pay more current income and do so with much greater certainty.

Comparing the dividend yield on common stocks with the coupon yield on high grade corporate bonds from 1976 to 2012,  shows the degree of sacrifice common stock investors make in terms of current income.

Clearly, even though the yield gap has narrowed a great deal in the past few years, common stocks still have a long way to go before they catch up with the current income levels available from bonds an most other types of fixed-income securities.


In other words, identifying a stock that will earn high returns requires that:

  • you not only identify a company that will exhibit strong future financial performance (in terms of sales and earnings) 
  • but also that you can spot that opportunity before other investors do and bid up the stock price.

Saturday, 17 December 2016

Uses of Common Stocks: as storehouse of value, to accumulate capital and as a source of income

Basically, common stocks can be used as:

1.  a "storehouse" of value,
2.  a way to accumulate capital, and,
3.  a source of income.

Storage of value

Storage of value is important to all investors, as nobody like to lose money.

However, some investors are more concerned about losses than are others.

They rank safety of principal as their most important stock selection criterion.

These investors are more quality-conscious and tend to gravitate toward blue chips and other non-speculative shares.

Accumulation of capital

Accumulation of capital, in contrast, is generally an important goal to those with long-term investment horizons.

These investors use the capital gains and/or dividends that stocks provide to build up their wealth.

Some use growth stocks for this purpose, while others do it with income shares, and still others us a little of both.

Source of income

Finally, some investors use stocks as a source of income.

To them, a dependable flow of dividends is essential.

High-yielding, good-quality income shares are usually their preferred investment vehicle.

Individual investors can use various investment strategies to reach their investment goals.

These include:

  1. buy and hold,
  2. current income,
  3. quality long term growth,
  4. aggressive stock management, and 
  5. speculation and short term trading.

The first 3 strategies appeal to investors who consider storage of value important.

Depending on the temperament of the investor and the time he or she has to devote to an investment program, any of these strategies might be used to accumulate capital.

In contrast, the current income strategy is the logical choice for those using stocks as a source of income.

Singapore investors lost over S$1 mil to online binary options scams

SINGAPORE (Dec 15): Singapore police has issued a warning over a “sharp rise” in scams involving online trading in binary options.

The Commercial Affairs Department (CAD) has received more than 30 reports from investors who have lost more than S$1 million to unregulated binary options trading platforms, authorities said in a press release on Wednesday.

Police said most victims are local Chinese males aged between 31 and 50, and include finance professionals as well as retirees.

“Binary options trading is attractive, because it sounds simple and the option providers or platforms often promise high, quick and safe returns,” police said in its statement. “In reality, binary options are speculative and risky, and many online platforms offering binary options trading are fraudulent.”

All or nothing

With a binary option, investors try to predict whether the price of the underlying asset will be above or below a specified price at a specified point in time.

That specified point in time is usually very near, ranging from a few minutes to a few months in the future.

Meanwhile, the underlying products can range widely, and include shares, currencies and commodities.

Unlike other types of options, holding a binary option does not give the investor the right to buy or sell the underlying asset. Investors receive a fixed payoff, if their prediction is correct, but lose the entire investment if they are wrong.

“That is why binary options are often also called ‘all or nothing’ options,” police said. “The risk of losing your entire investment is high, because correctly predicting short term price movements is difficult.”

Singapore investors lost over S$1 mil to online binary options scams

An investigation by Money Mail and the Bureau of Investigative Journalism found that the vast majority of binary option traders never make any money from it.

Some eight in 10 customers are reported to end up losing all their cash within five months. At some binary firms, the investigations revealed that just three in 100 customers ever make a profit.

Lured by initial profits and promises of financial advice, more bonuses and attractive rewards, most of the investors found it difficult to stop at one small investment and would put in more money.

In Singapore, these investors either lost all their monies or could not withdraw the balances in their accounts, police said.

Some also had unauthorised withdrawals made in their debit or credit cards after they had handed over their card details for payment.

Authorities said most of the binary options trading platforms encountered were usually unregulated entities based outside Singapore.

When things go wrong, the victims faced difficulties contacting these foreign operators, who commonly claim to be operating from the United Kingdom, Cyprus and Hong Kong.

Beware of scams

Police urged Singaporeans to exercise caution and keep in mind the following when dealing with binary options trading:

a) Even when offered by legitimate sellers, binary options trading is a high risk investment where you can easily lose all that you invested.

b) Investments which promise high returns usually come with high risks. Think carefully before making the investment. When in doubt, seek professional advice before engaging in any investment products.

c) Dealing with unregulated entities mean you may have very little recourse if things go wrong.

To find out which entities are regulated in Singapore, check the list of capital markets services licence holders under Monetary Authority of Singapore (MAS) and the list of licensed commodity brokers under International Enterprise (IE) Singapore.

You may also like to check the MAS Investor Alert List, which provides a listing of unregulated entities which may have been wrongly perceived as being licensed or authorised by MAS.

d) Even if you are dealing with an entity regulated in Singapore, some binary options offered by that regulated entity may not be regulated. This means that you may have minimal recourse if things go wrong. When in doubt, you should check with the regulated entity before investing in any binary option it offers.

e) Be wary of third party reviews, endorsements or success stories of binary option providers. These reviews and endorsements may have been paid for by the binary option providers. They may also attempt to gain your trust by warning you against a particular binary option provider while directing you to another binary option provider connected to them.

f) Be cautious of high pressure sales tactics used by representatives of binary option providers. These tactics include promises of quality financial advice or easy profits.

g) Be careful when sending money to overseas bank accounts via fund transfers, debit or credit card payments, and any other modes of payment. Always ensure that the end recipient is reliable before making any transfers or payments.

Likewise, do not give your personal particulars such as your name, identification number, passport details, bank account or credit and debit card details to others without first verifying whether they are legitimate.

ROE as a proxy for Competitive Advantage

The DuPont formula
ROE= (Net Profit/ Sales) X (Sales/ Assets) X (Assets/ Equity)
And we are left with:   
ROE = Net Profit/ Equity
The DuPont breakdown goes on to show why ROE is such a critical ratio for analysts and investors alike. 
It basically is combination of three ratios that reflect overall profitability and efficiency of a company. 
This breakdown also shows the bearing of six factors on ROE instead of the usual two that we assume are the beginning and end of it.

ROE as a proxy for Competitive Advantage:

Consistently High RoE figures do indicate that the company has a moat. 
As seen above in the Dupont breakdown of RoE, a company can have a high RoE 

  • either because it is able to sell its goods/services at a high margin 
  • or because  increase its returns by either selling its products at a high rate. 
Only the third option is undesirable i.e having a high leverage which would mean high indebtedness . 

Remember, we said a consistently high levels of RoE to be construed as an evidence of a moat. 
This is because the denominator of this ratio includes shareholders equity which in turn consists of   share capital plus retained earnings (also called reserves and surplus)
Share holder's equity= Share capital + Retained earnings
Now as the company generates higher returns on equity, the profits are added to the retained earnings. 
So the denominator of ROE keeps increasing and so either the company has to
  •  keep showing growth in its profits or 
  • find ways to reduce the denominator. 

The company can do that by 
  • either paying higher dividends 
  • or buying back shares
- both strategies lead to gains for shareholders. 

Working capital management is the main determinant in the liquidity position of a company.

Liquidity or Working Capital Ratios

Cash Conversion cycle is just one part of assessing the working capital position. 
Other is the computation of 
  • Current Ratio, 
  • Acid-test Ratio and 
  • Cash Ratio. 

Current Ratio

Current Ratio is the basic and the most used amongst the list of liquidity ratios. 
It is also known as working capital ratio and is stated as below:
Current Ratio= Current Assets/ Current Liabilities
The resultant figure represents the number of times current assets cover current liabilities. 
Higher the ratio better it is. 
However, this ratio can be higher even if cash is trapped in receivables and inventories.

Acid Test Ratio

Acid test ratio is also known as quick ratio and it considers only “highly” liquid assets in consideration.
Acid Test ratio = (Current Assets- Stock- prepaid expenses)/ Current Liabilities
Acid test ratio doesn't include inventories but does include receivables and so thought a refinement of current ratio may still mislead at times

Cash Ratio

This one is a further refinement of Acid Test ratio and considers only Cash and cash equivalents for the purpose of measuring liquidity. 
Cash Ratio = Cash + Cash equivalents / Current liabilities

The above ratios and Cash Conversion Cycle determine the working capital position of a company. 
However, we always maintain that one aspect of the entire financial position cannot be considered as representative of the total financial health of a company. 
So here are a few cautionary words for cases when you just have working capital figures to contend with.

Factors to consider when assessing working capital position of a Company

1.    Healthy and unhealthy working capital position can be generalized only according to the industry and sector an entity is operating in. Some entities by nature have higher liquidity and some low;
2.    Higher liquidity is not always favourable as it may indicate under-utilisation of resources and money. You will need to further dig in to find if this is the case;
3.    Consider recent sale, purchase, construction of an asset, pre-closure of loan or liquidation of a big liability owing to strategic decisions that affect liquidity tremendously;
4.    Change in trade terms, seasonal nature of goods sold also has a strong bearing on liquidity position.

Working capital management is extremely important for companies. 
It is the main determinant in the liquidity position of a company. 
Profitable companies can go bankrupt due to a paucity of liquidity.  

Friday, 16 December 2016

Components of Cash Conversion Cycle

Cash Conversion Cycle (CCC)

Cash Conversion cycle is the time taken by a trading or manufacturing concern to realise cash from its inventory and account receivables after meeting its outflows owing to short term payables including trade creditors. 
It is expressed in terms of number of days and can be defined as follows in form of a formula:-
CCC= Days’ Inventory Outstanding (DIO) + Days’ Sale Outstanding (DSO) – Days’ Purchase Outstanding (DPO)

Components of Cash Conversion Cycle - DIO, DSO and DPO

Days’ Sale Outstanding (DSO)

DSO is the measure to assess the number of days a concern gives credit to its customers. Let us explain it with a formula:
DSO= Average receivables/ daily sale
Average receivables: Opening balance + Closing Balance/2
Daily sales: Total annual sale/365
DSO can be calculated for every month as well. In fact when there is a revamp of credit terms then DSO should be computed for every month to understand the implication and drop or hike in DSO, as the case may be.

Days’ Purchase Outstanding (DPO)

DPO gives average credit term (days of credit) enjoyed by a concern from its trade creditors. In term of formula, it can be stated as follows:
DPO= Average payables/ Daily purchases
Average payables= Opening balance+ Closing Balance/2
Daily purchases= Total purchases/365
Just like DSO, DPO can also be computed monthly or any period of time as required.

Importance and usage of DSO and DPO

Now that we have discussed the meaning of DSO and DPO, let us understand their implication on a business and cash conversion cycle. 

Ideally, every trading concern must try to have a bigger DPO and smaller DSO, which essentially implies that they recover cash from debtors in shorter duration and pay off their creditors later.

For e.g. ABC Company has a DSO of 30 days and DPO of 40. This gives an advantage of 10 extra days to ABC Company to meet its payables and it enjoys healthy liquidity to meet its other production and day to day expenses as well.

DSO comparisons also help in effective credit control. If without any re-negotiations, a company observes that its DSO has risen then it means that the collection process is not working well. This situation can be rectified in many ways including putting processes like advance reminders and water tight system of invoicing in place for the starters. If a company has indeed renegotiated terms with both debtors and creditors, then the month on month DSO and DPO comparisons would show the result in line with such re-negotiations.

Days’ Inventory Outstanding (DIO)

The third pillar of CCC deals with inventory. DIO is the average days a trading concern takes to convert its inventory into sale and is stated as follows:
DIO= Average Inventory/ Day’s Cost of goods sold
Average inventory= Opening Balance + Closing Balance/2
Day’s cost of goods Sold (COGS)= Cost of goods sold/365
If the accounting period for which DIO is to be computed is shorter, then day’s COGS will be computed for such other period and 365 days will get replaced accordingly.

An Example

Cash Conversion Cycle (CCC) 
= (44 33) - 61
= 16 days
The above computation shows that the average days of credit granted by XYZ Corp is almost half at 33 days as compared to the credit days lent by it, which is 61 days.

The average days it takes XYZ Corp to sell its stock is 44 days and the number of days in which it converts its inventory and debtors into cash is just 16 days.

These figures picture a very liquid position of XYZ Corp where it is able to meet its able to generate working capital very efficiently.     

Ideally, every trading concern must try to have a bigger DPO and smaller DSO, which essentially implies that they recover cash from debtors in shorter duration and pay off their creditors later.

Understanding Working Capital

  1. The above figure shows a typical working capital cycle. 
  2. Cash is used to purchase raw materials . 
  3. The raw materials are then turned into finished goods and sold to customers, usually for a credit period. 
  4. Ultimately payment is received in cash from the customer and the cycle repeats. 

Sometimes working Capital can turn negative but before jumping to conclusion about it let us discuss it in length.

What Does Negative Working Capital Mean?

Now the first conclusion about negative working capital would be low efficiency and fact that an entity needs external funding even for day to day operations. 
But having excess of short term liabilities over short-term assets is not always unfavourable. 
  • A sudden surge in creditors or dip in debtors can be result of one-off bulk payments and adjustments that make working capital negative but for a short period of time.  
A negative working capital which sustains over extended period is definitely a cause of concern.
  • It could be because the finished product is being sold at very low margins or loss. This strategy is sometimes followed by companies who are looking at either increasing their market share or introducing new products. 
  • Another instance is sizeble bad debts where debtors have gone bankrupt or refused to pay.  In such a situation the debtors will have a write-off which would result in a dip in current assets. 
  • Loss in inventory by accident can also lead to negative working capital. 
But for example- financing a fixed asset by cash will make a hit at current assets position but it is a sign of efficiency where you are able to make investment in fixed assets by using internally generated funds!
  • So this is an instance of a favourable negative working capital.
Working capital is a critical factor to consider in assessing the financial health of any business vis. a vis. the efficient use of its resources.

Principles of Portfolio Planning

Investors benefit from holding portfolios of investments rather than single investments.

Without necessarily sacrificing returns, investors who hold portfolios can reduce risk.

Surprisingly, the volatility of a portfolio may be less than the volatilities of the individual assets that make up the portfolio.

When it comes to portfolios and risk, the whole is less than the sum of its parts!

Investment Goals

A portfolio is a collection of investments assembled to meet one or more investment goals.

Different investors have different objectives for their portfolios.

The primary goal of a growth-oriented portfolio is long-term price appreciation.

An income-oriented portfolio is designed to produce regular dividends and interest payments.

Portfolio Objectives

Setting portfolio objectives involves definite tradeoffs, such as the tradeoff

  • between risk and return or 
  • between potential price appreciation and income.

How you evaluate these tradeoffs will depend on your tax bracket, current income needs, and the ability to bear risk.

The key point is that your portfolio objectives must be established BEFORE you begin to invest.

The ultimate goal of an investor is an efficient portfolio, one that provides the highest return for a given level of risk.

Efficient portfolios are not necessarily easy to identify.

You usually must search out investment alternatives to get the best combinations of risk and return.

Thursday, 15 December 2016

An Acceptable Level of Risk

Individuals differ in the amount of risk that they are wiling to bear and the reurn that they require as compensation for bearing that risk.

1.  The risk-indifferent investor requires no change in return for a given increase in risk.

2.  The risk-averse investor requires an increase in return for a given risk increase.

3.  The risk-seeking investor gives up some return for more risk.

The majority of investors are risk averse.

The historical data on the risk and return of different investments from all over the work indicate that riskier investments tend to pay higher returns.

This simply reflects the fact that most investors are risk averse, so riskier investments must offer higher returns to attract buyers.

How much additional return is required to convince an investor to purchase a riskier investment?

The answer to that question varies from one person to another depending on the investor's degree of risk aversion.

A very risk-averse investor requires a great deal of compensation to take on additional risk.

Someone who is less risk averse does not require as much compensation to be persuaded to accept risk.

Determining a Satisfactory Investment

Time value of money techniques can be used to determine whether an investment's return is satisfactory given the investment's cost.

Ignoring risk at this point, a satisfactory investment would be one for which the present value of benefits (discounted at the appropriate discount rate) equals or exceeds its cost.

The three possible cost-benefit relationships and their interpretations follow:

1.  If the present value of the benefits equals the cost, you would earn a rate of return equal to the discount rate.

2.  If the present value of benefits exceeds the cost, you would earn a rate of return greater than the discount rate.

3.  If the present value of benefits is less than the cost, you would earn a rate of return less than the discount rate.

You would prefer only those investments for which the present value of benefits equals or exceeds its cost - situations 1 and 2.

In these cases, the rate of return would be equal to or greater than the discount rate.

Dividend - An Easy Pill to Swallow

On the first trading day of 2016, the stock of a company XYZ, sold for $33.66 per share, just 1.6% higher than its price exactly 1 year earlier ($33.16).

Though it might seem that 2016 was a poor year for company XYZ's shareholders, the stock paid dividends during the year totalling $1.52 and those dividends raised the total return on company XYZ in 2016 to 6.2%.

Why Return is Important

An asset's return is a key variable in the investment decision because it indicates how rapidly an investor can build wealth.

Naturally, because most people prefer to have more wealth rather than less, they prefer investments that offer high returns rather than low returns if all else is equal.

However, the returns on most investments are uncertain, so how do investors distinguish assets that offer high returns from those likely to produce low returns?

One way to make this kind of assessment is to examine the returns that different types of investments have produced in the past.

Historical Performance

Most people recognize that future performance is not guaranteed by past performance, but past data often provide a meaningful basis for future expectations.

A common practice in the investment world is to look closely at the historical record when formulating expectations about the future.

Cash Flow from Financing Activities

This is where the company reports the money that it took in and paid out in order to finance its activities. 

In other words, it calculates how much money the company spent or received from its stocks and bonds. 

This includes 

  • any dividend payments that the company made to its shareholders, 
  • any money that it made by selling new shares of stock to the public, 
  • any money it spent buying back shares of its stock from the public, 
  • any money it borrowed, and 
  • any money it used to repay money it had previously borrowed.

Cash Flows from Investing Activities

This section shows how much money the company has received (or lost) from its investing activities. 

It includes 

  • money that the company has made (or lost) by investing its excess cash in different investments (stocks, bonds, etc.), 
  • money the company has made (or lost) from buying or selling subsidiaries, and 
  • all the money the company has spent on its physical property, such as plants and equipment.

Cash Flows from Operating Activities

This is how much money the company received from its actual business operations.

This does not include cash received from other sources, such as investments. 

To calculate the cash flow from operating activities, the company starts with net income (from the income statement), then adds back in any 

  • depreciation expenses, 
  • deferred taxes, 
  • accounts payable and accounts receivables, and 
  • one-time charges.

Free Cash Flow

While free cash flow doesn't receive as much publicity as earnings do, it is considered by some experts to be a better indicator of a company's bottom line. 

Free cash flow is the amount of cash that a company has left over after it has paid all of its expenses, including investments. 

Whereas earnings reports are subject to a number of different accounting tricks which can artificially boost the bottom line, free cash flow is not. 

It is quite possible, for example, for a company to have positive earnings and negative free cash flow. 

Negative free cash flow is not necessarily an indication of a bad company, however; many young companies tend to put a lot of their cash into investments, which diminishes their free cash flow. 

But if a company is spending so much cash, you should probably be investigating 

  • why it is doing so and 
  • what sort of returns it is earning on its investments.