Investment Appraisal

When buying stocks, you are investing cash today in expectation of future returns.

There should  be a process to evaluate opportunities to see if their benefit is greater than their cost and also which stocks should recevie priority where capital is limited.

This process is known as "investment appraisal".

The main benefits from an investment are its future net cash inflows.  

Its two main costs are

• the amount of the actual investment (capital outflows) and 
• the cost of financing the investment over the long term (the cost of capital).

The non-financial benefits and costs of an investment as well as its risk are also releveant considerations.

There are several ways to appraise investments:

1.  Payback period

2.  Annual yield

3.  Measures which use discounted cash flows.

Payback Period

Payback Period (PBP) is the period of time required for the cumulative expected cash flows to equalize the initial investment or cash outflow.


1.  Equivalent or constant cash inflow.

PBP = Initial Investment / Cash Inflow


2.  Unequal Cash Inflow

PBP = N + [ (Initial Investment - Accumulated Cash Inflow for Year N)/Cash Flow for Year M ]

N = the number of years for the accumulated cash flows that had not exceeded the capital or investment.

M = the year where the total accumulated cash flow is equal to or more than the capital or investment.

Project Evaluation

The decisions of where to invest the company's resources have a major impact on the future competitiveness of the company.

Trying to get involved in the right projects is worth an effort, both to

• avoid wasting the company's time and resources in meaningless activities, and 
• to improve the chances of success.

Project evaluation is a process used to determine whether a firm's investments are worth pursuing.

Producing new products, buying a new machine and investing in a new plant are examples of firm's investment.

Investing in those activities involves a major capital expenditure, and management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time.



Capital Budgeting Factors

Factors involved in capital budgeting are:

1.  Initial Cost
The initial investment or cash capital required to start a project.

2.  Cash In Flow
The estimated cash amount that flows into a business due to operations of the project or business.

3.  Investment Period
The duration of the project and when it is estimated to be completed.

4.  Discount Factor
The value of interest that will be received or charged during the period of the project's execution and it will affect the present value of cash in flows for different years.

5.  Time Value of Money
The idea that a ringgit now is worth more than a ringgit in the future, even after adjusting for inflation, because a ringgit now can earn interest or other appreciation until the time the ringgit  in the future would be received.This theory has its base in the calculation for present value.



Factors influencing investment decision

A firm must make an investment decision to improve or increase the incomes of the company in order to compete in the market.

Investment environments include:

1.  Product development/enhancement
2.  Replacing equipment/machinery
3.  Exploration of new fields or business.



Project Evaluation Methods

Common methods used in evaluating projects, investments or alternatives are:

1.  Payback Period (PBP)
2.  Accounting Rate of Return/Average Rate of Return (ARR)
3.  Net Present Value (NPV)
4.  Profitability Index (PI)
5.  Internal Rate of Return (IRR)


In choosing an investment or project, select the project which generates HIGHER ARR, NPV, PI and IRR; and SHORTER PBP.



APPENDIX:

Investment Decisions

Some investment decisions are easy to make.

• Perhaps, a government safety regulation makes an item of capital expenditure compulsory.
• Or perhaps, an essential piece of machinery breaks down and just has to be replaced.

Many other investment decisions are not nearly so clear cut and hinge on whether the proposed expenditure will generate sufficient future cash savings to justify itself.

There are many very sophisticated techniques for aiding this decision.  Here are three techniques that are commonly used:

• Payback
• Return on investment
• Discounted cash flow.

Payback

This has the merit of being extremely simple to calculate and understand.  It is a simple measure of the period of time taken for the savings made to equal the capital expenditure.

Return on investment

This takes the average of the money saved over the life of the asset and expresses it as a percentage of the original sum invested.

Discounted cash flow.

This technique takes account of the fact that money paid or received in the future is not as valuable as money paid or received now.  For this reason, it is considered superior to payback and to return on investment.  However, it is not as simple to calculate and understand.  Discounted cash flow involves bringing the future values back to its Net Present Value.

Peter Lynch's strategy for all seasons

More than 80% of investment managers don't beat the market. Peter Lynch did it consistently over 13 years with Magellan. His secret: PEG ratios, and staying power.

20 September 07, John Reese

It stands to reason that professional mutual fund managers should be considerably more successful at picking stocks than the average investor. After all, people who have degrees in finance and years of practical experience in the market -- and who are willing to take your money in exchange for their expertise -- should be very good at what they do, right?

Unfortunately, many times that is not the case. In fact, my own research has shown that 80 to 90 percent of active fund managers fail to beat the market in the long term.

But there are, of course, fund managers who have proved you can beat the market over the long haul, and if you're looking for inspiration there's probably no better example than Peter Lynch. During his 13-year tenure as the head of Fidelity Investments' Magellan Fund, Lynch guided the fund to a 29.2 percent average yearly return -- nearly twice the 15.8 percent return that the S&P 500 posted during the same period. According to Barron's, over the last five years of Lynch's tenure, Magellan beat 99.5 percent of all other funds. Looked at another way, if you had invested $10,000 in Magellan the day Lynch took the helm, you would have had $280,000 on the day he retired 13 years later.

How did Lynch achieve such success where so many other professional investors failed? Interestingly, a big part of his approach involved something that is not at all exclusive to being a renowned professional fund manager: He invested in what he knew. Lynch believed that if you personally know something positive about a stock if you buy the company's products, like its marketing, etc. -- you can get a beat on successful businesses before professional investors get around to them. In fact, one of the things that led him to one of his most successful investments -- undergarment manufacturer Hanes -- was his wife's affinity for the company's new pantyhose years ago.

Investing in what you know is really just a starting point for Lynch, however. His strategy also has many quantitative aspects, and I was so impressed by it that it became the basis for one of my "Guru Strategies", computer models each of which mimics the approach of a different investing great. Here's a look at how my Lynch-based strategy works, and some examples of companies that fit the bill.

Different criteria on one PEG

An important aspect of Lynch's strategy is that he didn't apply the same rules to all stocks. He classified companies by their size and growth rate (and sometimes by the nature of their business), and used different sets of criteria to analyze these different groups.

His favorite type of investment was "fast-growers" -- companies whose earnings have been increasing at a rate of 20 to 50 percent per year. Other groups he focuses on in his book are large "stalwarts", which grow at a more moderate pace, and "slow-growers", which have single-digit growth rates but are attractive for their high dividend payouts.

Before I examine what Lynch looks for in each of these categories of stocks, however, I should note that there is one variable that Lynch considers crucial no matter what the stock's classification: the P/E/Growth ratio.

While the price/earnings ratio (which compares a company's per-share price to its per-share earnings) may be the best-known stock market variable, Lynch found that looking at the P/E ratio by itself was less useful than looking at it in comparison to a company's growth. The rationale was that higher P/E ratios are okay, provided that the firm is growing at an appropriate pace. If a company's P/E ratio was about even with or less than its growth rate (i.e. P/E divided by growth rate equals 1.0 or less), Lynch saw that as acceptable

Lynch found that this P/E/Growth ratio -- or "PEG" -- was a great way to identify growth stocks that were still selling at good prices. In fact, the P/E/G ratio became the most important variable he considered when looking at a stock, and his reliance on it is one of the things he is most known for in the investing world.

To show how the P/E/G can be more useful than the P/E ratio, Lynch cited Wal-Mart, America's largest retailer. In his book "One Up On Wall Street", he notes that Wal-Mart's P/E was rarely below 20 during its three-decade rise. Its growth rate, however, was consistently in the 25 to 30 percent range, generating huge profits for shareholders despite the P/E ratio not being particularly low. That also proved another one of Lynch's tenets: that you have plenty of time to identify and invest in exceptional growth companies, even after they have exhibited years, or even a decade, of rapid growth and have become quite large.

An example of a company with a very strong P/E/G ratio is energy giant Exxon Mobil (NYSE:XOM), which has a P/E of 12.15. When we divide that by its growth rate of 31.69 percent (based on the average of its three-, four-, and five-year earnings per share growth figures), we get a P/E/G ratio of 0.38. This not only betters my Lynch-based model's 1.0 maximum; it also falls into the strategy's best-case category (0.5 or below).

Fast-growers

Now let's take a look at those three categories I mentioned earlier, beginning with fast-growers. Exxon Mobil is an example of one such stock, because of its 31.69 percent growth rate.

For fast-growers, Lynch looks not only at the P/E/G, but also at the P/E ratio by itself. For large companies -- which my model views as those with annual sales greater than $1 billion -- he likes to see P/E ratios below 40, because he found that larger companies have trouble maintaining high enough growth to support P/Es over that threshold. (Smaller firms can have very high P/E ratios during their growth years, however).

Another quality Lynch looks for in fast-growers is manageable debt. He likes companies that are conservatively financed, and my Lynch-based model calls for debt to be no greater than 80 percent of equity. Exxon again makes the grade, with a debt/equity ratio of 7.56 percent.

An even better example of a fast-grower that meets this criterion is computer software power Microsoft (NASD:MSFT). Microsoft has no long-term debt, which my model considers exceptional. (Its 0.89 P/E/G ratio is another reason it passes my Lynch-based method.)

Lynch also made an astute observation about inventory, which can be applied not only to fast-growers but to other firms as well. He viewed it as a red flag when inventory increased more quickly than sales. (Inventory piling up indicates the products aren't as in-demand as the company had hoped.) My Lynch-based model thus likes the inventory/sales ratio to stay the same or decrease from year to year, but will allow for an increase of up to 5 percent if all other financials are in order. Exxon's inventory/sales ratio increased by just 0.32 percent this year while Microsoft's dropped by 1.13 percent, so each passes the test.

One caveat about "fast-growers": to Lynch, there is such a thing as too much growth. When a firm's historic growth rate is greater than 50 percent, he avoids it. Growth that high is unlikely to be maintained over the long run, and an investor shouldn’t pay for a stock on the basis of the assumption that a growth rate this high or higher will be maintained for long.

Stalwarts

Because of their large size (sales in the multi-billion-dollar range) and moderate earnings growth rate (10 to 19 percent per year), Lynch always keeps a few stalwarts in his portfolio, as they offer protection during recessions or hard times. An example of a stalwart that my Lynch-based model likes is credit card giant American Express (NYSE:AXP), which has a growth rate of 18.1 percent (again based on the average of the three-, four-, and five-year EPS growth rate figures) and annual sales of $29.8 billion.

One of the main differences between stalwarts and fast-growers is that dividends are often important for stalwarts, so Lynch adjusted the earnings portion of their P/E/G calculations for dividend yield. (He makes this adjustment by adding the yield, 1.01%, to the growth rate in the P/E/G formulathe yield supplements the EPS growth.) American Express's yield-adjusted P/E/G is 0.93, which comes in under my model's 1.0 upper limit.

Lynch also looked at debt for stalwarts, and my model again calls for debt to be no greater than 80 percent of equity.

When it comes to financial companies like American Express, however, debt is often a required part of business. Recognizing this, Lynch didn't apply the debt/equity ratio to financials. Instead, he looks at how a company's equity compares with its assets for a sign of financial health, and at how much of a return it is generating on those assets for a sign of its profitability.

The model I base on Lynch's writings calls for financial firms to have an equity/assets ratio of at least 5 percent, and a return on assets of at least 1 percent. At 8 percent and 3.18 percent, respectively, American Express passes both tests. (Note that while American Express is a stalwart, the equity/assets and return on assets figures are used for fast-growing and slow-growing financials as well.)

Slow-growers

Lynch was less keen on slow-growers and their single-digit growth than he was on fast-growers or stalwarts. But they can have high dividend yields, so they may be a good option if you're investing for income.

Lynch liked slow-growers to be large companies, so the model I base on his writings requires their sales to be greater than $1 billion. Just as with stalwarts, the P/E/G ratio for slow-growers is adjusted for dividend yield, and the debt-equity ratio should be below 80 percent (unless the firm is a financial).

One key difference when it comes to slow-growers: Because by definition they don't post big earnings increases, their dividend yields must be greater than 3 percent or greater than the yield of the S&P 500, whichever is larger.

Few slow-growers currently pass my Lynch-based model, but one that does is the US financial firm Comerica (NYSE: CMA), a Texas-based company that offers banking and financial management services in the US, Canada, and Mexico. Comerica's growth rate (7.34 percent, based on the average of the three-, four-, and five-year EPS figures) and high sales ($3.6 billion) make it a slow-grower, and its yield of 4.78 percent (which more than doubles the S&P's current 2.09 percent yield) is one reason my Lynch strategy considers it a good slow-grower. In addition, Comerica's yield-adjusted P/E/G is an acceptable 0.91, its equity/assets ratio is a healthy 9 percent, and its ROA is a strong 1.32 percent.

Be ready for all weathers

There is another critical aspect of Lynch's approach not specifically included in my quantitative model. It's simple in theory, but in practice it is one of the hardest things for an investor: Stay in the market.

Lynch recognized that the stock market was unpredictable in the short term, even to the smartest investors. In fact, he once said in an interview with American television station PBS that putting money into stocks and counting on having nice profits in a year or two is like "just like betting on red or black at the casino. ... What the market's going to do in one or two years, you don't know."

Over the long-term, however, good stocks rise like no other investment vehicle, something Lynch recognized. His philosophy: Use a proven strategy and stay in the market for the long term and you'll realize those gains; jump in and out and there's a good chance that you'll miss out on a chunk of them.

That, of course, means resisting the temptation to bail when the market takes some short-term hits, no easy task. But as Lynch once said, "The real key to making money in stocks is not to get scared out of them." If you have the fortitude to follow that advice -- and the discipline to follow Lynch's quantitative blueprints -- your portfolio should be much the better for it.

http://www.globes.co.il/serveen/globes/docview.asp?did=1000256306&fid=3011

Published by Globes [online], Israel business news - www.globes.co.il - on September 20, 2007

Stock valuation. Why does the value of a share of stocks depend on dividends?

Does the value of stocks depend on dividends or earnings?

Management determines its dividend policy by evaluating many factors, including:

• the tax differences between dividend income and capital gains,
• the need to generate internal funds to retire debt or invest, and,
• the desire to keep dividends relatively constant in the face of fluctuating earnings.

Since the price of a stock depends primarily on the present discounted value of all expected future dividends, it appers that dividend policy is crucial to determining the value of the stock.

However, this is not generally true. It does not matter how much is paid as dividends and how much is reinvested AS LONG AS the firm earns the same return on its retained earnings that shareholders demand on its stock. The reason for this is that dividends not paid today are reinvested by the firm and paid as even larger dividends in the future.

Dividend Payout Ratio

Management's choice of dividend payout ratio, which is the ratio of cash dividends to total earnings, does influence the timing of the dividend payments. 

The lower the dividend payout ratio (that is more earnings are retained), the smaller the dividends will be in the near future. Over time, however, dividends will rise and eventually will exceed the dividend path associated with a higher payout ratio.

Moreover, assuming that the firm earns the same rate on investment as the investors require from its equity (for example, ROE of 15%), the present value of these dividend streams will be identical no matter what payout ratio is chosen.

How to value Stocks?

Note that the price of the stock is always equal to the present value of ALL FUTURE DIVIDENDS and not the present value of future earnings. 

Earnings not paid to investors can have value only if they are paid as dividends or other cash disbursements at a later date. Valuing stock as the present discounted value of future earnings is manifestly wrong and greatly overstates the value of a firm. (Note: Firms that pay no dividends, such as Warren Buffett's Berkshire Hathaway, have value because their assets, which earn cash returns, can be liquidated and disbursed to shareholders in the future.)

John Burr Williams, one of the greatest investment analysts of the early part of the centrury and author of the classic The Theory of Investment Value, argued this point persuasively in 1938. He wrote: 

"Most people will object at once to the foregoing formula for valuing stocks by saying that it should use the present worth of future earnings, not future dividends. But should not earnings and dividends both give the same answer under the implicit assumptions of our critics? If earnings not paid out in dividends aree all successfully reinvested at compound interest for the benefit of the stockholder, as the critics imply, then these earnings should produce dividends later; if not, then they are money lost. Earnings are only a means to an end, and the means should not be mistaken for the end."


Ref: Stock for the Long Run, by Jeremy Siegel

http://myinvestingnotes.blogspot.com/2009/05/does-value-of-stocks-depend-on.html

Using PEG ratio: Not all growth is created equal.

As the risk increases, the PEG ratio of a firm decreases. When comparing the PEG ratios of firms with different risk levels, even within the same sector, the riskier firms should have lower PEG ratios than safer firms.

Not all growth is created equal. A firm that is able to grow at 20% a year, while paying out 50% of its earnings to stockholders, has higher quality growth than another firm with the same growth rate that reinvests all of its earnings back. Thus, the PEG ratio should increase as the payout ratio increases, for any given growth rate.

As with the PE ratio, the PEG ratio is used to compare the valuations of firms that are in the same business.  The PEG ratio is a function of:

• the risk,
• growth potential and
• the payout ratio of a firm.

http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf

http://myinvestingnotes.blogspot.com/2009/11/using-peg-ratio-not-all-growth-is.html

PE/G ratio

Some investment strategies seek growth for its own sake or growth for the sake of growth rather than growth for the sake of value. 


Wall Street wisdom (pardon the oxymoron) adheres to the KISS principle as its highest virtue: Keep It Short and Simple. Most highly prized by brokers are slogans that fit easily on t-shirts and bumper stickers. 


As an example, one popular investment rule of thumb is that for a fully and fairly valued growth stock, the stock's price-to-earnings ratio should be equal to the percentage of the growth rate of the earnings per share of the associated company, i.e. PE = G. As with any such rule of thumb, this is not only superficial but also arbitrary and capricious. 


A common screen based on this heuristic is the ratio of the PE ratio to the EPS growth rate, or the PE/G. In an effort to better fit the historical performance of cyclical stocks and large-cap stocks, ad hoc variations on the PE/G ratio include 

• (1) using an estimated future growth rate instead of an historical growth rate or PE/FG, 
• (2) adding the dividend yield percentage to the EPS growth rate percentage or PE/DG, and 
• (3) adding two time the dividend yield percentage to the EPS growth rate percentage or PE/2DG.

When choosing a stock to buy, don't overlook the PEG ratio

The figurative earnings can indicate a bargain

Stocks

Dollars & Sense

April 02, 2000|By Laura Pavlenko Lutton | Laura Pavlenko Lutton,MORNINGSTAR.COM

Bankers are sticklers for the details. It's their business to invest money in loans to individuals and businesses, and they expect to be repaid, on time and in full -- no excuses.

As stockholders, we should think like bankers. When we buy shares in a company, we're making an investment, and we should be paid back, too. The payback for shareholders is figurative, of course, but consider how much a company would have to earn before its cumulative earnings equal its current stock price. That period is called the PEG payback period, and it's based on the PEG ratio: a firm's price/earnings ratio divided by its expected growth rate. The PEG payback period is the time it would take a company to pay back its investors with earnings.

Take Schlumberger, the oil- and gas-services company. It has a PEG payback period of 15.3 years, so at the company's expected growth rate, Schlumberger would have to add up its earnings per share for 15.3 years straight before those earnings would equal its current stock price. (Morningstar includes each stock's PEG payback period in the "stock valuation" portion of its Quicktake report.)

The PEG payback period is good for gauging whether a company's expected earnings justify its current stock price. A high PEG payback period generally means shareholders are paying for a company with relatively low earnings. Stocks with low PEG payback periods aren't risk-free, but they're cheaper based on expected future earnings.

For this week's analyst picks, we stayed with companies that have PEG payback periods of less than 11 years. One company worth noting is Alltel, the nation's fifth-largest wireless telephone carrier. The Little Rock, Ark.-based company has a PEG payback period of 10.6 years -- a figure that has increased recently with Alltel's stock price.

Alltel's appeal comes from its growing wireless network. The company recently inked a deal to buy wireless assets from Bell Atlantic and GTE, two companies that have been forced by regulators to divest some assets in conjunction with their merger this spring.

The deal will give Alltel customers inexpensive access to Bell Atlantic and GTE's wireless networks so Alltel phones may "roam," or operate on the other companies' infrastructures, at a low cost. Alltel's sales growth has been outpacing the telecommunications-industry average. The company has also posted strong profitability ratios, which earns it B-plus grades from Morningstar for profitability.

Another PEG-payback qualifier is Tyco, the conglomerate that fell out of favor last year due to questions about past accounting practices. Those still-unproven accusations tarnished Tyco's reputation, but with a PEG payback period of 8.1 years and an otherwise solid track record, this company may be worth a look.

http://articles.baltimoresun.com/2000-04-02/business/0004080794_1_payback-periods-peg-ratio-alltel

The Longer the Payback Period, the Greater the Risk

The most useful thing about payback periods is that they give a good (albeit rough) idea of how risky an investment is. 

We may feel fairly confident in our assessment of a company's earnings potential over the next year or so, but that confidence usually diminishes as we peer farther into the future. 

Thus, the longer the payback period, the greater risk we run that we won't get the return we expect. 

That is especially true if the company we're looking at is a young firm without an established market position or is dependent on a rapidly changing technology.

Take Qualcomm QCOM, for example. This digital-wireless-communications powerhouse was the hottest stock on Wall Street in 1999 after appreciating 12-fold in 11 months. Its PEG payback is 12.4 years--not too bad considering its $350-plus stock price. But compare that with Allstate ALL, which watched its stock drop about 30% in 1999. Its PEG payback is 6.6 years. 

Qualcomm may be the sexier company and certainly has had upside for its investors, but sometimes the cheaper stock looks like a better deal.

After all, stocks with longer payback periods aren't just riskier, they also have lower rewards. 

Remember that the payback period is the amount of time it takes to double your money. 

If a stock has a payback period of five years, that means it doubles the amount of the original investment in five years. An investment that doubles in five years has an average rate of return of 15% per annum (on a scientific calculator, take the fifth root of 2, subtract 1, and multiply by 100). 

A payback period of 10 years implies a rate of return of a little more than 7%. At 20 years, the rate is less than 4%. And so on. 

The longer the payback period, the lower the rate of return.

Payback Period = Double Your Money

A payback period is the amount of time it takes for a company to accumulate enough in earnings to equal the amount of your original investment. 

That sounds complicated, but in simple terms, it is the time it would take you to double your money based on the profits a company is generating. 

There are a couple of payback periods to consider, and one of the simplest can be determined by looking at the stock's P/E, or the ratio of its price to its earnings per share. 

P/E is one way you can estimate how many years it would take for the company to accumulate earnings equal to its share price. 

• Imagine a $10 stock with $1 per share in earnings. 
• Based on its P/E of 10 ($10/$1), if the company continues to earn $1 per share every year, it would take 10 years for all those dollars to add up to the original $10 stock price. 
• So a stock with a P/E of 10 has a payback period of 10 years, assuming its earnings are the same each year.

But most companies don't make the same earnings year after year. As an investor, you're hoping the earnings will grow. 

To account for growth, there is something called the PEG payback period, which is based on the price/earnings growth (or PEG) ratio. 

The PEG ratio relates a company's price/earnings ratio (P/E) to its earnings growth. 

It is calculated by dividing a stock's forward P/E, or its P/E based on consensus analyst earnings estimates (what Wall Street analysts expect the company to earn over the next 12 months), by its forecasted earnings-growth rate (the rate at which analysts expect the company to grow).

PEG ratio = forward P/E / expected growth rate

Like P/E, the PEG ratio tells you how many years it will take for earnings to equal the stock price. But unlike P/E, it assumes earnings will grow at a certain rate.

Take our $10 stock with $1 per share in earnings. 

• If analysts' consensus estimates say the company will grow at a rate of 10%, we would increase each year's earnings by 10% before adding it up. 
• Therefore, the first year's earnings would be $1.10 (that's $1 times 1.1), the second year's would be $1.21 ($1.10 times 1.1), and so on. 
• Based on a 10% growth rate, it would take seven years before earnings added up to the original stock price. 

As you can see, the PEG payback period for any growing company will be shorter than the P/E payback period.

PEG and Payback Periods

If you own a home or a car, you are probably all too familiar with what happens when you take out a loan.

• A bank lends you a certain amount of money that you must pay back at a specified rate, such as one payment per month for five to 30 years. 
• In exchange for taking a risk that you won't repay the loan, the bank earns some revenue on top of its investment, based on the interest rate it charges.

 As a shareholder in a company, you're a lot like a bank. 

• When you buy stock, you're in essence lending a company your money so it can buy what it needs for its business and (hopefully) grow. 
• You get paid back as the company's earnings grow and its stock appreciates. 

But whereas a bank clearly establishes its profit margin and a timetable for being repaid, shareholders aren't that lucky. (It's a different story for bondholders, who literally loan the company money and do get scheduled interest payments.) 

It is possible, however, to estimate what you may earn on your investment and when you'll earn it by examining a stock's payback period.