Portfolio Accounting

Portfolio Accounting

A basic understanding of 'portfolio accounting' is necessary when wanting to calculate returns. Portfolio accounting is also very important when it comes to dealing with derivatives. Most of what will follow in this subchapter looks trivial, but can give one or two headaches in practical applications.

'Portfolio accounting' is about recording, classifying, and summarizing financial events that affect an investment portfolio.

Portfolio Definition

Although it might sound trivial, the definition of individual 'portfolios' isn't always that straight-forward in practice.

We shall define a 'portfolio' as an abstract accounting entity including at least one security and one cash account. The term 'abstract' merely points to the fact that this definition does not necessarily correspond to 'real-world' accounting entities.

Basic Relationships

The relationships below are expressed on a "net" basis (net of transactions costs, fees & withholdings taxes).

Ending Market Value = Beginning Market Value
                                     + Net Contributions
                                     + Gains&Losses

Net Contributions = Contributions - Withdrawals

G&L = Income
           + Net Capital Gains&Losses

Net Capital Gains&Losses = Sales - Purchases
                                             + Ending Market Value Securities
                                             - Beginning Market Value Securities

Ending Cash Balance = Net Contributions + Income + Sales -Purchases

Note that for return calculation purposes, "gains and losses" are defined on a 'beginning-of-calculation-period market value basis', and not on a 'cost basis' as in an accounting context. The differences between the two concepts of "gains and losses" are...

• Valuation: Accounting G&L are calculated based on cost prices at the time each security was purchased. When calculating investment returns, all securities are considered at theirmarket prices.
• Time Period: In calculating accounting G&L, the holding period of securities are relevant (because different holdings periods are mixed, an inventory model such as LIFO has to be specified additionally. The calculation of investment returns refers to a specific calendar period (for example, "monthly")and stocks and flows during this period only are relevant.

The further decomposition of "net gains and losses" in "realized" and "realized" components is not of particular interest for return calculation purposes. The only thing to remeber is not to include 'realized gains & losses' as 'income' when calculating investment returns: As realized gains & losses are reinvested, this would result in double-counting and therefore distortion of investment returns.

Market values must be calculated including accruals.

The above portfolio accouting realtionships can be illustrated graphically...

Click here for a large version of the above chart.

Market Valuation

Portfolios are valued at market prices ('Mark-to-Market').

Accruals should be reflected in market prices whenever possible. Accrual accounting is a must for fixed-income securities, but typically rather unimportant in the context of dividends on equity. Dividends are not payable unless the stock was owned on the record date, so dividends are accrued as income on valuation dates  from the ex-dividend date up to the payable date trade.

Valuation issues are a very important, but often neglected issue in return calcuation and therefore in investment performance analysis: 'garbage in, garbage out'.

Mark-to-Market versus Mark-To-Model, Mark-to-Market versus OTC...

For illiquid instruments, there is no market price available and MTM can become a serious problem. The choice of valuation model is very often under the control of asset managers. They can therefore take advantage to manipulate the prices so as to smooth the portfolio returns. If this is the case, the auto-correlation coefficient of the portfolio return series will be significant. As a result, volatility of returns (=risk) will be underestimated as well as the correlation of the fund with peer products or the benchmark. The diversification benefits of the portfolio to the investor will therefore be overestimated.

Cash Flows

Income (dividends, coupons) is included in return calculations if income is re-invested. Income is an internal cash flow. Selling/buying securities also generates internal cash flows (transfer of value from securities to cash account or vice versa)

Contributions and withdrawals are external cash flows. For convenience reasons, we use the summary term 'net contributions', defined as contributions minus withdrawals.

Some authors use the term 'cash flow' instead of net contributions. This can easily lead to confusion when mixing up internal with external 'cash flows'. We strongly recommend avoiding the term 'cash flow' in the context of return calcuations and substitute it with the relevant conpcets directly (income, contributions etc.)

Besides actual client orders, there exist other external cash flows (especially withholding taxes, fees). When presenting net contributions, customer orders and other external cash flows should be reported as separate line items.

Taxes

Terminology: 'after-tax' and 'before-tax' returns.

Difficult to generalize since tax rates are customer specific.

In the context of a specific portfolio, returns are normally stated on a 'before-tax' basis, where values are not subject to any deductions in respect of tax (whether incurred or not). Any payments to the tax office out of the portfolio are then treated as a withdrawal of funds. When calculating returns after taxes, tax payments outside the portfolio have to considered as contributions.

Reclaimable (withholding) taxes versus non-reclaimable taxes: any reclaimable taxes payed have to be consdiered as withdrawals. Reclaimable taxes received are contributions.

Fees

Investment fee structures differ significantly across countries and products. In a universal bank setting, for example, investors might use one bank for all investment management services. Such full-service providing banks might work with cross-funded (subsidized) fees, partially bundled or summed up to an all-inclusive fee (also known as wrap account programs). In the case of a wrap account, 'net-of-fee performance' would mean a net-of-management-and-brokerage/custody-fee performance while in a difference setting, 'net-of-fee performance' is understood as net ofmanagement fees only.

Such differences complicate net-of-fee performance calculations considerably and also affect comparability of returns within a company (aggregating different types of clients and accounts to composites) and between different asset management firms.

Another issue in reporting net returns is that a presented net-return might not be achieved by all clients due to differences in characteristics (volume) or simply bargaining power.

Brokerage Commission Costs are usually added to the purchase cost and subtracted from sales proceeds for both gross- and net-of-fee return calculations

Custodial Fees are typically not deducted from either gross or net performance and are treated as a withdrawal. This is justified when the costs are beyond the control of the investment manager.

Management Fees and other charges for advisory services provided by the asset manager are usually charged to the portfolio. These charges are treated as withdrawals in the calculation of 'gross-of-fees returns' (=before deduction of fees charged).  The same withdrawals are excluded in the calculation of a net-of-fees return (=after the deduction of fees charged). Management fees can also be charged outside the portfolio. It is important to include fees charged are in the calculation of net- and gross-of-fees returns. When fees have been paid from outside the fund, they are excluded from calculations when a gross of fees return is required.  They are treated as a contribution to the portfolio when a net of fees return is required.

To avoid distortions and "jumps", fees payed out of the portfolio should be "accrued"  whenever possible.

If fees are calculated as a percentage of average capital invested, the calculation methodology for average captial invested should be specified as detailed as possible.

Transaction Costs

Transaction costs are usually deducted: securities at 'cost prices'.

Often neglected, source of return, quality indicator for operationally efficient investment management.

Exchange Rates

Portfolio base currency, security currency, currency overlays, currency fowards.

Consistency is oftenan issue: consistency not only within portfolio, but also when benchmarks and other entities the portfolio is compared with are involved.

Data source for exchange rates used should always be disclosed.

http://www.andreassteiner.net/performanceanalysis/?Return_Calculation:Portfolio_Accounting

Portfolio's Return Calculator

Use these calculators to work out your portfolio's returns.

Detailed version:   CALCULATE YOUR PORTFOLIO'S RETURN

Simplified version:  Portfolio Rate of Return – Calculator

How to figure your portfolio's return

Q: How can individual investors calculate the rate of return on their portfolios if they have deposited or withdrawn money from the account?

A: I'm always intrigued when people do things with their investments they'd never do with their money in normal life.

Would you order a dish from a restaurant menu without knowing the price ahead of time? Would you buy a non-refundable airline ticket without knowing the fare? While there may be some exceptions, the answer will usually be no.

But investors keep buying stocks, bonds and mutual funds and have no idea what they're paying or, more important, getting in return. And they may be paying dearly either with large mutual fund fees or indirectly with lackluster performance.

Worse yet, they might be fixated on their one winning stock while ignoring the five dogs that are killing their portfolio.

Are you one of these people? You are if you don't know how to calculate the return of your portfolio. You'd be surprised how many people don't. The briefly famous Beardstown Ladies investment club thought they were brilliant investors until it was discovered they were not measuring their returns properly (they counted deposits to the account as investment returns).

Many brokers don't help. Few of them bother to provide rates of return for their customers' portfolios. The cynic in me suspects that if many active traders knew what their real returns were, they'd probably quit trading so much. To the credit of major mutual fund companies, most of them do calculate your performance data.

Well, it all gets cleared up right now. I'll show you how to do this yourself, using 2005. To get started, you'll need:

1. The balance of your portfolio on Dec. 31, 2004, available on your statements.

2. The portfolio balance on Dec. 30, 2005.

3. The dates and amounts of any deposits or withdrawals made during the year.

4. Unless you're a math genius, you'll need a financial calculator or Microsoft Excel.

Let's say your portfolio was worth $10,000 on Dec. 31, 2004. During the year, you deposited $1,000 on March 30, withdrew $500 June 30, deposited another $1,000 Sept. 30 and the portfolio ended the year worth $12,000.

Someone who didn't account for the deposits and withdrawals would assume they did well last year. After all, the portfolio gained 20% in value, not including the value of the deposits and withdrawals.

But let's do this correctly. We'll first do the problem assuming you have a Hewlett-Packard 12C financial calculator, a popular calculator handy for all investors. Incidentally, the calculator is celebrating its 25th anniversary. You can read more about it here.

Keep in mind that each number described above is actually a cash flow. We can plot it this way:

Initial cash flow: minus $10,000. We show this as a negative number because it's theoretically money coming out of your pocket to invest.

Cash flow 1: minus $1,000 — again, a negative number because the money is coming out of your pocket.

Cash flow 2: plus $500. This is positive number because the cash is coming into your pocket.

Cash flow 3: minus $1,000. Negative, see above.

Cash flow 4: plus $12,000. This is the money theoretically coming into your pocket from the investment.

The HP 12C makes this easy to calculate. Here are the keystrokes (note the "CHS" key makes the number negative):

Step 1: 10,000 CHS [g] Cf0

Step 2: 1,000 CHS [g] Cfj

Step 3: 500 [g] Cfj

Step 4: 1000 CHS [g] cfj

Step 5: 12000

Now that you've entered everything, all you have to do is hit the [f] IRR key, and the calculator does the rest. The HP12C will show you that the quarterly return on your portfolio is 1.14%. All you have to do is annualize that quarterly return. To do that, divide 1.14 by 100, add 1, take the sum to the fourth power, subtract 1 and then multiply by 100. You then derive an annualized return of 4.639%.

You might be proud of yourself until you realize that last year, the Standard & Poor's 500 index returned 4.9%, says Ibbotson Associates. In other words, you underperformed a basket of stocks that a monkey could have bought and held in an index fund. And that doesn't even include any taxes you may have paid if you sold any of the shares for a capital gain.

What if you don't have an HP 12C? You can do the same thing in Microsoft Excel. Below is what you'd type into the appropriate cells

Cell A1: -10,000

Cell A2: -1,000

Cell A3: 500

Cell A4: -1000

Cell A5: 12,000

Cell A6: =IRR(A1:A5)

Cell A7:=((((A6/100)+1)^4))-1*100

And you get the same answer in cell A7 that you got when using the HP 12C if you format the cells for "number" to four decimal places. Otherwise, Excel will round things off.

If all this seems like too much work, don't give up. Not knowing your portfolio return is like driving on the freeway blindfolded. Another option is to buy a software program that does the calculations for you.

One piece of software I've used that does this quite well is the BetterInvesting Portfolio Manager. This software program allows you to do enter each transaction into a checkbook-like register and it calculates your return with great precision. It's not cheap, but you can learn about the software and download a free trial here.

Matt Krantz is a financial markets reporter at USA TODAY. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt atmkrantz@usatoday.com.

Posted 2/27/2006 12:01 AM ET http://www.usatoday.com/money/perfi/columnist/krantz/2006-02-27-portfolio-return_x.htm Calculate your portfolio return here: Detailed version:   CALCULATE YOUR PORTFOLIO'S RETURN Simplified version:  Portfolio Rate of Return – Calculator

Calculating Intrinsic Value

Security Analysis 401: Calculating Intrinsic Value

By Sham Gad 
August 23, 2007 |

In the previous three articles in this "Security Analysis" series, I discussed the concept ofmargin of safety, explained why you should rely on intrinsic value to make investing decisions, and showed why you want to find great businesses with wide economic moats. Once you've taken those steps and found a business that looks attractive, you next need to determine theintrinsic value of that business, to find out whether a bargain of an investment opportunityexists.

Every business has an intrinsic value. According to John Burr Williams in his 1938 publicationThe Theory of Investment Value, that value is determined by the cash inflows and outflows -- discounted at an appropriate interest rate -- that can be expected to occur during the remaining life of the business.

This definition is painfully simple, but it works. Let's apply it to a couple of businesses so you can see for yourself.

Solid, stable cementCEMEX (NYSE: CX  ) is a Mexican producer and distributor of cement. Competing with the likes of LaFarge (NYSE: LR  ) , it is one of the largest cement players in the world. It produced free cash flow -- cash from operations less capital expenditures -- of about $2.6 billion in 2005 and around $2.75 billion in 2006. Meanwhile, between 2004 and 2005, it grew free cash flow by around 50%, but that same figure was virtually flat from 2005 to 2006. That may give you an inkling that it makes no sense to try predicting a different rate of cash flowgrowth each year. Instead, when attempting to calculate intrinsic value, you should stick to one or two consistent conservative growth rates, although smaller companies starting with a lower base figure can be assigned higher rates of growth. When calculating intrinsic value, I use a 10-year forecast, because I think that's an adequate time period to provide sufficient data, and I apply a 10% rate discount rate, which is equivalent to the S&P 500's historical return.

Cemex, however, is a huge business, and while it may experience some years in whichcash flows grow abnormally, it's more logical when determining its intrinsic value to use a meaningful conservative figure. Always work with a margin of safety.

In this case, it's reasonable to assume that Cemex can grow its free cash flow by 10% for four years. While this growth rate can continue for a longer period, I like to be extra cautious and predict that free cash flows stabilize at a 3% growth rate thereafter. Cemex is a very well-run company, and there will always be a need for cement in the world, so I think 3% free cash flow growth is very achievable.

Let's look at the calculations. Dollar figures are in billions.

Year	Free Cash Flow	Present Value of FCF
2007	$3.02	$2.75
2008	$3.30	$2.75
2009	$3.70	$2.75
2010	$4.02	$2.75
2011	$4.43	$2.75
2012	$4.56	$2.57
2013	$4.70	$2.41
2014	$4.83	$2.25
2015	$4.98	$2.11
2016	$5.13	$1.97

The sum of the present value (PV) of the free cash flows comes to about $25 billion.

Next, you need to determine a terminal value for the business. Conservatively, I assume that Cemex would be worth 10 times its 2016 free cash flow, or $51.3 billion, which has apresent value of $19.7 billion. So by adding all of the PV cash flows together, my estimate of intrinsic value for Cemex comes to about $45 billion. With about 790 million shares currently outstanding, Cemex has a per-share intrinsic value, based on my assumptions, of approximately $57 a share, versus the current stock price of $31.

Does this mean you should back up truck and load up on Cemex? No, even though I do think Cemex is a fantastic company selling at an attractive price. For one, the number ofshares outstanding 10 years from now will surely be a different number from what it stands at today. Assume, for example, that the share count rises to 1 billion shares and the intrinsic value comes down to $45 a share. Then you're talking about a whole different set of numbers.

Most importantly, though, you need to know the business inside and out in order to estimate cash flow growth with a high degree of confidence. The ability to assess the quality and competence of management thus becomes critical. Knowing how management spends company dollars tells you a lot about how much cash the company will produce years down the road. In short, do your due diligence ... and when you are done, do it again.

The hard part

Calculating intrinsic value is simple and straightforward. It's having accurate data that's the difficult part. That's why Benjamin Graham remarked: "You are neither right or wrong because the crowd disagrees with you. You are right because your data and reasoning are right." That's also why Warren Buffett, the best investor on the planet, spends a lot of time focusing on businesses with durable competitive advantages, such as the brand value that Coca-Cola(NYSE: KO  ) offers, or the monopoly-like industry that American Express (NYSE: AXP  ) operates in.

It's easy to predict future cash flows with a high degree of certainty for businesses like this -- ones that have wide economic moats insulating them from the threat of competition. That gets back to our last discussion. And it shows how all of our discussions tie together to make you a better investor.

http://www.fool.com/investing/value/2007/08/23/security-analysis-401-calculating-intrinsic-value.aspx