Monday 14 May 2012
Joris speaks to a trader about City short-termism, high pay, the excitement of recent years and why he now wants a way out
Derivatives trader: 'The trouble is, regulators are idiots'
Joris speaks to a trader about City short-termism, high pay, the excitement of recent years and why he now wants a way out
• This monologue is part of a series in which people across the financial sector speak about their working lives
• This monologue is part of a series in which people across the financial sector speak about their working lives
'Why would a smart, aggressive, competitive 22-year-old decide to work for the Financial Services Authority?' Photograph: Sean Potter/Alamy
We are meeting in Lombard One, a restaurant in the heart of the City popular with financial types where a beer goes for £4.50. He is a confident man in his early 30s, the son of south-east Asian immigrants who now works as a derivatives trader, at director level. It's around 6.30pm and he orders a beer.
"Why trading? I read maths in university, and I love the beauty of it. Success in trading is binary. In areas like history, geography or languages, grey is the most obvious shade. Trading, at its core, is black and white. I have generated value today, or I haven't.
"Why trading? There was the glamour of it. You know, the money, the girls, rock and roll without the guitars. Another thing is, in trading you get to define yourself from an early age. You come in at 22 and you can prove yourself right away. I know guys making £1m a year at 25. This doesn't happen a lot, but it does happen and that's such a contrast with other jobs. As you know, investment banking breaks down into financial markets, where I work, and advisory, such as mergers & acquisitions. I could never be in M&A. A friend of mine works there. He was told in the first year he couldn't leave the M25 [London ring road], ever. He had to stay within a radius where he could be in the office within an hour.
"In M&A you don't really get to do anything of value in the first years. Asthese guys in your interviews are saying you work horrible hours, fidgeting with pitch books and getting the spacing right. Worst of all: if you sell advice, like M&A bankers, you almost have to puff yourself up. Why would clients pay for your advice, unless you are the smartest person on earth? It's a salesman's job – you know, a dirty job?
"If you don't come from money, you realise early on that actually, money is quite important. Let's say experienced traders like me can make anywhere between £300k and £1m a year. Meanwhile somebody fighting for our country in Afghanistan is making £22,000. It's funny how that works. When you ask me if that's fair, I also think of the guy who is making £5m, while I know I am smarter than he is. Life isn't fair.
"I come into the office around 7, in time for the 7.15 morning meeting. There'll be salespeople there, and traders. The traders will get up and give their ideas; basically they're telling the salespeople, this is what you should be pushing with clients. Salespeople have spoken to their regular clients, and they might say, there's massive client interest for this or that. You don't get much out of these morning meetings.
"At 8 the market opens, and I'll be responding to both clients and the market. It can be so hectic you can't even go to the toilets. Or so dull you end up doing your internet shopping.
"At 4.30 the business closes, you calculate your P&L (profits and losses) and file a report on why you made or lost money. Around 5.30 people begin to drift away. The more complex stuff you trade, the longer you need. If you have positions in the US, you may need to stay in as markets there are open until 9pm London time.
"Trading is a seductive world. In a bull market, with prices going up, basically everybody makes money. You ask yourself, was it me or just the market going up? It's tempting to attribute everything to your brilliance. What do I say to people claiming that a monkey with darts regularly outperforms traders? Well, for me the money hits the bank every month.
"I wish I could take you on the trading floor. There's no privacy, people are meant to overhear each other on the phone. The toilets are always in a horrible condition. I don't know why, because people on a trading floor are animals? It's just how it is.
"I love to be one of those people there, the energy, the buzz … Weird thing is, sometimes you can feel the floor exhale before you see the price action on your screen that people are responding to. The price action might be a number coming out, say higher inflation or lower unemployment … It's almost like an opera.
"There's jealousy, of course. People whispering "he had a really easy book to trade", after you had a good year. I'd say the low point is when everybody around you is making money and for some reason you are not. Everyone has bad periods, like sportspeople. You need to be strong, tell yourself "it's fine, I'm good". It's everyone's fear: to have lost "it".
"What is "it"? Call it intuition, call it the equivalent of what Messi can do with a ball. In the morning you ask traders who have "it", what do you think the market is going to do? And they go: "up". And up it goes. It's quite something.
"There seems to be this blanket anger towards bankers. It's as if you'd say: all sportspeople are bad, after some doping scandal or obnoxious misconduct by a footballer. Outsiders seem to think we're all the same. But even among traders, there is equity (shares), commodities (oil, grain etc), fixed income … Within fixed income there are interest rates people and foreign exchange. Within equity there's say, the oil and gas sector, the financials sector etc – and these are completely different beasts from those trading CDOs (complex financial instruments).
"You've got prop traders who use the bank's money to make money for the bank. And flow traders, like me, who trade on behalf of clients. Again, a huge difference.
"For flow traders the holy grail is to become a prop trader, and be away from all the politics, salespeople, clients. "Prop" is the purest form of trading. It's dying out because regulators don't want banks to take risk with their own capital.
"How it works in flow trading. At the beginning of the day I have "a view" of how the market will go. On that basis I will take "positions". Then I wait for clients to call, or be called by our salespeople, who want to buy some of that position. We pocket a commission for doing so, and we may make money from the margin between what I bought the contracts for, and what I sold them on to clients for.
"I said earlier that the beauty of trading is the black and white, but actually there is grey. There's office politics involved when it gets decided what book you trade – for example, the oil and gas sector, or the financials sector. Clearly, there can be more client flow in one book than in another.
"Sometimes a client who is very important to the bank wants to do a trade you think isn't going to be profitable. Sometimes in the interest of holding on to that client you end up doing the trade. Then office politics kicks in because you want your manager to know you sacrificed your P&L. The industry is a microcosm of society, only more intense, sharper and more fast-paced.
"Traditionally banks and firms have cared only about so-called top-line revenue, the net number of how much money you made. But management should look below the line. Say you made a lot of money from one massive trade for a client. Is that really you? Also, firms should look at revenue in relation to risk. If nobody takes notice of the potential losses you exposed the bank to, then you get traders taking huge risks, obviously. Because the easiest way to make a lot of money is to take some massive position and hope it works out. 'Efficient use of capital' is the new buzzword. Capital used to be almost infinitely available. That's over.
"It's a valid question: do we, as a society, want 25-year-old traders making £1m a year? If not, you need regulation, on a global scale. The trouble is, regulators are idiots. I am sorry to put it so bluntly but you can't expect it any other way. If an investment bank hires a graduate, two years later they will be making over £100,000. Meanwhile at the regulators you are getting £30,000. Why would a smart, aggressive, competitive 22-year-old decide to work for the Financial Services Authority?
"You now have a generation who were told as graduates by their bank: we'll make your rich. They weren't taught to think in terms of risk. Basically at banks it's quite simple: if you are generating £100m a year in profits, you can be the biggest arsehole and get away with it.
"A thing that struck me going over the comments on your blog is that people seem to think all of us saw the crisis coming. But apart from Goldman and maybe Deutsche Bank, nobody expected this. I am also angry about the crisis. When I think of the CEO of some Wall Street bank that went bust, and he still has his $400m … I mean, I owned shares in some of these banks, and they've gone to zero.
"Another thing is some people don't seem to understand risk. Risk per se is not bad. Banking is about properly pricing the risk of everything. There are very different sorts of risk, for traders. We seem to be seen as gamblers, but I know of few people who live up to that cliche. It's really quite hard to take a huge gamble. There's risk and compliance, you have risk limits you can't exceed. If you suddenly take a massive position, somebody will see it.
"Sometimes I hear outsiders say about trading 'I could do it'. When we hire people we tell them, you have to be comfortable with running an amount of risk every day of your working life. You end up thinking about it in your sleep, while you eat. It starts when you wake up and never goes away. On an emotional level, it's not that easy.
"In the old days, before the democratisation of knowledge, only a limited number of people had access to information. Our sales guys would get calls from clients who read something in the FT. These days clients go on the internet themselves. Our added value is a lot less. Investment banks have this army of analysts putting out research, salespeople peddling it to clients, traders … Do we need all this?
"An element of panic is pervading the industry. What's our business model going to be? In the past 10 years I have never seen this pace of people dropping out. Pay will only go down. A lot of people are thinking, screw it, I'll survive as long as I can, take the money, and see what happens next.
"Generally the trading floor is meritocratic and I never felt any racism. A couple of pockets, like foreign exchange, are mostly populated by old school English white boys. No idea why that is.
"The trading floor is like a playground. I was in a minority in a white school and I have learnt to see how a comment about my background is meant. Jokes can be about your weight, hair, the university you went. It's an expression of camaraderie. There you are, sitting with two levels of screens in front of you, as in the trenches. You know that the guy to your right and the guy to your left both understand exactly what it is you're doing. We all have the same desire: to get on the floor, to make money.
"Derivatives flow traders have very little scope to rip off clients – a better word would be counter parties – actually, as these are professional investors. Multiple traders at multiple firms and banks can provide the kind of derivatives I am trading.
"In my experience salespeople have very weak technical knowledge of the products. If not, they would be trading themselves. With salespeople it's crucial they have this rapport with that really important client, so they can call him in bed at 10pm. We call this the ability to make the "first call in a non-standard environment". Say the shit hits the fan and we need to offload some inventory on a client. That's when you need the salesperson.
"Salespeople always want you to meet the clients, so they can say: here's my trader. Look at him. Just like a human being, he won't steal your children's inheritance.
"The repeal of the Glass-Stiegel Act allowed investment and retail banks to merge – that was a mistake in my view. There's no easy way to go back now. The Too Big To Fail banks have become even bigger. These banks will always find a way through. What so many people fail to grasp: banks are subject to the same discipline of quarterly earnings reports as the rest of the corporate world.
"Global heads of banks know: I have to make x billion in the next 18 months or I'm out. They can't say: it's going to be difficult for the next five years. The market demands results, from banks as much as from any other company.
"Bank CEOs are like salespeople. They are selling the dream to the outside world of how they are going to make the bank more profitable. The way it works, if you are a pension fund with shares in Morgan Stanley, and you see that Goldman Sachs made 50% more profit, you will not like that. These numbers make you look like a bad investor. So you put pressure on Morgan Stanley, saying, you have 18 months to prove you can turn this around or there'll be a sell-off.
"The short-termism is endemic. In my career I have almost never seen anyone trying to build something. There are just cycles of new guys coming in. They put forward a plan promising to make money in three or four years. So the pressure is huge, and the easiest way is take more risk. It doesn't always have to be obvious, visible risks, sometimes it can be "shadow" risks that are harder for outsiders to see.
"It's like an election cycle, really. You get new management coming in, and they will go for levers that can hit the revenue number within 18 months to three years. They go over the numbers and decide: this desk doesn't work. They fire the senior guy and bring in a new guy, for x million. New guy kicks out four more guys, and brings in his own. When after three years it hasn't worked out, the bank fires those five, and it starts all over.
"This is what a lot of people miss about Goldman Sachs. You look at most guys at the top there, they are Goldman guys. There's actually less short-termism there – for me their consistent management is one of their great strengths.
"Some managers are simply psychopaths. They come up to you on a day when you've lost money, and say: "you are losing money. Why are you losing money? Do you enjoy losing money?" I mean, that is not constructive, or is it? Management, on the whole, is terrible. You rarely get somebody who understands that managing me is not about competing with me, but about getting the best out of me.
"The City, or my niche in it, is like a club. Everybody knows everybody. We went to the same universities, at one time or another dated one another's girlfriends. It's relatively incestuous.
"The past few years were the most amazing, difficult, interesting times. Absolutely exhausting. In the morning you come in and RBS is down 40%. It's Sunday evening and you get a call: Lehman is about to go bust.
"That kind of excitement has washed by now. It's back to normal, the drudgery. I wonder, is this just what happens to people 10 years into a job? You get disillusioned? Everyone around me is thinking about exits. Then again, everyone in finance seems always to be playing with this idea of "getting out", of your "escape route".
"Banking is very honest, you can measure performance and keep score. On the other hand there are so many elements contributing to your performance that you do not control (market conditions, what product you trade, how interested clients are in what you offer them). So sometimes it feels like a very expensive prison term.
"Would I want my kids to work in finance? Most people would say no. Me too. I wouldn't feel they're adding anything. I find myself more and more interested in people who have built something. My life has revolved around a number on a screen for more than 10 years now. It can't be healthy to trade a number on a screen for your entire life?"
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Sunday 13 May 2012
Intelligent Investor Summary
Benjamin Graham's The Intelligent Investor
http://jeffpearson.efoliomn.com/iisSaturday 12 May 2012
Benjamin Graham on Market Behavior
In Security Analysis, Benjamin Graham emphasizes the importance of not only focusing on a firm’s potential and accounting statements, but to also pay great attention to the business cycle. Individual investors should research and create their own one year outlook for the market.
Almost any security may be a sound purchase at some real or prospective price and an indicated sale at another price.
- Benjamin Graham, Security Analysis
Think Long-Term
However, Graham also stresses that day-to-day and month-to-month fluctuations of the market should be ignored. Instead, investors should focus on the major shifts in market sentiment and estimating what stage of the business cylce we are in. Clearly today we are in a brutal bear market that has brought down the S&P 500 over 40% year to date. But we have to ask ourselves, what inning of this bear market are we in? Where do we see the strongest values in the market?
Benjamin Graham on Investing in Bear Markets
In a typical case of bear-market hysteria or pessimism the investor would be better off if he were not able to sell out so readily; in fact, he is often better off if he does not even know what changes are taking place in the market price of his securities.
- Benjamin Graham, Security Analysis
Graham’s sentiment on holding onto securities in a bear market could have taken a huge chunk out of someone’s portfolio this year, I know holding onto crashing stocks has severly hurt my portfolio. However at this state of the bear market I believe the above quote is appropriate.
It is ill-advised at this moment in time to liquidate investments into weakness. Your portfolio may depreciate in the coming months, but sometimes you have to take a 3 month deep breath and try your best to not follow your stock prices on a daily basis and just enjoy your dividend yields! To do this you have to be sure that your portfolio is filled with strong, value stocks with years of consistent earnings growth. Ignoring equity prices does not mean you should ignore the latest news from stocks you own. Shares should be sold if there is a fundamental shift in the companies’ long-term outlook.
Even though Warren Buffet’s 2 month-old investment in Goldman Sachs (GS) at $115 a share has fallen almost in half to $65 a share, I’m willing to bet he is sleeping well at night knowing he is invested in a first-in class company (although the investment banking class may be gone forever) and enjoying a 10% dividend yield from his preferred stock.
Don’t Purchase a Stock at Any Price
Finding the strongest values is no easy task, and Benjamin Graham gives some bull market advice that is worth remembering once this cycle changes gears. “Don’t purchase stocks atany price.” He writes that great companies don’t necessarily indicate a great investment if their stock price is comparatively high. Be a patient investor and wait until the company drops to an attractive level. For instance during a bull market in 2006 you could have bought Microsoft (MSFT) at a high of $30.19 or a low of $21.92 (or today at $19.15!) - a 27% variation. If a stock price of a company you have been watching continues to soar far above the intristic value (you can use my post on the Dividend Growth Model to estimate intrinsic value) you give the company, don’t feel like you missed the boat, in the long-term the price very well will come down to levels you like or their earnings will improve to increase your valutation.
When to Invest In Small Cap Stocks
Graham also notes that small cap stocks are more sensitive to swings in the overall market. Your position in small caps should be minimized in your portfolio if you have a weak outlook for the coming year and your small cap positions should be increased in bull markets. This sentiment is supported decades after Graham’s writing, consider comparing SPDR DJ Wilshire Small Cap Growth (DSG) which retreated 49% YTD vs. SPDR DJ Wilshire Large Cap Growth (ELG) which declined only (only!?) 43% YTD.
Beware of Bull Markets
Beware of “bargains” when most stock prices are high. An undervalued, neglected stock may continue to be neglected through the end of the bull market and may potential be one of the hardest hit stocks in the following bear market.
Market Environment, Potential Value, and Intristic Value Produce Market Price
http://www.theintelligentinvestor.net/benjamin-graham-on-market-behavior
Interesting interview by John Bogle.
Equity Valuation In Good Times And Bad
One very frustrating aspect of the global financial crisis of 2008-2009 was the awareness that the volatility was, in part, exacerbated by an accounting rule. During the late fall of 2008, the Financial Accounting Standards Board (FASB) finally took up discussion of FAS 157, Fair Value Measurements, and issued a recommendation to adopt certain modifications in the form of FAS 157-d, Determining the Fair Value of Financial Assets in a Market that is Not Active.
Determining Fair Value
The central issue that was reviewed: companies holding certain mortgage-backed securities had been required to "mark to market" the value of these investments. In a well-functioning securities market, marking to market is a reasonable way to determine fair value, in the same way that a comparable sales analysis - in a well-functioning real estate market - can offer clarity into the appropriate listing price for residential properties.
When capital markets become dislocated, forcing companies to mark their then-illiquid securities to an indeterminable market value creates a downward spiral of asset impairments, charges to earnings, and degraded capital positions. FAS 157-d recommended several remedies. One important and appropriate remedy is a greater reliance on discounting future cash flows to determine fair value in a distressed market. (For more, see Mark-To-Market Mayhem.)
Determining Fair Value
The central issue that was reviewed: companies holding certain mortgage-backed securities had been required to "mark to market" the value of these investments. In a well-functioning securities market, marking to market is a reasonable way to determine fair value, in the same way that a comparable sales analysis - in a well-functioning real estate market - can offer clarity into the appropriate listing price for residential properties.
When capital markets become dislocated, forcing companies to mark their then-illiquid securities to an indeterminable market value creates a downward spiral of asset impairments, charges to earnings, and degraded capital positions. FAS 157-d recommended several remedies. One important and appropriate remedy is a greater reliance on discounting future cash flows to determine fair value in a distressed market. (For more, see Mark-To-Market Mayhem.)
The Price is Right
During periods of systemic stress, valuation in the public equity markets offers a similar challenge to investors. While one can find a readily available market quote for shares of most common stocks, how confident can investors be that they are paying the correct price? One of the most common valuation methods relies on the P/E ratio of companies. In well-functioning markets, P/E ratios provide a quick and easy assessment of comparable value.
But what happens when the "E" becomes entirely uncertain? And, considering the seismic risk-repricing feature common to distressed markets, how confident can we be that earnings multiples represent fair values? Those market environments demand that we shelve, at least temporarily, our reliance on certain relative value measures, like P/E. Yet, it's clear that during a market melt-down, accurate valuation is as critical as it ever is. (For more, read Is The P/E Ratio A Good Market-Timing Indicator?)
One way to compare value measurements is by assigning various alternatives to the quadrant below.
Economic Accounting
During periods of systemic stress, valuation in the public equity markets offers a similar challenge to investors. While one can find a readily available market quote for shares of most common stocks, how confident can investors be that they are paying the correct price? One of the most common valuation methods relies on the P/E ratio of companies. In well-functioning markets, P/E ratios provide a quick and easy assessment of comparable value.
But what happens when the "E" becomes entirely uncertain? And, considering the seismic risk-repricing feature common to distressed markets, how confident can we be that earnings multiples represent fair values? Those market environments demand that we shelve, at least temporarily, our reliance on certain relative value measures, like P/E. Yet, it's clear that during a market melt-down, accurate valuation is as critical as it ever is. (For more, read Is The P/E Ratio A Good Market-Timing Indicator?)
One way to compare value measurements is by assigning various alternatives to the quadrant below.
Economic Accounting
Absolute - -
Relative - -
Economic measures describe an actual tangible value, while accounting measures approximate actual value and are impacted by GAAP accounting conventions. Absolute value measures describe value on a stand-alone basis. Relative measures are useful when comparing the same measure between two companies. To flesh this concept out a bit, we'll fill in the quadrants with example measures:
Economic Accounting
Absolute DCF ROE
Relative ER P/E
The discounted cash flow (DCF) method is economic in the sense that it relies on cash flow, an actual tangible benefit to equity holders. It is also absolute, as it relies on the company's own cost of capital, rather than a sense of where the rest of the industry or market is currently valued.
The Enterprise Ratio
A company's enterprise ratio (ER) is found by the following formula:
(market value of debt + market value of stock – cash / cash flow from operations)
Here, too, the components are all economic measures, but the resulting ratio is useful only in comparison to another company's Enterprise Ratio and thus, it is relative.
Return on Equity
Return on equity (ROE) can be estimated several ways, one of which is simply to divide the firm's net income by its shareholder equity. Net income and shareholder equity are GAAP measurements, thus ROE is an accounting function. But like DCF, ROE expresses a measure of return which holds meaning in absolute terms: a company which earns a return on equity in excess of its cost of equity capital has added value. (For more on ROE, read Keep Your Eyes On The ROE.)
P/E Ratio
Finally, the P/E ratio relies on earnings, which is a GAAP concept and it is useful only when compared to the P/E ratio of industry peers or a market index.
In his book, "Active Value Investing" (2007), Vitaliy Katsenelson argues that one prominent feature of secular range-bound markets is P/E multiple contraction. A long period in which stock prices fluctuate but do not progress can tend to diminish investor confidence, which is reflected in the multiple investors are willing to pay for a claim on a company's earnings. A growing number of strategists now believe that 2008-2009 was a secular range-bound market.
Answering the Tough Question
The implication is this: what is a fair multiple to pay in a range-bound market, where multiples aren't likely to be stable? If you think it is a difficult question to answer, you are in good company. Many investment analysts ask the same question. Ultimately, a P/E ratio is never objectively high or low; it always must be compared to something else to have meaning. In a market where value is difficult to discern, relative measures, like P/E, render less meaning than they do in more stable, secular bull markets.
The P/E ratio's usefulness during periods of market stress is further limited by its denominator, which is an accounting measure. Earnings, while important, are subject to many aspects of management discretion such as changes to amortization and depreciation schedules.
Alternatively, DCF analysis offers an approach to valuation which stands alone and at the same time projects a truer estimate of economic benefit.
DCF takes projected future cash flows and discounts them back to the present. The theoretical justification for this method is the sense that the intrinsic value of a financial asset is the value of the future cash flows which that asset generates. Alfred Rappaport argues in "Creating Shareholder Value" (1997) that cash flows from operations are the relevant numerator, because they represent the cash available to equity holders, which results from the core operations of the business. Many industrial companies require that operating cash flows be adjusted for depreciation and high levels of maintenance capital expenditures. In these cases, free cash flow may be a better figure to discount. (For a background on DCF, see our DCF Analysis Tutorial.)
The Enterprise Ratio
A company's enterprise ratio (ER) is found by the following formula:
(market value of debt + market value of stock – cash / cash flow from operations)
Here, too, the components are all economic measures, but the resulting ratio is useful only in comparison to another company's Enterprise Ratio and thus, it is relative.
Return on Equity
Return on equity (ROE) can be estimated several ways, one of which is simply to divide the firm's net income by its shareholder equity. Net income and shareholder equity are GAAP measurements, thus ROE is an accounting function. But like DCF, ROE expresses a measure of return which holds meaning in absolute terms: a company which earns a return on equity in excess of its cost of equity capital has added value. (For more on ROE, read Keep Your Eyes On The ROE.)
P/E Ratio
Finally, the P/E ratio relies on earnings, which is a GAAP concept and it is useful only when compared to the P/E ratio of industry peers or a market index.
In his book, "Active Value Investing" (2007), Vitaliy Katsenelson argues that one prominent feature of secular range-bound markets is P/E multiple contraction. A long period in which stock prices fluctuate but do not progress can tend to diminish investor confidence, which is reflected in the multiple investors are willing to pay for a claim on a company's earnings. A growing number of strategists now believe that 2008-2009 was a secular range-bound market.
Answering the Tough Question
The implication is this: what is a fair multiple to pay in a range-bound market, where multiples aren't likely to be stable? If you think it is a difficult question to answer, you are in good company. Many investment analysts ask the same question. Ultimately, a P/E ratio is never objectively high or low; it always must be compared to something else to have meaning. In a market where value is difficult to discern, relative measures, like P/E, render less meaning than they do in more stable, secular bull markets.
The P/E ratio's usefulness during periods of market stress is further limited by its denominator, which is an accounting measure. Earnings, while important, are subject to many aspects of management discretion such as changes to amortization and depreciation schedules.
Alternatively, DCF analysis offers an approach to valuation which stands alone and at the same time projects a truer estimate of economic benefit.
DCF takes projected future cash flows and discounts them back to the present. The theoretical justification for this method is the sense that the intrinsic value of a financial asset is the value of the future cash flows which that asset generates. Alfred Rappaport argues in "Creating Shareholder Value" (1997) that cash flows from operations are the relevant numerator, because they represent the cash available to equity holders, which results from the core operations of the business. Many industrial companies require that operating cash flows be adjusted for depreciation and high levels of maintenance capital expenditures. In these cases, free cash flow may be a better figure to discount. (For a background on DCF, see our DCF Analysis Tutorial.)
Discount Rate
Deriving the appropriate discount rate - the weighted average cost of capital - is a bit more complex. The weighted average cost of capital is comprised of a proportional cost of debt, which is approximated by the yield on the firm's long-term bonds, and the cost of equity. The cost of equity is expressed formulaically below:
Ke = rf + (rm – rf) * β
Where:
Limitations of DCF
Estimating future cash flows from operations requires a sales forecast, which may or may not be accurate; this possibility for error is compounded when forecasting over multiple periods. Moreover, since DCF relies on the above required return for equity formula, we note that the beta of a stock may overstate or understate the actual volatility of the security. Finally, the equity risk premium is not constant.
Likewise, we should point out that not all relative measures are inferior in distressed markets. As with P/E, the price / book ratio utilizes an accounting figure in its denominator. And though the appropriate multiple of price over book may be a relative measure, stocks which are trading below their book value (or, as is common during stressed markets, below tangible book value) offer a type of absolute value opportunity.
The Bottom Line
Intrinsic value and the degree it differs from market price are, ultimately, subjective matters. Severe market dislocations demand that we not only adjust valuations, but that we reassess the metrics by which we derive those valuations. Economic and absolute measures allow the analyst to filter out much of the noise in the market place and provide a theoretically sound means of determining intrinsic value. (For more on DCF, see our related article DCF Valuation: The Stock Market Sanity Check.)
Deriving the appropriate discount rate - the weighted average cost of capital - is a bit more complex. The weighted average cost of capital is comprised of a proportional cost of debt, which is approximated by the yield on the firm's long-term bonds, and the cost of equity. The cost of equity is expressed formulaically below:
Ke = rf + (rm – rf) * β
Where:
- Ke = the required rate of return on equity
- rf = the risk free rate
- rm – rf = the market risk premium
- β = beta coefficient = unsystematic risk
Limitations of DCF
Estimating future cash flows from operations requires a sales forecast, which may or may not be accurate; this possibility for error is compounded when forecasting over multiple periods. Moreover, since DCF relies on the above required return for equity formula, we note that the beta of a stock may overstate or understate the actual volatility of the security. Finally, the equity risk premium is not constant.
Likewise, we should point out that not all relative measures are inferior in distressed markets. As with P/E, the price / book ratio utilizes an accounting figure in its denominator. And though the appropriate multiple of price over book may be a relative measure, stocks which are trading below their book value (or, as is common during stressed markets, below tangible book value) offer a type of absolute value opportunity.
The Bottom Line
Intrinsic value and the degree it differs from market price are, ultimately, subjective matters. Severe market dislocations demand that we not only adjust valuations, but that we reassess the metrics by which we derive those valuations. Economic and absolute measures allow the analyst to filter out much of the noise in the market place and provide a theoretically sound means of determining intrinsic value. (For more on DCF, see our related article DCF Valuation: The Stock Market Sanity Check.)
by
Stephen Carr
Stephen Carr is principal and porfolio manager for Winthrop Capital Management in Carmel, Ind. Steve's particular areas of interest are equity valuation, dividend policy and behavioral finance.
Read more: http://www.investopedia.com/articles/fundamental-analysis/09/equity-valuation-good-bad.asp?partner=basics051112#ixzz1ubcQMER4
Wednesday 9 May 2012
KLSE Market P/E Ratio
As at 6th Jan 2012, our local market is valued at a P/E (Price per earning) of about 14.8x on 2012 earnings. In the other words, it is currently lower than the 10-year average P/E ratio of 16.7x. So, it would be good opportunity for investor to make own assessment and decision in the present market condition.
P/E ratio is commonly used by stock traders to value a company. It reflects whether a company’sshare price is overvalued or undervalued.
PE (Price per earning) = Current share price / EPS
It’s crucial for us to focus on individual stock using the market P/E ratio. It can prevent investor from being traded into a bubble situation which is the riskiest environment for an investor to indulge in.
The magic of a mentor
Tennis star Rafael Nadal was 17 when he beat his mentor Carlos Moya. Photo: Reuters
The day inevitably comes when all successful people overtake their mentors. It happened to tennis star Rafael Nadal at age 17 when he beat his mentor Carlos Moya (Moya was 27 at the time).
But even the best in the world will spruik the benefits of a mentor. World tennis No.1 Novak Djokovic still hasn't outgrown all his mentors despite his dominant ranking. He maintains a surprisingly strong relationship with Serbian retired women's handball and tennis player Jelena Gencic, who used to prescribe classical music and Pushkin poetry to the fiery Serbian prodigy to help him calm down and "be a better human being".
I like that definition of the mentoring relationship - an exchange that can make someone a "better human being". Of course mentoring isn't just about classical music or studying Russian poets, but it is a reminder to even the most senior executives that you are never too good to grow or to learn from the right mentor. In fact, if you ever think you know it all, it's generally a sign to pack your bags and get out before the rot sets in.
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The trick however is finding Mentor Right, not Mentor Wrong. A highly competent chief executive I know signed up for a state government-funded mentoring program that offered him a business mentor for several months. He thought it might sharpen his skills but there was a slight problem when the mentor turned up. The mentor was way out of his depth with my client who was a market leader in his field. The "expert" mentor couldn't help at all, so they had a couple of coffees and called it a day.
While that particular mentoring relationship didn't work out, I advised him to do a bit more homework about the type of mentor, the qualities and skills he was looking for in a mentor and explicit outcomes he wanted to achieve.
This means finding the best in your business and thinking laterally about how you would like to develop. Look at the leaders in your field and ask yourself: "Who can really help me become a better leader, sales person, manager, speaker or designer?"
A lot of people confuse mentor with coach. The difference is simple - mentor comes from the Latin word "mentore", which means "to be like". A great mentor imparts wisdom and shares knowledge with a less experienced colleague, while a coach doesn't have to be a master in their area of expertise.
Five-time Tour de France winner Eddy "The Cannibal" Merckx mentored Lance Armstrong to go two better and was a vital factor in helping Armstrong win seven titles. David Beckham was mentored by Bobby Charlton. And actor Laurence Olivier mentored Anthony Hopkins.
While elite sport has embraced the mentoring concept for decades, many business leaders incorrectly assume it is a developmental activity primarily for emerging leaders. There's a risk once corporate leaders reach the top of their game that, without accountability and constant growth, they will begin to stagnate and their performance will plateau.
Mentoring is also valuable in the succession process. The outgoing Commonwealth Bank managing director and chief executive, Ralph Norris, mentored the incumbent chief executive Ian Narev (a former management consultant) for 18 months before the handover in December 2011. Some of the most business-savvy executives swap their mentors over time as their needs change. Firstly, once your mentor has imparted all of the knowledge and skills you were searching for, it makes sense to finish/wind back this business relationship. Secondly, learning different skills from a range of different people over time will stretch you further as a leader.
Traits to look for in a mentor
Great experience and knowhow, has achieved high levels of success in their field;The skills and abilities you are looking for;
- A good listener and conversationalist;
- Trustworthy (ensuring that you feel comfortable disclosing personal information and even insecurities);
- A sharp observer who will challenge and stretch you;
- Shows genuine interest in you;Has strong problem-solving abilities;
- Offers a fresh perspective;
- Believes in your potential.
What is your experience with mentoring? Does it work?
Read more: http://www.smh.com.au/executive-style/management/blogs/performance-matters/the-magic-of-a-mentor-20120501-1xwhi.html#ixzz1uJl49COv
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