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. 

Valuing Stocks - Absolute or Intrinsic Valuation

The two basic method of valuing stocks are;

• Relative valuation
• Absolute or Intrinsic valuation

Usually, absolute value is estimated by calculating the present value of the company's future free cash flows (cash flow minus capital spending).

The present value of that future-income stream is the theoretically correct value of the stock.

This method has its own difficulties and is less frequently used, but absolute value deserves a place in every investor's arsenal of valuation tools.

Calculating the absolute value of a stock isn't easy.  It is tough to forecast:

• how fast a company's free cash flow will grow, 
• how long they'll grow, and 
• at what rate they should be discounted back to the present.  

We estimate stocks's absolute values by inputting our estimates of a company's growth rate, profitability, and the efficiency with which it uses its assets into a discounted cash flow model.  The result is an analyst-driven estimate of a stock's fair value in absolute terms.

In an imperfect world, opting for the much easier - if less pure - method of relative valuation often makes sense.  

However, when the companies you are using as your benchmark are themselves mis-priced, relative valuation can lead you astray; without a reliable measurement tool, your measurements will be off.  That last point is crucial.

If the S&P 500, for example, is trading at a P/E ratio that is very high by historical standards, using it as a benchmark can be hazardous.  

A stock can appear much cheaper than the overall market and still be quite expensive in absolute terms.  So what's an investor to do?  

Unfortunately, there aren't any easy answers.  

The best way to approach stock valuation is by using many different methods, the same way you would if you were valuing a used car or a house.

Checking out what similar houses in a neighbourhood have sold for is akin to relative valuation, and walking through a house you're interested in - looking at the construction and quality of materials - is similar to intrinsic valuation.  

A judicious mix of both methods will serve you well.

Valuing Stocks - Relative Valuation

There are two basic methods of valuing stocks:

• Relative valuation
• Absolute valuation or Intrinsic Valuation

The most frequently used method is relative valuation, which compares a stock's valuation with those of other stocks or with the company's own historical valuations.  

For example, if you were considering the relative valuation for a chemical company CC, you would compare its stock's price/earnings ratio (or its price/sales ratio, etc.) with that of other chemicals makers or with that of the overall stock market.  

• If CC has a P/E ratio of 16 and the average for the industry is closer to, say 25, CC's shares are cheap on a relative basis.  
• You can also compare CC's P/E with the average P/E of an index, such as the S&P 500,  to see whether CC still looked cheap.  

The problem with relative valuations is that not all companies are made alike - not even all chemicals makers.

There could be very good reasons why CC has a lower P/E than its average peer.  

• Maybe the company doesn't have the growth prospects of other chemicals companies.  
• Maybe the possible liability from a product litigation rightly puts a damper on the stock's price.  

After all, a Hyundai has a lower sticker price than a Mercedes, but for very good reasons.

The key is to research your stocks well and be aware of the factors that might justifiably make them cheaper or more expensive than similar stocks.

Common Valuation Ratios

Let's look at the ways in which a stock's price compared with the value of the underlying company can be represented.

Valuations are usually expressed as the ratio of a company's share price to an aspect of its financial performance, such as:

• price/earnings (P/E), 
• price/sales (P/S), 
• price/book value (P/B),
• price/cash flow (P/CF), or 
• price/estimated growth rate (P/EG)

We know that a stock's value is a combination of the company's present condition and its future prospects, and it is usually measured by a series of ratios.

But how do we decide if that value is too high, too low, or just right?

This is where things can get tricky, because valuing stocks is sometimes more an art than a science.  

That's why it is not uncommon for two analysts to look at the same company and come up with different conclusions.

Valuing Stocks - What Is a Stock's Value?

The value of most stocks is a combination of the current value of the company and the value of the profits it will make in the future.

In general, the more growth the market expects from a company, the more the company's market value will owe to expected future profits.  

Take online bookseller YY, for example.  By most measures, company YY has little or no current value; it has only minuscule book value and is gushing red ink.  Liquidating company YY would leave its investors with zilch.  But the market thinks the company's future profit potential is so bright that it has pinned a multibillion-dollar worth (the company's market capitalization) on the stock.

Another way to think of a stock's value is that a company's stock price consists of a combination of what you are paying for the company's current level of profitability and what you're paying for its earnings growth.

Since company YY is far from profitable then,  the stock price is based almost entirely on expectations of future growth.  That is one reason company YY's stock is so volatile.

As those expectations rise and fall, so does the price of its stock.

In comparison, the stock price of another stock XX largely reflects the company's current value, not its future growth.  Company XX is quite profitable, but no one expects it to grow terribly fast.

Valuing Stocks

Valuing a stock is a lot like buying a car.

There are lots of great cars out there, but the sticker price may be more than the actual worth of the car.   Some manufacturers command a premium price because their cars have a certain cachet, not because their cars are necessarily more reliable or of better quality than others on the market.

It is the same thing with stocks.

Some stocks are valued much more richly than others because they are hot or popular with investors, not because the companies are more profitable or have better growth prospects,

The ability to decide whether a company's stock price accurately reflects its performance is the heart of stock valuation.

The Risks of Debt-Driven Returns on Equity

The three levers of ROE are:
- net profit margin  (achieve through operational efficiency)
- asset turnover (achieve through operational efficiency)
- financial leverage (achieve through employing high debt)

But does it matter if a company's high ROE comes from high debt and not operating efficiency?

If a company has a steady or steadily growing business, it might not matter that much.

For example, companies in the consumer-staples sector, where demand is stable, can handle fairly large debt loads with little problem.  And the judicious use of debt by such companies can be a boon to shareholders, boosting profitability without unduly increasing risk.

If a company's business is cyclical or volatile in some other way, though, watch out.

The problem is that debt comes with fixed costs in the form of interest payments.  The company has to make those interest payments every year, whether business is good or bad.

When a company increases debt, it increases its fixed costs as a percentage of total costs.

In years when business is good, a company with high fixed costs as a percentage of total costs can make for a great profitability because once those costs are covered, any additional sales the company makes fall straight to the bottom line.

When business is bad, however, the fixed costs of debt push earnings even lower.  

That is why debt is sometimes referred to as leverage:  It levers earnings, making strong earnings stronger and weak earnings weaker.

When companies in cyclical or volatile businesses have a lot of leverage, their earnings therefore become even more volatile.  

So the next time you're thinking about profitability, make the distinction between the kind that is internally generated (through operational efficiencies) and the kind that is inflated by debt (through leverage).

You can make a lot of money of stocks of companies structured like the latter, but your return is more assured with stocks of companies like the former.

Financial Leverage - Lever of ROE

The three levers of ROE are net margin, asset turnover and financial leverage.

The third lever of ROE, financial leverage, is a measure of how much debt the company carries.

The way in which raising financial leverage increases ROE is a little less intuitive.

If a company adds debt, its assets increase (because of the cash inflows from the debt issuance) and so does its total debt.

Equity = Assets - Total Liabilities
Assets = Equity + Total Liabilities

Since equity is equal to assets minus total debt, a company can decrease its equity as a percentage of its assets by increasing its debt.

ROE
= Net Profit/Revenue  x  Revenue/ Asset   x   Asset/Equity
=  ROA  x  Asset/Equity

In other words, assets - the numerator of the financial leverage figure - increases, so the overall financial leverage number rises, boosting ROE.

Net Margin and Asset Turnover - Levers of ROE

The three levers of ROE are net margin, asset turnovers and financial leverage.

Not all the 3 levers of ROE are made equal.

The first two levers, net margin and asset turnover, are measures of how efficient a company's operations are.

Increasing net margins - which means a company is turning a larger portion of its sales into profits - will increase profitability.  

A high asset turnover, which expresses how many times a company sells, or turns over its assets, in a year is also a sign of efficiency.

The product of net margin and asset turnover is called return on assets, or ROA, and it is an excellent measure of operational profitability.

ROA = Net Profit Margin x Asset Turnover

The higher a company's ROA, the better.

Some companies emphasize high net margins to pump up their ROA; others emphasize rapid turnover.  

For example:

Coca Cola KO

Between 1994 and 1998, Coke's net margins averaged 18%.

Coke was able to leverage its strong brand name into higher prices, resulting in fat net margins.

Cott COTTF, a Canadian produce of discount, non-brand-name soda.

Cotts's average net margin was less than 5%.  

Cott, on the other hand, targeted the low end of the market with bargain prices, earning a slimmer profit margin on each sale but (hopefully) moving a lot more merchandise per unit of assets.

Cott's asset turnover during the same period was 1.7, compared with Coke's 1.1.  But that wasn't nearly enough to offset Coke's much higher net margins, and Coke's ROA of 24% trounced Cott's 4%.  

This is not to say that focusing on asset turnover at the expense of margins is always a bad thing.  

Wal-Mart WMT

Wal-Mart WMT has lower margins than most other major retailers because it emphasizes lower prices.  

But Wal-Mart also generates a higher ROA than most of these competitors because it operates so efficiently that its asset turnover is much higher.

In 1998, for example, Wal-Mart''s asset turnover was 2.8, as opposed to 1.1 for old-line retailer Sears S and 2.0 for rival discounter Dayton-Hudson DH.

Levers of ROE

Return on equity, or ROE, is the most common measure of a company's profitability.

But ROE is itself the product of 3 ratios, or levers:

• net margin (earnings/revenues, expressed as a percentage),
• asset turnover (revenues/assets), and,
• financial leverage (assets/equity).

ROE 

= Net Profit Margin x Asset Turnover X Financial Leverage

= Net Profit/Revenue  x  Revenue/Total Asset  x   Total Asset/Equity

= Net Profit/Equity

Multiplying the three levers together gives us ROE, and raising any one of these three levers will increase ROE.

ROE and Internet Stocks

As an example, consider the fastest growing segment of 1999, Internet stocks.

Most Internet companies are growing rapidly, but few of them are generating profits.



Apart from America Online AOL and its 25% ROE in 1999, none have generated a high return on capital. 


In 1999, the ROE for market darling Amazon.com AMZN was negative 270%.

• In other words, for each dollar shareholders had invested in the company, Amazon lost $2.70.  
• To replenish the lost capital, the company must either issue debt or turn to shareholders for more money -  and there are still plenty of people willing to pony up the money to own a piece of Amazon.  
• If Amazon is going to justify its price, it will eventually have to generate good returns on capital, and whether it can do that depends on which pundits you listen to.  

But there is no argument that returns on capital are the engine that drives stock prices in the long run.


Companies that go on to earn good returns on capital - ROEs of more than 15% or 20% - will probably make good investments.   

Those that struggle to earn a decent return will probably be wretched investments, regardless of how fast they grow.  

So, if someone tries to talk you into investing $10,000 in a restaurant or a few hundred share of an Internet stock, don't ask how fast the company will grow.  Ask how the heck it is going to earn a good return on its capital.

Why Return on Equity Matters

Let's say you want to open a whole chain of restaurants.

In the early years of building your business empire, you will be adding to your capital base aggressively.  

But because of the costs of opening restaurants, you will probably take losses; most companies in their formative stages lose money.  

If after a few years you have sunk $500,000 into your restaurants but are losing $50,000 annually, your return on capital is negative 10%.

It is not necessarily bad for a company to earn a negative return on equity - if it can earn a high return in the future, that is.

An investor will stomach a negative 10% ROE for his restaurants if he believes they can earn much higher returns in the future.

The trouble is, in a company's rapid-growth phase, when returns on equity are most often small or negative, it is tough to separate a good business (one that can earn a high ROE) from a bad business (one not able to).  After all, each is losing money.

Analyzing such companies means asking questions like

• "Is this a company with enough pricing power to eventually command a premium price for its product?"
• And "Is this a company with enough of a cost advantage that it can undercut the competition?"

It means, in other words, asking whether the company's business can either generate a high net margin (profit/sales) or a high asset turnover (sales/assets), the two key components of a high return on capital. 

Return on Equity - it is the long-term return on capital that excites

The way analysts usually measure return on capital for publicly traded companies is return on equity, or ROE.  

ROE =  Net earnings / Shareholders' equity

Shareholders' equity, or equity capital = Total assets - Total liabilities

Shareholders' equity is the part of the company owned by stockholders - the capital they have invested in the company.

A company X earned an incredible 63% on its equity capital in 1999.   In other words, for every $1 of shareholder money invested in the firm, this company X generated an annual profit of $0.63.

Be careful, though.  It is easier to post a large ROE in a single year than it is to maintain that large ROE over a longer period.

Company Y, for example, earned 58% on its equity in 1999, but if you average the company's ROEs over the five-year period from 1995 to 1999, the figure drops to a much less impressive 19%.

It is that long-term return on capital that we're interested in.

Measuring Returns on Capital

What makes a company great?

It is not rapid growth.

It's not landing on a best-of-the-year list.

Rather, it is the ability to generate high returns on capital.

Suppose you decide to open a business.  The money you spend building the business is your capital.

Whether the business is a good investment depends on how much profit you make as a percentage of that capital.

If you earn a profit of $10,000 in a given year and you've invested $100,000 in building the business, you've made a 10% return on your capital.

Not spectacular, but better than a savings account.

Valuation of Bonds and Shares

Valuation of Bonds and Shares

View more presentations from Biswajit Ghosh

Valuation of Bonds and Shares

GSB711-Lecture-Note-04-Valuation-of-Bonds-and-Shares

View more presentations from University of New England

Warren Buffett's Way

Warren Buffett’s Way

View more presentations from moneyweb

Warren Buffett - "The Sage of Omaha"

Warren Buffett

View more presentations from Mr.Yes!

Warren Buffett Presentation

Warren Buffett Presentation

View more presentations from ilenegoldberg

Margin of Safety

Even after you think you have a good handle on what a stock should be worth, it is important to buy at a discount to this estimated fair value to give an adequate margin of safety.

After all, no projection about the future is foolproof, and protecting yourself from unforeseen events is entirely prudent.

For instance, if a company's new product falls flat and profit growth doesn't materialize, you want to be protected.

It is also important to realise that some companies are riskier and harder to predict than others.  In general, the riskier a company is, the larger the margin of safety should be.

The bottom line is that if you don't use a lot of discipline and conservatism in figuring out the prices you are willing to pay for stocks, you will regret it eventually.  

You might be able to sell some of your overvalued shares to some sucker who is willing to pay an even more inflated price, but in the end, this kind of speculating is the investing equivalent of musical chairs, with the last one holding the stock the loser.  Don't let it be you.

Buy at a price below fair value with an adequate margin of safety and sleep well at night.

Waiting for the Fat Pitch

How do I make sure I don't overpay for something?

The answer:  If the pitcher doesn't throw one right down the middle, you don't have to swing the bat.  Unlike in baseball, there is no penalty for being patient in investing.

You should spend a fair amount of time placing a value on a stock before you even think about buying it, and only buy stocks that you are confident are undervalued.

Learning how to value  a stock takes work, but it can be done.

Price Matters

Price matters in the stock market.

Just like you wouldn't run out and pay $10 a gallon for gasoline, why would you pay 100 times earnings for a company that is growing 15% a year?

Do you think the people who paid $212 for Yahoo YHOO in January 2000 are ever going to get their money back?

Yahoo's a good company, but it may take a very long time for the stock to get back to its old highs.

The same could be said of many other technology stocks and also even those technology companies with moats around them that got clobbered in post 2000.

Remember - the single greatest determinant of a company's return in your portfolio is the price you pay for its shares.

As important as it is to understand the quality of a company - its growth prospects, competitive position, and so forth - it is even more vital that you pay a fair price for the firm's shares.

You'll make a lot more money buying decent firms with low valuations than by paying premium prices for premium companies.  Why?  Because the future is uncertain, and low valuations leave a lot more room for error.

Buying at a Discount to Fair Value

Even though you know about economic moats and have perhaps uncovered a company that has at least one good-sized moat, unfortunately, your work is only half done at this point.  (Quality & Management)

You cannot just go out and pay whatever the market is asking for this stock until you calculate what it's worth (the intrinsic value).  (Valuation)

Otherwise, you might end up having to hold the stock for many, many years to get a decent return on your money.

And in some cases, you might never get one.

Using Free Cash Flow

Company ABC.

1995  Earnings    $100,000        FCF -$7.0 million
1996  Earnings    $5.9 million      FCF -$28.0 million
1997  Earnings    $12.3 million    FCF -$57.4 million

Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.

Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.  


Company OPQ.

1997  Earnings    $6,945 million     FCF  +$5,507 million
1998  Earnings    $6,068 million     FCF  +$5,634 million
1999  Earnings    $7.932 million     FCF  +$7,932 million 

Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.

Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.   


Company DEF

1996   Earnings   $1,473 million   FCF  - $2,532million
1997   Earnings   $787 million      FCF  - $2,347 million
1998   Earnings   $  28 million      FCF  - $2,187 million

Company DEF's revenues actually declined during this period.
FCFs were consistently negative for the same period.

Company DEF spends an amount equal to about 20% of its long-term assets in a single year.


-----


How to use Free Cash Flow (FCF)?


Think of FCF as another bottom line.


Good and great companies generate lots of positive FCFs.


Negative FCF isn't necessarily bad, but it suggests you're dealing with either a speculative investment (such as Company ABC) or an underperformer (such as Company DEF).


Above all, negative FCF or a high level of capital spending naturally raises other questions.

1. If the company is spending so much money, is it at least earning a high premium on that capital?
2. And is all that spending paying off in rapid sales and profit growth?

If you are a careful investor, you'll want to know the answers to those questions before letting the company spend your money.

When Capital Spending Doesn't Generate Cash Flow

Company ABC.

1995  Earnings    $100,000        FCF -$7.0 million
1996  Earnings    $5.9 million      FCF -$28.0 million
1997  Earnings    $12.3 million    FCF -$57.4 million

Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.

Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.  



Company OPQ.

1997  Earnings    $6,945 million     FCF  +$5,507 million
1998  Earnings    $6,068 million     FCF  +$5,634 million
1999  Earnings    $7.932 million     FCF  +$7,932 million 

Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.

Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.  




Company DEF

1996   Earnings   $1,473 million   FCF  - $2,532million
1997   Earnings   $787 million      FCF  - $2,347 million
1998   Earnings   $  28 million      FCF  - $2,187 million

Company DEF's revenues actually declined during this period.
FCFs were consistently negative for the same period.

Company DEF spends an amount equal to about 20% of its long-term assets in a single year.


What really hurts is when a company spends aggressively but its performance stinks.

If a company is spending like mad, it had better be increasing its sales - and its profits - at a rapid rate.  

Company ABC and Company OPQ pass that test.

Company DEF doesn't.

Company DEF is a mature company and for it to generate such meager free cash flows is bad enough.

But when a company spends an amount equal to about 20% of its long-term assets in a single year, you expect to see rapid growth.  Yet, Company DEF's revenues actually declined during this period; the company's long-term record of growth is poor when you consider how much money gets plowed into the company.

Big Capital Spending and Cash Flow Can Work Together

Company ABC.

1995  Earnings    $100,000        FCF -$7.0million
1996  Earnings    $5.9million      FCF -$28.0million
1997  Earnings    $12.3million    FCF -$57.4million


Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.




Company OPQ.



1997  Earnings    $6,945million     FCF  +$5,507million
1998  Earnings    $6,068million     FCF  +$5,634million
1999  Earnings    $7.932million     FCF  +$7,932million 


Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.






Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.  


Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.  


Both Company ABC and Company OPQ spend vast sums relative to their asset bases.  However, we see a big difference when we look at their respective FCFs.

• These positive FCFs mean Company OPQ has money left over even after its large capital-spending budgets.  
• By contrast, Company ABC, must turn to investors or lenders to make up the difference.  Only by selling new shares to the public or taking out a loan can Company ABC fund its aggressive spending.

What free cash flow tells you

What free cash flow (FCF) tells us that earnings don't?

Let us have a look at Company ABC.

From 1995 through 1997, the company posted $100,000, $5.9 million, and $12.3 million in earnings.  Nice growth, right?

The company's FCF, by contrast, was negative $7.0 million, negative $28.0 million, and negative $57.4 million.  FCFs also grew - but in the opposite direction as earnings.

That's not necessarily bad.

FCF is equal to the cash a company generates minus the amount it invests.

Company ABC is investing a lot, which is why its FCFs are negative.



How much is a lot (of capital expenditure)?

A quick way to tell how quickly a company tears through money is to compare its capital spending with its long-term assets (mostly, its plant and equipment).  

While not perfect, the comparison at least gives us an idea of how aggressively a company is spending.  

Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.  That's a prolific spender.

At the opposite end of the spectrum would be company like Company XYZ, which cruises along spending an amount equal to about 5% of its long-term assets.

When you see a percentage as high as 30% or 40%, chances are you're dealing with a young company just getting on its feet.

What is Free Cash Flow (FCF)?

FCF represents the cash a firm has generated for its shareholders, after paying its expenses and investing in its growth.

FCF = Total cash flow (Earnings with noncash charges added back in)  - capital spending

FCF can be very useful in assessing a company's financial health because it strips away all the accounting assumptions built into earnings.

A company's earnings maybe high and growing, but until you look at FCF, you don't know if the company's really generated money in a given year or not.

If you're an owner, FCF is ultimately what you're interested in.  FCFs represent real cash.  Earnings do not.

When to Sell a Stock

Just as there are no hard-and-fast rules as to when to buy a stock, there are no hard-and-fast rules as to when to sell.

Investors typically spend a lot of their time researching their stock purchases than they spend considering their selling decisions.

Unfortunately, selling decisions are often made in the heat of the moment, after a stock has already taken a beating in the market.

The best way to know when to sell a stock is to know why you own it in the first place.

1. Did you love the company's fundamentals?  Then you should know when they are changing for the worse.
2. Was the company the industry leader?  Then you should keep a close eye on the competition, and know when it is catching up to your company.
3. Did you love the industry?  Then you need to watch for an industry downturn.
4. Did you buy the stock because it was undervalued?  Then you should have a firm idea of what you think fair value is.

Don't Sell Based on Price Alone

You will be poorly served if you watch only your stock's price.

When markets go through one of their periodic hiccups, investors who know why they own a stock are less likely to panic and sell after the stock has already tanked.  In addition, there are the nasty tax consequences of selling frequently.  By making sure every sell decision is justified, you'll inevitably cut down on capital-gains taxes.

Avoiding impulsive selling decisions may be one of the best ways to improve long-term investment returns.  While the decision to buy a stock is (or should be) the end result of an extended period of research, the decision to sell is often done in the heat of the moment, after a stock has already been crushed. 

But what good does it do to sell after the stock has fallen?  Whatever the bad news was, it has already been incorporated into the stock price.  At this juncture, investors should ask themselves:  why they own this stock.  Are the reasons for owning the stock still intact?  If so, the more rational reaction to a dropping stock price might be to take advantage of the lower price and buy more.  Likewise, investors may actually sell off a gem of a stock just because it has had a great run.  But myriad examples show that a great company can outperform the market year after year.  The fact is, most of us would be better off if we could block out all those graphs of past stock performance, since they convey no information we can use profitably in the here and now.

The Five Year Rule for Buying a House

by THURSDAY BRAM 

• 193Share
• Email

When I first considered buying a house, my entire family got involved. I have the luck of being related to real estate agents, investors and other experts that are more than happy to give advice about buying a property — even before you ask.

The first thing they asked me was exactly how long I expected to stay in the house. Most people don’t know these sorts of things for sure, but we wanted to make sure that I’d own the house for at least five years.

The Upgrade Cycle

It definitely varies by geographic area — if not by specific neighborhood — but a lot of folks in my area will buy a townhouse or condo as their starter home. After about three years, they’ll start looking for a bigger place to upgrade to, either a bigger townhouse or a standalone home. Depending on the family, that upgrade cycle can go through a couple of times as people work their way up to a house that they are happy with and is big enough for their family.

The thought seems to be that if you’re making a little more money every year, by three years out you’ll be in a position to afford a bigger house. And everyone knows assumes that buying is more cost-effective than renting — as long as you’re paying down the principal on your mortgage, you’re going to come out ahead.

But with an upgrade cycle of about three years, you’re actually losing money.

The Five Year Rule

When you purchase a house, the general rule is that you want to be sure to be in the same location for at least five years. Otherwise, financially, you’re probably going to take a hit.

The first hit is your closing costs. Every time you go through closing — buying and selling — money hits the table. Depending on where your house happens to be, the buyers and sellers pay different amounts, but everyone pays something. We can easily be talking about thousands of dollars and limiting how often you have to pay out that kind of money is always a good idea.

But you take a second hit when you look at your mortgage statement to see exactly where those monthly checks you send in are going. The way mortgages are structured, you pay much more interest in the first few years that you own a house. Usually, it isn’t until you’re about five years into paying down that mortgage that you’ve made enough progress on the principal that the math actually works out that you’ve gotten a better deal than paying that monthly check to a landlord.

David’s Note: When you take out a mortgage, you are paying an interest rate on what you owe. So, in the first year, when the principal is highest, the interests you need to pay is the highest as well. However, since the monthly payment is the same through the loan (at least with a fixed rate mortgage anyway), more of the payment will be used to cover the interests payments, and therefore less goes towards the principal. As your principle goes down, your interests payments will go down, leaving more of your check to go towards the principal.

If you can wait at least five years to move, you’re in a better position to be ahead of the game.

Defeating the Five Year Rule

Five years is a generality. If you add in a couple of other factors, you can make buying a house that you don’t plan to stay in long-term a better choice.

The biggest factor is how much you’re going to pay on your mortgage. A lot of people buy as much house as they can afford, according to what lenders offer them. That’s usually the upper end of what you can financially manage. If, however, you buy at the lower end of what you can afford and make extra payments, you can pay off a bigger chunk of the principal. You need to run the numbers for the specific house you’ve got your eye on, but you can often come out ahead.

You may also consider buying a house that you won’t stay in for five years — but that you also won’t turn around and sell. It’s not out of question to purchase a home, start paying it down and fixing it up so that you can turn around and rent it out. You do need to be careful that you’re choosing a house that you can afford even if you don’t have a renter, on top of a mortgage for your next home. There are plenty of other arrangements that can work out similarly, but you need to study up on real estate before making such a choice.

But if you’re buying just on the basis of what the bank says that you can afford and you don’t want to think about it, stay in the rentals until you’re ready to spend at least five years in the same home.

David’s Note: Here is a quick and dirty formula that you can use to help you figure out whether it’s better to buy or sell that works with any duration of ownership. Try to determine the answer to: Seller and Buyer Agent Fees When You Sell + Purchase Price + Maintenance Cost for the Time of Occupancy + Interest Paid on Mortgage + Investment Gains from Your Down Payment + Taxes Paid Such as Property Tax + Closing Costs – Selling Price. This number could come out negative or positive, but if it’s lower than the rents you would have paid during the same time frame, then you would be better off buying. If the number is higher, meaning that the selling price wasn’t high enough to cover all those costs, then renting would be the more cost effective choice.

Of course, the big question mark is your selling price, which you sort of have to estimate. Also, note the obvious that the higher the selling price, the more buying makes sense. The five year rule is actually pretty arbitrary, but if you assume that the long term trend of real estate is up, do you see why buying makes sense the longer you stay in the home?

http://moneyning.com/housing/the-five-year-rule-for-buying-a-house/