Original Investment Objectives regardless of the Market
...disciplined method of investing to achieve stated investment objectives.
Wednesday, 7 September 2011
Basic Investment Objectives
The options for investing our savings are continually increasing, yet every single investment vehicle can be easily categorized according to three fundamental characteristics - safety, income and growth - which also correspond to types of investor objectives. While it is possible for an investor to have more than one of these objectives, the success of one must come at the expense of others. Let's examine these three types of objectives, the investments that are used to achieve them and the ways in which investors can incorporate them in devising a strategy.
Safety
Perhaps there is truth to the axiom that there is no such thing as a completely safe and secure investment. Yet we can get close to ultimate safety for our investment funds through the purchase of government-issued securities in stable economic systems, or through the purchase of the highest quality corporate bonds issued by the economy's top companies. Such securities are arguably the best means of preserving principal while receiving a specified rate of return.
The safest investments are usually found in the money market and include such securities as Treasury bills (T-bills), certificates of deposit (CD), commercial paper or bankers' acceptance slips; or in the fixed income (bond) market in the form of municipal and other government bonds, and in corporate bonds. The securities listed above are ordered according to the typical spectrum of increasing risk and, in turn, increasing potential yield. To compensate for their higher risk, corporate bonds return a greater yield than T-bills. (For more insight on treasuries, read Buy Treasuries Directly From The Fed.)
It is important to realize that there's an enormous range of relative risk within the bond market. At one end are government and high-grade corporate bonds, which are considered some of the safest investments around; at the other end are junk bonds, which have a lowerinvestment grade and may have more risk than some of the more speculative stocks. In other words, it's incorrect to think that corporate bonds are always safe, but most instruments from the money market can be considered very safe.
IncomeThe safest investments are also the ones that are likely to have the lowest rate of income return, or yield. Investors must inevitably sacrifice a degree of safety if they want to increase their yields. This is the inverse relationship between safety and yield: as yield increases, safety generally goes down, and vice versa.
In order to increase their rate of investment return and take on risk above that of money market instruments or government bonds, investors may choose to purchase corporate bonds or preferred shares with lower investment ratings. Investment grade bonds rated at A or AA are slightly riskier than AAA bonds, but presumably also offer a higher income return than AAA bonds. Similarly, BBB rated bonds can be thought to carry medium risk but offer less potential income than junk bonds, which offer the highest potential bond yields available, but at the highest possible risk. Junk bonds are the most likely to default.
Most investors, even the most conservative-minded ones, want some level of income generation in their portfolios, even if it's just to keep up with the economy's rate of inflation. But maximizing income return can be an overarching principle for a portfolio, especially for individuals who require a fixed sum from their portfolio every month. A retired person who requires a certain amount of money every month is well served by holding reasonably safe assets that provide funds over and above other income-generating assets, such as pension plans, for example.
Growth of Capital
This discussion has thus far been concerned only with safety and yield as investing objectives, and has not considered the potential of other assets to provide a rate of return from an increase in value, often referred to as a capital gain. Capital gains are entirely different from yield in that they are only realized when the security is sold for a price that is higher than the price at which it was originally purchased. Selling at a lower price is referred to as a capital loss. Therefore, investors seeking capital gains are likely not those who need a fixed, ongoing source of investment returns from their portfolio, but rather those who seek the possibility of longer-term growth.
Growth of capital is most closely associated with the purchase of common stock, particularly growth securities, which offer low yields but considerable opportunity for increase in value. For this reason, common stock generally ranks among the most speculative of investments as their return depends on what will happen in an unpredictable future. Blue-chip stocks, by contrast, can potentially offer the best of all worlds by possessing reasonable safety, modest income and potential for growth in capital generated by long-term increases in corporate revenues and earnings as the company matures. Yet rarely is any common stock able to provide the near-absolute safety and income-generation of government bonds.
It is also important to note that capital gains offer potential tax advantages by virtue of their lower tax rate in most jurisdictions. Funds that are garnered through common stock offerings, for example, are often geared toward the growth plans of small companies, a process that is extremely important for the growth of the overall economy. In order to encourage investments in these areas, governments choose to tax capital gains at a lower rate than income. Such systems serve to encourage entrepreneurship and the founding of new businesses that help the economy grow.
Secondary Objectives
Tax Minimization
An investor may pursue certain investments in order to adopt tax minimization as part of his or her investment strategy. A highly-paid executive, for example, may want to seek investments with favorable tax treatment in order to lessen his or her overall income tax burden. Making contributions to an IRA or other tax-sheltered retirement plan, such as a 401(k), can be an effective tax minimization strategy. (For related reading, see Which Retirement Plan Is Best?)
Marketability / Liquidity
Many of the investments we have discussed are reasonably illiquid, which means they cannot be immediately sold and easily converted into cash. Achieving a degree of liquidity, however, requires the sacrifice of a certain level of income or potential for capital gains.
Common stock is often considered the most liquid of investments, since it can usually be sold within a day or two of the decision to sell. Bonds can also be fairly marketable, but some bonds are highly illiquid, or non-tradable, possessing a fixed term. Similarly, money market instruments may only be redeemable at the precise date at which the fixed term ends. If an investor seeks liquidity, money market assets and non-tradable bonds aren't likely to be held in his or her portfolio.
Conclusion
As we have seen from each of the five objectives discussed above, the advantages of one often comes at the expense of the benefits of another. If an investor desires growth, for instance, he or she must often sacrifice some income and safety. Therefore, most portfolios will be guided by one pre-eminent objective, with all other potential objectives occupying less significant weight in the overall scheme.
Choosing a single strategic objective and assigning weightings to all other possible objectives is a process that depends on such factors as the investor's temperament, his or her stage of life, marital status, family situation, and so forth. Out of the multitude of possibilities out there, each investor is sure to find an appropriate mix of investment opportunities. You need only be concerned with spending the appropriate amount of time and effort in finding, studying and deciding on the opportunities that match your objectives.
Posted: Sep 1, 2008 Safety
Perhaps there is truth to the axiom that there is no such thing as a completely safe and secure investment. Yet we can get close to ultimate safety for our investment funds through the purchase of government-issued securities in stable economic systems, or through the purchase of the highest quality corporate bonds issued by the economy's top companies. Such securities are arguably the best means of preserving principal while receiving a specified rate of return.
The safest investments are usually found in the money market and include such securities as Treasury bills (T-bills), certificates of deposit (CD), commercial paper or bankers' acceptance slips; or in the fixed income (bond) market in the form of municipal and other government bonds, and in corporate bonds. The securities listed above are ordered according to the typical spectrum of increasing risk and, in turn, increasing potential yield. To compensate for their higher risk, corporate bonds return a greater yield than T-bills. (For more insight on treasuries, read Buy Treasuries Directly From The Fed.)
It is important to realize that there's an enormous range of relative risk within the bond market. At one end are government and high-grade corporate bonds, which are considered some of the safest investments around; at the other end are junk bonds, which have a lowerinvestment grade and may have more risk than some of the more speculative stocks. In other words, it's incorrect to think that corporate bonds are always safe, but most instruments from the money market can be considered very safe.
IncomeThe safest investments are also the ones that are likely to have the lowest rate of income return, or yield. Investors must inevitably sacrifice a degree of safety if they want to increase their yields. This is the inverse relationship between safety and yield: as yield increases, safety generally goes down, and vice versa.
In order to increase their rate of investment return and take on risk above that of money market instruments or government bonds, investors may choose to purchase corporate bonds or preferred shares with lower investment ratings. Investment grade bonds rated at A or AA are slightly riskier than AAA bonds, but presumably also offer a higher income return than AAA bonds. Similarly, BBB rated bonds can be thought to carry medium risk but offer less potential income than junk bonds, which offer the highest potential bond yields available, but at the highest possible risk. Junk bonds are the most likely to default.
Most investors, even the most conservative-minded ones, want some level of income generation in their portfolios, even if it's just to keep up with the economy's rate of inflation. But maximizing income return can be an overarching principle for a portfolio, especially for individuals who require a fixed sum from their portfolio every month. A retired person who requires a certain amount of money every month is well served by holding reasonably safe assets that provide funds over and above other income-generating assets, such as pension plans, for example.
Growth of Capital
This discussion has thus far been concerned only with safety and yield as investing objectives, and has not considered the potential of other assets to provide a rate of return from an increase in value, often referred to as a capital gain. Capital gains are entirely different from yield in that they are only realized when the security is sold for a price that is higher than the price at which it was originally purchased. Selling at a lower price is referred to as a capital loss. Therefore, investors seeking capital gains are likely not those who need a fixed, ongoing source of investment returns from their portfolio, but rather those who seek the possibility of longer-term growth.
Growth of capital is most closely associated with the purchase of common stock, particularly growth securities, which offer low yields but considerable opportunity for increase in value. For this reason, common stock generally ranks among the most speculative of investments as their return depends on what will happen in an unpredictable future. Blue-chip stocks, by contrast, can potentially offer the best of all worlds by possessing reasonable safety, modest income and potential for growth in capital generated by long-term increases in corporate revenues and earnings as the company matures. Yet rarely is any common stock able to provide the near-absolute safety and income-generation of government bonds.
It is also important to note that capital gains offer potential tax advantages by virtue of their lower tax rate in most jurisdictions. Funds that are garnered through common stock offerings, for example, are often geared toward the growth plans of small companies, a process that is extremely important for the growth of the overall economy. In order to encourage investments in these areas, governments choose to tax capital gains at a lower rate than income. Such systems serve to encourage entrepreneurship and the founding of new businesses that help the economy grow.
Secondary Objectives
Tax Minimization
An investor may pursue certain investments in order to adopt tax minimization as part of his or her investment strategy. A highly-paid executive, for example, may want to seek investments with favorable tax treatment in order to lessen his or her overall income tax burden. Making contributions to an IRA or other tax-sheltered retirement plan, such as a 401(k), can be an effective tax minimization strategy. (For related reading, see Which Retirement Plan Is Best?)
Marketability / Liquidity
Many of the investments we have discussed are reasonably illiquid, which means they cannot be immediately sold and easily converted into cash. Achieving a degree of liquidity, however, requires the sacrifice of a certain level of income or potential for capital gains.
Common stock is often considered the most liquid of investments, since it can usually be sold within a day or two of the decision to sell. Bonds can also be fairly marketable, but some bonds are highly illiquid, or non-tradable, possessing a fixed term. Similarly, money market instruments may only be redeemable at the precise date at which the fixed term ends. If an investor seeks liquidity, money market assets and non-tradable bonds aren't likely to be held in his or her portfolio.
Conclusion
As we have seen from each of the five objectives discussed above, the advantages of one often comes at the expense of the benefits of another. If an investor desires growth, for instance, he or she must often sacrifice some income and safety. Therefore, most portfolios will be guided by one pre-eminent objective, with all other potential objectives occupying less significant weight in the overall scheme.
Choosing a single strategic objective and assigning weightings to all other possible objectives is a process that depends on such factors as the investor's temperament, his or her stage of life, marital status, family situation, and so forth. Out of the multitude of possibilities out there, each investor is sure to find an appropriate mix of investment opportunities. You need only be concerned with spending the appropriate amount of time and effort in finding, studying and deciding on the opportunities that match your objectives.
Read more: http://www.investopedia.com/articles/basics/04/032604.asp#ixzz1XDtcyAaU
Tuesday, 6 September 2011
Free Cash Flow Return on Invested Capital
Free Cash Flow Analysis of NetFlix
Mar 10, 2010
The following is a free cash flow analysis of NetFlix’s(NFLX) using FROIC and Price to Free Cash Flow.
FROIC for those who don’t know is = Free Cash Flow Return on Invested Capital.
Over the years I have tested out various ratios and have found very few that can compete with FROIC, in getting down to the real cash that a company is generating on Main Street .
Basically FROIC tells the investor how much free cash flow is actually generated as a percentage of the total capital that the company employs. To put it more simply, “How much free cash flow is generated for every $1 of capital that a company employs”
How does one calculate FROIC?
FROIC = Free Cash Flow/Total Capital
The way to determine Free Cash Flow is by taking a company's “Cash from Operations” and subtracting its “Capital expenditures” from it.
So in Netflix’s case its 2009 “Cash from Operations” was $325.1 million while its capital expenditures were only $45.9 million. Thus when we subtract $45.1 from $325.1 we get $280 million in free cash flow. We next take the company's $280 in free cash flow and divide it by its 58.416 million diluted shares outstanding and we get $4.79 a share in free cash flow.
If we then divide that number into the closing price of March 9, 2010 of $69.94, ($69.94/$4.79) we get a price to free cash flow of 14.6.
A price to free cash flow result of 14.6 is very attractive and I proved that in doing a backtest on price to free cash flow in the investment process”, using the DJIA 30 stocks from 1950-2007, and found that by only buying stocks that were selling for 15 times their price to free cash flow or less one would have substantially beat the DJIA 30 by a very large margin compared to buying the entire Index.
Now that we have seen what the free cash flow is for Netflix, let us now go and determine what its total capital employed is.
Basically Total Capital = Long Term Debt + Shareholders Equity
Taking just basic Total Capital is too easy in my view and I prefer is make it a little more difficult for a company to pass this test and add “other long term debt” to the equation. So for NetFlix we have the following for the year 2009.
Long Term Debt = $200 million
Other Long Term Debt = $54.2 million
Shareholders Equity = $199 million
When you add all those together you get $453.20 million for total capital employed.
Having done that we can now calculate FROIC as $280/$453.2 million or 61.78%.
What does this 61.78% mean?
For every $1 of total capital employed, NetFlix generates 62 cents in free cash flow.
I welcome everyone to go and try out FROIC on your own. In the end you will find that there are very few companies whose stock price trades for less than 15 times their free cash flow and generates 61.785 cents in free cash flow for every dollar of capital employed.
http://seekingalpha.com/instablog/498843-peter-mycroft-psaras/58154-free-cash-flow-analysis-of-netflix
A cash cow is a company with plenty of free cash flow.
A cash cow is a company with plenty of free cash flow - that is, the cash left over after the company meets its necessary yearly expenses.
Cash cows tend to be slow-growing, mature companies that dominate their industries. Their strong market share and competitive barriers to entry translate into recurring revenues, high profit margins and robust cash flow. Compared to younger companies - which tend to reinvest their profits more aggressively to fuel future growth - more mature businesses (with less room for growth) often generate more free cash since the initial capital outlay required to establish their businesses has already been made
Finally, a cash cow can often be a tempting takeover target. If a cash cow company seems like it can no longer use its excess cash to boost value for shareholders, it is likely to attract acquirers that can.
The Life of the Cash Cow: Free Cash Flow
To see if a company is worthy of cash-cow status, you of course need to calculate its free cash flow. To do so, you take cash from operations and subtract capital expenditures for the same period:
Free Cash Flow = Cash Flow from Operations - Capital Expenditure
The more free cash the company produces the better. A good rule of thumb is to look for companies with free cash flow that is more than 10% of sales revenue.
Cows That Stand Apart from the Herd: Price and Efficiency
A Low Cash Flow Multiple
Once you've spotted a cash cow stock, is it worth buying? For starters, look for companies with a low free cash flow multiple: simply, divide the company's stock price (more precisely, its market capitalization) by its underlying free cash flow. With that calculation, you can compare how much cash power the share price buys - or, conversely, you see how much investors pay for one dollar of free cash flow.
Free cash flow multiples are a good starting point for finding reasonably priced cash cows. But be careful.
High Efficiency Ratios
Besides looking for low free cash flow multiples, seek out attractive efficiency ratios. An attractive return on equity (ROE) can help you ensure that the company is reinvesting its cash at a high rate of return.
Return on Equity = (Annual Net Income / Average Shareholders' Equity)
To double check that the company is not using debt leverage to give ROE an artificial boost, you may also want to examine return on assets (ROA).
ROA = Return on Assets = (Annual Net Income / Total Assets)
An ROA higher than 5% is normally considered a solid performance for most companies.
Conclusion
Cash cows generate a heap of cash. That's certainly exciting, but not enough for investors. If they provide other attractions, such as high return on equity and return on assets, and if they trade at a reasonable price, then cash cows are worth a closer look.
http://www.investopedia.com/articles/stocks/05/cashcow.asp#axzz1X5QRWuqP
SUMMARY:
Cash cow is a company with plenty of free cash flow.
FCF/Total Sales Revenue > 10%
Low Price/FCF multiple
High ROE > 15%
ROA > 5%
Also read:
Free Cash Flow Return on Invested Capital.
Cash cows tend to be slow-growing, mature companies that dominate their industries. Their strong market share and competitive barriers to entry translate into recurring revenues, high profit margins and robust cash flow. Compared to younger companies - which tend to reinvest their profits more aggressively to fuel future growth - more mature businesses (with less room for growth) often generate more free cash since the initial capital outlay required to establish their businesses has already been made
Finally, a cash cow can often be a tempting takeover target. If a cash cow company seems like it can no longer use its excess cash to boost value for shareholders, it is likely to attract acquirers that can.
The Life of the Cash Cow: Free Cash Flow
To see if a company is worthy of cash-cow status, you of course need to calculate its free cash flow. To do so, you take cash from operations and subtract capital expenditures for the same period:
Free Cash Flow = Cash Flow from Operations - Capital Expenditure
The more free cash the company produces the better. A good rule of thumb is to look for companies with free cash flow that is more than 10% of sales revenue.
Cows That Stand Apart from the Herd: Price and Efficiency
A Low Cash Flow Multiple
Once you've spotted a cash cow stock, is it worth buying? For starters, look for companies with a low free cash flow multiple: simply, divide the company's stock price (more precisely, its market capitalization) by its underlying free cash flow. With that calculation, you can compare how much cash power the share price buys - or, conversely, you see how much investors pay for one dollar of free cash flow.
Free cash flow multiples are a good starting point for finding reasonably priced cash cows. But be careful.
High Efficiency Ratios
Besides looking for low free cash flow multiples, seek out attractive efficiency ratios. An attractive return on equity (ROE) can help you ensure that the company is reinvesting its cash at a high rate of return.
Return on Equity = (Annual Net Income / Average Shareholders' Equity)
To double check that the company is not using debt leverage to give ROE an artificial boost, you may also want to examine return on assets (ROA).
ROA = Return on Assets = (Annual Net Income / Total Assets)
An ROA higher than 5% is normally considered a solid performance for most companies.
Conclusion
Cash cows generate a heap of cash. That's certainly exciting, but not enough for investors. If they provide other attractions, such as high return on equity and return on assets, and if they trade at a reasonable price, then cash cows are worth a closer look.
http://www.investopedia.com/articles/stocks/05/cashcow.asp#axzz1X5QRWuqP
SUMMARY:
Cash cow is a company with plenty of free cash flow.
FCF/Total Sales Revenue > 10%
Low Price/FCF multiple
High ROE > 15%
ROA > 5%
Also read:
Free Cash Flow Return on Invested Capital.
Monday, 5 September 2011
How to avoid common pitfalls
Published: 2011/09/05
EVERYONE makes mistakes one time or another. As investors, we need to learn from our investment mistakes by recognising them and making the appropriate adjustments to our investing discipline.
Many people invest without learning adequately about the investment process or the different investment products and without considering what they really want to achieve over the long term. These kind of investors often react negatively to the short-term volatility of the markets, heed the advice of self-proclaimed gurus, enter the markets at an inopportune time, and subsequently end up with a mountain of losses.
The following are some of the common mistakes that investors make that can hurt the performance of their portfolio:
* Not preparing emergency funds before investing
Investing without any allocated emergency funds is like going water rafting without a life jacket. Before venturing out to the markets, investors are advised to set aside at least three to six months of expenses to take care of financial emergencies (such as a job loss) or unexpected cash flow problems. The fundamental purpose of this cash buffer is to provide both fiscal and emotional stability during times of personal economic upheaval.
* Market timing
Although markets may move in cycles, this does not necessarily mean that we can determine when to enter and exit the market at its lows and peaks respectively. Seasoned and successful investors like Warren Buffett do not use market-timing tools because they, more often than not, do not work. Thus, individual investors will save themselves from substantial losses if they stay away from trying to time the market. In fact, given their limited experience in understanding financial markets, individual investors would do better focusing on investing in unit trusts for the long run.
* Procrastination
Investors should not procrastinate when investing because an early start can make a world of difference in the potential returns as a longer time horizon will allow compounding interest to work effectively. Meanwhile, the longer you wait to get started with your investments, the more money you will have to put in to get the same returns as someone who started investing earlier.
* Taking too much or too little risk
As risk and returns go hand-in-hand, the amount of risk you take when investing can determine your potential returns. Nevertheless, there are those who take too much or too little risk. Investors who are high-risk takers often end up as speculators and often make investments without conducting prior research. However, investors who are too conservative may bear the risk of inflation eating into their purchasing power. Instead of merely relying on your risk tolerance to shape your investments, you should also take into consideration your financial goals and time horizon.
* Lack of diversification
Diversification is among the most fundamental principle of investing to a flourishing investment portfolio. Even so, many investors neglect to properly address this step by putting all of their eggs (investment) into one basket (asset). A well-diversified portfolio will adhere to all components of asset allocation - considering risk tolerance, investment capital available, investment time horizon and the current portfolio's asset class weightings.
* Becoming emotional in making investment decisions
Most investors allow emotions - especially greed and fear - to drive their investment decisions. For instance, emotional investors will be tempted to sell an investment when its price falls sharply. As a result of following their emotions and gut instincts, many investors end up "selling at the lows and buying at the highs" of the market. Instead, they should objectively evaluate the reasons for the price decline and see whether they are caused by broader market conditions.
* Lack of research
Investors should do their homework before investing. Successful investing requires on-going time and effort, which includes investors conducting their own investment research. Investors should also take note that past performance of an investment is not an indication of future performance.
* Panicking during bear markets
During major bear markets, it is common to see investors letting emotions get the better of them and in the process they sell off their investments in a panic frenzy. Investors who hold a long-term stance would not be affected by these gyrations of the stock markets. Instead, they might view market weakness as an opportunity to accumulate under-valued blue chip stocks at attractive prices.
Everyone make errors in their investments but what separates the winners from the losers are those who apply what they learn from their mistakes. The key to successful investing is not to avoid risk altogether but to recognise the risks you are taking.
To avoid unpleasant surprises, do your homework. Nothing beats reading the prospectuses and checking the long-term performance of the investments. As American fund manager Ronald W. Roge once said: "People rush into purchases even when they don't understand what they are buying. People do more research when they buy a refrigerator or a VCR than when they invest thousands in (the markets)."
Even millionaires make mistakes (and learn from them).
Benjamin Graham went bankrupt on three separate occasions as an investor. But each time, he documented and studied his failures, and he was eventually able to impart this investment wisdom to countless others, including Warren Buffett, who in turn learned from his own mistakes and failures.
Early in Buffett's career, he mistakenly believed he could save a failing textile mill. After being forced to liquidate its textile operations, Buffett learned to pay up for quality. He turned that failing company into a US$140 billion (RM417.2 billion) business.
Another great example is Pixar's John Lasseter. After he graduated from college, Disney hired him to captain its Jungle Cruise ride at Disneyland. Later, the company gave him a shot at being an animator, and he quickly recognised the ability of new computer technologies to revolutionise animation. However, Disney was so unimpressed with his first feature that Lasseter was fired on the spot. So, he went back to the drawing board.
After fine-tuning his processes, he moved on to the company that would become Pixar, where he has won two Academy Awards and churned out a string of blockbuster hits that include Toy Story, A Bug's Life, and Cars. Ironically, he and partner Steve Jobs later sold Pixar to Disney for US$7.4 billion (RM25.1 billion).
Moral of the story: Always learn from your mistakes.
For more information, please contact Public Mutual's Hotline at 03-6207 5000 or visit www.publicmutual.com.my.
Read more: How to avoid common pitfalls http://www.btimes.com.my/Current_News/BTIMES/articles/pbmutual4/Article/#ixzz1X5kEnY5h
EVERYONE makes mistakes one time or another. As investors, we need to learn from our investment mistakes by recognising them and making the appropriate adjustments to our investing discipline.
Many people invest without learning adequately about the investment process or the different investment products and without considering what they really want to achieve over the long term. These kind of investors often react negatively to the short-term volatility of the markets, heed the advice of self-proclaimed gurus, enter the markets at an inopportune time, and subsequently end up with a mountain of losses.
The following are some of the common mistakes that investors make that can hurt the performance of their portfolio:
* Not preparing emergency funds before investing
* Market timing
Although markets may move in cycles, this does not necessarily mean that we can determine when to enter and exit the market at its lows and peaks respectively. Seasoned and successful investors like Warren Buffett do not use market-timing tools because they, more often than not, do not work. Thus, individual investors will save themselves from substantial losses if they stay away from trying to time the market. In fact, given their limited experience in understanding financial markets, individual investors would do better focusing on investing in unit trusts for the long run.
* Procrastination
Investors should not procrastinate when investing because an early start can make a world of difference in the potential returns as a longer time horizon will allow compounding interest to work effectively. Meanwhile, the longer you wait to get started with your investments, the more money you will have to put in to get the same returns as someone who started investing earlier.
* Taking too much or too little risk
As risk and returns go hand-in-hand, the amount of risk you take when investing can determine your potential returns. Nevertheless, there are those who take too much or too little risk. Investors who are high-risk takers often end up as speculators and often make investments without conducting prior research. However, investors who are too conservative may bear the risk of inflation eating into their purchasing power. Instead of merely relying on your risk tolerance to shape your investments, you should also take into consideration your financial goals and time horizon.
* Lack of diversification
Diversification is among the most fundamental principle of investing to a flourishing investment portfolio. Even so, many investors neglect to properly address this step by putting all of their eggs (investment) into one basket (asset). A well-diversified portfolio will adhere to all components of asset allocation - considering risk tolerance, investment capital available, investment time horizon and the current portfolio's asset class weightings.
* Becoming emotional in making investment decisions
Most investors allow emotions - especially greed and fear - to drive their investment decisions. For instance, emotional investors will be tempted to sell an investment when its price falls sharply. As a result of following their emotions and gut instincts, many investors end up "selling at the lows and buying at the highs" of the market. Instead, they should objectively evaluate the reasons for the price decline and see whether they are caused by broader market conditions.
* Lack of research
Investors should do their homework before investing. Successful investing requires on-going time and effort, which includes investors conducting their own investment research. Investors should also take note that past performance of an investment is not an indication of future performance.
* Panicking during bear markets
During major bear markets, it is common to see investors letting emotions get the better of them and in the process they sell off their investments in a panic frenzy. Investors who hold a long-term stance would not be affected by these gyrations of the stock markets. Instead, they might view market weakness as an opportunity to accumulate under-valued blue chip stocks at attractive prices.
Everyone make errors in their investments but what separates the winners from the losers are those who apply what they learn from their mistakes. The key to successful investing is not to avoid risk altogether but to recognise the risks you are taking.
To avoid unpleasant surprises, do your homework. Nothing beats reading the prospectuses and checking the long-term performance of the investments. As American fund manager Ronald W. Roge once said: "People rush into purchases even when they don't understand what they are buying. People do more research when they buy a refrigerator or a VCR than when they invest thousands in (the markets)."
Even millionaires make mistakes (and learn from them).
Benjamin Graham went bankrupt on three separate occasions as an investor. But each time, he documented and studied his failures, and he was eventually able to impart this investment wisdom to countless others, including Warren Buffett, who in turn learned from his own mistakes and failures.
Early in Buffett's career, he mistakenly believed he could save a failing textile mill. After being forced to liquidate its textile operations, Buffett learned to pay up for quality. He turned that failing company into a US$140 billion (RM417.2 billion) business.
Another great example is Pixar's John Lasseter. After he graduated from college, Disney hired him to captain its Jungle Cruise ride at Disneyland. Later, the company gave him a shot at being an animator, and he quickly recognised the ability of new computer technologies to revolutionise animation. However, Disney was so unimpressed with his first feature that Lasseter was fired on the spot. So, he went back to the drawing board.
After fine-tuning his processes, he moved on to the company that would become Pixar, where he has won two Academy Awards and churned out a string of blockbuster hits that include Toy Story, A Bug's Life, and Cars. Ironically, he and partner Steve Jobs later sold Pixar to Disney for US$7.4 billion (RM25.1 billion).
Moral of the story: Always learn from your mistakes.
For more information, please contact Public Mutual's Hotline at 03-6207 5000 or visit www.publicmutual.com.my.
Read more: How to avoid common pitfalls http://www.btimes.com.my/Current_News/BTIMES/articles/pbmutual4/Article/#ixzz1X5kEnY5h
Hiding in Cash. Is It Time to Get Back Into the Markets?
by Walter Updegrave
Friday, September 2, 2011
My wife and I are 43 and have about $350,000 in retirement accounts. Over the last couple of years, I've moved the money between stock, bond and money-market funds. But since I'm nervous about the market, all of it is in money funds now. What's the best way to move back into the markets? — K.A., Bay City, Mich.
The answer to your question lies in an important investing lesson I think we can all draw from Hurricane Irene.
No, I'm not talking about the kind of knee-jerk lesson that's typically offered up: "Insurers will be raising premiums to pay for storm damage, so buy insurance stocks!" (Never mind that by the time you read the advice the stocks have probably already moved on that news.)
I'm referring to a deeper insight we can draw from the events leading up to and following the storm's onslaught that we can use to help improve our investing strategy for the long term — and, I hope, get you to stop shifting your savings around in a vain attempt to outsmart the market.
As you no doubt recall, in the days prior to Irene's arrival we experienced another storm of sorts — a drenching downpour of media coverage predicting devastation and chaos in the storm's wake.
But here's a question: How much of that coverage focused on possible destruction in inland areas in Vermont, New Hampshire and upstate New York, where swollen rivers and bloated streams have inflicted massive property damage and even resulted in loss of life?
The answer, of course, is practically none. News reports focused almost exclusively on coastal areas. Which makes sense, as those areas are most vulnerable to hurricanes and such.
So what in the name of Al Roker does this have to do with your question about when to move your retirement savings back into the markets? The answer is that, as with tropical storms, things don't always play out in the economy and the markets the way we expect.
As investors we may feel that we know what lies ahead and that we can use that knowledge to avoid losses or rack up gains. But that confidence is unwarranted, and acting on it can lead to investing decisions we may later regret.
Take the downgrading of U.S. debt by credit-rating firm Standard & Poor's last month. In the days and weeks leading up that unprecedented event, the consensus was that a downgrade would lead to higher interest rates as investors demanded a higher premium to hold Treasury securities that no longer held S&P's triple-A rating.
But did that happen? No. Far from shunning U.S. debt, investors flocked to it as a safe haven in a troubled world, driving yields down. So anyone who bet against Treasuries on the theory that the downgrade would devastate their value bet wrong.
And what about all the sturm und drang during the days of the debt-ceiling drama that the stock market was on the verge of falling apart? The market slid, but it's not exactly Armageddon. Besides, anyone who's patting himself on the back for getting out of the market in late July or early August and avoiding that decline also ought to ask himself if he's so smart, why didn't he get out in late April, when stock prices were at their most recent peak?
My point is that when it comes to investing, there are so many variables that determine the prices of stocks, bonds and other investments that it's virtually impossible not just to predict what might happen, but to know how investors will ultimately react to whatever does happen.
The more moves you make in the face of this uncertainty, the more chances you have to get it wrong, and do yourself financial harm. Which brings me to my advice for you, as well as for anyone else sitting in cash and wondering when to get back into the market: Stop the guessing game, already.
Rather than try to dart in and out of different asset classes, you're better off investing in a broadly diversified retirement portfolio of stocks and bonds that matches your time horizon (how long the money will remain invested) and your tolerance for risk (how large a loss you can take before you panic and sell). And then stick with that portfolio through the markets ups and downs.
At age 43, you've still got a lot of years of investing ahead of you and plenty of time to recover from market setbacks. So you can still afford to invest largely for growth. Generally, someone your age might have 70% to 80% or so of their retirement savings in stock funds, and the rest in bonds.
As you age, you can gradually shift more into bonds to protect your capital, perhaps ending up somewhere around 50% stocks - 50% bonds at retirement time. But that's just a general guideline. You'll want to adjust that blend to your own tastes.
For help in doing that, you can try different stock-bond combinations at Morningstar's Asset Allocator, a tool that can give you a sense of how different mixes might perform.
This approach won't immunize you from losses. But avoiding losses altogether shouldn't be your aim when investing retirement savings. The goal is to end up with a nest egg that will be large enough to support you once you call it a career.
And the best way to do that is to create a portfolio that can participate in stocks' growth over long periods of time while affording enough short-term protection from downturns so you don't abandon your strategy.
So I suggest you settle on a portfolio that's right for you and divvy up your savings accordingly (and do it as soon as possible, don't dollar-cost average your way to your chosen mix).
Or you can continue to do what you've been doing, and hop back and forth between cash, bonds, stocks or whatever — and hope the markets take the path you expect.
http://finance.yahoo.com/focus-retirement/article/113440/hiding-cash-get-back-into-markets-cnnmoney?mod=fidelity-managingwealth&cat=fidelity_2010_managing_wealth
Friday, September 2, 2011
My wife and I are 43 and have about $350,000 in retirement accounts. Over the last couple of years, I've moved the money between stock, bond and money-market funds. But since I'm nervous about the market, all of it is in money funds now. What's the best way to move back into the markets? — K.A., Bay City, Mich.
The answer to your question lies in an important investing lesson I think we can all draw from Hurricane Irene.
No, I'm not talking about the kind of knee-jerk lesson that's typically offered up: "Insurers will be raising premiums to pay for storm damage, so buy insurance stocks!" (Never mind that by the time you read the advice the stocks have probably already moved on that news.)
I'm referring to a deeper insight we can draw from the events leading up to and following the storm's onslaught that we can use to help improve our investing strategy for the long term — and, I hope, get you to stop shifting your savings around in a vain attempt to outsmart the market.
As you no doubt recall, in the days prior to Irene's arrival we experienced another storm of sorts — a drenching downpour of media coverage predicting devastation and chaos in the storm's wake.
But here's a question: How much of that coverage focused on possible destruction in inland areas in Vermont, New Hampshire and upstate New York, where swollen rivers and bloated streams have inflicted massive property damage and even resulted in loss of life?
The answer, of course, is practically none. News reports focused almost exclusively on coastal areas. Which makes sense, as those areas are most vulnerable to hurricanes and such.
So what in the name of Al Roker does this have to do with your question about when to move your retirement savings back into the markets? The answer is that, as with tropical storms, things don't always play out in the economy and the markets the way we expect.
As investors we may feel that we know what lies ahead and that we can use that knowledge to avoid losses or rack up gains. But that confidence is unwarranted, and acting on it can lead to investing decisions we may later regret.
Take the downgrading of U.S. debt by credit-rating firm Standard & Poor's last month. In the days and weeks leading up that unprecedented event, the consensus was that a downgrade would lead to higher interest rates as investors demanded a higher premium to hold Treasury securities that no longer held S&P's triple-A rating.
But did that happen? No. Far from shunning U.S. debt, investors flocked to it as a safe haven in a troubled world, driving yields down. So anyone who bet against Treasuries on the theory that the downgrade would devastate their value bet wrong.
And what about all the sturm und drang during the days of the debt-ceiling drama that the stock market was on the verge of falling apart? The market slid, but it's not exactly Armageddon. Besides, anyone who's patting himself on the back for getting out of the market in late July or early August and avoiding that decline also ought to ask himself if he's so smart, why didn't he get out in late April, when stock prices were at their most recent peak?
My point is that when it comes to investing, there are so many variables that determine the prices of stocks, bonds and other investments that it's virtually impossible not just to predict what might happen, but to know how investors will ultimately react to whatever does happen.
The more moves you make in the face of this uncertainty, the more chances you have to get it wrong, and do yourself financial harm. Which brings me to my advice for you, as well as for anyone else sitting in cash and wondering when to get back into the market: Stop the guessing game, already.
Rather than try to dart in and out of different asset classes, you're better off investing in a broadly diversified retirement portfolio of stocks and bonds that matches your time horizon (how long the money will remain invested) and your tolerance for risk (how large a loss you can take before you panic and sell). And then stick with that portfolio through the markets ups and downs.
At age 43, you've still got a lot of years of investing ahead of you and plenty of time to recover from market setbacks. So you can still afford to invest largely for growth. Generally, someone your age might have 70% to 80% or so of their retirement savings in stock funds, and the rest in bonds.
As you age, you can gradually shift more into bonds to protect your capital, perhaps ending up somewhere around 50% stocks - 50% bonds at retirement time. But that's just a general guideline. You'll want to adjust that blend to your own tastes.
For help in doing that, you can try different stock-bond combinations at Morningstar's Asset Allocator, a tool that can give you a sense of how different mixes might perform.
This approach won't immunize you from losses. But avoiding losses altogether shouldn't be your aim when investing retirement savings. The goal is to end up with a nest egg that will be large enough to support you once you call it a career.
And the best way to do that is to create a portfolio that can participate in stocks' growth over long periods of time while affording enough short-term protection from downturns so you don't abandon your strategy.
So I suggest you settle on a portfolio that's right for you and divvy up your savings accordingly (and do it as soon as possible, don't dollar-cost average your way to your chosen mix).
Or you can continue to do what you've been doing, and hop back and forth between cash, bonds, stocks or whatever — and hope the markets take the path you expect.
http://finance.yahoo.com/focus-retirement/article/113440/hiding-cash-get-back-into-markets-cnnmoney?mod=fidelity-managingwealth&cat=fidelity_2010_managing_wealth
Spotting Cash Cows
Spotting Cash Cows
Posted: Aug 26, 2005
Posted: Aug 26, 2005
Cash cows are just what the name implies - companies that can be milked for further ongoing profits with little expense. Producing plenty of cash, these companies can reinvest in new systems and plants, pay for acquisitions and support themselves when the economy slows. They have the capacity to increase their dividend or reinvest that cash to boost returns further. Either way, shareholders stand to benefit. To help you spot cash cows that are worthy of your investment, we look at what sets these companies apart and offer some guidelines for assessing them.
The Cash Cow: An Overview
A cash cow is a company with plenty of free cash flow - that is, the cash left over after the company meets its necessary yearly expenses. Smart investors really like this kind of company because it can fund its own growth and value. A cash cow can reinvest free cash to grow its own business - thereby boosting shareholder returns - without sacrificing profitability or turning to shareholders for additional capital. Alternatively, it can return the free cash flow to shareholders through bigger dividend payments or share buybacks.
Cash cows tend to be slow-growing, mature companies that dominate their industries. Their strong market share and competitive barriers to entry translate into recurring revenues, high profit margins and robust cash flow. Compared to younger companies - which tend to reinvest their profits more aggressively to fuel future growth - more mature businesses (with less room for growth) often generate more free cash since the initial capital outlay required to establish their businesses has already been made.
Finally, a cash cow can often be a tempting takeover target. If a cash cow company seems like it can no longer use its excess cash to boost value for shareholders, it is likely to attract acquirers that can. (For more on what this means, see The Basics of Mergers and Acquisitions.)
The Life of the Cash Cow: Free Cash Flow
To see if a company is worthy of cash-cow status, you of course need to calculate its free cash flow. To do so, you take cash from operations and subtract capital expenditures for the same period:
Free Cash Flow = Cash Flow from Operations - Capital Expenditure
(For more on calculating free cash flow, see Free Cash Flow: Free, But Not Always Easy.)
The more free cash the company produces the better. A good rule of thumb is to look for companies with free cash flow that is more than 10% of sales revenue.
Consumer products giant Procter & Gamble (PG), for example, fits the cash cow mold. Procter & Gamble's brand name power and its dominant market share have given it its cash-generating power. Take a look at the company's Form 10-K 2004 Annual Report's (filed on Sept 9, 2004) Consolidated Statement of Cash Flows (scroll to sec. 39, p.166). You'll see that the company consistently generated high free cash flows - these even exceeded its reported net income: at end-2004, Procter & Gamble's free cash flow was $7.34 billion (operating cash flow - capital expenditure = $9.36B - $2.02B), or more than 14% of its $51.4 billion sales revenue (net sales on the Consolidated Statements of Earnings). In 2004, PG produced real cash for its shareholders - a lot of it.
Cows That Stand Apart from the Herd: Price and Efficiency
A Low Cash Flow Multiple
Once you've spotted a cash cow stock, is it worth buying? For starters, look for companies with a low free cash flow multiple: simply, divide the company's stock price (more precisely, its market capitalization) by its underlying free cash flow. With that calculation, you can compare how much cash power the share price buys - or, conversely, you see how much investors pay for one dollar of free cash flow.
To find PG's free cash flow multiple, we'll look at its stock price on the day it filed its 2004 10-K form, which was Sept 9, 2004. On that day, the stock closed at $56.09 (see PG's trading quote that day on Investopedia's stock research resource). With about 2.5 billion shares outstanding, Procter & Gamble's market value was about $140.2 billion.
So, at the financial year-end 2004, PG was trading at about 19 times its current free cash flow ($140.2 billion market value divided by 2004 free cash flow of $7.34 billion). By comparison, direct competitor Unilever traded at about 25 times free cash flow, suggesting that Procter & Gamble was reasonably priced.
Free cash flow multiples are a good starting point for finding reasonably priced cash cows. But be careful: sometimes a company will have a temporarily low free cash flow multiple because its share price has plummeted due to a serious problem. Or its cash flow may be erratic and unpredictable. So, take care with very small companies and those with wild performance swings.
High Efficiency Ratios
Besides looking for low free cash flow multiples, seek out attractive efficiency ratios. An attractive return on equity (ROE) can help you ensure that the company is reinvesting its cash at a high rate of return.
Return on Equity = (Annual Net Income / Average Shareholders' Equity)
You can find net income (also known as "net earnings") on the income statement (also known as "statement of earnings"), and shareholders' equity appears near the bottom of a company's balance sheet.
On this front, PG performed exceedingly well. The company's 2004 net earnings was $6.5 billion - see the Consolidated Statement of Earnings p.35 (p.161 in the PDF) on the 10-K - and its shareholders' equity was $17.28 billion - see the Consolidated Balance Sheets p.37 (p.163 in the PDF). That means ROE amounted to nearly 38%. In other words, Procter & Gamble was able to milk 38 cents worth of profits from each dollar invested by shareholders. (For more on evaluating this metric, see Keep Your Eyes On The ROE.)
To double check that the company is not using debt leverage to give ROE an artificial boost, you may also want to examine return on assets (ROA). (For more on this topic, see Understanding The Subtleties Of ROA Vs ROE.)
ROA = Return on Assets = (Annual Net Income / Total Assets)
Turning again to Procter & Gamble's 2004 Consolidated Statement of Earnings and Balance Sheets, you'll see that the company delivered an impressive 11.4% ROA (net earnings / total assets = $6.5B / $57.05B). An ROA higher than 5% is normally considered a solid performance for most companies. Procter & Gamble's ROA should have reassured investors that it was doing a good job of reinvesting its free cash flow.
Conclusion
Cash cows generate a heap of cash. That's certainly exciting, but not enough for investors. If they provide other attractions, such as high return on equity and return on assets, and if they trade at a reasonable price, then cash cows are worth a closer look.
by Ben McClure
Ben McClure is a long-time contributor to Investopedia.com.
Read more: http://www.investopedia.com/articles/stocks/05/cashcow.asp#ixzz1X5R2fwXM
The Cash Cow: An Overview
A cash cow is a company with plenty of free cash flow - that is, the cash left over after the company meets its necessary yearly expenses. Smart investors really like this kind of company because it can fund its own growth and value. A cash cow can reinvest free cash to grow its own business - thereby boosting shareholder returns - without sacrificing profitability or turning to shareholders for additional capital. Alternatively, it can return the free cash flow to shareholders through bigger dividend payments or share buybacks.
Cash cows tend to be slow-growing, mature companies that dominate their industries. Their strong market share and competitive barriers to entry translate into recurring revenues, high profit margins and robust cash flow. Compared to younger companies - which tend to reinvest their profits more aggressively to fuel future growth - more mature businesses (with less room for growth) often generate more free cash since the initial capital outlay required to establish their businesses has already been made.
Finally, a cash cow can often be a tempting takeover target. If a cash cow company seems like it can no longer use its excess cash to boost value for shareholders, it is likely to attract acquirers that can. (For more on what this means, see The Basics of Mergers and Acquisitions.)
The Life of the Cash Cow: Free Cash Flow
To see if a company is worthy of cash-cow status, you of course need to calculate its free cash flow. To do so, you take cash from operations and subtract capital expenditures for the same period:
Free Cash Flow = Cash Flow from Operations - Capital Expenditure
(For more on calculating free cash flow, see Free Cash Flow: Free, But Not Always Easy.)
The more free cash the company produces the better. A good rule of thumb is to look for companies with free cash flow that is more than 10% of sales revenue.
Consumer products giant Procter & Gamble (PG), for example, fits the cash cow mold. Procter & Gamble's brand name power and its dominant market share have given it its cash-generating power. Take a look at the company's Form 10-K 2004 Annual Report's (filed on Sept 9, 2004) Consolidated Statement of Cash Flows (scroll to sec. 39, p.166). You'll see that the company consistently generated high free cash flows - these even exceeded its reported net income: at end-2004, Procter & Gamble's free cash flow was $7.34 billion (operating cash flow - capital expenditure = $9.36B - $2.02B), or more than 14% of its $51.4 billion sales revenue (net sales on the Consolidated Statements of Earnings). In 2004, PG produced real cash for its shareholders - a lot of it.
Cows That Stand Apart from the Herd: Price and Efficiency
A Low Cash Flow Multiple
Once you've spotted a cash cow stock, is it worth buying? For starters, look for companies with a low free cash flow multiple: simply, divide the company's stock price (more precisely, its market capitalization) by its underlying free cash flow. With that calculation, you can compare how much cash power the share price buys - or, conversely, you see how much investors pay for one dollar of free cash flow.
To find PG's free cash flow multiple, we'll look at its stock price on the day it filed its 2004 10-K form, which was Sept 9, 2004. On that day, the stock closed at $56.09 (see PG's trading quote that day on Investopedia's stock research resource). With about 2.5 billion shares outstanding, Procter & Gamble's market value was about $140.2 billion.
So, at the financial year-end 2004, PG was trading at about 19 times its current free cash flow ($140.2 billion market value divided by 2004 free cash flow of $7.34 billion). By comparison, direct competitor Unilever traded at about 25 times free cash flow, suggesting that Procter & Gamble was reasonably priced.
Free cash flow multiples are a good starting point for finding reasonably priced cash cows. But be careful: sometimes a company will have a temporarily low free cash flow multiple because its share price has plummeted due to a serious problem. Or its cash flow may be erratic and unpredictable. So, take care with very small companies and those with wild performance swings.
High Efficiency Ratios
Besides looking for low free cash flow multiples, seek out attractive efficiency ratios. An attractive return on equity (ROE) can help you ensure that the company is reinvesting its cash at a high rate of return.
Return on Equity = (Annual Net Income / Average Shareholders' Equity)
You can find net income (also known as "net earnings") on the income statement (also known as "statement of earnings"), and shareholders' equity appears near the bottom of a company's balance sheet.
On this front, PG performed exceedingly well. The company's 2004 net earnings was $6.5 billion - see the Consolidated Statement of Earnings p.35 (p.161 in the PDF) on the 10-K - and its shareholders' equity was $17.28 billion - see the Consolidated Balance Sheets p.37 (p.163 in the PDF). That means ROE amounted to nearly 38%. In other words, Procter & Gamble was able to milk 38 cents worth of profits from each dollar invested by shareholders. (For more on evaluating this metric, see Keep Your Eyes On The ROE.)
To double check that the company is not using debt leverage to give ROE an artificial boost, you may also want to examine return on assets (ROA). (For more on this topic, see Understanding The Subtleties Of ROA Vs ROE.)
ROA = Return on Assets = (Annual Net Income / Total Assets)
Turning again to Procter & Gamble's 2004 Consolidated Statement of Earnings and Balance Sheets, you'll see that the company delivered an impressive 11.4% ROA (net earnings / total assets = $6.5B / $57.05B). An ROA higher than 5% is normally considered a solid performance for most companies. Procter & Gamble's ROA should have reassured investors that it was doing a good job of reinvesting its free cash flow.
Conclusion
Cash cows generate a heap of cash. That's certainly exciting, but not enough for investors. If they provide other attractions, such as high return on equity and return on assets, and if they trade at a reasonable price, then cash cows are worth a closer look.
by Ben McClure
Ben McClure is a long-time contributor to Investopedia.com.
Read more: http://www.investopedia.com/articles/stocks/05/cashcow.asp#ixzz1X5R2fwXM
Product portfolio - the Boston Matrix (or Boston Box)
Introduction
The business portfolio is the collection of businesses and products that make up the company. The best business portfolio is one that fits the company's strengths and helps exploit the most attractive opportunities.
The company must:
(1) Analyse its current business portfolio and decide which businesses should receive more or less investment, and
(2) Develop growth strategies for adding new products and businesses to the portfolio, whilst at the same time deciding when products and businesses should no longer be retained.
Methods of Portfolio Planning
The two best-known portfolio planning methods are from the Boston Consulting Group (the subject of this revision note) and by General Electric/Shell. In each method, the first step is to identify the various Strategic Business Units ("SBU's") in a company portfolio. An SBU is a unit of the company that has a separate mission and objectives and that can be planned independently from the other businesses. An SBU can be a company division, a product line or even individual brands - it all depends on how the company is organised.
The Boston Consulting Group Box ("BCG Box")
Using the BCG Box (an example is illustrated above) a company classifies all its SBU's according to two dimensions:
On the horizontal axis: relative market share - this serves as a measure of SBU strength in the market
On the vertical axis: market growth rate - this provides a measure of market attractiveness
By dividing the matrix into four areas, four types of SBU can be distinguished:
Stars - Stars are high growth businesses or products competing in markets where they are relatively strong compared with the competition. Often they need heavy investment to sustain their growth. Eventually their growth will slow and, assuming they maintain their relative market share, will become cash cows.
Cash Cows - Cash cows are low-growth businesses or products with a relatively high market share. These are mature, successful businesses with relatively little need for investment. They need to be managed for continued profit - so that they continue to generate the strong cash flows that the company needs for its Stars.
Question marks - Question marks are businesses or products with low market share but which operate in higher growth markets. This suggests that they have potential, but may require substantial investment in order to grow market share at the expense of more powerful competitors. Management have to think hard about "question marks" - which ones should they invest in? Which ones should they allow to fail or shrink?
Dogs - Unsurprisingly, the term "dogs" refers to businesses or products that have low relative share in unattractive, low-growth markets. Dogs may generate enough cash to break-even, but they are rarely, if ever, worth investing in.
Using the BCG Box to determine strategy
Once a company has classified its SBU's, it must decide what to do with them. In the diagram above, the company has one large cash cow (the size of the circle is proportional to the SBU's sales), a large dog and two, smaller stars and question marks.
Conventional strategic thinking suggests there are four possible strategies for each SBU:
(1) Build Share: here the company can invest to increase market share (for example turning a "question mark" into a star)
(2) Hold: here the company invests just enough to keep the SBU in its present position
(3) Harvest: here the company reduces the amount of investment in order to maximise the short-term cash flows and profits from the SBU. This may have the effect of turning Stars into Cash Cows.
(4) Divest: the company can divest the SBU by phasing it out or selling it - in order to use the resources elsewhere (e.g. investing in the more promising "question marks").
Sunday, 4 September 2011
How to derive the intrinsic value of an asset?
1. How to derive the intrinsic value of an asset?
Discounted cash flow DCF analysis can be used to value any asset, including stocks, bonds and real estate.
The present value PV of an asset is the discounted value of all its future cash flows.
This PV is also the intrinsic value of the asset.
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2. What are the steps in DCF analysis to derive intrinsic value of a stock?
DCF analysis is predicated on the premise that a share of stock must be worth the present value of all the future cash flows it is expected to generate for the investors.
This begins by estimating what those future cash flows will be. There is tremendous potential for error here.
Once the projected cash flows are estimated, they have to be discounted back to the present in order to determine what they are worth in current dollars.
The discount rate itself is a function of the general level of interest rates in the economy and the risk of an investment.
Those who are willing to apply themselves and learn how to conduct a proper DCF analysis give themselves a distinct advantage over those who do not want to bother to learn the technique.
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3. What cash flows projections are used in a DCF analysis to calculate intrinsic value of a stock?
There is more to cash flows than dividends. The cash flows do not actually have to be paid out to the investors to be included in a DCF analysis.
The shareholders have rights to the cash flows whether or not they actually receive them. These cash flow might be reinvested in the company, but technically they belong to the shareholders. Therefore, a proper DCF analysis must include all the cash flows, whether they are paid out to investors or retained within the company and reinvested.
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4. Why is the DCF analysis the preferred method Buffett uses to calculate the intrinsic values of his stocks?
Conducting a proper DCF analysis is as much art as it is science.
However, Buffett relies on this methodology because he knows that it is the only theoretically correct way to determine what a stock is worth.
The ability to make good projections is what distinguishes Buffett from other investors. Buffett excels at this game.
Buffett finds undervalued stocks using the DCF approach. Fortunately, conducting a DCF analysis is not easy. It is also one of Buffett's favorite ways to spot undervalued stocks.
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5. What is the difference between value stocks (low price multiple e.g.low PE, low P/B, low P/CF, or P/S) and undervalued stocks?
Buffett may have a general preference for value stocks over growth stocks, but only because value stocks are more likely than growth stocks to be undervalued. It would really be more accurate to call Buffett an "undervalued" investor.
The point is that when he says he likes to buy cheap stocks, he is not talking about price multiples. Instead, he is talking about discounting cash flows to find stocks with intrinsic values that are greater than what he would ahve to pay for them in the market.
Thus, Buffett is not really looking to buy cheap stocks at all. Instead, he is looking to buy stocks cheap.
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Buffett likes to control risk. He does this primarily by avoiding companies if he thinks there is too much uncertainty about their future cash flows.
Furthermore, because he believes there is little risk in buying companies that have predictable cash flows, he feels comfortable using the so-called risk-free rate to discount their projected cash flows. More specifically, he starts with the yield on U.S. Treasury bonds and makes some adjustments to it.
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A more conservative approach would argue for the use of a higher rate - in particular, one that properly reflects the stock's market-related risk. Buffett believes he does not need to account for risk in the discount rate since he consciously avoids stocks that he considers too risky.
Analysts and academics have criticized Buffett for this. They say that by using a discount rate that does not properly reflect risk, he is more likely to erroneously conclude that an overvalued stock is undervalued. Furthermore, by ignoring companies whose cash flows are difficult to understand, he is likely to miss out on great investment opportunities. Buffett stands guilty as charged, yet his track record speaks for itself.
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10 Essential Questions to Ask When Deciding What Multiple to Pay For a Stock
Buffett has correctly pointed out that the correct way to value a business is to calculate the discounted value of all its future cash flows. The concept is simple. The application is not.
For many businesses, it is difficult to calculate this with a level of precision that has much utility.
Some businesses are sufficiently predictable that a careful business analyst can make a reasonable and useful calculation of its DCF, or what Buffett calls its intrinsic value.
Also, sometimes in periods of extreme dislocation, a business will sell at such a depressed price that you can reasonably conclude that the market price is below intrinsic value, even if the range of possible DCFs is large.
The multiple at which a stock trades is nothing more than a shorthand proxy for its DCF.
In Buffett’s 1991 letter to shareholders, he concluded that, assuming a discount rate of 10%, a business earning $1 million of free-cash and with long-term growth prospects of 6% would be worth $25 million or 25 times earnings.
A no-growth business also earning $1 million would be worth about 10 times earnings.
Business 1: $1 million / (10%-6%) = $25 million
Business 2: $ 1 million / (10%) = $10 million
As a practical matter, what types of things should you be thinking about when deciding if you are dealing with a company that deserves a multiple of 25 times earnings versus one that only deserves a multiple of ten times earnings. There are many factors to consider.
Venture capitalist Bill Gurley has written an excellent list of characteristics to consider when evaluating a company and determining what multiple to use when valuing its earnings.
You should carefully think about each of these and add them to your checklists for evaluating a business.
I’ve put Gurley’s characteristics in the form of a question.
1. Does the business have a sustainable competitive advantage (Buffett’s moat)?
2. Does the business benefit from any network effects?
3. Are the business’s revenue and earning visible and predictable?
4. Are customers locked in? Are there high switching costs?
5. Are gross margins high?
6. Is marginal profitability expected to increase or decline?
7. Is a material part of sales concentrated in a few powerful customers?
8. Is the business dependent on one or more major partners?
9. Is the business growing organically or is heavy marketing spending required for growth?
10. How fast and how much is the business expected to grow?
Written by Greg Speicher
Discounted cash flow DCF analysis can be used to value any asset, including stocks, bonds and real estate.
The present value PV of an asset is the discounted value of all its future cash flows.
This PV is also the intrinsic value of the asset.
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2. What are the steps in DCF analysis to derive intrinsic value of a stock?
DCF analysis is predicated on the premise that a share of stock must be worth the present value of all the future cash flows it is expected to generate for the investors.
This begins by estimating what those future cash flows will be. There is tremendous potential for error here.
Once the projected cash flows are estimated, they have to be discounted back to the present in order to determine what they are worth in current dollars.
The discount rate itself is a function of the general level of interest rates in the economy and the risk of an investment.
Those who are willing to apply themselves and learn how to conduct a proper DCF analysis give themselves a distinct advantage over those who do not want to bother to learn the technique.
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3. What cash flows projections are used in a DCF analysis to calculate intrinsic value of a stock?
There is more to cash flows than dividends. The cash flows do not actually have to be paid out to the investors to be included in a DCF analysis.
The shareholders have rights to the cash flows whether or not they actually receive them. These cash flow might be reinvested in the company, but technically they belong to the shareholders. Therefore, a proper DCF analysis must include all the cash flows, whether they are paid out to investors or retained within the company and reinvested.
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4. Why is the DCF analysis the preferred method Buffett uses to calculate the intrinsic values of his stocks?
Conducting a proper DCF analysis is as much art as it is science.
However, Buffett relies on this methodology because he knows that it is the only theoretically correct way to determine what a stock is worth.
The ability to make good projections is what distinguishes Buffett from other investors. Buffett excels at this game.
Buffett finds undervalued stocks using the DCF approach. Fortunately, conducting a DCF analysis is not easy. It is also one of Buffett's favorite ways to spot undervalued stocks.
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5. What is the difference between value stocks (low price multiple e.g.low PE, low P/B, low P/CF, or P/S) and undervalued stocks?
Buffett may have a general preference for value stocks over growth stocks, but only because value stocks are more likely than growth stocks to be undervalued. It would really be more accurate to call Buffett an "undervalued" investor.
The point is that when he says he likes to buy cheap stocks, he is not talking about price multiples. Instead, he is talking about discounting cash flows to find stocks with intrinsic values that are greater than what he would ahve to pay for them in the market.
Thus, Buffett is not really looking to buy cheap stocks at all. Instead, he is looking to buy stocks cheap.
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Buffett likes to control risk. He does this primarily by avoiding companies if he thinks there is too much uncertainty about their future cash flows.
Furthermore, because he believes there is little risk in buying companies that have predictable cash flows, he feels comfortable using the so-called risk-free rate to discount their projected cash flows. More specifically, he starts with the yield on U.S. Treasury bonds and makes some adjustments to it.
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A more conservative approach would argue for the use of a higher rate - in particular, one that properly reflects the stock's market-related risk. Buffett believes he does not need to account for risk in the discount rate since he consciously avoids stocks that he considers too risky.
Analysts and academics have criticized Buffett for this. They say that by using a discount rate that does not properly reflect risk, he is more likely to erroneously conclude that an overvalued stock is undervalued. Furthermore, by ignoring companies whose cash flows are difficult to understand, he is likely to miss out on great investment opportunities. Buffett stands guilty as charged, yet his track record speaks for itself.
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10 Essential Questions to Ask When Deciding What Multiple to Pay For a Stock
Buffett has correctly pointed out that the correct way to value a business is to calculate the discounted value of all its future cash flows. The concept is simple. The application is not.
For many businesses, it is difficult to calculate this with a level of precision that has much utility.
Some businesses are sufficiently predictable that a careful business analyst can make a reasonable and useful calculation of its DCF, or what Buffett calls its intrinsic value.
Also, sometimes in periods of extreme dislocation, a business will sell at such a depressed price that you can reasonably conclude that the market price is below intrinsic value, even if the range of possible DCFs is large.
The multiple at which a stock trades is nothing more than a shorthand proxy for its DCF.
In Buffett’s 1991 letter to shareholders, he concluded that, assuming a discount rate of 10%, a business earning $1 million of free-cash and with long-term growth prospects of 6% would be worth $25 million or 25 times earnings.
A no-growth business also earning $1 million would be worth about 10 times earnings.
Business 1: $1 million / (10%-6%) = $25 million
Business 2: $ 1 million / (10%) = $10 million
As a practical matter, what types of things should you be thinking about when deciding if you are dealing with a company that deserves a multiple of 25 times earnings versus one that only deserves a multiple of ten times earnings. There are many factors to consider.
Venture capitalist Bill Gurley has written an excellent list of characteristics to consider when evaluating a company and determining what multiple to use when valuing its earnings.
You should carefully think about each of these and add them to your checklists for evaluating a business.
I’ve put Gurley’s characteristics in the form of a question.
1. Does the business have a sustainable competitive advantage (Buffett’s moat)?
2. Does the business benefit from any network effects?
3. Are the business’s revenue and earning visible and predictable?
4. Are customers locked in? Are there high switching costs?
5. Are gross margins high?
6. Is marginal profitability expected to increase or decline?
7. Is a material part of sales concentrated in a few powerful customers?
8. Is the business dependent on one or more major partners?
9. Is the business growing organically or is heavy marketing spending required for growth?
10. How fast and how much is the business expected to grow?
Written by Greg Speicher
Intrinsic Value Basics
Theoretically and practically, the value received for owning a business or a security is the dollar return amount received over time from your investment.
That return may come
- as a single payment at the end of the ownership period for selling the stock or business,
- as payments at regular intervals during ownership, or
- (often) as a combination of the two.
But growth and time value of money have a major impact on the final valuation of equity investment returns. In fact, intrinsic valuation is a lot about assessing the effects of future growth on future returns and then assigning a present value to those returns.
The following "how" questions can guide the appraisal of business returns.
How much?
How soon?
How long?
How consistent?
How valuable?
How much?
How many dollars of return will the business produce, either to distribute to shareholders or to invest productively in the business?
Key drivers are profitability and growth rates - and the collection of business factors that drive that profitability and growth.
How soon?
Big payoffs are nice, but if you have to wait 30 years for them, they aren't as valuable. Remember the time value of money.
If two companies produce the same return, but one does it sooner, that company has more value because those dollars can be reinvested elsewhere sooner for more return.
How long?
Although future returns have less value than current returns, they do have substantial value; and 20, 30, or 50 years of those returns can't be ignored, particularly in a profitable, growing business.
How consistent?
A company producing slow, steady growth and return is usually more valuable than one that's all over the map.
A greater variability, or uncertainty, around projected returns calls for more conservative growth and/or discounting assumptions.
How valuable?
Finally, after assessing potential returns (how much, how soon, how long, how consistent), you must assign a current value to those returns.
That value is driven by the value of the investment money as it may be used elsewhere. A return may look attractive - until the investor realizes that he or she can achieve the same return with a bond or a less risky investment.
Valuing the returns involves discounting (using a discount rate) to bring future returns back to fair current value. The discount rate is your personal cost of capital - in this case, the rate of return you expect to deploy capital here versus elsewhere.
Sooner isn't always better.
A business producing quick, short-term bucks may not be more valuable than one that produces slow, steady growth.
The quick-bucker may be cyclical and go through years of diminished or even negative returns. Even though the quick-bucker produces a lot of value in the first few years, that may not be better than sustained growth and value produced later on by the slower, steadier comapny.
The quick-bucker may be relying on a technology or some other competitive advantage that could dissipate or dissapper altogether. Likewise, a company with a long-term and sustainable advantage, sometimes known as a "moat" keeping competitors away, may beat a company with very high but only short-term returns.
Bottom line:
It's a combination of how much, how soon, how long, and how consistent.
The tortoise often beats the hare.
Present value calculator
http://www.moneychimp.com/calculator/present_value_calculator.htm
Inputs
Future Value: $
Years:
Discount Rate: %
Results
Present Value: $
That return may come
- as a single payment at the end of the ownership period for selling the stock or business,
- as payments at regular intervals during ownership, or
- (often) as a combination of the two.
But growth and time value of money have a major impact on the final valuation of equity investment returns. In fact, intrinsic valuation is a lot about assessing the effects of future growth on future returns and then assigning a present value to those returns.
The following "how" questions can guide the appraisal of business returns.
How much?
How soon?
How long?
How consistent?
How valuable?
How much?
How many dollars of return will the business produce, either to distribute to shareholders or to invest productively in the business?
Key drivers are profitability and growth rates - and the collection of business factors that drive that profitability and growth.
How soon?
Big payoffs are nice, but if you have to wait 30 years for them, they aren't as valuable. Remember the time value of money.
If two companies produce the same return, but one does it sooner, that company has more value because those dollars can be reinvested elsewhere sooner for more return.
How long?
Although future returns have less value than current returns, they do have substantial value; and 20, 30, or 50 years of those returns can't be ignored, particularly in a profitable, growing business.
How consistent?
A company producing slow, steady growth and return is usually more valuable than one that's all over the map.
A greater variability, or uncertainty, around projected returns calls for more conservative growth and/or discounting assumptions.
How valuable?
Finally, after assessing potential returns (how much, how soon, how long, how consistent), you must assign a current value to those returns.
That value is driven by the value of the investment money as it may be used elsewhere. A return may look attractive - until the investor realizes that he or she can achieve the same return with a bond or a less risky investment.
Valuing the returns involves discounting (using a discount rate) to bring future returns back to fair current value. The discount rate is your personal cost of capital - in this case, the rate of return you expect to deploy capital here versus elsewhere.
Sooner isn't always better.
A business producing quick, short-term bucks may not be more valuable than one that produces slow, steady growth.
The quick-bucker may be cyclical and go through years of diminished or even negative returns. Even though the quick-bucker produces a lot of value in the first few years, that may not be better than sustained growth and value produced later on by the slower, steadier comapny.
The quick-bucker may be relying on a technology or some other competitive advantage that could dissipate or dissapper altogether. Likewise, a company with a long-term and sustainable advantage, sometimes known as a "moat" keeping competitors away, may beat a company with very high but only short-term returns.
Bottom line:
It's a combination of how much, how soon, how long, and how consistent.
The tortoise often beats the hare.
Present value calculator
http://www.moneychimp.com/calculator/present_value_calculator.htm
Inputs
Future Value: $
Years:
Discount Rate: %
Results
Present Value: $
Intrinsic Value Basics: Valuing a Business - Seth Klarman's 3 Methods
Valuing a Business - Seth Klarman's 3 Methods
"Price is what you pay. Value is what you get." says Buffett. Valuing a business is, therefore, a fundamental skill that every value investor must master to be able to discern the intrinsic value of a business from publicly available information.
The truth is all of us can recognize a discount when we see one. When I shop for organic fuji apples, I know they are at a discount at $2.39/lb if they normally sell for $3.99/lb. Keeping an eye on the price tags is the key. But when it comes to recognizing a business selling on a discount, the share price does not always reflect the value of a business. This is because a business is made up of people. Hence, businesses evolve for better or for worse. When a business evolve into a more valuable business, the share price must at some point reflect this change.
The trouble is no one perceives the value of a business the same way. This is why even Ian Cumming and Joseph Steinberg couldn't agree on the same intrinsic value for Leucadia. So when you throw the entire population of investors and speculators in the mix, you get a variable share price that changes by the second.
Business valuation is as much an art as a science. There is no one value that is the absolute right value for a company. Because of the imperfect knowledge of the future, we can only come up with a range of values for a company. Below are the three methods of business valuation that Seth Klarman postulates every value investor should have in his warchest.
1. Discounted Cash Flow / Net Present Value
In Theory of Investment Value, John Burr Williams was among the first to introduce the discounted cash flow (DCF) analysis. Seth Klarman categorizes this under the net present value (NPV) method. With a properly chosen discount rate and reasonably predictable future cash flows, the NPV method yields the closest to precise valuation of a profitable business.
DCF basically calculates the present value of all future cash flows by applying a discount rate. The discount rate is the interest that you would like to be compensated for incurring the opportunity cost of giving up alternative, less risky investments. The riskier the investment the higher the discount rate should be. Generally, the short term US Treasury securities are considered risk-free alternatives. In other words, if you are accepting a higher risk for an equity investment, you should expect to earn an interest higher than the current US Treasury yield. Don't just apply a 10% discount rate on all analysis. A smaller, less liquid company probably deserves a higher discount rate, say 12% - 15%, than its blue chip counterpart.
Despite its proximity to accuracy, DCF has a flaw: it depends on predictable future cash flows which no one can reliably estimate given the massive number of variables. Unlike a bond, the earnings of a business are not fixed every year. A one percent difference in your growth assumption can have a huge impact on the NPV. Unfortunately, most investors are overly optimistic when it comes to estimating growth. The best defense here is to err on the side of caution and always pick the more conservative estimate.
2. Liquidation
The net present value analysis works great for determining the value of a profitable business with predictable future cash flows. But when it comes to valuing an unprofitable business, the NPV analysis falls apart. Since there is no future cash flow, you can't calculate the NPV. Thus, most investors, unwilling to part with NPV, would simply pass on investing in unprofitable businesses. But this is precisely why investors who are willing to spend the time scouring the floors for cigar butts could find some wonderful bargains.
To value an unprofitable business, an investor needs to be extra conservative since many of these businesses are already troubled businesses headed for the dead pool. Typically, only tangible assets are considered. Intangibles such as brand names are assumed to be worthless. A good shortcut to evaluate the liquidation value of a business is to calculate the net-net working capital. Net-net working capital is calculated by subtracting current and long term liabilities from current assets. If the company trades below its net-net working capital and it is not depleting its net-net working capital nor does it have any off-balance sheet liabilities, the failing company could be a very successful investment.
However, there is a shortcoming with the net-net working capital analysis. Most of the time, in a liquidation, a company sells pieces of standalone operating entities too. These operating entities could very well be profitable going concerns despite its parent's fallout. The net-net working capital analysis would have underestimated the worth of these subsidiaries. Often, in this situation, investors resort to a breakup analysis to evaluate the worth of the subsidiaries. Basically, you treat the subsidiaries just like you would any company when valuing a business; applying the proper analysis. Once you have the values of each of its subsidiaries you sum them up to arrive at the total value of the parent. This is also known as the sum-of-parts analysis.
3. Market Value
The market value analysis is the best and only sensible valuation method for closed-end funds. Closed-end funds are funds that are closed to new capital after launch and their shares can be traded at any time in open market. Unlike a mutual fund, a closed-end fund usually trades at a premium or a discount to its net asset value (NAV). The NAV of a closed-end fund is the sum of all its securities. Since the value of the securities are realized when sold to the market, only a market value analysis of the securities makes sense.
Some investors make the mistake of extending the market value analysis to valuing companies. The reasoning behind this is simple, but irrational; if a similar company in the same industry trades at 12 times pretax cash flow, this company should trade at the same multiple. This is what Seth Klarman calls "circular reasoning". What if all the companies in the industry are overvalued?
A more appropriate relative valuation method for companies is the private market value analysis. The assumption here is that in a private transaction where sophisticated businessmen are involved, businesses are often bought at fair prices or at reasonable premiums. Often times, this is true. But when considering a leveraged buyout transaction for comparison, an investor has to be cautious about whether the buyer overpaid.
Conclusion
All three valuation methods are not without flaws. Therefore, it is sometimes necessary to use several methods simultaneously to arrive at a more comfortable estimate. It is important to pick the right tool for the right job lest you contract the man-with-a-hammer syndrome. As Munger would say, "To a man with a hammer, every problem looks like a nail."
"Price is what you pay. Value is what you get." says Buffett. Valuing a business is, therefore, a fundamental skill that every value investor must master to be able to discern the intrinsic value of a business from publicly available information.
The truth is all of us can recognize a discount when we see one. When I shop for organic fuji apples, I know they are at a discount at $2.39/lb if they normally sell for $3.99/lb. Keeping an eye on the price tags is the key. But when it comes to recognizing a business selling on a discount, the share price does not always reflect the value of a business. This is because a business is made up of people. Hence, businesses evolve for better or for worse. When a business evolve into a more valuable business, the share price must at some point reflect this change.
The trouble is no one perceives the value of a business the same way. This is why even Ian Cumming and Joseph Steinberg couldn't agree on the same intrinsic value for Leucadia. So when you throw the entire population of investors and speculators in the mix, you get a variable share price that changes by the second.
Business valuation is as much an art as a science. There is no one value that is the absolute right value for a company. Because of the imperfect knowledge of the future, we can only come up with a range of values for a company. Below are the three methods of business valuation that Seth Klarman postulates every value investor should have in his warchest.
1. Discounted Cash Flow / Net Present Value
In Theory of Investment Value, John Burr Williams was among the first to introduce the discounted cash flow (DCF) analysis. Seth Klarman categorizes this under the net present value (NPV) method. With a properly chosen discount rate and reasonably predictable future cash flows, the NPV method yields the closest to precise valuation of a profitable business.
DCF basically calculates the present value of all future cash flows by applying a discount rate. The discount rate is the interest that you would like to be compensated for incurring the opportunity cost of giving up alternative, less risky investments. The riskier the investment the higher the discount rate should be. Generally, the short term US Treasury securities are considered risk-free alternatives. In other words, if you are accepting a higher risk for an equity investment, you should expect to earn an interest higher than the current US Treasury yield. Don't just apply a 10% discount rate on all analysis. A smaller, less liquid company probably deserves a higher discount rate, say 12% - 15%, than its blue chip counterpart.
Despite its proximity to accuracy, DCF has a flaw: it depends on predictable future cash flows which no one can reliably estimate given the massive number of variables. Unlike a bond, the earnings of a business are not fixed every year. A one percent difference in your growth assumption can have a huge impact on the NPV. Unfortunately, most investors are overly optimistic when it comes to estimating growth. The best defense here is to err on the side of caution and always pick the more conservative estimate.
2. Liquidation
The net present value analysis works great for determining the value of a profitable business with predictable future cash flows. But when it comes to valuing an unprofitable business, the NPV analysis falls apart. Since there is no future cash flow, you can't calculate the NPV. Thus, most investors, unwilling to part with NPV, would simply pass on investing in unprofitable businesses. But this is precisely why investors who are willing to spend the time scouring the floors for cigar butts could find some wonderful bargains.
To value an unprofitable business, an investor needs to be extra conservative since many of these businesses are already troubled businesses headed for the dead pool. Typically, only tangible assets are considered. Intangibles such as brand names are assumed to be worthless. A good shortcut to evaluate the liquidation value of a business is to calculate the net-net working capital. Net-net working capital is calculated by subtracting current and long term liabilities from current assets. If the company trades below its net-net working capital and it is not depleting its net-net working capital nor does it have any off-balance sheet liabilities, the failing company could be a very successful investment.
However, there is a shortcoming with the net-net working capital analysis. Most of the time, in a liquidation, a company sells pieces of standalone operating entities too. These operating entities could very well be profitable going concerns despite its parent's fallout. The net-net working capital analysis would have underestimated the worth of these subsidiaries. Often, in this situation, investors resort to a breakup analysis to evaluate the worth of the subsidiaries. Basically, you treat the subsidiaries just like you would any company when valuing a business; applying the proper analysis. Once you have the values of each of its subsidiaries you sum them up to arrive at the total value of the parent. This is also known as the sum-of-parts analysis.
3. Market Value
The market value analysis is the best and only sensible valuation method for closed-end funds. Closed-end funds are funds that are closed to new capital after launch and their shares can be traded at any time in open market. Unlike a mutual fund, a closed-end fund usually trades at a premium or a discount to its net asset value (NAV). The NAV of a closed-end fund is the sum of all its securities. Since the value of the securities are realized when sold to the market, only a market value analysis of the securities makes sense.
Some investors make the mistake of extending the market value analysis to valuing companies. The reasoning behind this is simple, but irrational; if a similar company in the same industry trades at 12 times pretax cash flow, this company should trade at the same multiple. This is what Seth Klarman calls "circular reasoning". What if all the companies in the industry are overvalued?
A more appropriate relative valuation method for companies is the private market value analysis. The assumption here is that in a private transaction where sophisticated businessmen are involved, businesses are often bought at fair prices or at reasonable premiums. Often times, this is true. But when considering a leveraged buyout transaction for comparison, an investor has to be cautious about whether the buyer overpaid.
Conclusion
All three valuation methods are not without flaws. Therefore, it is sometimes necessary to use several methods simultaneously to arrive at a more comfortable estimate. It is important to pick the right tool for the right job lest you contract the man-with-a-hammer syndrome. As Munger would say, "To a man with a hammer, every problem looks like a nail."
Saturday, 3 September 2011
What Does Net Present Value - NPV Mean?
What Does Net Present Value - NPV Mean?
In addition to the formula, net present value can often be calculated using tables, and spreadsheets such as Microsoft Excel.
The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.
NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.
Formula:
NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.
Formula:
In addition to the formula, net present value can often be calculated using tables, and spreadsheets such as Microsoft Excel.
 | |
| Watch: Understanding Net Present Value |
Investopedia explains Net Present Value - NPV
NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.
For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company.
NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.
For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company.
http://www.investopedia.com/terms/n/npv.asp?partner=basics090211#ixzz1WtS9g5kS
Thursday, 1 September 2011
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