Saturday, 10 September 2011
Friday, 9 September 2011
Market PE
From a valuation standpoint, the Rule of 20 continues to point to 1500 on current trailing earnings, for a 15-20% upside potential to fair value. This remains a good target for this year. However, the risk of a technical correction towards the 200 day m.a. is not insignificant, skewing the risk/reward ratio and raising a yellow flag for the shorter term.
Thursday, 8 September 2011
What is a Bond?
A bond is essentially a loan an investor makes to the bonds’ issuer. That issuer can be the federal government (as in the case of Treasury bonds) or a local government (municipal bonds), government-sponsored enterprises (like Fannie Mae), companies (corporate bonds) or even foreign governments or international corporations.
The investor, or bond buyer, generally receives regular interest payments on the loan until the bond matures or is “called,” at which point the issuer repays you the principal. Bond funds pool money from many investors to buy individual bonds according to the fund’s investment objective.
Most bonds pay regular interest until the bond matures.
Callable bonds allow the issuer to repay the bond before maturity.
Zero-coupon bonds offer a deep discount and pay all the accumulated interest at maturity.
Who issues bonds?
Governments, government sponsored enterprises and corporations issue bonds to raise money for their endeavors. The financial health of the issuer determines how highly (or not) the bonds are rated; higher rated bonds are considered to be safer and therefore pay less interest, whereas lower-rated bonds pay higher interest rates to compensate investors for taking on more perceived risk. An issuer’s credit rating can change in either direction over time. In addition to the ratings and interest payments, the institution issuing the bonds can also determine whether or not the income is taxable. A roundup of the types of bonds and information on their issuers follows:
Treasury bonds
The U.S. Treasury issues bonds to pay for government activities and service the national debt. Treasuries are considered to be extremely low-risk if held to maturity, since they are backed by “the full faith and credit” of the U.S. government. Because of their safety, they tend to offer lower yields than other bonds. Income from Treasury bonds is exempt from state and local taxes.
The U.S. Treasury issues bonds to pay for government activities and service the national debt. Treasuries are considered to be extremely low-risk if held to maturity, since they are backed by “the full faith and credit” of the U.S. government. Because of their safety, they tend to offer lower yields than other bonds. Income from Treasury bonds is exempt from state and local taxes.
Agency bonds
Government-Sponsored Enterprises issue bonds to support their mandates, which typically involve ensuring certain segments of the population—like farmers, students and homeowners—are able to borrow at affordable rates. Examples include Fannie Mae, Freddie Mac, and the Tennessee Valley Authority. Yields are higher than government bonds, representing their higher level of risk, though are still considered to be on the lower end of the risk spectrum. Some income from agency bonds, like Fannie Mae and Freddie Mac are taxable. Others are exempt from state and local taxes.
Government-Sponsored Enterprises issue bonds to support their mandates, which typically involve ensuring certain segments of the population—like farmers, students and homeowners—are able to borrow at affordable rates. Examples include Fannie Mae, Freddie Mac, and the Tennessee Valley Authority. Yields are higher than government bonds, representing their higher level of risk, though are still considered to be on the lower end of the risk spectrum. Some income from agency bonds, like Fannie Mae and Freddie Mac are taxable. Others are exempt from state and local taxes.
Municipal bonds
States, cities, counties and towns issue bonds to pay for public projects (roads, sewers) and finance other activities. The majority of munis are exempt from federal income taxes and, in most cases, also exempt from state and local taxes if the investor is a resident in the state of issuance. As a result, the yields tend to be lower, but still may provide more after-tax income for investors in higher tax brackets.
States, cities, counties and towns issue bonds to pay for public projects (roads, sewers) and finance other activities. The majority of munis are exempt from federal income taxes and, in most cases, also exempt from state and local taxes if the investor is a resident in the state of issuance. As a result, the yields tend to be lower, but still may provide more after-tax income for investors in higher tax brackets.
Corporate bonds
Corporations issue bonds to expand, modernize, cover expenses and finance other activities. The yield and risk are generally higher than government and municipal bonds. Rating agencies help you assess the credit risk by rating the bonds according to the issuing company’s perceived creditworthiness. Income from corporate bonds is fully taxable.
Corporations issue bonds to expand, modernize, cover expenses and finance other activities. The yield and risk are generally higher than government and municipal bonds. Rating agencies help you assess the credit risk by rating the bonds according to the issuing company’s perceived creditworthiness. Income from corporate bonds is fully taxable.
Mortgage-backed securities
Banks and other lending institutions pool mortgages and “securitize” them so investors can buy bonds that are backed by income from people repaying their mortgages. This raises money so the lenders can offer more mortgages. Examples of MBS issuers include Ginnie Mae, Fannie Mae, and Freddie Mac. Mortgage-backed bonds have a yield that typically exceeds high-grade corporate bonds. The major risk of these bonds is if borrowers repay their mortgages in a "refinancing boom," it could have an impact on the investment's average life and potentially its yield. These bonds can also prove risky if many people default on their mortgages. Mortgage-backed bonds are fully taxable.
Banks and other lending institutions pool mortgages and “securitize” them so investors can buy bonds that are backed by income from people repaying their mortgages. This raises money so the lenders can offer more mortgages. Examples of MBS issuers include Ginnie Mae, Fannie Mae, and Freddie Mac. Mortgage-backed bonds have a yield that typically exceeds high-grade corporate bonds. The major risk of these bonds is if borrowers repay their mortgages in a "refinancing boom," it could have an impact on the investment's average life and potentially its yield. These bonds can also prove risky if many people default on their mortgages. Mortgage-backed bonds are fully taxable.
High yield bonds
Some issuers simply aren’t as credit-worthy as others. These can include local and foreign governments, but generally high yield bonds refer to corporate bonds issued by companies that are considered to be at greater risk of not paying interest and/or returning principal at maturity. As a result, the issuer will pay a higher rate to entice investors to take on the added risk. Ratings agencies such as Standard & Poor’s, Moody’s and Fitch evaluate the financial health of a bond issuer and assign a rating that indicates their opinion of whether the bond is investment grade or not. Bonds rated below investment grade are considered speculative and higher risk.
Some issuers simply aren’t as credit-worthy as others. These can include local and foreign governments, but generally high yield bonds refer to corporate bonds issued by companies that are considered to be at greater risk of not paying interest and/or returning principal at maturity. As a result, the issuer will pay a higher rate to entice investors to take on the added risk. Ratings agencies such as Standard & Poor’s, Moody’s and Fitch evaluate the financial health of a bond issuer and assign a rating that indicates their opinion of whether the bond is investment grade or not. Bonds rated below investment grade are considered speculative and higher risk.
How a typical bond works
Bonds have three major components:
The first is the face value, also called par value. This is the value the bond holder will receive at maturity unless the issuer defaults. Investors pay par when they buy the bond at its original face value. If bonds are retired by the issuer before maturity, bond holders may receive the par value or a slight premium. The price investors pay when buying on the secondary market (in other words, not directly from the bond’s issuer) may be more or less than the face value. See Bond Prices, Rates, and Yields.
Bonds also have a coupon rate. This is the annual rate of interest payable on the bond. (The term coupon hearkens to the time bond certificates were issued on paper and had actual coupons that investors would detach and bring to the bank to collect the interest.) The higher the coupon rate, the higher the interest payments the owner receives. With fixed-rate bonds, the coupon rate is set at the time the bond is issued and does not change. Most bonds make interest payments semiannually, although some bonds offer monthly and quarterly payments.
Third, bonds have a stated maturity date. Generally, this is the date on which the money you've loaned the issuer is repaid to you (assuming the bond doesn't have any call or redemption features).
Callable bonds
Callable bonds are bonds that the issuer can repay early, sometimes after a period of several years, at a predetermined price. The attraction of callable bonds is that they typically offer higher rates than non-callable bonds.
However, you should understand the call risk. If interest rates drop low enough, the bond's issuer can save money by repaying its callable bonds and issuing new bonds at lower coupon rates. If this happens, the bond holder's interest payments cease and they receive their principal early. If the bond holder then reinvests the principal in bonds with similar characteristics (such as credit rating), he or she will likely have to accept a lower coupon rate, one that is more consistent with prevailing interest rates. This will lower monthly interest payments.
Example: A callable bond
An investor purchases a $30,000 10-year callable bond paying 6.5% interest, which is a higher interest rate than similar non-callable bonds. The bond is callable after five years at a price of 103—that is, 103% of the face value, or $30,900. If interest rates drop enough, the investor may wind up with their principal returned and, when seeking to reinvest the principal, be looking at yields that have fallen since the time of their original investment.
An investor purchases a $30,000 10-year callable bond paying 6.5% interest, which is a higher interest rate than similar non-callable bonds. The bond is callable after five years at a price of 103—that is, 103% of the face value, or $30,900. If interest rates drop enough, the investor may wind up with their principal returned and, when seeking to reinvest the principal, be looking at yields that have fallen since the time of their original investment.
Zero coupon bonds
Zero coupon bonds, also known as “Strips”, are bonds that do not make periodic interest payments (in other words, there’s no coupon). Instead, you buy the bond at a discounted price and receive one payment at maturity. The payment is equal to the principal you invested plus the accumulated interest earned (compounded annually to maturity).
Perhaps the best-known example of a zero-coupon bond is a U.S. savings bond, which is a "non marketable" Treasury security that can be bought directly from the Treasury or most banks. (Fidelity sells other “marketable” zero-coupon Treasury securities that can be bought and sold on the secondary market.) There’s a reason these bonds are a favorite gift of many parents and grandparents: Zero coupon bonds are attractive when you want to save for a defined objective and date, such as when a child starts college. You receive your principal and interest in one lump sum at maturity.
Let’s say you’re saving for your child’s college education, which will begin in 10 years. You could buy a 10-year zero coupon bond that costs you $16,000, though its face value is $20,000. In 10 years, at maturity, you receive face value of $20K.
Zero coupon bonds have a few drawbacks. First, in most cases, you’ll have to pay taxes annually on the interest, even though you do not actually receive the interest until maturity. This can be offset if you buy the bonds in a tax-deferred retirement account, or in a custodial account for a child in situations where the child pays little or no tax.
Zero coupon bonds can also be particularly volatile in the open market, and particularly susceptible to interest rate risk. (For more on this and other risks, see Risks of Fixed Income Investing.) This doesn't matter if you keep the bond to maturity. But if you need to sell it early, you could incur a substantial loss.
In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties.
Lower-quality debt securities generally offer higher yields, but also involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Any fixed income security sold or redeemed prior to maturity may be subject to loss.
Lower-quality debt securities generally offer higher yields, but also involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Any fixed income security sold or redeemed prior to maturity may be subject to loss.
Wednesday, 7 September 2011
Investment Objectives
Original Investment Objectives regardless of the Market
...disciplined method of investing to achieve stated investment objectives.
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
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