Why the P/E Ratio Is Dangerous
By Rex Moore
June 19, 2009
I have no doubt that the most widely used valuation tool by individual investors is the price-to-earnings ratio (P/E). Unfortunately, it may also be the most dangerous tool, because it's so misunderstood. Today, I'll talk (well, type) a little about what the P/E's problems are and how you can overcome them.
What it is
On the surface, this is a very simple and informative ratio -- a company's stock price divided by its last 12 months of earnings per share. So we can look and see that Monsanto earned $4.10 per share over the past year. At today's price around $81.30, its P/E ratio is $81.30 / $4.10 = 20. You might also hear the hip Wall Street crowd say "Monsanto has a multiple of 20" -- because it sounds so cool.
Because you obviously want more earnings for every dollar you invest, a lower P/E is considered more attractive. After all, you'd rather be paying $40.65 per share for Monsanto's $4.10 in earnings (P/E = 10) than $81.30 (P/E = 20), right?
Yes, absolutely -- why wouldn't you want to pay less for the exact same earnings stream? The same principle also applies when comparing different businesses, as long as they are equal in all other respects.
What it isn't
Of course, things are never equal in the investing world (you didn't need me to tell you that), and this is where problems creep in. It's also why the P/E ratio should never be the only tool you use to value a business, for several reasons. Let's look at three of them.
1. Forward to the future
A glance at most any financial data provider tells us that Cisco Systems (Nasdaq: CSCO) is trading at a P/E of 16. Juniper Networks (Nasdaq: JNPR) has a multiple of 31. So Cisco must be a better value, right?
Well … maybe. It's rare to find two businesses that are exactly alike, and these two certainly have their differences. Also, analysts estimate Juniper will grow earnings about 18% annually over the next five years, while Cisco is only projected to grow at around 10% per year. So there you run into a big problem with the P/E -- it's a short-sighted, usually backward-looking tool. If one company is able to double its earnings in a few short years while another remains stagnant, the former could be a much better value despite a higher multiple. Yet you wouldn't know it from the single-snapshot picture the P/E provides.
The "forward P/E" published by some sources is a better tool, because it uses the next year's estimated earnings for the "E" part of the equation, instead of the previous year's earnings. But that still provides only a very limited snapshot. This chart illustrates just how tough it is to get a handle on this simple ratio.
Company
Estimated 2-Year Growth Rate
Trailing P/E
Forward P/E*
Apollo Group (Nasdaq: APOL)
69%
16
15
USEC (NYSE: USU)
91%
17
15
Visa (NYSE: V)
49%
41
20
Baidu.com (Nasdaq: BIDU)
77%
65
44
Data provided by Capital IQ, a division of Standard & Poor's. *Using next 12 months' earnings estimate.
The first two companies look like bargains compared to their growth rates, but you should question just how likely they are to achieve this future growth. The second two appear expensive looking backward, but much more reasonable looking forward. But how much growth will there be after the next couple of years? So many variables!
2. Focus on fundamentals
As the previous example shows, the P/E becomes more useful if you can get a grasp on just how much in earnings a company will be able to achieve over the coming years. But in order to do this, you'll need to study the underlying business and understand its margins, scalability, competitive position within the industry, etc. This fundamental analysis goes a long way toward putting the P/E in its proper perspective.
3. The fiction of accounting
Another problem comes in defining "earnings," the denominator in our equation. Like Donald Trump's hair color, it isn't always what it seems. In fact, unlike Donald's hair, it's so easy to massage and manipulate the earnings number that it's a wonder the Street still hangs on every penny. While one company may report a largely honest number, its competitor may be padding the EPS in order to "meet estimates." In the end, stuff like that usually catches up to these companies -- and, in turn, their shareholders.
My story
The best way to think about the P/E ratio reinforces what Motley Fool co-founders Tom and David Gardner tell members of their Stock Advisor investing service: You must understand that you're buying a business when you buy a stock. I'd heard that often enough, but it took a real-life example to drive the point home.
Several years ago, a friend and I considered buying a sporting goods store. It was a family-run business, with virtually no debt -- or cash -- on the balance sheet. The owner wanted $100,000 for it.
What's the most important thing you'd want to know if you'd been in our situation? Right: how much money we could reasonably expect to earn over the next few years. We didn't care about the fiction of accounting earnings (point No. 3 above) -- we wanted to know how much in real cash profits the business could pull in.
If it were $10,000 per year, we'd be getting the company at a P/E of 10 ($100,000 / $10,000 = 10). If it were $5,000, that's a much less attractive multiple of 20.
We dived into the fundamental analysis to figure out the real earning power of the company (point No. 2). The short story is, we thought we could make the business much more efficient (improving the margins), but future revenue and earnings growth (point No. 1) seemed very limited due to several well-financed competitors in the area.
In assessing whether this was a smart purchase, we used the three points to come up with our decision. In the end, we passed on the purchase because the P/E we calculated was over 20. Using that number hand-in-hand with our analysis, we knew it would have taken too long for us to even recoup our original investment. But the exercise itself was a lesson I'll never forget.
The lesson
Using P/E as a standalone valuation tool could cost you big-time. Isolating on any single metric, for that matter, is a recipe for disaster.
When David recommended Amazon.com (Nasdaq: AMZN) in September 2002, he acknowledged that its P/E of 75 carried risks. But his fundamental analysis convinced him the company deserved that multiple, and the stock is up more than 400% since.
Rex Moore is a Fool analyst who's been cleared to operate heavy machinery. He owns no companies mentioned in this article. Amazon.com is a Motley Fool Stock Advisor selection. Baidu is a Rule Breakers pick. The Fool has a disclosure policy.
http://www.fool.com/investing/general/2009/06/19/why-the-pe-ratio-is-dangerous.aspx
Tuesday 23 June 2009
Valuing a business using PE
The best way to think about the P/E ratio: You must understand that you're buying a business when you buy a stock. Here is a real-life example to drive the point home.
Several years ago, a friend and I considered buying a sporting goods store. It was a family-run business, with virtually no debt -- or cash -- on the balance sheet. The owner wanted $100,000 for it.
What's the most important thing you'd want to know if you'd been in our situation? Right: how much money we could reasonably expect to earn over the next few years. We didn't care about the fiction of accounting earnings (point No. 1) -- we wanted to know how much in real cash profits the business could pull in.
If it were $10,000 per year, we'd be getting the company at a P/E of 10 ($100,000 / $10,000 = 10). If it were $5,000, that's a much less attractive multiple of 20.
We dived into the fundamental analysis to figure out the real earning power of the company (point No. 2). The short story is, we thought we could make the business much more efficient (improving the margins), but future revenue and earnings growth (point No. 3) seemed very limited due to several well-financed competitors in the area.
In assessing whether this was a smart purchase, we used the three points to come up with our decision. In the end, we passed on the purchase because the P/E we calculated was over 20. Using that number hand-in-hand with our analysis, we knew it would have taken too long for us to even recoup our original investment. But the exercise itself was a lesson I'll never forget.
http://www.fool.com/investing/general/2009/06/19/why-the-pe-ratio-is-dangerous.aspx
To recap:
When buying a small business:
Point 1: Past accounting earnings are a guide, but can be manipulated. More importantly is to conservatively assess the real earning power or cash profits of this company over the next few years.
Point 2: Can you increase this real earning power through improving its efficiency - the profit margins?
Point 3: Assess its future revenue growth and earnings growth. Are these sustainable?
Having assessed the quality of the business and its management, the other decisions one has to make are:
Point 4: Would you like to own or run the business of this company?
- If the answer is no, walk away.
- If the answer is yes, proceed on to next step.
Point 5: Is the seller's price attractive for you to own this company? Given your target of a certain return on your investment, what is the 'maximum' price (akin to intrinsic value) you are willing to pay to own this company?
Point 6: Can you buy this company at a discount to your price? Ask for a discount from the seller? Maybe 'wait' for a discount from the seller? Also remember, it is also alright to buy at a fair price, especially if it is a good business with good fundamentals, up for sale for various reasons.
Essentially, this is not dissimilar to our use of QVM method in assessing which companys' stocks to invest in. (Q=Quality, V=Value, M=Management)
Market turns down again
We need to prepare ourselves to “fish” good quality stocks at reasonable price levels if the market turns down again.
Monday 22 June 2009
An Interesting Comeback Calculator
http://www.nytimes.com/interactive/2009/01/06/business/20090106-comeback-graphic.html
Calculate Your Financial Comeback
Has your portfolio plummeted? So has ours. Use our Comeback CalculatorSM to calculate when your investments could return to their peak levels.
--------------------------------------------------------------------------------
June 20, 2009
Your Money
For Older Investors, Old Rules May Not Apply
By TARA SIEGEL BERNARD
The stock market’s damage has already been done. And if you’re one of those people near or already in retirement, you already know you’re going to have to work longer, save more or spend less.
But what should you do right now with the money you have left? Should you wade back into the stock market, if you bailed out when the market was plunging? Or if you watched your investments drop and then recover a little in the last few months, should you just hold on? What happens if the market doesn’t fully recover for a long time? (That happened in Japan in the ’90s.)
This economic downturn has been steep enough and frightening enough to undermine the idea that the stock market, over time, will always deliver. So a lot of investors have retreated to a more conservative stance.
The wisdom of that move is debatable. The investment industry warns that becoming too defensive is costly in the long run. Its argument goes something like this: People are living longer, retirement may last 25 or 30 years and stocks are supposed to protect you from the ravages of inflation. And since stocks tend to outpace most investments over long periods of time, the industry says, your savings will do all right in the end.
But some people are no longer comfortable with that logic. There’s even a new study that contends holding stocks over long periods of time may be riskier than previously thought. Robert F. Stambaugh, a finance professor at the Wharton School at the University of Pennsylvania and a co-author of the report, said most investment research only accounted for the risk of short-term market swings around the stock market’s average gain over time. It doesn’t factor in the fact, he said, that the average itself is subject to change.
So what should retirees and pre-retirees make of all of this?
“If another decline in the market is going to bankrupt you or put you out of business or destroy your retirement account, you should not go back into the stock market,” said John C. Bogle, the founder of Vanguard and viewed by many as the father of index investing. “It’s not complicated. The stock market can go up and down a lot and nobody really knows how much and when.”
What’s worked for Mr. Bogle may not work for you, but his method isn’t a bad place to start. “I have this threadbare rule that has worked very well for me,” he said in an interview this week. “Your bond position should equal your age.” Mr. Bogle, by the way, is 80 years old.
That’s a rather conservative recommendation, by many financial planners’ standards. In fact, Vanguard itself offers products that are more aggressive. Its target-date funds — whose investment mix grows more conservative as retirement nears — recommend that people retiring in 2010 (generally, people who are 65) should split their savings evenly between stock and bonds.
Charles Schwab, by contrast, has recently reduced the risk for its target-date funds. The company’s 2010 fund will allocate about 40 percent to stock funds next year, down from 50 percent in the past. “It’s a reflection that our clients’ appetite for risk has changed,” said Peter Crawford, a senior vice president at Charles Schwab Investment Management.
But you shouldn’t simply view your investments through the lens of how much you allocate to different investments (though you will need to come up with a plan). Instead, you should work your way backward. First, consider how much you will need to live when you’re retired and then figure out how you’ll pay for it.
Nearing Retirement
Ideally, you should have started to slowly shrink your stock position over your working career. But some financial planners have become more conservative about that. Before the market’s sharp downturn, Warren McIntyre, a financial planner in Troy, Mich., typically reduced his clients’ stock allocations by about 1 percent each year. Now, for older investors, he ratchets down their stocks by 2 percent each year once they reach 60. So a 65-year-old’s investments would be evenly split between stocks and bonds.
Other planners are taking even more defensive positions. “We are still very concerned about the status of the economic recovery and remain quite defensive as a result,” said Chip Addis, a financial planner in Wayne, Pa., who invests his clients’ portfolios in only 40 percent stocks.
Of course, there’s no one formula. Milo Benningfield, a fee-only planner in San Francisco, for instance, said he put a 61-year-old client in a portfolio with 60 percent in diversified stocks and alternatives (like real estate) and 40 percent in fixed-income (largely split among high-quality, short-term and intermediate-term bonds and cash). But this client can afford to take that risk — the client owns a house, rental property and has other holdings outside the portfolio.
The picture may change for pre-retirees who are 61 and close to meeting their savings goals, but can’t afford to lose any money. “We would ask ourselves to what degree, if any, can you afford equities,” Mr. Benningfield said. If inflation was their only concern, he might invest their money across a ladder of Treasury Inflation-Protected Securities, or TIPS, which are backed by the government and keep pace with inflation.
But since retirees generally spend money on entertainment, health care and food — whose costs often exceed the general rate of inflation — he said he might invest 40 to 50 percent of their money in a portfolio of diversified stock funds (with at least 30 percent of that in international stock funds). But, he added, “Cash is risky, stocks and bonds are risky, life is risky.”
As to those investors who got out of stocks, Mr. Bogle said it might be time for some of them to get back in. “But I would take two years to do it,” he said. “Maybe average in over eight quarters, and do an eighth each quarter. I am just not in favor of doing things in a hurry or emotionally.”
And then? “Don’t touch it,” he said, emphatically. “One of my rules is don’t do something. Just stand there.”
Retirement
Several planners recommended different variations on a similar strategy for retirees. Set aside anywhere from eight to 15 years of your expected expenses — that includes food, utilities, housing, insurance — in bonds and cash. That way, you’ll never have to tap your stock holdings at the worst possible moment.
“Once you have that in place, you feel like you can weather any economic storm,” said Chip Simon, a financial planner in Poughkeepsie, N.Y.
When you have figured out how much it costs to live each year, the next step is to see how much Social Security will cover. Whatever is left needs to be financed by your retirement portfolio. And the general rule of thumb is that you shouldn’t withdraw more than 4 percent of your portfolio (adjusted for inflation) each year.
There are different ways to invest your cash and bond holdings.
Rick Rodgers, a financial planner in Lancaster, Pa., invests 10 years of annual expenses in a bond ladder, with an equal amount coming due every six months. The ladder can include high-quality corporate bonds, Treasury notes, certificates of deposit or municipal bonds, depending on the retiree’s tax bracket. Mr. Simon takes a similar approach using a 15-year ladder of zero-coupon bonds. He says that investors can start building the ladder in their 50s, with the first rung coming due the year they retire.
Some advisers also say you can guarantee you’ll be able to cover your basic expenses by purchasing an immediate annuity from an insurance company. The annuity pays you a stream of income until you die. “You can buy four small ones from four insurers if you are worried about insolvency risk,” said Dallas L. Salisbury, president of the Employee Benefit Research Institute. “And if you are just worried about inflation protection, you can do TIPS.”
But you should probably delay any annuity purchases because payouts rise with interest rates. With current rates so low, and the possibility of inflation later, advisers said it’s best to wait a few years. You can also research inflation-adjusted annuities, but you’ll receive lower payouts in the beginning, Mr. Benningfield said, adding: “Less than most people can stomach.”
Calculate Your Financial Comeback
Has your portfolio plummeted? So has ours. Use our Comeback CalculatorSM to calculate when your investments could return to their peak levels.
--------------------------------------------------------------------------------
June 20, 2009
Your Money
For Older Investors, Old Rules May Not Apply
By TARA SIEGEL BERNARD
The stock market’s damage has already been done. And if you’re one of those people near or already in retirement, you already know you’re going to have to work longer, save more or spend less.
But what should you do right now with the money you have left? Should you wade back into the stock market, if you bailed out when the market was plunging? Or if you watched your investments drop and then recover a little in the last few months, should you just hold on? What happens if the market doesn’t fully recover for a long time? (That happened in Japan in the ’90s.)
This economic downturn has been steep enough and frightening enough to undermine the idea that the stock market, over time, will always deliver. So a lot of investors have retreated to a more conservative stance.
The wisdom of that move is debatable. The investment industry warns that becoming too defensive is costly in the long run. Its argument goes something like this: People are living longer, retirement may last 25 or 30 years and stocks are supposed to protect you from the ravages of inflation. And since stocks tend to outpace most investments over long periods of time, the industry says, your savings will do all right in the end.
But some people are no longer comfortable with that logic. There’s even a new study that contends holding stocks over long periods of time may be riskier than previously thought. Robert F. Stambaugh, a finance professor at the Wharton School at the University of Pennsylvania and a co-author of the report, said most investment research only accounted for the risk of short-term market swings around the stock market’s average gain over time. It doesn’t factor in the fact, he said, that the average itself is subject to change.
So what should retirees and pre-retirees make of all of this?
“If another decline in the market is going to bankrupt you or put you out of business or destroy your retirement account, you should not go back into the stock market,” said John C. Bogle, the founder of Vanguard and viewed by many as the father of index investing. “It’s not complicated. The stock market can go up and down a lot and nobody really knows how much and when.”
What’s worked for Mr. Bogle may not work for you, but his method isn’t a bad place to start. “I have this threadbare rule that has worked very well for me,” he said in an interview this week. “Your bond position should equal your age.” Mr. Bogle, by the way, is 80 years old.
That’s a rather conservative recommendation, by many financial planners’ standards. In fact, Vanguard itself offers products that are more aggressive. Its target-date funds — whose investment mix grows more conservative as retirement nears — recommend that people retiring in 2010 (generally, people who are 65) should split their savings evenly between stock and bonds.
Charles Schwab, by contrast, has recently reduced the risk for its target-date funds. The company’s 2010 fund will allocate about 40 percent to stock funds next year, down from 50 percent in the past. “It’s a reflection that our clients’ appetite for risk has changed,” said Peter Crawford, a senior vice president at Charles Schwab Investment Management.
But you shouldn’t simply view your investments through the lens of how much you allocate to different investments (though you will need to come up with a plan). Instead, you should work your way backward. First, consider how much you will need to live when you’re retired and then figure out how you’ll pay for it.
Nearing Retirement
Ideally, you should have started to slowly shrink your stock position over your working career. But some financial planners have become more conservative about that. Before the market’s sharp downturn, Warren McIntyre, a financial planner in Troy, Mich., typically reduced his clients’ stock allocations by about 1 percent each year. Now, for older investors, he ratchets down their stocks by 2 percent each year once they reach 60. So a 65-year-old’s investments would be evenly split between stocks and bonds.
Other planners are taking even more defensive positions. “We are still very concerned about the status of the economic recovery and remain quite defensive as a result,” said Chip Addis, a financial planner in Wayne, Pa., who invests his clients’ portfolios in only 40 percent stocks.
Of course, there’s no one formula. Milo Benningfield, a fee-only planner in San Francisco, for instance, said he put a 61-year-old client in a portfolio with 60 percent in diversified stocks and alternatives (like real estate) and 40 percent in fixed-income (largely split among high-quality, short-term and intermediate-term bonds and cash). But this client can afford to take that risk — the client owns a house, rental property and has other holdings outside the portfolio.
The picture may change for pre-retirees who are 61 and close to meeting their savings goals, but can’t afford to lose any money. “We would ask ourselves to what degree, if any, can you afford equities,” Mr. Benningfield said. If inflation was their only concern, he might invest their money across a ladder of Treasury Inflation-Protected Securities, or TIPS, which are backed by the government and keep pace with inflation.
But since retirees generally spend money on entertainment, health care and food — whose costs often exceed the general rate of inflation — he said he might invest 40 to 50 percent of their money in a portfolio of diversified stock funds (with at least 30 percent of that in international stock funds). But, he added, “Cash is risky, stocks and bonds are risky, life is risky.”
As to those investors who got out of stocks, Mr. Bogle said it might be time for some of them to get back in. “But I would take two years to do it,” he said. “Maybe average in over eight quarters, and do an eighth each quarter. I am just not in favor of doing things in a hurry or emotionally.”
And then? “Don’t touch it,” he said, emphatically. “One of my rules is don’t do something. Just stand there.”
Retirement
Several planners recommended different variations on a similar strategy for retirees. Set aside anywhere from eight to 15 years of your expected expenses — that includes food, utilities, housing, insurance — in bonds and cash. That way, you’ll never have to tap your stock holdings at the worst possible moment.
“Once you have that in place, you feel like you can weather any economic storm,” said Chip Simon, a financial planner in Poughkeepsie, N.Y.
When you have figured out how much it costs to live each year, the next step is to see how much Social Security will cover. Whatever is left needs to be financed by your retirement portfolio. And the general rule of thumb is that you shouldn’t withdraw more than 4 percent of your portfolio (adjusted for inflation) each year.
There are different ways to invest your cash and bond holdings.
Rick Rodgers, a financial planner in Lancaster, Pa., invests 10 years of annual expenses in a bond ladder, with an equal amount coming due every six months. The ladder can include high-quality corporate bonds, Treasury notes, certificates of deposit or municipal bonds, depending on the retiree’s tax bracket. Mr. Simon takes a similar approach using a 15-year ladder of zero-coupon bonds. He says that investors can start building the ladder in their 50s, with the first rung coming due the year they retire.
Some advisers also say you can guarantee you’ll be able to cover your basic expenses by purchasing an immediate annuity from an insurance company. The annuity pays you a stream of income until you die. “You can buy four small ones from four insurers if you are worried about insolvency risk,” said Dallas L. Salisbury, president of the Employee Benefit Research Institute. “And if you are just worried about inflation protection, you can do TIPS.”
But you should probably delay any annuity purchases because payouts rise with interest rates. With current rates so low, and the possibility of inflation later, advisers said it’s best to wait a few years. You can also research inflation-adjusted annuities, but you’ll receive lower payouts in the beginning, Mr. Benningfield said, adding: “Less than most people can stomach.”
Learn from the Worst: Summary
We have learned that we have a lot going against us when it comes to investing in the stock market -
Therefore, it is important to have good philosophy and strategy on how to stay in the market and avoid these pitfalls.
Summary
While the stock market is unpredictable in the short term, it becomes predictable - and predictably good - over the long term. In fact, it has proven to be far and away the best long-term investment vehicle of all-time, especially when inflation is factored in.
Despite that fact, the vast majority of individual investors, mutual fund managers, and stock recommendation newsletters fail to beat the market over the long run, often underperforming by wide margins.
The reason for most underperformance is that investors' emotions lead them astray, causing them to react to short-term price movements and the interpretation of those movements by experts featured in the media. This leads to selling low and buying high.
Much of the stock market's gains come on a limited number of days - and no one knows exactly when those big days will occur; if you jump in and out of the market, you risk missing them.
In order to make money by timing the market, you need to be right on about 75% of your market calls - and research shows that most investors, even so-called experts don't come closee to that success rate.
- our brains,
- our emotions,
- timing, and even,
- the mutual fund industry itself.
Therefore, it is important to have good philosophy and strategy on how to stay in the market and avoid these pitfalls.
Summary
While the stock market is unpredictable in the short term, it becomes predictable - and predictably good - over the long term. In fact, it has proven to be far and away the best long-term investment vehicle of all-time, especially when inflation is factored in.
Despite that fact, the vast majority of individual investors, mutual fund managers, and stock recommendation newsletters fail to beat the market over the long run, often underperforming by wide margins.
The reason for most underperformance is that investors' emotions lead them astray, causing them to react to short-term price movements and the interpretation of those movements by experts featured in the media. This leads to selling low and buying high.
Much of the stock market's gains come on a limited number of days - and no one knows exactly when those big days will occur; if you jump in and out of the market, you risk missing them.
In order to make money by timing the market, you need to be right on about 75% of your market calls - and research shows that most investors, even so-called experts don't come closee to that success rate.
Learn from the Worst: The Best Way Not to Miss the Boat - Don't Get Off in the First Place
Many investors, however, either don't expect or just plain cannot tolerate the short-term discomfort of the stock market, and they'll do just about anything to try to avoid it.
Some will ignore stocks altogether, not wanting to deal with the short-term risk involved. Instead, they will put their money into bonds, Treasury bills, or even just keep it in a CD or savings account. After all, while those options don't have nearly the upside of stocks, you can't lose money with them. Or can you?
There are flaws in this logic. The reason: inflation. If, for example, all of your money is in a savings account that is earninng 2% interest per year but inflation is at 3% per year, the relative worth of your money isn't increasing by 2% annually; it's actually declining.
Since, World War II, the threat of infaltion to fixed-income investments has been very real. In his book Contrarian Investment Strategies, Dreman notes that:
Some will ignore stocks altogether, not wanting to deal with the short-term risk involved. Instead, they will put their money into bonds, Treasury bills, or even just keep it in a CD or savings account. After all, while those options don't have nearly the upside of stocks, you can't lose money with them. Or can you?
There are flaws in this logic. The reason: inflation. If, for example, all of your money is in a savings account that is earninng 2% interest per year but inflation is at 3% per year, the relative worth of your money isn't increasing by 2% annually; it's actually declining.
Since, World War II, the threat of infaltion to fixed-income investments has been very real. In his book Contrarian Investment Strategies, Dreman notes that:
- when adjusted for inflation, stocks returned an average of 7.5% from 1946 to 1996;
- when also adjusted for inflation, however, bonds had an average annual return of just 0.86%, gold actually declined by 0.13% per year, and T-bills returned just 0.42% annually.
Looked at another way, the average annual T-bill return before inflation was 4.8% during that period, about 2.5 x less than what stocks returned before inflation - not great, but not bad considering that T-bills are essentially risk-free; after inflation is factored in, however, stocks returned about 18x as much as T-bills per year.
Based on information like that, Dreman concluded that inflation was a far greater risk to long-term investors than short-term stock market volatility.
While some will try to avoid short-term market discomfort by avoiding stocks altogether, others, of course, believe they can skirt the stock market's short-term anxiety and still reap the long-term rewards. But much more often than not, they will end up with all the short-term discomfort and none of the long-term gains.
Part of the reason is that, most investors who try to time the market end up buying high and selling low. But there's also another important reason that is critical to understand - the nature of when and how the stock market makes its gains. In a 2007 article for CNNMoney, Jeanne Sahadi touched on this concept.
Citing data from Ibbotson Associates, Sahadi said tha if you had invested $100 in the S&P 500 in 1926, you would have had $307,700 in 2006 - a pretty staggering gain. But if you had been out of the market for the best-performing 40 months of that lengthy 972-month period, you would have had just $1,923 in 2006. That means that 99% of the gains over that 81-year period came in just 4 percent of the months.
The principle holds over shorter periods, as well. If you invested $100 in 1987, you'd have had $931 by the end of 2006, Sahadi noted. But if you were out of the market for the 17 best trading months of that 240-month period, you'd have ended up with just $232. In this case, 84% of the gains came in 7% of the months.
The bottom line: While the market rises substantially over time, much of its increases come on a relatively small portion of trading days - and no one knows for sure when they're going to come. If you jump in and out of the market based on short-term fluctuations you're bound to miss some of those big days - and you can't get them back.
Another point to note. In a market where the vast majority of gains come on a small number of days, you don't just have to be right more than you're wrong if you want to make money timing the market - you have to be right a whole lot more than you're wrong. That's what the research of William Sharpe shows. Sharpe found that in order to make money with a market-timing approach, you need to be right in your timing decisions at least 74% of the time - not just 51% , as many assume. Consider that statistic showed that the most accurate human forecasters were right about 20% of the time - and you see that most market timers won't even come close to succeeding.
Learn from the Worst: Our Emotions - Need for an Emotional Rescue
If we don't succeed at it, why do we keep trying to time the market? Given the short-term unpredictability of the stock market, it's pretty much inevitable that we'll fail if we try to time our participation in stocks, yet we always think we can learn to do it.
- "Man, it was so obvious that I should have done last time; now that I've learned my lesson, I'll be able to time things right next time." We tell ourseleves, even though it wasn't obvious what we should have done last time, and it won't be obvious whenit comes to future market-timing decisions (hindsight bias).
- "And time and time again, when one of our stocks starts declining, we jump off of it and onto the latest "hot" stock, only to watch our old stock rise and our new, flashy stock fall."
Our emotions
We are emotional creatures, and in many cases throughout life, that's a good thing. When we are in danger, for example, we feel fear, and our brains interpret this feeling as a signal to flee for safety's sake.
In the stock market, however, emotion is one of our greatest enemies. Our intstincts tell us to flee when we see danger, and danger is what we see when our investments start losing value -
- danger of losing our money,
- danger of not being able to afford to send our children to college,
- danger of not being able to afford to retire when we want to retire.
And, just as with other dangers we perceive, our first reaction is to flee - or, in this case, sell.
Now, when it comes to being attacked by an animal or a mugger who is trying to hurt you, fleeing from harm is a good instinct to have. But in the stock market, fleeing can, in fact, lead to great harm. That's because the danger we often sense in the stock market is false danger.
Perfectly good stocks fluctuate over the short-term (there's typically a 40 to 50% difference between a stock's high and the low for the previous 12 months), and sometimes it's due to factors that have nothing to do with their real value. (Think of the example in which one company is negatively impacted when another company in its industry posts a bad earnings report.) Because of the array of factors that go into its day-to-day movements, we just can't predict what the market's or an individual stock's short-term fluctuations will be with any degree of accuracy.
Nevertheless, we still act on them, and a big reason is emotion.
Peter Lynch once explained this phenomenon in an interview.
- "As the market starts going down, you say, 'Oh, it'll be fine."
- Then "it starts going down more and people get laid off, a friend of yours loses their job or a company has 10,000 employees and they lay off 200. The other 9.800 people start to worry, or somebody says their house price just went down. These are little thoughts that start to creep to the front of your brain."
- People even start thinking about past financial disasters, bringing thoughts of such calamities as the Great Depression to the front of their minds, even if the current situation is nowhere near as bad.
In today's world of nonstop media hype and sensational headlines, it's very difficult to keep those thoughts from entering our minds. And the more they do, the more likely we are to make bad investment decisions.
Dallbar's study of investor behaviour shows that the percentage of investors who correctly predict the direction of the market is much lower during down markets than it is during rising markets.
During falling markets, when people have already been losing money, the fear of losing even more can cause many to cash out, even if the downturn is just one of Wall Street's periodic short-term hiccups. (Behavioural finance referes to this a myopic loss aversion.) Often, investors are then slow to jump back in when the market turns around, so they miss out on the bounce-back gains.
And it's important to remember that the market does bounce back, even when your fears and worries are telling you that "this time is different, this time the market won't recover." In fact, over time, the market climbs higher than any other investment vehicles.
According to reserach performed by Roger Ibbotson, Rex Sinquefield, and Ibbotson Associates, in the 20-year period that ended at the end of 2006, the S&P averaged an 11.8% annual compound return, beating long-term corporate bonds (8.6%), long-term government bonds (8.6%), and Treasury bills (4.5%).
While unpredictable in the short term, the performance of the stock market becomes quite predictable - and predictably good - when looked at over the long term.
Imagine, for a moment, that the market is a helium-filled balloon that you set loose outside on a gusty day. From moment to moment, it's hard to tell where the balloon is headed. It gets pushed around from side to side by the wind - that is, earnings reports, economic data, analysts' ratings, pundits' predictions - and sometimes even gets knocked downward. From moment to moment, you'd be foolish to bet someone exactly which way the balloon will go, since there's no way predict which way the wind will blow. But it's almost a sure bet that, over a longer period of time, it will end up a lot higher than it started.
In his book Stocks for the Long Run, Jeremy Seigel states that the market has averaged an annual compound return of 11.2% in the period 1946 to 2006. Siegel also examines those returns for their standard deviations. This is a statistical measure to show the rangee of returns in a "normal" year during a particular period.
If a stock has returned an average of 10% annually over a particular period with a standard deviation of 5%, for example, that means that about 2/3 rds of the time, its returns have been between 5% (the average return minus the standard deviation) and 15% (the average plus the standard deviation).
According to Siegel, the annual standard deviation of the market has been about 17% in the 1946 - 2006 period, which means that about 2/3rds of the time during the 60-year time frame, returns were between -5.8% and 28.2% , a huge potential year-to-year difference. (And that's the range returns fell into about 2/3 rd of the time; in other years they were even further from the average.)
The fact that such major year-to-year fluctuations can - and many times do - occur in the stock market makes for a lot of anxious times in the short term, but that anxiety is simply the price you pay for the excellent long-term returns that the stock market gives you. If stocks earned 10 or 12 % per year and were a smooth ride, why would anyone ever invest in anything else? This concept is known as the equity risk premium.
The bottom line: There are no free lunches in the stock market. If you want the long-term benefits of stocks, you've got to pay the price of short-term discomfort.
Ref: The Guru Investor by John P. Reese
Learn from the Worst: Market Timing - The Most Dangerous Game
Every day, millions of investors, try to discern where the market will head tomorrow, next week, or next month.
Market timing occurs when people move in and out of the stock market with the intent of taking advantage of anticipated short-term price movements.
Market timing can be
Market timing occurs when people move in and out of the stock market with the intent of taking advantage of anticipated short-term price movements.
Market timing can be
- as simple as you want it - maybe you've heard from a friend that the market is about to take off, so you invest in stocks - or
- as complex as you want it - perhaps you've developed an elaborate model that uses various economic indicators to predict which way the market will go in the next month.
Whatever way you go about it, though, it's not likely to end well, because the market is simply too complex and irrational in the short-term for anyone to correctly and reliably predict its movements.
Want proof that market timing doesn't work?
1. Research performed by Dalbar, Inc (in its 2007 Quantitative Analysis of Investor Behaviour): The firm notes that the S&P has grown an average of 11.8% per year from 1987 through 2006, an impressive gain. During this period, however, the average equity investor averaged a return of just 4.3%.
- The reason? As markets rise, the data shows that investors "pour cash" into mutual funds, and when a decline starts, a "selling frenzy" begins.
- In other words, the research shows that investors tend to do the opposite of the old stock market adage, "Buy low, sell high."
2. A few years ago, the investment research company Morningstar began tracking mutual fund performance in a new way. Normally, mutual fund returns are reported as though an investor remained invested in the fund throughout the full reporting period. A fund's three-year return, for example, is reported as the percentage increase or decrease an investor would have seen if he had been invested in the fund for the entire three previous years.
In a methodology paper ('Morningstar Investor Return'), Morningstar says it found that this "total return" percentage doesn't accurately portray how well investors in a particular fund really fare.
- The reason: While the "total return" percentage measures how a fund does over a specific period, people often don't stick with the fund for that entire period; instead, they jump in and out of it.
- And, according to Morningstar, the returns that the typical investor in a particular fund actually realizes (the "investor returns") tend to be lower than the fund's total return - implying that people pick the wrong times to jump in and out of the fund (or the market).
3. While investors themselves deserve some of the blame for this, mutual funds sometimes don't help. In its investor returns methodology paper, Morningstar states that if firms encourage short-term trading and trendy funds, or if they advertise short-term returns and promote high-risk funds, they may not be looking out for their investors' long-term interests.
- Their investors' actual returns will likely be lower than the fund's total return.
- (The fees mutual funds charge also don't help, something Bogle stresses; those costs make it so that the fund manager has to beat the market just for his client to net market-matching returns.)
Learn from the Worst: Expert
With all the convoluted factors that drive the stock market, predicting which way it will go in the short term is just about impossible.
But wait. A certain group of people that the media refer to as "experts", how are their predictions? These self-assured sounding commentators that we find on TV, the Internet, or print news tell us that they know just what the latest round of earnings reports or economic figures will mean for stocks. After all, they're experts; don't they have to be at least pretty good at predicting economicand stock markt trends?
Unfortunately, research shows that they don't. Let's see how well the stock picks of most "experts" who appeared in the media actually did. Research on this showed there was no consistency or predictability in the performance of these pundits. The best performers in one week, one month, one quarter, six months, or one year were almost guaranteed to be entirely different in the next period; basically, you couldn't make money by picking a top performing expert as measured over a short period of time and following him or her.
"Experts" are far from infallible. A study found the best forecasters - even the "experts" - couldn't explain more than 20% of the toal variability in outcomes. "Consider what this means. On all sorts of questions you care about - Where will the Dow be in two years? Will the federal deficit balloon as baby-boomers retire? - your judgement is as good as the experts'. Not almost as good. Every bit as good." (This was from a 2006 article for Fortune, Geoffrey Colvin examined this concept by reviewing the book Expert Political Judgment: How Good Is It? How Can We Know?)
Colvin also noted that the study found that the experts' "awfulness" was pretty consistent regardless of their educational background, the duration of their experience, and whether or not they had access to classified materials. In fact, it found "but one consistent differentiator: fame. The more famous the experts, the worse they performed," Colvin said.
So, if that's the case, why do so-called "experts" still get so much publicity and air time? The reason is another result of our human nature. As humans, we want to believe the world " is not just a big game of dice and that things happen for good reasons and wise people can figure it all out." And since people like to hear from confident sounding experts who appear to be able to figure it all out, the media likes to give them air time - and the experts like to get that air time because it pays. This relationship was described as a "symbiotic triangle" - it is tempting to say "they need each other too much to terminate a relationship merely because it is based on an illusion."
The bottom line: Just because someone sits in front of a camera with a microphone and speaks confidently doesn't mean he or she has any sort of clairvoyant powers when it comes to the stock market. In fact, the odds are that four out of every five times, they'll be wrong!
Learn from the Worst: The Futility of Forecasting
Having established that most investors - professionals and amateur - underperform the market, the obvious question is, why?
How can so many smart people fare so poorly?
Perhaps, the greatest reason, is the fact that we are human. The way we think, the way we perceive things and feel emotions - has become a major topic in the investing world in recent years. Behavioural finance and neuroeconomics examine how psychology and physiology affect the way we deal with our money. And in general, the findings show that we humans are investing in the stock market with the deck stacked against us.
Zweig authored a book on neureconomics titled Your Money and Your Brain. One of the main points Zweig stressed is that human beings are excellent at quickly recognizing patterns in their environment. Being able to do so has been a key to our species' survival, enabling our ancestors to evade capture, find shelter, and learn how to plant the right crops in the right places. Those are all good, and often essential, things to know.
When it comes to investing, this ability ends up being a liability. "Our incorrigible search for patterns leads us to assume that order exists where it often doesn't. Almost everyone has an opinion about whether the Dow will go up or down from here, or whether a particular stock will continue to rise. And everyone wants to believe that the financial future can be foretold." But the truth, is that it can't - at least not in the day to day, short-term way that most investors think it can.
Everyday on Wall Street, something happens that makes people think they should invest more money in the stock market, or, conversely, makes them pull money out of the market. Earnings reports, analysts' rating changes, a report about how retail sales were last month - all o fthese things can send the market into a sudden surge or a precipitous decline. The reason: People view each of these items as a harbinger of what is to come, both for the economy and the stock market.
On the surface, it may sound reasonable to try to weigh each of these factors when considering which way the market will go. But when we look deeper, this line of thinking has a couple of major problems.
Here is one more wrench: the fact that good economic news doesn't even always portend stock gains, just as bad economic news doesn't always precede stock market declines. In fact, according to the Wall Street Journal, the market performed better during the recessions of 1980, 1981-1982, 1990-1991, and 2001 than it did in the six months leading up to them. And in the first three of those examples, stocks actually gained ground during the recession.
How can so many smart people fare so poorly?
Perhaps, the greatest reason, is the fact that we are human. The way we think, the way we perceive things and feel emotions - has become a major topic in the investing world in recent years. Behavioural finance and neuroeconomics examine how psychology and physiology affect the way we deal with our money. And in general, the findings show that we humans are investing in the stock market with the deck stacked against us.
Zweig authored a book on neureconomics titled Your Money and Your Brain. One of the main points Zweig stressed is that human beings are excellent at quickly recognizing patterns in their environment. Being able to do so has been a key to our species' survival, enabling our ancestors to evade capture, find shelter, and learn how to plant the right crops in the right places. Those are all good, and often essential, things to know.
When it comes to investing, this ability ends up being a liability. "Our incorrigible search for patterns leads us to assume that order exists where it often doesn't. Almost everyone has an opinion about whether the Dow will go up or down from here, or whether a particular stock will continue to rise. And everyone wants to believe that the financial future can be foretold." But the truth, is that it can't - at least not in the day to day, short-term way that most investors think it can.
Everyday on Wall Street, something happens that makes people think they should invest more money in the stock market, or, conversely, makes them pull money out of the market. Earnings reports, analysts' rating changes, a report about how retail sales were last month - all o fthese things can send the market into a sudden surge or a precipitous decline. The reason: People view each of these items as a harbinger of what is to come, both for the economy and the stock market.
On the surface, it may sound reasonable to try to weigh each of these factors when considering which way the market will go. But when we look deeper, this line of thinking has a couple of major problems.
- It discounts the incredible complexity of the stock market. There are so many factors that go into the market's day-to-day machinations; the earnings reports, analysts' ratings, and retail sales figures mentioned above are just the tip of the iceberg. Inflation readings, consumer spending reports, economic growth figures, fuel prices, recommendations of well-known pundits, news about a company's new products, the decisions of institutions to buy and sell because they have hit an internal taget or need to free up cash for redemptions - all of these and much, much more can also impact how stocks mvoe from day to day, or even hour to hour or minute to minute. One stock can even move simply because another stock in its industry reports its quarterly earnings. Very large, prominent companies such as Wal-Mart or IBM are considered bellwethers in their industries, for example, and a good or bad earnings report from them is often interpreted - sometimes inaccurately - as a sign of how the rest of companies in their industries will perform.
- When it comes to the monthly, quarterly, or annual economic and earnings reports, the market doesn't just move on the raw data in the reports; quite often, it moves more on how that data compares to what analysts had projected it to be . A company can post horrible earnings for a quarter, and its stock price migh rise because the results actually exceeded analysts' expectations. Or conversely, it can announce earnings growth of 200%, but fall if analysts were expecting 225% growth.
Here is one more wrench: the fact that good economic news doesn't even always portend stock gains, just as bad economic news doesn't always precede stock market declines. In fact, according to the Wall Street Journal, the market performed better during the recessions of 1980, 1981-1982, 1990-1991, and 2001 than it did in the six months leading up to them. And in the first three of those examples, stocks actually gained ground during the recession.
Learn from the Worst: The Fallen
"From the errors of others, a wise man corrects his own."
We are going to examine how and why investors have failed so that you'll be ready when confronted with the same pitfalls.
The Fallen
It's a pretty crowded place. There are the professionals - the mutual fund managers, the newsletter publishers, and the individual stock pickers.
Mutual Fund Managers
Most mutual fund managers fail to beat the returns you'd get if you had just bought an index fund that tracks the S&P 500. (The S&P 500 index is generally what people refer to when they talk about beating 'the market').
John Bogle (Vanguard Group): From 1983 through 2003, the average equity fund returned an average of 10.3% annually, while the S&P grew at a 13 % pace. A 2.7% spread between the S&P and mutual fund managers' performances may not seem like all that much. But, the compounded returns you get in the stock market can turn that kind of difference into a lot of money very quickly. A $10,000 investment that grows at 13% per year compounded annually, for example, will give you a shade over $115,000 after 20 years; at 10.3% per year, you'd end up with about $44,000 less than that (approximately $71,000).
O'Shaughnessy: "The best 10 years, ending December 31,1994, saw only 26% of the traditionally managed active mutual funds beating the S&P index." That means that just over a quarter of fund managers earned their clients market-beating returns in the best of those periods!
"Less than half of the funds that beat the S&P 500 for the 10 years ending May 31, 2004 did so by more than 2% per year on a compound basis." What's more - this is a key point - these statistics didn't include all the funds that failed to survive a particular 10-year period, meaning that his findings actually overstate the collective performance of equity funds.
Newsletter Publishers
These are investors - some professionals and some amateur - who write monthly or quarterly publications (many are published online) that give their assessment of the economy as well as their own stock picks. They sound official and authoritative and sometimes even have large reseach staffs working for them.
But while they can attract thousands of readers, more often than not their advice is lacking. Hubert Financial Digest monitors investment newsletters and tracks the performance of their picks said in a 2004 Dallas Morning News article that about 80% of newsletters don't keep pace with the S&P 500 over long periods of time.
And just as their individual stock picks are often subpar, newsletter publishers also have a difficult time just picking the general direction of the market.
A National Bureau for Economic Research study of 237 newsletter strategies done in the 1990s found that, between June 1980 and December 1992, there was "no evidence to suggest that investment newsletteres as a group have any knowledge over and above the common level of predictability."
While their advertisements and promises may sound tempting, the data indicates that newsletter publishers and money managers have a weak record when it comes to beating the market. Their collective track record, however, is far better than that of individual investors.
Individual Investors
John Bogle: He has addressed the issue of individual investors' returns and his findings paint an equally glum picture. He told that congressional committee in 2004 that he estimated individuals investors in equity fund has averaged an annual gain of just 3% over the previous 20 years, during which time the S&P 500 grew 13% per year.
We are going to examine how and why investors have failed so that you'll be ready when confronted with the same pitfalls.
The Fallen
It's a pretty crowded place. There are the professionals - the mutual fund managers, the newsletter publishers, and the individual stock pickers.
Mutual Fund Managers
Most mutual fund managers fail to beat the returns you'd get if you had just bought an index fund that tracks the S&P 500. (The S&P 500 index is generally what people refer to when they talk about beating 'the market').
John Bogle (Vanguard Group): From 1983 through 2003, the average equity fund returned an average of 10.3% annually, while the S&P grew at a 13 % pace. A 2.7% spread between the S&P and mutual fund managers' performances may not seem like all that much. But, the compounded returns you get in the stock market can turn that kind of difference into a lot of money very quickly. A $10,000 investment that grows at 13% per year compounded annually, for example, will give you a shade over $115,000 after 20 years; at 10.3% per year, you'd end up with about $44,000 less than that (approximately $71,000).
O'Shaughnessy: "The best 10 years, ending December 31,1994, saw only 26% of the traditionally managed active mutual funds beating the S&P index." That means that just over a quarter of fund managers earned their clients market-beating returns in the best of those periods!
"Less than half of the funds that beat the S&P 500 for the 10 years ending May 31, 2004 did so by more than 2% per year on a compound basis." What's more - this is a key point - these statistics didn't include all the funds that failed to survive a particular 10-year period, meaning that his findings actually overstate the collective performance of equity funds.
Newsletter Publishers
These are investors - some professionals and some amateur - who write monthly or quarterly publications (many are published online) that give their assessment of the economy as well as their own stock picks. They sound official and authoritative and sometimes even have large reseach staffs working for them.
But while they can attract thousands of readers, more often than not their advice is lacking. Hubert Financial Digest monitors investment newsletters and tracks the performance of their picks said in a 2004 Dallas Morning News article that about 80% of newsletters don't keep pace with the S&P 500 over long periods of time.
And just as their individual stock picks are often subpar, newsletter publishers also have a difficult time just picking the general direction of the market.
A National Bureau for Economic Research study of 237 newsletter strategies done in the 1990s found that, between June 1980 and December 1992, there was "no evidence to suggest that investment newsletteres as a group have any knowledge over and above the common level of predictability."
While their advertisements and promises may sound tempting, the data indicates that newsletter publishers and money managers have a weak record when it comes to beating the market. Their collective track record, however, is far better than that of individual investors.
Individual Investors
John Bogle: He has addressed the issue of individual investors' returns and his findings paint an equally glum picture. He told that congressional committee in 2004 that he estimated individuals investors in equity fund has averaged an annual gain of just 3% over the previous 20 years, during which time the S&P 500 grew 13% per year.
Sunday 21 June 2009
Inventory Management
Managing inventory is a juggling act. Excessive stocks can place a heavy burden on the cash resources of a business. Insufficient stocks can result in lost sales, delays for customers etc.
The key is to know how quickly your overall stock is moving or, put another way, how long each item of stock sit on shelves before being sold. Obviously, average stock-holding periods will be influenced by the nature of the business. For example, a fresh vegetable shop might turn over its entire stock every few days while a motor factory would be much slower as it may carry a wide range of rarely-used spare parts in case somebody needs them.
Nowadays, many large manufacturers operate on a just-in-time (JIT) basis whereby all the components to be assembled on a particular today, arrive at the factory early that morning, no earlier - no later. This helps to minimize manufacturing costs as JIT stocks:
The key issue for a business is to identify the fast and slow stock movers with the objectives of :
Remember that stock sitting on shelves for long periods of time ties up money which is not working for you.
For better stock control, try the following:
Our range of financial planners, Exl-Plan and Cashflow Plan, contain extensive facilities for exploring alternative stock-holding strategies. See also the white paper on Making Cashflow Forecasts and Checklist for Improving Cashflow.
http://www.planware.org/workingcapital.htm
The key is to know how quickly your overall stock is moving or, put another way, how long each item of stock sit on shelves before being sold. Obviously, average stock-holding periods will be influenced by the nature of the business. For example, a fresh vegetable shop might turn over its entire stock every few days while a motor factory would be much slower as it may carry a wide range of rarely-used spare parts in case somebody needs them.
Nowadays, many large manufacturers operate on a just-in-time (JIT) basis whereby all the components to be assembled on a particular today, arrive at the factory early that morning, no earlier - no later. This helps to minimize manufacturing costs as JIT stocks:
- take up little space,
- minimize stock-holding and
- virtually eliminate the risks of obsolete or damaged stock.
The key issue for a business is to identify the fast and slow stock movers with the objectives of :
- establishing optimum stock levels for each category and, thereby,
- minimize the cash tied up in stocks.
Factors to be considered when determining optimum stock levels include:
- What are the projected sales of each product?
- How widely available are raw materials, components etc.?
- How long does it take for delivery by suppliers?
- Can you remove slow movers from your product range without compromising best sellers?
Remember that stock sitting on shelves for long periods of time ties up money which is not working for you.
For better stock control, try the following:
- Review the effectiveness of existing purchasing and inventory systems.
- Know the stock turn for all major items of inventory.
- Apply tight controls to the significant few items and simplify controls for the trivial many.
- Sell off outdated or slow moving merchandise - it gets more difficult to sell the longer you keep it.
- Consider having part of your product outsourced to another manufacturer rather than make it yourself.
- Review your security procedures to ensure that no stock "is going out the back door !"
Higher than necessary stock levels tie up cash and cost more in insurance, accommodation costs and interest charges.
Our range of financial planners, Exl-Plan and Cashflow Plan, contain extensive facilities for exploring alternative stock-holding strategies. See also the white paper on Making Cashflow Forecasts and Checklist for Improving Cashflow.
http://www.planware.org/workingcapital.htm
Calculating Cashflow and Cashflow Planning
Calculating Cashflow:
Normally, the main sources of cash inflows to a business are
Cash outflows include
http://www.planware.org/cashflowforecast.htm
Normally, the main sources of cash inflows to a business are
- receipts from sales,
- increases in bank loans,
- proceeds of share issues and asset disposals, and
- other income such as interest earned.
Cash outflows include
- payments to suppliers and staff,
- capital and interest repayments for loans,
- dividends,
- taxation and
- capital expenditure.
Net cash flow is the difference between the inflows and outflows within a given period.
- A projected cumulative positive net cash flow over several periods highlights the capacity of a business to generate surplus cash and, conversely,
- a cumulative negative cash flow indicates the amount of additional cash required to sustain the business.
Cashflow planning:
Cashflow planning entails
- forecasting and tabulating all significant cash inflows relating to sales, new loans, interest received etc. and
- then analyzing in detail the timing of expected payments relating to suppliers, wages, other expenses, capital expenditure, loan repayments, dividends, tax, interest payments etc.
- The difference between the cash in- and out-flows within a given period indicates the net cash flow.
- When this net cash flow is added to or subtracted from opening bank balances, any likely short-term bank funding requirements can be ascertained.
http://www.planware.org/cashflowforecast.htm
Key Working Capital Ratios & Sources of Additional Working Capital
Stock Turnover(in days)
Average Stock * 365/Cost of Goods Sold
= x days
On average, you turn over the value of your entire stock every x days. You may need to break this down into product groups for effective stock management.Obsolete stock, slow moving lines will extend overall stock turnover days. Faster production, fewer product lines, just in time ordering will reduce average days.
Receivables Ratio(in days)
Debtors * 365/Sales
= x days
It take you on average x days to collect monies due to you. If your official credit terms are 45 day and it takes you 65 days... why ?One or more large or slow debts can drag out the average days. Effective debtor management will minimize the days.
Payables Ratio(in days)
Creditors * 365/Cost of Sales (or Purchases)
= x days
On average, you pay your suppliers every x days. If you negotiate better credit terms this will increase. If you pay earlier, say, to get a discount this will decline. If you simply defer paying your suppliers (without agreement) this will also increase - but your reputation, the quality of service and any flexibility provided by your suppliers may suffer.
Current Ratio
Total Current Assets/Total Current Liabilities
= x times
Current Assets are assets that you can readily turn in to cash or will do so within 12 months in the course of business. Current Liabilities are amount you are due to pay within the coming 12 months. For example, 1.5 times means that you should be able to lay your hands on $1.50 for every $1.00 you owe. Less than 1 times e.g. 0.75 means that you could have liquidity problems and be under pressure to generate sufficient cash to meet oncoming demands.
Quick Ratio
(Total Current Assets - Inventory)/Total Current Liabilities
= x times
Similar to the Current Ratio but takes account of the fact that it may take time to convert inventory into cash.
Working Capital Ratio
(Inventory + Receivables - Payables)/Sales
As % Sales
A high percentage means that working capital needs are high relative to your sales.
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An example:
Company A monthly inventory = $30
Company A annual purchases = $360
Inventory turnover = $30 x12 / $360 = 1 month = 30 days
The bank gives a interest free facility for the first 15 days; after then, interests will be charged on a daily basis from the first day of purchase.
The company presently uses the bank facility of $30.
How can this company manages its cash flow better? How can this company saves on its interest payment?
Company A can continues to enjoy the bank's interest free facility if it can get its inventory turnover to be less than 15 days. This will free up working capital that can be used for other parts of its business.
To save on interest, company can increase its own working capital by injecting cash in the form of equity or a loan from owners. This cash can be used to settle the bank facility at the time period of 15 days, that is, before the facility incurs interest charges. How much cash should be injected into its working capital for this? To do so, would require (15 days/30 days ) x $30 = $15 cash to be injected in the form of equity or loan by the owners, for extra working capital.
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Sources of Additional Working Capital
http://www.planware.org/workingcapital.htm
Average Stock * 365/Cost of Goods Sold
= x days
On average, you turn over the value of your entire stock every x days. You may need to break this down into product groups for effective stock management.Obsolete stock, slow moving lines will extend overall stock turnover days. Faster production, fewer product lines, just in time ordering will reduce average days.
Receivables Ratio(in days)
Debtors * 365/Sales
= x days
It take you on average x days to collect monies due to you. If your official credit terms are 45 day and it takes you 65 days... why ?One or more large or slow debts can drag out the average days. Effective debtor management will minimize the days.
Payables Ratio(in days)
Creditors * 365/Cost of Sales (or Purchases)
= x days
On average, you pay your suppliers every x days. If you negotiate better credit terms this will increase. If you pay earlier, say, to get a discount this will decline. If you simply defer paying your suppliers (without agreement) this will also increase - but your reputation, the quality of service and any flexibility provided by your suppliers may suffer.
Current Ratio
Total Current Assets/Total Current Liabilities
= x times
Current Assets are assets that you can readily turn in to cash or will do so within 12 months in the course of business. Current Liabilities are amount you are due to pay within the coming 12 months. For example, 1.5 times means that you should be able to lay your hands on $1.50 for every $1.00 you owe. Less than 1 times e.g. 0.75 means that you could have liquidity problems and be under pressure to generate sufficient cash to meet oncoming demands.
Quick Ratio
(Total Current Assets - Inventory)/Total Current Liabilities
= x times
Similar to the Current Ratio but takes account of the fact that it may take time to convert inventory into cash.
Working Capital Ratio
(Inventory + Receivables - Payables)/Sales
As % Sales
A high percentage means that working capital needs are high relative to your sales.
----
An example:
Company A monthly inventory = $30
Company A annual purchases = $360
Inventory turnover = $30 x12 / $360 = 1 month = 30 days
The bank gives a interest free facility for the first 15 days; after then, interests will be charged on a daily basis from the first day of purchase.
The company presently uses the bank facility of $30.
How can this company manages its cash flow better? How can this company saves on its interest payment?
Company A can continues to enjoy the bank's interest free facility if it can get its inventory turnover to be less than 15 days. This will free up working capital that can be used for other parts of its business.
To save on interest, company can increase its own working capital by injecting cash in the form of equity or a loan from owners. This cash can be used to settle the bank facility at the time period of 15 days, that is, before the facility incurs interest charges. How much cash should be injected into its working capital for this? To do so, would require (15 days/30 days ) x $30 = $15 cash to be injected in the form of equity or loan by the owners, for extra working capital.
----
Sources of Additional Working Capital
Sources of additional working capital include the following:
- Existing cash reserves
- Profits (when you secure it as cash !)
- Payables (credit from suppliers)
- New equity or loans from shareholders
- Bank overdrafts or lines of credit
- Long-term loans
If you have insufficient working capital and try to increase sales, you can easily over-stretch the financial resources of the business. This is called overtrading.
Early warning signs include:
- Pressure on existing cash
- Exceptional cash generating activities e.g. offering high discounts for early cash payment
- Bank overdraft exceeds authorized limit
- Seeking greater overdrafts or lines of credit
- Part-paying suppliers or other creditors
- Paying bills in cash to secure additional supplies
- Management pre-occupation with surviving rather than managing
- Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of a cheque).
http://www.planware.org/workingcapital.htm
Short-term gain, long-term pain
Just reviewing my transactions in one of my stocks which I have invested since the 1990s. This review starts from May 2006.
The bought and sold transactions since May 2006
15-May-06 xx Bought at 3.98 Present price 8.35 Gain 4.370
31-May-06 xx Bought at 4.06 Present price 8.35 Gain 4.290
13-Jun-06 xx Bought at 3.92 Present price 8.35 Gain 4.430
26-Mar-07 xx Bought at 5.75 Present price 8.35 Gain 2.600
29-Mar-07 xx Bought at 5.95 Present price 8.35 Gain 2.400
03-Jun-07 xx Sold some at 5.3
28-Aug-07 xx Bought at 8.25 Present price 8.35 Gain 0.100
28-Jan-08 xx Sold some at 8.05
06-May-09 xx Bought at 7.70 Present price 8.35 Gain 0.650
05-Jun-09 xx Bought at 7.95 Present price 8.35 Gain 0.400
Stock xxx Avg Price --- Present price 8.35 Gain ---
The present price of this stock is 8.35.
The annual dividend yield of this stock is better than the present FD rate.
Its share price peaked at 9.25 in second half of 2007.
During the severe 2007 - 2008 bear market, the share price was at the lowest of $6.30 in September 2008.
Observations:
There were 10 transactions: 10 buys and 2 sells (partial).
Buying this stock at regular intervals has been profitable.
The prices of the stock bought in the early years were lower than those bought in the later years.
The share price of this stock (good quality company) has reflected its eps and eps growth rate over time.
At the lowest share price of $6.30, the average price of all the transactions were still lower than this market price.
Some stocks were sold for various reasons (e.g. to lock in gains/ or in anticipation of market downturn/ asset allocation/ etc.) in Jun 07 and Jan 08 for 5.30 and 8.05. The present price of this stock at 8.35 is higher than these selling prices.
DISCUSSION:
1. Buying this stock for the long term is safe and profitable.
2. Short term volatilities offer opportunities to buy this stock at bargain prices.
3. The above buying is almost akin to dollar cost averaging (upwards) and it is safe. Dollar cost averaging (downwards) is also safe and probably can give even better returns.
4. Selling this stock at anytime during the 2007-2009 severe bear market and not reinvesting into the same stock at lower prices, gives a lower return than the investor who held onto his stocks during the same period.
5. Lump sum investing into this stock at bargain prices in the earlier years, may give a better return, than dollar cost averaging the same amount over a very long time frame. Dollar cost averaging over a few months (for example 6 months) is almost equivalent to lump sum investing.
6. Timing the market is difficult. Study the above transactions:
8. The average price of all the above transactions were significantly lower than the market price almost all the time. This is so even when the market price was at its lowest of $6.30. This gain provides a significant buffer and confidence to the investor of this stock. A value investor would be happy to hold or even load up on this share at the low prices.
CONCLUSION:
It is safe and profitable to buy and hold this and selective stocks.
Selective stocks can be held safely for the long term, even in a severe bear market.
Selling a good quality stock for short-term gain, generates cash which will need to be reinvested. This is not without its associated risks, including, that of not achieving your objective of superior gains in your investments (for example, 15% per year, doubling in 5 years).
Timing the market to buy and to sell is tempting, but is difficult. (trust me on this).
Selling and buying incurs some costs, and when are done frequently, will reduce your returns.
The bought and sold transactions since May 2006
15-May-06 xx Bought at 3.98 Present price 8.35 Gain 4.370
31-May-06 xx Bought at 4.06 Present price 8.35 Gain 4.290
13-Jun-06 xx Bought at 3.92 Present price 8.35 Gain 4.430
26-Mar-07 xx Bought at 5.75 Present price 8.35 Gain 2.600
29-Mar-07 xx Bought at 5.95 Present price 8.35 Gain 2.400
03-Jun-07 xx Sold some at 5.3
28-Aug-07 xx Bought at 8.25 Present price 8.35 Gain 0.100
28-Jan-08 xx Sold some at 8.05
06-May-09 xx Bought at 7.70 Present price 8.35 Gain 0.650
05-Jun-09 xx Bought at 7.95 Present price 8.35 Gain 0.400
Stock xxx Avg Price --- Present price 8.35 Gain ---
The present price of this stock is 8.35.
The annual dividend yield of this stock is better than the present FD rate.
Its share price peaked at 9.25 in second half of 2007.
During the severe 2007 - 2008 bear market, the share price was at the lowest of $6.30 in September 2008.
Observations:
There were 10 transactions: 10 buys and 2 sells (partial).
Buying this stock at regular intervals has been profitable.
The prices of the stock bought in the early years were lower than those bought in the later years.
The share price of this stock (good quality company) has reflected its eps and eps growth rate over time.
At the lowest share price of $6.30, the average price of all the transactions were still lower than this market price.
Some stocks were sold for various reasons (e.g. to lock in gains/ or in anticipation of market downturn/ asset allocation/ etc.) in Jun 07 and Jan 08 for 5.30 and 8.05. The present price of this stock at 8.35 is higher than these selling prices.
DISCUSSION:
1. Buying this stock for the long term is safe and profitable.
2. Short term volatilities offer opportunities to buy this stock at bargain prices.
3. The above buying is almost akin to dollar cost averaging (upwards) and it is safe. Dollar cost averaging (downwards) is also safe and probably can give even better returns.
4. Selling this stock at anytime during the 2007-2009 severe bear market and not reinvesting into the same stock at lower prices, gives a lower return than the investor who held onto his stocks during the same period.
5. Lump sum investing into this stock at bargain prices in the earlier years, may give a better return, than dollar cost averaging the same amount over a very long time frame. Dollar cost averaging over a few months (for example 6 months) is almost equivalent to lump sum investing.
6. Timing the market is difficult. Study the above transactions:
- Did this investor buy during the depth of the 2007 - 2009 severe bear market? (This investor has to put in more work on this topic!)
- Did this investor sell at the height of the bull market?
8. The average price of all the above transactions were significantly lower than the market price almost all the time. This is so even when the market price was at its lowest of $6.30. This gain provides a significant buffer and confidence to the investor of this stock. A value investor would be happy to hold or even load up on this share at the low prices.
CONCLUSION:
It is safe and profitable to buy and hold this and selective stocks.
Selective stocks can be held safely for the long term, even in a severe bear market.
Selling a good quality stock for short-term gain, generates cash which will need to be reinvested. This is not without its associated risks, including, that of not achieving your objective of superior gains in your investments (for example, 15% per year, doubling in 5 years).
Timing the market to buy and to sell is tempting, but is difficult. (trust me on this).
Selling and buying incurs some costs, and when are done frequently, will reduce your returns.
Saturday 20 June 2009
Working Capital Cycle & Working Capital Management
Working Capital
This measures the funds that are readily available to operate a business.
Working capital comprises the total net current assets of a business, which are its stocks, debtors and cash - minus its creditors.
Why it is important
It is vital for a company to have sufficient working capital to meet all its requirements. The faster a business expands, the greater will be its working capital needs.
If current assets do not exceed current liabilities, a company may well run into trouble paying creditors who want their money quickly.
Indeed, the leading cause of business failure is not lack of profitability, but rather lack of working capital, which helps to explain why some experts advise: 'Use someone else's money every chance you get and don't let anyone else use yours.'
How it works in practice
Working capital is also called net current assets or current capital.
Working capital = Current assets - Current liabilities
Current assets are cash and assets that can be converted to cash within one year or a normal operating cycle; current liabilities are monies owed that are due within one year.
What is working capital cycle
The working capital cycle describes capital (usually cash) as it moves through a company:
This measures the funds that are readily available to operate a business.
Working capital comprises the total net current assets of a business, which are its stocks, debtors and cash - minus its creditors.
Why it is important
It is vital for a company to have sufficient working capital to meet all its requirements. The faster a business expands, the greater will be its working capital needs.
If current assets do not exceed current liabilities, a company may well run into trouble paying creditors who want their money quickly.
Indeed, the leading cause of business failure is not lack of profitability, but rather lack of working capital, which helps to explain why some experts advise: 'Use someone else's money every chance you get and don't let anyone else use yours.'
How it works in practice
Working capital is also called net current assets or current capital.
Working capital = Current assets - Current liabilities
Current assets are cash and assets that can be converted to cash within one year or a normal operating cycle; current liabilities are monies owed that are due within one year.
What is working capital cycle
The working capital cycle describes capital (usually cash) as it moves through a company:
- it first flows from a company to pay for supplies, materials, finished goods inventory, and wages to workers who produce goods and services.
- It then flows into a company as goods and services are sold and as new investment equity and loans are received.
Each stage of the cycle consumers time.
The more time the stages consume, the greater the demand on working capital.
Cash ----> pay for supplies, materials, finished goods inventory and wages to workers who produce goods and services ---> goods and services are sold and new investment equity and loans are received ---> Cash
Tricks of the trade
- Good management of working capital includes action like collecting receivables faster and moving inventory more quickly; generating more cash increases working capital.
- While it can be tempting to use cash to pay for fixed assets like computers or vehicles, doing so reduces the amount of cash available for working capital.
- If working capital is tight, consider other ways of financing capital investment, such as loans, fresh equity, or leasing.
- Early warning signs of insufficient working capital include:
The more time the stages consume, the greater the demand on working capital.
Cash ----> pay for supplies, materials, finished goods inventory and wages to workers who produce goods and services ---> goods and services are sold and new investment equity and loans are received ---> Cash
Tricks of the trade
- Good management of working capital includes action like collecting receivables faster and moving inventory more quickly; generating more cash increases working capital.
- While it can be tempting to use cash to pay for fixed assets like computers or vehicles, doing so reduces the amount of cash available for working capital.
- If working capital is tight, consider other ways of financing capital investment, such as loans, fresh equity, or leasing.
- Early warning signs of insufficient working capital include:
- pressure on existing cash;
- exceptional cash generating activities such as offering high discounts for early payment;
- increasing lines of credit;
- partial payments to suppliers and creditors;
- a preoccupation with surviving rather than managing;
- frequent short-term emergency requests to the bank, for example, to help pay wages, pending receipt of a cheque.
- Several ratios measure how effectively and efficiently working capital is being used. (Key Working Capital Ratios : Stock Turnover(in days), Receivables Ratio(in days) , Payables Ratio(in days) , Current Ratio, Quick Ratio, Working Capital Ratio)
Also read:
Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.
How to assess a banking stock
Nett Interest Income
- Loan Loss & Prov.
+ Non-Interest Income
-----------------------
Net Revenue
- Non-Interest Expense
-----------------------
Profit Before Tax
-----------------------
Profit After Tax (Earnings)
How well is the bank managing these risks: interest rate risk, credit risk and liquidity risk?
Is the bank conservatively managed and consistently delivering solid but not knockout profits?
Get a feel for,
Here's a list of some major metrics to consider:
1. Strong Capital Base
2. Return on Equity and Return on Assets
3. Efficiency Ratios
4. Net Interest Margins
5. Strong Revenues
6. Price-to-Book
Find the answers to the following questions before investing into a banking stock:
What is the bank's capital ratio (equity-to-assets ratio)? Compare this to the industry average.
What is the level of loan loss reserves relative to non-performing assets?
Is the ROE in the mid to high-teen?
Is the ROA in the 1.2% to 1.4% range?
Is the efficiency ratio (non-interest expense/net revenues) under 55%?
What is its net interest margin (net interest income/average earning assets? (Most banks' margin fall into the 3% - 4% range. )
Track the net interest margins and ask what is the trend? Is it rising? If yes, why?
- Loan Loss & Prov.
+ Non-Interest Income
-----------------------
Net Revenue
- Non-Interest Expense
-----------------------
Profit Before Tax
-----------------------
Profit After Tax (Earnings)
How well is the bank managing these risks: interest rate risk, credit risk and liquidity risk?
Is the bank conservatively managed and consistently delivering solid but not knockout profits?
Get a feel for,
- the kind of lending they do,
- the way that risk is managed,
- the quality of management, and
- the amount of equity capital the bank holds.
Here's a list of some major metrics to consider:
1. Strong Capital Base
2. Return on Equity and Return on Assets
3. Efficiency Ratios
4. Net Interest Margins
5. Strong Revenues
6. Price-to-Book
Find the answers to the following questions before investing into a banking stock:
What is the bank's capital ratio (equity-to-assets ratio)? Compare this to the industry average.
What is the level of loan loss reserves relative to non-performing assets?
Is the ROE in the mid to high-teen?
Is the ROA in the 1.2% to 1.4% range?
Is the efficiency ratio (non-interest expense/net revenues) under 55%?
What is its net interest margin (net interest income/average earning assets? (Most banks' margin fall into the 3% - 4% range. )
Track the net interest margins and ask what is the trend? Is it rising? If yes, why?
- Is falling interest rates pushing up net interest margins?
- Examine the bank's loan categories. Is the bank moving into different lending areas pushing up net interest margins?
What is the revenue growth? Is this above-average revenue growth?
- Is this revenue growth due to growth in the non-interest income (fee income)?
- What is the percentage of fee income to the net revenue? How fast is this growing? (Fee income made up 42% of bank industry revenue in 2001 and has grown at an 11.6% compound annual rate over the past 2 decades.)
- Is this revenue growth due to growth in interest income? Is this due to paying slightly lower rate on deposits and charging slightly higher rate on loans?
What is the book value of the bank? What is the Price-to-Book ratio? (The base value for a bank should be the book value. For any premium above that, investors are paying for future growth and excess earnings. Typically, big banks have traded in the 2x or 3x book range over the past decade; regionals have often traded for less than that.)
Friday 19 June 2009
Hallmarks of Success for Banks: Price-to-Book
Banks' balance sheets consist mostly of financial assets with varying degrees of liquidity.
Book value is a good proxy for the value of a banking stock.
Assuming the assets and liabilities closely approximate their reported value, the base value for a bank should be book value. For any premium above that, investors are paying for future growth and excess earnings.
Seldom do banks trade for less than book, but if they do, the bank's assets could be distressed.
Bank stocks are volatile creatures, and you can find good values if you're patient - especially because even the best banks will generally be hit hard when any high-profile blowup occurs in the financial services sector.
Lying up several banks for a relative P/B valuation isn't as good as putting together a discounted cash flow model, but for this industry, it can be a reasonable approximation of the value of the business.
Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book
Book value is a good proxy for the value of a banking stock.
Assuming the assets and liabilities closely approximate their reported value, the base value for a bank should be book value. For any premium above that, investors are paying for future growth and excess earnings.
Seldom do banks trade for less than book, but if they do, the bank's assets could be distressed.
Typically, big banks have traded in the two or three times book range over the past decade; regionals have often traded for less than that.
A solid bank trading at less than 2x book value is often worth a closer look. Remember, there is almost always a reason the bank is selling at a discount, so be sure you understood the risks.
On the other hand, some banks are worth 3x book value or more, but we would exercise caution before paying that much.
Bank stocks are volatile creatures, and you can find good values if you're patient - especially because even the best banks will generally be hit hard when any high-profile blowup occurs in the financial services sector.
Lying up several banks for a relative P/B valuation isn't as good as putting together a discounted cash flow model, but for this industry, it can be a reasonable approximation of the value of the business.
Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book
Hallmarks of Success for Banks: Strong Revenues
Above-average revenue growth: Historically, many of the best performing bank investments have been those that have proven capable of above-average revenue growth.
Wide margins have generally been elusive in a commodity industry that competes on service quality.
Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book
Wide margins have generally been elusive in a commodity industry that competes on service quality.
- But, some of the most successful banks have been able to cross-sell new services, which adds to fee income, or
- pay a slightly lower rate on deposits and charge a slightly higher rate on loans.
Keep an eye on 3 major metrics:
- 1. net interest margin
- 2. fee income as a percent of total revenues, and
- 3. fee income growth.
The net interest margin can vary widely depending on
- economic factors,
- the interest rate environment, and
- the type of business the lender focuses on,
so it's best to compare the bank you're interested in to other similar institutions.
Fee income made up 42% of bank industry revenue in 2001 and has grown at an 11.6% compound annual rate over the past 2 decades.
A large and diversified company such as Fifth Third generates more than 40% of its net revenues from fee income, whereas smaller, less diversified companies such as thrifts (e.g. Golden West) get just 10% to 12% of income from fees.
Make sure, therefore, that you're comparing similar companies and that you understand the company's strategy. As always, examine the number over a period of time to get a sense of the trend.
Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book
Hallmarks of Success for Banks: Net Interest Margins
Another simple measure to watch is net interest margin.
Net interest margin
= net interest income / average earning assets
Virtually all banks report net interest margins because it measures lending profitability.
There is a wide variety of net interest margins, depending on the type of lending a bank engages in.
Most banks' margins fall into the 3% - 4% range.
Track margins over time to get a feel for the trend.
If margins are rising:
Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book
Net interest margin
= net interest income / average earning assets
Virtually all banks report net interest margins because it measures lending profitability.
There is a wide variety of net interest margins, depending on the type of lending a bank engages in.
Most banks' margins fall into the 3% - 4% range.
Track margins over time to get a feel for the trend.
If margins are rising:
- Check to see what's been happening with interest rates. (Falling rates generally push up net interest margins.)
- In addition, examine the bank's loan categories to see whether the bank has been moving into different lending areas. For example, credit card loans typically carry much higher interest rates than residential mortgages, but credit card lending is also riskier than lending money secured by a house.
Related posts:
Hallmarks of Success for Banks
Hallmarks of Success for Banks: Strong Capital Base
Hallmarks of Success for Banks: ROE and ROA
Hallmarks of Success for Banks: Efficiency Ratios
Hallmarks of Success for Banks: Net Interest Margins
Hallmarks of Success for Banks: Strong Revenues
Hallmarks of Success for Banks: Price-to-Book
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