Archive for the ‘Value Investing’ Category

Is it time to buy stocks in times of intense fear and volatility? Part 1: Introduction

Monday, October 27th, 2008

Let’s say you are a long-term investor who is not into timing the bottom of the stock market. After having seen the market falling into intense panic and fear over the past few weeks, you may wonder whether it is now time to buy stocks for their long-term value. No doubt, in this climate of intense volatility and fear in the market, stocks of good businesses along with the bad ones are indiscriminately sold. Even if a depression is coming, not all businesses will be affected equally. Some of the better quality ones will fare better (and even thrive) in such a harsh environment. For example, during the Great Depression, some businesses’ profit even grew (see Which industry?s profitability grew as the Great Depression progressed?)!

Surely, some of these stocks are undervalued by now right? Should you buy now? Even Warren Buffett is buying.

Well, the answer will depend on your personal circumstances. More specifically, it depends on your current level of leverage. In other words, the right answer to this question for two different people can be different. In the coming articles, we will explain how to go about answering this question based on probability, reward and loss. Keep in tune!

Choosing the businesses with strong economics- Part 1: avoiding poor economics businesses

Wednesday, October 15th, 2008

Yesterday, in Two uncertainties of valuing a business- risk & earnings, we mentioned that risk and earnings are the two uncertainties in valuing a business. As we said in that article,

However, not all businesses are the same. Some are so straightforward that it is very easy to have a very accurate estimate of their future earnings. Others are so complicated that any attempts at estimating their future earnings are at best rough guesstimates.

Today, we will start off with a mini-series about choosing businesses that have strong economics. Such businesses have relatively lower uncertainties regarding their earnings and are also much less risky. Businesses with weak economics are much more difficult to value because of their higher risks and earnings uncertainties. For today’s article, we will look at identifying such businesses to avoid.

First, what are businesses with poor economics? They are the ones in price-competitive industries. As this book, The New Buffettology explains,

A price-competitive type of business manufactures or sells a product or service that many other businesses sell and competes for customers solely on the basis of price.

Example of such business is steel making, agriculture and manufacturing of mass generic products like clothes hangers. If you see a businesses in which its customers’ strongest motivation to buy is price, then you know it has poor economics. For such businesses to survive and defeat their competitors, they have to beat their competitors in costs. To beat their competitors in costs, they have to continuously engage in ruthless cost-cutting measures and improvements in techniques to keep their businesses competitive. This often requires additional capital expenditures and energy to keep the wheels running non-stop, which translate to more long-term debt and less distribution of profits to shareholders. Often, cost-cutting measures and improvement techniques are easily replicated. Therefore, businesses in price-competitive industries end up under-cutting each other continuously, which erodes profit over time. For such businesses, good quality and intelligent management is crucial to keep the business profitable. Also, they are more prone to strokes of bad luck.

So, to be a successful investor, the first step is to avoid businesses with poor economics.

Two uncertainties of valuing a business- risk & earnings

Monday, September 29th, 2008

In our previous article, Measuring the value of an investment, we learnt about the theory and mathematics behind the valuation of a business under artificial conditions that are clearly defined. Under such conditions, we know exactly the business’s future earnings and its risk relative to government bonds. Therefore, valuing artificial businesses is easy and straightforward. But in the real world, earnings and risks are the very things that cannot be so easily and clearly defined and quantified. As we said in that article,

So far, this is the theory behind value investing. In practice, in a world of uncertainty and Black Swans, it is not possible to know the exact amount of future cash flow of any business. Also, risk is not something that we can easily quantify nicely in order to derive a value for the discount rate. That is the ?art? of investing.

Thus, we should not be under the impression that the dollar number that is produced from the valuation of a real-world business is a scientifically precise number. Rather, no matter how precise that number is, it is just an estimate. And it is far more important for that number to be accurate than for it to be precise. If you are confused with what this means, we suggest that you read our previous article, Confusion between precision & accuracy and Example of precisely inaccurate information.

First, we will discuss the earnings of a business. Stock analysts spend a lot of effort trying to divine the future cash flows of the business that they are analysing. However, not all businesses are the same. Some are so straightforward that it is very easy to have a very accurate estimate of their future earnings. Others are so complicated that any attempts at estimating their future earnings are at best rough guesstimates. For some, they can even be unpredictable or volatile. To be a successful investor, you will do better to avoid businesses that you find difficult to come up with accurate earnings estimates. We will explain the characteristics of businesses that favour accurate earnings estimates in future articles.

Next, we will discuss the risk of a business. The mainstream finance uses volatility of prices to define risk. As we said before in How do you define risk?,

In today?s financial services industry, a large part of risk is defined by the volatility of the price?the more volatile the investment is, the more ?risky? it is. This definition of risk arises from the fact that retail investors tend to perceive the safety of an investment in terms of how much of its value can be preserved within a given period of time.

But we see risk differently. As we explained before in Measuring the value of an investment, the risk in value investing is a relative concept. The payments of government bonds are assumed to be completely risk-free whereas the earnings of a business are not so certain. Risk relates to how secure the future earnings of a business is. To illustrate this concept, let’s suppose there are two different businesses with identical earnings estimates. One is located in a geologically stable place (e.g. Singapore) while the other is located in an earthquake prone area (e.g. Tokyo). We can say that the latter one carries more risk because its earnings can be cut due to an earthquake. Therefore, it will carry a higher discount rate.

Between earnings and risk, the latter is the most subjective of all in the business’s valuation. In a world of Black Swans, risk is not something that can be easily quantified into a precise number (discount rate). It is also a number that cannot be verified for correctness. For earnings, all we have to do is to compare earnings estimates with the actual earnings to have a gauge of the estimate’s accuracy. But you cannot do so for the discount rate. Thus, in any valuation of a business, the discount rate is the first to be fudged by analysts.

Bear that in mind when you look at analyst reports on the price targets of stocks.

What is the meaning of ?oversold?? Part 2: Value perspective

Tuesday, September 16th, 2008

Continuing from our previous article, What is the meaning of ?oversold?? Part 1: Technical analysis perspective, we will explain the meaning of “oversold” from the value-investing perspective.

In Are some Aussie resource stocks oversold?, Pete, our regular reader commented that,

So on one hand, if demand is the same, then they are oversold, but on the other hand, if demand is decreasing, then even though they are currently oversold, the current oversold price may become a nominal price in the near future?
Eg: BHP shares may be worth $40 now, but trade at $35 or so. But due to lack of demand, by December, they may only be ‘worth’ $35. Although by then my guess is that they would be oversold even more to $30, etc.

On that note, when we say the resource stocks might be oversold, is it perhaps a bit like real-estate, where they are in fact not oversold at their current prices, but were in fact ‘over-bought’ in the first place, and are now returning to more normal levels? Perhaps they are still overbought now, just less so?

Before you read on further, please make sure that you understand the concept of value investing in our guide, Value investing for dummies. Particularly, pay attention to the first 4 articles. What follows will assume the pre-requisite understanding of these articles in the guide.

The important things to understand about the mining business is this:

  1. It’s revenue is very much dependent on the price of the commodities it sells (this is a very obvious point).
  2. It’s a price taker in general. In other words, most mining businesses do not have the market power to affect prices. The exception will be BHP and Rio Tinto as they have enough market power to affect the price of iron.
  3. It’s products (e.g. copper, zinc) is relatively very much un-differentiable from those of their competitors unlike the more traditional businesses.
  4. A mining business do not have an theoretical infinite life as some other traditional businesses. That is because ALL mines have a finite amount of the commodity that can be economically extracted. In other words, there is a finite life to every mine/oil/gas field at a specific rate of extraction.

The problem is, the future earnings of a mining company is notoriously difficult to predict. For example, these factors will affect the future earnings:

  1. Commodity prices (that’s obvious point).
  2. Cost of its input (energy is one of the major inputs and that in itself is a commodity whose prices are at the mercy of the markets).
  3. Exchange rate. Since commodity prices are denominated in US dollars, an Australian mining business’s earnings will be dependent on the exchange rate.
  4. The future quantity of the commodities it will produce. Obviously, profits rise when the sale price increases or the quantity of the produce increases. That will depend on the outcome of the development and exploration projects of the mining business.

Within point (1) i.e. the commodity price, there are many factors that will have impact on it:

  1. Underlying demand- this is the real physical demand of the commodity needed by people and nations.
  2. Investment demand or hoarding- This is the second type of demand in which the buyers and sellers do not have interests in the physical commodity. Instead, they trade the commodity in the context of money shuffling.
  3. Physical supply of the commodity- for example, as commodity prices collapses, some mines become uneconomical and close down as a result. This will reduce the supply of commodity produced. Other supply disruptions include strikes, natural disasters and so on. Or there may be new mining projects that start to produce and increase the supply to the market.

Now, let us look at point (1) and (2) that affects the price of commodities. As we explained before in Analysing recent falls in oil prices?real vs investment demand,

Now, let?s go back to oil. What makes up the demand for oil? There are basically two types of demand for oil: (1) The physical demand where the real side of the economy uses for its everyday needs and (2) The investment demand where the financial side of the economy shifts the money here and there from one asset class to the other. We need to ask ourselves the following question: Has the physical demand for oil changed? Will it change in the long run?

In today’s globalised financial system, the investment demand (we like to call it “hoarding” instead) has increasingly significant impact on prices. To complicate the issue, it is very difficult (or impossible, depending on your theoretical inclination) to sift between investment demand and physical demand as the commodity trades are made through complex web of intermediaries and relationships. As we questioned in Price fluctuations and hoarding

In today?s context, does a sudden fall in the price of a commodity (e.g. oil, iron, grain, wheat) mean that its underlying demand has suddenly fallen or its supply has suddenly increased? Obviously, the answer is no.

Let’s say that prices were originally too high because of the artificial demand from investment (or rather, hoarding). Now that the de-leveraging process (see Is the credit crisis the end of the beginning?) is under way, forced liquidation and flight from commodities from these investors/hoarders will send prices down very rapidly. As the change in physical demand/supply of commodities tend to move very much slower (relatively) than the change in investment demand/supply, we believe that this forced selling will tend to cause prices to undershoot (i.e. drop to too low) in the short term.

Now, consider this: as price falls by a lot all of a sudden (due to the sell-off by investors/hoarders), guess what will happen to the physical demand? Obviously, physical demand will increase. To a certain extent, this sell-off will result in a change in the composition of demand (between physical and investment demands). If the miners can increase production in response to increased demand, this will counteract the negative effects of falling prices on profits.

Next, as we mentioned before in Are some Aussie resource stocks oversold?, although commodity prices are falling in US dollars, it has not fallen as much in Aussie dollars.

Another consideration: as investors/hoarders sell commodities indiscriminately, the prices get undershoot. The stock market tends to overreact and price the business as if the prices of commodities will fall even further as rapidly as before. That is, it extrapolates the direction and speed of further commodity price falls too far out. It also tends to ignore the positive counteracting effects on profits as well (e.g. increased physical demand and falling Aussie exchange rate). Now, we will have a second ‘layer’ of price undershooting.

Finally, we will provide a qualifier: it is still possible for commodity prices to fall further in say, 2009 and 2010. But assuming that:

  1. Central bankers will eventually resort to money printing (see Understanding the big picture in the inflation-deflation debate) in the context of…
  2. long-run growth in Chinese and Indian demand (see Are we in a long-term inflationary environment?) and
  3. Physical demand will not collapse as much and as suddenly in the longer term as the short-term prices seem to suggests, …

… we believe that the long-run earnings of some mining businesses may not be as devastating as what their stock prices suggests. If these resource stock prices continue to plunge further, it will come to a point that it will be priced as if there will be a devastating world-wide Greater Deflationary Depression along with perpetual Chinese/Indian anarchy/revolution/chaos.

But having said that, remember that as we said before, all mines/oil/gas fields have a finite life. In the absence of potential new production from future exploration and mining development projects, a mining business will cease after an estimated number of years, after the supply of commodities are being exhausted. The implication is that if the downturn is severe and long enough, some mining businesses may not last long enough to be able to realise the value of the long-term inflationary trend of commodities. On the other hand, a mining business may choose to ‘extend’ the life of its mines by hibernating (e.g. laying off workers, entering maintenance mode and doing nothing) and waking up when commodity prices are more favourable for production.

A warning though: we are not suggesting that you go out and throw all your entire life-savings into any resource stocks now. Not all resource stocks are undervalued right now. And there is still scope for further commodity price deflation in 2009 and 2010. You have to do your homework and look at each company on a case-by-case basis. Even then, after you have decided which stock to buy, you still have to decide at what price you think it is a bargain. Even then, you still have to decide when to buy. And yet even then, this does not mean that stock prices will not fall further.

We will finish this article with an interesting quote on Jimmy Rogers (see Jim Rogers Talks About Latest Investment Activity) for you to think about:

The bull market [in oil] will not end until somebody finds a lot of oil, or unless we have worldwide economic collapse, perpetual economic collapseā€¦

I will tell you I’ve not sold any oil. Even if it goes to $75, I don’t plan to sell any oil.

Do NOT see it as a recommendation for oil or oil stocks (note that Jimmy Rogers has an interest in oil). Rather, see it as window to his line of thinking.

Should value investors be ‘bullish’ in a bear market?

Tuesday, July 15th, 2008

Some of you may have subscribed to value-oriented stock research newsletter. One thing you may notice is that as the market enters deeper into the bear market, the number of “Buy” recommendation increases. From that perspective, these value-oriented stock research are ‘bullish.’

Before we comment on the wisdom of their recommendations, we will have to explain the philosophy of value-oriented stock research. As we explained to one of our reader’s comment in Confidence back? Beware of bear market rally,

… for long-term value investors, they follow the ?bottom-up? approach. That is, they (i.e. the value investor) invest in businesses based mainly on its individual merits (i.e. is it a good solid long-term safe businesses whose stock price is undervalued? Bear Stearns is definitely ruled out in this case) and not worry about the macroeconomic big picture, the business cycle, e.t.c. … In that sense, such value investors are neither ?bullish? or ?bearish.? Rather, they have a neutral view on the business cycle and other macroeconomic big-picture.

Here, we see a potential trap for the unwary value investor. Back in February last year, as we explained in What to avoid at the peak of the business cycle?,

One of the common mistakes that novice investors often make is to extrapolate the past earnings of cyclical stocks into the indefinite future during the turning points of the business cycle. Since the stock market always anticipates the future earnings of companies, cyclical companies will look ?cheap? (i.e. low P/E ratio) during the peak of the boom.

During the turning point of the business cycle, the P/E ratios of good quality companies in a bear market may look very enticingly cheap. But as we explained in Why accumulating stocks on the ?cheap? can be deadly to your wealth?, during such a time,

… a falling average P/E ratio does not imply that stocks in general are cheap. Yes, with careful and judicious stock picking skills, you may be able to find really cheap stocks. But do not let falling average P/E ratio fool you.

Low P/E plus the “Buy” recommendations from the value-oriented stock research may make buying stocks of good quality companies look like astute contrarian moves.

But this is where the Achilles? heel of value-oriented stock research lies. Because they hold a neutral view on the macroeconomic big picture and business cycle, they can severely underestimate the effects of a protracted downturn in the earnings of businesses. This news article, Bottom-up analysts ignore the big picture, sums it well:

“You have got a set of numbers that assumes some sort of recovery,” Macquarie’s equity strategist, Tanya Branwhite, said when releasing the report. “Unfortunately, that’s premised on the cycle we have seen in the last five to 10 years. What is facing the economy at the moment is nothing like we have seen in the last five to 10 years.”

One value-oriented stock research (which we will not name) believes that this current bear market will be like any other ‘typical’ bear market in the past- the downturn will last only 12 to 18 months. In other words, their position is that this coming recession will only be a V-shape or U-shape recession (see What type of recession is coming?). If they are wrong about that (i.e. the coming recession is an L-shape one), then their current “Buy” recommendation will be very wrong.

To illustrate this point, we will give you two examples.

After the stock market crash of 1987, the world economy did not fall into a Depression as initially feared. By 1989, stock markets had more or less recovered. If you bought into the market after the crash, you would have profited greatly.

But what if you bought into the market after the stock market crash of 1929 (see The Great Crash of 1929)? Or you bought Japanese stocks just after the bursting of the bubble in the late 1980s? The outcome will be completely different if you had done so.

In short, not all bear market purchase will turn out to be astute if the timing is way too early.

Should you liquidate your asset?

Monday, July 7th, 2008

Back in How do we prepare for a possible economic crisis?, one of our readers asked,

A lot of us, simply do not have free floating (saved) money to worry about. What we have, instead, are huge debts that are closely tied to the so-called, and as yet unrealised, ?equity? we are supposed to have in the assets that we borrowed against.

But for the rest, all I see is a sea of debt with an island in the hazy distance that is supposed to be my ?equity? in assets held hostage by banks as security. So, to simplify it to the bare bones, the first question for many is, not whether one should buy gold or silver, but whether one should liquidate assets in which one supposedly has some equity.

Now, armed with a new understanding of value-investing and what assets truly are (see Value investing for dummies), you may see this problem in a different light. Let’s suppose you bought a property with a market price of $900,000 and an outstanding debt of $600,000 to go with it, leaving you with an ‘equity’ of $300,000.

Your mortgage debt is an asset to the bank because you are ‘selling’ yourself to it by committing part of your future earnings as money to be put into the bank’s pocket. Let’s suppose your mortgage rate is 10%. At that rate, you will be paying $63,185.16 per year to the bank for the next 30 years. Now, let’s calculate the value of you as an asset. Using a discount rate of 10%, the value of $63,185.16 of cash flow per year for 30 years is $595,641.10. This figure is the present value of your debt to the bank.

Now, look at your property as an income-producing asset. Let’s suppose you can rent it out forever and ever at $600 per week ($31,200 per year) initially. Let’s assume thatt income from that asset can grow at an annual rate of 5% forever and ever (i.e. property income more than keep up with the RBA’s upper band of inflation targeting). Again, we apply the same discount rate of 9% (i.e. your employment income is higher risk than the income derived from your asset). Guess what the intrinsic value of your asset is? In this case, given such generous assumption, it works out to only $780,000!

Now, let’s suppose that instead of borrowing to buy a property, you borrow $600,000, plus your $300,000 equity, buy $900,000 worth of risk-free government bond at a rate of return of 6.50%. For this risk-free investment, you will receive $58,500 of yearly income which you re-invest into the government bond immediately. By definition, the value of that $58,500 of yearly re-invested income is $900,000.

In other words, it is simply not rational to invest in property because you are better off putting that money in risk-free government bonds (or better still, term deposits that currently pays as high as 8%). Some ‘investors’ may use the prospect of capital appreciations as a reason for ‘investing’ in property. But this will only work if there is the next fool willing to pay over-inflated and irrational price for your property. As we said before in Difference between ?assets? and real assets,

That is why there are property speculators ?investing? in houses that are far overvalued and getting caught out in a property price bubble when the business cycle turns. In essence, the property price bubble is a Ponzi scheme that collapses when the economy runs out of money through a credit contraction brought about by the credit crisis or rising interest rates.

Once credit deflation sets in the economy, the economy starts to run out of fools. Many ‘investors’ turn out to be the last fool. In times of deflation, many people will find that the ‘value’ (market price) of their property turns out to be illusionary. You may want to read our other article, Aussie household debt not as bad as it seems? for more details on that.

The lesson here is this: if you purchase the property below its intrinsic present value, you need not worry about its market price.

Effects of inflation on value of investment

Sunday, July 6th, 2008

Continuing from Measuring the value of an investment, we learnt about measuring the value of an investment relative to the risk-free returns of long-term government bonds. But that does not take into account the effects of inflation on your investment. This is a factor that is often forgotten, which in this age of rampant monetary debasement will seriously undermine your investment returns in real terms. As we said back in February 2007 in Have we escaped from the dangers of inflation?,

Today, the global spigot of liquidity (see Liquidity?Global Markets Face `Severe Correction,? Faber Says on the concept of ?liquidity?) is wide open, spewing out huge amounts of money and money substitutes into the [global] financial system.

The world was lulled in to a false sense of seemingly low price inflation through the rise of Chinese manufacturing power. Consequently, this gives investors a false confidence of fiat money being a reliable store of value. Today’s climate of rampant global price inflation is payback time for such economic folly. If we are right, the world is marching towards stagflation (low/negative economic growth, rising unemployment and rising prices) along with a deflation in asset prices. This is the worst environment for investors.

Inflation is a relatively new phenomenon in the latter half of the 20th century. As we quoted the late Professor Murray Rothbard in A brief history of money and its breakdown- Part 2,

Since the U.S. went completely off gold in August 1971 and established the Friedmanite fluctuating fiat system in March 1973, the United States and the world have suffered the most intense and most sustained bout of peacetime inflation in the history of the world. It should be clear by now that this is scarcely a coincidence.

Under the good old days (prior to the First World War) of the gold standard, there was no such thing as inflation (except for periods of war). Prices were relatively stable over the centuries. In fact, they tended to fall because of economic growth (similar to why the prices of computers and technology products fall because of increased productivity). For more information, you may want to refer to our guide, What is inflation and deflation?.

Therefore, as investors, you have to understand the relation between the value of your investments and inflation.

First, how are long-term government bonds priced? As you may already know, the free market sets the prices of long-term government bonds. As we explained before in Measuring the value of an investment, the price is inversely related to the rate of return (yield).

In theory, the price of long-term government bonds reflects the market’s expectation of long-term price inflation. Assuming that the market is right about long-term inflation in its pricing of the bonds, the value of your investments will automatically factor in inflation. Hence, as we said before in Is the value of an asset its price?, since the value of an asset is relative to the long-term government bond, the value of a long-term government bond is relative to price inflation.

Now, what happens if you believe that the market is severely underestimating long-term price inflation (i.e. the price of long-term government bond is way too high)? This is the situation that we reported in Marc Faber: Bernanke Policy Will ?Destroy? U.S. Dollar, where Marc Faber said that the 10-year and 30-year US Treasury bond market was (and still is today) a “disaster waiting to happen.” Notice what he said:

The arguments for stocks is frequently that you take the earnings yield of the stock market and compare it with the bond yield and people compare it to Treasury bonds. I think you should take the earnings yield of equities and compare it with, say, a typical S&P company, and that is a yield that correspond to, say, a triple-B, and so, basically as of today, some bonds are more attractive than equity.

What do you think will happen to stock prices if one day, the US Treasury market correctly reflects price inflation?

Measuring the value of an investment

Thursday, July 3rd, 2008

If you have not realised already, our previous article, Is the value of an asset its price?, is the beginning of a series explaining the concept of value investing. If you understand value investing, you will then be able to understand the investment philosophy of Warren Buffett, the famous investor who is currently the richest man on earth.

Mind you, value investing is counter-intuitive. It requires that you truly understand the difference between price and value- price is what you pay for and value is what you get. The problem is, the financial market/industry often uses these two words interchangeably, which means that their meaning gets merged in our sub-consciousness. To be an outstanding investor, it is important for you to de-merge the meaning of these two words in your mind. What we are trying to do here is to expand on what Rich Dad, Poor Dad taught about what an asset truly is.

Now, back to the crux of this article…

In the context of investing, when you pay a price for an asset, you are sacrificing current consumption in order to receive the asset’s future cash flow for future consumption.

For example, if you pay $100 for a newly issued 10-year government bond that pays 6% per annum, you are sacrificing $100 of today’s consumption in order to receive $6 per year for the next 10 years. That 6% is your rate of return on your investment. Now, let’s say you decide to sell your government bond to Tom at $90. The rate of return for Tom is 6/90 = 6.67%. Let’s say Tom sells the bond to Dick at $110, the rate of return for him will be 6/110 = 5.45%. Thus, the rate of return of the bond is inverse to the price paid for it.

Next, let’s suppose you pay $100 for a rate of return of 10% per annum. When you receive that $10 at the end of the year, you re-invest it into another asset that also pays 10% rate of return. At the end of the second year, you will receive $11, for which you re-invest it into yet another asset that pays the same rate of return. You do that for all the money that you receive at the end of the year for the next 8 years. What will you have in 10 years time? The answer is $259. In Excel, the formula is “=FV(10%,10,0,-100)”. That $259 is the future value of the $100 at 10% compounding (i.e. you re-invest all returns in the intermediate years) rate of return. The $100 is the present value of the $259.

Now, let’s say you have a business enterprise that is as risk-free as long-term government bonds. Let’s say your business can earn $200 of cash per year for the next 10 years. How much should you sell your business to someone else? The way to calculate it is to add up all the present value of each of the $200 of future cash inflow per year. But which interest rate should you use in your present value calculation? Since your business is as risk-free as government bonds, it should be the rate of return of a long-term government bond based on its current market price. Let’s say that the current market price of 6% government bond is $110 (the price that Dick paid). Then the current rate of return (yield) for that bond is 5.45%. That 5.45% that we use in our present value calculate is called the discount rate (we will explain what discount rate means later). We will put all that calculation on a table:

Discount Rate: 5.45%

Year Cash-flow Present value of cash flow
1 $200.00 $189.66
2 $200.00 $179.86
3 $200.00 $170.57
4 $200.00 $161.75
5 $200.00 $153.39
6 $200.00 $145.46
7 $200.00 $137.94
8 $200.00 $130.81
9 $200.00 $124.05
10 $200.00 $117.64

Total present values=$1511.15.

That is, if you pay $1511.15 for a long term government bond today with a rate of return of 5.45% and re-invest all the cash inflow each year, you will end up with $2569.06 in 10 years time. On the other hand, if you re-invest all the $200 that your business earns each year in the same bond, you will also end up with $2559.06 in 10 years time too. Since your business is as risk-free as long-term government bonds, you are indifferent between the two options. Therefore, the present value of your business is $1511.15. If you can sell your business above the present value of your business, then you are better off doing so.

Now, what if your business is much riskier (as all businesses are) than the government bond? Then the investor who is about to pay for your business will have to demand a higher rate of return. To do so, he has to pay a lower price than $1511.15 (remember, we said above that the “rate of return of the bond is inverse to the price paid for it.”). The lower price reflects the higher rate of return that the investor demands for taking the risk of your business failing. To reflect the higher risk of the business, we turn up the discount rate from 5.45% to, say, 10%. This time, the table will look like this:

Discount Rate: 10%

Year Cash-flow Present value of cash flow
1 $200.00 $181.82
2 $200.00 $165.29
3 $200.00 $150.26
4 $200.00 $136.60
5 $200.00 $124.18
6 $200.00 $112.89
7 $200.00 $102.63
8 $200.00 $93.30
9 $200.00 $84.82
10 $200.00 $77.11

Total present values=$1228.91.

Say, if the investor believes that a higher return of 10% is sufficient to compensate him for the additional risk, then he will be willing to pay not more than $1228.91.

So far, this is the theory behind value investing. In practice, in a world of uncertainty and Black Swans, it is not possible to know the exact amount of future cash flow of any business. Also, risk is not something that we can easily quantify nicely in order to derive a value for the discount rate. That is the ‘art’ of investing.

In the next article, we will explain how inflation is related to the value of your investment.

Is the value of an asset its price?

Wednesday, July 2nd, 2008

Continuing from our previous article, Difference between ?assets? and real assets, we will discuss two concepts that are often confused with each other- price and value.

Everyone knows about price. So, we will not talk more about it. But the trick question is: is the value of an asset based on its price? In accounting, the value of an accounting asset (as opposed to the definition of an asset that we mentioned in Difference between ?assets? and real assets) is based on price, whether historical price of some kind of derivative of market price. In today’s speculative mindset, the quality of our investing endeavours is often judged according to the price it can fetch on the market. For example, the 2007-2008 financial year was marked by abysmal ‘performance’ of the stock market, which implies abysmal performance of our superannuation funds. Basically, this means that the price of stocks have fallen. In this kind of herd mentality, it is often easy to associate price with value.

But as investors, we have to understand that there is a difference between price and value. The former is just an easily understood nominal number. Value, on the other hand, is a relative concept. The value of something implies its worth relative to something else. So, what is the value of an asset? As we explained before in Difference between ?assets? and real assets, an asset is something that

… puts money into your pocket periodically.

Therefore, the value of an asset is a measure of the worth of its cash flow relative to the cash flow of something else. What is the “something else” that an asset’s value is compared against? Well, it is the cash flow fetched by a long-term government bond. In other words, the cash flow of the long-term government bond is used as a yardstick for which we measure the value of an asset’s cash flow.

Government bonds are theoretically zero risk in nominal terms (not in real terms though) because it cannot default on its loan (well, not if the government happens to the Russian government in 1998) as it has the power of the monetary printing press.

The cash flow of an asset, on the other hand is full of risks compared to the long-term government bond. Behind an asset is always a business enterprise, which can fail in its ability to earn cash to its owners’ satisfaction- the business may even fail completely. Therefore, to compensate its owners of that higher risk, it has to earn a return higher than the risk-free government bond. The riskier the business enterprise is, the higher the rate of return should be demanded.

In the next article, we will explain what the return on an investment is. That will involve more mathematics.

Difference between ‘assets’ and real assets

Monday, June 30th, 2008

From our previous article, How do we prepare for a possible economic crisis?, one of our readers asked:

A lot of us, simply do not have free floating (saved) money to worry about. What we have, instead, are huge debts that are closely tied to the so-called, and as yet unrealised, ?equity? we are supposed to have in the assets that we borrowed against.

But for the rest, all I see is a sea of debt with an island in the hazy distance that is supposed to be my ?equity? in assets held hostage by banks as security. So, to simplify it to the bare bones, the first question for many is, not whether one should buy gold or silver, but whether one should liquidate assets in which one supposedly has some equity.

Before we continue, we must stress again that we are not providing financial advice of any sorts in this web publication. All views expressed are merely our own personal opinions. With this disclaimer, we can now proceed to what we think…

This question from our reader requires a long and thoughtful answer. Therefore, we will answer it over the course of a few articles.

First, we must be sure of the meaning of “asset.” This word is often misused and misunderstood, leading people to make the wrong investment decisions. We will use Rich Dad, Poor Dad‘s definition- an asset is something that puts money into your pocket regularly.

That definition may sound too simple, but many people do not really understand this concept, thinking that an ‘asset’ is something that can go up in price. That is why there are property speculators ‘investing’ in houses that are far overvalued and getting caught out in a property price bubble when the business cycle turns. In essence, the property price bubble is a Ponzi scheme that collapses when the economy runs out of money through a credit contraction brought about by the credit crisis or rising interest rates. If you read the newspapers today, you will find ‘investors’ bemoaning the horrible superannuation returns of the past financial year because the stock prices were ‘performing’ very badly. Fund managers are judged according to how prices of ‘assets’ under management ‘performs.’ As we said before in Harmful effects of inflation,

The surging asset prices (e.g. stocks, bonds, properties, commodities and yes, even artwork!) of the past several years are not signs of a strong economy. Rather, they are symptoms of inflation, brought about by speculation.

Without a proper understanding of what an asset is, many people mistook rising prices for wealth and could not see them for what they truly are- inflation. If an asset is something that can go up in price, then in this time of commodity price inflation, a sack of rice (or a bottle of vegetable oil, or a can of petrol, etc) is also an asset! In fact, there are plenty of ‘assets’ in Zimbabwe today, with the prices of stuffs going up exponentially.

If we return to the fundamental definition of an asset being something that puts money into your pocket periodically, then we put ourselves in the right frame of mind in evaluating the value of assets. Next article, we will talk about the value of assets.