Showing posts with label financial independence. Show all posts
Showing posts with label financial independence. Show all posts

Thursday, March 8, 2012

Standard Deviation is Fun!

In general, investors prefer positively skewed distributions over negatively skewed ones (it is much more fun to own an investment that generates a +10% return versus an investment that delivers say a negative 40% return. See, positive distribution is all the rage.) Also, when it comes to kurtosis, the fatness of the tail, investors prefer a lower likelihood of jumps (lower kurtosis) than an investment with a higher likelihood of skipping around (higher kurtosis).

And now, just for the hell of it, standard deviation:

An investment with an average return of 5%, a standard deviation of 7% and a variance of 40%

Definitions Just for You

Standard Deviation:In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment's volatility. Standard deviation is also known as historical volatility and is used by investors as a gauge for the amount of expected volatility.”[i] In a normal distribution, 68.37% of the values lie within one standard deviation, 95.45% within two and 99.73% lie within three standard deviations. For example, 99.73% of the returns would lie in the range of -16% to 26% for our investment example with an average return of 5% and a standard deviation of 7%.

Here’s the math:

7% * 3 = 21%

5% + 21% = 26%

5% - 21% = -16%

Variance, the Nerdy Math Definition: A measure of the dispersion of a set of data points around their mean value.

The Explanation: “Variance measures the variability (volatility) from an average. Volatility is a measure of risk, so this statistic can help determine the risk an investor might take on when purchasing a specific security.”[ii]



Annualized Standard Deviation = 7% x the square root of 12 = 24%

Annualized Variance = 40% x 12 = 480%

Bottom line:

“Without making comparisons to the standard deviations in stock returns of other companies, we cannot really draw any conclusions about the relative risk of [a stock] by just looking at its standard deviation.”[iii]

Semi-variance just give you the downside to the investment. In other words, it is a measurement of only the negative returns from the average return. Think of semi as semi-under average or as “Oh my god that semi is coming straight towards us and soon we will be underneath it.” In general, a stock or investment with small positive returns and large negative returns will have a semi-variance that is higher than the variance.

A Cacophony of Risk – Yeah Boy!

· Project Specific

· Competitive

· Industry-Specific

· International

· Market


_____________________________________________________________________________

Building a Small Business That Warren Buffett Would Love,available at Amazon.comorBarnesandNoble.com.
The over-arching vision of Building a Small Business That Warren Buffett Would Loveis to create
One Million Jobs.
Like us on Facebook to find out how you can support this mission!





[i] Investopedia is the bomb – investopedia.com

[ii] Did I mention how great Investopedia is? Dot com!

[iii] Damodaran, Aswath, Applied Corporate Finance, p. 56, 2006, John Wiley and Sons, Hoboken, New Jersey

Monday, March 5, 2012

Corporate Finance the Investment Decision

The Investment Decision

Invest in assets that earn a return greater than the minimum acceptable hurdle rate.

The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used to fund it.[i]

Any thorough business model will attempt to measure the risk involved in a particular investment and will therefore provide the necessary return given the risk which becomes the hurdle rate for the project.

Among other things, a good risk and return model should a) come up with standardized risk measures that allows investors to draw individual asset conclusions as to whether its risk is above or below-average, b) “it should translate the measure of risk into a rate of return that the investor should demand as compensation for bearing the risk”[ii] and c) in addition to explaining past returns it should also predict future results.



[i] Damodaran, Aswath, Applied Coroporate Finance, John Wiley and Sons, Hoboken, NJ p 50, 2004

[ii] Damodaran, Aswath, Applied Coroporate Finance, John Wiley and Sons, Hoboken, NJ p 52, 2004

Friday, March 2, 2012

The Ultimate Goal: Value Maximization

“There is general agreement, at least among corporate finance theorists that the objective when making decisions in a business is to maximize value.”[i]

Alternative Objectives

  • Maximize Market Share
  • Profit Maximization Objectives
  • Size/Revenue Objectives

Maximize Market Share

The bottom line in market share growth is that the management of the company values market share growth investments over investments that increase market share less.

Market Share: “The percentage of an industry or market’s total sales that is earned by a particular company over a specified time period.”[ii] Increases and decreases in market share is a sign of relative competiveness of a company’s products or services and allows a company to realize economies of scale: operational costs are fanned out over a greater breadth of revenue and ultimately, profitability should increase.

Profit Maximization Objectives

Profits can be measured thus, just as in maximizing the stock price, profit maximization is something that management can easily keep an eye on. The rationale behind profit maximization is that “higher profits translate into higher value in the long run” [iii] which is true in an earnings valuation model such as Warren Buffett’s:

How Warren Buffett Determines the Price

Now let us examine how the big chief determines price. Again, leading up to this point on our “Building a Small Business Warren Buffett Would Love the Flowchart, ™” we have defined a consumer monopoly company that generates strong and consistent earnings, with a high return on equity and the ability to retain earnings. At this point on the map we are concerned with the retained earnings adding value to the small business. (See Figure 5.1.)


Warren Buffett invests in businesses that, via the ability to consistently retain earnings at a high return on equity, will exponentially grow in value over time. In order to build a business that Warren Buffett would love, and create wealth, you must have the ability to increase the value of your business over time and use Warren Buffett’s methodology for determining price in order to measure your business’ value.

What follows is how Warren Buffett uses the return on equity of a business along with the current per share shareholder’s equity value in order to project a future trading price and rate of return. (See Table 5.5.)

Table 5.5 Determining Value Using Equity Share Value [table in text]

MCD

KO

DIS

Average ROE

21.1%

32.2%

9.1%

Average Annual Dividend Yield

3.0%

3.0%

0.9%

True Equity Rate of Growth of Shareholder's Equity

18.1%

29.2%

8.2%

Total Shares (in millions)

1,080

2,295

1,899

Total Equity (in millions)

15,458

31,003

37,519

Per-Share Shareholder’s Equity Value

$ 14.31

$ 13.51

$ 19.76

N

10

10

10

I/Y

18.1%

29.2%

8.2%

PV

14.31

$ 13.51

$ 19.76

CPT FV—Future Per-Share Value of Company’s Shareholder's Equity

$ 75.82

$ 175.37

$ 43.30

Projected Future EPS

$ 16.03

$ 56.50

$ 3.94

Average 10-year P/E

20

23

25

Company's per share projected future 2020 trading price

$ 320.64

$ 1,299.60

$ 98.41

PV (company's current price)

$ 75.78

$ 65.22

$ 42.97

FV

$ 320.64

$ 1,299.60

$ 98.41

N

10

10

10

CPT I/Y (The company's projected annual compounding rate of return)

15.5%

34.9%

8.6%

Projected Future Trading Price of the Company's Stock

$ 320.64

$ 1,299.60

$ 98.41

Current Trading Price

$ 75.78

$ 65.22

$ 42.97

Explanation

First, any yield attributed to the payout of dividends is subtracted from the average 10-year return on equity in order to reach the true rate of equity growth of shareholder’s equity, or in other words, the true return on equity. The reasoning behind this calculation is to exclude dividends from our subsequent compounding calculations, since they are paid out and truly play no part in the future compounding of the equity.

Next, we find the total shares outstanding and total equity in the company from the balance sheet (easy to obtain from Morningstar.com for public companies) and divide the total equity by the number of shares outstanding in order to determine the per-share shareholder’s equity value. This figure is not necessarily the share price, but it represents the amount of equity in the company that each shareholder can technically claim per share.

Our next step is to determine the future value of the company’s per-share equity value, using the true rate of growth of our equity, and the current per-share equity values—in this case, $14.31, $13.51, and $19.76 for McDonald’s, Coke, and Disney respectively. These calculations can easily be computed using a BAII Plus business calculator and by plugging in, in the case of McDonald’s, 10 for N or the number of years, 18.1 percent for I/Y or the interest rate, and $14.31 for the present value.

Hit “compute,” “FV” to find the future value, and you should get $320.64 for McDonald’s. What this tells us is that if McDonald’s continues to generate an average 18.1 percent return on equity, in 10 years the equity value per share should grow to $75.82. (See why predictability is so important? We could not count on any Mc-reliability going forward 10 years if some degree of consistency was not present in their history.)

From this result, we can use the full 21 percent return on equity for McDonald’s, multiplied by the future $75.82 equity share value, in order to determine that the company should have $16.03 in earnings per share. (Remember, the “return” portion of return on equity equates to earnings. By simply multiplying the historic average return on equity by the future per-share equity value, we should be able to determine the future earnings per share.) We then multiply this result by the average 10-year historic price to earnings ratio (again, Morningstar.com is invaluable for this information) in order to determine the theoretical future share price. If price divided by earnings results in the P/E ratio, then using some simple algebra, solving for P should give us the price.

Price/Earnings = P/E Ratio

Price/$16.03 = 20

$16.03 (Price/$16.03) = 20 * $16.03

Price = $320.64

Breaking out our BA II Plus calculator again, we plug in the current price of MCD, (at the time of this writing $75.78), $320.64 for the future value, 10 for N or the number of years, and compute the I/Y, which gives us the company’s projected annual compounding rate of return. In McDonald’s case it is 15.52 percent.

Projected Future Trading Price: $320.64

Current Trading Price: $75.78

Projected Annual Compounding Rate of Return: 15.52%

Always remember as well that the price you pay determines your rate of return, similar to the old adage for buying a house: “You make your money when you buy.” Similar, yet different. So, if you waited to buy McDonald’s at a price of $65, then your rate of return would go up to 17.3 percent.

Is This Good or Bad?

You tell me. In a mutual fund I can expect to achieve a 10 to 11 percent return a year over the long haul. CDs and T-bills are paying between 3 and 5 percent, and my fourplex averages about a 10 percent rate of return. In my opinion, 15.52 percent is a great return. Coke and Disney have projected returns of 34.88 percent (whoa!) and 8.64 percent respectively.

Is This Reliable?

You’ve seen the reasoning for picking companies that have reliable historic indicators: a consumer monopoly; staple, invaluable branding; a strong track record of consistent earnings with a consistent high return on equity. All roads lead to Rome, and in this case, the roads have led us here (in a buggy with Warren Buffett in the passenger’s seat), and this is how Warren Buffett determines the future value of a stock and his expected rate of return.

It is always nice to have some verification though, especially in the realm of “if it sounds too good to be true.” Coke has a 34.88 percent projected return—good golly! This sounds really great, but let us take a look at Buffett’s second valuation technique and see if we can get some corroboration around this spectacular return.

But first …

The problem lies in making short-term decisions that increase current profitability at the expense of long-term profitability. For example: if we own a taxi-cab company and forego the expense of changing the oil in order to ratchet up the near-term profitability. We may pocket more profit but down the road, those engines are going to blow up and cost us much more.

Size/Revenue Objectives

This is the Alexander the Great, “empire building” objective. The more the merrier, correct? Under this objective CEOs gobble up as much corporate real estate possible with no clear strategic imperative. Now, in the kingdom of Warren Buffett, when two consumer monopolies such as Fruit of the Loom and Russell Athletics marry, the combination can have synergistic, positive results.

_________________________________________________________________

Building a Small Business That Warren Buffett Would Love,available at Amazon.comorBarnesandNoble.com.
The over-arching vision of Building a Small Business That Warren Buffett Would Loveis to create
One Million Jobs.
Like us on Facebook to find out how you can support this mission!





[i] Damodaran, Aswath – Applied Corporate Finance, Second Edition, John Wiley and Sons – 2006, Hoboken, New Jersey p 34

[iii] Damodaran, Aswath – Applied Corporate Finance, Second Edition, John Wiley and Sons – 2006, Hoboken, New Jersey p 35

Thursday, February 16, 2012

McDonald's, Coke and Campbell's Relative Valuation

Relative Valuation Comparing Three Consumer Monopoly Companies




McDonald's

Industry Average - Hotels & Restaurants

Coke

Industry Average - Hotels & Restaurants

Campbell's

Industry Average - Food Products

P/E (Trailing Twelve Months)

18.8%

27.4%

18.4%

16.8%

13.14%

10.36

P/E (5-Year Average)

19.5%

28.4%

17.8%

21.1%

16.18%

28.5

PEG Ratio

1.9%

1.7%

2.9%

58.0%

2.78%

2.21%

Price/Cash Flow (Most Recent Quarter)

18.5%

14.1%

17.6%

19.4%

7.68%

14.72%

Price/Cash Flow (TTM)

15.6%

15.4%

14.7%

15.8%

9.59%

16.36%

Price/Sales (Most Recent Quarter P/E)

3.7%

2.6%

3.5%

3.7%

1.17%

10.22%

Price/Sales (TTM)

3.8%

2.8%

3.3%

2.9%

1.31%

1.34%

Price/Book

7.2%

6.5%

4.7%

4.0%

9.65%

0.70%



Definitions:

Trailing Twelve Months – the last 12 months of data. Think of this as a “rolling” metric. Trailing twelve months for October 2015 would be October 2014 to September 2015.

P/E – the price to earnings ratio or a company found by dividing the company’s current share price to its per-share earnings. Can be used for relative valuation purposes. A firm trading at a P/E of 5 appears cheap compared to a firm trading at a P/E of 20. Lower is better.

PEG Ratio – the price to earnings growth ratio, a forward-looking metric, found by dividing the stock price of a company by its earnings growth. Peter Lynch asserts that a company that is fairly priced will equal its growth rate and thus, a fairly valued company will have a PEG equal to 1.

Price / Cash Flow – similar to the price to earnings ratio except price to cash flow removes the effects of depreciation and other non-cash factors. This truly whittles the relative valuation down to the cash and is found by dividing the Share Price by the Cash Flow Per Share.

Price / Sales – a fairly useless metric that doesn’t take into account expenses or debt. It is useful when comparing similar companies. Found by dividing a firm’s current stock price by its revenue per share.

Price / Book – Also known as the price to equity ratio, it is found by dividing the current closing price of the stock by the latest quarter’s book value per share with book value being Total Assets – Intangible Assets and Liabilities. “A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company.” [i]


So, just looking across this, the only guy that shows some potential value at this point is Campbell's with a Price to Cash Flow ratio that is fairly below the industry average. Of course the company is also exhibiting a high Price to Book value so all in all, these companies appear fairly valued using relative valuation, no value meals here!

_____________________________________________________________________

Building a Small Business That Warren Buffett Would Love,available at Amazon.comorBarnesandNoble.com.
The over-arching vision of Building a Small Business That Warren Buffett Would Loveis to create
One Million Jobs.
Like us on Facebook to find out how you can support this mission!