Investing Tutorial - Part 3 (Stock Valuation)

Last post, we talked about stock valuation metrics and how they relate to the concept of "margin of safety". I said I would give a clearer idea of what this is in my last post, so here goes. Margin of safety is assurance, by a specific margin (usually in the 20 to 40% range, but the larger the better), that the stock or bond you are buying is worth significantly more than what you are paying (i.e. its current price). But, margin of safety is a very amorphous term because it is difficult, if not impossible, to determine the true intrinsic value of a  company (what the company is truly worth).

The process by which stock analysts and others who invest for a living determine what a stock is actually worth is called discounted cash flow analysis.  This process is based on the premise that a company is only worth the sum of its earnings discounted back to some present value, where the discounting factor is the sum of the yield on U.S. treasury bonds plus some desired additional rate of return. For a visual lesson on how to perform a discounted cash flow analysis on your own, check out the video below.

After determining how much a company is worth using a discounted cash flow analysis, you should compare that value (make sure to divide the company value by the number of shares outstanding) to the actual stock value. For instance, if your DCF analysis tells you that a company is worth $34 a share, but it is trading at $22 a share on a stock exchange, then the stock is trading at a 36% discount (($34 - $22)/$34) to its intrinsic value. In other words, this stock has a 36% margin of safety. If on the other hand, your DCF stated that the stock was worth $15 and it was trading at $24, there would be no margin of safety. Benjamin Graham and Warren Buffett warn against buying stocks with no margin of safety or even small margins of safety since the margin of safety concept is intended to shield the investor from his own errors.

If you watched the video above, you saw that the stock analyst has to make lots of projections as to the growth rate of a company, potential tax rates, and the rates at which operating expenses will grow. And the more things one has to project, the easier it is to get things wrong. Fortunately, one doesn't have to use a DCF analysis in order to determine if a stock provides adequate margin of safety. She can just look at the metrics that I pointed to in the last post: P/E, P/BV, and P/FCF.

P/E
The faster that a company is growing, the higher that its P/E will usually be. As a general rule, the investor should look for companies that are growing fast, but have comparatively low P/Es (under 15x). A comparatively low P/E ratio, along with a growth rate that is equal to or higher than the nominal P/E (the actual number for the P/E), is indicative of a margin of safety.

Here's a quick example because I know that last sentence was a little confusing. Let's say you find a stock with a P/E ratio of 10. This is a great start, but if it the underlying company is growing at 5% a year, there might not be a margin of safety. Conversely, if a stock is trading at 10x earnings, but growing at 14% a year, this is certainly indicative of a margin of safety and it means the stock warrants further investigation!

Price to Book Value 
As I mentioned last post, the book value of a company is the total amount of assets minus the total amount of liabilities. Essentially, it is the surplus, or what really makes a company valuable. When looking for margin of safety using this metric, just as when you are using the P/E, lower numbers are better. (Usually a multiple in between 2x and 4x is considered low.) When a company has a low price to book value, often times its assets - such as land that is being accounted for on the balance sheet at cost - are being woefully undervalued. The trick though, is to find companies with low P/BV and low, but steady growth and a dividend. The stock market treats steady growers very well, especially if they have a dividend. Low P/BV with a dividend usually means a margin of safety because even if you are wrong about the assets being undervalued, the dividend will provide downside cushion, AND, the market will probably not punish the stock for missing earnings estimates since its multiple is already so low.

In the next post, I will talk about the last major valuation metric, which is Price to Free Cash Flow. We'll get a little into the weeds, but it will be worth it.

Investing Tutorial - Part 2 (Stock Valuation)

In the last post, we were discussing the relationship of my analogy to companies, or their stocks as investments. If you haven't read the previous post, this post won't make much sense, so I encourage you to go back and read it. That being said, let's move forward.

What makes a great company great? Think about a company like Nike. It has great (cool and stylish) products, a large and loyal customer base, and great brand recognition. The same goes for Apple. And those  aforementioned qualities are the reasons these companies' stock prices have soared over the last two decades. Great products and a loyal customer base usually translate into consistently high revenues, which also, for these companies, equals higher earnings.

Investment analysts determine whether or not a company is "expensive" by determining what multiple of earnings or some other metric of profitability/worth that the stock is trading at. For instance, if a company has $2.00 per share of earnings and its stock price is $20, its "price to earnings ratio" or P/E multiple, is 10. Similarly, if a company has the same $2.00 per share worth of earnings, but has a stock price of $100, that stock's P/E multiple is 50. An average P/E is about 20 -25 and the P/E ratio will vary depending on the industry that the company is in. Fast growing technology companies usually have nosebleed P/E ratios and more boring companies like car companies or waste removal companies trade at lower multiples. This is because investors are willing to pay more for companies that are growing really fast.

Facebook is an example of a fast growing company that trades at a high multiple, and is a cautionary tale about investing in high multiple stocks. Unless you live under a rock, you've probably heard that Facebook recently had an IPO (initial public offering). And when it came public, its P/E multiple was a whopping 155!! (This was calculated by dividing its initial price at the time of the IPO of $45 by its earnings of $.29.) Since then, the stock has lost approximately 60% of its value and it still trades at a multiple of 65! And remember that I said a normal P/E is in the 20 - 25 range.

Here we return to Graham's admonition regarding thorough research and ensuring to the best of one's ability that an investment will not lose money. Although it is impossible to determine whether an investment will lose money (unless of course you're a fortune teller, in which case, please call me), there are ways to mitigate risk certainly. It has been empirically proven that stocks with high multiples get treated more harshly by Wall Street (in terms of high volume selling that drives down the price) when they fail to meet expectations than below average multiple stocks. This is because high expectations are already taken into account by the price. So if high multiple stocks seem to be risky, then it follows that low multiple stocks should be less risky.

For the most part, that assertion is true and a whole body of investing has evolved around that very premise. The type of investing that focuses on stocks with low multiples of price to earnings, or price to free cash flow, or price to book value is called value investing.

Value investing, in keeping with Benjamin Graham's assertion about protecting principal, proposes that the best way to do so is to buy stocks with what's called a margin of safety. In the next post, I'll discuss this concept in greater depth and talk about how to calculate it.

Investing Tutorial - Part 1 (Stock Valuation)

Benjamin Graham - the mentor of Warren Buffett, one of the world's richest men and greatest investors - wrote in his seminal treatise on investing, that the difference between an investment and speculation is that an investment is something that after thorough research provides safety of principal and an adequate return. Anything else, Graham warned, is speculation.
[CD] Security Analysis By Graham, Benjamin (Google Affiliate Ad)

In the Investing Tutorial Series that I am starting today, I will be discussing basic investment tenets that will hopefully help my readership take their financial destinies into their own hands. Today's topic is stock valuation. And crucial to the topic of stock valuation are the two primary principles behind why anyone would invest in the first place: 1) to combat the corrosive effects of inflation; 2) to take advantage of the benefits of compound interest. Let's tackle these two concepts briefly before getting a little into the weeds with stock valuation.

When governments print money to satisfy their own financial obligations, or banks make it easy for people to borrow money, the amount of money in circulation increases. When the amount of money/currency in circulation in a particular economy increases, the value of that currently goes down. When the value of currency goes down, prices go up to make up for the fact that the value of goods and services  being provided has remained relatively stable. Humans invest in the stock and debt markets in search of investments that will exceed the rate of return on "risk-free" assets (assets on which you will not lose money) like U.S. Treasury bonds.  By finding these investments - assuming that they go up in value - investors can assure themselves that their purchasing power will at least keep up with inflation, thereby enabling them to maintain their present standard of living in old age.

With regard to the second principle behind why we invest, Albert Einstein once said, "Compound interest is the eighth wonder of the world. Those who understand it, earn it...those who don't, pay it." Compound interest, for the uninitiated, is the interest that accrues on principal (the initial amount invested) and the interest  that had previously accrued. The chart below demonstrates the power of compound investing:

 
Here, $1000 and nothing more is invested over the course of 10 years and the various lines demonstrate what happens at different interest rates. It's not important now, but if you want to know how to calculate compound interest, here's a formula:  F.A. = P * (1 + I.R.)^N, where F.A. is the final amount including principal, P is the principal amount, I.R. is the interest rate used for compounding in decimal format, and N is the number of years the principal has been invested.

So, how does all of this relate to stock valuation? Well, remember how Graham said that an investment involves safety of principal. Another way of saying keep your principal safe is "don't lose money"! Graham isn't telling us not to lose money just because losing money is no fun. He's telling us this because when we don't preserve our principal, it is harder to take advantage of compounding interest and thereby combat inflation. Here's an example.

Suppose you have $10,000 to invest and your husband's friend comes along and gives you a "hot" stock tip. You oblige and plunk $10,000 of your hard earned money into this stock as an "investment", but because you didn't do as Graham advised in failing to research this stock, you lose 50% of your money and this investment is now worth $5,000. In order to just get even, you have to earn a 100% return. Let's say you lost 25% instead and your investment was now worth $7,500 instead of $10,000. You would have to earn a 33% return in order to get back to even.

The moral of the story is that capital preservation is key in any investment undertaking. After realizing that not losing money is key, the next step in analyzing an investment is determining its value or how expensive it is. Determination of an investment's value determines whether or not you will be preserving your capital, and on your way to capital appreciation, as opposed to placing your capital at risk of permanent loss. By how expensive an investment is, I don't mean how high its price is. A stock can be priced at $1,000 and be inexpensive and a stock can also be $10 and be super expensive. Let me explain.

If I offered you a new Ferrari for $25,000, $25,000 might be a high price, but you would recognize that given how amazing of a car a Ferrari is, its value is way higher. Similarly, if I offered you a pen for $100, although $100 might be a nominal amount to you, you would say that the pen is overpriced and you'd be right. How does this analogy relate to stocks and the underlying companies? Join me in the next post as we explore how a company's valuation determines whether you should invest.

Money Memes, Myths, and Misunderstandings

The brain is an extremely powerful apparatus. It is capable of bringing things into existence. Every great invention that has ever come to fruition has come about as a result of the human brain. Mankind has for centuries turned thought into reality. The brain perceives what could be and then transmutes that thought into a tangible reality.

Since the brain is so powerful and can turn its thoughts into reality, it should come as no surprise that the way  we perceive things heavily influences our reality. And unfortunately, there are a lot of societal forces which are largely negative, which influence our views on money.

These views come in the form of memes, myths, and basic misunderstandings. And sometimes all of these "m"'s overlap. A meme is defined as an element of culture that is passed from one individual to another by nongenetic means, especially imitation. A myth, as you well know, is a lie that is commonly believed. And a misunderstanding is well, a misunderstanding.

A lot of times, these memes, myths, and misunderstandings come to shape our views about money and thereby leave us impoverished, both literally and figuratively. I'll go through a few to show you what I mean.

"MONEY DOESN'T GROW ON TREES."

Well the picture above proves that wrong. 'Nuff said. :-) Now of course money doesn't grow on trees.
But the saying is meant to tell people that money is scarce and that having it or receiving it is difficult. All of the self help gurus that I've read have always preached that what one focuses on expands in his reality. (Here we return to the concept that the brain is a powerful machine.) And what does the meme/misunderstanding that money is scarce generate? You guessed it - money scarcity. Some skeptics might say that the saying is intended to let people know that they have to "work hard" for money, but what is that really saying? That money doesn't come easily. Guess what though? Money does come easily though, if you have enough of it.

Think about a billionaire. The interest that she earns on that billion dollars every year is more than a whole lot of people can ever dream about having in their lives. And these billionaires believe that money comes easily and for them it does. I know there are some still who might say that this doesn't work if you only have a little bit of money and I hear you. But as humans, we have to aspire and if you are feeling negative about a situation, it will likely remain negative - just like how if a person begins thinking angry thoughts, his body will produce the same hormones as if he actually was angry. By now, I hope you get the picture. Perception creates reality, so choose your 'perceptions' carefully.

"MONEY IS THE ROOT OF ALL EVIL."

Now this statement also falls into the meme and misunderstanding category, but it's mostly a misunderstanding, thankfully. Even though America is the great melting pot and was founded on principles of freedom of religion, its predominant religion is Christianity. And in the Bible, in 1Timothy Chapter 6 verse 10,   it says "For the love of money is the root of all evil."

Here Jesus is talking about how people can make money an idol and God doesn't like idols. But it's not that money itself is evil. It's just a tool and it can be used in a positive fashion to build up God's kingdom. Think about that the next time someone spews such silliness.

As I alluded to earlier, our thoughts control our actions and if you think that money is evil, you will subconsciously find a way to rid yourself of it. I mean, who wants something evil in their lives. A lot of times, people will say that they want to be wealthy, but have an underlying belief such as money is evil, that is incongruent  with their stated desire. If you want anything in life, you can have it. You just have to be congruent about it.

"THE ECONOMY IS TOO TOUGH RIGHT NOW FOR ME TO GET AHEAD."

That statement in quotes above is a complete and utter myth!

In 2006, I read something that didn't come back to me until about a month ago. The article I was reading said that "more millionaires were created during the Great Depression than at any other time in American history."  That statement is so powerful that I think it bears repeating. "More millionaires were created during the Great Depression than at any other time in American history."

Today's economic environment is harsh and I personally do think we're in a depression and not a recession. But that doesn't mean you can't succeed financially. When I began to think on the high number of millionaires created during the Great Depression, I think about how these millionaires must have seen tremendous opportunity and this inspires me. A few weeks back, I was looking for a job and was not making any headway whatsoever, no matter how many resumes I sent out. And then I realized that I could make money off of my blog, and that I should start my own financial coaching site. Fortunately, I'm currently in the process of filing the LLC papers and building a website and client base. I use myself as an example not to brag, especially since I'm just getting started. But I use myself to show that every crisis presents an opportunity.
In this economic climate, people need financial coaching more than ever, and I've never really liked working for anyone else. So why not start my own financial caching business? Voila!

The moral of the story is that it is possible to live your ideal life. However, you must be clear on what you want and you must rid yourself of any limit beliefs regarding money. Your limiting beliefs will most certainly keep your wallet thin and make you miserable. Feel free to share any limiting beliefs that you've found within yourself that you're getting rid of.  

Sexual Energy Transmutation and Wealth

It was about six years ago to the date that I came across the famous book by Napoleon Hill called "Think and Grow Rich". When I first picked it up, I thought to myself, "Great, now I'll know all I need to know about how to get rich." Ha! Boy, did I have a lot to learn. I don't say that to put the book down as it is a great book and is widely regarded as such. But I've realized that it's one thing to just read about the precepts in a book, and it's another to actually put them to work on a daily basis in your life.

One of the things that Napoleon Hill talks about in the book, and that I've struggled with implementing in my life, is the "transmutation of sexual energy". Although I'm not sure (partly because Hill doesn't explicitly say what sexual energy is), I perceive this "sexual energy" that Hill is referring to as semen. So essentially Hill is saying transform your lust, and therefore your semen, into wealth through a redirection of your thoughts. Instead of aimlessly spewing (pun intended) your semen through masturbation and looking at porn, direct that  sexual energy (which is a very potent force) into a wealth generating pursuit.

As I said earlier, I've always had a problem with the implementation of this part of Hill's recipe for wealth. I have an extremely high sex drive, and ever since I was 11 years old, I've been looking at porn. The longest I've ever gone with looking at it is 7 months and that was last year. And the longest I've gone without masturbation has been a month. But now, I'm embarking on a new journey to give up those two vices and direct my energy toward more constructive activities. Today is day 25 of abstinence from pornography and day 2 of my journey of abstinence from masturbation. I'm not necessarily sure that doing these two things will  result in any financial change in my life, but for the longest time, a little voice in my head has been telling me to  do them. So since I have nothing to lose, and everything to gain, I'm gonna try and see where I end up a year from now.

Feel free to join me on my journey and let me know what your experience is.

Back At It and Why I Do This

Hello everyone.
I apologize for the extremely long hiatus. However, because lots of kind strangers have asked me to start writing again, I've decided to acquiesce and do so.

I figure that I should begin this series of new posts by reiterating why I started this blog in the first place. If you ask my mom, she'll tell you that ever since I could speak, I've always talked about becoming rich. Any of my previous girlfriends can also attest to the fact that I talk about my dreams of being wealthy a lot. Call it an obsession. Don't get me wrong - I understand that money doesn't necessarily buy happiness. There are certainly lots of people with more money than they know what to do with who are unhappy. However, there are also a lot of people who are poor and absolutely miserable. Money CAN buy peace of mind, among other things.

My desire to be rich comes from multiple places. I didn't grow up poor, but I was working class and went to an extremely prestigious boarding school for high school. When I got there, I saw how the 'other side' lived. Before arriving at my high school, I didn't know that there were people who owned three homes and could afford to pay $30,000+ a year to send their kids to high school. And while in high school, my roommate and best friend to this day always read books about investing while I was out at parties on Saturday nights. I've always had a certain facility with numbers and the thought of making money with my intellect as opposed to the sweat of my brow appealed to me.

As a result, I began learning about how to handle money - how to invest it and how to make it grow. I began reading books and watching the financial news. In college, I would take every dollar I received from my job as a cashier in the Student Union and throw it at the stock market. I didn't really know anything about how to pick stocks, so I decided to subscribe to a stock picking newsletter. I made a few hundred dollars as a result and knew that I wanted to be a member of the investor class. After college, I lived at home and saved up a little over $15,000 and invested it. Over the next two years or so, I had to dip into that stash and eventually it was depleted. I subsequently built it back up two times through diligent saving and investing, but because of the expenses of life, I eventually had to use it all again.

Let me just say before I go any further that I can think of only a few experiences in life which are more exhilarating than waking up in the morning and seeing $1600 more in your bank account than the previous day, all because you decided to buy a particular investment. I want everyone to have that experience. I don't necessarily believe there's a plutocratic conspiracy to keep the majority of people in the dark about how to handle money, but a lot of people indeed are in the dark about it. This needn't be the case.

The conventional wisdom is that if you go to school, get an education, and work hard, then maybe you can retire a millionaire with a fat 401(k) plan or Individual Retirement Account (IRA). That doesn't sound appealing to me at all and I hope that it doesn't sound appealing to you either. I want to get rich and I want you to get rich also and not just rich, but rich while you're young enough to enjoy it! On a side note, here's a link to an article about how getting too much education can be a bad financial move:

http://online.wsj.com/article/SB10001424052748703389004575033063806327030.html?mod=WSJ_hpp_MIDDLENexttoWhatsNewsForth

Back to what I was saying before. In this blog, I'll be dropping some common and uncommon
financial knowledge about how to achieve not just your financial goals, but your life goals, because let's face it, money affords you options. If there's anything you would like me to explore, don't hesitate to contact me at jcp182000@yahoo.com. I'm always open to suggestions because I'm still learning about money and will continue to do so until I die. Here's to getting rich together someday!

-JCP aka JP $ (JP Dollar)

Chasing After the Wind

Hello everyone.
It's been a while since I last posted, but I do have a valid excuse. I've been absolutely swamped at work. Swamped to the point where remaining at the office until 10 or 11 or even 12 some nights is not uncommon - at least it's been this way for the past two weeks. For those of you who don't know, I work at a large Wall Street law firm as a paralegal. And I'm on one deal that has consumed a tremendous amount of my personal time.

Working these hours has made me realize something very profound. Actually, I already knew it, but doing this much overtime has really driven it home. Working long hours at something you don't love doing just for the money is not worth it. Not even a little bit. Let me explain.

At my law firm, the starting salary for first year associates is $160,000. Granted, that's a lot of money, but it's not the most money one can make. And a high price is paid for that $160K, both in terms of quality of life and mental health. As a paralegal, it's expected that I'm going to be doing overtime every now and then. But in general, I can leave the office at 5:30. Lawyers at big firms like mine, however, routinely leave the office around 8 or 9 and they get in around 8:30 or so in the morning. This past week, when I was leaving the office at 11, I saw at least six of the attorneys on my floor still at the office. This is ridiculous! Why do people forsake having time to do the fun things they love and spending time with friends and family in order to ensure that some deal goes through? The simple answer is the allure of the greenback.

This would make sense on a basic level if lots of money would bring people lots of happiness. Unfortunately, thinking that money will bring you happiness is like what Solomon in Ecclesiastes describes as "chasing after the wind". Most humans, not just lawyers, seem to think that the next promotion, the next raise, the next person that he or she sleeps with, the next new car or pair of clothes will bring us happiness. And these things do bring us temporary happiness, but soon it fades away. We're left looking for something else to fill a void in us and provide that peace to calm our restlessness. If this isn't true for you, I know that it's certainly been the case for me.

In light of this realization, I've recently begun asking myself why I want to make the type of money that I want. Is it so I can buy lots of cars or nice accoutrements for an expensive apartment? Is it so I can impress women and my friends by taking them out to fancy dinners? No. And I'm not sure what I will get out of being a millionaire several times over. There are plenty of unhappy, even miserable millionaires. I think fundamentally what I'm looking for is security to know that I can weather any financial storm, to be able to help out family members who need it, and to make sure my children don't need student loans when they go to college. I'm going to go even further though and ask if even these most basic of things will make me happy. I'm not too sure, but I think that in all of our strivings, it's important to take a step back and reflect on what the driving forces are behind our dreams of wealth. Please feel free to send me your thoughts on this issue at jcp182000@yahoo.com or jcp182000@gmail.com or post them on this blog.

Thanks for reading and until next time...