## Saturday, December 30, 2006

### How much money do you need - Part 2

This is the sequel to my first post on this blog. There is actually another way to think about how much money you would need in a lifetime and it's quite logical (well at least to me...).

Assuming that you would be working 2/3 of the time in your entire life, you should be saving at least 1/3 of your pay. The key word here is AT LEAST. Bcos we must not forget inflation.

Now say if you are currently 30 yrs old, you earn \$3000 per mth, you expect to retire at 60 and live until 75, i.e. you work 30 yrs out of 45 yrs of your life (2/3) and have no income for the last 15 yrs (1/3 of 45). You should be saving at least 1/3 of your pay i.e. \$1000 in order to maintain your current lifestyle until the day you go to heaven (or wherever you want to go that won't need money from Earth... hehe).

Why is this so? Bcos the 1/3 that you save for 30 yrs (which amts to \$1000 x 12 x 30 = \$360,000) will be just enough to cover you for the next 15 yrs when you don't work at all (\$360,000 /(15 x 12) = \$2000 = the amt you are spending now every mth). That is assuming no inflation.

Hence similarly if you want to retire at 50 and die at 70 (which means you work 20 yrs and don't work 20 yrs) you would need to save at least 50% of your pay. Which probably means 90% of Singaporean cannot retire at 50 and die at 70, bcos if they want to retire at 50 they must die, say at 55 in order not to rely on their children or the state or any other entity to support them. How fun.

So what happens when we take inflation into account? Well it simply means you have to save more, or make your money work harder (i.e. invest lor). If inflation is 3%, then for every dollar you save, it must earn 3% every year until you retire. If you believe in this blog which says investment earns 8%, then all is well.

If you intend to cover inflation by saving more, it gets tricky bcos inflation goes on yearly but you only save the same amt every month. This means that for Year 1 you will need to save 3% x 30 (yrs) = 90% more and Year 2 you need to save 3% x 29 (yrs) = 87% more and so on (i.e. Year 1 you need to save \$1900 per mth, Year 2 you need to save \$1870 per mth and so on).

But you only earn \$3000 per mth remember? How to save \$1900? It cannot be done, so the answer is you should spend less, much lesser than the original \$2000 per mth. As a rule of thumb, I think saving 50% of your salary should be quite ok. Which then means a lot of pple in Singapore are probably not ok... Count on me Singapore, count on me to go broke before 50!

## Tuesday, December 26, 2006

### Discounted Cash Flow or DCF

Discounted Cash Flow or DCF is the most complicated way to value a stock and also probably quite useless to most people. Well, not if you are good at math or if you are called Buffett or Graham or Dodd. Buffett uses very simplified DCF to try to value stocks and is probably quite good at it, given how much he has earned (umm, in case you don't know, it's about 1/3 of what the whole of Singapore earns). Too bad he doesn't blog.

Well I guess I would just try to describe the concept of DCF, bcos the math will simply freak out a lot of people. But having said that, it's probably A level or 1st year university math so if you really want to know, can google it and try to figure it out.

Ok the concept is basically adding up all the cashflow over the life of the firm and try to determine how much it is today.

Perhaps it is easier to use an example:

Firm A will generate \$1 of cashflow over the next 50 yrs, what is its value (or intrinsic value) today?

Well the simple answer is simply \$1 x 50 = \$50 (QED).

Ok, but how can be so simple?

Now we must understand that \$1 next year is not the same as \$1 today. And \$1 two years out is also different. The difference is due to interest.

So \$1 next year is actually equal to \$0.97 today bcos if we put \$0.97 in the bank today, it will earn 3% interest and become \$1 next year. And \$1 two years out is roughly \$0.93 today bcos if we put \$0.93 into the bank today, it will earn 3% interest in 1 yr, and both the interest and principal after Year 1 will earn another 3% interest, which brings the total to \$1 two years from now.

So once we calculated the present value of all those future \$1 (50 of them), we add them all up and we get the intrinsic value of the firm. For the above example, the answer is \$25.7.

If you are wondering how to get \$25.7, key this "=PV(3%,50,1,0)" in Excel and it will spit out the answer. Need more help, pls email me.

Well, not so hard after all I guess. But the questions below will make you realize what makes it hard.

First, how the hell do we know if Firm A can actually earn \$1 every year for the next 50 yrs? And what will the interest rate be in 50 yrs time? And why only 50 yrs, shouldn't a company exist longer than that?

So that's the hard part, for every input, there is some uncertainty. With DCF, you can have infinite no. of inputs, and that's uncertainty times infinity. How fun. Personally I prefer to stick with PER and EPS estimates.

and Definition: Value Investing

## Monday, December 18, 2006

### Industry Life Cycle

According to Buddhism, there are four phases in Life: Birth, Aging, Sickness and Death. The funny thing is, business schools teach a similar theory about industries.

This is the what makes investment interesting I guess. It is not just about making money. It encompasses knowledge from different fields like philosophy, religion, social science, accounting, economics, finance etc. Which means you have to know a lot before you can invest and make money. Investment is about knowledge. Investment is also about your style, your view of the world and about your ability to stomach losses and conquer your greed.

Okay, back to the main topic, so similar to Buddhism, industries follow a four phase life cycle:

1) Infancy: Few players, growth rate: 10-20% e.g. Fuel Cell
2) Growth: Many players, growth rate: 50-400% e.g. LCD TV
3) Mature: Ogliopoly, growth rate: 5% e.g. Oil majors like Shell
4) Decline: Ogliopoly, growth rate: -5 to 0% e.g. Photo film

Industries can be broken down into these four phases and depending on which phase an industry or company is in, we can see some characteristics pertaining to that phase and frame our expectations accordingly.

1) Infancy: This phase marks the beginning of a new industry, technologies are only recently discovered and business models are still evolving. Growth is limited due to limited demand and lack of funding and interest. Usually marks the 1st 5-10 yrs of a new industry.

2) Growth: At a certain point, an infant industry hits an inflexion point and starts to grow spectacularly. Competitors also start to enter the industry causing prices to come down. But declining prices lead to even stronger demand for products. Stock market starts to get very interested at this stage. Growth phase usually marks the next 10-30 yrs of strong growth.

3) Mature: A growth industry will eventually mature when penetration rate reaches a certain level and/or demand runs out. Growth rate declines to single digits. Weak players exit the business as they cannot compete at low prices and low sales volume. Industry usually consolidates to a few strong players.

4) Declining: This is similar to death in Buddhism life cycle. The industry cannot continue to exist as there is no longer any demand for its products.

It is important to note that these are theories. They do not work perfectly in the real world. Some industries go from Infancy and straight to Decline (e.g. MD players?). Some enjoy growth for 40-50 yrs (autos: is it still growth or mature?). Some industries reach mature stage in 3 yrs (Internet auctions, online stores?). Some industry simply cannot fit into any phase (e.g. consulting?).

Once we understand which phase an industry or company is in, we can better size up its growth potential, investment return and other big picture aspects.

and Secular Trends

## Tuesday, December 12, 2006

### Dividend yield

For a list of dividend stocks (as of Jan 2009), see Free Cash Flow and Dividend Stocks.

Dividend yield is the stock dividend per share (DPS) divided by its share price. E.g. if Company A gives 10c dividend in 1 yr and its share price is \$1, then its dividend yield is 10%.

Alas, as we can guess, it is very unlikely that a stock will be able to sustain a 10% dividend yield for long periods. The simple reason being that if it does payout 10% handsomely forever, why would the original owners list the company? They might as well keep it private and keep the 10%. There are times when the market collapse and dividend yield hits 10% but it is unlikely to remain cheap for long as the stock would rebound quickly. But if you do find one in the current market, let us know! So that we can all buy. Huat Ah!

Globally market dividend yield ranges from 2-4%, but some individual companies do give much higher yield (usually that also mean the company has not much growth prospect). In Singapore the average dividend yield is also around 3-4%, which is not much higher than fixed deposit rate, but actually quite ok by global standards.

Personally I think dividend is very important because it may be the only form of incremental income for a value investor (who prefers to buy and hold stocks). If a company does not pay dividend, there is no way to get cash out of your investment except by selling the shares. But if you would like to hold the shares because you think the company will continue to grow, what can you do? Value investors also need cash to buy groceries right? Not much use holding on to stock certificates until you are one leg into the coffin, isn't it?

Also, by paying dividend, the company shows that it has its shareholders in mind. Excess capital is always returned to shareholders if it cannot be put into better use. Of course, a growth co. needs ALL the money to invest and grow, and they don't pay dividend. Investors sometimes take that excuse, but usually also taken for a ride. However some growth company do grow big and when they are ready, they pay dividend as well, e.g. Microsoft.

However, Berkshire Hathaway has never paid dividend since Singapore got independent because its owner-manager, our hero Warren Buffett, thinks that he can use put the money into better use. And he has done that.

Since most if not all companies are not like Berkshire, we should expect them to return investors some of the money the firm has earned.

and Earnings yield

## Monday, December 04, 2006

### Industry Food Chain

This reminds me of primary school days, when the small fish eats plankton and the big fish eats the small fish and all the crap right? Well with production and business, it's almost the same.

Industry food chain refers to the process by which raw material is being passed through different manufacturers as semi-finished products and finally being made into end-products for the consumer. The most famous one is the semiconductor food chain. But since this food chain is far too complicated, even for sell-side semiconductor analysts, I shall use another relative simple one.

Honey -> Bee -> Bird -> Human

Ok, ok, before you click the "x" at the top-right corner,

Wafer suppliers -> Foundry -> Chip makers -> Consumer electronics

Well that's the simple semiconductor food chain, but what makes the actual chain so complicated is that at every level, there are equipment suppliers and fabless design houses and testing equipment makers and OEM manufacturers so the whole thing turns into a huge spider-web which is good for putting around your workstation to impress sweet young secretaries.

Ok, but what's so useful about learning this? The short answer is Bottleneck. By understanding the food chain we can find out where is bottleneck. i.e. the point in the food chain when there is less capacity than demand, or where there is limited no. of players and hence they have the bargaining power over everyone else. (See Porter 5 Forces.)

Take the example of the hard-disk drive (HDD) industry. HDD is part of the huge spider web within the IT/semiconductor food chain. If we take a closer look at its food chain specifically, it is something like

Materials (Magnets, metal screws, glass discs)
-> Components (recording heads, motors, connectors)
-> Hard-disk drive makers (Seagate, Western Digital etc)
-> Consumer electronics (PC, Ipod, HDD-DVD recorder etc)

There are currently only 5 or 6 players globally in the assembler space. Seagate being the market leader with 40% share, followed by Western Digital and some Japanese and Korean players. However there are countless material suppliers, component makers, as well as consumer electronics players.

2 years ago when Ipod became the No.1 item on everyone's wishlist and when Flash memory was still too expensive, HDD was in super short supply. A bottleneck formed at the assembler space gave HDD assemblers huge bargaining power over its suppliers and customers.

As we can expect, HDD assemblers' stock prices shot through the roof together with Apple and those who have bought these assemblers laughed their way to the bank. Well that is if they sold, today flash memory is rapidly replacing HDD and we all know what is happening now.

and Secular trends

## Sunday, November 26, 2006

### Porter 5 forces

Michael Porter, elder brother of Harry Potter, wrote and published a book in 1980 called Competitive Strategy that helped frameworked how we should look at an industry and the forces that interact with the various companies in the same industry. Ok, just kidding hor, Michael Porter is a real academic while Harry Potter is a wizard in a bestselling septology i.e. a story with seven episodes!

Well what Mr Porter said was somewhat common sense but they will nevertheless teach it in business school and set 1 exam question on this per semester. Anyways, the canonical Porter's five forces are

1) Existing competitive rivalry between industry players
2) Threat of new market entrants
4) Power of suppliers
5) Threat of substitute products (including technology change)

An industry leader/formidable player should be able to tackle all the forces with ease. As an example, let's look at the aircraft makers: Airbus and Boeing.

1) Rivalry between these two players: yes they are somewhat bitter rivals, but on the whole, because there are only two players, price competition is quite limited, and profitability remains high.

2) New market entrants? Not likely, since they are the leaders with all the experience, no airline will think of getting planes from new entrants. Well maybe African airlines buying cheap Russian planes, but overall, not a big threat.

3) With over 100 airlines, basically the airlines don't have any bargaining power. Boeing and Airbus set the price, airlines just accept. If they don't there will be 99 airlines waiting to buy anyway.

4) Suppliers, well depending on the parts, suppliers can be quite powderful. Especially high-end stuff like engines etc. Hence they (Boeing and Airbus) may lose out here.

5) Substitute? Er like flying cars? Or high-speed broomsticks? Well sorry this is not Hogwarts, so in short, no threat from substitutes.

So Boeing and Airbus are in a good position, of the 5 forces, they have the upper-hand in 4 of them. Of course, this is just one aspect to look at one industry. Will be introducing more!

and Secular trends

## Tuesday, November 21, 2006

### Company cheatsheet and stuff - not to be missed!

According to Philip Fisher, one of Buffett's teachers (besides Ben Graham), you cannot never compile a cheatsheet for a company. You have to constantly sniff out info on the company, keep talking to anybody and everybody, from suppliers to customers to employees etc. So analysing a company probably takes like two gozillion years and Frodo have completed the Mt Doom trip like 15 times.

In our world of MTV and instant gratification. Nobody has time for this crap right? So yours truly here has compiled a the ultimate cheatsheet to look at when you first lay your eyes on a company.

I must stress that this cheatsheet is not exhaustive. There are probably another 1,001 things that you should look at. But it should be a good way to start. Also remember than the time you spent researching a company is inversely proportional to the risk that you will lose money. i.e. more research less risk.

But then again who has time to wait for Frodo to go Mt Doom 15x considering we don't even have time to make babies. So I have also kindly calculate the optimal time to spend research a co.

This would be roughly 30 hrs for beginners and 10 hrs for more lao jiao people. But after analysing, this does not mean that you should buy or sell the stock immediately. You should wait for a good time to enter or exit. Investing needs patience, so watch less MTV.

Anyway, to save you from more bull shit, here's the list.

Company specific factors
Mkt cap greater than S\$100mn
Operating Profit greater than S\$10mn
OPM greater than 10%
Dividend yield greater than 4%
D/E Ratio less than 1x
Growth greater than 5%
ROE greater than 15%
ROA greater than 5%
(Usually these factors can be put into a screening tool to screen out companies that meet these criterias, but I have not found a free screening tool yet... if anyone can find one, pls inform me ok?)

Qualitative factors
Industry climate and firm's position
Strengths and weaknesses of the firm
Major risks for the firm

Valuations
PER less than 18x
PBR less than 4x
EV/EBITDA less than 10x
(These can be put into the screening tool as well)

There are a few things to take note. Even if a firm fails to meet 1 or 2 criteria, it doesn't mean that the stock is lousy. If there are good reasons, it is still a buy. If you try to find a stock that meets everything, probably there won't be any. That's why the each criteria is actually not too strict to begin with. Also, qualitative info matters, that's why it pays to read annual reports, research reports and business news.

and Investment Process

## Sunday, November 12, 2006

### Investment Process

An investment process is a SOP (yucks I hate to use this acronym!) that you follow when you want to invest in a stock. For the sake of many non-Singaporean guys and Singaporean gals who have never bother to find out what their boyfriends did in the most unproductive 2.5 yrs of their lives. SOP stands for Standard Operating Procedure: a set of strict execution procedure to follow, during NS.

Anyways, SOP for investing is pretty simple, for me. You should modify your own investment process to suit your style. Investing is as much about your personal style as making money. Your investment process should help to drive your investment philosophy. The process I follow is summarized below

1) Screening
2) Fundamental analysis
3) Valuation
4) Technical
5) Monitor

Screening is the most tedious part of the whole process. Usually it takes a long time to come up with stock ideas if you do not have the relevant tools. Professional fund managers use screening tools to "screen" stocks that fulfill certain criteria. This would be like low PER, high earnings growth, high ROE etc.

Fundamental analysis is what a main part of this blog has been talking about. Things like financial statements analysis, financial ratios, SWOT analysis, intrinsic value etc. The company that you want to invest in must first pass the screening, and then you look in-depth into the company. This is the part when you see the company under the microscope. Scrutinize everything.

If everything looks ok up till now, look at valuations from all angles, PER, PBR, EV/EBITDA etc. A good company must be cheap. If it is expensive, there is no value to be gained by buying. See this post.

Technicals: buy when the timing is right. The general market is on a positive trend, but not too bullish. No analysts are looking to downgrade the stock. i.e. most of them have SELL or NEUTRAL ratings. Charts look ok. Overall sentiment is good but not overly optimistic. Of course, true value investors do not look at this because over time, prices correct themselves and move towards its intrinsic value. But a stock can still drop 10% 2 days after you bought them. If you don't like to stomach this kind of shock, better take a look at technicals.

And finally, when you have bought a stock. Monitor it. Not by looking at its daily price. But by looking at its business. Make sure they are making money, doing the right thing. If things are not going as expected. Sell.

Investing in a stock should be viewed very much like buying an house or a car. The more homework you do, the less likely get conned or lose money.

and Brokers cannot be trusted

## Sunday, November 05, 2006

### Secular trends

Secular trend is one phrase that makes monkeys on Wall Street salivate profusely. It is as if they see bananas coming to them in tsunami waves or something. Well actually, investors probably also imagine tsunamis of dividends pouring over them and that's why they scramble to ride these trends at all cost.

Our world is defined by huge trends or secular trends that last for some time, usually 5-10 years. In the 60s and 70s we have autocars, 80s we have Japan Inc, and the beginning of the 20yr US bull market. 90s was IT and Tech, Media, Telecoms (Ouch!), and now China and commodities.

Note: more often than not, the trend goes into bubble mode and the Greater Fool Game begins. It it important to know the difference and decide for yourself if participating in the Greater Fool Game is what you want.

Betting on these trends will reap you rewards far bigger than day-trading or any other money-making scheme you can ever think of, including building 2 x Integrated Resort to attract oil money, Chinaman yuan, high rollers' money and dunno what else.

Ok, perhaps the reward is not as big as being faithful and good to your spouse. Real life example: University Don flirting with China Gal. Umm, there are other ways to bet on China okay, and they don't need \$7k per mth.

Anyways, identifying such trends require good grasp of global condition and some innovative thinking. This I would say 99.99% of the brokers and their analysts lack. For a good reason. If you identify a trend, you need not buy and sell all the time. Just ride with trend until the cows come home. And this is not good for the brokerage business.

So what are the trends going forward? By right, you should go think for yourself, but since I am writing this, and you are reading fervently, I guess I am obliged to share. Most of these are not new, so pls don't say I have no orginality or what.

1) Silver market: The world is aging rapidly as the baby boomers retire, cash in their pension money or CPF, they will need to find ways to spend it. In most other countries, they spend in on travel, buying houses, cars, buying LCD TVs etc. Hence the global boom in real estate, LCD TVs and autos. But sadly in Singapore, our baby boomers spend it on? *Drumrolls* China Gal! So Buy Prada.

The stock, not the bag.

2) China consumer market: Let's face it, The 21st century belongs to China. We have probably only been through 1/3 of the big China story. So far they simply built 10,000 factories and produced enough stuff to drown Mordor's army 2 times. The Chinese consumers haven't even started spending yet. When they do, it will be interesting.

If you think about it, in the past 5 yrs, every big secular trend was actually due to China. Why did commodities go up? Why did steel prices tripled? Why did oil price shoot through the roof? Why can Walmart conquer the world with its cheap stuff? China. China. China.

Why is Singapore building 2 x Integrated Resort? To create more jobs for China gals and get more University Dons to spend \$7k on China Gals. In short, China again.

Although the whole world has been talking about China for the past 10 yrs, we are probably not finished yet. China is probably Singapore in the early 80s. We have more to go.

Of course, there will be other secular trends. They will be up to us to find out. It will probably be difficult. You need probably 10 mental workout per week, and talk to 20 think-tank people regularly. But when you do, pls update this blog.

and Mr Market

## Monday, October 30, 2006

### Earnings yield

Earnings yield is the reciprocal of the Price Earnings Ratio or P/E Ratio or PER. For those mathematically inclined, well you know what's a reciprocal, as in not "you love someone and someone love you back" that kind lah.

For those who thought that it was "you love someone and someone love you back", umm ok you are wrong and here's the correct formula:

P/E Ratio = Share price / Earnings per share (EPS)
Earnings yield = Earnings per share (EPS) / Share price

or

P/E Ratio = Mkt cap / Net Profit
Earnings yield = Net Profit / Market cap

If you still having problems, try reading a few related posts below.
1) Price Earnings Ratio
2) Market Cap
3) Net Profit

Ok, now that we know what is Earnings Yield, let's try to examine it further. Now if you think about it, Earnings Yield is actually the return that you can get by investing in this stock. Say if a stock has an Earnings Yield of 10%, it means that by investing \$100 in the stock, you would get \$110 back by the end of the year.

Now if you get this, cheaper P/E means higher return right? Because Earnings Yield of 10% would mean that the P/E of the stock is 10x. (10% = 0.1 and reciprocal of 0.1 = 10.) And P/E of 10x is damn bloody cheap because it means that the stock can give you 10% return p.a. and as we all know (hopefully) investment on average earns you 5-8% over the long run.

Consider NOL, which trades at P/E of 3x, it means that its earnings yield is 33%. Sounds like a screaming buy right? Actually, it is a huge debate right now, nobody knows the answer. This is because no one is sure that the P/E can remain at 3x, say 5 yrs from now. This means that some players in the market think that NOL may lose truckloads of money in the next 5 yrs. And he is not willing to buy it now, even if NOL is super cheap today.

As with intrinsic value and forward PER (i.e. P/E ratio in the future) guesswork is involved here. And the guesswork is the usually the one thing that determines whether you will lose truckloads of money or not. Well investing is not easy, I guess. Earnings yield is just another tool to try to make solving a 10 trillion step equation 1 step easier.

and Expectations vs Reality

## Tuesday, October 24, 2006

### What the heck drives stock prices?

Now this is the million dollar question isn't it? I am delighted to inform you that there are a million answers. Below is a non-exhaustive list of the most relevant answers.

1) The weather
2) Coffeeshop talk on stocks
3) Greenspan's or now Bernanke's facial expressions
4) Fart from sell-side analysts
5) This blog (when MoneyMind features it in 6 yrs time)

There are another 999,993 answers that drive stock prices in the short run which I will omit for obvious reason of space constraint. And two answers that drive stock prices in the long run. By long run, I do not mean 24 hours, or 2 weeks, or 3 months. Sorry, 2 yr with your steady also not long enough. Long run means 5 to 10 to 30 years. Yes, really really LONG RUN.

The answer is consistent earnings growth and valuations. If a company can consistently grow its earnings for the next 30 yrs, AND, further if current stock price has not factor that in, then the stock is a buy.

Now if you really think about it, how many co.s 30 yrs ago grew their earnings for 30 straight yrs? And if they did, wouldn't their earnings probably be like a gozillion times larger since it is compounded over 30 yrs. Well you are right and the answer is, maybe about 5 co.s, globally.

This illustrates how hard it is to find a good company and how harder it is to find one that actually trades below its intrinsic value. This is the truth. And this is value investing. But it is not impossible and the prove is Warren Buffett.

Now just for the fun of it, I have included a list of irrelevant stuff that will drive a lot of monkeys on Wall Street crazy. Be careful when you show this list, sometimes they will be delighted and shit bananas and sometimes they will run wild without their shirts.

1) Quarterly earnings announcement
2) Recommendation change from sell-side analysts
3) Technical outbreaks on stock charts
4) Update on economic indicators
5) News on stocks like M&A, new product launch, CEO change, dividend increase, share buyback, alliance with competitors, entry into new businesses etc

and SWOT analysis

## Thursday, October 19, 2006

### EV/EBITDA

As I have mentioned before, on Wall Street, when one no. is divided by the other, cults are formed. This ratio is behind one of the biggest, most controversial cult around. Why is it so? First, because it is very difficult to pronounce. It has 5 syllabus. There are only about 10 words in Singlish with 5 syllabus, so most Singaporeans won't be able to pronounce it, including the blogger who writes this blog.

EV/EBITDA, pronounced as (EE-VEE-EE-BIT-DAH) tries to measure the cheapness of a stock. i.e. similar to other valuation metrics like PER or PBR. Pls do not try to pronounce it as EVITA, I know it is very tempting but pls don't. Regardless of whether you are a fan of Madonna or Britney Spears.

EV stands for Enterprise Value which is the value of the entire firm to both shareholders and debtholders. Its formula is shown below:

EV = Market Cap + Net Debt
Market Cap = Read this post
Net Debt = Total Debt - Cash

And EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortization. Whatever that means. Well for those really interested, read this post. For those really not interested, well let's just say EBITDA tries really hard to measure some kind of profit (not the kind most good old value investors would like lah).

So, in essence, EV/EBITDA tries to measure the intrinsic value or cheapness of a company, just like PER or PBR. But it looks at it from the perspective of both the shareholder and the debtor. (The other two ratios only look at it from the shareholder's perspective.)

On top (the numerator), it takes into account both market value (or market cap) of the company, and its debt. At the bottom (the denominator), it looks at profits before interest, tax and even depreciation. Well from this ratio's creator's point of view, this is profit attributable to both the shareholder and the debtholder.

So, there you have it, a new ingenious ratio, and a cult is born. EV/EBITDA followers now flood the markets. Rituals are performed now and then when analysts hold hands and chant EV/EBITDA 20 times, and the leader shouts "hip hip", and the rest let out "hurray". Like Singapore secondary schools' sports day.

Ok, just kidding, shit like this don't happen anymore. Singapore secondary schools have moved on to Queen's "We'll Rock You", which used to be a JC thingy. But here's what's really important. EV/EBITDA ranges from 5-25x nowadays with fair value usually at 10-15x.

and SWOT analysis

## Saturday, October 14, 2006

### Intrinsic Value - Part 2

This post is updated in 2013.

The intrinsic value is determined by the future cashflows that an asset earns. In the case of stocks, it is earnings and is partially transferred to investors via dividends. In the case of property, it's the future cashflows coming from the rental income. In bonds, it is interest income. In businesses, it is real cash generated. When an asset has no cashflow, we can safely say that it has no value. This means that in today’s context, there are many things actually being masqueraded as investments such as wine, art, watches and some may even consider gold.

The ways and means to calculate intrinsic value is called Valuation. In the purest form, it is by discounting all the future cashflows back to the present and that determines the intrinsic value. This methodology is known as discounted cashflow or DCF. This is very high level stuff and for those who are really, really interested, please continue to read my 1,500 word thesis under the Value Investing Page.

Luckily, for the rest of us, I have updated this simple methodology to determine a stock's intrinsic value right here, in this post. For an earlier tongue-in-cheek discussion, please refer to my previous post on intrinsic value. In this post, I shall attempt to calculate the intrinsic value of some stock using PER and EPS. Now please understand this is really cutting really big and round corners.

Anyway, the idea behind is actually quite simple. Basically you must first have an idea of what is the true PER of the stock, and what is its sustainable EPS, say 5 to 10 years in the future. PER stands for price earnings ratio and it represents a multiple that we should pay when buying something based on its earnings power. EPS, which stands for earnings per share, is one simple way to measure that earnings power.

A simple analogy is property, Singaporeans' favourite topic. The equivalent of EPS would be the rental income and the equivalent of the multiple is the inverse of the rental yield that we are prepared to pay. Say Sky Habitat (my favourite property in Bishan) has an annual rental of \$48,000 (or \$4,000 per month) and the right rental yield should be 4%, or inversely a "mulitple" of 1/0.04 = 25x. This means that the price of this Sky Habitat condo should be 48k x 25 which gives us \$1,200,000. Today Sky Habitat condo sells for \$1,500,000 to \$2,000,000. What does this says about its price vs intrinsic value? :)

In the case of stocks, we can use the same methodology by multiplying the PER with EPS and get the intrinsic value. For those still blur, don't worry, here's the formula:

PER = Share price / Earnings per share (EPS)

if we swap the formula around,

Intrinsic value = true PER x sustainable EPS

Simple right? But do take note of the words in italics: true and sustainable.

So, how do we know what is the true PER of the stock? The true PER isn't next year's PER as it is commonly used in today's market. It is a reflection of the really correct multiple that we should use. This has to be determined by looking at the historical multiple of the stock in question, or by comparing with peers, or by thinking in terms of the growth, stability of the business etc. Usually, the multiple ranges from 12-18x. Personally, I would be very reluctant to pay for anything more than 18x PER. There is a lot more in-depth discussion on this and it can really intellectual simulating and interesting. I am not kidding. Interested parties please continue to read my 1,500 word thesis under the Value Investing Page.

Next we need to determine its sustainable EPS. Again this is not the current EPS, or next year's EPS. It has to be a sustainable EPS over a decent time period, say, 5 to 10 years. In fact, for most value investors, they would be looking for sustainable EPS over much longer periods, like 10 or even 20 years. Of course it is almost impossible to be able to determine with accuracy over such time frame. Which is why Buffett has a tendency to invest in certain kinds of businesses which allows for some predictability over long time frames.

Ok let's use a real stock to illustrate this intrinsic value thing. I would like to use Singtel, our largest stock that has the longest history.

Singtel has managed an average EPS of 22c to 28c over the last 10 years. So assuming that it can maintain this, we can say that it's sustainable EPS is probably 25c. Now we need to determine its true PER. Again looking at its own history, it has traded around 12x to 17x.  Globally telcos have also traded around 8x to 20x PE. So what's the right number to use? There isn't really much science here, I would use 15x.

So Singtel's intrinsic value should be 0.25 x 15 = \$3.75. Today it is trading at \$3.60. So it's a buy?

Well, the answer is no, because our calculations may be wrong. What if the true PER is 14x? Or what if the potential EPS is only 22c?. If you work if this new set of no.s, (0.22 x 14 = \$3.08) Singtel is now 15% overvalued!

Intrinsic value is not just a single number, it has a range of probable values. It changes when we use different assumptions and nobody ever gets it right. And I really mean nobody, not even the Gahmen and definitely not the Korean pop group who declared "Nobody, Nobody but You".

Ok jokes aside. Since we can never be sure we got the intrinsiv value, that's where we need the margin of safety comes in. For those not-so-familiar, pls read the post on margin of safety.

However, if Singtel ever trades at \$2.00. Then it is definitely a buy, because no matter how you tweak the two no.s (PER or EPS), you probably find it very hard to get Singtel's intrinsic value to go below 2 bucks. In fact, Singtel has only traded at 2 bucks for a brief period over the last 10 years, the recent bout during the Global Financial Crisis in 2008 which is like 5 years ago. In other words, it is damn bloody difficult to find great companies trading below its probable range of acceptable intrinsic values for long. This is the challenge and this is value investing.

Singtel's stock price from 2004 to 2013

and Expectations vs Reality

## Saturday, October 07, 2006

### SWOT Analysis

SWOT Analysis is a method developed to analyse an individual company through a framework. It is much loved by Wall Street and you can usually find it in the Initiation Reports of companies by Wall Street analysts. This pretty much tells you that SWOT analysis is perhaps as useful as a piano is to a monkey who is hungry for bananas. i.e. quite useless. Nevertheless, let's take a look.

SWOT stands for Strengths, Weaknesses, Opportunities and Threats which is basically four aspects of looking at a certain company and see if it is worth investing. The words are probably self-explanatory but as an example, let's see how it works.

Strengths: Usually depicts the company's plus points, like having a high market share, or a competitive edge over its rivals, or the ability to raise prices despite public outcry, with the support from the Government (yup that's the right spelling, also don't forget the capital G).

Weaknesses: The company's minuses, like high operating costs, weak product pipeline, poor branding, poor customer service, zero disclosure to shareholders and/or potential investors, labelled as an ugly duckling on Wall Street (that's pretty bad, because Wall Street doesn't like swans either) etc.

Opportunities: Events that will affect the company positively, like a new market for its products, or potential for the firm to be acquired, or the ability to acquire other smaller competitors, or Gahmen, oops sorry, Government support etc.

Threats: Things that will threaten the company's position. E.g. unfavourable regulatory changes, entry of a formidable new competitor, technological evolution that will render the co's product useless, consolidation between suppliers or clients etc.

So that's how SWOT does it. Systematically analyze four aspects and determine the company's position in each of them. Perhaps the takeaway behind SWOT is not just looking at the four aspects but more to analyse a company using a framework or system. This will help one to see the company is a better light, and hopefully make a better investment decision.

PS: Takeaway literally means "da bao" i.e. taking some good food/good babe back home or taking away an important lesson to be remembered.

and Financial Ratios

## Sunday, October 01, 2006

### Is investing a zero-sum game?

This is one question that I would like to answer a long time ago but have always thought I don't have a good answer yet. Nevertheless, I shall attempt to answer that today. Is investing a zero-sum game? I think the answer is both yes and no.

BTW, this post is talking about investing in general, which include fixed deposits, bonds, stocks etc, so not just stock alone, ok hor?

The answer is partly yes, it is a zero-sum game, because whatever you buy, you will have to sell to make a real profit (as in not just paper gain), and whoever bought it from you would be deprived from the amount that you profited. So whatever you gained, he would have "lost" (or failed to gain).

However, we must understand that the world's economy has been growing on average 3-5% p.a. for the past 100 yrs and stocks have grown at roughly 10% p.a. while bonds roughly 5% p.a. So in aggregate, investors would have earned roughly 5-8% (Hence this blog is called 8% p.a., in case you haven't realized), depending on their portfolio mix and also assuming that whatever they invested in did not go bankrupt or go into default. (Actually if they diversify, even if some investments become zero, others would have made up for it. So in aggregate their portfolios will still earn a positive return)

So this is to say, even when you sold your stock at a profit to the next guy, he will not necessarily lose money, because in aggregate, everything will grow, at the very least, with the world economy. He will at least earn 3-5%, if he simply buy government bonds, or 10% if he put everything into stocks.

In other words, the "zero" in the zero-sum is actually 3-5% (which is also roughly the global GDP growth rate) and for stocks, the zero is maybe 8-10%, depending which market you invest in. Hence the "no": as in investing is not a zero-sum game, if someone earns money, it does not mean that someone else is losing money.

To conclude, in the game of investing when you make a realized profit, you deprived someone of that profit but if the next person holds it long enough, he will not lose money, because at the very worse, his investment will grow at the same rate with global economy.

and Markowitz Portfolio Theory

## Wednesday, September 27, 2006

### Straight line depreciation and crooked line depreciation

Depreciation is one concept that allows a lot of creative management to do a lot of creative accounting. They are so creative that when they sit in front of the PC, the sound card leaps out of the motherboard and give them bearhugs.

Just to mention a few ways how depreciation can help make really ugly no.s look like The Swan, here are the popular tricks:

1) Increasing or reducing the depreciation life
2) Using crooked line depreciation
3) Depreciate things that are not supposed to be depreciable

Let's use the previous analogy of Ah Gou, the rogue taxi driver to see how each trick works.

In 1), Ah Gou decides that his taxi (which cost S\$1000) can actually last 20 yrs, so assuming he still earns S\$200, instead of booking only S\$100 of profit, he can now book S\$150 of profit, and the value of his taxi only drop to S\$950 instead of S\$900.

In 2), Ah Gou still depreciate over 10yrs, but he can depreciate the taxi less for the 1st few years, say, \$80 for the 1st year, again he can book a higher profit of S\$200 - S\$80 = S\$120. (In real life, usually company front-load depreciation so that subsequent years will look good, or so that they can sell their assets and book profits, like what SIA does with its planes)

In 3), say Ah Gou bought a phone for his personal use, but his clients got the no. and started calling him up to book his taxi. (Ok, mobile phones are not invented yet, but just an example ok?) He depreciate this cost of the phone (S\$100) for 10yrs as well, so bcos of the phone, he earns more, say \$250, but he only book the total depreciation of S\$100 (car) + S\$10 (phone) = S\$110. And his profits increased to \$140.

So as you can see, it is up to creative management and accountants what they want to do right? In the 3 examples, profits was easily increased by 20%-50% (\$100->\$120, \$140, \$150). Welcome to the World of Wall StreetCraft, where investors are the lowest lifeform and cannot help but fall into the ubiquitous booby traps.

and Fixed Asset and Depreciation

## Sunday, September 24, 2006

### Fixed Asset and Depreciation

Fixed Asset refers to asset that are fixed. (that was helpful wasn't it.) They include stuff like

1) Property, Plant and Equipment
2) Building and Structure
3) Furniture and Fixture
4) Land

Basically they are assets that are held by the company for its business operations and are not intended for sale and are held on for the long term.

Different industries will require different amount of fixed asset (heavy industries like automakers, or transportation sector like railway will need a lot of fixed asset but online co.s will require minimal fixed asset) but recently the general trend is for corporates to reduce fixed asset.

Fixed assets are usually depreciated over 10-30 years to determine its cost impact on the business operation. The value of the fixed asset is then reduced by the amount that was depreciated.

Ok, analogy time. Imagine in the 60s, when policemen still wear shorts, and anyone can buy a car and use it as a taxi, let's say that Ah Gou bought one such car for S\$1000 and decided to be a rogue taxi driver for 10 yrs.

So after 1 yr, assuming straight line depreciation and assuming he earned \$200 in 1 yr, he would have booked a profit of S\$200-S\$100 = S\$100 of profit (assuming no other costs) and his taxi would be worth S\$900.

And after 2 yrs, the taxi will be worth S\$800 and by the tenth yr it will be zero. That's straight line depreciation, where the depreciation cost per yr is the same.

and Why does the balance sheet balance?

## Tuesday, September 12, 2006

### Asset Turnover

Asset Turnover is probably one of the most important ratios that Wall Street invented but ironically also the most overlooked because it's regarded as not-so-sexy and desperately needs some extreme makeover.

If Asset Turnover is so ugly then why is it important then? Well, Greenspan is ugly too in case you didn't notice. But his fart affects the lives of millions, if not billions.

Asset Turnover measures the revenue that can be generated by \$1 of the firm's asset. i.e. how much money can be made from \$1 of asset. It is calculated by dividing Sales over Total Assets. Do not under-estimate significance of this ratio. If only you knew its power...

Ok, so much so for the lousy parody. To increase the firm's Asset Turnover while keeping Asset constant requires operational efficiency improvement. This cannot be done if the company is slack or has a lousy management.

This ratio also has some weight partly because both its components no.s are large no.s and large no.s are not easy to manipulate. (e.g. you can make your OP increase by 50% easily by pushing back some costs, but you cannot increase your sales 50% or decrease your assets 50% overnight.)

But this also means that comparison between different companies gets tricky. You get into situations when you try to compare Asset Turnover of Firm A at 1.0614x vs that of Firm B at 1.0615x. So which is better? You can't really say for sure, unless you are a Nobel Laureate for Applied Rocket Science for Not-So-Meaningful Financial Ratio Calculation.

Hence Asset Turnover may be useful only for historical comparison. If the Asset Turnover of a company has improved from 0.9x to 1.1x, you know that it has successfully generated more sales for every dollar of asset. This no an easy feat, especially if companies are already operating at full capacity. If they can increase Asset Turnover while at full capacity, it means that they somehow can make their existing facilities work harder (by streamlining processes or making existing pool of workers work harder etc) to generate the extra revenue.

However Asset Turnover cannot be used for companies that does not generate its revenue from tangible assets. (e.g. online businesses with no assets to speak of.) In such cases, we have no choice but to return to more popular measures like ROE or OP margin

## Monday, August 21, 2006

### More Net Profit

Net Profit may be subjected to multiple rounds of creative accounting (i.e. legally faking no.s or cooking the books to produce no.s) but it does measure the profit that should go to shareholders. To put it into another perspective, if the company has integrity and assuming that it does not cook its books, then Net Profit is a true measure of the profit attributable to shareholders.

As a rule of thumb, Net Profit should be 50-70% of Operating Profit. This is worked below:

Assuming that a company has \$100 in operating profit, then

Operating Profit \$100
Recurring Profit \$90 (say interest expense is 10% of OP)
No XO loss or gain as it should be
Tax rate 20% (i.e. tax is \$18)
Net Profit \$72

Hence a good co. would have a Net Profit of roughly 50-70% of OP, depending largely on the tax rate. In Singapore, however, there are a few companies that has Net Profit that is greater than Operating Profit. This is usually because they have a lot of profit gained after OP like sale of investment in stocks, properties or simply income from cash holdings.

The most prominent example is SPH. For several years, SPH sold various investments that it held in Singapore stocks like Starhub, M1 etc. These huge gains from investments are allocated at the Recurring Profit level and hence even after taxes are deducted, Net Profit is much higher than it should be, sometimes even higher than OP.

and P&L Statement

## Saturday, August 19, 2006

As with Hollywood as its sequel, prequel and trilogy and quadrilogy. We revisit the P&L or income statement with a vengeance. This time we vent our anger on Net Profit.

The Net Profit is usually the last line in the P&L statement and is usually the number that is most looked at, much like the youngest and most beautiful daughter in the family. In reality, this no. bears little significance to the operations of the company but as we know Wall Street, they like things most when they do not make sense.

Net Profit has little to do with the company’s business because it measures a lot of "costs" that are progressively less relevant to the company's core operations. To recap, we all know that the most relevant costs of any business operations will be

1. Cost of Goods Sold (COGS)
2. Sales, General and Adminstrative Expenses (SG&A)

The no. after these costs are subtracted is the Operating Profit (OP). After OP, interest expenses are deducted, because lenders take the first cut of what is left as they always do. Of course the some companies do not borrow, so they have interest income instead. The number after interest is accounted for is called by various names like Recurring Profit or Ordinary Profit or Earnings Before Tax and extraordinary items etc.

After this, we have extraordinary losses or gains (also known as XO loss or gain, not to be confused with the other XO which is a hard liquor). This is where companies hide all the bad stuff usually and you see extraordinary losses or gains every year, which makes you wonder if they are extraordinary or exactly ordinary.

After that, we have taxes and after taxes we finally come to Net Profit, which is profit that is attributable to the shareholders of the company. (If you think about it, shareholders are ranked behind 1. Customers 2. Workers, 3. Debt holders, 4. Disasters 5. the Taxman, which makes investors the lowest lifeform.) You must understand that at every level, no.s are subjected to manipulation and hence when it comes to Net Profit, this no. actually has no integrity left.

Nevertheless, when Net Profit is divided by the no. of shares outstanding (i.e. no. of shares issued by the company which is still in circulation), we get another big ticket no. called EPS, or earnings per share. EPS is the most talked about no. on Wall Street because it is used to calculate the Price Earnings Ratio, or P/E ratio. And this ratio determines how cheap or expensive is the stock.

### The Guru = Warren Buffett (a.k.a. Sage of Omaha)

With numerous references to The Guru on this blog, I reckon I should give a proper introduction to the person who made this blog's existence a reality. This is really for those who are asking yourselves, "What the heck is Warren Buffett?".

Warren Buffett is not a kind of eat-all-you-can buffet typically charged at \$25+++ in Singapore restaurants. Warren Buffett is the world's 2nd richest man and the world's first person to donate 85% of his enormous wealth (which is roughly USD 40bn or 40% of Singapore's GDP) to charity. Imagine the whole of Singapore donating 40% of their salary to NKF.

He is also a practitioner in a style of investing known as Value Investing which has made a handful of people very rich. This is the reason why it is promoted on this blog.

For a detailed biography of Warren Buffett, try googling him or alternatively you can go to this link at Wikipedia on Buffett. No, I am sorry, Warren Buffett does not have a blog. He only tried going online a few days ago to play bridge with other people not living in Omaha, which is somewhere in the middle of nowhere in US.

and Margin of Safety

## Friday, August 18, 2006

### The Greater Fool Theory

The Greater Fool Theory or Greater Fool Game looks at stock bubbles, Ponzi scheme and MLM from another perspective. Essentially you try to get into the game as early as possible and sell your stuff to the next person or the Greater Fool. Now the next person is the Greater Fool because by buying what you have proposed to sell, he probably doesn't gain anything (or every little). Try visualizing magnetic beds or slimming pills or purple crystals that claim to do wonders but the effects are impossible to quantify.

So the only way he can get out of this trap is to find a Greater Fool (than himself) and sell it to him. As long as you are not the Greatest Fool, you will win the game. In MLM and Ponzi scheme, the Greatest Fools are people at the lowest level of the pyramid. The reason why MLM and other Ponzi Scheme and stock bubbles can carry on for some time is because the Greatest Fool or Fools have not joined yet. So those in the game can continue to have fun.

A true value investor however, does not like to participate in the Greater Fool Game. He believes in buying things below their intrinsic value and in the Greater Fool Theory, intrinsic value of any product or stock is way, way, way below its market value. (i.e. you are buying something worth \$1 with \$100.)

There is no right or wrong about making money. Depending on your investment philosophy, you can engage in Greater Fool Games all your life and make truckloads of monies. And throw a few shillings to the down-and-out value investor staying true to his philosophy. (FYI: Warren Buffett lost 50% of his wealth during the IT bubble by staying true to his invesment philosophy.)

Just make sure that you are not the Greatest Fool.

### The Pyramid or Ponzi Scheme and the Positive Feedback Loop

As some of you would have guessed after reading the previous post, a bubble is very much similar to a Pyramid Scheme or Ponzi Scheme. These are essentially elaborated setup that promise riches to those who join but are bound to fail because they are not based on fundamentally sound economics.

*Pls google those bombastic terms if you are still blur, confused, wondering what the heck pyramids in Egypt have to with do soap bubbles or thinking that Ponzi was a disciple of Sun Zi, the great military strategist in China 2,000 years ago. If you did, don't worry, I thought Ponzi was a disciple of Confucius or Kong Zi*

A Pyramid Scheme or Ponzi Scheme (also exhibited in other forms like Rat Society, MLM, etc) has two characteristics:

1) The person who joins have to cough up some amt of money
2) The person can recruit others to join under him, the recruits in turn cough up an amt and the person on top gets a cut

This scheme essentially benefits early birds as they are the ones who can enjoy more income as more and more people join. But it is bound to fail because it is not based on fundamental economic growth and no. of people who will join will eventually run out.

However at the start, the early birds usually enjoy some success. This is because as more people join them, they see money rolling in and they reaped back their initial investment. This is called the Positive Feedback Loop.

The success of the early birds convinced them and their friends that the scheme worked and they fervently recruit more people. This is what happens in stock bubbles. Early adopters buy stocks and see their wealth grow. They spread the word, more people join them. But since this is not based on real economic growth, at some point, there will be less buyers than sellers and everything collapses.

MLM is an ingenious way that masks a product into the Ponzi Scheme. The selling price is set ridiculously high to feed those at the top of the pyramid. But it is also bound to fail because there will be a point where you simply cannot get any more buyers to cough out those exorbitant rates for mildly useful health products, magnetic beds or the other shady products with unmeasurable usefulness.

The same goes for internet ads promising huge returns in days or weeks. It will only work if you are an early bird. Chances that you are an early bird is as good as finding a \$10 bill in the middle of Orchard Road. (i.e. very low lah, bcos someone would have picked it up. But not impossible.)

## Thursday, August 17, 2006

### Irrational Exuberance

Once in a while, the stock market goes into bubble mode, or what the guru terms as irrational exuberance. In Singapore, this phenomenon probably exhibits in one of the following ways:

1) The STI chart looks like the left half the Eiffel Tower in Paris
2) Two or more friends are switching career into finance
3) Local TV did a drama/talk show/charity program on stock trading
4) A taxi driver recommends a stock to you
5) You actually think if you should buy the stock he recommended
6) This blog gets prime time coverage on Channel U
7) Your grandma wants to open a brokerage account
8) The market cap of a sexy stock is bigger than the GDP of some countries in S.E. Asia

You get the idea. For those of us born before 2000, we've been there, done that and some are still licking our wounds but secretly wishing that those days will come around again, and this time we will do it right. Right?

Well let's see what really happened. In the World of Wall StreetCraft, probably around 1995, some cleric created a portal and invited some friends to join him. But the catch was that the friends had to pay a small sum of money to buy their entrance ticket. They did.

For a while, the group of friends were feeling good. The portal offered warmth, companionship and a lot of promise. It linked to different places in the world and new technologies were created. Soon more people joined, and for everyone that joined, people in the portal enjoyed some income.

As more and more people joined, the portal started to get crowded, boundaries were pushed out to acommodate more people and entrance ticket got expensive. Some left the portal but more people joined. Entrance ticket got ridiculously expensive but a lot of other folks did not want to be left out and paid up.

By now the portal looked very roundish, yes like a bubble, and full of people inside quashed around but getting very euphoric. This was because the value of their entrance tickets is worth more than what they could have earned in 20 lifetimes. They felt like gods and goddesses in heaven eating grapes and stuff. This was when grandmas in Singapore heard about the portal and wanted to join as well.

Now the grandmas in Singapore were the last people to join the portal and suddenly everyone realized that no more income can be gained since everyone was already in. This was when they realized the portal was getting stuffy as well and everyone wanted out.

Overnight as everyone rushed out, entrance tickets became worthless and a lot of grandmas and clerics who bought the tickets late lost their shirts. In fact they lost everything they had, some moved on, but some remained in fantasy, constantly hallucinating about the good days where they were eating grapes and stuff in heaven.

Actually not everyone joined the portal. A group of obsured people known as value investors watched the whole portal episode by the sidelines. Cajoled to join but they knew better. They knew what was irrational exuberance. In the end, they were the ones who picked up the pieces, drank the wine and had the last laugh.

## Wednesday, August 16, 2006

### Financial ratios

In Singapore, when you divide one no. by another, it is usually to achieve some specific purpose and you will forget all about it in like 2 seconds. E.g. you go to a restaurant with 12 friends and when you get the bill, you simply divide it by 12, and forget all about it.

On Wall Street, when you divide one no. by another, it has divine meaning. Cult leaders and religious factions are formed. So much so that some no.s have an ® mark beside them. And R stands for Religion.

Ok R does not stand for Religion, but it is true that some no.s when divided by another has an ® mark beside them. These no.s are also known as financial ratios.

Wall Street thinks that by divided one no. by another, you can normalize things and hence comparison can be made for different co.s. Much as I despise Wall Street, I think that sometimes ratios make sense. E.g. when I divided the dollar value of all the presents I bought for my wife by the no. of times I skip washing dishes, I can determine the efficiency of the presents. It works out to be \$12.6 for per dishwashing session. Anyone needs some financial planning on dishwashing?

Anyway, below is a non-exhaustive list of financial ratios and their meanings.

1) Operating Margin (OP/Sales): Efficiency of the firm's operations, this no. range from -90% to +90%, the higher the better.

2) Asset Turnover (Sales/Total Asset): Efficiency of the firm's assets in creating sales, this no. is usually 1.x, the higher the better.

3) Return on Equity (Net Profit/Equity): Rate of return attributed to shareholders, this no. is usually 5-40%, on average around 20%, the higher the better.

4) Return on Asset (Net Profit/Total Asset): Rate of return attributed to the whole firm, this no. is usually 2-30%, the higher the better.

5) Dividend Yield (Dividend per share/Share Price): Rate of return of dividends, this no. is usually 0% to 10%. In Singapore, anything higher than 5% is considered very good.

6) Other ratios that we talked about: PER, PBR, Net debt-to-equity, cash-to-market cap, EV/EBITDA.

7) Another 10,016 ratios that we did not talk about, created by Wall Street analysts. Maybe you can still find 1 or 2 useful ratios in there.

Essentially ratios are quite useful when you want to analyze a company but try not to be a cult leader and read into ratios religiously. By that I mean you try to contemplate if \$12.5 per dishwashing session is more efficient that \$12.6 per dishwashing session. They are useful but not that useful. They give a sense of how the company is performing, you still need to do more homework after that.

## Tuesday, August 15, 2006

### Financing cash flow or CFF

Financing cash flow (or CFF) is usually the last instalment in this trilogy within the trilogy (phew!) i.e. that last portion of the cash flow statement and it deals with the financing needs (both equity and debt) of the company. This would usually involve repayment of debt, or increase in borrowing, dividend payment, equity capital reduction, increase in equity, share buyback etc.

Ok, ok, this may be too heavy, let's go back to Finance 101. A firm needs capital to run its business. There are two ways to get capital,

1) you borrow from bank, this is call debt
2) you raise money from the stock market, this is call equity

Financing cashflow deals with what the firm does with its capital. Increase debt? Decrease debt? Increase equity? Reduce equity? Pay dividend? Or outright equity reduction etc.

Hence, it would be useful to observe how the company is changing its capital structure from this part of the statement. Just like it would be useful to see if your spouse finance her spending needs through debt or something else (most likely through you though), and since buying a company entails as much commitment as sleeping with someone for the rest of your life, it pays to know.

In Singapore, a lot of companies are trying to reduce its equity base (SPH, Singpost etc) in order to make some financial ratios (like ROE) look good. (i.e. some spouse is trying to fake financial stability here) However that is just part of the story, the other part is *drumrolls* to return money back to their No.1 shareholder: Temasek Holdings. Of course, minority shareholders will stand to benefit as well, hence while it last, it would not be a bad idea to invest in these stocks.

## Sunday, August 13, 2006

### Investing cash flow or CFI

Investing cash flow (or CFI) is usually the 2nd portion of the cash flow statement and it measures the money that the firm use for its investment activities. The most important no. here is the Capex no. Now "Capex" may sound like a new brand of designer clothes but it's not. But maybe someone can start one hehe. Anyway, Capex is the short form for Capital Expenditure. This is what the firm needs to invest in (usually in new equipment, new technology or new offices etc) in order to stay competitive in its business.

This no. however is not labelled as "Capex" in the cash flow statement but usually goes by some obsure label like "Acquisition of New Property, Plant and Equipment". Why is this so? One good reason that I can think of is because auditors love to make life difficult for a lot of people and sell-side analysts, investor relations managers get to keep their jobs by having to explain what "Acquisition of New Property, Plant and Equipment" really mean.

Other no.s that are quite boring that goes into investing cash flow as well will include:
1) Sale of Property, Plant and Equipment (opposite of capex)
2) Purchase and Sale of Investment Securities
3) Acquisition of new subsidiaries or associated companies etc

One need not worry too much about those no.s unless they have a few more digits than the rest of the no.s in the cashflow statement. Meaning they are super big or super negative and it pays to know why that is so.

## Sunday, August 06, 2006

### The Cash Flow Statement

The last installment of the financial statements trilogy (which is usually the most boring as well) is the cash flow statement. To most people, the cash flow statement is of least importance and perhaps that is why it is always found after the other two. However, as with trilogies, it is also where you can find the truth about companies. But son, you can't handle the truth!

The conventional thinking is that it is easy to manipulate earnings, costs or even sales but it is much harder for companies to manipulate cash flows.

Cash flow measures the actual inflow and outflow of cash into and out of the firm. Hence while sales can be manipulated (e.g. by recognising sales from the future), a cash outflow is a cash outflow. When a cash outflow becomes a cash inflow, there are only two explanations:

1) This is fraud, the no.s are fake, don't trust them
2) The money is in the washing machine, going through the laundry

A company that has a poor cashflow is something to look out for. It is usually an early warning for bigger trouble to come. Avoid at all cost.

The cash flow statement is also further classfied into three sub segments (whoa...a trilogy within a trilogy...)

1) The cash flow from operations or operating cash flow (CFO)
2) The cash flow from investments or investing cash flow (CFI)
3) The cash flow from financing or financing cash flow (CFF)

The most important no. to look out for is undoubtedly the operating cash flow (CFO), *For the really blur people reading this, pls don't get confuse with the other CFO which stands for Chief Financial Officer*.

This no. (i.e. CFO) measures the actual cash inflow from the firm's core operations and it should always be a positive number. If it is not, it means the company cannot earn money from its core businesses and all alarms should sound and you should press the panic button and unload everything, if you own it, and avoid at all cost if you don't.

## Friday, August 04, 2006

### Risk, Return and the Markowitz Portfolio Theory

Harry M. Markowitz won the 1990 Nobel Prize for telling the world two fundamental truths about investment: "Higher risk, higher return" and "Don't put all your eggs in one basket". Much as I sounded as if he deserved the Novena Primary School Mathematics Competition Runner-up, I must point out that his findings were mathematically elegant. (I know you are saying "yeah right" but trust me, it's true, I was genuinely amazed by the beauty in its simplicity.)

Nevertheless, the important implications of his modern portfolio theory still hold true in today's investment arena.

To briefly summarize what was his theory all about, we need to assume that the markets are efficient. The efficient market hypothesis essentially assumes a lot of things that do not make sense but academics love them anyway. Just to mention a few, efficient market assumes that all investors are rational (well if you think monkeys are rational), zero transaction cost (hmmm if sell-side analysts are monkeys and work for bananas) and that information flows freely (monkeys talk to one another all the time and need not buy one another bananas for info) etc. These we all know are not true.

However, that is not the point, the point is once we assume markets are efficient, according to Markowitz the only way we can make more money is to

1) To take more risk (by investing in riskier assets)
2) To diversify (by investing into different asset classes which are not correlated)

This is graphically represented above in what is known as the Efficient Frontier. The Efficient Frontier represents the maximum return that can be achieved at a specific level of risk. If an investor wants to achieve a higher rate of return, she can invest in riskier assets, like equities or venture capital (This is the "Higher Risk, Higher Return" part). This can be easily visualized as shifting from one point (e.g. Bonds) to another point (e.g. Equities) on the right of the same Efficient Frontier.

Now she can also choose to invest in many different kinds of assets (commodities, real estate etc), hence not putting all the eggs in one basket. This will push out the Efficient Frontier (a parallel shift of the whole Efficient Frontier upwards), enabling the investor to reap more return for any given level of risk.

So as I said, elegant math that explained two truths about investment.

## Wednesday, August 02, 2006

### The Players

Know yourself, know your enemy and you can fight a hundred battles and win a hundred battles. This timeless quote from Sun Tze holds true for players in the stock market as well. (I also got a bit of ink lah!) Although a true value investor (see also value investing) would not worry about matters other than those that are related to the intrinsic value of the company, one must be mindful of the forces that move stock prices. This would allow us to buy a good company at cheaper prices and also help us determine when to take profits.

As a basic introduction, here is a (non-exhaustive) list of players in major markets

1) Institutional investors (mutual funds, pension funds, etc)
2) Hedge funds (Macro, long-short, long-only, arbitrage, quant)
3) Brokers (Investment banks, traders, investment arm)
4) Retail investors (rookies, day-traders, investors)

To give you flavour, for a moment let's think of Zouk as the market, then the discription becomes

1) The incumbents, always around, deep, skilful, in control
2) New kids on the block, funky, attention seeking and scoring big
3) The pimps, gd at managing relationships & taking commissions
4) Participating on the sidelines, usually at the losing end

Institutional investors continue to be the major class of investors in the world. They usually invest in benchmarks (like STI, S&P or Nikkei) and their investment activities revolve around their benchmarks as well. Hence on average they are the trend-followers rather than the trend-leaders. Of course there are the top fund managers who can identify trends way before everyone else. But when the majority follows a trend, they move markets big time.

Perhaps the most important takeaway is that hedge funds have become a major force in the markets. Hedge funds are usually small investment outfits that invest with radical strategies to make a lot of money with leverage. Hence the name "hedge fund" is actually a misnomer. Hedge funds take a lot of risk to produce their desired return. They are responsible for a lot of volatility in stock prices nowadays and they are increasing their asset under management, for better or worse.

## Monday, July 31, 2006

### Expectations vs Reality

The stock market moves on expectations, not on its actual performance. If the market expects Firm A to grow its earnings by 20% for the next 5 years, the stock will rally 100% in the next 5 weeks. It does not matter if Firm A can actually grow its earnings 100% after 5 years. Similarly, if the street expects Firm B to miss its forecast, Firm B's stock will not wait for the announcement and then plunge. It will plunge today.

Zooming out to the bigger picture, if everyone expects the Singapore IR (i.e. Integrated Resort, where you integrate treadmills with slot machines with massage chairs placed toilets maintained by elite toilet specialists) to be an extraordinary success. It does not necessarily need to be an extraordinary success 5 yrs down the road for money to pour in by the truckload. It only needs everyone to think that it is a success, and everything from real estate prices, to ERP, bus fare, taxi fare, to stock prices except salaries and banana prices will skyrocket.

I used earnings and the IR to explain this phenomenon, but it can apply to everything, from favourable regulation changes to M&A rumours. The stock moves on what the collective thinking of all the investors point towards to and not the actual scenario that will eventually play out. If one can understand this, it is easy to see that this phenomenon has two impact:

1) The market may be wrong, but since the actual scenario does not happen immediately, at the meantime, the market is right. Hence the saying "the market is always right".

2) The market may be right, but it will almost always overreact (e.g. factoring 5 yrs of earnings in 5 weeks) and the scenario is played out in a shorter time frame than expected.

In the long run, the market moves towards the actual scenario and the market corrects its past mistakes. Hence value investing, by trying to estimate the intrinsic value of the company, stands the test of time and the idiosyncracies of the market.

## Wednesday, July 26, 2006

### Cash and Debt

Perhaps the most important information that can be derived from analysing the balance sheet is whether the company has good financial health. This is determined by how much cash or debt the company holds.
Needless to say, a company that has no debt will be better than one that has. But what is the optimal level of debt? The academic answer will involve corporate finance and things like WACC (pronouced as "whack" as in the sound that is made when you use a baseball bat and smash it on your broker's forehead) which I hope to touch on in future, but not now. For a rough gauge, perhaps we can look at two simple ratios.
1. Net Debt to Equity ratio
2. Cash to Market Cap ratio
For a company that has debt, we first subtract cash from its debt to get its net debt level. Next we simply divide its net debt by its shareholders' equity. E.g. Firm A has \$100 Debt but \$20 Cash and \$80 Equity. Hence Net Debt to Equity = (100-20)/80 = 1. This means that Firm A employs as much debt as equity to finance its business. (Which is not very good lah, imagine your wife borrows from you \$1000 for every \$1000 she has to buy a Prada bag!)
In Singapore, a company with a Net Debt to Equity ratio of 1 or 100% is considered very bad since most listed companies here has no debt. This is especially true for the best companies around.
Now if the company has no debt, then how much cash is enough? The other ratio that people look at is the Cash to Market Cap ratio. This is simply taking cash that the company holds divided by its market capitalization. I would say that a ratio above 20% would be considered very good. This ratio rarely goes above 50% because if it does, essentially you are buying for the company's operations at a 50% discount. (i.e. your wife propose to sell her total net worth to you for \$100,000, she has \$50,000 in her bank and you get a cut of whatever she makes for the rest of her working life. Sounds good huh?)
To illustrate further, imagine that a company has a Cash to Market Cap ratio of 100%. Essentially, you bought the company for free, because its cash would have paid you the amount you forked out, plus you get the company's business which will continue to generate cashflow FOC.

## Friday, July 21, 2006

### Components of the balance sheet

The balance sheet can be further broken down to its various components. Reminds me of chemistry when a molecule can be broken down into atoms, and one atom can be broken down into electron, neutron, protron and recently they discovered even these can be broken down into G-strings or something.

So, in the balance sheet, assets can also be broken down into current assets and non-current assets. Liabilities can be broken down into current liabilities and non-current liabilities. These sub-levels will consist of individual components that makes up the basic building blocks (yes, that's it, no more G-strings) of the balance sheet. Below is a not-so-short list of important items to know:

Assets

- Current Assets
• Cash
• Marketable securities or short-term investments
• Accounts Receivables
• Inventory
- Non-current Assets
• Fixed Assets (Property, Plant and Equipment (PP&E)
• Intangibles
• Long-term investments
Liabilities

- Current Liabilities
• Accounts payables
• Short-term borrowing (short-term debt)
- Non-current Liabilities
• Long-term borrowings (long-term debt)
• Other long-term liabilities (pension liabilities, deferred tax liabilities etc)

Shareholders' Equity

• Paid-in capital
• Retained earnings

## Friday, July 14, 2006

### Why does the balance sheet balance?

Actually, the balance sheet may not necessarily balance. A balance sheet that does not balance is called an unbalanced relationship.

Ok... Sorry for the bo liao joke. But just to share a fact, in most financial models built by analysts, the balance sheet does not balance and they don’t know why.

Anyways, the balance sheet balances because that is how it is defined. By definition,

Assets - Liabilities = Shareholders' Equity

Hence on the balance sheet, Assets are shown on the left, Liabilities and Shareholders' Equity are shown on the right. To illustrate, assuming one bah chor mee start-up borrowed \$10,000 to buy a bah chor mee store that cost \$20,000 with initial capital of \$10,000. Its balance sheet would look like this:

Assets (bah chor mee store) \$20,000
Liabilities \$10,000
Equity (or initial capital) \$10,000

Assets \$20,000 - Liabilities \$10,000 = Shareholders' Equity \$10,000

This has to be the case because initial capital and borrowing add up to the value of the asset that the company has for it to run its business. Now assume that after 1 year, the store generates \$18,000 of profits by selling tons of bah chor mee (both with and without liver). Its balance sheet would look like this:

Assets \$38,000 (Store \$20,000 + Cash from profits \$18,000)
Liabilities \$10,000
Equity \$28,000

Assets \$38,000 - Liabilities \$10,000 = Shareholders' Equity \$28,000

Again the balance sheet balances because any entry into any parts of the balance sheet would have a corresponding cancelling entry on another part. In this case, Assets increases by \$18,000 and Equity by \$18,000 as well.

## Sunday, July 09, 2006

### Brokers, analysts, advisors, investment bankers, private bankers etc cannot be trusted

Why do brokers provide research service to their clients? Brokers, or analysts (from sell-side brokers), or investment bankers or private bankers for the matter, thrives on activity. Activity is their friend, and is what drives their profits. For every trade that you make, they will take a cut, regardless of whether you are buying or selling.

Now bearing this in mind, does it make sense for research analysts, working for brokerage firms to make a BUY recommendation and do nothing for the next 5 to 10 years? So, in a sense, research analysts from sell-side can only make short-term calls, to generate churning. They may not realize it, they may genuinely want to analyze companies and give their client good advice, but the system is in place for them to generate churning.

In the markets, to make short-term calls is like throwing a coin and then trying to guess whether it is heads or tails. Research estimates that investment professionals are right 40-50% of the time. The best guys are right 60% of the time. Trusting an analyst to make a correct short-term call is as good as trusting a monkey to throw a dart on chart to determine a stock's target price.

Having said that, brokers are good for information and flows, so use them for that. As far as they want to project an image that they are on our side, we must remember that their interests and ours are not aligned. We must be careful not to let them suck away precious returns in the form of transaction costs.