Wednesday, May 31, 2006

Price to book

Besides the price earnings ratio, another widely use valuation metric is the price to book ratio, or PBR. This is simply price of the stock divided by its book value per share.

The book value of a stock is also called its shareholders' equity which is whatever that is left for shareholders after all its assets are sold and all its liabilities are paid off (shareholders' equity = assets - liabilities)

By right, a stock should never trade below its book value, because this means that we should sell everything the co. has, pay all its debt and distribute what is left back to shareholders, which is more than the stock price on the market. So theoretically, one can arbitrage when a stock trades below its book value.

Now if you don't get the above, it is saying that some dumb babe is selling you her car for $5,000, but if you take out the tires, the engine, the stereo and all other parts and sell them separately, you get back $10,000. You tell the babe this but she is still grateful that you bought her car at $5,000 anyway.

By left, stocks trade below book value for as many reasons as why your wife refuses to let you meet your buddies for coffee, and as Warren Buffett learned, buying each and every stock below book value does not guarantee good return.

See Price Earnings Ratio

Friday, May 26, 2006

The Efficient Market Hypothesis (or EMH), its myth and reality

The Efficient Market Hypothesis states that stocks or other investment instruments always trade at their fair value (or intrinsic value) because investors always react rationally to new information entering the market and prices would instantaneously reflect this. Hence it is futile for people to try to beat the market (i.e. try to earn more return than the average market return) through stock-picking or by other means.

In fact, one book says that you can open the newspaper page on stock quotes, give a monkey some darts to throw at the stocks and then buy them (the stocks, not the monkey). Voila, the stocks will perform as well as those picked by a professional fund manager. And you can pay the monkey truckloads of bananas.

In everyday life, EMH is similar to saying it is very hard for you to find money on the ground while shopping along Orchard Road, because chances are someone has already picked it up.

However, if the EMH is true, and nobody could beat the market, how do we explain Warren Buffett, or Peter Lynch? These are people who has beaten the market for not 1-2yrs but 20-30yrs, and they made 20-30% per annum, far higher than the average of 5-8%.

As with most things in life, I think the truth is somewhere in between. The market is efficient and it is hard to find undervalued stocks, but there are people who are "six sigma events", like Tiger Woods, Michael Jordan, Mother Theresa, Albert Einstein and Warren Buffett. With effort, practice and knowledge, we can still invest and make money, we may never earn 30% p.a. but 8% p.a. is not unachievable.

Wednesday, May 24, 2006

Margin of Safety

The margin of safety (coined by Benjamin Graham, father of value investing) is a concept of buying investments that are significantly cheaper than its intrinsic value. The key word here is "significant". We need to buy with a margin of safety to minimize the risk of losing any money.
Let's put it this way, imagine that you are going out on a date with a chio babe and you think you will need S$100 for that night. Will you bring $105 or will you bring $300? That is the meaning of margin of safety. *For those still blur, the answer is S$300 because she might bring two of her chio friends and you are in deep shit if you only have S$105 in your pocket.*
Going back to my favourite analogy, let's assume that our friend bought the golden tap to re-sell it to another buyer. According to his calculations (see previous entry), which was the same as ours, the golden tap is worth $1060, and he bought it for $1000. So he could have sold the tap to another buyer who is willing to pay $1060 and he earns $60.
However as you can see, this trade does not have a margin of safety. What if the tap can only sell for $900 because our assumptions were wrong? What if gold dropped 10% the next day? If he bought the tap for $500, then the trade would have earned the praise of the guru himself, by having a good margin of safety.

Friday, May 19, 2006

What is the intrinsic value of a golden tap?

The intrinsic value of a stock or an investment is its true or inherent value based on some valuation method and it is usually different from its market value.

Going back to my favourite analogy of the golden tap, I would like to ask this question: what is the intrinsic value of a golden tap? We know that the market value is S$1000, well because someone paid that much for it. But is that its true or intrinsic value? To calculate this, we make a few simple assumptions.

1) The golden tap used 28g or 1 ounce of gold
2) Manufacturing, processing cost is S$100 (10% of S$1000)
3) Price of gold at the time of purchase was US$600 (or S$960) per ounce

Adding up the no.s, we have S$100 + S$960 = S$1060, the intrinsic value of the golden tap according to my valuation method. So, our friend did not overpay for his golden tap.

In our example, intrinsic value = market value, but in reality that is rarely the case, more often than not, market value is greater than intrinsic value. For luxury goods, like a Prada bag, market value is probably 10-20 times more than its intrinsic value, in my opinion. (However, there are different valuation methods to derive at a product's intrinsic value. Perhaps a Prada bag owner's valuation method is something like: $10 cost of leather, $990 ability-to-show-the-world-I-own-a-Prada-bag).

The goal of investing, is to find an investment which has an intrinsic value significantly higher than its market value. This kind of investing is also known as value investing, pioneered by Benjamin Graham and David Dodd and later Warren Buffett, the world's most successful value investor.

Thursday, May 18, 2006

Investment cannot make you filthy rich, if your last name isn't Buffett

Considering that investment can only make 5-8% on average in the long run, we cannot expect investment to bring home the bacon, can we? Going back to my first post, an average Singaporean earns S$3k per month, assuming that she can save S$1,000 every month, which is very optimistic (i.e. S$60k after 5yrs) and she starts to invest after saving S$60k. She earns 8% of S$60k = S$4.8k per yr, which is S$400 per mth. Well not enough to buy a tap for a certain foundation director some years back, enough to eat, pay off some bills for others. Not exactly a huge amt.

Let's have a bigger example. Consider that a household accumulated savings of S$500k, which probably could be accumulated by some of you, the aspiring readers reading this now, or roughly speaking the top 10% households in Singapore given that their annual household income probably exceeds S$150k, ie this amount can be saved in less than 10 yrs.

So giving this amt the higher return of 8% would give income of S$40k per yr. Now we are getting to something. S$40k could probably pay for most expenses like food, mortgage, utility and phone bills etc. But not the extravagant stuff like a Europe tour, or a nice 1.8L car which today (2012) costs *gasp* a cool S$100k.

So my point is: investment can give you incremental income (S$400 in the first example), if you invest as well as an average investor on Earth. And if your base is big enough, ie S$500k, it can give you some maintenance income, but nothing more. Kid's education, insurance, medical bills and Inflation, the biggest killer - these are things that are not factored in the S$40k maintenance income that we talked about.

And as it is, 8% return every year is quite a high target over long investment horizons of 20-30 years. Very few professional fund managers actually achieve 8%.

So, contrary to what banks, brokers and most financial advisers would advise, investment cannot help you grow your wealth to make you eligible for private banking overnight. Next time you want to gauge the knowledge of the sweet young relationship manager peddling another structured note, ask her what she thinks is a likely return target over 20 years. The answer is 5-8%. If she says anything higher, leave immediately. Well you should still leave even if she got it right since most structured products don't help you make money. Unless she looks like Cecilia or Anne Hathaway :)

Investment cannot make you filthy rich. Over a long period of time, like 30-40 years, it might get you a good retirement nest, if we do things right and get that 5-8%pa over the long run. The easiest way to do that might be simply buying ETFs, or exchange traded funds that allows you to buy whole markets with minimum fees.

To achieve more than that, ie to invest and get 10-20%pa over say 20-30 years, you need to put in a lot of work into analysing macro trends, industries and stocks. It's a full-time job in itself. It might actually work out better to focus on your day job and do it better and get that General Manager position.

However if your last name is Buffett (not Buffet as in-eat-all-you-can type one hor), the story turns out to be quite different. You would have made 25% annual return on your investments for the last 40 years and earned US$30bn. Your "incremental income" on investment would have made you the 2nd richest man on Earth (after a certain Gates who likes to build Windows with security holes) and you will be the only guy in the Top 10 Richest People List that have made your money through investment. Too bad most of us are Lees, or Tans, or Ngs.

Tuesday, May 16, 2006

Market cap (or market capitalization)

Market cap is a cap that you can buy for S$5 at a pasa malam market.

Ok, just kidding lah, don't choke and fall off the chair, PC chairs with rollers are getting less robust these days. Below is the real definition.

Market capitalization (a.k.a. market cap) is simply the share price x the no. of outstanding shares that the company has issued. It is a measure of the "perceived" value of the company. To paraphase, market cap is what the participants in the stock market thinks how much a company is worth, it may or may not reflect its true value, or the intrinsic value of the firm.

Monday, May 15, 2006

Great company, good stock but not a good buy

One important tenet about investment is to separate a good stock from a good investment. What do I mean by that? A good stock or a good company is one that consistently delivers earnings, capable of making good strategic decisions, always one step ahead of competition and the leader in its field. Essentially the WalMarts, the Googles and the Toyotas of the world. A good company however may not be a good investment, because its "goodness" is already factored in the share price. A good investment is buying a good company at a cheap price. That is, buying WalMart 30 years ago, when nobody has heard of it and when it was trading at a huge discount to its intrinsic value.

To put it in another perspective:
- a good stock = a good babe
- a good investment = dating a good babe at a cheap price
- a bad investment = dating a good babe at an expensive price

As another analogy, take the Dom Perignon champagne. It cost roughly S$200 per bottle. Is it expensive? To answer that we need to know its true or intrinsic value. For consumer products, an easy way is to breakdown its cost components. For the champagne, probably goes like S$50 labour, S$40 processing, S$20 packaging, S$10 logistics, S$10 admin cost (I am arbitrarily putting in no.s here), the rest of it the Dom Perignon's brand, taste, prestige and heritage. When you buy a bottle of Dom Perignon for S$200, you are paying all these, so you probably did not overpay or underpay.

In other words it is fairly priced (i.e. going on a date with a good babe at an expensive price). When you buy a great company like Google, or WalMart, it is the same. Chances are you are not buying them at a bargain price. This is what it means: its "goodness" is already factored into the share price.

So how do we find a stock that is a good investment? That is the question, isn't it? Just like going on a cheap and good date with a good babe, good investments don't come by easily. One has to dig, to search, often to find that it is not so good after all. But they do exist. At least the guru, Mr Buffett managed to find 12, and that made him a billionaire.

Price Earnings Ratio, PER, P/E Ratio

How do you actually measure the cheapness of a stock? SMRT shares trade at $1.40 and NOL trades at $3.00, is SMRT cheaper than NOL? The answer is a big NO. The price of the stock does not tell you whether it is cheap or not. Sadly, I would say 99% of the 1st-time investors never knew how to calculate the value of a stock when they first started investing. And needless to say, they also never heard of the all-important P/E ratio.

The P/E ratio is the most widely used yardstick to value a stock (i.e. to see if the stock is cheap or expensive). It is simply the price of the stock divided by its earnings per share. E.g. SMRT trades at $1.40 today, and its expected EPS for 2007 is $0.08, if you divide $1.40 by $0.08, you get SMRT's P/E ratio which is 18x.

PER tries to determine the value of a product by dividing its price by its quality. Here the quality of the company is determined by how much money it makes.

To give a simple analogy, Car A and Car B sells for $10,000 and $20,000 respectively. (ok I know this is ridiculous, the cheapest car in Singapore sells for $30,000 and it is made in China, but this is just example, ok, example.) Car A saves $200 of petrol per year while Car B saves $500 of petrol per year after driving the same distance. Which is a cheaper car?

Answer: Car B, because the Price / Petrol Savings is lower for B ($20,000/$500 = 40) than A ($10,000/$200 = 50). Similarly, a stock with a lower P/E ratio is cheaper stock, because for a certain price, you are getting better quality (i.e. the company generates more earnings). Historically, P/E for major markets have fluctuated from 10 to 40. (40 during the IT bubble). P/E ratios of individual stocks can be as low as 2 or 3. This simple but effective rule has been proven to make money over the long run.

The P/E ratio might be the single most important no. in investment as it gives an investor a quick and fairly accurate sense of how much a company is worth. Over the years, analysts and academics developed other valuation metrics like EV/EBITDA, EVA (with a copyright) PEG ratio etc, but nothing beats the simplicity of P/E. Surprisingly, most retail investors probably never heard about this when they buy their first stock and mainstream business news fail to mention this important ratio most of the time.

Sunday, May 14, 2006

How much money do you need in a lifetime?

This post is updated in 2012.

Before we start talking about how to make our money earn money for ourselves, we must first ask ourselves, how much money do we need in a lifetime? For those of us who lived our lives running on treadmills (this blogger included) like rodents running in their spinning wheels, and have never given two seconds to think about it, the answer will be quite astonishing.

It will be around S$1,000,000 to S$3,000,000 for most Singaporeans. (Don't fall off your chair!)

Based on my simple and yet totally unrealistic calculations, assuming that you need S$800 to survive per month multiplied by, say, 60 years (I am assuming the youngest reader here should be around 20 years old, and expected to live until 80. If you intend to live till 95, you need to add a few years), this comes up to S$576,000. Assuming you live in the cheapest available HDB flat, which is around S$300,000. So you need S$870,000 for one lifetime (ok 12% short of a Million but you get the idea).

Oh, btw, we haven't factor in inflation. Once we put that in, it should cross the million dollar mark. In fact, probably by a huge margin.

Ok, we got the cost, now let's work on the income. For an average Singaporean, with a monthly pay of S$3k, and assuming that they work 40 years, in one lifetime, they can earn S$1,440,000. So there is a buffer of S$440,000, this will be needed to pay for insurance, children's education, parents' allowance and hospital bills, car loans, restaurant dinners, presents, medical fees, annual tours, gym fees (so that we can continue to run on treadmills obviously) and all the other indulgence in life. Of course, the biggest killer is inflation, over such long time frame, even if we just put in 2-3% inflation, the total cost would increase by 20-40%. Which means that a significant population of Singaporeans will not earn enough to support themselves in old age.

How did we get to the S$3 million number? Well assuming a more luxurious life (i.e. living in a condo and running on condo treadmills) will give you the S$3mn lifetime spending. Btw (ie by the way) an average condo now cost $1.5m in Singapore.

So that is the sad truth. We would need to be a millionaire just to scrape by this existence (well strictly speaking the comparison is wrong but anyways) and we will probably never have enough money to fulfill the 5C dream or any other dream that is worth dreaming unless we get a few important things right plus a lot of luck.

But how important is it to know how much you need? I would say that it helps to frame a lot of key financial matters so that we are at least aware of them. And this is different for everybody. For a start, it can help us to understand what is the minimum sum that we have to save and earn (which is why CPF has the much debated and controversial minimum sum) and the maximum potential that we can likely achieve in this lifetime, esp for those of us who are in the workforce for some time and can more or less calculate our lifetime earnings.

It must also be stressed that investment cannot make you filthy rich, for most of us, it will help us get incremental income. But to try to rely on investment return to replace income generation from our day jobs so as we can retire and be "financially free", will take a lot of time and effort and most will fail in trying to achieve that bcos the expectations and methodologies are incorrect or unsuitable. It is also said that the two years in life where people are most likely to die are: the year that we were born, and the year we retire.

So while we are at this retiring/financially free topic, I have to say that retiring is a bad option bcos we might just die or we lose income too early and risk running out of money before we die. But what is much less understood is that the whole concept of "financial freedom" is a gimmick that does not necessarily help us fulfill what we want in life. I have also discussed this in this post: "More on Financial Freedom".

To sum up, the answer to this question kind of requires us to think more holistically about issues involving not just income and savings but also whether condos and fast cars are really what we want, what about money for the kids, the parents and also ultimately what do we really want to do with our lives. Perhaps we should start thinking more critically.