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.

See also What drives stock prices
and Expectations vs Reality

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

See also Good company but not a good buy
and SWOT analysis

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.

See also Financial Ratios
and SWOT analysis

Intrinsic Value - Part 2

Ok, we are back in the business of Part 2 and 2nd chances. This time round, we take a second look at intrinsic value. Actually I am beginning to like the word intrinsic. Maybe someone should start a fashion label called Intrinsic and make the exact same handbag that Prada makes and price it $27.18 or something.

Well, to recap, the intrinsic value of a stock or an investment is its true or inherent value based on some valuation method. For more on its concept, pls 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 like saying Singapore under 16 Basketball Team is trying to beat NBA All Stars, i.e. it is impossible but we like your spirit, so please go ahead and malu yourself.

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 potential EPS, say 5 yrs down the road. Then you can multiply PER by EPS and get the intrinsic value or target price. (Yes this is the dreaded target price given by analysts, and yes, none of them ever got that right and most likely, yours truly here won't get it as well.)

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 or target share price = true PER x potential EPS

Simple right?

So, how do we know what is the true PER of the stock? Usually by looking at the market and industry PER. So today, STI trades at 15x PER and the airlines in Asia trade at 20x on average. So we can assume that SIA should trade roughly around this range. Let's arbitrarily assume that the true PER for SIA is 17x.

Next we need to determine its potential EPS. SIA managed an EPS of $1 in 2005. So assuming that it can maintain this level, say 5 yrs later. We have its potential EPS at $1. So to get its intrinsic value (or target price), simply multiply 17 x 1 = $17. SIA should trade at $17. Today it is trading at $15.7. So is it a buy?

Well, the answer is no, because our calculations may be wrong. What if the true PER is 15x? Or what if the potential EPS is only 80c?. If you work if this new set of no.s, (15 x 0.8 = 12) SIA should trade at $12. So how? Suck thumb lor.

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. I mean NOBODY, not even the Gahmen. That's where margin of safety comes in. For those not-so-familiar, pls read the post on margin of safety.

In a nutshell, if ever SIA trades at $3. Then it is definitely a buy, because no matter how you tweak the two no.s (PER or EPS), you can never get below $3. But SIA will never trade at $3 unless Sept 11 happens on Christmas and New Year in 5 major cities or something. In other words, it is damn bloody difficult to find stock that trades below its probable range of acceptable intrinsic values . This is the challenge and this is value investing.

See also Definition: Value investing
and Expectations vs Reality

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.

See also Expectations vs Reality
and Financial Ratios

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.

See also The Greater Fool Theory
and Markowitz Portfolio Theory