Thursday, July 21, 2011

Problems and Solutions to Singapore’s Education System Part I

This is a discussion dedicated to most parents who suffer from the idiosyncrasies of our education system. I have spent some time thinking about this and have decided to blog this despite its irrelevance to investment, although economics would help us understand how we can try to tackle some of the issues.

The discussions here would be focused on primary education rather than the whole education system which I believe deserves more scrutiny and research. I have identified 3 main issues or problems that are probably well-recognized by most Singaporeans. They are

1. Elitism in our education system
2. Escalating peripheral costs: predominantly private tuition
3. Good teachers, or the lack of them

Elitism in our education system usually refers to pouring resources into the top performers in the belief that the best brains in our country should be allowed to develop their full potential and when they in turn contribute to society, the benefits would be shared by all. I would not delve into this elitism topic by itself bcos I think that would probably need an entirely new blog. Rather I am looking at how elitism affect the economics of our education system.

One side effect of this elitist system is this: it creates scarcity. In economics, scarcity is a big thing. We all know economics is about supply and demand. Scarcity limits supply, encourages demand and causes prices to skyrocket. Think branded goods, gold and precious commodities, iPad 2, iPhone 5, luxury sports cars, exclusive events etc.

In our elitist education system, scarcity is created in multiple arenas: we emphasize exam grades on just four subjects, we have branded schools like Raffles, Nanyang, we have our Gifted Education Programs, SAP schools, through-trains, ex-teachers turned tutors that are highly sought after. All these drive up scarcity premium, encourage high demand and drive up prices. From tuition fees to property prices near schools to perhaps even prices of school buses.

In fact, we can argue that the whole Singapore system seems to have this indulgence with scarcity, or creating bottlenecks in the system that drive prices one way: up. Think ERP, COE, HDB flats, Class A wards, private hospitals, high-end restaurants, exclusive clubs, high-end condominiums, high-end spa and gyms, high-end this, high-end that, Singapore Airlines PPS membership, Solitaire membership, the list continues.

Well we can understand that listed co.s might want to have more of these scarcity premium to earn better profits to satisfy shareholders. But as a Government, the objective might well be the opposite. To eliminated scarcity as much as possible so that the bulk of the society benefits.

Partly related to this point of scarcity is the big issue of our education system being reductionist ie not holistic, or not well-rounded. In fact, at the primary school level, it’s basically about language and science. I did a quick Wikipedia read-up and found out that primary education in other countries usually also involve subjects like music, drawing, elementary instructions in nature, history, geography, sports and lessons combined with practical work experiences around the school compound.

Sure, we do have some of these in Singapore, but they are never emphasized and not part of PLSE, the all important high stake exam, and hence easily neglected. Whereas in other countries, it is the overall performance that counts, not one exam. The overall performance incorporates all subjects, including sports and music and qualitative assessment of the form teachers.

Elites need to be separated from the rest of the junk. We rank our schools, our classes, our teachers, our kids and we have this super granular system whereby each PSLE student has a three digit score. Btw I still remember mine! Why are we obsessed with ranking? Bcos we want to rank these PSLE students so that we can figure out who are the elites and can go to the limited number of top schools, where significant amount of resources are poured in to nurture our best talents. Yes, we want to create scarcity!

While rankings are required at the tertiary or higher levels to facilitate university entrance, it might be counter-productive at the primary school level. It takes the fun out of learning and turns learning into stress. Again, a simple wiki-study will reveal that most primary schools in other countries employ a more holistic and less granular grading system. In Finland, the country regarded as having the best education system in world, numerical grading is not found on report cards in the early years. And, there are also no high stakes exams. Ever. Well at least in primary school level.

Learning is about the children, not about grades and rankings.

Next post, we look at the solutions.

See all posts!
Part 1
Part 2
Part 3
Part 4

Tuesday, July 12, 2011

The Many Faces of PE - DCF

A lot of people like to say that PE is not robust enough. Ultimately a company is the present value of its future cashflow and how does one simple ratio determine it? We need to have a full model of all it's future cashflow, discount it back to today's earnings, add it up and we have the true value of the firm. How can one simple no. like PE determine the true value of a company?

Well, actually, it kinda does a great job at that.

PE is actually not that different with DCF.

Let's start with DCF. DCF is basically discounted cashflow of a firm:

Discount rate: 6%, Growth: 2%

Yr 0 EPS $1.00 - DCF to Yr 0 = $1
Yr 1 EPS $1.02 - DCF to Yr 0 = $0.96
Yr 2 EPS $1.04 - DCF to Yr 0 = $0.93
Yr 28 EPS $1.74 - DCF to Yr 0 = $0.34
Yr 29 EPS $1.78 - DCF to Yr 0 = $0.33

The calculations above shows you that this firm earns $1 per share and increases it by 2% every year, and will continue to do so for 30 years. To calculate the value of the firm, we need to discount these future cashflow back to today. So you can see that in Yr 1, ie next yr, it is actually making only $0.96 in today's dollar, Yr 2 it's $0.93 and in Yr 29 it's $0.33 in today's dollar.

Now adding these up gives you $18, which should be the intrinsic value of the firm.

Incidentally, if you think of the inverse of PE, which is the earnings yield and compare it against the discount rate of 6%, you can say that the right PE for the firm is 1 divided 0.06 which is 17x.

Using this to calculate the intrinsic value, we use next yr's EPS of $1.02 multiply by 17x, which gives you $17.4, not so different from the $18 calculated using the complicated discount cashflow.

In fact, if we know that the firm will continue to grow 2% for 30 years, we should be using a higher EPS, maybe say a Yr 2 EPS, which will give you $17.7 intrinsic value, just 2% different with the DCF calculated value of $18.

So PE while simple, gives you a quick but somewhat accurate way to calculate the intrinsic value of a stock.

Of course, there are a few caveats here:

1. Why 30 yrs? Shouldn't a company exist forever?

Yes in the example above, DCF lasted only 30 yrs but in reality companies can exist longer than that. In fact, we need to do DCF for 100 years in order for the last few years to become small enough such that it doesn't matter. Alternative, most people will actually stop after 5 or 10 yrs, and put in a terminal value and discount that back to today. But in doing so, basically, we are applying the PE methodology on the terminal value, and this value actually constitutes a larger part of the final intrinsic value. So essentially, we are still using PE this way.

2. Shouldn't a company grow faster than 2%?

Yes that is true, but with our example, when we put in a high growth rate for 30 yrs, the no.s become astronomical and can't be justified rationally. This is the power of compound interest which we have also discussed. For example, if we put in 8% growth, intrinsic value becomes $40 after 30 yrs, that's 40x PE based on next yr's earnings. Hence for very long periods, like 30 yrs, we have to assume that the average growth is small.

3. What if we change the discount rate?

The discount rate is the most sensitive part of the whole DCF methodology, changing it slight would alter the picture significantly. For example, changing the discount rate from 6% to 4% brings the intrinsic value to $23 from $18. Which is why most people doing DCF usually put in a sensitivity table showing how the intrinsic value changes as discount rate changes.

Putting this altogether, I think the main message is: you can use DCF if you have a good grasp of the various assumptions going into it, ie the growth rate, discount rate and how things changes over the next 5, 10, 30 years. Now if someone can really get all these right, then perhaps he should be doing something greater, like save the world and be the next Messiah or something. Why bother investing money, which really doesn't add value to the society?

Well if all you want is to get a quick answer to a ballpark intrinsic value, using a ballpark EPS multiplied by a rational PE multiple (between 10-18x) would suffice in most cases.