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!

See also Investment cannot make you filthy rich

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.

See also Intrinsic Value Part 2
and Definition: Value Investing

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.

See also Porter's 5 Forces
and Secular Trends

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.

See also Company cheatsheet
and Earnings yield

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.

See also SWOT analysis
and Secular trends