My Interpretation of
Value-Investing
This article’s purpose is to give the reader a succinct
description of value-investing. The
examples used herein are kept very simple as details and nuances would violate
the goal. Finance is much more
complicated but an understanding of the general themes will serve investors
well and almost certainly help any reader determine if they are or should be a
value-investor. If I offered you a one
dollar bill for 75˘ or less would you take me up on it? Read on because that is value-investing in a
nutshell!
Executive Summary
·
Value-investing
is a science whereby the financial statements of a company are analyzed and a
model of expected future performance is derived. This is called fundamental analysis.
·
Fundamental
analysis leads to the calculation of an intrinsic value (fair price) range
which is subsequently compared to the market price.
·
Value-investors
determine intrinsic value using: asset
valuation, earnings projections, and/or discounted free cash flow. Many use several techniques in order to
verify values derived by the others.
·
Value-investors
look for stocks that are trading at a discount to intrinsic value believing
they will move towards this increased value in a reasonable amount of time.
·
Value-investors
use conservative figures when projecting the future growth of a company thus
limiting the possibility of erring on the downside. This is called the margin of safety.
·
Value-investors
only invest in areas they understand.
This is called their circle of competence.
·
Value-investors
do not try to time the market. They are
content to invest and wait for the crowd to come to them. Many times value-investors run contrary to
the crowd as this is when the best opportunities arise.
·
Value-investors
sell a stock when: one, it reaches
intrinsic value; two, the economics of the company decline thus decreasing
intrinsic value to or below current market price; three, better opportunities
arise.
·
Value-investing
has been used successfully by many well-known investors and I believe it is the
soundest philosophy. See the table at
the end of this article for some examples.
A Brief History
Value-investing was conceived by Benjamin Graham around
1930. He was one of the first to look at
investing as more of a science than an art.
For decades investors bought stocks for reasons based on a belief in
their business, rumor, wanting to follow the masses, and pure speculation to
name a few. Graham saw the frivolity of
all this and set out to formulate a theory based on the real reasons stocks do
well over extended periods. His seminal
works, Security Analysis and The Intelligent Investor, have
influenced thousands of investors.
Value-investing has been used by some of the most successful investors
in history with the most famous being none other than Warren Buffett. Others
include: Charley Munger, Charles Brandes,
Bill Ruane, Richard Cunniff,
David Dreman, Bill Miller, Bob Olstein,
Christopher and William Browne, and Bill Nygren. The table at the end of this article depicts
some of their performance.
Value-investing is a school of thought whereby an intrinsic
value (fair price) is calculated and subsequently compared to the market
price. Graham used a company’s financial
statements to determine how it had performed historically, how its financial
situation appeared at a given point in time, and how it was likely to perform
in the future. From this he calculated a
range of values that he thought represented the economic worth of a company. This is called fundamental analysis. Value-investors look for stocks that are
trading at a discount to intrinsic value believing they will move towards this
increased value in a reasonable amount of time.
Value-investors feel downside risk is limited because conservative
predictions are used in determining intrinsic value
and a company’s fundamentals are above required levels. Because capital preservation is likely even
if fundamentals erode in the short-term; investors can take a position with a
fair amount of confidence. This is
called the margin of safety.
Because value-investors use conservative figures in
determining whether or not to invest in a company and also look for a margin of
safety, they will generally miss the huge success stories such as Microsoft,
Cisco, and Intel. They will, however,
also miss severe downturns like the bubble blow-up of the early 21st
century. Over time, value-investing has
proven to be the method that leads to market beating returns as value-investors
look for a respectable return on their capital versus those who want five,
tenfold, and even higher increases in unrealistic time frames.
Value-investing has evolved over time and one of the first
variances involved industry analysis.
Graham was rumored to say he did not even care to know the industry in
which a company operated as a good investment only depends on the numbers. Following generations of value-investors
began to analyze industry fundamentals and compare companies in each to
determine which was the strongest. To
Graham, a cheap stock in a bad industry was better than a fairly priced stock
in a great industry. The reason for this
may be explained by the fact that investors of that generation used the returns
on different types of bonds as harbingers of future growth. Today, investors have the benefit of several
additional decades of corporate growth and return information from which they
can rely. This is not to say bond yields
should be ignored, just that they are not as prevalent in analysis. Additionally, the lack of advanced
information technology made it more difficult for the value-investor of the
early 20th century to amass data.
Another evolution involved the analysis of management:
Graham did not partake in this. Even
Warren Buffett has said, “When a management team with
a great reputation gets into a business with a bad reputation, it is usually
the reputation of the business that remains intact.” However, Buffett
does believe in a strong management team as they do make a difference. The key is to find a great company in a great
business that has a strong management team.
Investors today, in almost all schools of thought, analyze management;
even giving rock star status (and compensation) to the great managers of our
time. Management does matter as has
become evident from the shenanigans at the likes of Tyco, MCI Worldcom, Enron, and Healthsouth. A value-investor will look for a management
team that owns a significant portion of the company because their interests are
tied to those of the other shareholders.
Basic Accounting
Perhaps the greatest divergence within the value-investing
school is the manner in which intrinsic value is determined. I believe most value-investors use multiple
techniques, but some are comfortable with concentrating on one. A brief accounting lesson is in order for
those who have not been exposed to finance, so if you have you may choose to
skip this section. Companies release
financial statements quarterly which must include an income statement, a balance
sheet, a cash flow statement, and a statement of shareholders’ (owners’)
equity. The first three are of the
greatest interest so I will forego the last in order to maintain brevity.
The Balance Sheet:
The balance sheet can be thought of as a company’s financial picture at
a given point in time. It consists of
three sections: assets, liabilities, and owners’ equity. Assets are incorporated onto the balance
sheet at the cost the entity paid for them and represent items that are
expected to bring future economic benefits to the company. Liabilities represent claims against
assets. Owners’ equity represents the
difference between the assets and liabilities and is roughly the amount the
owners of the entity could claim if the company is liquidated. It is also called book value as it reflects
the net value of a company as depicted in their financial statements. Investors divide a company’s stock price by
the owners’ equity per share to derive a figure called the price to book value.
Assets – Liabilities = Owners’ Equity
(Book Value)
A simple company with only a building on their balance sheet
is a good example. If a company pays
$500,000 by contributing $50,000 and borrowing $450,000 the balance sheet would
show assets of $500,000, liabilities of $450,000 and owners’ equity of
$50,000. If in one year the loan’s
principle has been paid down to $445,000; assets are $500,000, liabilities are
$445,000, and owner’s equity is $55,000.
Take note that the assets remain $500,000 irrespective of the change in
the real estate market; even if the building could now sell for $550,000. This is very important to understand because
it is the foundation for one of the techniques used by value-investors. If the company is trading for $16.50 and has
ten thousand shares outstanding, its price to book ratio is 3.
Book Value per Share = $55,000 ÷
10,000 = $5.50
Price to Book Value = $16.50 ÷ $5.50
= 3
The Income Statement:
The income statement depicts a company’s revenue, expenses, and net
income over a period of time. Revenue is
the compensation a company hopes to realize by selling its assets or rendering
services. If a legitimate sale is made
during the period, the value is added to revenue. Expenses represent money spent to make the
revenue attributed to the accounting period.
They include such items as materials used to make the product sold,
commissions paid to the salesperson responsible, interest paid on loans, and
taxes. Expenses are deducted from
revenue to determine the amount of money made during the period: this is called net income. In other words, assets and liabilities change
in value during the accounting period and the net income represents the sum of
most of the changes. The remaining
changes are not depicted in the income statement and are beyond the scope of
this article. Positive net income
increases owners’ equity and vice versa.
Investors divide net income by the average number of shares outstanding,
during the period, in order to derive a figure called earnings per share.
Revenues – Expenses = Net Income
For example, if we sell $1,000,000 of clothes to our
customers and incur expenses of:
$600,000 to make the clothes, $250,000 to run our internal operations,
$20,000 in commissions paid to our sales-force, $15,000 of depreciation on our
building, $10,000 for interest on our outstanding loans, and $42,000 in taxes;
our net income and earnings per share would be calculated as follows…
| Revenue | $1,000,000 |
| Cost of Goods Sold | $600,000 |
| Gross Profit | $400,000 |
| Cost of Operations | $250,000 |
| Commissions | $20,000 |
| Depreciation | $15,000 |
| Operating Income | $115,000 |
| Interest Expense | $10,000 |
| Income before taxes | $105,000 |
| Taxes | $42,000 |
| Net Income | $63,000 |
| Average Shares Out. | 10,000 |
Earnings per Share = $63,000 ÷ 10,000 = $6.30 |
The Statement of Cash
Flows: The statement of cash flows represents actual
money flowing into and out of the company during the accounting period. It is divided in three sections: cash flows
from operating activities, cash flows from financing activities, and cash flows
from investing activities. These cash
flows represent money made from normal business activities and changes in
certain areas of the balance sheet.
Remember, the income statement gives credit for economic activity that
occurred during the accounting period regardless of whether money changed
hands. In reality, actual money flows
during a period mostly come from economic activity in prior periods. Let’s assume December is the end of our
accounting period. If we sell a shirt in
December for $10 and are paid in January, we account for $10 on the income
statement as revenue, in December, but it will not show up on the statement of
cash flows for the period ending in December.
It will show up on the statement of cash flows for the period ending the
following March as companies report results quarterly. This would be an operating cash flow as it
represents our business intent. If we
borrowed $100,000 from the bank and received the money in the current period,
it would show up under cash flows from financing activities. If we purchased a sewing machine to make our
shirts in a previous period, but subsequently paid for it during this period,
it would show up under cash flows from investing activities. Simply put, think of the income statement as
a representation of business consummated during a period and the statement of
cash flows as money actually changing hands during the period.
The Elements of Value Investing
1. Finding Intrinsic Value: With a basic understanding of the
financial statements, one can begin to appreciate how the value-investor
determines intrinsic value. There are
three basic methods: valuing the assets
of a company, projecting the earnings of a company, and discounting the future
free cash flows. Each method has its
advantages and drawbacks.
Most value-investors will use multiple methods hoping the
results of one will confirm the others.
Intrinsic value is a range of values as opposed to a single number. The tighter the range stemming from the
different methods, the more confident the value-investor can be in his
work. Depending on his skills, the
value-investor will place more weight on the results coming from his preferred
method(s).
2. Valuing the Assets:
Some value-investors estimate the current value of the assets on a
company’s balance sheet in order to determine its liquidation value. In other words, if all the assets were sold
on the open market and all the liabilities were paid, how much owners’ equity
would remain. If the investor can
purchase the company for less than the estimated value and liquidate it, a
profit will be made. This technique is
extremely hard and only used by those with extensive knowledge about market
prices in different regions for various types of assets.
Fresh Del Monte Produce is a great example. They own property in several countries,
freighters, trucking companies, and other assets such as a global customer base
and patents on certain types of produce.
Valuing their assets would entail finding the market price for land in
such places as Hawaii, Costa Rica, Guatemala, Brazil, and the continental
United States to name a few. Remember,
if the land was purchased in 1997, it is valued on the balance sheet at the
purchase price, not the current market price.
Additionally the freighters, subsidiaries, and patents would need to be
valued as they too are listed at the purchase price.
Investors using this technique stand to make very large
profits if they can wrest control from the owners. It is sometimes used when outsiders feel
management is not utilizing the assets to their fullest extent. It is also used when assets are not currently
producing earnings and hence cash flow.
Examples would include timber, mining, and railroad companies.
3. Projecting the Earnings:
A value can be estimated by projecting earnings into the future and then
applying a price/earnings (P/E) multiple.
If a company earns one dollar per share and sells for fifteen dollars in
the market, it is said to have a P/E multiple of fifteen. Two things the investor should realize about
the P/E multiple are: the inverse is the
current rate of return on an investment, and it represents the number of years
it will take an investor to recapture the initial cash outlay if earnings
remain flat and they are all paid out as a dividend. A company with a P/E of 15 yields 6.67% and
one would need to wait fifteen years to recapture the initial cash outlay. Consider the P/E multiples of some technology
companies during the end of the twentieth-century (over 300), in this light,
and you may alter your thinking.
Granted, the vast majority of investments are made in companies that
have increasing earnings and estimating this growth rate has a distinct affect
on value. Those believing a company will
have a higher growth rate are willing to pay more. Obviously in the late 1990’s, many were using
astronomical growth rates to determine fair value. A company’s earnings growth should be close
to its P/E ratio. Assuming a constant
price, if the earnings fail to grow at the rate of the P/E ratio, the P/E ratio
will increase over time thus making the company less attractive; if the
earnings grow faster than the P/E ratio, the P/E ratio will decrease and the
company will become more attractive.
This is one of the reasons prices fluctuate: P/E ratios tend to remain
fairly consistent over time and as earnings estimates change, so does the
price. Remember, using higher growth
rates leads to higher intrinsic values and should growth fall short, the value
will decline. This is why companies with
high growth expectations decline so precipitously when business slows.
The value-investor may calculate future earnings as such…
Company A currently earns $1 per share and has grown earnings by a compounded
rate of 7% for the last five years so if this continues for an additional five
years before decreasing to 5% what is the future value? In ten years the earnings will be $1.79. If the company has traded at a P/E of between
15 and 18 over the last five years, and the investor feels this will continue,
an intrinsic-value range of $26.85 to $32.22 will be assigned. The value-investor must now determine if the
investment, if purchased today, will yield the necessary return. One can easily see that an intrinsic-value
range can be wide and thus it is imperative to hone in on a realistic value
from which a return can be calculated.
Value-investors are reluctant to use large growth rates and
project too far into the future. My
research leads me to believe many look five years into the future and almost
no-one more than ten years.
Additionally, growth rates are heavily scrutinized with the basic
thinking being that as companies become large, their growth will trend with the
economy.
4. Using Free Cash Flow:
Value can also be determined by discounting free cash flows. The free cash flow of a company is determined
by deducting capital expenditures from operating cash flow. Remember, operating cash flow is money
actually flowing into a company because of its intended business
transactions. Capital expenditures
represent cash outlays for equipment needed to sustain the business. A clothing manufacturer would need to
purchase sewing machines as older ones become obsolete or operations would
eventually cease.
The value-investor can project cash flows for a given period
of time and discount them at a required rate of return to determine a company’s
intrinsic value. Generally, the going
concern principle is applied which means that an investor will assume the
company will be in existence indefinitely.
The potential pitfall to this method is that the value-investor is
forced to look far into the future, which normally is less preferred than other
methods. However, when distant cash
flows are discounted they become a very small percentage of the value thus
limiting the projection risk. Bond
analysis is similar in that the cash flows are known as is the terminal value;
one simply discounts them at the required rate of return to determine the
current value. The trick to bonds is
determining the likelihood that payments will be made as promised and the trick
to company cash flows is making accurate predictions.
A second way to use free cash flows to determine intrinsic
value is to look at the company’s price to free cash flow ratio. This method is identical to the
aforementioned earnings projection method but has one distinct advantage; when
reporting financial results, cash flows are harder to manipulate than
earnings. Many value-investors use it
because limited time frames can be incorporated.
5. The Transaction:
Once an intrinsic value is determined, the value-investor must turn to
the markets to find opportunities. By
continually comparing intrinsic value to market price the value-investor will
find entry points into stocks in selected companies. There are hundreds of reasons that a
company’s stock can fall below intrinsic value including: earnings falling
short of the crowd’s expectations, a large investor deciding to liquidate a
position, poor economic news, and geopolitical turmoil to name a very few. The value-investor needs to determine if a
particular event changes the intrinsic value of a company or is simply an
overreaction by the market.
Overreactions present the best opportunities as companies can rebound in
such a manner as to give the value-investor the required return. Two examples will hopefully add clarity.
In the early summer of 2002, Sealed Air Corporation became
embroiled in a lawsuit charging fraudulent transfer. Fraudulent transfer basically means that if
you expect you are going to owe someone money, you cannot rid yourself of
assets at ridiculous prices to spite them.
Sealed Air had purchased a division of W.R. Grace & Company: who was
in the midst of asbestos litigation claims.
Prosecutors contended that Sealed Air had purchased said division at
below market prices and should thus pay a portion of W.R. Grace’s
liability. Sealed Air was never involved
with anything asbestos related; neither was the division they purchased. Many value-investors pounced on this
opportunity as Sealed Air was well run with an intrinsic value far above the
price at which it was selling. By
October, the mess was cleared up and the stock went from $15 to $38 in short
order.
About the same time, Tyco International Limited saw its
stock get clobbered because of reported management improprieties. The truth of the management improprieties
remains to be settled as of this writing, but the stock has gone from a low of
roughly $7 to $32. What happened? Angry shareholders forced several managers
and board members to resign and replaced them with a CEO that built a new
management team. Some of the reported
earnings were improper and thus restated; but the cash flows were largely
intact after the new numbers were released!
Value-investors snapped up the stock and made market beating
returns. Cash flows are hard to fudge
and those depicted showed a company with great businesses.
Selling a stock is as important as buying it. There are three main reasons to sell a
stock: its price has reached or exceeded
intrinsic value, the economics of the company have declined thus decreasing
intrinsic value to or below the current price, or a better opportunity to
deploy capital elsewhere has arisen. It
gives one much satisfaction to see an investment perform well thus reaching its
true value and this is the best of the three aforementioned situations. As discussed, stock prices can increase right
through the calculated intrinsic value and stay above it for sustained periods
so the savvy investor will keep a close watch on the stock as opposed to
selling it as soon as it reaches the desired price. On the contrary, the economics of a company
can decline during the holding period due to unforeseen circumstances thus
reducing intrinsic value. The
value-investor must decide whether the company is likely to rebound in an
acceptable period of time or remain at lower levels. If the latter is likely to occur, selling the
stock is the best option. Finally,
better opportunities may surface thus causing the value-investor to alter
course. If the likely returns, taking
trading costs and taxes into account, exceed the expected returns of the
current holding; one should reallocate the capital. This happens as situations change and new
opportunities arise.
6. Markets:
The value-investor can only do so much analysis; the rest comes down to
the market. Supply and demand is the
crux of market theory: values increase when there are more buyers than sellers
and vice versa. There are many schools
of thought and most likely a stock will need to appeal to several in order for
it to significantly increase in value.
Value-investors tend to purchase stocks as opportunities arise and wait
for sentiment to change which can require undue patience. The advantage is that while many investors
from other disciplines will miss the initial increase, which can be the
largest, the value-investor takes advantage of the entire amount. The risk is that while waiting something else
goes wrong or things get worse.
The current state of technology coupled with reduced
commissions has made it easier to dart into and out of positions thus causing
increased market volatility. When one
mutual fund sours on a company and begins selling, many others get wind of it
and do the same. Much of this occurs
because managers’ performances are judged on a quarterly basis based on their
return versus a benchmark: such as the S&P 500 Index. Because of this myopic criterion, many
mangers operate in a skittish manner by trading in and out of stocks at a
relatively quick pace. This can be a
value investors dream!
Several other factors such as wars, election results,
political unrest, oil prices, etc. can cause wild market fluctuations from
which a value-oriented investor can benefit.
Most successful investors have a solid knowledge of market history and
are able to apply past circumstances to current situations. As thousands of variables affect markets no
two periods coincide, but major themes can dictate direction. Value-investors tend to concentrate on
individual opportunities, however, as opposed to trying to time markets based
on macro-economic data.
7. Personality:
I feel most value-investors share certain personality traits that set
them apart from others employing different schools of thought. First and foremost, the value-investor must
be patient. There is a difference
between a great company and a great stock:
The Coca-Cola Company comes to mind.
It has impeccable financials that have improved over time, a great
management team, and tremendous potential, but the stock trades well above its
intrinsic value range and has for some time. Over the last ten years (August 1994 to
August 2004) it has appreciated about 6.75% per annum while paying a dividend
of less than 2%. Thus a value-investor
must wait for an opportunity to take a position in Coca-Cola and it may never
come as markets can keep stocks overpriced for extended periods. On the other side of the coin, one must wait
for the market to recognize a company’s true value and this may take some time
as well, but the value investor is willing to wait for a sustained period
because the potential upside will negate the lackluster returns of the
past. I usually wait for a couple of
years before deciding to reallocate the capital unless a better opportunity arises or a company’s situation
deteriorates. Many times a stock will
stabilize at lower price levels as the management fixes the problems thus
limiting downside risk.
Value-investors abhor running with the crowd; in fact, they
run contra most of the time as opportunity arises when most others shun a
stock. The best value-investors are able
to follow companies that have fallen and invest when they sense things are
improving. This is a fairly recent trend
as short-term performance has become too popular with the unsophisticated. Historically, value-investors took positions
knowing it may take several years for things to improve. They were perfectly willing to wait as
companies would eventually make up for lost time and outperform the
market. Value-investors knew they were
not smart enough to time the market and did not want to miss the initial move
up as it could be the most dramatic.
More recently, value-investors tend to wait for a sign that a company’s
fortunes have stabilized but still invest before most others.
Value-investors tend to have a better understanding of their
limitations and thus invest only when they feel comfortable with the industry
in which a company operates. Warren Buffett refers to this as the circle of competence. Older value-investors tend to avoid
technology companies but the younger crowd does not. I believe this is because those born prior to
about 1955 were not exposed to technology during their developmental
years. I could bore the reader with
hundreds of examples but will suffice in asking if you can connect a home
network, program an MP3 player, or set up a computer? Most kids over the age of thirteen can. This is simply because it has become a big
part of their lives through exposure in several arenas. Thus, younger value-investors can expand
their circle of competence into areas where older ones may feel uncomfortable.
8. The New Breed:
Value-investing has evolved over time, but the underlying principles
remain. Determining intrinsic value,
purchasing a stock priced below it, and waiting for the market to realize it
remains the objective. What has
changed? The following bullet points sum
up the new breed of value-investor.
·
They
put a greater weight on free cash flow as the figures are harder to
manipulate. Asset valuation has become
tougher due to global expansion and complicated financing arrangements. Earnings projection is widely used if reported
figures seem to be accurate.
·
Circles
of competence have expanded because younger value-investors grew up with
technology and became proficient in its use.
This is true especially in technological areas such as
telecommunications and computers. Biotechnology
may be the next area of expansion, but very few value-investors currently look
to this area: mainly due to limited exposure and the rate of advance in the
industry.
·
Increased
information flow now allows the value-investor to follow beaten down stocks
leading to better timed transactions.
Many value-investors call the period a company is trying to recover “the
seasoning period”.
·
The
market is the ultimate judge of a value-investor’s work and must support his
estimation of intrinsic value or expected returns will not be realized. The investing community has become
increasingly comfortable with cash flow for the reasons mentioned herein; as
such, its proper use gives the investor a higher probability of success.
9. Major Schools of
Thought: There are three basic schools of thought in
the investing field but each has been broken down by factions of investors who
try to build upon the main theme. The
three fields are value-investing, growth-investing, and indexing. The names are somewhat confusing as any
investor is looking for a certain level of growth in capital: growth-investors simply assume a company will
expand cash earnings at a more rapid pace than will value-investors. As this article has discussed value-investing
extensively, the focus will be on the remaining two: growth-investing and indexing.
Growth-investors concentrate on different fundamentals than
value-investors, but attempt to predict future values by using earnings
projections much the same way. They look
for companies likely to grow earnings at much higher rates than average because
they believe the stock’s price will increase at the same above average
pace. The problem with this philosophy
lies in the fact that the subject company’s stock price reflects the higher
growth rate and is subject to fall if the growth fails to materialize. It is riskier because of a greater amount of
down-side risk. Growth-investors have
almost no margin of safety.
Growth-investors tend to run with the crowd in that they
jump into popular investments believing the momentum will continue upward. A popular moniker is “the bigger fool theory”
because growth investors believe there will always be someone willing to pay
more for an investment than they have.
Value-investors look for companies on sale while growth investors look
for the current hot idea. Granted,
value-investors will miss opportunities like Cisco and Microsoft but they will
also avoid the failures like CMGI and Redback
Networks. Benjamin Graham referred to
growth-oriented investors as speculators in that they put risky assumptions
into their analyses; value-oriented investors he considered true investors
because they used realistic assumptions.
The third school of thought is indexing: which means that a large number of stocks
making up a particular market or segment thereof are purchased. If the investor wants exposure to the U.S. markets, an index such as the S&P 500
is purchased; if the target is U.S.
industrial companies, many of the stocks in this class are purchased. This method is popular with many who adhere
to the Efficient Market Hypothesis; a detailed discussion of which is beyond
the scope of this article. The basic
theme, however, is that at any given time an investment is properly valued
based on all information known, both public and private. As such, adherents do not believe one can
make profits above the level of risk they assume.
Investing involves two basic decisions: which asset classes will be used and which
specific investments will be made within each class. Indexers place their emphasis on the first
decision while virtually ignoring the latter.
Growth and value-oriented investors consider both.
10. Conclusion:
There is a
difference between speculating and investing: which hopefully you now
realize. To sum it all up, making a
financial commitment based on accurate information and realistic predictions
constitutes investing. Any other capital
outlay represents speculation.
Definitions
Accounting Period – A length of time at the end of which companies
publicly report their financial results.
In the United States,
un-audited results are reported every three months with audited results being
reported at the end of the fiscal year.
Annualized Return – If the percentage return represents a
period that does not coincide with an entire year, it can be altered to do so
in order to compare it with returns that do.
A 10% return made in 9 months is equal to a 13.55% return made in 12
months. A 20% return made in 18 months
is equal to a 12.92% return made in 12 months.
Audit – This is a process whereby a company will submit
their financial calculations to a group of professionals, not linked to the
company, for review. The company will
usually incorporate any recommended changes or report the differences of
opinion in a public release.
Discounting - A financial technique whereby a future value
is reduced to a present value by applying an interest rate. For example, $1 invested today at 10%
interest would be worth $1.10 in a year.
Discounting $1.10 for one year at 10% yields $1. Discounting can be done over multiple periods
to reach a present value for a string of cash flows. Taking the example one step further, $1
invested at 10% per annum will be worth $1.61 in five years. Discounting $1.61 for five years at 10%
yields $1.
Fiscal Year – The 365 day period in which a company
operates. It can begin on the first day
of any month and end accordingly. Most
companies use the calendar year.
Fundamental Analysis – The
mathematical analysis of a company’s financial statements.
Intrinsic Value – An estimation of the economic worth of an
entity, either today or at some time in the future, from which an investor can
determine the potential return.
Margin of Safety – A confidence level gained by using cautious
projections when determining intrinsic value.
Savvy investors realize they will err in making future economic
predictions; however, if the chances for upside surprise outnumber the
contrary, they can be content in feeling confident they will realize the
expected return.
Market – A group of buyers and sellers all vying for the
same item or group thereof with the intent of making a profit.
Percentage Return – The fractional amount of an investor’s
profit to the initial cash outlay.
Return – The amount of money an investor receives, upon
selling an investment, above the amount paid.
