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Showing posts with label General. Show all posts
Showing posts with label General. Show all posts
Sunday, April 5, 2009
Saturday, March 14, 2009
How to select a stock- Part VII- Finding the right price of a stock
In this post, we will learn about how to find the right price for a stock. Many people confuse good companies with a good stock. If they like a company’s business model, they purchase its stock without any consideration of the price it is trading at. What matters more in investment is that you have bought a stock at the right price. If you have bought stocks of a great company at a very high price level, it may not turn out to be a great investment. On the contrary, if you have bought stocks of a good company at a good price level (cheap), you may get good return on your investment. It’s important to buy cheap.
A stock price is supposedly an indicator of net present value of future earnings for the stock on per share basis. This is also called the intrinsic value of a stock. However, the problem with this concept is that one needs to predict the future to be able to arrive at the right stock price. Millions of people have tried predicting future in the past, but rarely have we seen anybody doing so accurately. This very concept leads to a lot of investing mistakes by millions of people. A lot of analysts get into the game of predicting future earnings through various esoteric mathematical formulae. Nobody gets it right!
A good approach for stock selection could be following what legendary Investment Guru Benjamin Graham advised- follow the principles of ‘margin of safety’ and ‘diversification’.
The margin of safety concept says what you are buying should be worth more than what you are paying by a wide margin. Such a simple thing, but it’s really difficult to act on it considering the problem in assessing the value of a stock. Graham says you shouldn’t get into the business of predicting the future; instead, use the past performance to assess the ability of the company to keep producing decent earnings in future. Hence, if the company has a current earning of about 12% of the stock price (i.e. a PE ratio of 8), and meets all our criteria of selection as mentioned in my previous posts, and risk free return (of a 10-year government bond) is 6%, you have a good margin of safety in the stock. There is no general formula for all industries. However, in most of the cases, the PE ratio should not go beyond 15. The higher the PE ratio, the more future growth dependent your return on the stock becomes. Never buy a stock if you believe it is fully priced even if it is of the best performing company.
Diversification is linked with the concept of margin of safety. Let me explain. If you are playing dart, and you are good at it; what are your chances of hitting bulls eye once if you have only once dart? What if you have ten darts? Of course, you will have much better chances of hitting Bull’s Eye at least once if you have ten darts. Do you understand the difference? If you have margin of safety in your favor, your chances of making good returns or at least not incurring loss in a portfolio of diversified stocks becomes pretty high. However, there is a caution here. Diversification will work to your favor if you have diversified in stocks with good margin of safety. It will hurt you badly if you have bought all losers. Diversification in overpriced stocks will ensure that you most likely incur loss on your investment. So, be careful. Don’t buy costly stocks. Always maintain a diversified portfolio of good stocks bought with a margin of safety.
With this, the series on ‘how to select stocks for investing’ ends. I hope I have been able to give you a few basic guidelines on how to go about picking stocks for investment. I must add that these are indicative guidelines and by no means exhaustive. You will do well if you use these guidelines along with your own research and experience backed by some sound reasoning.
A stock price is supposedly an indicator of net present value of future earnings for the stock on per share basis. This is also called the intrinsic value of a stock. However, the problem with this concept is that one needs to predict the future to be able to arrive at the right stock price. Millions of people have tried predicting future in the past, but rarely have we seen anybody doing so accurately. This very concept leads to a lot of investing mistakes by millions of people. A lot of analysts get into the game of predicting future earnings through various esoteric mathematical formulae. Nobody gets it right!
A good approach for stock selection could be following what legendary Investment Guru Benjamin Graham advised- follow the principles of ‘margin of safety’ and ‘diversification’.
The margin of safety concept says what you are buying should be worth more than what you are paying by a wide margin. Such a simple thing, but it’s really difficult to act on it considering the problem in assessing the value of a stock. Graham says you shouldn’t get into the business of predicting the future; instead, use the past performance to assess the ability of the company to keep producing decent earnings in future. Hence, if the company has a current earning of about 12% of the stock price (i.e. a PE ratio of 8), and meets all our criteria of selection as mentioned in my previous posts, and risk free return (of a 10-year government bond) is 6%, you have a good margin of safety in the stock. There is no general formula for all industries. However, in most of the cases, the PE ratio should not go beyond 15. The higher the PE ratio, the more future growth dependent your return on the stock becomes. Never buy a stock if you believe it is fully priced even if it is of the best performing company.
Diversification is linked with the concept of margin of safety. Let me explain. If you are playing dart, and you are good at it; what are your chances of hitting bulls eye once if you have only once dart? What if you have ten darts? Of course, you will have much better chances of hitting Bull’s Eye at least once if you have ten darts. Do you understand the difference? If you have margin of safety in your favor, your chances of making good returns or at least not incurring loss in a portfolio of diversified stocks becomes pretty high. However, there is a caution here. Diversification will work to your favor if you have diversified in stocks with good margin of safety. It will hurt you badly if you have bought all losers. Diversification in overpriced stocks will ensure that you most likely incur loss on your investment. So, be careful. Don’t buy costly stocks. Always maintain a diversified portfolio of good stocks bought with a margin of safety.
With this, the series on ‘how to select stocks for investing’ ends. I hope I have been able to give you a few basic guidelines on how to go about picking stocks for investment. I must add that these are indicative guidelines and by no means exhaustive. You will do well if you use these guidelines along with your own research and experience backed by some sound reasoning.
Sunday, February 22, 2009
How to select a stock- Part V- Retained Earnings and Dividend Income
When you are thinking about investing in a company by owning its common stock, you need to see whether the company is using the profit generated in the best possible manner. There are two ways in which a company can make use of its earnings- return a part of the profits to its shareholders by paying dividend or use the earnings profitably to grow the earnings of the future.
Different companies use different ways of sharing wealth with their shareholders. One company might choose to pay a handsome dividend to their shareholders every year. Another company might decide to use the whole earning for investing in future growth and pay nothing to its shareholders. A third company may choose to pay a relatively small amount as dividend and invest the remaining amount in the business. Here, one could wonder how a beginner could decide which company is a better investment.
You should ask a question- if the company decides to keep the profits with itself, will it be able to generate a better rate of return on retained earnings than the return you would have got by investing it in some other opportunities available with you. If the company can do a better job with the retained earnings than you can in terms of generating a good rate of return, it should retain the earnings. Otherwise it should pay dividend to investors.
You can assess a company’s capability of generating superior returns by looking at the history of earning growth. If the growth in earnings in the past has been superior, you can trust the management with the retained earnings. If there is no history to look through, you should try to understand where the management is trying to invest in future. If you believe that the management is pursuing a worthwhile investment opportunity and can generate a good return reliably, you can trust the management with the retained earnings.
You should consider another factor in your analysis. If the company is giving you dividend, you have got money in your hands and you can earn real return on it by keeping in a safe investment opportunity. However, if you trust a company with retained earnings, there is a possibility that the company may not be able to give you superior returns in future. To compensate for this risk, ideally, the future earning prospects with retained earnings should far outweigh the earnings you can achieve yourself.
You will find that many companies pursuing growth opportunities are not paying dividends to shareholders. Similarly, many companies have matured in their earnings and are generating cash flow on consistent basis have been paying handsome dividends to their shareholders. These companies may not be having growth opportunities that can justify the use of earnings. Which companies you want to invest in depends on your personal judgment of the growth opportunities and your own ability to generate returns on dividend income. If you are in doubt, perhaps you should opt for the safety of dividend income rather than the probability of expected future earnings.
We have two more topics to cover in this series of ‘how to select a stock for investing’. Watch out for the next post in this series next week.
Different companies use different ways of sharing wealth with their shareholders. One company might choose to pay a handsome dividend to their shareholders every year. Another company might decide to use the whole earning for investing in future growth and pay nothing to its shareholders. A third company may choose to pay a relatively small amount as dividend and invest the remaining amount in the business. Here, one could wonder how a beginner could decide which company is a better investment.
You should ask a question- if the company decides to keep the profits with itself, will it be able to generate a better rate of return on retained earnings than the return you would have got by investing it in some other opportunities available with you. If the company can do a better job with the retained earnings than you can in terms of generating a good rate of return, it should retain the earnings. Otherwise it should pay dividend to investors.
You can assess a company’s capability of generating superior returns by looking at the history of earning growth. If the growth in earnings in the past has been superior, you can trust the management with the retained earnings. If there is no history to look through, you should try to understand where the management is trying to invest in future. If you believe that the management is pursuing a worthwhile investment opportunity and can generate a good return reliably, you can trust the management with the retained earnings.
You should consider another factor in your analysis. If the company is giving you dividend, you have got money in your hands and you can earn real return on it by keeping in a safe investment opportunity. However, if you trust a company with retained earnings, there is a possibility that the company may not be able to give you superior returns in future. To compensate for this risk, ideally, the future earning prospects with retained earnings should far outweigh the earnings you can achieve yourself.
You will find that many companies pursuing growth opportunities are not paying dividends to shareholders. Similarly, many companies have matured in their earnings and are generating cash flow on consistent basis have been paying handsome dividends to their shareholders. These companies may not be having growth opportunities that can justify the use of earnings. Which companies you want to invest in depends on your personal judgment of the growth opportunities and your own ability to generate returns on dividend income. If you are in doubt, perhaps you should opt for the safety of dividend income rather than the probability of expected future earnings.
We have two more topics to cover in this series of ‘how to select a stock for investing’. Watch out for the next post in this series next week.
Friday, January 16, 2009
How to select a stock- Value and Price of a stock
While many of you are aware that by owning a stock you own a company partially, I am not sure if everybody knows how a stock is valued or how its price is determined. For most of us, it is a number that keeps moving up and down based on the whims and fancies of some unknown factors. Most retail investors invest in a stock not on the basis of their research, but on the basis of tips and market rumors. Which is what makes investing in stocks a thrilling but self-defeating activity for most of them.
I think it’s important that we learn how a stock is valued and priced. This should give us an insight into how to select a promising stock later.
So, what is the value of a stock? Plainly put, it is the cumulative present value of the money the company makes at present and in future, divided by the number of total shares with various shareholders. How do you calculate it? Again putting very simplistically, you need to know the amount of cash the company is currently generating and will be generating in future. Calculate the present value of all this cash and divide it by the number of shares (I will not be getting into detailed calculations, as it’s not required. If you are more interested in finding out actual calculation, you can google ‘calculate intrinsic stock value’.) And you got the intrinsic value of a stock. Another method would be looking at the possible dividend stream of the company (current and future) and calculating its present value. Does this give you the actual price of a stock? No. I know you are disappointed with this answer and are wondering why on earth did I explain all this if the answer was going to be a ‘No’.
Let me try to explain.
When you calculate the value of a stock using any of the two methods given above, you have found out ‘intrinsic’ or ‘fair’ value of a stock. Unfortunately, calculating this value requires you to assume quite a few things including possible growth rate of the earnings as well as average discount rate (the rate of return for a risk free investment like government bonds). These assumptions vary based on each individual’s perception of the future. Therefore, agreeing on one particular value of intrinsic or fair value of a stock itself is a difficult task.
There are some other factors too. You would have seen stock prices moving by more than 10 to 20% in one single trading session for a few stocks. Does that mean that the value of a stock has changed in a single session? No. But the perceived value of the stock has changed. And all of us may have different perceived values for the same stock. Which is what matters as none of us know the actual intrinsic value of a stock. All of us can make guesses. Some of us make intelligent guesses. Some of us make foolish guesses. The difference in perceived values of a stock in the eyes of different people keeps a stock price moving. Factors like supply and demand of a stock, economic conditions, market sentiments, liquidity in the market, etc apart from the intrinsic value play a major role in determining the price of a stock at any point in time. You would have seen many stocks tanking by more than 30%-50% in the recent economic downturn. This is because now the perception about the future of these stocks has changed in the eyes of the investors.
All this is fine. But how can we ensure that we make money in the stock market. The answer is simple- by making intelligent guesses rather than foolish ones. How do we do that- that will be the subject of my next post. Till then, think about what I have written in this post.
I think it’s important that we learn how a stock is valued and priced. This should give us an insight into how to select a promising stock later.
So, what is the value of a stock? Plainly put, it is the cumulative present value of the money the company makes at present and in future, divided by the number of total shares with various shareholders. How do you calculate it? Again putting very simplistically, you need to know the amount of cash the company is currently generating and will be generating in future. Calculate the present value of all this cash and divide it by the number of shares (I will not be getting into detailed calculations, as it’s not required. If you are more interested in finding out actual calculation, you can google ‘calculate intrinsic stock value’.) And you got the intrinsic value of a stock. Another method would be looking at the possible dividend stream of the company (current and future) and calculating its present value. Does this give you the actual price of a stock? No. I know you are disappointed with this answer and are wondering why on earth did I explain all this if the answer was going to be a ‘No’.
Let me try to explain.
When you calculate the value of a stock using any of the two methods given above, you have found out ‘intrinsic’ or ‘fair’ value of a stock. Unfortunately, calculating this value requires you to assume quite a few things including possible growth rate of the earnings as well as average discount rate (the rate of return for a risk free investment like government bonds). These assumptions vary based on each individual’s perception of the future. Therefore, agreeing on one particular value of intrinsic or fair value of a stock itself is a difficult task.
There are some other factors too. You would have seen stock prices moving by more than 10 to 20% in one single trading session for a few stocks. Does that mean that the value of a stock has changed in a single session? No. But the perceived value of the stock has changed. And all of us may have different perceived values for the same stock. Which is what matters as none of us know the actual intrinsic value of a stock. All of us can make guesses. Some of us make intelligent guesses. Some of us make foolish guesses. The difference in perceived values of a stock in the eyes of different people keeps a stock price moving. Factors like supply and demand of a stock, economic conditions, market sentiments, liquidity in the market, etc apart from the intrinsic value play a major role in determining the price of a stock at any point in time. You would have seen many stocks tanking by more than 30%-50% in the recent economic downturn. This is because now the perception about the future of these stocks has changed in the eyes of the investors.
All this is fine. But how can we ensure that we make money in the stock market. The answer is simple- by making intelligent guesses rather than foolish ones. How do we do that- that will be the subject of my next post. Till then, think about what I have written in this post.
Sunday, January 11, 2009
Make money by Investing in Stocks
A new investor always grapples with a lot of questions like:
How can I start investing in stocks?
What are the things to know before I start investing?
How should I research a stock?
How much risk should I take?
How long should I invest in a stock for before selling it?
Should I invest in stocks, or mutual funds or derivatives?
How should I select a stock for investing?
How can I ensure that I don’t lose money in the stock market?
So, if you are a new investor, and you are having these questions, don’t worry. All the investors face these questions and struggle finding right answers of these queries. In this blog, I will try to help you find your own answers of these questions to the best of my abilities. However, before we start discussing how to invest in stocks, let’s discuss a few basic issues, which are very important and will lay the foundation of our discussion.
Research: Buy stocks only if you are willing to spend some time researching stocks. If you don’t do research yourself, but still want to invest in stocks, then you should invest in equity oriented mutual funds. Hopefully, you will get decent returns on your money. Finding a good mutual fund in itself will require you to do some research on its past performance vis-à-vis its competitors, current philosophy of investing and fund management. In that sense, there are no free lunches- a little bit of effort is required if you want to make money anywhere. But once you have identified a good mutual fund, you don’t need to actively research stocks.
Investing in stock based on tips, or what others are buying or saying, is like gambling. And you don’t want to gamble with your money. If you still want to go ahead with gambling, then there so many other places to lose money.
Day trading: Only people who benefit from day trading on continuous basis are stockbrokers. They make money irrespective of your loss or profit, as they earn a percentage on every transaction you do. I have not seen anybody else making money consistently in day trading. If you have been lucky, may be you will make a few quick bucks. After that, the law of averages will catch up with you. To my mind, it’s a big farce and pure gamble that has been created to get people hooked to the stock market and keep up the volume of trades. Therefore, if you are thinking that I am going to give you tips on how to make some quick bucks, sorry to disappoint you. If anybody knows where exactly a stock is going to be in next one hour or two, he would not be advising you. Instead he will play the game himself and become a billionaire. This should help you understand the reality of day trading.
Derivatives: While finance professionals talk fondly about derivatives as investment instruments, these are complicated products and work primarily on speculation of large players in the stock market. You don’t have a good chance to make money in derivatives, as it’s not a level playing field. A retail investors should stay as far from derivatives as possible.
Short-term Vs Long-term: Short term investing is not investing; it’s speculation. At the cost of sounding repetitive, let me say again that short-term investment is gambling. There is a chance that you can make money in short term, but that will be pure chance. A stock price at any point in time is dependent on its intrinsic value (the real and reasonable potential of a stock), sentiments in the market, liquidity in the market, etc. When you are investing in a stock, you are trying to believe that the market will value this stock more in future and reward you for your early discovery. In a sense, you buy a stock at a price below its intrinsic value, and you will sell it when the market realizes that the stock is worth more. However, if you bought a stock when the liquidity and sentiments were good. And, suddenly, everything changes. The stock market crashes, liquidity dries up and everybody looks pessimistic about future. What happens to your stock? It tanks in the short term. However, sooner or later, things will get better and liquidity, sentiments will be positive; and you will find that the stock realizes its real potential. If you were a short-term investor, you would have sold the stock when the it tanked and lost money. However, if you invested for long term, you would hold on as you believe in the value of your investment and finally make money on your stock when things get better. Therefore, your chances of making money on a stock in long term are better than those in short term irrespective of the market sentiments and bull or bear phases. This is assuming that you have identified a good stock and bought it at a price, which is cheaper than its intrinsic value. A corollary is that if you need your money back in short term, you should not invest in stocks; instead you should invest in safe financial products like FD, debt oriented mutual funds, government bonds, etc.
It’s been a long post and I can go on and on. However, you should take rest and think about the points I discussed so that you can digest them and develop your own thoughts. Whatever I discussed today sets the tone for the things to come. Stay tuned.
How can I start investing in stocks?
What are the things to know before I start investing?
How should I research a stock?
How much risk should I take?
How long should I invest in a stock for before selling it?
Should I invest in stocks, or mutual funds or derivatives?
How should I select a stock for investing?
How can I ensure that I don’t lose money in the stock market?
So, if you are a new investor, and you are having these questions, don’t worry. All the investors face these questions and struggle finding right answers of these queries. In this blog, I will try to help you find your own answers of these questions to the best of my abilities. However, before we start discussing how to invest in stocks, let’s discuss a few basic issues, which are very important and will lay the foundation of our discussion.
Research: Buy stocks only if you are willing to spend some time researching stocks. If you don’t do research yourself, but still want to invest in stocks, then you should invest in equity oriented mutual funds. Hopefully, you will get decent returns on your money. Finding a good mutual fund in itself will require you to do some research on its past performance vis-à-vis its competitors, current philosophy of investing and fund management. In that sense, there are no free lunches- a little bit of effort is required if you want to make money anywhere. But once you have identified a good mutual fund, you don’t need to actively research stocks.
Investing in stock based on tips, or what others are buying or saying, is like gambling. And you don’t want to gamble with your money. If you still want to go ahead with gambling, then there so many other places to lose money.
Day trading: Only people who benefit from day trading on continuous basis are stockbrokers. They make money irrespective of your loss or profit, as they earn a percentage on every transaction you do. I have not seen anybody else making money consistently in day trading. If you have been lucky, may be you will make a few quick bucks. After that, the law of averages will catch up with you. To my mind, it’s a big farce and pure gamble that has been created to get people hooked to the stock market and keep up the volume of trades. Therefore, if you are thinking that I am going to give you tips on how to make some quick bucks, sorry to disappoint you. If anybody knows where exactly a stock is going to be in next one hour or two, he would not be advising you. Instead he will play the game himself and become a billionaire. This should help you understand the reality of day trading.
Derivatives: While finance professionals talk fondly about derivatives as investment instruments, these are complicated products and work primarily on speculation of large players in the stock market. You don’t have a good chance to make money in derivatives, as it’s not a level playing field. A retail investors should stay as far from derivatives as possible.
Short-term Vs Long-term: Short term investing is not investing; it’s speculation. At the cost of sounding repetitive, let me say again that short-term investment is gambling. There is a chance that you can make money in short term, but that will be pure chance. A stock price at any point in time is dependent on its intrinsic value (the real and reasonable potential of a stock), sentiments in the market, liquidity in the market, etc. When you are investing in a stock, you are trying to believe that the market will value this stock more in future and reward you for your early discovery. In a sense, you buy a stock at a price below its intrinsic value, and you will sell it when the market realizes that the stock is worth more. However, if you bought a stock when the liquidity and sentiments were good. And, suddenly, everything changes. The stock market crashes, liquidity dries up and everybody looks pessimistic about future. What happens to your stock? It tanks in the short term. However, sooner or later, things will get better and liquidity, sentiments will be positive; and you will find that the stock realizes its real potential. If you were a short-term investor, you would have sold the stock when the it tanked and lost money. However, if you invested for long term, you would hold on as you believe in the value of your investment and finally make money on your stock when things get better. Therefore, your chances of making money on a stock in long term are better than those in short term irrespective of the market sentiments and bull or bear phases. This is assuming that you have identified a good stock and bought it at a price, which is cheaper than its intrinsic value. A corollary is that if you need your money back in short term, you should not invest in stocks; instead you should invest in safe financial products like FD, debt oriented mutual funds, government bonds, etc.
It’s been a long post and I can go on and on. However, you should take rest and think about the points I discussed so that you can digest them and develop your own thoughts. Whatever I discussed today sets the tone for the things to come. Stay tuned.
Saturday, January 10, 2009
Basics of investing in stocks
Welcome to Basics of Investing in Stocks for beginners. This site will provide tips, insights and techniques for investing in the stock market to help beginners make money without losing sleep. If you want any particular topic to be covered or have any specific question, you can post a comment mentioning the same. I will try to answer your queries honestly and to the best of my abilities.
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