The Investment FAQ  Advice
This is a discussion on The Investment FAQ  Advice within the T2W Feedback & Announcements forums, part of the Off the Grid category; Check http://investfaq.com/ for updates Subject: Advice  Beginning Investors LastRevised: 1 Aug 1998 ContributedBy: Steven Pearson, E. Green, lott@investfaq.com Investing ...

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Check http://investfaq.com/ for updates Subject: Advice  Beginning Investors LastRevised: 1 Aug 1998 ContributedBy: Steven Pearson, E. Green, lott@investfaq.com Investing is just one aspect of personal finance. People often seem to have the itch to try their hand at investing before they get the rest of their act together. This is a big mistake. For this reason, it's a good idea for "new investors" to hit the library and read maybe three different overall guides to personal finance  three for different perspectives, and because common themes will emerge (repetition implies authority?). Personal finance issues include making a budget, sticking to a budget, saving money towards major purchases or retirement, managing debt appropriately, insuring your property, etc. Appropriate books that focus on personal finance include the following (the links point to Amazon.com): * Janet Bamford et al. The Consumer Reports Money Book: How to Get It, Save It, and Spend It Wisely (3rd edn) * Andrew Tobias The Only Investment Guide You'll Ever Need * Eric Tyson Personal Finance for Dummies Another great resource for learning about investing, insurance, stocks, etc. is the Wall Street Journal's Section C front page. Beginners should make a special effort to get the Friday edition of the WSJ because a column named "Getting Going" usually appears on that day and discusses issues in, well, getting going on investments. If you don't want to spend the dollar or so for the WSJ, try your local library. What I am specifically NOT talking about is most anything that appears on a list of investing/stock market books that are posted in misc.invest.* from time to time. This includes books like Market Logic, One Up on Wall Street, Beating the Dow, Winning on Wall Street, The Intelligent Investor, etc. These are not general enough. They are investment books, not personal finance books. Many "beginning investors" have no business investing in stocks. The books recommended above give good overall money management, budgeting, purchasing, insurance, taxes, estate issues, and investing backgrounds from which to build a personal framework. Only after that should one explore particular investments. If someone needs to unload some cash in the meantime, they should put it in a money market fund, or yes, even a bank account, until they complete their basic training. While I sympathize with those who view this education as a daunting task, I don't see any better answer. People who know next to nothing and always depend on "professional advisors" to handhold them through all transactions are simply sheep asking to be fleeced (they may not actually be fleeced, but most of them will at least get their tails bobbed). In the long run, an individual is the only person ultimately responsible for his or her own financial situation. Beginners may want to look further in The Investment FAQ for the articles that discuss the basics of mutual funds , basics of stocks , and basics of bonds . For more indepth material, browse the Investment FAQ bookshelf with its recommended books about personal finance and investments. Check http://investfaq.com/ for updates Subject: Advice  Errors in Investing LastRevised: 2 Aug 1999 ContributedBy: lott@investfaq.com , tprice at engr.msstate.edu The Wall Street Journal of June 18, 1991 had an article on pages C1/C10 on Investment Errors and how to avoid them. As summarized from that article, the errors are: * Not following an investment objective when you build a portfolio. * Buying too many mutual funds. * Not researching a oneproduct stock before you buy. * Believing that you can pick market highs and lows (time the market). * Taking profits early. * Not cutting your losses. * Buying the hottest {stock, mutual fund} from last year. Here's a recent quote that underscores the last item. When asked "What's the biggest mistake individual investors make?" on Wall $treet Week, John Bogle, founder and senior chairman of Vanguard mutual funds, said "Extrapolating the trend" or buying the hot stock. On a final note, get this quote on market timing: In the 1980s if you were out of the market on the ten best trading days of the decade you missed onethird of the total return. Check http://investfaq.com/ for updates Subject: Advice  Using a FullService Broker LastRevised: 23 Mar 1998 ContributedBy: Bill Rini (bill at moneypages.com), lott@investfaq.com There are several reasons to choose a fullservice broker over a discount or web broker. People use a fullservice broker because they may not want to do their own research, because they are only interested in longterm investing, because they like to hear the broker's investment ideas, etc. But another important reason is that not everybody likes to trade. I may want retirement planning services from my broker. I may want to buy 3 or 4 mutual funds and have my broker worry about them. If my broker is a financial planner, perhaps I want tax or estate advice on certain investment options. Maybe I'm saving for my newborn child's education but I have no idea or desire to work out a plan to make sure the money is there when she or he needs it. A huge reason to stick with a fullservice broker is access to initial public offerings (IPOs). These are generally reserved for the very best clients, where best is defined as "someone who generates lots of revenue," so someone who trades just a few times a year doesn't have a chance. But if you can afford to trade frequently at the fullservice commission rates, you may be favored with access to some great IPOs. And the real big one for a lot of people is quite simply time . Full service brokerage clients also tend to be higher net worth individuals as well. If I'm a doctor or lawyer, I can probably make more money by focusing on my business than spending it researching stocks. For many people today, time is a more valuable commodity than money. In fact, it doesn't even have to do with how wealthy you are. Americans, in general, work some pretty insane hours. Spending time researching stocks or staying up on the market is quality time not spent with family, friends, or doing things that they enjoy. On the other hand some people enjoy the market and for those people there are discount brokers. The one thing that sort of scares me about the difference between full service and discount brokers is that a pretty good chunk of discount brokerage firm clients are not that educated about investing. They look at a $20 commission (discount broker) and a $50 commission (full service broker) and they decide they can't afford to invest with a full service broker. Instead they plow their life savings into some wonder stock they heard about from a friend (hey, it's only a $20 commission, why not?) and lose a few hundred or thousand bucks when the investment goes south. Not that a broker is going to pick winners 100% of the time but at least the broker can guide or mentor a beginning investor until they learn enough to know what to look for and what not to look for in a stock. I look at the $30 difference in what the two types of brokerage firms charge as the rebate for education and doing my own research. If you're not going to educate yourself or do your own research, you don't deserve the rebate. For more insights from Bill Rini, visit The Syndicate: http://www.moneypages.com Check http://investfaq.com/ for updates Subject: Advice  OneLine Wisdom LastRevised: 22 Aug 1993 ContributedBy: Maurice Suhre This is a collection of oneline pieces of investment wisdom, with brief explanations. Use and apply at your own risk or discretion. They are not in any particular order. Hang up on cold calls. While it is theoretically possible that someone is going to offer you the opportunity of a lifetime, it is more likely that it is some sort of scam. Even if it is legitimate, the caller cannot know your financial position, goals, risk tolerance, or any other parameters which should be considered when selecting investments. If you can't bear the thought of hanging up, ask for material to be sent by mail. Don't invest in anything you don't understand. There were horror stories of people who had lost fortunes by being short puts during the 87 crash. I imagine that they had no idea of the risks they were taking. Also, all the complaints about penny stocks, whether fraudulent or not, are partially a result of not understanding the risks and mechanisms. If it sounds too good to be true, it probably is [too good to be true]. Also stated as ``There ain't no such thing as a free lunch (TANSTAAFL).'' Remember, every investment opportunity competes with every other investment opportunity. If one seems wildly better than the others, there are probably hidden risks or you don't understand something. If your only tool is a hammer, every problem looks like a nail. Someone (possibly a financial planner) with a very limited selection of products will naturally try to jam you into those which s/he sells. These may be less suitable than other products not carried. Don't rush into an investment. If someone tells you that the opportunity is closing, filling up fast, or in any other way suggests a time pressure, be very leery. Very low priced stocks require special treatment. Risks are substantial, bid/asked spreads are large, prices are volatile, and commissions are relatively high. You need a broker who knows how to purchase these stocks and dicker for a good price. Check http://investfaq.com/ for updates Subject: Advice  Paying for Investment Advice LastRevised: 25 Apr 1997 ContributedBy: lott@investfaq.com I'm no expert, but there's a simple rule that you should use to evaluate all advice that is offered to you, especially advice for which someone who doesn't know you is asking significant sums of money. Ask yourself why the person is selling or giving it to you. If it sounds like a sure ticket to riches, then why is the person wasting their time on YOU when they could be out there making piles of dough? Of course I'm offering advice here in this article, so let's turn the tables on me right now. What's in it for me? Well, if you're reading this article from my web site, look up at the top of the page. If you have images turned on, you'll see a banner ad. I get a tiny payment each time a person loads one of my pages with an ad. So my motivation is to provide informative articles in order to lure visitors to the site. Of course if you're reading this from the plaintext version of the FAQ, you won't see any ads, but please do stop by the site sometime! ;) So if someone promises you advice that will yield 1020% monthly returns, perhaps at a price of some $3,000, you should immediately get suspicious. If this were really true  i.e., if you pay for the advice you'll immediately start getting these returns  you would be making over 300% annually (compounded). Hey, that would sure be great, I wouldn't have a day job anymore. And if it were true, wouldn't you think that the person trying to sell it to you would forget all about selling and just watch his or her money triple every year? But they're not doing that, which should give you a pretty good idea about where the money's being made, namely from you . I'm not trying to say that you should never pay for advice, just that you should not overpay for advice. Some advice, especially the sort that comes from $15 books on personal finance and investments can easily be worth ten times that sum. Advice from your CPA or tax advisor will probably cost you a 3 or even 4digit figure, but since it's specialized to your case and comes from a professional, that's probably money well spent. It seems appropriate to close this article with a quote that I learned from Robert Heinlein books, but it's probably older than that: TANSTAAFL  there ain't no such thing as a free lunch. Check http://investfaq.com/ for updates Subject: Advice  Researching a Company LastRevised: 3 Jun 1997 ContributedBy: George Regnery (regnery at ix.netcom.com) This article gives a basic idea of some steps that you might take to research a company. Many sites on the web will help you in your quest for information, and this article gives a few of them. You might look for the following. 1. What multiple of earnings is the company trading at versus other companies in the industry? The site http://www.stocksmart.com does this comparison reasonably well, and they base it on forward earnings instead of historical earnings, which is also good. 2. Is the stock near a high or low, and how has it done recently. This is usually considered technical analysis. More sophisticated (or at least more complicated) studies can also be performed. There are several sites that will give you historical graphs; one is http://www.stockmaster.com 3. When compared with other companies in the industry, how much times the book value or times sales is the company trading? For this information, the site http://www.marketguide.com is a good place to start. 4. Does the company have good products, good management, good future prospects? Are they being sued? Do they have patents? What's the competition like? Do they have long term contracts established? Is their brand name recognized? Depending on the industry, some or all of these questions may be relevant. There isn't a simple web site for this information, of course. The Hoover's profiles have some limited information to at least let you get a feel for the basics of the company. And the SEC has lots of information in their Edgar databank. 5. Management. Does the company have competent people running it? The backgrounds of the directors can be found in proxy statements (14As) in the Edgar database. Note that proxies are written by the companies, though. Another thing I would suggest looking at is the compensation structure of the CEO and other top management. Don't worry so much about the raw figure of how they are paid  instead, look to see how that compensation is structured. If the management gets a big base but bonuses are a small portion, look carefully at the company. For some industries, like electric utilities, this is OK, because the management isn't going to make a huge difference (utilities are highly regulated, and thus the management is preventing from making a lot of decisions). However, in a high tech industry, or many other industries, watch your step if the mgmt. gets a big base and the bonus is insignificant. This means that they won't be any better off financially if the company makes a lot of profits vs. no profits (unless, of course, they own a lot of stock). This information is all in the Proxies at the SEC. Also check to see if the company has a shareholder rights plan, because if they do, the management likely doesn't give a damn about shareholder rights, but rather cares about their own jobs. (These plans are commonly used to defend against unfriendly takeovers and therefore provide a safety blanket for management.) These suggestions should get you started. Also check the article elsewhere in this FAQ on free information sources for more resources away from the web. Check http://investfaq.com/ for updates Subject: Advice  Target Stock Prices LastRevised: 25 Jun 2000 ContributedBy: blash404 at aol.com A target price for a stock is a figure published by a securities industry person, usually an analyst. The idea is that the target price is a prediction, a guess about where the stock is headed. Target prices usually are associated with a date by which the stock is expected to hit the target. With that explanation out of the way.. Why do people suddenly think that the term du jour "target price" has any meaning?? Consider the sources of these numbers. They're ALWAYS issued by someone who has a vested interest in the issue: It could be an analyst whose firm was the underwriter, it could be an analyst whose firm is brownnosing the company, it could be a firm with a large position in the stock, it could be an individual trying to talk the stock up so he can get out even, or it could be the "pump" segment of a pumpanddump operation. There is also a chance that the analyst has no agenda and honestly thinks the stock price is really going places. But in all too many cases it’s nothing more than wishful guesswork (unless they have a crystal ball that works), so the advice here: ignore target prices, especially ones for internet companies. Check http://investfaq.com/ for updates Subject: Analysis  Annual Reports LastRevised: 31 Oct 1995 ContributedBy: Jerry Bailey, lott@investfaq.com The June 1994 Issue of "Better Investing" magazine, page 26 has a threepage article about reading and understanding company annual reports. I will paraphrase: 1. Start with the notes and read from back to front since the front is management fluff. 2. Look for litigation that could obliterate equity, a pension plan in sad shape, or accounting changes that inflated earnings. 3. Use it to evaluate management. I only read the boring things of the companies I am holding for long term growth. If I am planning a quick in and out, such as buying depressed stocks like BBA, CML, CLE, etc.), I don't waste my time. 4. Look for notes to offer relevant details; not "selected" and "certain" assets. Revenue and operating profits of operating divisions, geographical divisions, etc. 5. How the company keeps its books, especially as compared to other companies in its industry. 6. Inventory. Did it go down because of a different accounting method? 7. What assets does the company own and what assets are leased? If you do much of this, I really recommend just reading the article. The following list of resources may also help. * John A. Tracy has written an an easytoread and informative book named How to Read a Financial Report (4th edn., Wiley, 1993). This book should give you a good start. You won't become a graduate student in finance by reading it, but it will certainly help you grasp the nuts and bolts of annual reports. * ABC News offers the following article: http://abcnews.go.com/sections/busin...rtstocks4.html * IBM offers a web site with much information about understanding financial reports: http://www.ibm.com/FinancialGuide/ Check http://investfaq.com/ for updates Subject: Analysis  Beta and Alpha LastRevised: 22 Oct 1997 ContributedBy: Ajay Shah ( http://www.igidr.ac.in/~ajayshah ), R. Shukla, Bob Pierce (rbp at investor.pgh.pa.us) Beta is the sensitivity of a stock's returns to the returns on some market index (e.g., S&P 500). Beta values can be roughly characterized as follows: * b less than 0 Negative beta is possible but not likely. People thought gold stocks should have negative betas but that hasn't been true. * b equal to 0 Cash under your mattress, assuming no inflation * beta between 0 and 1 Lowvolatility investments (e.g., utility stocks) * b equal to 1 Matching the index (e.g., for the S&P 500, an index fund) * b greater than 1 Anything more volatile than the index (e.g., small cap. funds) * b much greater than 1 (tending toward infinity) Impossible, because the stock would be expected to go to zero on any market decline. 23 is probably as high as you will get. More interesting is the idea that securities MAY have different betas in up and down markets. Forbes used to (and may still) rate mutual funds for bull and bear market performance. Alpha is a measure of residual risk (sometimes called "selecting risk") of an investment relative to some market index. For all the gory details on Alpha, please see a book on technical analysis. Here is an example showing the inner details of the beta calculation process: Suppose we collected endofthemonth prices and any dividends for a stock and the S&P 500 index for 61 months (0..60). We need n + 1 price observations to calculate n holding period returns, so since we would like to index the returns as 1..60, the prices are indexed 0..60. Also, professional beta services use monthly data over a five year period. Now, calculate monthly holding period returns using the prices and dividends. For example, the return for month 2 will be calculated as: r_2 = ( p_2  p_1 + d_2 ) / p_1 Here r denotes return, p denotes price, and d denotes dividend. The following table of monthly data may help in visualizing the process. (Monthly data is preferred in the profession because investors' horizons are said to be monthly.) Nr. Date Price Div.(*) Return 0 12/31/86 45.20 0.00  1 01/31/87 47.00 0.00 0.0398 2 02/28/87 46.75 0.30 0.0011 . ... ... ... ... 59 11/30/91 46.75 0.30 0.0011 60 12/31/91 48.00 0.00 0.0267 (*) Dividend refers to the dividend paid during the period. They are assumed to be paid on the date. For example, the dividend of 0.30 could have been paid between 02/01/87 and 02/28/87, but is assumed to be paid on 02/28/87. So now we'll have a series of 60 returns on the stock and the index (1...61). Plot the returns on a graph and fit the bestfit line (visually or using some least squares process):  * / stock  * * */ * returns * * / *  * / *  * /* * *  / * *  / *   + index returns The slope of the line is Beta. Merrill Lynch, Wells Fargo, and others use a very similar process (they differ in which index they use and in some econometric nuances). Now what does Beta mean? A lot of disservice has been done to Beta in the popular press because of trying to simplify the concept. A beta of 1.5 does not mean that is the market goes up by 10 points, the stock will go up by 15 points. It doesn't even mean that if the market has a return (over some period, say a month) of 2%, the stock will have a return of 3%. To understand Beta, look at the equation of the line we just fitted: stock return = alpha + beta * index return Technically speaking, alpha is the intercept in the estimation model. It is expected to be equal to riskfree rate times (1  beta). But it is best ignored by most people. In another (very similar equation) the intercept, which is also called alpha, is a measure of superior performance. Therefore, by computing the derivative, we can write: Change in stock return = beta * change in index return So, truly and technically speaking, if the market return is 2% above its mean, the stock return would be 3% above its mean, if the stock beta is 1.5. One shot at interpreting beta is the following. On a day the (S&Ptype) market index goes up by 1%, a stock with beta of 1.5 will go up by 1.5% + epsilon. Thus it won't go up by exactly 1.5%, but by something different. The good thing is that the epsilon values for different stocks are guaranteed to be uncorrelated with each other. Hence in a diversified portfolio, you can expect all the epsilons (of different stocks) to cancel out. Thus if you hold a diversified portfolio, the beta of a stock characterizes that stock's response to fluctuations in the market portfolio. So in a diversified portfolio, the beta of stock X is a good summary of its risk properties with respect to the "systematic risk", which is fluctuations in the market index. A stock with high beta responds strongly to variations in the market, and a stock with low beta is relatively insensitive to variations in the market. E.g. if you had a portfolio of beta 1.2, and decided to add a stock with beta 1.5, then you know that you are slightly increasing the riskiness (and average return) of your portfolio. This conclusion is reached by merely comparing two numbers (1.2 and 1.5). That parsimony of computation is the major contribution of the notion of "beta". Conversely if you got cold feet about the variability of your beta = 1.2 portfolio, you could augment it with a few companies with beta less than 1. If you had wished to figure such conclusions without the notion of beta, you would have had to deal with large covariance matrices and nontrivial computations. Finally, a reference. See Malkiel, A Random Walk Down Wall Street , for more information on beta as an estimate of risk. Here are a few links that offer information about beta. * Barra Inc. offers historical and predicted beta values for stocks that make up the major indexes. Visit this URL: http://www.Barra.COM/MktIndices/default.asp * For a brief discussion of using Beta and Alpha values to pick stocks, visit this URL: http://sunflower.singnet.com.sg/~midaz/Select1.htm Check http://investfaq.com/ for updates Subject: Analysis  BooktoBill Ratio LastRevised: 19 Aug 1993 ContributedBy: Timothy May The booktobill ration is the ratio of business "booked" (orders taken) to business "billed" (products shipped and bills sent). A booktobill of 1.0 implies incoming business = outgoing product. Often in downturns, the btb drops to 0.9, sometimes even lower. A btb of 1.1 or higher is very encouraging. Check http://investfaq.com/ for updates Subject: Analysis  Book Value LastRevised: 23 Mar 1998 ContributedBy: Art Kamlet (artkamlet at aol.com) In simplest terms, Book Value is Assets less Liabilities. The problem is Assets includes, as stated, existing land & buildings, inventory, cash in the bank, etc. held by the company. The problem in assuming you can sell off these assets and receive their listed value is that such values are accounting numbers, but otherwise pretty unrealistic. Consider a company owning a 40 year old building in downtown Chicago. That building might have been depreciated fully and is carried on the books for $0, while having a resale value of millions. The book value grossly understates the selloff value of the company. On the other hand, consider a fastchanging industry with 4yearold computer equipment which has a few more years to go before being fully depreciated, but that equipment couldn't be sold for even 10 cents on the dollar. Here the book value overstates the selloff value. So consider book value to be assets less liabilities, which are just numbers, not real items. If you want to know how much a company should be sold off for, hire a good investment banker, which is often done on takeover bids. Check http://investfaq.com/ for updates Subject: Analysis  Computing Compound Return LastRevised: 30 Dec 1995 ContributedBy: Paul Randolph (paulr4 at hotmail.com) To calculate the compounded return on an investment, just figure out the factor by which the original investment multiplied. For example, if $1000 became $3200 in 10 years, then the multiplying factor is 3200/1000 or 3.2. Now take the 10th root of 3.2 (the multiplying factor) and you get a compounded return of 1.1233498 (12.3% per year). To see that this works, note that 1.1233498 ** 10 = 3.2 (i.e., 1.233498 raised to the 10th power equals 3.2). Here is another way of saying the same thing. This calculation assumes that all gains are reinvested, so the following formula applies: TR = (1 + AR) ** YR where TR is total return (present value/initial value), AR is the compound annualized return, and YR is years. The symbol '**' is used to denote exponentiation (2 ** 3 = 8). To calculate annualized return, the following formula applies: AR = (TR ** (1/YR))  1 Thus a total return of 950% in 20 years would be equivalent to an annualized return of 11.914454%. Note that the 950% includes your initial investment of 100% (by definition) plus a gain of 850%. For those of you using spreadsheets such as Excel, you would use the following formula to compute AR for the example discussed above (the common computer symbol used to denote exponentiation is the caret or hat on top of the 6). = TR ^ (1 / YR)  1 where TR = 9.5 and YR = 20. If you want to be creative and have AR recalculated every time you open your file, you can substitute something like the following for YR: ( (*cell*  TODAY() ) / 365) Of course you will have to replace '*cell*' by the appropriate address of the cell that contains the date on which you bought the security. Check http://investfaq.com/ for updates Subject: Analysis  Future and Present Value of Money LastRevised: 28 Jan 1994 ContributedBy: lott@investfaq.com This note explains briefly two concepts concerning the timevalueofmoney, namely future and present value. Careful application of these concepts will help you evaluate investment opportunities such as real estate, life insurance, and many others. Future Value Future value is simply the sum to which a dollar amount invested today will grow given some appreciation rate. To compute the future value of a sum invested today, the formula for interest that is compounded monthly is: fv = principal * [ (1 + rrate/12) ** (12 * termy) ] where fv = future value principal = dollar value you have now termy = term, in years rrate = annual rate of return in decimal (i.e., use .05 for 5%) Note that the symbol '**' is used to denote exponentiation (2 ** 3 = 8). For interest that is compounded annually, use the formula: fv = principal * [ (1 + rrate) ** (termy) ] Example: I invest 1,000 today at 10% for 10 years compounded monthly. The future value of this amount is 2707.04. Note that the formula for future value is the formula from Case 1 of present value (below), but solved for the futuresum rather than the present value. Present Value Present value is the value in today's dollars assigned to an amount of money in the future, based on some estimate rateofreturn over the longterm. In this analysis, rateofreturn is calculated based on monthly compounding. Two cases of present value are discussed next. Case 1 involves a single sum that stays invested over time. Case 2 involves a cash stream that is paid regularly over time (e.g., rent payments), and requires that you also calculate the effects of inflation. Case 1a: Present value of money invested over time. This tells you what a future sum is worth today, given some rate of return over the time between now and the future. Another way to read this is that you must invest the present value today at the rateofreturn to have some future sum in some years from now (but this only considers the raw dollars, not the purchasing power). To compute the present value of an invested sum, the formula for interest that is compounded monthly is: futuresum pv =  (1 + rrate/12) ** (12 * termy) where * futuresum = dollar value you want to have in termy years * termy = term, in years * rrate = annual rate of return that you can expect, in decimal Example: I need to have 10,000 in 5 years. The present value of 10,000 assuming an 8% monthly compounded rateofreturn is 6712.10. I.e., 6712 will grow to 10k in 5 years at 8%. Case 1b: Effects of inflation This formulation can also be used to estimate the effects of inflation; i.e., compute the real purchasing power of present and future sums. Simply use an estimated rate of inflation instead of a rate of return for the rrate variable in the equation. Example: In 30 years I will receive 1,000,000 (a megabuck). What is that amount of money worth today (what is the buying power), assuming a rate of inflation of 4.5%? The answer is 259,895.65 Case 2: Present value of a cash stream. This tells you the cost in today's dollars of money that you pay over time. Usually the payments that you make increase over the term. Basically, the money you pay in 10 years is worth less than that which you pay tomorrow, and this equation lets you compute just how much less. In this analysis, inflation is compounded yearly. A reasonable estimate for longterm inflation is 4.5%, but inflation has historically varied tremendously by country and time period. To compute the present value of a cash stream, the formula is: month=12 * termy paymt * (1 + irate) ** int ((month  1)/ 12) pv = SUM  month=1 (1 + rrate/12) ** (month  1) where * pv = present value * SUM (a.k.a. sigma) means to sum the terms on the righthand side over the range of the variable 'month'; i.e., compute the expression for month=1, then for month=2, and so on then add them all up * month = month number * int() = the integral part of the number; i.e., round to the closest whole number; this is used to compute the year number from the month number * termy = term, in years * paymt = monthly payment, in dollars * irate = rate of inflation (increase in payment/year), in decimal * rrate = rate of return on money that you can expect, in decimal Example: You pay $500/month in rent over 10 years and estimate that inflation is 4.5% over the period (your payment increases with inflation.) Present value is 49,530.57 Two small C programs for computing future and present value are available. See the article Software  Archive of InvestmentRelated Programs in this FAQ for more information. Check http://investfaq.com/ for updates Subject: Analysis  Goodwill LastRevised: 18 Jul 1993 ContributedBy: John Keefe Goodwill is an asset that is created when one company acquires another. It represents the difference between the price the acquiror pays and the "fair market value" of the acquired company's assets. For example, if JerryCo bought Ford Motor for $15 billion, and the accountants determined that Ford's assets (plant and equipment) were worth $13 billion, $2 billion of the purchase price would be allocated to goodwill on the balance sheet. In theory the goodwill is the value of the acquired company over and above the hard assets, and it is usually thought to represent the value of the acquired company's "franchise," that is, the loyalty of its customers, the expertise of its employees; namely, the intangible factors that make people do business with the company. What is the effect on book value? Well, book value usually tries to measure the liquidation value of a company  what you could sell it for in a hurry. The accountants look only at the fair market value of the hard assets, thus goodwill is usually deducted from total assets when book value is calculated. For most companies in most industries, book value is next to meaningless, because assets like plant and equipment are on the books at their old historical costs, rather than current values. But since it's an easy number to calculate, and easy to understand, lots of investors (both professional and amateur) use it in deciding when to buy and sell stocks. Check http://investfaq.com/ for updates Subject: Analysis  Internal Rate of Return (IRR) LastRevised: 25 June 1999 ContributedBy: Christopher Yost (cpy at world.std.com), Rich Carreiro (rlcarr at animato.arlington.ma.us) If you have an investment that requires and produces a number of cash flows over time, the internal rate of return is defined to be the discount rate that makes the net present value of those cash flows equal to zero. This article discusses computing the internal rate of return on periodic payments, which might be regular payments into a portfolio or other savings program, or payments against a loan. Both scenarios are discussed in some detail. We'll begin with a savings program. Assume that a sum "P" has been invested into some mutual fund or like account and that additional deposits "p" are made to the account each month for "n" months. Assume further that investments are made at the beginning of each month, implying that interest accrues for a full "n" months on the first payment and for one month on the last payment. Given all this data, how can we compute the future value of the account at any month? Or if we know the value, what was the rate of return? The relevant formula that will help answer these questions is: F = P(1+i)**n  [p(1+i)((1+i)**n  1)/i] In this formula, "F" is the future value of your investment (i.e., the value after "n" months or "n" weeks or "n" yearswhatever the period over which the investments are made), "P" is the present value of your investment (i.e., the amount of money you have already invested), "p" is the payment each period, "n" is the number of periods you are interested in, and "i" is the interest rate per period. Note that the symbol '**' is used to denote exponentiation (2 ** 3 = 8). Very important! The values "P" and "p" should be negative . This formula and the ones below are devised to accord with the standard practice of representing cash paid out as negative and cash received (as in the case of a loan) as positive. This may not be very intuitive, but it is a convention that seems to be employed by most financial programs and spreadsheet functions. The formula used to compute loan payments is very similar, but as is appropriate for a loan, it assumes that all payments "p" are made at the end of each period: F = P(1+i)**n  [p((1+i)**n  1)/i] Note that this formula can also be used for investments if you need to assume that they are made at the end of each period. With respect to loans, the formula isn't very useful in this form, but by setting "F" to zero, the future value (one hopes) of the loan, it can be manipulated to yield some more useful information. To find what size payments are needed to payoff a loan of the amount "P" in "n" periods, the formula becomes this: Pi(1+i)**n p =  (1+i)**n  1 If you want to find the number of periods that will be required to payoff a loan use this formula: log(p)  log(Pi  p) n =  log(1+i) Keep in mind that the "i" in all these formula is the interest rate per period . If you have been given an annual rate to work with, you can find the monthly rate by adding 1 to annual rate, taking the 12th root of that number, and then subtracting 1. The formula is: i = ( r + 1 ) ** 1/12  1 where "r" is the rate. Conversely, if you are working with a monthly rateor any periodic rateyou may need to compound it to obtain a number you can compare applestoapples with other rates. For example, a 1 year CD paying 12% in simple interest is not as good an investment as an investment paying 1% compounded per month. If you put $1000 into each, you'll have $1120 in the CD at the end of the year but $1000*(1.01)**12 = $1126.82 in the other investment due to compounding. In this way, interest rates of any kind can be converted to a "simple 1year CD equivalent" for the purposes of comparison. (See the article "Computing Compound Return" for more information.) You cannot manipulate these formulas to get a formula for "i," but that rate can be found using any financial calculator, spreadsheet, or program capable of calculating Internal Rate of Return or IRR. Technically, IRR is a discount rate: the rate at which the present value of a series of investments is equal to the present value of the returns on those investments. As such, it can be found not only for equal, periodic investments such as those considered here but for any series of investments and returns. For example, if you have made a number of irregular purchases and sales of a particular stock, the IRR on your transactions will give you a picture of your overall rate of return. For the matter at hand, however, the important thing to remember is that since IRR involves calculations of present value (and therefore the timevalue of money), the sequence of investments and returns is significant. Here's an example. Let's say you buy some shares of Wild Thing Conservative Growth Fund, then buy some more shares, sell some, have some dividends reinvested, even take a cash distribution. Here's how to compute the IRR. You first have to define the sign of the cash flows. Pick positive for flows into the portfolio, and negative for flows out of the portfolio (you could pick the opposite convention, but in this article we'll use positive for flows in, and negative for flows out). Remember that the only thing that counts are flows between your wallet and the portfolio. For example, dividends do NOT result in cash flow unless they are withdrawn from the portfolio. If they remain in the portfolio, be they reinvested or allowed to sit there as free cash, they do NOT represent a flow. There are also two special flows to define. The first flow is positive and is the value of the portfolio at the start of the period over which IRR is being computed. The last flow is negative and is the value of the portfolio at the end of the period over which IRR is being computed. The IRR that you compute is the rate of return per whatever time unit you are using. If you use years, you get an annualized rate. If you use (say) months, you get a monthly rate which you'll then have to annualize in the usual way, and so forth. On to actually calculating it... We first have the net present value or NPV: N NPV(C, t, d) = Sum C[i ]/(1+d)^t[i ] i=0 where: C[i ] is the ith cash flow (C[0] is the first, C[N] is the last). d is the assumed discount rate. t[i ] is the time between the first cash flow and the ith. Obviously, t[0]=0 and t[N]=the length of time under consideration. Pick whatever units of time you like, but remember that IRR will end up being rate of return per chosen time unit. Given that definition, IRR is defined by the equation: NPV(C, t, IRR) = 0. In other words, the IRR is the discount rate which sets the NPV of the given cash flows made at the given times to zero. In general there is no closedform solution for IRR. One must find it iteratively. In other words, pick a value for IRR. Plug it into the NPV calculation. See how close to zero the NPV is. Based on that, pick a different IRR value and repeat until the NPV is as close to zero as you care. Note that in the case of a single initial investment and no further investments made, the calculation collapses into: (Initial Value)  (Final Value)/(1+IRR)^T = 0 or (Initial Value)*(1+IRR)^T  (Final Value) = 0 Initial*(1+IRR)^T = Final (1+IRR)^T = Final/Initial And finally the quite familiar: IRR = (Final/Inital)^(1/T)  1 A program named 'irr' that calculates IRR is available. See the article Software  Archive of InvestmentRelated Programs in this FAQ for more information. Check http://investfaq.com/ for updates Subject: Analysis  Paying Debts Early versus Making Investments LastRevised: 14 July 2000 ContributedBy: Gary Snyder, Thomas Price (tprice at engr.msstate.edu), lott@investfaq.com , John A. Weeks III (john at johnweeks.com) This article analyzes the question of whether you should apply any extra cash you might have lying around to making extra payments on a debt, or whether you should instead leave the debt on its regular payment schedule and invest the cash instead. An equivalent question is whether you should cash out an existing investment to pay down debt, or just let it ride. We'll focus on the example of a first mortgage on a house, but the analysis works (with some changes) for a car loan, creditcard debt, etc. Before we compare debts with investments, it's important to frame the debate. A bit of financial planning is appropriate here; there are several articles in the FAQ about that. To start with, an individual should have an emergency fund of 36 months of living expenses. Emergency funds need to be readily available (when was the last emergency that you could plan for), like in a bank, credit union, or maybe a money market fund. And most people would not consider these investments. So the first thing to do with cash is arguably to establish this sort of rainyday fund. If you have to cash out a stock to get this fund, that's ok; remember, emergencies rarely happen at market tops. Before we run numbers, I'd like to point out two important issues here. The most important issue to remember is risk. Making early payments to a loan exposes you to relatively few risks (once the loan is paid, it stays paid), but two notable risks are liquidity and opportunity. The liquidity risk is that you might not have cash when you need it (but see above for the mitigation strategy of a rainyday fund). The opportunity risk is the possibility that a better opportunity might present itself and you would be unable to take advantage of it since you gave the bank your extra cash. And when you invest money, you generally expose yourself to market risk (the investment's price might fall) as well as other risks that might cause you to lose money. Of course the other important issue (you probably guessed) is taxes. The interest paid on home mortgages is deductable, so that acts to reduce the cost of the loan below the official interest rate on the loan. Not true for creditcard debt, etc. Also, monies earned from an investment are taxed, so that acts to reduce the return on the investment. One more caveat. If you simply cannot save; i.e., you would cash out the investments darned quick, then paying down debt may be a good choice! And owning a home gives you a place to live, especially if you plan to live in it on a modest income. Finally, all you can do in advance is estimate, guess, and hope. No one will never know the answer to "what is best" until long after it is too late to take that best course of action. You have to take your shot today, and see where it lands tomorrow. Now we'll run some numbers. If you have debt as well as cash that you will invest, then maintaining the debt (instead of paying it) costs you whatever the interest rate on the loan is minus whatever you make from the investment. So to justify your choice of investing the cash, basically you're trying to determine whether you can achieve a return on your investment that is better than the interest rate on the debt. For example, you might have a mortgage that has an aftertax rate of 6%, but you find a very safe investment with a guaranteed, aftertax return of 9% (I should be so lucky). In this case, you almost certainly should invest the money. But the analysis is never this easy  it invariably depends on knowing what the investments will yield in the future. But don't give up hope. Although it is impossible to predict with certainty what an investment will return, you can still estimate two things, the likely return and the level of risk. Since paying down any debt entails much lower risk than making an investment, you need to get a higher level of return to assume the market risk (just to name one) of an investment. In other words, the investment has to pay you to assume the risk to justify the investment. It would be foolish to turn down a riskfree 10% (i.e., to pay off a debt with an aftertax interest rate of 10%) to try to get an aftertax rate of 10.5% from an investment in the stock market, but it might make very good sense to turn down a riskfree 6.5%. It is a matter of personal taste how big the difference between the return on the investment and the riskfree return has to be (it's called the risk premium), but thinking like this at least lets you frame the question. Next we'll characterize some investments and their associated risks. Note that characterizing risk is difficult, and we'll only do a relatively superficial job it. The purpose of this article is to get you thinking about the options, not to take each to the last decimal point. Above we mentioned that paying the debt is a lowrisk alternative. When it comes to selecting investments that potentially will yield more than paying down the debt, you have many options. The option you choose should be the one that maximizes your return subject to a given level of risk (from one point of view). Paying off the loan generates a rocksolid guaranteed return. The best option you have at approximately this level of risk is to invest in a shortterm, highgrade corporate bond fund. The key market risk in this investment is that interest rates will go up by more than 1%; another risk of a bond fund is that companies like AT&T will start to default on their loans. Not quite rocksolid guaranteed, but close. Anyway, these funds have yielded about 6% historically. Next in the scale of risk is longerterm bonds, or lower rated bonds. Investing in a highyield (junk) bond fund is actually quite safe, although riskier than the shortterm, high grade bond fund described above. This investment should generate 78% pretax (off the top of my head), but could also lose a significant amount of money over short periods. This happened in the junk bond market during the summer of 1998, so it's by no means a remote possibility. The last investment I'll mention here are US stock investments. Historically these investments have earned about 1011%/year over long periods of time, but losing money is a serious possibility over periods of time less than three years, and a return of 8%/year for an investment held 20 years is not unlikely. Conservatively, I'd expect about an 89% return going forward. I'd hope for much more, but that's all I'd count on. Stated another way, I'd choose a stock investment over a CD paying 6%, but not a CD paying 10%. Don't overlook the fact that the analysis basically attempted to answer the question of whether you should put all your extra cash into the market versus your mortgage. I think the right answer is somewhere in between. Of course it's nice to be debt free, but paying down your debts to the point that you have no available cash could really hurt you if your car suddenly dies, etc. You should have some savings to cushion you against emergencies. And of course it's nice to have lots of longterm investments, but don't neglect the guaranteed rate of return that is assured by paying down debt versus the completely unguaranteed rate of return to be found in the markets. The best thing to do is ask yourself what you are the most comfortable with, and ignore trying to optimize variables that you cannot control. If debt makes you nervous, then pay off the house. If you don't worry about debt, then keep the mortgage, and keep your money invested. If you don't mind the ups and downs of the market, then keep invested in stocks (they will go up over the long term). If the market has you nervous, pull out some or all of it, and ladder it into corporate bonds. In short, each person needs to find the right balance for his or her situation. Check http://investfaq.com/ for updates Subject: Analysis  PriceEarnings (P/E) Ratio LastRevised: 27 Jan 1998 ContributedBy: E. Green, Aaron Schindler, Thomas Busillo, lott@investfaq.com P/E is shorthand for the ratio of a company's share price to its pershare earnings. For example, a P/E ratio of 10 means that the company has $1 of annual, pershare earnings for every $10 in share price. Earnings by definition are after all taxes etc. A company's P/E ratio is computed by dividing the current market price of one share of a company's stock by that company's pershare earnings. A company's pershare earnings are simply the company's aftertax profit divided by number of outstanding shares. For example, a company that earned $5M last year, with a million shares outstanding, had earnings per share of $5. If that company's stock currently sells for $50/share, it has a P/E of 10. Stated differently, at this price, investors are willing to pay $10 for every $1 of last year's earnings. P/Es are traditionally computed with trailing earnings (earnings from the past 12 months, called a trailing P/E) but are sometimes computed with leading earnings (earnings projected for the upcoming 12month period, called a leading P/E). Some analysts will exclude onetime gains or losses from a quarterly earnings report when computing this figure, others will include it. Adding to the confusion is the possibility of a late earnings report from a company; computation of a trailing P/E based on incomplete data is rather tricky. (I'm being polite; it's misleading, but that doesn't stop the brokerage houses from reporting something.) Even worse, some methods use socalled negative earnings (i.e., losses) to compute a negative P/E, while other methods define the P/E of a lossmaking company to be zero. The many ways to compute a P/E may lead to wide variation in the reporting of a figure such as the "P/E for the S&P whatever." Worst of all, it's usually next to impossible to discover the method used to generate a particular P/E figure, chart, or report. Like other indicators, P/E is best viewed over time, looking for a trend. A company with a steadily increasing P/E is being viewed by the investment community as becoming more and more speculative. And of course a company's P/E ratio changes every day as the stock price fluctuates. The price/earnings ratio is commonly used as a tool for determining the value the market has placed on a common stock. A lot can be said about this little number, but in short, companies expected to grow and have higher earnings in the future should have a higher P/E than companies in decline. For example, if Amgen has a lot of products in the pipeline, I wouldn't mind paying a large multiple of its current earnings to buy the stock. It will have a large P/E. I am expecting it to grow quickly. A common rule of thumb is that a company's P/E ratio should be approximately equal to that company's growth rate. PE is a much better comparison of the value of a stock than the price. A $10 stock with a PE of 40 is much more "expensive" than a $100 stock with a PE of 6. You are paying more for the $10 stock's future earnings stream. The $10 stock is probably a small company with an exciting product with few competitors. The $100 stock is probably pretty staid  maybe a buggy whip manufacturer. It's difficult to say whether a particular P/E is high or low, but there are a number of factors you should consider. First, it's useful to look at the forward and historical earnings growth rate. For example, if a company has been growing at 10% per year over the past five years but has a P/E ratio of 75, then conventional wisdom would say that the shares are expensive. Second, it's important to consider the P/E ratio for the industry sector. For example, consumer products companies will probably have very different P/E ratios than internet service providers. Finally, a stock could have a high trailingyear P/E ratio, but if the earnings rise, at the end of the year it will have a low P/E after the new earnings report is released. Thus a stock with a low P/E ratio can accurately be said to be cheap only if the futureearnings P/E is low. If the trailing P/E is low, investors may be running from the stock and driving its price down, which only makes the stock look cheap. Check http://investfaq.com/ for updates The Investment FAQ is a collection of frequently asked questions and answers about investments and personal finance. This is a plaintext version of The Investment FAQ, part 2 of 18. The web site always has the latest version, including inline links. Please browse http://investfaq.com/ Terms of Use The following terms and conditions apply to the plaintext version of The Investment FAQ that is posted regularly to various newsgroups. Different terms and conditions apply to documents on The Investment FAQ web site. The Investment FAQ is copyright 2000 by Christopher Lott, and is protected by copyright as a collective work and/or compilation, pursuant to U.S. copyright laws, international conventions, and other copyright laws. The contents of The Investment FAQ are intended for personal use, not for sale or other commercial redistribution. The plaintext version of The Investment FAQ may be copied, stored, made available on web sites, or distributed on electronic media provided the following conditions are met: + The URL of The Investment FAQ home page is displayed prominently. + No fees or compensation are charged for this information, excluding charges for the media used to distribute it. + No advertisements appear on the same web page as this material. + Proper attribution is given to the authors of individual articles. + This copyright notice is included intact. Disclaimers Neither the compiler of nor contributors to The Investment FAQ make any express or implied warranties (including, without limitation, any warranty of merchantability or fitness for a particular purpose or use) regarding the information supplied. The Investment FAQ is provided to the user "as is". Neither the compiler nor contributors warrant that The Investment FAQ will be error free. Neither the compiler nor contributors will be liable to any user or anyone else for any inaccuracy, error or omission, regardless of cause, in The Investment FAQ or for any damages (whether direct or indirect, consequential, punitive or exemplary) resulting therefrom. Rules, regulations, laws, conditions, rates, and such information discussed in this FAQ all change quite rapidly. Information given here was current at the time of writing but is almost guaranteed to be out of date by the time you read it. Mention of a product does not constitute an endorsement. Answers to questions sometimes rely on information given in other answers. Readers outside the USA can reach US800 telephone numbers, for a charge, using a service such as MCI's Call USA. All prices are listed in US dollars unless otherwise specified. Please send comments and new submissions to the compiler. Compilation Copyright (c) 2000 by Christopher Lott. 
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