Archive for November, 2008


Stock Beta

Filed Under: Glossary by Bill — 2 Comments
November 18, 2008

You’ll often hear the term risk/reward ratio.  Part of this is understanding how a stock generally moves compared to the market (or other stock, or whatever you’re comparing it too)  There a a few tools or concepts that are helpful in analyzing risk.

Stock Alpha

The alpha measures the return (or loss) compared to the expected return.  If your pricing model predicts a stocks return to be 7% and it has returned 9% then the alpha would be 2%.

Stock Beta

Stock beta or the beta coefficient is calculated using regression analysis.  Essentially it’s a stock’s volatility compared to the market.  Beta of 1 means they move the same, 0.5 means it’ll likely move 1/2 as much as the general market.  Less risk but less reward.  The stock beta of Lowes is 0.83.  So Lowes is less volatile then the general market.

Sharpe Ratio

The sharpe ratio is the (expected return – risk free return)/standard deviation of returns.  This ratio allows you to compare two investment choices and determine which ones has the best possibility of return without adding too much risk to your investment.

Remember, even with your best ideas the volatility can either physically or mentally wipe you out, you have to understand just what the potential swings are and what you can handle before you enter a trade.

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DOW Stock

Filed Under: Glossary by Bill — 3 Comments
November 16, 2008

The DOW Jones Industrial Average is a compilation of 30 US stocks weighted at different levels maintained by The Wall Street Journal. There is no specific stated criteria for a stock to become a DOW Stock however DOW stocks are generally considered Blue chip stocks or stocks with long histories of consistent growth.

Here are the current DOW stocks:

COMPANY NAME TICKER Weight
3M Co. MMM 5.9
Alcoa Inc. AA 1.0
American Express Co. AXP 1.9
AT&T Inc. T 2.6
Bank of America Corp. BAC 1.5
Boeing Co. BA 3.8
Caterpillar Inc. CAT 3.5
Chevron Corp. CVX 6.8
Citigroup Inc. C 0.9
Coca-Cola Co. KO 4.2
E.I. DuPont de Nemours & Co. DD 2.6
Exxon Mobil Corp. XOM 6.9
General Electric Co. GE 1.5
General Motors Corp. GM 0.3
Hewlett-Packard Co. HPQ 2.9
Home Depot Inc. HD 1.9
Intel Corp. INTC 1.2
International Business Machines Corp. IBM 7.5
Johnson & Johnson JNJ 5.6
JPMorgan Chase & Co. JPM 3.2
Kraft Foods Inc. Cl A KFT 2.6
McDonald’s Corp. MCD 5.3
Merck & Co. Inc. MRK 2.6
Microsoft Corp. MSFT 1.9
Pfizer Inc. PFE 1.5
Procter & Gamble Co. PG 5.9
United Technologies Corp. UTX 4.7
Verizon Communications Inc. VZ 2.8
Wal-Mart Stores Inc. WMT 4.9
Walt Disney Co. DIS 2.0

The DOW is listed in nearly every newspaper and talked on the news every trading day.  However, remember that while the DOW is correlated with the complete market it is not every stock.  Just because the DOW is having a down day doesn’t mean everyone had a bad one.

Also, keep in mind when you are looking at a chart of the DOW over a long period of time; the stocks that make up the DOW average changes over time.  This greatly increases the potential variation from the long term trend.

An interesting side note – notice the large fall during the Great Depression.  Even though today’s economy is bad we haven’t realized any fall anywhere similar to that time frame.  Watch the charts and not the news.

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Investing Market – 10 Better Things To Do With Your Money

Filed Under: Investment Strategy by Bill — 9 Comments
November 15, 2008

Ever been up at 3AM and seen some trade signal guaranteeing 100% returns per day or have a friend (cabby, pilot, accountant, burger king guy) tell you a hot tip or about a hedge fund that’s going to make him millions?  Then there is the thousands of books written on investing, trading, and other forms of market manipulation.  This is what I call the investing market.  Often new investors are much more interested in the investing market than the stock market or bond market or futures market or options market.  It’s sad really. 

I’m not saying that all investment how to products are bad things, just how is anyone able to evaluate claims of these packages or services without knowing anything about the true investing market – where you actually buy and sell.  Everyone should know the basics before they buy into a niche program.  Here’s 10 things you should probably do before spending your money in the investing market.

  1. Invest For Yourself- Up the amounts your contributing to your IRA or 401k.  Especially if you’re not receiving the full match from your employer.  Most investment strategies don’t beat the tax savings you’ll receive, especially when you begin to factor risk/reward ratios.
  2. Invest in Yourself - If there is a class or degree that would significantly increase your salary in a job that you would enjoy doing more or moves you in the life direction you want to do, go do it!  Trust me you are smart enough and you have the time.  In fact I’m going today to go check out an MBA program.  Not that I want to work a 9 to 5 forever, but I can still increase my salary to a much greater percent then my investment income per amount of effort.  Sometimes that’s just the truth of it.
  3. Read classic investment / stock trading books -  Some of my personal favorites are Reminiscences of a Stock Operator and Security Analysis.  Avoid investing market books like “how to make a bazillion dollars in 30 days with no risk because I did it while in a coma with one eye and so can you!!”
  4. Pay Down Debt – If you have credit cards with 24% interest then you’ve just found yourself a guaranteed 24% return for awhile.  Ha! Beat that investing market.  I’m writing a 1 page site now that just says pay your high interest debt and marketing it at 3AM, I’ll be rich Bwaahahaha!
  5. Take a couple days off – Use the money to pay your bills since you didn’t work and use the time to read investment blogs and sites.  You’ll learn some basics and hear the good and bad about thousands of investment marketing items.
  6. Go for a long shot – Do you have that high risk, high leverage, insane return idea floating in your head.  Go for it – it’s better than most of those investment products out there and you’ll learn a lot about yourself, your risk tolerance, and how your ideas match your strategy.  Plus it may hit and you can send me a large sum of money as a thank you for encouraging you.
  7. Buy a new outfit- That’s right, go shopping, and then in your new spiffy clothes go out and meet some people outside of your friends circle.  A good professional group of contacts can do amazing things.  My group of long time friends are amazing for all sorts of personal issues, but when I want to bounce an idea off them involving LEAP pricing most of them just glaze over.  But a group of investors or accountants, or entrepreneurs may be thrilled.  It’s good to know people.
  8. Donate – Sometimes after reading, writing, dreaming, and thinking about money for the 48 hours straight it’s good to remember we are human.  Donate to your favorite charity or church instead of placing another book or CD on your shelf you weren’t going to read anyways.  The dividends on an donation go way beyond monetary value.
  9. Get a faster computer / Internet connection – When it comes to investing or trading information is king and if you only have 1 hour per day to learn or practice your strategy you don’t want to spend that time waiting for websites to load, or have your computer freeze in the middle of that perfect trade.  No investing market product will help you if you’re disconnected from the market.
  10. Take your significant other on a vacation- An unhealthy relationship will destroy your financial life faster than any bad investment.  The emotional strain will distract you and legal and impulse buying cost can get ridiculous also.  So remember to take time with those who are important to you, keep first things first, then crush the stock market.

Remember, every time you choose to buy something you could be buying something else.  Caveat emptor.

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How To Value A Stock

Filed Under: Fundamental by Bill — 2 Comments
November 11, 2008

There are many methods for evaluating the value of a given stock; today I’d like to write about the pros and cons of a few of the more common methods.

Free Cash Flow (FCF)

Free Cash Flow is equal to Net Income + Amortization / Depreciation – Changes in Working Capital – Capital Expenditures.

What is good about free cash flow for evaluating a company is that free cash shows a company’s ability to pay down debt, buy back shares, or pay dividends in the present.   These are very shareholder friendly activities.  Many investors spend much effort focusing on earning estimates, however earnings often factor many “guesstimates” and balancing cost of goods sold with various depreciation rules, free cash flow focuses on the real money.

A company with declining or negative free cash flow may be forced into a debt cycle or be forced into bad deals to get financing for operations.  However, a company may also have increased R&D or financing to improve operations and this may be a huge payoff in the long run.  So verify each of the components of the free cash flow to determine if you like where the money is going.

Operating Cash Flow (OCF)

Operating Cash Flow = Earning Before Interest and Taxes (EBIT) + Depreciation – Taxes

This is the money a business generates through its operations.  What I particularly like about this is that it adds back depreciation as this isn’t truly money spent.  A common suggestion is to verify operating cash flow hasn’t fallen with improving earnings.  If this happens it may be a sign that the company is using funny accounting tricks to temporarily boost earnings.

Free Cash Flow For The Firm (FCFF)

This is another measure that calculates how much cash the company has left after all it’s true expenses.

Free Cash Flow For The Firm = Operating Cash Flow – Taxes – Changes In Net Working Capital – Changes In Investments

Dividend Discount Model

The dividend discount model takes expected future dividends and brings them to present day money.  The formula is Future Dividends Per Share / (Discount Rate – Dividend Growth Rate).  If the outcome of the Dividend Discount Valuation is greater than the value of the stock than the stock may be undervalued.  The problem I have with this formula is it’s only as good as the assumptions you make.  The dividend growth rate may change suddenly because a company was paying too much in dividends and ran out of cash or your discount rate may be different than someone else’s discount rate.  Whenever I have the ability to tweak a variable I may tweak that variabe to match my emotions on the stock.  This is a dangerous path for my style of investing, you need to know if emotions get in your way also.

Discounted Cash Flow (DCF)

With the discounted cash flow valuation you estimate the Free Cash Flow projections as far out as reasonable and then use your discounted rate to bring those cash flows into today’s dollars.  It is nearly impossible to estimate cash flow too far in the future so often after 10 years or so a simple annuity – or fixed rate of return is assumed.  If you have the information to make good to great estimates of free cash flow this can be an incredibly powerful tool to compare one company to another from a true investment point, however, it is subject to being only as good as the numbers as you plug into them.

I hope you enjoyed the quick summary of fundamental valuation tools.  There are many more variations of these including other types of growth models.  Also, many of these valuations can also be used in various ratios like Price / Free Cash Flow to compare one stock to another.

Let me know what valuations you use and why you prefer them.  Are any of them good linked with technical indicators?

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