Welcome to another blog post by me, LJ Nissen. In this guide we are going to be talking about technical analysis for beginners.
When I first started out trading a few years ago there weren’t too many resources available for rookie traders.
Sure, there were tips on which stocks to trade and how to do it with technical analysis, but not from a point of view where the whole situation was considered.
As a result I made enumerable mistakes where I lost almost all my money – doing what I otherwise really wanted to do.
The situation felt awkward.
After many years working in a very interesting field – scientific research – I had finally found my passion, but now I couldn’t do it because I didn’t have the resources.
It felt frustrating so in this article I wanted to change that.
Here I want to help you find your way around the technical terms used when trading stock.
I would like to give you a bottoms-up guide of the whole process.
A process that will span everything from your personal finances and online brokers to methods of trading that are good for beginners.
So let’s dive in!
If you don’t mind, I’m going to start with a few assumptions that I make about you.
The reason for me doing so is that it helps me as author of this guide to help you with technical analysis.
The assumptions are probably not completely correct, but close enough for you to have an interest in what I write:
I’m also going to assume that you at least have a basic understanding of how the internet works.
Even if these assumptions are off by far you will get value out of this article anyway. So please continue reading!
One big advantage that you have when you are betting on the race track over somebody trading is that you always bet a fixed amount.
You go up the counter and put a 20 dollar bill to bet on a specific horse in a specific race and then you watch the horses run.
What will happen if your horse does not win?
You will only have lost your 20 dollars.
When you are trading you do not have that advantage. If a trade goes against you, you can lose more money than anticipated.
That is why trading the stock market can be a very dangerous game if you have people that are financially dependent on you.
So what you need is a system where you know in advance how big your gains and losses will be.
What the systems does is that it takes the emotion out of your trades so that you can focus on executing them.
There are several systems that you can use.
What I will propose in this post is a system that works for me, but it may be that you have come up with a better one.
The point being that you need to limit your losses and maximize your gains and the only way to do that is by being systematic about your trades.
That is the only way to make money consistently.
My first advice if you are only starting out is to start small.
My recommendation would be to start with a minimal account of 10000 USD.
In that way you will have a good balance between making gains and limiting losses.
The amount is small enough so that you can live with the losses that you will inevitably make while learning.
At the same time the amount is big enough so that you can feel the gains when you make them.
That is the main reason why I don’t like to trade with demo accounts.
After all what’s the point in trading if you don’t reap the rewards?
The problem if you are using a too small amount is that you will not be able to reap the rewards of a good trade when you make it.
Similarly if you are using a too big amount to start with you will feel stressed every time a trade goes against you.
This is the mindset that you need to learn:
Not all of your trades will be beneficial and some of your trades will go against you.
Of course, the opposite is also true in that you can also expect some gains, but this should not be a cause for being cocky.
Another thing that is crucial when trading is to keep a record of each trade.
That can be a hand written journal in a file or in electronic form. It really doesn’t matter.
That way you can go back and review what had happened to a particular trade, when you got out of the trade or if you were stopped out.
In this way trading is a lot like doing experiments in the lab (my former profession).
The most important thing in research is the lab journal and the same goes for trading.
In the journal you should always note things like date and time, points of entry and exit and how much money you had put into that particular trade.
I cannot stress the importance of the journal strongly enough. Please keep one for your own sake.
That way you can go back to your trades, review them and see what worked and what did not work and why.
Now, companies usually report their earnings four times a year and the price swings happening after those results have been published can be violent.
Those price swings are not coming from the results themselves but from the expectations of the results.
For example, if the market expects company ABC to have consistently good earnings, but ABC misses slightly on earnings growth, the sell-off that can follow may be violent.
Under those circumstances you don’t want to hold your stock and it is better to get out.
If there is one thing that I have learnt in life it is that we all need systems in order to function.
It can be a system of movements that you are performing every day when you are in your car or it can be a system when dealing with your daily chores.
It doesn’t matter what it is. We all need systems to make life easier.
This is especially true when you are trading.
Well, for one you need a system that will limit yourself to the downside as well as to the upside, but the bottom line is that you need those rules in order to function.
What does not work is to live life without the constraints of rules. Then everything from cleanliness in the house to a healthy food intake will start to fall apart.
So what rules can be applied to trading?
In essence, we need a system where we can:
It is as simple as that.
Trying this out, the best thing that I’ve come up was developed by Quint Tatro of Tatro Capital.
Experimenting with this back and forth, the method is what I now call the “3-step” method.
What you do is that you set aside a small percentage of your account for each trade.
That will be a small amount in the order of magnitude of 0.5% of your total account.
It is very important that you do not exceed this amount under any circumstances.
Remember that your money is the life blood of this business.
By using technical analysis you will then be able to identify where to get in and – most importantly – where the particular trade is no longer viable.
That point will be your stop.
Now, whatever happens always respect your stops.
That point cannot be stressed enough.
You don’t want to find yourself in a situation where you lose copious amounts of money and only seeing the losses getting bigger and bigger by the hour and minute.
Now the advantage of doing this is that you can then calculate how much you would lose if the trade goes against you and you reach your stop.
That way you know exactly how much you are betting. In this way, trading gets similar to the race track.
So let’s get into some numbers.
What I prefer is to use a spreadsheet for this purpose, but you can do it any way you want.
The calculations will look something like this:
Figure 1. Spreadsheet of entry and exit points when using the 3-step method of trading stocks.
In Figure 1 you can see how we plan our trade.
We will get in at a particular price, in this case 9 USD.
Now if the trade does not go in our favor we will be stopped out 8.5 USD.
What we will then do is to calculate the differential between our entry point and our stop and add that value to our entry point.
In this case it would be:
9.0 USD – 8.5 USD = 0.5 USD.
If we add this to our entry point we will have what I call 1x.
Then when we set up our trade we can define at which point we will get out.
What you will then do is to get out at three instances: 1x, 2x and 3x.
We take one third off at each exit point.
Now we have set up a system that:
These are the two main characteristics that we want from a trading system: The ability to know how much money there is at stake and to be able to sleep at night.
The method may seem awkward at first but when you get used to it, it becomes second nature.
Please take a few moments to familiarize yourself with the steps before implementing them.
Now we have come to the part where I will introduce you to the technical patterns involved in trading.
Of course the charts themselves are not a prediction of how the market will behave, they will merely lay out what is probable based on experience.
My favorite technical indicator is the moving average.
What the moving average does is that it takes the average opening and closing values and plot them in a curve that will be displayed in the chart.
When looking at charts I usually display three moving averages which are good for different purposes.
I’m using the 10-period, the 20-period and the 50-period moving averages.
In Figure 2 there is an example of what I mean.
Figure 2. Weekly chart of the exchange traded fund GLD in August of 2015. The 10-, 20- and 50-period moving average are shown in yellow, red and blue, respectively.
When I look at a weekly chart, the intermediate term movements will be determined by the direction of the 50-week moving average.
Similarly, the 10-week moving average will tell you more about the direction in the short term.
Now, the 10-week moving average is for all intents and purposes similar to the 50-day moving average.
If your stock is trading above the 50-day moving average it is a bullish sign near term.
If, on the other hand it is trading below the 50-day moving average it is bearish.
The 10- and 20-period moving averages are useful for looking at the movements that are extremely near term and personally I don’t find them to be particularly useful.
One thing that must be grasped with chart movements is the concept of resistance and support.
This goes back to the mass psychology of the markets and tells you when the last trader is changing his or her position.
A resistance zone will appear when there are enough traders willing to sell stock at a particular level.
Similarly, a support zone appears when traders are willing to buy at a particular level.
Let me illustrate what I mean with a chart.
In the chart, a support zone is found at the 100 USD level and similarly a resistance zone is found around 200.
Figure 3. Chart of the ETF BOIL illustrating the concept of resistance and support zones.
When a support or resistance zone is then finally broken, the chart will move out of the zone without hindrance and the moves can be violent.
Again, mass psychology can explain what happens.
There is no one willing to buy the ETF beyond the 230 level and once it drops below support at the 100 USD level it will quickly move down to a new support level around 40 USD.
One of the more effective chart patterns is a reflection of the above, the pennant.
In the pattern, a resistance zone and a support zone is gradually merged together reducing the volatility in the trading of the stock.
What it means is that buyers and sellers are gradually moving closer to one another and when one of those finally gives way the move will be particularly violent in either direction.
Figure 4. Daily chart of the dollar index, DXY0, illustrating the concept of a pennant.
Resistance and support zones are here represented with converging straight lines.
Head and shoulders patterns appear when discrete moves out of resistance/support zones can be observed.
The chart may first have broken out of resistance only to find itself with a new level of resistance higher than the first where it is then trading for a given amount of time.
If it cannot hold this level and falls back to the first level it will find that the old level of resistance is now support and the chart will move sideways for some time.
What then happens is that this support zone is gradually giving way and when it is up the chart action will be particularly violent.
The fall can then be semi-quantified in that the move from the first resistance zone to the second (left shoulder to head) will also apply to the right shoulder.
In Figure 5 there is an illustration of the chart action.
Figure 5. Head and shoulders chart action. The zone of resistance of the left shoulder is represented to the left, the head in the middle and the right shoulder to the right. The distance, d, between the left/right shoulder and the head can be applied to quantify the size of the move.
In this article I’ve been talking about the need to start small if you are an aspiring trader and want to start out with technical analysis.
If you are a beginner I suggest you to use somewhere between 8000 and 10000 USD in your trading account.
That amount is big enough so that you limit your losses when they occur and at the same time lets you dip your toes into the gains that can really be made.
What I’ve also been talking about in this article is the need for a system that takes the emotion out of your trades.
The best system that I have come up with is what I call the 3-step method of trading stocks.
What it does is that when a particular trade is identified a small percentage – usually 0.5 % – of your total trading account is committed.
The first thing that you then do is that you identify your stop which will be the point where you will have to admit failure and move on.
Not to do this is a very dangerous game so always respect your stops!
You will then measure the distance between the stop and the entry point in the chart to identify the 1x, 2x and 3x points which will be your exit points.
I have also talked briefly about different chart patterns. What they mean, their limitations and how you can use them to your advantage.
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Published August 20’th 2015.
This time we will look a bit more in depth on how to use Microsoft Excel for financial calculations.
What we will look at today is Financial statements and how to use them in order to understand the financial health of a company.
In particular we will look at:
The first thing to grasp is that we will look at the numbers and look at them through the eyes of people in finance.
They use the numbers differently than the people in accounting and we will show you how.
In the last article we talked about this formula:
Assets = Liabilities + Equity
Everyone in finance is using this equation and not just in finance but also in accounting.
What the Balance sheet does is that it reflects the equation.
The Balance sheet is a snapshot of the Firm’s account balances at the last day of the reporting period.
The assets are divided into Current assets and Non-current assets where the Current portion is assets that can be turned into cash within 12 months.
Then per definition Cash is a Current asset. Then we Accounts receivable which is accounts that will be cash soon. Inventory is another Current asset. The whole point of inventory is so that you can sell it and get cash.
The Current assets are important not only in finance, but also in accounting, auditing and banking. It’s very important to see a business’ Current assets, because if they don’t have very many current assets perhaps they cannot pay their bills.
The Non-current portion are fixed assets that cannot be easily transformed into cash. These are your buildings, your trucks or patents or the long-term assets that actually define your business.
This is what you’ve invested in because you think you can make a profit from this.
In a financial statement you will see different periods. That is because you want to compare one year’s numbers to another.
We will also talk about the other side of the equation, which are the liabilities. These are the funds that the company have at its disposal.
The company either goes out and get debt (current), it borrows money long-term (bonds) or it issues equity to get its funds which means the cash it is going to use to buy its assets.
Current liabilities are liabilities that need to be reimbursed within a year – much like the current assets which are assets that can be converted into cash within a year.
Current liabilities are the bills the company need to pay within one year.
As you can see, within the current liabilities there are two items Accounts payable and Notes payable.
Accounts payable is when the company goes out and buys products that it has to pay for. Notes payable is when the company borrows money that it has to reimburse within a year.
The combined current liabilities and non-current liabilities represent debt on the balance sheet.
In cell A19 you can see that we’ve written Common stock and paid-in surplus. What that means is that if the company issues common stock and they are being priced at $22 but were supposed only to be worth $20, the paid-in surplus is the $2 that the stockholders pay in order to own the company.
Retained earnings belong to the shareholders and they are to be paid back to the shareholders in the form of dividends, but sometimes they are not.
If they are not paid out to the shareholders they can be used within the company in the form of investment.
The way to account for such a situation is to label the item Retained earnings.
Finally we add it all up. First we calculate total liabilities which is the sum between current and non-current liabilities.
Then we calculate total liabilities plus shareholders’ equity which is just what it sounds like.
Why is it called the Balance sheet?
That’s because there’s an equal sign in the formula Asset = Liabilities + Equity which means that the two sides have to balance each other.
So what I do in cell B24 (Figure 2) is that I add the total assets from Figure 1 in cell B18 and in cell C24 (Figure 2) I add the Total liabilities and Shareholders’ equity from cell B22:
The result that we get in D24 is then TRUE.
Remember that Current assets are assets that the firm easily can convert into cash and that the Current liabilities are the bills that the company needs to pay within 12 months.
If your current liabilities are greater than your current assets it means you’re in trouble and you need to find cash somehow.
The Net working capital is the term that is used and it is defined as Current assets – Current liabilities.
The Net working capital is the short-term capital that the firm has to work with.
We will use the Net working capital when we do our cash flow calculations and we will also use it in the next chapter when we do analysis of financial statements.
In accounting you will see that the term Net working capital is used but in finance the term Capital is used more broadly for all assets.
If we now have our Current assets and Current liabilities on different sheets like this:
If we now want to calculate the Net working capital we do it like this:
In the sheet Working capital we type an equal sign in cell D16.
We then click on the sheet Assets in Figure 5. and we click on Current assets (cell B13):
If we look in the formula bar in Figure 7 we see that we have now activated cell B13 in the sheet called Assets. The exclamation sign means that we are using a different sheet for our data.
We then type a “-“-sign (1) and click on the “liabilities”-sheet (2) in Figure 5:
Then we click in cell B16 and hit Enter and we are immediately brought back to the Working capital sheet.
What’s important to remember here is not to click on Working capital sheet but rather hit Enter (if you don’t hit Enter your formula will be ruined).
If we then go back to the Working capital sheet and hit the F2 key, this will appear:
Of course, different businesses have different values for their Net working capital, but in general, the number should be positive.
We will then turn our attention to Liquidity:
Liquidity is important because if you run out of it you’re in trouble.
If your working capital is getting too small then maybe you have to sell assets to get cash for the company.
Liquidity is defined as:
How quickly an asset can be converted into cash.
Furthermore, liquidity has two dimensions:
There are highly liquid assets which can be sold quickly without loss of value. (This can be inventory or a short-term investment).
How liquid is cash? That is the most liquid.
How liquid is accounts receivable? You can quite easily convert accounts receivable into cash. In fact you can sell those assets to bank and get cash in return.
The we have illiquid assets which are assets that cannot be sold quickly without significant price reduction. Examples of this are machinery and buildings.
You can almost sell anything if you reduce the price enough.
On the Balance sheet the items are usually listed in decreasing liquidity so that the most liquid assets come first.
Another aspect of liquidity is that businesses that have it can go out and get a loan easily.
A firm needs a positive working capital in order to pay its bills, but there is another aspect to it:
The reason why a lot of companies are keeping a lot of cash on their balance sheets is so that they can go out and buy other businesses quickly.
The last point is that you probably don’t want to have too much cash on your balance sheet because it doesn’t earn any return.
We will then turn our attention to building a balance sheet:
The first thing that we want to look at is assets. What I do is that I type en equal sign in cell B10 and then I write SUM( and I highlight cells B7 and B8:
Then we do the same thing for the liabilities in cell E7 and E8:
The result in E10 will of course be $550.
How are we then going to calculate the equity? If you remember the fundamental accounting equation:
Assets = Liabilities + Equity
In other words:
Equity = Assets – Liabilities
So what we do is that we take the assets and we subtract the liabilities:
Then finally we can check that liabilities and equity equal assets, like so:
And the result in cell E12 is of course $1650.
In finance we have Assets which are the use of the funds and on the other side of the equation we have Debt and Equity. Debt and Equity represent the source of funds:
If we look at the Source of funds we will see that there are two different items: Debt and Equity. What is the difference between the two?
The debt is a Fixed claim and is something that you must pay back to the lender at some point in the future + interest.
The Equity on the other hand is Residual claim which means that you as a company does not have to pay the holder back
If I go out and buy a stock of ABC Corp. in the stock market for $50, the company does not have to pay me back if the stock loses value.
If the company goes bankrupt and there isn’t enough money around to pay off the creditors I get nothing. Residual means “left over”.
Then we have dividends which are only paid out once there is something left over.
Why then would anybody like to do equity if it’s always residual?
It’s because of the upside. If you invest in a well run business with equity that is steadily growing then you can make a lot of money.
Interest expenses (cash out) are tax deductible. This means that when you are paying your taxes you will pay a little bit less if you have interest payments.
Let’s say that you are paying $2500 in interest then if you deduct the interest payments you will less than that (let’s say $2300).
On the other hand dividends (cash out) are not tax deductible which means that there is a slight advantage of using debt.
The creditors are also paid first during bankruptcy while if you have equity you will get whatever is left over.
We will now turn our attention to debt:
The question of whether to use debt or equity to raise funds is called Capital structure.
The term Financial leverage is used when the firm has debt. If you are using debt wisely you can reap the benefits of having your debt tax deductible and put the capital to productive use.
The more debt you have, the higher your leverage.
Leverage can magnify both gains and losses.
This will be the last topic that we will cover about the Balance sheet:
The Market value is the amount that you would get if you sold your equity stake.
For financial assets like stocks and debt you can go out and see what the value is every day.
But for a lot of equity this is not really possible so we need to estimate the market value.
Otherwise you do not know for sure until you sell your asset.
For fixed assets like machines and trucks finding a market value becomes much more difficult.
That is why accountants have invented the Book Value.
When I buy the business outright, the machines, the buildings and the inventory, that receipt is telling me what it is and will be the sum that I’m going to record.
That is also called the Historical cost principle and it is required by the Generally Accepted Accounting Principles (GAAP).
Then the Book value of the company often does not take into account the company’s most valuable assets such as:
These are all intangible assets, but it can be tangible assets also where the value of the assets can change radically from the price that you paid.
The Market value of an asset is almost always different from the Book value.
The goal of the financial management is to maximize the market value of the stock. At least in theory this is a good thing.
That means that the financial manager is more interested in the market value than he or she is of the book value.
We are given these numbers so we don’t have to research them:
Now we will calculate the Book value of the assets and we begin by adding cell B5 to the Book value in cell B16:
We then add the Book value of the Fixed assets to cell B17:
Then we do the same thing for the Market value. We begin by adding the Net working capital to cell C16:
We then continue the Market value of the Fixed assets (cell B4):
Finally we highlight cells B18 and C18 and use the keyboard shortcut Alt + =.
What that does is that it calculates an auto sum of the numbers above it:
We can then see that we have different numbers for Book and Market Value.
Finally we do the same thing for liabilities.
First we assume that the Book and Market value for the Long-term debt is the same:
So what is then Shareholders’ equity?
Remember the fundamental accounting equation in Figure 16:
Assets = Debt + Equity
That means if we fill in Total assets from cells B19 and C19 into B27 and C27:
we can then calculate Shareholders’ equity by subtraction:
Then we do the same thing for the Market value in cell C26.
The final result is like this:
In this section we will talk about the Income statement.
The Income statement is different from the Balance sheet in that it shows revenues, expenses and net income for the whole period.
On the other hand, what the Balance sheet showed us was valid just for a particular day.
The first thing that we are going to look at is the Revenue:
Total Revenue is the accounting term used for the Total sales of the business during the period.
Then we have Net sales which is the Amount earned by the business from delivering products or services.
You get this from taking the Total revenue and then subtracting any expenses.
Another thing that is important to recognize is that the company cannot record revenue before the product is delivered to the customer.
In accounting that is called accrual accounting.
The definition of accrual accounting is this:
As you can see there is both an Expense and Revenue meaning of the word.
If the business receives a bill and it isn’t due until 30 days later, they have to record the expense at the earlier date.
This is then an example of a hypothetical Income statement:
As you can see the statement is valid for the whole period ending on December 31, 2016.
For publicly traded stocks the reporting periods are either annual or by quarter.
In Figure 31 you will find a made up Income statement:
An Income statement is profit or loss for the whole period ( in this case the period is a whole year.)
We have our Total revenue and Cost of goods sold.
If you sell a widget for $100 and you paid $50 for it, you will record $100 as revenue and $50 for cost of goods sold.
If you look in cell C6 you will find an item called Depreciation and this is where accrual accounting comes in.
This is where the cash may be spent at at a different period from where it is received. We will look into when to book an expense like that.
It could come as cash, or it could come later as accounts receivables as we saw in the balance sheet.
Then we have Earnings before interest and tax which we get by subtracting Cost of goods sold and Depreciation from the Total revenue.
We calculate this by adding a formula. We first take Total revenue in cell C4 and subtract the sum between the Cost of goods sold in cell C5 and Depreciation in cell C6:
The result in cell C7 is then of course $1,928,000. We then do the same thing when we calculate the Taxable income by subtracting Interest paid (C8) from Earnings before interest and tax (C7):
The result in cell C9 is of course $1,856,000. Finally we are doing the same thing when we are calculating the Net income in cell C11 by subtracting taxes in cell C10 from Taxable income in cell C10:
The final Net income in cell C11 is then $1,536,00. The Net income (or the Earnings) can go in one of two places. Because technically they belong to the shareholders they can either be paid out in dividends or they can be plowed back into the business to buy more assets.
Generally if the company keeps a lot of retained earnings, it’s because they have good ideas of to make the company grow.
If we go back to the Balance sheet (Figure 8) and take a look at the item that is called Retained earnings, we now understand where that item comes from.
So in order to calculate how much money ABC Corp is keeping to plow back into the company we need to take the Dividend (cell C13) and subtract from the Net income (cell C11):
We will also consider the total number of shares outstanding. This means that at this particular date, the 31 December 2016, there were 210,000,000 shares outstanding.
Then we can calculate Earnings per share by dividing Net income (cell C11) x 1000 (because our numbers are divided by 1000 to begin with) by Shares outstanding (cell C15).
The formula looks like this:
The result in cell C16 will then be $7.31.
After that we continue with Dividend per share where we divide the Total dividend paid out in cell C13 (x 1000) with the total number of shares outstanding (cell C15):
The result in cell C17 will then be $0.31 which means that in this case the company keeps a lot of the earnings.
Then we come into the subject of depreciation:
In the following example we are using trucks for FedEx for $10 million with a Salvage value of 500,000 and an estimated time in use of 7 years:
The salvage value is what you would get out of your investment in a fire sale:
What this means is that if the cash goes out the first year, but that the Depreciation event is accounted for every year.
That means that there is no cash associated with it because it all went out the first year.
To give you an example of what I mean we first need to discuss the Matching principle:
This is part of the concept of accrual accounting that we discussed earlier in this chapter. What it means is basically that we need to add revenue and expenses in the right period so that they finally add up.
If we then look at Figure 39 again we see that we have a linear depreciation for our purchase of the assets over 7 years.
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Hormel Foods produces and commercializes various meat and food products.
The company is expensive at a trailing P/E of 21.5 and considering an average of the past three years’ earnings it looks even worse at 26.3. The Book value is negative due to the high Goodwill component of the Balance sheet which consequently gives a negative Price to Book value.
The Current assets to Current liabilities ratio looks good at 1.9 with a Net working capital of $975 million. The biggest problem for Hormel is its debt where the Debt to equity ratio is very high at 5.0.
The Free cash flow last year came in at $735 million which equates to $1.36 per share. The Free cash flow allows the company to pay out a dividend 58 cents (1.7%). The dividend has been uninterrupted and increasing for more than 25 years which makes the part of the Dividend aristocrats.
Hormel would be a good investment if it was about half the price, but now it is too expensive for me. I would not buy new stock at this point, but if you already own it by all means : HOLD.
Guillemot makes hardware for DJ’s and for the gaming industry. The company is based in Brittany – France and its has a Total revenue of €64,200,000.
The company seems reasonably valued at a P/E of 9.2. However, its earnings history makes the current P/E ratio a bit deceptive. Its result last year was positive, but the previous four years it made a loss. Altogether Guillemot’s earnings need to be taken with a pinch of salt.
The Price to book ratio looks alright at 1.4.
The company has a negative free cash flow and consequently it does not pay any dividend (which considering its erratic earnings history is not strange).
The company has a Net working capital of €21.4 m which tells us that the company can pay its bills in the short-term. The Debt to equity ratio, on the other hand, is high at 1.2. The Return on equity is a feeble 11%.
Guillemot is an interesting company with a lot of potential. However for somebody looking for value in the small-cap space its earnings seem to be a little bit too erratic.
S&W Seed Company is an agricultural company that is specializing in the breeding, growing and commercialization of alfalfa seeds.
SANW is expensive at trailing a P/E of 172. The average earnings over the past three years is looking even worse at a negative 6 cents.
Consequently the P/E ratio over the average three years is negative.
The Price to Book value is 2.9 which is very high.
The earnings are to say the least erratic over the years. Last year they 2 cents per share and the year before the company had a loss of 25 cents per share.
The Shiller earnings since 2009 are a negative 4 cents.
Then we come to the balance sheet and here things looks a little better.
The Working capital is a solid $16,000,000 which equates to $1.08 per share.
The company has a Debt to equity ratio of 0.9 and a Current assets to Current liabilities ratio of 1.4.
The company has a good Free cash flow of $4,000,000, but they do not pay out any dividend which seems reasonable given their non-existent earnings.
S&W Seed has great potential, but it is not an investment for me at current prices.
PDL BioPharma Inc. has two major sources of income: They generate income from royalty agreements from bigger pharmaceutical companies and they sell generically manufactured products in the United States and in Europe.
The stock is very cheap at a trailing P/E of 5.7 and the P/E for the average 3 preceding years is 1.6 which looks very cheap. The price to book value is 0.5 which is also very good.
The Balance Sheet looks very good working capital and low debt levels. The only thing that is wrong with the company is the decreased earnings for 2016 compared to 2015. The lower earnings continued in Q1 of 2017 which indicates structural problems.
The company’s free cash flow is a solid $100 Million which equates to $0.62 per share. Of this they were only paying out 10 cents in dividends last year but their dividend history seems a bit erratic.
The company is active in a niche which is highly dependent on clinical trials and permits from the NIH which makes it tricky. But if you are like me and you are looking for cheap stocks and low valuations PDL Biopharma certainly looks cheap at these prices.
Quarto Group is lossmaking so a trailing P/E value does not make sense.
However, when looking at a P/E with the average past three years’ earnings it becomes 18.4 (when taking into account last year’s loss).
The Shiller P/E over 7 years comes in at 11.7 so the company does not look overvalued.
The company has a lot of goodwill which will be subtracted from the equity in order to get to Book value.
The equity valuations are therefore not looking good.
Debt to equity is 3.6 and and Price to Book value is 19.2.
Free cash flow is good at $40 million which allows for a good dividend of 10 cents.
Quarto has a history of paying out uninterrupted and increasing dividends for more than ten years.
If you can live with the fluctuating earnings then Quarto Group Inc. is actually not expensive.
However the debt situation of the company makes it tricky. At current prices I would call it a HOLD.
Last week I listened to an interesting interview with the famous gold investor Martin Armstrong on Eric Townsend’s Macrovoices.
In the interview Armstrong lays out a bullish case for stocks even if he recognizes that they are already overvalued.
The reason Armstrong gives is that bond yields are so low that stocks by default look attractive.
This especially is true for well ran companies with solid earnings, low debt and good dividend yields.
This brings me to today’s stock which is Cummins Inc.
The stock is expensive at a P/E ratio of 19.3 and taking the average over the past three years it only becomes marginally better at a P/E of 19.0.
The Price to Book ratio is 4.2 which is exceptionally high.
The company earns a Free cash flow of $1.4 billion which allows them to pay out a reasonable dividend of $4.00 or 2.5%.
The dividend history looks good with consistent and increasing dividend payments for more than 15 years.
The Balance sheet looks good with a Net working capital of $3.8 billion and a Current assets to Current Liabilities ratio of 1.8.
The Debt to equity ratio is 1.1 which is on the high side in my opinion, but nothing out of the extraordinary.
Cummins Inc. to me looks overvalued at current prices. It is however a well run company with solid earnings and cash flow. Had these been normal times I would not have bought such expensive shares, but Martin Armstrong may be on to something.
Dillard’s is traded on the New York Stock Exchange under the ticker symbol DDS.
Dillard’s is a well ran business with solid earnings, solid cash flow and overall performance.
The trailing P/E ratio 11.2 and the P/E over the average three years is 8.4.
Free cash flow is healthy at $412,000,000 which corresponds to $12 per share.
The dividend is also at a paltry 26 cents per share which is too low considering the Free cash flow.
But DDS’ overall financials look more than reasonable.
For instance, the ratio between Current assets and Current liabilities is 1.9, but the Debt to equity ratio is a little bit high at 1.3.
Return on equity is 10%.
Negatives are that the company is involved in buying its own stock which only favor the ones who are selling the stock.
Dillard’s seem reasonably priced with a good Free cash flow, but with a high Debt to equity ratio.
I would consider the stock as a BUY at these prices.
Today I will look at one of the best value Faroese companies around: P/F Bakkafrost A/S.
The company is traded on the Norwegian Stock Exchange under the ticker BAKKA but they report their financials in Danish kroner.
Bakkafrost looks cheap at a P/E ratio of 7.9, but when looking at the average of the past three years’ earnings it comes in at 10.8 which does not look that impressive.
The Price to book ratio is 3.0 which is not cheap.
The Balance sheet on the other hand looks more than OK. The company has a Debt to equity ratio of 0.5 and a Working capital to debt ratio of 1.6.
Current assets to current liabilities is very good at 7.2.
The company has a Free cash flow of 163 Million DKK which equates 3.34 DKK a share.
This does not pay for the dividend at 8.70 DKK per share, but the dividend has been steady and increasing for the past 5 years.
Even if the stock is not really cheap at 206 DKK, I would still consider it a BUY today.
Today I will take a look at one of the best run French companies: Inter Parfums SA (ticker (Paris): ITP)
Inter Parfums is a cosmetics and perfume company based in Paris.
The company is very well run with solid earnings and cash flow.
However, for the stability you will have to pay. The trailing P/E ratio is 30.0 and the P/E ratio over the past trailing years’ is 32.6.
The Price to book value is a hefty 4.1.
The balance sheet looks very good: The company has a Working capital of €280 million and a Debt to equity ratio of 0.4 which is considered to be low risk.
The ratio between Current assets and Current liabilities is also good at 3.5.
Cash flow and dividend:
The company has a Free cash flow of €42 million which equates to €1.28 per share.
Of this they pay out a dividend of €0.50 which amounts to a yield of 1.7% – a reflection of the high price.
In summary I would not buy new stock at these prices. However, if you already own it I would hold on to the stock and keeping on reinvesting the dividend.
Today I would like to look at fundamental analysis of The Cato Corporation (ticker: CATO).
The company is an extremely well run apparel business based in North Carolina.
The trailing P/E value is 9.0 and if you look at the preceding three years’ earnings the P/E comes in at 10.1.
The Price to Book is a healthy 1.5.
The company has a healthy looking Balance sheet with a Working capital of $280 million and Net working capital of $242 million.
The Debt to Equity ratio is 0.56 which is considered as low risk.
The Free cash flow is $67 million and the company pays out a dividend of $1.20 per share.
The company only has three years’ history of paying out uninterrupted and increasing dividends, but this is misleading because the dividends have been paid for more than 15 years.
The current dividend yield is 5.5% which is good.
At these prices The Cato Corporation is a BUY.
Today I would like to look at fundamental analysis of one the best ran British small-cap stocks, Treatt Plc.
As always I prefer first to look at the valuation numbers and here it becomes clear that the stock is expensive.
You have to pay a hefty 28.8 times the trailing earnings for the stock.
When you look at the average three preceding years, the stock is even more expensive at 32.7 times trailing earnings.
Already here I would hesitate, but it gets worse. At these market prices, you are paying 5.2 times Book Value which obviously is not cheap.
The Balance Sheet looks far better. The Debt to Equity ratio is 0.9 and the Working Capital to Debt is 1.1.
The ratio between Current Assets and Current Liabilities is 3.3 which is very good.
Treatt Plc. has a Net Working Capital of £21,000,000 which equates to about 40p per share.
The dividend history looks good with more than 15 years of non-interrupted and increasing dividends.
The current dividend yield is only 1.3 percent which obviously is a reflection of the high price.
If you already own Treatt Plc. by all means keep the stock, but if you do not I wouldn’t buy it at these prices.
The Balance Sheet looks very good, but I would not buy the assets at this price.
The company has a good dividend history, but the feeble yield is a reflection of the price.
The reason for this is that I’ve recently been watching a Youtube channel called Now You Know that show a lot of news about Tesla Motors.
So I thought that I should look into the hype and see for myself if there was anything to it.
What I did was that I went to Tesla’s website and I downloaded their financial reports.
The numbers are shocking.
Tesla has been in business for almost ten years and in none of those they have made any money.
Granted, the loss last year was less than the year before, but still the second largest loss out of these ten years.
Looking at the balance sheet it’s very much the same story.
Its total debt is a staggering 16.8 billion dollars and the free cash flow is a negative 1.4 billion.
No wonder that the stock is losing more than 5 percent as I write this.
Who in their right mind would want to invest in something like that?
It’s clear that if you buy Tesla stock you hope that the earnings will materialize in the future.
At $259 those hopes are very expensive.
Elon Musk may be an excellent visionary, but his abilities as a CEO of Tesla Motors are not as good.
Today I want to look at technical analysis of precious metals and other commodities.
This is a weekly chart of crude oil:
Prices are now just between the descending and the ascending trend lines.
Where they go from here is not clear, but I would give it a slightly higher probability of going lower rather than higher (60:40).
This is weekly chart of the HUI:
Prices are stuck between the 100-week and the 50-week moving average.
Chances are about 50:50 that they go up or down.
In the bullish scenario prices are lifted by the 100-week moving average and go higher through the descending trend line.
I would give such a scenario a probability of 40 per cent.
In the bearish scenario prices are being pressed down by the declining 50-week moving average.
Given the lower high in February I would give such a scenario a probability of 60 per cent.
This is a weekly chart of platinum:
In the bullish scenario prices are going through both the 100-week and the 50-week moving average.
Because I don’t think that this is likely I give it a low probability of 20 per cent.
In this scenario prices are being pushed down by the descending 100-week moving average and then they are being pushed down through the vertical trend line.
I give this a probability of 30 per cent.
This resembles the one above with the only difference that prices are bouncing off the vertical (or slightly ascending) trend line.
I give this a probability of 50 per cent.
This is a weekly silver chart:
The chart is stuck between the ascending and the descending trend lines.
Where it will go from here is anybody’s guess.
It can go up and it can go down. Nobody knows for sure.
This is what a weekly chart of gold looks like:
What we see in the chart is that we are now pushing up against the 50-week moving average.
Prices seem to be getting squeezed between the 100-week and 50-week moving average.
In this scenario prices go through the 50-week moving average and continue up through the descending trend line.
Because of the lower high in February I give such a scenario a low probability of 20 per cent.
In this scenario prices are first going up until they reach the descending trend line and after that they go down.
I give this a slightly higher probability than the one above: 40 per cent.
In the bearish scenario prices are simply falling down from where they currently are.
Given the current nature of the chart I give such a scenario a low probability of 10 per cent.
In this scenario prices are first going down and then rebounding at the ascending trend line.
If we ignore the reasons why the chart would fall in the first place, I would give such a scenario a probability of 30 per cent.
This is weekly chart of Randgold:
In the bullish scenario prices are being pushed up by the ascending 100-week moving average.
Because prices are now above the 50-week moving average it is not at all implausible.
I would give such a scenario a probability of 0 per cent.
In this scenario prices are being pushed down by the declining 50-week moving average.
I would give such a scenario a probability of 30 per cent.
(note: the company was formerly known as Silver Wheaton.)
This is a weekly chart of Wheaton Precious Metals Corp:
In this scenario prices are following the ascending trend line upwards.
In favor of this is the rising 100-week moving average, but that’s about it.
I would give such a scenario a low probability of 20 per cent.
There is possibly a head and shoulders pattern forming in the chart.
What this means is that the downside of the chart is the ten points that the “head” is higher than the right “shoulder”.
This means that prices may drop all the way back to ten.
I would give such a scenario a probability of 80 per cent.
This is a weekly chart of crude oil:
It is obvious from the chart that we have two opposing trends working.
Eventually one of them will win, but I do not know which.
I would however put a slightly higher probability on a bearish scenario, but it would not surprise me if the outcome instead was bullish.
This is a chart of the gold bugs index:
In this scenario prices go up and through the declining 50-week moving average.
Given the nature of the chart I give this scenario a low probability of 20 per cent.
In this scenario prices are going down and continue through the ascending trend line.
Given the lower high achieved in February I give this scenario a probability of 30 per cent.
In this scenario prices first go down and then bounce up once they have hit the ascending trend line.
I give this scenario a probability of 50 per cent.
This is a weekly chart of gold:
In the bullish scenario prices obviously go up from here. They not only go up but through the 50-week moving average as well as the descending trend line.
Given the downward pressure exerted by the upper trend line I give such a scenario a low probability of 20 per cent.
In this scenario prices are going down through the 100-week moving average and continue down.
Given the lower high in February I give this scenario a high probability: 80 per cent.
This is a weekly chart of IAMGOLD:
It looks as thogh prices are being lifted by the ascending trend line and that they are continuing up at least until the descending trend line.
I would currently give such a scenario a high probability of 70 per cent.
Of course I can also argue for a bearish outcome where prices tumble from here.
In favor of this argument is the lower high that we reached in February.
I would give such a scenario a probability of 30 per cent.
This is a weekly chart of Yamana:
The chart looks heavy and I prefer to write about the bearish interpretation first.
We are beginning to see a head and shoulders pattern develop in the chart.
Where that will lead us is difficult to say for sure, but the text book reading of the Head and shoulders is the following:
The High point in the head = $6
High point of right shoulder = $3.60
Difference: $6 – $3.60 = $2.40
In today’s post I want to look at valuation of gold stocks.
The last few days I’ve been trying to wrap my head around how to value gold stocks.
It’s not as easy as just valuing a normal manufacturing company with Debt to equity, Price to earnings or by Price to book value because of the resources in the ground.
This makes it inevitable to normalize all the values according to either production or reserves.
The first thing that we will look at is how to calculate the cash cost per ounce produced.
The cash cost is calculated by subtracting Operational cash flow from Total revenue:
Cash cost = Total revenue – Operational cash flow
To get to grips with what this means we can visualize the subtraction like this:
Which is equivalent to this:
Then to calculate the Cash cost per ounce we divide with the total production for the year:
Total cash cost per ounce = Total cash cost / Total production
The next thing that we will look at is an estimate of how much money can come into the company through sales of the metal.
If we estimate that the company produces X ounces of metal in the year, the average cost of production is Y $ per ounce and that the average price of the metal is Z $ per ounce then the estimated operational cash flow of the company is:
Estimated operational cash flow (OCF) = X (ounces produced) * ( Y ($ per ounce) – Z ($ per ounce))
This number we will use in subsequent valuation calculations.
We can then use the Operational cash flow and calculate a Price to Cash flow ratio where a lower number indicates a cheaper stock.
If, for instance, the Price to Cash flow ratio is 5 then investors are paying $5 for each additional dollar of Cash flow.
Typically this number ranges from 3 x to 30 x and the lower the number the cheaper the stock.
We can also use the the Market cap to figure out a valuation to forecast production ratio.
Here again the lower this number gets, the lower the stock is valued in the market.
Typically this number ranges from about $1000 per ounce to $25,000 per ounce.
The lower the Market cap is per ounce of forecast production the cheaper the stock.
What we look at here is the Valuation (or the Market cap) and divide with the total number of ounces that the company has in reserves.
This number typically ranges from $100 to $1000 depending on the location of the resource.
Again this is a valuation metric where a lower number is cheaper.
This is the classic valuation ratio where the price of the stock is divided by the earnings.
For gold stocks this number is usually higher than for ordinary stocks and a number of 50 is not unusual.
The lower the number the cheaper the stock.
The question then of course becomes:
How can it be that the Gold stocks are so expensive that investors are gladly paying 50 times earnings to get it?
The reason is that investors are paying for the gold reserves and the gold production that the company have.
The equity valuation is just a part of the value.
So that you better understand what I mean when I talk about the value of different gold stocks, I will now give some examples:
The first is of a hypothetical gold mine ABC Gold Inc. that has the following Cash flow and Income statement:
We then hit Enter and we get the result that we want in cell B6 ($1360,000,000).
Then we continue to calculate the Cash cost per ounce by dividing B6 with B5:
Here again we hit Enter and we get the Cash cost per ounce in cell B7:
So what do we do with these numbers?
Well the first thing we can do is to calculate the Estimated operational cash flow at a given gold price:
Let’s say that we estimate that the average gold price will be $1350 per ounce in 2017, the Total cash cost per ounce was $817 in 2016 and that the company forecasts a production of 1,725,000 ounces in 2017, then the Estimated operational cash flow per ounce will be:
We then see that the Estimated cash flow per ounce is $533 and to get to the Estimated operational cash flow we multiply B12 with B10:
The result is of course as in Figure 9:
In today’s post we have been looking at the valuation of gold stocks as a function of their production and reserves in the ground.
Here are the ten rules of wealth building that we have discovered throughout the years. Don’t consider these principles absolute rules, but more of a guidance to how to think about your wealth in order to accumulate it. The principles are:
Today we have been talking about the ten principles of wealth building and how they relate to your personal fortune. They are more of a guidance on how to think about money and not absolute rules. As always the first step is the most difficult.
Today I would like to take a stab at the question “why is the Shiller P/E flawed?”
The cyclically adjusted P/E-ratio is calculated by taking the average over the past ten years’ inflation adjusted earnings.
This may sound as a good way of looking at the value of a company, but this way of looking at deep value is actually not the best way to go about. I will explain why it is not in this post.
First of all when you are calculating the Shiller P/E you are averaging over the previous ten years.
What that means is that one years’ calculation contains almost the same information as next year.
To illustrate what I mean consider this figure:
The first selection contains the same years as the second selection. Only one year changes.
So, in effect, you only have data points each tenth year and not each year as it is presented.
The Shiller P/E is only a way of looking in the rear view mirror and not ahead.
As we all know a trailing P/E does not give you any information about coming earnings.
It does, however, give you an idea of past earnings.
If you want to make real money in the market you will have to guess future earnings which a Shiller P/E does not do.
Then ten years is a long time. We all know that.
During this time small-cap companies often change and sometimes even dramatically.
Their business model may change so to calculate an average over ten years makes no sense.
Moreover, the accounting methodology over the past ten years has changed which makes the Shiller P/E even more flawed.
Instead I propose to look at the inflation adjusted earnings of the past three years and using that as a guess for next year.
I believe this is a better metric because it gives the investor a clearer idea of what to expect for next year’s earnings.
In this guide we will lay out the basics of why you want to invest your money based on the value that you get from your investment and why an approach like Warren Buffet’s almost always outperform in the long run. We will talk about value investing in the broad sense as well as the traps you want to avoid. We will not get too deep into technicalities like return on equity and working capital although we will briefly mention them. We will especially talk about how you as an investor can manage your money for the better and how you can build your nest egg – slowly.
(Note: If you would like to know more about the financials of Tesla Motors please read this article.)
To invest your money is both easy and hard at the same time. If you just want to invest somewhere you can do that with the click of a button, but if you want to invest wisely it’s a little bit harder. To invest wisely you have to go through the financial statements that are found in the quarterly or annual reports of the companies that you are interested in. When that is done, you need a framework for telling if the stock is worth buying or not.
When we first started investing many years ago and then sold our holdings at a profit, we thought that we ruled the world. There was nothing stopping us from making a killing in the stock market. We bought shares like there was no tomorrow. The only question that was relevant to us was how much money we could possibly deploy for our next speculation.
But then something happened. The market fell.
When it did there was no bottom to our losses. Everything that we had gained during the previous years was now lost and then some.
Wise from our experiences we laid out another strategy, one that was based on value instead of spectacular growth. One where a steady cash flow was more important than spikes in earnings.
This is why we write this guide. To prevent others from making our mistakes and to teach them how to be prudent with their hard earned money. This is especially true if you like sleeping well at night without any financial worries.
We caution you to take a more prudent approach with your cash and do your due diligence before you buy or sell any security. Never buy securities without asking for advice from a qualified adviser. You should always ask yourself if the investment decision you are about to make is justified by the fundamentals. If it is then go ahead, if it’s not then wait until it is.
There are many examples of occasions where the market has been severely wrong. We see them almost every day. These occasions ultimately create good buying and selling points for every shrewd investor out there. But you have to remember being patient.
Here we are going to talk about allocating your portfolio. What proportion of stocks to bonds you should keep and how to deal with the urge to speculate.
There is nothing giving you more thrill than seeing the ball fall at the right number when you’re at roulette table at the casino. This feeling of exhilaration is very strong and also very addictive. But it deceives you. The next time you will not be that lucky and when looking at it objectively, you have the odds stacked against you. After all, that is how the casinos around the world are making their money, by making sure that they will win more times than they will lose.
The same is true for investing. You can see a speculative stock go up two or three times in price over a short period of time. But to believe that you are consistently able to time the market so that you always buy low and sell high is just unrealistic. Sure you may be able to have a few quick wins, but they will almost invariably be accompanied with losses that exceed your gains.
You therefore have to have a system in place that prevents you from speculating. Keep a proportion of your portfolio – the smaller the better – aside for your speculation, but never mix money you gain from speculation with money for investment. What we suggest is keeping a proportion of 10 per cent or less aside for speculation. That way you can participate in the excitement, but you will never let it overtake your life.
Furthermore, there is a misconception out in the public that says that investing is like betting in the casino. We would like take a different view. Where betting is ultimately dependent on luck, the same cannot be said about investment. Investing is about putting money to work and getting a reasonable reward in return.
The safer this return is the better.
Regarding portfolio allocation it depends on the where in the market we are. In normal times the prices of bonds are the opposite of the prices of stocks. Therefore you should try to keep an equal balance between the two.
However, at times the prices of stocks are depressed while the prices of bonds are high. In such a situation it makes sense to increase the stock proportion in your portfolio. We suggest that you never exceed 90 per cent stocks when they are undervalued and that you don’t exceed 90 per cent bonds when stocks are overvalued. That way you will keep an even balance in your portfolio at all times.
Ultimately it depends on how high corporate- and treasury bond yields are compared to the average yield on stocks. As we write this interest rates are chillingly low. In fact they are so low that treasury bonds do not correspond to our of a good investment. Instead you have to look into the world of investment grade corporate bonds. These are rated by rating agencies according to how likely they are to continue paying out their return. An investment grade bond has at least a rating of BBB.
Here we will discuss what to do when the market plummets and the need to resist any urge to sell good investments just because the market has been going down. Similarly, we will also discuss the psychological urge to buy more stock when prices have been going up.
When the market goes up it is very easy to buy more securities in the hope that they will continue to go up. That may very well happen for a while. But then reality sets in and the security that you bought for dear money will sense gravity and eventually fall to the ground.
The lesson learned over and over again is that there is always a fair price of the securities that you buy. This means that it is wrong to look at a rising price in the market as a vindication of having made the correct decisions regarding a security. If anything, a rising price signify that what you are about to buy has become more expensive and that you will get less value out of it in the long run.
In the same way, a falling price signify a cheaper security and gives you the opportunity to buy more of the stock than before. The only reason to buy or sell any security is if the fundamentals of that security have changed. If they have then, by all means, go ahead and buy or sell. If the fundamental situation does not change then you are better off holding onto your securities.
The financial media is to blame for much of the hype that has surrounded the stock market in recent years. Often media don’t reflect that investing in essence is a rather boring activity. This is especially true when we are talking about value stocks.
The average investor would actually be better off had the securities in his or her portfolio been unquoted. That way he or she would be sure not to fall into the mass hunt that has proliferated in the financial media. The media often portray the business of investing as a kind of safari where it is all about killing big animals.
The true business of investing is very different. It is not a question about winning against the pros, it is about beating yourself in your own game. If you take a long term view and buy stock at a regular basis and reinvest your dividends in a disciplined manner, you are almost certain to succeed.
That is not to say that you should forget about the ups and downs of the stock market all together. If you see that your stock plummets, you need to sit down and harshly once again check the fundamentals. Are the steady earnings constant or are they slipping? Has the company taken on more debt? Does it finance its dividends with borrowed money? If it does then the market is right and you have to sell, but if it isn’t then you should take advantage of the low prices and buy more stock.
This is why we recommend holding on to your stocks for at least 5 years. That way with the dividends reinvested you should see a real accretion of your wealth during this period.
To sum this up: the more the market falls, the more value you will get out of your securities. Do not fall into the trap of selling just because everybody else is selling.
Here we will discuss the merits of mutual funds and index funds and how they can help the lay investor to grow his/her wealth.
One of the most common ways of investing is to leave the hassle of finding investment-worthy stocks to others. There were more than nine thousand different mutual funds in the US alone in 2014. As an aggregate they are almost perfect, but only just. Their biggest drawback is that they charge a hefty fee for the sake of looking after your money. You can pay anywhere from 0.25 percent all the way up 1.5 percent depending on what type of mutual fund it is.
This brings us to another aspect of stock picking which is that past performance almost never is a good guide for future rewards. A mutual fund may start out small, but inevitably, as the fund grows in size, it will attract more money. When the fund attracts more money it has a set of bad decisions to make:
Thus, there simply are no good options for the money managers who manage big accounts. So what they tend to do is that they indulge in the process of “herding” which means that most mutual funds buy the same kinds of stocks and at similar proportions as everyone else.
Another thing that may affect the long-term performance of the fund is that a top stock picking manager may be recruited to a competing fund. Good managers with good track records are almost always sought after, which is another reason that these are paid so well.
For the lay investor there is another possibility which is to buy an index fund. The upside to these is that management fees are low – it is not very complicated to buy equal amounts of the S&P 500, for instance. Another positive is that the fund will always follow the index – no worse or no better – which is good because it is fiendishly difficult to beat the index over time. Another plus is that you will always receive the aggregate dividend yield that the index pays. For somebody who is not very interested in stocks this is an almost ideal solution.
The downside is of course that they are boring. You will be able to look at the performance of the index to tell yourself how much money you have made recently. There will be no excitement when a stock finally takes off and you see that its price increases by the day. Likewise you will probably not see your stocks go down too much in value either. If you just want to participate in the stock market without doing the extra work it takes to analyze individual stocks, this may be the solution for you. As we shall see, the work of a financial analyst is very different.
In this chapter we will look into what determines the value of a security. How the operational cash flow, the assets on the balance sheet and the debt ultimately decides what kind of return you will get from your security.
If you have ever seen an annual report you will see that it contains a lot of information. If it’s a retail company you will likely find sales volumes in different regions of the company, if it’s a mining company there are many pages about reserves and resources and if it is a technology company there are probably discussions about their recent technological advances.
But what we are interested in as investors are the financial statements. You will see that they are divided into three parts:
The income statement is about how much money the company has made in the period (1) and how much money it has paid in taxes (2). When you subtract (2) from (1) you end up with the Earnings that the company has made in the period.
This Earnings number is then divided by the total number of shares to find the Earnings per share during the reporting period.
When you then look at the current price of the stock and divide it with the Earnings per share, you will get the price to earnings ratio or the P/E ratio. If you on the other hand are using last year’s P/E number you are in effect calculating the trailing P/E ratio and similarly if you are using an estimate of analysts expectations of next year’s earnings, you are determining the forward P/E ratio.
What this all boils down to is that it tells you something about about how much profits a share in the company will buy. A common share in a company is nothing but a stake in the profits.
There is a problem with P/E ratio however and that is that the number does not take into account the earnings over time. To do that we have to calculate an average over the past years’ earnings and adjust for inflation. Then we can use this average number just as we did when we calculated the real P/E-ratio. This is called Cyclically Adjusted Price to Earnings (CAPE) ratio and was introduced by the economist Robert Shiller in his book Irrational Exuberance from 2000.
The balance sheet is where the company is stating all its belongings and debts. The belongings are called Assets and are further divided into Current- and Non-current assets where the current assets are assets that can be sold over the next 12 months and the non-current assets cannot. On the one hand you have the assets (a) and on another you have the liabilities (b). Then you subtract the liabilities from the assets to end up with the Shareholder’s equity which is precisely defined as the Total assets minus the Total liabilities.
Then we prefer to divide the short-term liabilities, the long-term liabilities and the total liabilities with the shareholders equity to figure out if the debt is sustainable or not. If it is not then the company runs the risk of seeing the debt eat in to their earnings due to amortization. This will of course create a vicious circle.
When is the debt too much?
The debt levels vary significantly across different sectors. Some types of businesses are very capital intense and therefore highly leveraged (or running on borrowed money). Other businesses don’t need so much money, but can rather start to churn out money with a laptop computer from home. So it’s difficult to make a definitive statement about much debt is too much. For a mining company or a shipping company which are very capital intensive may see debt levels (i.e. total liabilities to shareholders’ equity) of more that two whereas a startup tech company may have very low debt levels.
The cash flow statement is where the cash that has goes in and goes out of the company during the reporting period is reported. The statement is divided into three different categories. These are usually divided into cash flow from Operational activities, Investment activities and Financing activities. The free cash flow is the money that the company can use for discretionary purposes, i.e. paying out dividends to shareholders.
The free cash-flow is defined by subtracting Investment in plants and equipment (CAPEX) under Investment activities from the Operational cash flow. The formula looks like this:
Another thing that is important is how much the company pays out in dividends, i.e. the dividend yield. You want to look for companies that pay a good dividend, but also has a history of increasing that dividend over time. Most companies that are doing well in this respect also has good cash flow coverage of their dividend. It makes sense, otherwise they would not be able to sustain their dividends.
A warning here is in place. Just because the company has a high dividend does not mean that the dividend is safe. For instance, the major oil companies nowadays almost exclusively has a high dividend yield, but that is more a reflection of the risk that you are running when investing in those companies. One way to check this is to make sure that the dividend is fully covered by the free cash flow.
The lower the P/E-ratio and the higher the dividend yield is, the more value you will get out of your investment. In mature companies this may be difficult, but in the small-cap space finding so-called “double-sevens” is most definitely feasible. A “double-seven” is a a company with a P/E ratio of 7 as well as a dividend yield of 7. The trouble here is that the cash flow is not as stable for a small-cap stock and may vary a little bit more than for more bigger companies, but anyway they are worth looking into.
We also want to mention the Return on equity or the ROE. The ROE is defined as the companies’ net income over the period divided by the shareholders’ equity. This is a measure of how much profit the company makes per dollar of shareholder investment. For a good profitable business an ROE of at least 17 percent should be sought after.
The last thing that we want to mention is the net net working capital. The net net working capital has been popularized by legendary investor Benjamin Graham who figured out a good way of valuing stocks in the stock market. The method involves taking the Working capital (current assets less current liabilities) and then subtracting any additional debt.
We can then divide the net working capital with the total number of shares to end up with a number for the intrinsic value of the shares. In the 1920’s and 30’s these numbers were at times surprisingly close to the quoted value and extraordinary bargains could be found. In today’s stock market these extreme values are seldom found because, let’s face it, a stock that is priced for its net working capital is priced for liquidation. In today’s market liquidations are rare and the costs associated are huge. They also take a long time to unwind.
The upside of this is of course that if you buy a stock that is priced by its Net Working Capital you are protected by their assets value (like plants and buildings) which effectively puts a floor beneath the price.
To conclude we would like to emphasize that what matters is the consecutiveness of the earnings in relation to their price. We would therefore propose the following list when we select a stock:
This chapter will contain a few real life examples of what we are teaching. We will in particular look at some of the stocks that we picked out in our small-cap screen at the end of last year.
We will compare two small-cap stocks that trade on the New York Stock Echange: “The Buckle” (BKE), an apparel company and “Cummins Inc.”, a company that manufactures natural gas engines.
What we did here was that we used data from the annual reports, Yahoo and Morningstar to come up with this:
What is clear from the data is that the earnings are pretty constant over the three years. They are decreasing slightly, but not so much that it justifies the stock to go from 53.39 USD in December of 2014 to 24 USD on this Friday the third of October. That is a good sign.
If we then calculate the cyclical P/E ratio we see that the averaged earnings over the last three years puts cyclically adjusted price-to-earnings ratio (CAPE) at 7.32. We see that the dividend yield is OK and we have a good free cash flow to pay for the dividends.
In all, when we are analyzing the stock we conclude that the market has weighed too much importance to the decreased earnings in 2015. The prudent thing would therefore be to buy more of the stock rather than selling. Therefore our recommendation for this stock is BUY.
If we then look at Cummins Inc. instead we see this:
What we see here is that the earnings are increasing over the years, but are they increasing too much? We see that the price has gone from 89 USD to 128 USD over the last year while the earnings have increased from 3.70 USD per share to 4.5 USD per share. The increased earnings do not reflect such an explosive increase in the price and the cyclical P/E ratio is much higher today than at the beginning of the year.
Taken altogether we do not recommend buying this share at this point. It is simply too expensive. If you already own it, by all means keep it, and reinvest your dividends so that you will receive a higher dividend next time. Another possibility would be to take some profits so that you can invest in other companies. In the small-cap space there are plenty of stocks with sufficiently low P/E ratios at all times. Therefore, if you look at a sufficiently low P/E ratio and a good dividend yield, you will always be able to find good investment options in this field.
In this guide we have been trying lay out the basics of value investing. We have been trying to answer the questions of what a good investment is, what constitutes value in an investment and how to deal with your non-discretionary spending whilst investing them in the market.
Value investing is not something that will make you rich quickly, but rather a technique for the turtles. The power of it comes from the “compound interest” that you will experience when you reinvest your dividends in the same stock. If you have bought shares in a good value company with a steady earnings, you will see that your wealth increases exponentially with time.
To the questions of what to buy and when to buy we have given real life examples which makes it easier for you to follow along.
This time I will look a bit more in depth on how to use Microsoft Excel for financial calculations.
How can I use Excel to get the best out of my data?
Chances are that you are going to have to look into the data that you have entered again in a year or two years.
So how do I organize a spreadsheet so that I can see what I’ve done when I come back?
Excel is a very powerful tool once you know how to use it.
The secret is called labeling and with that I mean to properly label all the cells in order to easily be able to go back and change.
But to start off this chapter I will discuss some financial metrics and why they are important.
So why is it an exciting time to study finance?
The reason is that we had a financial crisis in 2009 and still to this day we are seeing the repercussions of that meltdown.
We all got into a lot of trouble and the financial institutions that we depend on for our daily lives lost a lot of money.
Some of the questions that people are asking themselves in the aftermath of the financial crisis are:
These are questions that people in finance and economics assumed they had the answer to for years, but now they are getting more cautious.
What I will be talking about in this chapter is:
There are many forms of business, but the most common is Sole Proprietorship where just one person owns the company.
This particular form is easy to start and the least regulated kind of business there is.
Another advantage is that there is single taxation. You only get taxed on whatever your income is.
On the downside, it is quite difficult to raise funding.
Another thing is that you as a private person have unlimited liability. This means that if you get sued you can not only all the assets in the company, but also your personal belongings.
Finally, it is pretty difficult to sell your ownership compared to if you, for example, own a corporation. If you have shares in a corporation, you can just sell them on the market.
When many own the company it is called a Partnership or a Corporation.
A General Partnership means that you invest and work for the company whereas a limited Partnership means that you just invest.
A Partnership is easy to start and it is more regulated than a Sole Proprietorship.
If you have a Partnership it is somewhat difficult to raise money.
There is also the same problem as with a Sole Proprietorship – there is unlimited liability. So if you get sued, the court can take all your Partnership and personal assets.
It’s difficult to sell ownership if you want to.
But on the positive side: In a Partnership there is Single Taxation just as in Sole Proprietorship.
A Corporation is when instead of having a person owning the business there is a separate legal “person” who owns it.
On the negative side with this form of ownership:
On the positive side with a Corporation:
Regarding the last point, there are two kinds of financial markets:
If you buy shares in the Primary market, the shares are issued by the corporation and sold to you.
This means that the shares (or securities) are issued by the Corporation.
Now, if you own the shares, you can go and sells them to whoever you want and you do that in the secondary market.
This means that after the sale in the Primary market, you can buy or sell shares, debt or equity to your liking in the secondary market.
Why is a Corporation a better form a better form of ownership than a Sole Proprietorship or a Partnership?
It’s because of the limited liability of a Corporation. If you get sued, the courts will only take assets belonging to the Corporation and not your car.
The main reason why a Corporation is the better alternative, however, is that it allows you to finance your idea far easier.
In other words it is pretty easy to get funds (equity or debt).
So if I were to summarize why a Corporation is the better alternative:
Because this article is about corporate finance, I will now get into the structure of a corporation (Figure 1.)
At the top of the Corporation there are the Shareholders. When you own a stock of Corporation, you are the owner of that Corporation and owners vote and bring in a Board of Directors.
The Board of Directors then hire the managers. The managers are then working inside the company and running the company.
Finally, it is the managers who employ the employees who work in the company.
Because this is a finance class we will of course discuss the role of finance inside a corporation (Figure 2.)
Above the horizontal line in Figure 2. is the Board Of Directors. Below the line is inside the corporation.
The role of the Chief Financial Officer is then to supervise the corporation’s financial activities.
To his/her help, he/she has these people to help:
On top there is the CFO or Chief Financial Officer.
Below there is the Treasurer and below him/her there are different people like Cash Manager who supervise the cash flows of the company.
The Credit Manager who look into questions like if the company is going to extend credit to certain customers.
Capital Expenditures is about what kind of projects or machinery the business might engage in. They do that by using cash flow analysis.
Financial Planning is about figuring out the company ‘s needs for issuing debt or stock to raise cash.
Then there is the Controller under whom there’s the accounting part of the Corporation.
The equation goes like this:
Asset = Liability + Equity
The equation is the fundamental part of Accounting and as such it has been around for more than 600 years.
What does it mean?
1./ If you have an asset – in the example I use a house – worth $200,000 and your loan on the house is $150,000 (liability), then you have $50,000 left in equity.
Imagine that a company buys trucks for its operations, buying other businesses, real estate or even inventory: Those are all assets.
What this means is that if you have a good new idea you can either pay for it yourself, you can borrow the money or use some combination of the two.
2./ The idea behind buying an asset is that you will make money in the end.
If for instance we use the example of a company buying delivery trucks – then the company needs to pay for it in order to get cash back in return.
The GAP definition of an asset is that it will provide a probable future economic benefit to the owner.
A liability is a promise to pay back the loan plus interest on that loan.
If the Company defaults on its loan, the house will go to the bank. That is a contractual obligation.
If you default on the loan, the bank gets paid first. That is also true in business. The person or the entity that has loaned the money gets paid first.
In the example above, there is $50,000 in equity.
If the bank is only able to get $100,000 for the house – that doesn’t cover the debt, but it’s all they get – you will get nothing.
If anything is left over, you will get it.
The way to think about it is whatever is left over after you pay all the Bankers.
The definition of finance is as follows:
What this means is:
The third point comes from the fact that finance is all about the future and since the future is unknown finance is difficult.
What we do in finance is that we are looking into the future and doing lots of estimates to decide what to do.
The goal of financial management is to maximize the current value per share of existing stock (market value of equity).
Theoretically this is a good goal because the owners own the company and the financial manager works for the owners.
However, there are a few problems and let’s look at a few of them:
1./ The Agency Problem with Corporations
This is what the Agency Problem means:
The shareholders own the company and are what is called “principal”.
The managers run the business and are what is called “agents”.
According to the definition an “agent” is working for somebody and in this case for the shareholders or the “principal”.
The agent is supposed to act in the best interest of the principal.
But because the agent is inside the company the agent has custody of the assets.
Managers do not always act ethically or legally.
2./ Financial-, Accounting- and Management-Gurus invent ways to circumvent laws that protect the owners.
There are many examples in financial history of companies having gone out and borrowed money in the market.
This money has then been accounted for as debt on the balance sheet just as it should be (a liability).
But then they bought the debt back and recorded the debt as an asset on the balance sheet instead.
This is fraud and illegal.
Another example is insurance companies that invented policies that circumvented the regulations and the law.
This was also illegal.
3./ Financial markets are efficient.
The definition of finance depends on financial markets being efficient.
What that means is that the assets are accurately priced in the market.
Obviously, we all know that this is not always true, but as a general rule it should hold.
However, there have been two major bubbles over the past 20 years:
When you have a bubble, the market is telling you that the companies, or more broadly, the assets involved are worth a lot of money, but they are not.
What can happen then is that the bubble pops and loses all its inflated value at once.
This way a lot of people can lose a lot of money quickly.
If there is a manager inside a company and he/she is trying to maximize the value of the company, but the market value is not fair, the goal itself cannot be achieved.
That means that everyone is left guessing what the market value of the company is.
Here’s an example of a house in 2003 to 2007:
The market was telling the participants that houses worth more and more during the bubble years, but they were not as we could see when the bubble popped in 2007.
The process can be summarized like so:
There are of course several reasons why you would want to study finance.
First of all we have the Personal side:
What are the careers that you can have in finance?
In this class we are going to study corporate finance, but there are other areas of finance as well:
In finance cash flow is everything.
This is an example of how cash can flow through a corporation:
In the figure it says A. The Firm issues securities. That can be the company having an initial public offering or an IPO.
Then people in financial markets decide to buy some stock so the cash goes from right to left and into the business.
Then we have B. Firm invest in assets which can be that the company buys for example machines or buildings.
Why is the company buying the assets? They of course do it to get a return on their investment.
Then we have C. Cash flow from Firm’s assets. This means that the company has earned a return on its investments and now the cash is flowing in three different directions:
The take home message here is that in finance what matters is Cash flow and not accounting numbers.
This article is based on the excellent work of the man behind the Youtube-channel Excelisfun.
How come Warren Buffett is such a fantastic investor?
To answer that question we first need to look into what Warren Buffett has actually done.
He studied at Columbia University under the legendary Benjamin Graham where he learned the fundamentals of value investing.
What a value investor does is that he or she is looking for securities which prices are below its intrinsic worth.
What matters is the price. Buffett knows that if he can buy a well-run company for pennies on the dollar, sooner or later the market will appreciate its error and see the price of the security rise.
That is value investing and that was exactly what he did in the early days of his investing career.
For instance he bought a 5% stake in in American Express in the mid-1960’s for $13 million dollars.
There are of course a few metrics that he looks at when investing in a company:
Good luck with your investments. If you want to look at value metrics of small-cap stocks you can look here.