I just finished reading Fareed Zakaria’s article (The Cover Story in Newsweek June 22,2009) “The Capitalist Manifesto; Greed is Good”. The article is very good and everyone should read it in about three years when the U.S. and Global economies are running at an improving pace. Go to the following link.
Sunday, June 14, 2009
Wednesday, June 3, 2009
DERIVATIVES
What the heck are they? Some of you know about this from your college math days. Now I’m talking about stocks. How in the world do you get the first or second derivative of a share of stock.
The first derivative is a share of stock. A share of stock is supposed to represent ownership in a public company. And, it does. But, the value may not be quite what the buyer expects. Did you ever notice when looking at the data associated with the stock of a public company the column headed by something like P/E? P stands for Price and E stands for earnings. Will Rogers said “When buying stocks. Buy them when the price is low and sell them when the price goes up. If the price doesn’t go up, then don’t buy them”. Great advice.
A price earnings ratio of ten ( P/E = 10 ) tells us that the current price is equal to ten times the annual earnings. You need to be careful here. The first question is” which annual earnings”. The number could be based on the trailing earnings. That might be the prior fiscal year. Or, it could be based on the earnings for the latest four quarters. Or, the P/E could be based on an estimate of future earnings.
When you invest $100, how much do you expect in return? A good return might be 10% per year. If one borrows $100 from a bank at 6%, he will pay $6 in interest every year he keeps the money. So we could borrow $100 at 6% and then invest it in a company with a P/E of 10 and we would theoretically be ahead every year by $4. Except, how do you get the money out of your stock investment? They might pay dividends. But, hardly ever do they pay out all their earnings in dividends to the shareholder. So, you might have to sell the stock to someone. Now when you buy the stock you pay the brokerage firm a fee and when you sell the stock you will have to pay a fee. These could be as much as 1% on each end. I wonder what the market price of your stock is one year later? If the P/E is still at 10, what would the price be? It depends on the earnings of the company one year later. If the earnings went up 10%, would you expect the stock price to go up 10%? What is the possibility of the a company raising its earnings 10% in one year? Do you know? How would you decide which stock to buy? I guess we could look at the earnings history of the company. I happen to know that a company that is able to increase its earning 10% consistently every year is a very well run and fortunate company. Ten percent is hard to achieve. Most good companies have annual earnings increases in the range of 5-8% annually. Companies with earnings growth rates in this range usually don’t have P/E ratios of 10. In average times their P/E ratios will be more like 17-22. So, an investment of $100 in this company would be represent earnings in the range of 5% of the share price. Do you still want to take the risk of paying $6 to invest in a company that makes $5 on your investment?
When the market crashed in 2008, the average P/E on the NYSE was north of (bigger than) 40. You not only have the variable of how the company business is going but pricing is confounded by the rational or irrational buying action of individuals and
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