Discounted Cash Flow Analysis

Discounted cash flow analysis is a method of valuing an asset using the concepts of the time value of money. Having one dollar today and one dollar in 1920 is not the same. The reason for this is inflation. Instead of inflation, one could take into account other parameters such as US Treasury Bonds returns. US treasury Bonds could be considered as almost risk free since it is guarantied by US government. For example, an arithmetic average (1928-2010) of annual returns on Treasury Bonds is about 5%.

We say that Future Value (or FV) is a value that is expected in some future, and that Present Value (or PV) is an actual value today. Relationship between Future Value and Present Value is given by the formula FV = PV * (1+i)^n. Having FV you can easily calculate PV = FV/(1+i)^n. Where i is an interest rate, and n is usually number of years.

Let's say that we have two offers for our house. The first one is $150,000 in two years, and the second one is $165,000 in four years. Which offer is better assuming other parameters equal? The second offer is obviously bigger, but is it better? It makes sense only to compare present values. Therefore we will compute PV for both offers.

The first offer:

From 150,000=PV*(1+5%)^2, we compute PV=150,000/(1+5%)^2=$136054

The second offer:

From 165,000=PV*(1+5%)^4, we compute PV=165,000/(1+5%)^4=$135746

Therefore the first offer is better. We took 5% as a low risk annual return.

The second offer might be better for different annual returns. Let's se what happens if we use 3% interest rate.

The first offer:

From 150,000=PV*(1+3%)^2, we compute PV=150,000/(1+3%)^2=$141389

The second offer:

From 165,000=PV*(1+3%)^4, we compute PV=165,000/(1+3%)^4=$146600

Therefore the second offer is better. We see that results of a comparison depends on interest rate you choose. For different problems you might choose different interest rates. For example, for real estates you might choose a conservative (low) rate , and for IT industry you might choose a higher rate.

Things could get more complicated if we there are several cash flow. We should do the math for every one of them. Let's say that we have two offers. The first one is $100,000 in two years and $60,000 in four years. The second one is $31,000 per year for the next five years.

The first offer:

$100,000 in two years would be $90703 today, while $60,000 would be $49362. The total is $140.065

The second offer would yield: 29524+28118+26779+25504+24289 which is 134214.

Therefore the first offer is better.

Investment Strategy: Invest in Small Cap Companies

Small cap stocks stands for the stocks of companies that have a small market capitalization. A small market capitalization usually means that the market capitalization is less than $1 billion. A large cap stock stands for the stocks of companies that have a large market capitalization. A large market capitalization usually means that the capitalization is greater than $10 billion.

Small capitalization companies tend to bring greater risk and greater gains. In order to grow, each company must earn money by increasing sales and earnings. That stands for the small cap companies too. As they bring more risk, you should be more careful with this investment strategy.

There are several advantages of the small capitalization companies. First of all, they have a greater growth potential. It would be nice to invest in the companies that will eventually grow like Microsoft or Google. The stocks of small capitalization companies tend to be cheaper and therefore more available. There are more small companies than large ones. For example, there are a few large companies in each sector such as Microsoft vs. Apple, Pepsi vs. Coke etc. Having more opportunities leaves more room to diversify a portfolio.

The definition of large cap and small cap may change over time, and may be different for different brokerage houses. A share price of a small cap company is not necessarily small. Keep in mind that a small cap company have small market share and the money they borrow is expensive which means that such companies carry a greater risk. Also, they tend to use profit to accelerate their growth instead of paying the dividends.

Investment Strategy - Trading the News

Trading the News strategy is based on an analysis of the news related to a certain stock (or some other financial instrument). The good news usually imply that the stock price will rise, and the bad news imply that the stock price will fall. The rule is quite simple: sell if the news are bad, buy if the news are good.

There is a great variety of news that can influence a certain stock: an announcement about corporate profits, a change in management, a rumor about a merger, the results of a rival firm or even the sport news. It is hard to track all the news so an investor is usually focused on a certain type of equity. Even that is difficult to handle, so it is usually necessary to focus on a few stocks.

All the news have some degree of accuracy. The rumors are usually less accurate, while the reports are very accurate. Even reports can be inaccurate but it is less probable, because someone may have to face sanctions if they hide something.

Also, all the news can be more or less important. For example, the invention of a car is very important for a railroad company, and the invention of a computer is not that important for an undertaker.

The third aspect of the news is how frequent you can get it. For example, you can always find a rumor about anything, especially on the Internet. On the other hand, financial reports are available quarterly.

The fourth aspect of the news is how fast you can get them. This is a very important aspect, because when you notice the news, it is usually to late to do something. Meaning that if the news are bad, the price of the stock have already fell down. In order to follow this strategy you should be almost always online looking for the news.

Strategy: Buy Loser Stocks

According to the analysis of DeBondt and Thaler, portfolio of the 35 biggest losers in a previous year outperformed the market by 30% after five years. It is interesting that the portfolio of the 35 biggest winners in a previous year underperformed the market by 10%. On the long run the winner portfolio will outperform the loser portfolio, but on the short run (three to five years) the loser portfolio will perform better. Therefore this strategy says: Create a loser portfolio and sell it after three to five years.

It is not entirely clear why this strategy works. Perhaps the reason is that those companies had "extremely bad luck", and that in the following years the "bad luck" will turn around. For a certain period of time the loser stocks will continue to lose, and the winner stocks will continue to win, but after that "the wheel of fortune" should turn around. Therefore, selling stocks in the first year is likely to generate a loss. If you might need that money soon, this is not a good strategy for you.

It is important to notice that the loser stocks are not losers without a reason, meaning that the loser stocks tend to have a greater risk. It is even possible that some loser stocks will cease to exist. Also they tend to have a low price, and therefore higher transaction costs, and higher transaction costs might turn this strategy unprofitable. It is important to find a balance between the risk, time available and the transaction costs.

Investment Strategy: Buy stocks with high dividend yields

The dividend yield is dividend per share divided by the price per share. The dividend yield is also called the dividend-price ratio. The dividend per share is the dividend for the previous year, while the price per share is the current price on the stock market. Instead of dividend per share for the previous year, estimated dividend per share for the next year might be used.

A high dividend yield means that a stock is under priced or that the company is facing problems. Similarly, a low dividend yield might be a sign that a stock is over priced. To determine the health of a company you must check the other fundamental parameters.

The dividend yield of the Dow Jones Industrial Average has fluctuated between 3% and 6.0%. The highest Dow Jones dividend yield was about 15% (1932), and the lowest dividend yield of the DJIA was below 1.5% (2000). At the moment (April 2010) the dividend yield of the DJIA is about 2.7%. It is also important to notice that a profit can be either reinvested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. Therefore the dividend yield might be zero. Well established companies usually have higher dividend yields. Growth oriented companies usually have lower dividend yields.

Investment strategy: Buying stocks with low price to sales ratios

The Price-to-Sales (or Price/Sales or P/S) ratio is defined as (Market Capitalization)/(Sales). The market capitalization is the current price of a share multiplied by number of shares. The sales is the revenue from sales for the previous year. This ratio could be also calculated as (Share price)/(Sales per share).

P/S ratio measure how much is the market willing to pay for the each dollar of sales. For example, if the P/E ratio is 15 then investors are willing to pay 15$ for each dollar of sales. Low P/S ratio might indicate that the company is either undervalued or in troubles. It is necessary to check other parameters to see which is true. Price / Sales could be used as a substitute for a Price to Earnings ratio when the earnings are negative. The Earnings could be negative because it is calculated as Sales-Expenses. It is important to compare P/S ratio to the P/S ratios of other companies in a given industry. It is also necessary to check for trends of this and other ratios. Some companies have cycles in earnings and sales. There might be more expenses in one year than in the previous one. At the same time the company might have more sales than in the previous year. In that case P/E ratio could be low or even negative, while the company is actually getting better.

It is important to notice that low Price to Sales ratio might mean that there is something fundamentally wrong with that company. Always assume that there is a reason why the company has small P/S ratio, and look for parameters confirming that. If you find little or no evidence that the company is in troubles, then consider this as a buy signal.

Investment strategy: Buy low P/E Ratio stocks

Price-Earning Ratio is calculated as (Current share price)/(Earnings per share), and and we usually write P/E. This ratio reflects how much the market is willing to pay for each dollar from earnings. For example, if the P/E ratio is 15 then investors are willing to pay 15$ for each dollar of earnings. Depending on what earnings are used in the calculation we have past (or trailing), current and future P/E ratio. The past P/E ratio use actual earnings for previous four quarters. The current P/E ratio is calculated actual earnings for the previous two quarters and the projected earnings for the the following two quarters. The future P/E ratio is entirely based on projected earnings for the next year. The price is current share price on the stock market.

High Price to earnings ratio of a company means that the market expect that the EPS of that stock will be increased. If the company doesn't meat that expectation, the price will go down. Low P/E ratio means that the market expect that the EPS is going down. If the company doesn't meat that expectation, price will go up. Such stocks are good opportunities for buying.

The P/E ratio below average for the appropriate industry, might be a buy signal. The market "thinks" that a company with a lower P/E ratio then its industry is less attractive than an average company in that industry. You should figure out whether the market is wrong or not. Also it is necessary to consider a long term trend. For example in 1982 the P/E ratio of the S&P500 index was about 7, while in 1999 it was about 34. As with other ratios, you should consider the other parameters of the company.