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Long Term Investing is about Future Cash Flow

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Ultimately, in long term investing, fundamentals and cash flow are paramount for an investor (an investor is a business owner).

Years ago, a hockey game between the Boston Bruins and Edmonton Oilers had been paused for some technical issues with the stadium lights. To kill some time, the announcers started interviewing people including the Edmonton Oilers, Wayne Gretzky, undoubtedly the world’s greatest hockey player at the time. The announcer stated that Gretzky wasn’t the biggest guy in the league, or the strongest, or the fastest or the toughest, yet he was regarded as the greatest hockey player in the world.  So, how then did Gretzky explain his own genius?  Gretzky simply replied:

“I don’t go where the puck is; I go where the puck is going to be!”

In a simple one liner, Gretzky confirmed that his success did not come from chasing the puck. Instead it came from staying one step ahead and by anticipating  where the puck would  likely go next.

Thus, it is important to look at the future potential of a stock or investment instead of focusing solely on past performance. Long term investing is about looking from the perspective of a business owner at a company’s fundamentals and cash flow.

Cash Flow

In finance, cash flow (CF) is the term used to describe the amount of cash (currency) that is generated or consumed in a given time period by a business. It has many uses in both operating a business and in performing financial analysis. In fact, it’s one of the most important metrics in all of finance and accounting.

Every investment is the present value of all future cash flow.

Many investors are lured by short term performance.  They are interested in finding the latest, hottest, top performing stocks and investments driven by the financial entertainment media.  However, investors who buy those top performing investments today may not necessarily enjoy the same returns in the future. In investing, it’s essential you approach buying stocks like a business owner.

Cash flow is not the same as net income (or profit).

While cash flow describes the movement of money into and out of your business, profit is the surplus of money your business has after you’ve subtracted the revenue from your expenses.

The inflow and outflow of cash into and out of a company reflects the health of that company’s operations. That’s why it’s important as an investor (business owner) to be able to understand a company’s fundamentals and cash flow.

Cash flow is more dynamic in concept then profit – as it measures the movement of money – then profit, which simply demonstrates how much money you have left over after your expenses have been deducted. Even a profitable business can fail if a business doesn’t have a healthy cash flow.

Without a healthy cash flow, profit is meaningless.

Many successful companies (like Amazon, Twitter, Uber and Yelp) actually existed a long time without profits, but no company can survive without a healthy cash flow. For small to mid-cap companies, profit is still important, but cash flow is vital.

If you don’t have cash on hand, you can’t pay for your company’s basic needs like rent, employee salaries, electricity or equipment. If you don’t have enough cash on hand to replenish inventory or pay operating expenses, you will become unable to generate new sales. If you can’t afford operating expenses, your company will eventually fail. That’s why cash flow is such an accurate predictor of an investment or company’s success.

Cash Flow From Operating Activities

The operating activities reflects how much cash is generated from a company’s products or services. Positive (and increasing) cash flow from operating activities indicates that the core business activities of the company are thriving.

Cash Flow From Investing Activities

Investing activities include any purchase or sale of an asset, loans made to vendors or received from customers or any payments related to a merger or acquisition is included in this category. In short, changes in equipment, assets, or investments relate to cash from investing.

Cash Flow From Financing Activities

Cash flow from financing activities shows the net flows of cash that are used to fund the company. Financing activities include transactions involving debt, equity, and dividends. Some examples are: issuance of equity (shares), payment of dividends, issuance of debt (e.g. bonds) and repayment of debt.

Free Cash Flow

One of the most important financial number is free cash flow (FCF). It is the cash flow available to all the creditors and investors in a company, including common stockholders, preferred shareholders, and lenders.

You can calculate FCF, if not provided, quickly. FCF = Operating cash flow – capital expenditures (aka. CAPEX). Simply, capital expenditures on the CFS is the line item “Purchase of Property, Plant and Equipment” (PPE). the PPE expenditure is the “maintenance amount” of running a business. Though it says “purchase”, this includes repairing, renewal and/or maintenance of the companies assets.

No company can survive without a healthy cash flow.

Generally, you want to see a steady increase in cash flow from operations. If this number is growing (while debt being in control) at a rate of 10% or more annually.

However, past performance cannot guarantee future results. In other words: don’t assume that an investment is going to continue to perform well in the future simply because it’s done well during a specific time period in the past. 

Two of the key ingredients for success in investing is understanding that cash flow is king and your a business owner when you purchase a company’s stock.

References:

  1. https://ignorethestreet.com/cash-flow-statement-fundamentals/
  2. http://www.momentumcapitalfunding.com/cash-flow-fundamentals-business-owners/
  3. https://corporatefinanceinstitute.com/resources/knowledge/finance/cash-flow/
  4. https://www.powerofpositivity.com/make-you-rich-quotes/

Long Term Investing is about Your Behavior

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Investing and managing money successfully is all about how you behave. Morgan Housel

Most investors are not as smart as they thought they were a year ago in the midst of a raging bull market and rising stock prices. Fortunately, they’re also not as dumb as they feel today during a market correction, says Morgan Housel, author of “The Psychology of Money”

Investing, specifically successful investing, is, and has always been, the study of how people behave with money. And behavior is hard to teach, even to really smart and educated people. Effectively, success in investing is achieved by being patient and remaining calm through ‘punctuated moments of terror’ and volatility in the market.

You can’t sum up behavior with systems to follow, formulas to memorize or spreadsheet models to follow, according to Housel. Behavior is both inborn and learned, varies by person, is hard to to measure, changes over time, and people are prone to deny its existence, especially when describing themselves.

Actually, the best strategy is to invest as a long-term business owner which isn’t widely practiced on Wall Street or Main Street. It’s one thing to say you care about long-term value and another to actually behave as a long-term business owner. None of this is easy, but it’s never been easy. That’s what makes investing interesting.

The only thing that you can control in investing is your own behavior.

There is the old pilot quip that their jobs flying airplanes are “hours and hours of boredom punctuated by moments of sheer terror.” It’s the same in investing. Your success as an investor will be determined by how you respond to punctuated moments of terror, not the years spent on cruise control.

Managing money and investing isn’t necessarily about what you know; it’s how you behave. But that’s not how finance is typically taught or discussed in business school and at financial institutions. The financial industry talks too much about what to do, and not enough about what happens in your head when you try to do it.

There were 1,428 months between 1900 and 2019. Just over 300 of them were during a recession. So by keeping your cool and staying in the market during just the 22% of the time the economy was in or near a recession would have allowed your investments to compound and to grow significantly.

You must invest in the U.S. stock market every month, rain or shine. It doesn’t matter if economists are screaming about a looming recession or new bear market. You just keep investing. How you behaved as an investor during a few months will have the greatest impact on your lifetime returns.

There is the old pilot quip that their jobs are “hours and hours of boredom punctuated by moments of sheer terror.” It’s the same in investing. Your success as an investor will be determined by how you respond to punctuated moments of terror, not the years spent on cruise control.

For many investors, they are their own worst enemies. Since, the biggest risk to you as an investor is yourself and your own biases, your win mindset, your own misconceptions, your own behaviors, that impact your returns as an investor.

“Investing is not the study of finance. It’s a study of how people behave with money. It’s a really broad, all-encompassing field of how people make decisions around risk and greed and fear and scarcity and opportunity,” says Housel.

You can’t control what the economy is going to do or how the market will react. You can’t control what the Fed is going to do next. The only thing that you can control in investing is your own behavior. Thus, it’s important you realize that the one thing you can control, your behavior, is the thing that makes the biggest difference over time. Your investing behavior is the most fundamental factor in your investing success.

Simply, investing is about how you behave with money. And, it’s the ability to sacrifice spending money in the present with the expectation of making money in the future. Investing is a risk.

“A good definition of an investing genius is the man or woman who can do the average thing when all those around them are going crazy.” Morgan Housel

References:

  1. https://acquirersmultiple.com/2021/11/morgan-housel-investing-behavior-is-inborn/
  2. https://www.msn.com/en-us/money/topstocks/how-to-prep-for-a-bear-market-morgan-housel/vi-AAThrqT
  3. https://acquirersmultiple.com/2020/09/morgan-housel-the-importance-of-remaining-calm-through-punctuated-moments-of-terror-in-the-market/
  4. https://www.cmcmarkets.com/en/opto/investing-psychology-with-morgan-housel
  5. https://acquirersmultiple.com/2020/08/morgan-housel-the-only-thing-that-you-can-control-in-investing-is-your-own-behavior/

Build Wealth in 2022: Dave Ramsey

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According to a recent survey, eight out of 10 of everyday millionaires invested in their employer’s 401(k) plan, and that simple step was a key to their wealth building. Not only that, but three out of four of those surveyed invested money in brokerage accounts outside of their company plans.

Moreover, they didn’t risk their money on single-stock investments or “an opportunity they couldn’t pass up.” In fact, no millionaire in the study said single-stock investing was a big factor in their financial success. Single stocks didn’t even make the top three list of factors for reaching their net worth.

The people in the study became millionaires by consistently saving over time. In fact, they worked, saved and invested for an average of 28 years before hitting the million-dollar mark, and most of them reached that milestone at age 49.

Dreams of trips to visit grandkids, travel adventures, and family celebrations at your paid-for home. That’s the kind of retirement many Americans dream about. You don’t have to earn six figures to turn this dream into a reality. But you do have to live and plan today with that goal in mind.

It’s important to get started building wealth no matter how old you are. Depending on your income and current financial circumstances, it might take some folks longer than others. But the fact is, you will get there if you do these five things over and over again.

Here are the five keys to building wealth:

1. Have a Written Plan for Your Money (aka a Budget)

No one “accidentally” wins at anything—and you are not the exception! If you want to build wealth, you have to plan for it. And that’s exactly what a budget is—it’s just a written plan for your money.

You have to sit down at the start of each month and give every dollar an assignment—and then stick to it! When our team completed The National Study of Millionaires, we found that 93% of millionaires said they stick to the budgets they create. Ninety-three percent! Getting on a budget is the foundation of any wealth-building plan.     

2. Get Out (and Stay Out) of Debt

According to Dave Ramsey, the only “good debt” is paid-off debt. Your most powerful wealth-building tool is your income. And when you spend your whole life sending loan payments to banks and credit card companies, you end up with less money to save and invest for your future. It’s time to break the cycle!

Trying to save and invest while you’re still in debt is like running a marathon with your feet chained together. That’s dumb with a capital D! Get debt out of your life first. Then you can start thinking about building wealth.

3. Live on Less Than You Make

Proverbs 21:20 says that in the house of the wise are stores of choice food and oil, but a man devours all he has. Translation? Wealthy people don’t blow all their money on stupid stuff. The myth that millionaires live lavish lifestyles that include Ferraris in their garage and lobster dinners every night is just that—a foolish myth. 

Here’s the truth: 94% of the millionaires we studied said they live on less than they make. The typical millionaire has never carried a credit card balance in their entire lives, spends $200 or less on restaurants each month, and still shops with coupons—even after reaching millionaire status!1 So ask yourself: Do you want to act rich or actually become rich? The choice is yours.

4. Save for Retirement

According to The National Study of Millionaires, 3 out of 4 millionaires (75%) said that regular, consistent investing over a long period of time is the reason for their success. They don’t get distracted by market swings or trendy stocks or get-rich-quick schemes—they actually save money and invest!

Being debt-free and having money in the bank to cover emergencies gives you the foundation you need to start saving for retirement. Once you get to that point, invest 15% of your gross income into retirement accounts like a 401(k) and Roth IRA. When you do that month after month, decade after decade, you know what you’re going to have in your nest egg? Money! Lots of it!

5. Be Outrageously Generous

Don’t miss this, y’all. At the end of the day, true financial peace is having the freedom to live and give like no one else. When you write a plan for your money, get rid of debt, live on less than you make, and start investing for the future, you can be as generous as you want to be and help change the world around you.

But when you make giving a part of your life, it doesn’t just change those around you—it changes you. Studies have shown over and over again that generosity leads to more happiness, contentment and a better quality of life.3 You can’t put a price tag on that!

How to Build Wealth at Any Age

That’s some big-picture financial advice that works no matter how old you are or how much money you make. It’s also true that each decade of your life will have specific challenges and opportunities. So let’s break things down decade by decade to see what you can do to maximize your savings potential.

In fact, the majority of millionaires didn’t even grow up around a lot of money. According to the survey, eight out of 10 millionaires come from families at or below middle-income level. Only 2% of millionaires surveyed said they came from an upper-income family.

The National Study of Millionaires showed a dramatic difference between how Americans think wealthy people get their money and how they actually earn and spend their money.

The salaries wealthy people make is not as much as you might think. The majority of millionaires in the study didn’t have high-level, high-salary jobs. In fact, only 15% of millionaires were in senior leadership roles, such as vice president or C-suite roles (CEO, CFO, COO, etc.). Ninety-three percent (93%) of millionaires said they got their wealth because they worked hard, and saved for the future and invested for the long term, not because they had big salaries.

References:

  1. https://www.ramseysolutions.com/retirement/the-national-study-of-millionaires-research
  2. https://www.ramseysolutions.com/retirement/how-to-build-wealth
  3. https://www.ramseysolutions.com/retirement/the-national-study-of-millionaires-research

Fear of Higher Interest Rates Ending Technology Stocks Growth

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Technology stocks have been the driving force behind the longest-running bull market in history.

The technology sector is vast, comprising gadget makers, software developers, wireless providers, streaming services, semiconductor companies, and cloud computing providers, to name just a few, according to Motley Fool. Any company that sells a product or service heavily infused with technology likely belongs to the tech sector.

And, the pandemic has been mostly positive for the tech industry. Companies like Amazon have thrived as consumers shifted hard toward e-commerce. Additionally, companies like Microsoft have also done well, buoyed by demand for collaboration software, devices, gaming, and cloud computing services as people spend more time at home.

Many of the most valuable companies in the world are technology companies.

Growth stocks have outperformed for 12 years and counting. Since the end of the Great Recession in 2009, growth stocks have been a driving force on Wall Street. Many of the most valuable companies in the world, like Apple and Microsoft, are technology companies.

Historically low lending interest rates and the Federal Reserve’s ongoing quantitative easing measures have created a pool of abundant cheap capital that fast-paced businesses have used to expand operations and investors have used to fuel the longest running bull market.

Technology stocks have been a key component of the market’s rising trend. Since the financial markets collapsed, demand for consumer electronics and related products and services has caused the tech sector to far outperform every other segment. 

However, revenue growth is starting to slow, although the delta variant surge may drive consumers away from stores once again. The economic dynamics favoring technology’s 12 year growth are changing.

Inflation is running rampant, and the Federal Reserve has indicated it’s become more hawkish on fighting it, indicating as many as three interest rate hikes may be in the cards calendar year 2022, effectively ending its loose money policy. Higher interest rates hurt growth stocks because growth stocks intrinsic value is based on the value of their future earnings. And, those future earnings are not worth as much if interest rates go up.

To best analyze tech stocks, first determine if the company is profitable or not.

For mature tech companies that produce profits, the price-to-earnings ratio is a useful metric. Divide stock price by per-share earnings and you get a multiple that tells you how highly the market values the company’s current earnings. The higher the multiple, the more value the market is placing on future earnings growth.

Many tech companies aren’t profitable, so the price-to-earnings ratio can’t be used evaluate them.

Revenue growth matters more for these younger companies.

If you’re investing in something unproven, you want to make sure it has solid revenue growth.

For unprofitable tech companies, it’s important that the bottom line be moving from losses toward profits.

As a company grows, it should become more efficient, especially when it comes to the sales and managing expenses. If it’s not, or if spending is growing as a percentage of revenue, that could indicate something is wrong.

Ultimately, a good tech stock is one that trades at a reasonable valuation given its growth prospects.

Accurately figuring out those growth prospects is the hard part. If you expect earnings to skyrocket in the coming years, paying a premium for the stock can make sense. But if you’re wrong about those growth prospects, your investment may not work out.

Thus, investing in technology stocks can be risky, but you can reduce your risk by investing only when you feel confident their growth prospects justify their often lofty price to earnings valuations.

References:

  1. https://www.fool.com/investing/2022/01/20/2-top-tech-stocks-ready-for-a-bull-run/
  2. https://www.fool.com/auth/authenticate/
  3. https://www.fool.com/investing/stock-market/market-sectors/information-technology/

Financial Freedom

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“It’s the ability to live and maintain the lifestyle which you desire without having to work or rely on anyone for money.” T Harv Eker

Financial Peace guru Dave Ramsey proclaims that “Financial freedom means that you get to make life decisions without being overly stressed about the financial impact because you are prepared. You control your finances instead of being controlled by them.”

It’s about having complete control over your finances which is the fruit of hard work, sacrifice and time. And, as a result, all of that effort and planning was well worth it!

Nevertheless, reaching financial freedom may be challenging but not impossible. It also may seem complicated, but in just a straightforward calculation, you can easily estimate of how much money you’ll need to be financially free.

What is financial freedom? Financial freedom is the ability to live the remainder of your life without outside help, working if you choose, but doing so only if you desire. It’s the ability to have the things you want and need, despite any occurrence other than the most catastrophic of outside circumstance.

To calculate your Financial Freedom Number, the total amount of money required to give you a sufficient income to cover your living expenses for the rest of your life

Step 1: Calculate Your Spending

Know how much you are spending each year. If you’ve done a financial analysis (net worth and cash flow), created a budget, and monitored your cash flow, then you’re ahead.

Take your monthly budget and multiply that amount by 12. Make sure you include periodic expenses such as annual premiums and dues or quarterly bills. Also include continued monthly contributions into accounts like your emergency fund, vacation clubs, car maintenance, etc.

Add all these together to get your Yearly Spending Total.

Keep in mind the lower the spending total, the lower the amount of money you’ll need to become financially independent. Learn how to lower your monthly household expenses and determine the difference between needs and wants.

Step 2: Choose Your Safe Withdrawal Rate

The safe withdrawal rate (also referred to as SWR) is a conservative method that retirees use to determine how much money can be withdrawn from accounts each year without running out of money for the rest of their lives.

The safe withdrawal rate method instructs financially independent people to take out a small percentage between 3-4% of their investment portfolios to mitigate worst-case scenarios. This withdrawal percentage is from the Trinity Study.

The Trinity Study found the 4% rule applies through all market ups and downs. By making sure you do not withdraw more than 4% of your initial investments each year, your assets should last for the rest of your life.

Step 3: Calculate Your Financial Independence (FI) Number

Your FI number is your Yearly Spending Total divided by your Safe Withdrawal Rate.

To find the amount of money you’ll need to be financially independent, take your Yearly Spending Total and divide it by your SWR.

For example:

  • Yearly Spending: $40,000
  • Safe Withdrawal Rate: 4%

Financial Independence Number = Yearly Spending / SWR

  • $40,000 / 0.04 = $1,000,000

Who becomes financially free? According to most financial advisors, compulsive savers and discipline investors tend to become financially free since:

  • They live on and spend less they earn.
  • They organize their time, energy and money efficiently in ways conducive to building wealth.
  • They have a strong belief that gaining financial freedom and independence is far more important than displaying high social status and financial symbols.
  • Their parents did not keep on helping them financially.
  • They have a keen insight to recognize financial and wealth building opportunities.

Net worth is the most important number in personal finance and represents your financial scorecard. Your net worth includes your investments, but it also includes other assets that might not generate income for you. Net Worth can be defined to mean:

  • Income (earned or passive)
  • Savings
  • Investing to grow and to put your money to work for you)
  • Simple and more frugal lifestyle

Financial freedom means different things to different people, and different people need vastly different amounts of wealth to feel financially free.

Maybe financial freedom means being debt-free, or having more time to spend with your family, or being able to quit corporate America, or having $5,000 a month in passive income, or making enough money to work from your laptop anywhere in the world, or having enough money so you never have to work another day in your life.

Ultimately, the amount you need comes down to the life you want to live, where you want to live it, what you value, and what brings you joy. Joy is defined as a feeling of great pleasure and happiness caused by something exceptionally good, satisfying, or delightful—aka “The Good Life.”

It is worth clearly articulating what the different levels of financial freedom mean. Grant Sabatier’s book, Financial Freedom: A Proven Path to All the Money You’ll Ever Need, the levels of financial freedom are:

Seven Levels of Financial Freedom

  1. Clarity, when you figure out where you are financially (net worth and cash flow) and where you want to go
  2. Self-sufficiency, when you earn enough money to cover your expenses
  3. Breathing room, when you escape living paycheck to paycheck
  4. Stability, when you have six months of living expenses saved and bad debt, like credit card debt, repaid
  5. Flexibility, when you have at least two years of living expenses invested
  6. Financial independence, when you can live off the income generated by your investments and work becomes optional
  7. Abundant wealth, when you have more money than you’ll ever need

The difference between income and wealth: Wealth is accumulated assets, cash, stocks, bonds, real estate investments, and they have passive income. Simply, they don’t have to work if they don’t want to.

Accumulating wealth and becoming wealthy requires knowing what you want, discipline, taking responsibility and have a plan.

Hundreds of thousands of Americans have great incomes, but you wouldn’t call them wealthy because of debt and lack of accumulated assets, instead:

  • They owe for their homes
  • They owe for their cars and boats.
  • They have little savings and investments
  • They have few “paid for” assets
  • They have negative net worth

Essentially, if you make a great income and spend it all, you will not become wealthy. Often, high income earners’ true net worth is far less than they think it is.

Here are several factors and steps to improve your financial life:

  • Establishing financial goals
  • Paying yourself first and automate the process
  • Creating and sticking to a budget. Know where you money goes.
  • Paying down and/or eliminating credit card and other bad debt. Debt which is taking from your future to pay for your past.
  • Saving for the future and investing for the long term consistently
  • Investing the maximum in your employer’s 401(k)
  • Living on and spending less than you earn
  • Simplify – separating your needs from your wants. You don’t need to keep buying stuff.

Financial freedom can look something like this:

  • Freedom to choose a career you love without worrying about money
  • Freedom to take a luxury vacation every year without it straining your budget
  • Freedom to pay cash for a new boat
  • Freedom to respond to the needs of others with outrageous generosity
  • Freedom to retire a whole decade early

When you have financial freedom, you have options.

“Your worth consists in what you are and not in what you have. What you are will show in what you do.” Thomas Edison

References:

  1. https://www.phroogal.com/calculate-financial-independence-number/
  2. https://www.ramseysolutions.com/retirement/what-is-financial-freedom
  3. https://thefinanciallyindependentmillennial.com/steps-to-financial-freedom/

Discounted Cash Flow

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Investments are the discounted present value of all future free cash flow.

Discounted cash flow (DCF) is a method of investment valuation in which future cash flows are discounted back to a present value using the time-value of money.

Present value (PV) is a financial calculation that measures the worth of a future amount of money or an investment’s future cash flow in today’s dollars adjusted for interest and inflation. In other words, it compares the buying power of one future dollar to purchasing power of one today.

PV is an indication of whether the money an investor receives today can earn a return in the future. Investors calculate the present value of a firm’s expected cash flows to decide if the stock is worth investing in today.

An investment’s worth is equal to the present value of all projected discounted future cash flows.

Discounted cash flow is a way of evaluating a potential investment by estimating future income streams and determining the present worth of all of those cash flows in order to compare the cost of the investment to its return.

When an investor is trying to determine how to spend capital, it is important to determine whether or not investments will result in a positive return. The DCF method allows an investor to determine the value of the future projected cash flow in today’s dollars. An investor can subtract the amount spent on the investment from the present value of future cash flows to calculate the net present value of the investment.

In other words, they can calculate how much money the investment will make in today’s dollars and compare it with the cost of the investment. NPV and Internal Rate of Return are the methods used in Discounted Cash Flow.

The Net Present Value (NPV) represents the present value of cash flow. The NPV can also be called as the difference between the present values of cash inflow and cash outflow. To calculate the net present value of an investment using the discounted cash flows method:

Example – an investor is considering investing in property that would cost his LLC $1,000,000 and he hold it for 5 years. What is the net present value of this investment using the discounted cash flows method?

The investor determined the discount rate to be 10%. With this information, he calculated the following future discounted cash flows:

  • Year 1 = $130,000
  • Year 2 = $150,000
  • Year 3 = $200,000
  • Year 4 = $210,000
  • Year 5 = $200,000

The total projected cash flows is $890,000.

The net present value of this investment is $890,000-$1,000,000 which is equal to -$110,000.

In this example, an investor should not make this investment because the original cost (cost basis) is greater than the value of the future discounted cash flow creating a negative return over the time period.

As in this example, the DCF is compared with the initial investment. If the DCF is greater than the original cost, the investment is profitable. The higher the DCF, the greater return the investment generates. If the DCF is lower than the present cost, investors should rather hold the cash.

An investor’s expected cash flows are at a discount rate that is actually the expected return. The discount rate is inversely correlated to the future cash flows. The higher the discount rate, the lower the present value of the expected cash flows.

The NPV represents the present value of cash flow and is generally used for comparing both the internal and the external investments of a company. DCF is a method to calculate the value of an investment based on the present value of its future cash flow.

References:

  1. https://www.myaccountingcourse.com/accounting-dictionary/discounted-cash-flow
  2. https://corporatefinanceinstitute.com/resources/knowledge/valuation/discounted-cash-flow-dcf/
  3. https://www.myaccountingcourse.com/accounting-dictionary/present-value

Margin of Safety

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“If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger the margin of safety you’d need. If you’re driving a truck across a bridge that says it holds 10,000 pounds and you’ve got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it’s over the Grand Canyon, you may feel you want a little larger margin of safety.” Warren Buffett

Billionaire investor Warren Buffett, Chairman and CEO, Berkshire Hathaway, said, “The three most important words in investing are margin of safety.” Margin of Safety is a measure of how “on sale” a company’s stock price is compared to the true value of the company. You need to be able to determine the value of a company and from that value determine a “buy price”. The difference between the two is the margin of safety.

Effectively, margin of safety means you pay less for an asset than what it’s intrinsically worth. It means to buy $10 dollar bills for $5 dollars. That’s the secret to great and successful investing. The margin of safety is the difference between the intrinsic value of a stock and the current market price of the stock. The intrinsic value of an asset is its actual value, that is, the present value of the asset found by calculating the total discounted future income it’s expected to generate.

The intrinsic value is calculated based on the 10 year discounted free cash flow (DFCF).

In other words, if the stock price of a company is below the actual value of the free cash flow (income) and assets of a company, the percentage difference is the Margin of Safety.  This is the discounted price at which you are buying a share in the company.

A higher margin of safety will reduce your investment risk. If an investor can buy a stock below its intrinsic value, the potential for a bad outcome, risk, is usually lower.

Warren Buffett likes a margin of safety of over 30%, meaning the stock price could drop by 30%, and he would still not lose money. Margin of safety is only an estimate of a stock’s risk and profit potential.

Buffett determines margin of safety by estimating the current and predicted earnings from a company from today and for the next ten years.  He then discounts the cash flow against inflation to get the current value of that cash.  This is the Intrinsic Value of the company. He bases intrinsic value on the discounted future free cash flows. He believes cash is a company’s most valuable asset, so he tries to project how much future cash a business will generate.

Margin of Safety is a value investing principle strategy. If the total value of all shares of a company is 30% less than the intrinsic value of that company, then the margin of safety would be 30%. In other words, if the stock price of a company is below the actual value of the cash flow and assets of a company, the percentage difference is the Margin of Safety.  This is the discounted price at which you are buying a share in the company. Most value investors believe that the higher the margin of safety, the better.  In reality, a margin of safety between 30% and 50% is reasonable.

The Margin of Safety is the percentage difference between a company’s Fair Value per share and its actual stock price. If a company has profits and assets that outweigh a company’s stock market valuation, this represents a Margin of Safety for the investor. The higher the margin of safety, the better.

Margin of safety is only an estimate of a stock’s risk and profit potential. Most value investors believe that the higher the margin of safety, the better.  And, the larger the margin of safety, the more irrational the market has become. 

One of the keys to getting a great margin of safety is to understand that price and value is not the same thing. Price is what you pay for something, but the value is what you get.

The stock market rises about four out of every five years or about 80% of the time, according to Nick Murray. Said another way, the market only falls 20% of the time. You can fear that 20% or cheer for it.

No one ever got wealthy paying full price or top dollar for financial assets, according to Buffett. Most successful investors got that way buying assets that were distressed, out of favor, and therefore on sale. Unfortunately, few people see it that way. You need to take advantage of the sale during market selloffs and corrections when it occurs. Your money literally goes further because you can buy more share at lower prices that lead to market-beating returns later on.

If you want to make good long-term investment returns, you need to minimize your risk by purchasing companies selling at a significant discount to their intrinsic value due to market volatility. 

References:

  1. https://novelinvestor.com/10-lessons-learned-nick-murray/
  2. https://www.ruleoneinvesting.com/blog/how-to-invest/how-to-invest-margin-of-safety-the-growth-rate/
  3. https://www.liberatedstocktrader.com/margin-of-safety/

Inflation and the Bond Market

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The bond market—Treasuries, high-grade corporate bonds, and municipal bonds—are experiencing depressed yields in the 1% to 3% range and near-record negative real rates with inflation running at 6%. Barron’s

Real interest rates can be effectively negative if the rate of inflation exceeds the nominal interest rate, according to Investopedia. Real interest rate refers to interest paid to borrowers minus the rate of inflation. There are instances, especially during periods of high inflation, where lenders are effectively paying borrowers when they, the borrowers, take out a loan. This is called a negative interest rate environment.

The real interest rate is the nominal interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to a bond investor. The real interest rate is calculated as the difference between the nominal interest rate and the inflation rate:

Real Interest Rate = Nominal Interest Rate – Inflation (Expected or Actual)

While the nominal interest rate is the interest rate actually paid on a loan or bond, the real interest rate is a reflection of the change in purchasing power derived from a bond or given up by the borrower. Real interest rates can be effectively negative if inflation exceeds the nominal interest rate of the bond.

There is risk for bond returns in 2022, when the Federal Reserve is widely expected to start lifting short-term interest rates to manage inflation.

And things could get worst for bonds if inflation persists. That could force the Fed to tighten more aggressively. It wouldn’t take a big rise in rates to generate negative returns on most bonds. The 30-year Treasury, now yielding just 1.9%, and most municipals yield 2% or less and junk bonds yield an average of 5%. Bonds would drop significantly in price if rates rise a percentage point.

The real interest rate adjusts the observed market interest rate for the effects of inflation.

“Cash has been trash for a long time but there are now new contenders for the investment garbage can. Intermediate to long-term bond funds are in that trash receptacle for sure.” Bill Gross, “Bond King”

References:

  1. https://www.barrons.com/articles/best-income-investments-for-2022-51640802442
  2. https://www.investopedia.com/terms/n/negative-interest-rate.asp

Tips for New Investors

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Getting started can be the biggest hurdle for new investors.

To get started, it’s important for new investors to set clear investment objectives, open a brokerage account, create a plan, and start investing with a long-term view. You’ll gain knowledge over time. While your investment strategy may change, getting started sooner rather than later is a good first step.

Additionally, every new investor should first make an honest assessment of where they are in life and their financial priorities. And they should leave emotion out of it. And, begin investing early in life so your money will have plenty of time to grow. A 10-year difference can have a significant effect on compounding returns.

https://fb.watch/9iNk-bRTiD/

Putting together a successful investment portfolio takes a combination of research, an investing plan, patience, and a little bit of risk.

For instance, there is plenty of research showing that frequently buying and selling stocks often leads to significantly lower long term returns than buying and holding. According to the investment research, investors who try to time the market more often get lower returns, but they also introduce more volatility into their portfolio.

By paying a lower price for an investment relative to its earnings or intrinsic value, one would expect a higher income yield in the near term, as well as the greater appreciation over the long term to the extent that free cash flow, earnings and net income increases in the future (of course, all investments involve risk and there can be no guarantees of any returns).

References:

  1. https://www.thebalance.com/the-6-dumbest-things-new-stock-investors-do-357191
  2. https://www.thebalance.com/things-investors-should-know-357631

Inflation: The Elephant in the Room

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November’s CPI report showed consumer prices rising at rates last seen four decades ago.

Inflation is the biggest risk facing the equity market and is likely to end the record long bull-market. Inflation has a long history of eroding the value of financial assets and brings with it higher interest rates as central bankers try to tamp it down.

The annual inflation rate accelerated significantly in 2021, from about 0.5% at the start of the year to over 3% by September. This was driven by increased demand as the economy reopened and by a sharp rise in energy prices, among other factors.

In October, inflation measured by the consumer price index was up 6.2% from a year earlier, the highest annual rate since November 1990. It marked the sixth straight month above 5%. Kiplinger expects inflation to hit 6.6% by year-end 2021 before falling back to 2.8% by the end of 2022 – above the 2% average rate of the past decade.

“Inflation is in the air, and it risks becoming a market issue, an economic issue and a political issue,” says Katie Nixon, chief investment officer at Northern Trust Wealth Management.

As we enter 2022, inflation is expected to remain a risk amid higher food and gas prices, rising pressures from non-energy industrial sectors such as steel and chemicals, higher food and consumer goods prices, and increases in the energy prices.

Economists expect headline CPI to peak between 4.5% and 5% in the first half of 2022 and approach 2.5% year over year by the end of 2022.

References;

  1. https://www.kiplinger.com/investing/stocks/stocks-to-buy/603814/where-to-invest-in-2022
  2. https://investor.vanguard.com/investor-resources-education/article/simple-strategies-for-reducing-inflation-risk