Income statements can surprise investors

March 15, 2016

[updates: 3/18/2016, 3/28/16 addition of the ‘customer-derived profit’ concept of EBIT]

No other report of profit exerts greater influence on the Stock Market than that of a company’s net income. Why? Stock analysts make predictions of future net income that influence the decisions of investors.  Eventual announcements of actual net income may be very pleasing or disappointing news to investors who then generate a surge of trading in the market place.

The company’s only sources of income are customers, investments, and investors.  For an established company, customers are the preferred source of profit!  Operating income (a.k.a. EBIT) is the profit earned from customers.  The adjustment of EBIT by extra items yields net income.  Net income (a.k.a. Earnings, EPS) represents the profit that a company can share with its stock holders. Market regulators require companies to reveal the operating income and net income in quarterly and annual income statements.

Income statements are designed to reveal how business operations generate net income. The purpose of this article is to describe the income statement of companies outside the banking and insurance industries. Hopefully this article will help you perform a fundamental analysis of most companies listed in the stock market.

Structure

The Income Statement is one of 3 financial statements that companies report to investors on a quarterly and annual basis. Accountants prepare the statement by consolidating all of the company’s non-cash transactions into a standardized ledger that measures the business operations used to earn a profit. Chart 1 shows the main elements of an income statement:

incomestatement

Chart 1

Total Revenues are also called the top line of the income statement. They measure the net sales of all products. Operating expenses are used to acquire, sell, and distribute the products. Extra items are additional transactions that don’t generate sales, but increase or reduce the profit from sales. Net income is also called the bottom line of the company. Net income is the profit that a company can share with its stock holders.

Relevant information

In my opinion, the “LINE ITEM” column in Table 1 lists the income statement’s most relevant information for individual investors. The “$” column shows the relevant measurement in units of U.S. dollars. The “% OF SALES” and “PROFIT MARGIN” columns display convenient ways of analyzing the income statement. At the time of this writing, I collected the “$” and “% OF SALES” data from a company’s ‘financials’ tab in morningstar.com. I simply toggled the statement’s ‘view’ command to switch from $ to %.

mainitems

Table 1.

“Revenue” (a.k.a. Total revenues, Sales) is the total value of all products shipped to customers during the reporting period. The revenue is usually recorded at the time of delivery before any cash payment is made by the customer. “Gross profit” is the remaining revenue after deducting all costs of production from the Sales. “Operating income” is the remaining revenue after deducting all other expenses of operating the business from the gross profit. “Income before taxes” is the remaining revenue after adjusting the operating income available to pay taxes. Net income is the company’s earnings after the revenue is reduced by all operating expenses and extra items.

There are several line items of net income listed in every income statement.

  • “Net income available to common shareholders” represents the residual net income after payments of dividends to the company’s preferred shareholders.
  • “Diluted Earnings per share” (EPS) is the portion of “net income income available to common shareholders” divided by diluted shares. Diluted shares are all outstanding shares (“basic shares”) plus the potential gain of shares from convertible securities.

Fundamental analysis of profitability

Profit margins are percentages of Revenue that represent intermediate and final profits. The profit margins in Table 1 measure the impact of production, operating expenses, and extra items on the company’s sales. Here are the units of measurement:

  • Gross margin = 100 * Gross profit / Revenue = 41.3% = 43.1 cents of every sales dollar.
  • Operating margin = 100 * Operating income / Revenue = 22.4 % = 22.4 cents of every sales dollar.
  • Net margin = 100 * Net income / Revenue = 14.2% = 14.2 cents of every sales dollar.

In table 1, the gross margin reveals that after paying all costs of production, the company is left with 43.1 cents from every dollar of revenue to pay for the remaining operating expenses. Costs of production include all expenses of manufacturing goods and providing services. The manufacturing process requires equipment, labor, and basic materials to build an inventory of finished goods. The provision of services requires labor and equipment. A company can be more profitable by reducing its costs of production.

The operating margin (Table 1) represents a residual revenue of 22.4 cents per sales dollar after paying all costs of production plus the costs of maintaining the business and selling the product. Think of the operating margin as customer-derived profit.  A company can earn more profit from its customers by cutting some of its operating expenses.

Net income is the remaining profit after paying operating expenses and adjusting for extra items such as government taxes. In table 1, the net margin is 14.2 cents for every dollar of revenue. The company could be more profitable by cutting some of its expenses or earning extra income. The net income is available to reward share holders in a variety of ways that eventually translate into capital gains and possibly dividends. For example, the earnings per share (a derivative of the net income) enables thousands of stock market participants to place a value on each share of ownership in the company. An increase in market value would allow stockholders to sell their shares for a capital gain.

Fundamental analysis of the competition

The business performance of 2 or more companies in the same industry can be compared by assessing their profit margins. Table 2 provides an hypothetical example of how 2 competitors manage their business revenue. For every sales dollar, company A is less profitable than company B as revealed by A’s lower profit margins. Why is B more profitable? Its 66% gross margin reflects a lower cost of production that ultimately generates a higher net margin of 24%. Game over!

Table 2.

Table 2.

Notice that company A is more efficient at maintaining its business and selling its product. Company A’s 19 percentage-point difference between 41% and 22% is less than company B’s 33 percentage-point difference between 66% and 33%. For every dollar of sales, Company A was better at squeezing some profit from its customers with lower maintenance and sales costs. Also notice that the impact of extra items (e.g. potential taxes) was nearly the same for both companies; 8 percentage-point versus 9 percentage-point differences between the operating and net margins.

Conclusions

Income statements report a set of measurements that investors can use to analyze a company’s business operations and its ability to earn a profit. The company’s operating income (‘EBIT’) and net income (‘EPS’) are the key elements of an income statement.  Operating income is used to calculate the operating margin, which measures how much profit the company earns out of every sales dollar from its customers.  The net income  depends on total revenue and efficient management.  For every dollar of revenue, the company that operates more efficiently has a better chance of earning a net income as measured in separate ways by the net margin and EPS.  The company’s earnings per share (EPS) represent the profit that the company can share with its stock holders. There are several ways to increase the EPS: boost sales, trim costs, retrieve shares, and seek extra income.

Copyright © 2016 Douglas R. Knight


Lead article: Stock Index Funds

January 16, 2016

The only way an individual investor can quickly invest in hundreds of different stocks is to buy shares of a stock index fund. The tremendous advantage is an immediate ownership of a diversified portfolio in one affordable investment. It’s the surest way of earning the stock market’s returns provided the correct investment is held through a series of ‘bull’ and ‘bear’ markets. Selecting the ‘correct’ fund requires only a few hours of easy research based on the following information:

INDEX. Stock index funds are passively-managed investment funds designed to imitate a stock index. The index measures the investment performance of a hypothetical portfolio of stocks. Some indices are riskier than others by virtue of the underlying securities in the hypothetical portfolio. For example, micro-cap stocks are riskier than all stocks combined by virtue of differences in turnover, liquidity, and diversification.

FUND MANAGEMENT. The investment fund is an actual portfolio of stocks that are managed for the benefit of the fund’s shareholders. Passive management is an investment style that imitates the performance of the selected index. Active management intentionally avoids imitating the index and is a more costly endeavor.

The legal structure of an index fund regulates its style of management. A unit investment trust (UIT) is bound by a trust agreement to manage a portfolio of fixed composition. The UIT has an unmanaged portfolio because there is no allowance for adjustment of composition by the manager. The open-end investment company (OEIC) operates a managed portfolio of adjustable composition. The OEIC is bound by its investment strategy to operate either a passively or actively managed fund. OEIC managers of an index fund are bound to passive management but have leeway to supplement the fund’s income by revising, lending, or borrowing a minor portion of the portfolio. These operations may increase the risk and tax burden of investment.

PRICING. The pricing mechanism of an index fund is closely regulated. Mutual funds are OEICs that trade shares at net asset value (NAV); in other words, they are priced at the fund’s net worth-per-share. The mutual fund’s share price is not quoted until the next day because the NAV is determined after trading hours from closing prices of the underlying stocks. Mutual funds are marketed through an authorized broker and guaranteed to be priced at the NAV. Exchange-traded funds (ETFs) are OEICs or UITs that trade the fund’s shares in the stock market, which means that the share price is quoted by public auction during trading hours. ETFs are traded the same way as stocks. The intraday net asset value (iNAV) and share price are continually updated and reported by the stock market. The fund’s share price is linked to the fund’s iNAV by arbitrage. Individual investors can neither participate in arbitrage nor redeem ETFs at NAV.

FEES. Managers of investment funds are compensated by charging an annual expense ratio that diminishes the NAV. Competition has decreased the expense ratio of stock index funds to only a few basis points (1 basis point = 0.01%), but beware that the expense ratios of bond index funds and actively managed mutual funds are typically higher; read the prospectus. Mutual funds are notorious for adding special fees to trades and imposing minimal holding periods; check with the broker and read the prospectus. New, small index funds are at risk for early termination when the NAV fails to grow above an estimated fifty million dollars. The expense ratios of small funds generate insufficient compensation for the fund sponsors, so they close shop.

TAXES. OEICs and UITs are registered Investment companies (RICs) that pass all income taxes to the shareholders. The amount of tax depends on dividends and capital gains earned by the fund. Managed portfolios incur a higher tax burden due to the more frequent turnover of portfolio securities. Consequently, mutual fund shareholders pay taxes on unrealized capital gains that ETF shareholders don’t have to pay. In theory, UITs are more tax efficient than OEICs.

INVESTMENT PERFORMANCE. During the 10 year period of 2006-2015, the compound annual growth rate of Standard and Poor’s 500 Total Return Index was 7.2%. In comparison, the growth rates of an index ETF (ticker: SPY) and an index mutual fund (ticker: VFINX) were 7.1% and 7.0% respectively. The slight differences in performance were due to an expense ratio, tracking error, and pricing error of the investment funds compared to the index.

OTHER INDEX FUNDS. There are indices to measure the investment performance of bonds, commodities, precious metals, and other assets. Likewise, there are mutual funds and ETFs that track the various indices. Bond index funds are managed by OEICs and require frequent turnover of the underlying bonds. The index funds for commodities, precious metals, and other assets are structured as grantor trusts, partnerships, or debt instruments. Stock index funds are generally less expensive, taxed at lower rates, and less risky than other index funds. Leveraged ETFs are exceptionally risky investments designed for same-day trading.

CONCLUSION. A broad-market stock index fund is the correct investment for earning returns from the entire stock market or a sector of the stock market. Simply choose an established, reputable index for the particular market that interests you. Then choose an established, reputable mutual fund or ETF that imitates the index. Use screeners or reputable fund families to select appropriate funds. Verify the fund’s expense ratio, extra fees (if any), NAV, longevity, and passive management by reading the prospectus and/or research reports. XTF.com is a free and excellent rating service for screening and assessing ETFs. Cross check your research with a trusted broker.


What is a good growth stock?

December 22, 2015

Theme

—profitable companies attract investors—

A good growth stock represents the profitable company that sells desirable products. The company’s business earnings should grow nearly 6% annually so as to match the growth rate of the U.S. Economy (about 3.5%) and compensate the rate of U.S.Inflation (about 2%); otherwise, the company might do well to liquidate its business and reinvest in securities.

Growth stock investors seek an annual rate of return that exceeds the U.S. Stock Market’s historical 8-10% annual rate of return. The basic approach is to buy stocks at a low price and sell them at a high price, but that is easier said than done. Investors can help realize high returns by selecting stocks from well managed companies, holding the stocks through an adequate growth period, to offset price volatility, and diversifying their stock portfolio.

Evaluating the company

Does the company earn respectable profits with a sustainable business? The answer is yes if the company has a:

  • growth rate of earnings that surpasses 6% annually.
  • future growth rate of earnings that surpasses 6% annually.
  • durable business with a sustainable growth rate.

Growth rate. The company that recognizes and satisfies the needs of customers will accumulate sales with the demand for its product. Profitability is the combination of sales growth coupled with efficient management of business expenses. In other words, the profitable company has a respectable growth rate of sales with respect to time, respectable rate of earnings with respect to sales, and consequently, a respectable growth rate of earnings with respect to time.

Earnings are the net income from sales after payment of expenses. The growth rate of earnings matches the growth rate of sales when the company runs its business in a consistent manner. Both sales and earnings should grow annually by at least 6% to outperform the national economy and compensate for the effect of inflation. Growth investors typically monitor the company’s earnings per share (EPS) on a quarterly basis. The EPS should grow at a compound annual growth rate of 6%, or more, as determined from at least 5 years of historical data. When evaluating a company’s earnings, consider the possibility that management is manipulating the EPS to earn higher compensation.

Future growth rate. The earnings estimate is an analyst’s quarterly or annual forecast of the EPS. The estimate is more uncertain when the forecast extends to 3-5 years. Investors use the earnings estimate to track a company’s performance and to derive a future range of share prices. The growth investor should seek companies with earnings estimates above the 6% compound annual growth rate.

Durable business. Any company can be driven out of business by an economic disaster in the entire industry, strong competition, and a declining market for the company’s product. The durable company has sufficient financial strength to survive hard times coupled with the competitive advantages needed to maintain its market position. The sustainable growth rate is a measure of the company’s capacity for earnings growth, assuming there’s room for growth of sales in the product’s market. An analysis of market opportunity is used to estimate the future demand for the company’s product.

Evaluating the stock

If a profitable company attracts investors, its stock price will rise with investors’ demand for shares. The attractive stock may be detected by a:

  • favorable valuation
  • price momentum
  • projected annual return above 10%

Favorable valuation. Growth investors place a high value on the company’s EPS for the simple reason that EPS represents the net income that generates an investment return. The 2 sources of investment return are dividends and capital gains. If the company choses to pay dividends, they are derived from the net income. Capital gains are the amount of profit from an increase in share price generated by investor-demand.

The price of a growth-stock tends to increase with the rise in EPS. This relationship is measured by the price-to-earnings ratio (P/E or PE). The current P/E is today’s price divided by the EPS of the past 12 months. The current P/E reveals what investors are willing to pay for each dollar of company earnings. The relative P/E is a ratio of the current P/E to past P/Es or to some benchmark P/E such as the average P/E of the stock market. At parity, the relative P/E is 1.0. Stocks below parity are undervalued by market participants and may be trading at prices that favor buyers. Conversely, stocks above parity are overvalued and may be trading at prices that favor sellers. There are other ways of assessing the value of a stock such as the calculation of fair value performed by stock analysts.

Price momentum. Another characteristic of the growth stock is that its share price is likely to continue in the direction of an upward trend as long as there’s a demand for shares. A review of historical prices will reveal the direction of price momentum.

Projected annual return. The reason that growth investors should seek returns above the 8%-10% total return of the stock market is that an alternative investment in index funds will capture the market’s return. One way of projecting the stock’s annual return is to multiply the future EPS by a P/E ratio to obtain the future share price. The difference from today’s price represents the future capital gain. Factoring in the stock’s dividend yield will give the projected annual return.

Risk management

The primary hazards of incurring a loss are,

  • company risk
  • market risk
  • portfolio risk

Company risk. Poor management can weaken the company and reduce its profitability. A fundamental analysis of the company, which includes a review of the financial statements, can help reduce the possibility of investing in a poorly managed company. Periodic reviews of financial statements and company news are needed to reassess the company’s management efficiency and help prevent a serious capital loss from investment.

Market risk. Volatility is the moment-to-moment fluctuation in share price that results from trading activity in the stock market. Greater volatility produces greater upside and downside risks. Upside risk is the potential gain from an investment. It represents a reasoned guess of the future peak share price. Downside risk is the potential loss. Volatility, upside risk, and downside risk are calculated in several ways. Generally speaking, riskier investments should be held for longer time periods to improve the chance of earning an estimated return.

Portfolio risk. A concentrated portfolio has a large investment in one stock compared to others. Any capital loss from the largest holding could seriously degrade the investment return of the whole portfolio. The potential impact of capital loss from a large investment can be reduced by re-allocating the principal among stocks that are diversified with respect to industry and company size.

Conclusions

A good growth stock outperforms the stock market because the company’s earnings grow faster than the Economy. One way detecting a good growth stock is to find the company that has a good sales record, bright future for earnings, and durability. Then determine what value other investors place on the stock in today’s market and future years. A potential capital gain of 10% or higher is a good growth investment.

Copyright © 2015 Douglas R. Knight


Business stories in financial statements

December 11, 2015

[updated on 2/6/2016]

Companies report their business results in financial statements on a regular basis.  Otherwise, how could they, the companies, attract serious investors?

Financial statements describe the use of money to sell products and grow a business.  The statements are prepared by accountants who consolidate business transactions into standardized measurements of profitability, cash flow, and net worth.  Those measurements represent stories of business success. The purpose of this article is to describe the framework and core stories of financial statements.

Accounting

Companies use financial accounts to perform a large variety of business functions. The effective use of accounts generates a profit for the company and its investors.

There are accounts for banking, payroll, supplies, customers, investors, shipping, advisors, taxes, and many other essential functions. Non-cash and cash transactions are recorded in the appropriate accounts. For example, each sale to a customer is initially recorded as a non-cash transaction in the customer’s account based on the price in the shipping statement. Later, the customer’s payment is recorded as a cash transaction in the company’s bank statement. In another example, the company initially records its purchase of supplies as an non-cash transaction recorded on a receipt. Later, the company’s payment to the supplier is recorded as a cash transaction in the company’s bank statement.

Accrual accounting. Accrual accounting is the practice of recording non-cash transactions at the time of transaction. The data are collected from invoices, promissory notes, and other documents of unpaid transactions.

Non-accrual accounting. Non-accrual accounting is the practice of recording cash payments. Data for cash payments are collected from bank statements and other documents of paid transactions.

GAAP. U.S. stock companies are required to publish financial statements that conform to Generally Accepted Accounting Principles (GAAP). Foreign countries may allow companies to publish financial statements using non-GAAP methods.

Framework

framework.001

Numerous financial transactions during the entire fiscal period are consolidated into line items of the income and cash flow statements. The values of all assets and liabilities at the end of the fiscal period are consolidated into line items of the balance sheet.

Income statement. The unpaid transactions of business operations are organized into revenues, expenses, and net income (Eq. 1). The statement’s top line is called total revenues and represents all recorded sales during the fiscal period. Every sale is typically recorded at the time the product is shipped to a customer. Cash payment is expected at a different time and is not recorded in the income statement. The statement’s bottom line is called net income and represents the residual value of all sales after deduction of all the expenses incurred during the fiscal period.

net Income = Total revenues – Total expenses          (Eq. 1)

Cash flow statement. The company’s payments are separated into categories of net operating cash flow (CFO or OCF), net investing (CFI), and net finance (CFF). The net value of each category is the balance between total cash inflow and outflow for the entire fiscal period. All cash surpluses and deficits are relegated to the category called net Cash Flow (Eq. 2). Companies that focus on growth attempt to maintain their net Cash Flow close to a zero balance. Investments in growth are paid through the CFI with funds obtained from the CFO or the CFF.

net Cash Flow = net CFO + net CFI + net CFF          (Eq. 2)

Balance sheet. The total book value is the net value of all corporate assets and liabilities at the end of the fiscal period (Eq. 3). The total book value is sometimes called the shareholders’ equity, net worth, or net asset value.

Total book value = Total assets – Total liabilities          (Eq. 3)

Core stories

Financial statements are designed to measure profitability and cash flow during the fiscal period and net worth at the end of the fiscal period. A simple analysis of measurements can reveal the company’s business performance.

Profitability.  The income statement describes how the company used sales and expenses to earn a profit during the fiscal period. The income statement might reveal that expensive business operations forced the company to sell a large number of products in order to be profitable.

Cash flow.  The cash flow statement describes how the company used its money during the fiscal period. If the company paid for growth, the basic scheme was to use its cash from customers or investors to grow by purchasing more assets for the business or investing in other companies.

Net worth.  Net worth is measured by the total book value at the end of the reporting period and provides a momentary valuation of the company. A company with considerable net worth has much greater value in total assets than in obligations to pay future expenses. The investor would judge that company to be financially strong.

Publications

Companies distribute their financial statements to the U.S. Securities and Exchange Commission (SEC), investors, financial services companies, and brokerage firms. Free copies can be obtained from the SEC.gov website, corporate websites, financial websites, and brokerage firms.

Domestic companies listed in U.S. stock markets file forms 10-K and 10-Q with the SEC. Form 10-K is an annual filing that contains financial statements for the fiscal year. 10-K is useful for performing a fundamental analysis of the company. Form 10-Q is a quarterly filing that also contains financial statements. 10-Q is useful for making quarterly reviews of the company.

Summary

Financial statements measure a company’s profitability, cash flow, and net worth. These measurements reveal the company’s business performance as a factor for making investment decisions. Free copies of financial statements are available in the internet.

Copyright © 2015 Douglas R. Knight


Where do good stocks come from? From good companies!

July 17, 2015

Good companies issue good stocks!
There’s a strong relationship between good companies and their stocks. That’s why some of the most successful investors rely almost exclusively on picking good companies for investment (ref. 1). Conversely, companies on the verge of bankruptcy are very risky investments. Some investors don’t understand this. Case in point was the declaration of bankruptcy by Lehman Brothers. After Lehman declared bankruptcy and its stock was delisted from the New York Stock Exchange, some investors continued to trade Lehman’s stock in the over-the-counter market at pennies per share; it was a big loss for them.

References
1. Growing Rich with Growth Stocks, by Kirk Kazanjian. New York Institute of Finance, Paramus, ©1999.


Investment styles

June 14, 2015

An investment style describes the way an investor earns a total return. The many possible investment styles can be characterized by the holding period (i.e., length of ownership) and method of valuation. Individual investors typically choose between the cyclic, growth, and value styles. Day traders hold stocks less than a day to earn small change from each share. This style is favored by a group of professional speculators and will not be discussed in this article.

A stock investor’s total return is an accumulation of dividends and capital gains. Dividends are the company’s occasional cash distributions to shareholders. Dividends can be withdrawn from the investor’s brokerage account, saved in the brokerage account as cash, or reinvested in stock. Capital gains (‘price appreciation’) are the increase in market value of a stock as calculated by the change in price since purchase multiplied by the number of shares owned. Conversely, capital losses (‘price depreciation’) are the decrease in market value caused by a price change. Capital gains(losses) are realized or unrealized cash flows. The realized gain(loss) produces an actual change the investor’s cash balance resulting from a sale. The unrealized gain(loss) is a theoretical change in cash balance at the moment of accounting.

Investors generally expect capital gains to exceed dividends. Capital gains are only earned by selling shares above the purchase price [this is the principle of ‘buy LOW’, ‘sell HIGH’; remember that a trading fee is charged for each transaction]. The following chart illustrates 3 strategies for earning capital gains:

styles

The “share price” (built into the Y axis) is what traders quote for one share of stock at a particular moment in time. The smooth curves show 3 different trends as the share price moves into the future (along the X axis). In reality, the share price oscillates throughout the trading day as a result of various market forces. However, the curves are drawn as smooth lines for the purpose of forecasting the share price. The future price can’t be predicted with absolute certainty. It’s always true that the further into the future, the less certain an investor can be about predicting the price. Investors can choose to manage the uncertainty in different ways as illustrated by the position and shape of the curves in the graph. The first way (red curve) is to earn a quick profit from a cyclic market. This method requires a gift for timing the market so that the investor can buy at a low price and sell at a high price in a relatively short time period of weeks to months. Second (blue curve), the investor can place a future value on the stock by forecasting the long term growth of company earnings in the belief that stock market participants will pay a higher price for the growth of earnings. If the investor’s analysis is correct, the future selling price will be higher than the present purchasing price. Third (black curve), the unit price may be ‘beaten down’ by a market panic or by other mechanisms causing market participants to lose interest in the stock. The analyst may find that the economic value of the company is worth more than the value of the stock by an amount called the ‘margin of error’. If that margin of error is 50%, then ‘value investors’ are fond of describing their stock purchase as buying a dollar for 50 cents. They will hold the stock as long as it takes for market participants to restore the stock price to the intrinsic value of the company. They are taking a risk that the stock price continues to fall as the company goes out of business.

Analysts make a distinction between the economic value of a company and the market value of that company’s stock. The cyclic investor pays more attention to market value. Growth and Value investors analyze the relationship between company and market value. They believe that over a period of years, the market value of the stock will rise with the economic value of the company. During the holding period they will accumulate any dividend payouts in their cash account or reinvest the dividends in more shares of stock. The accumulation of dividends and capital gains is called compounding the returns.

The future is uncertain. Many unexpected events can affect the share price following the initial purchase. Re-valuation of the company and its stock are essential to managing the risk of a long-term stock investment.


What is a stock?

June 12, 2015

A stock certifies an investor’s share of beneficial ownership in a company.  Beneficial owners are entitled to protection from liability for any of the company’s actions while receiving dividend payments from the company (at the pleasure of the company), voting on issues of corporate governance, and either selling their shares in the stock market or sharing proceeds from a liquidation of the company.

Each share is equally valued in proportion to the total number of outstanding shares issued by the company. Capitalists initially obtain shares in a private market known as the primary market and can chose to sell their shares to individual investors in a public market known as the secondary market. The secondary market is better known as the Stock market.

Here’s an example of an old fashioned stock certificate:

stockcertificate

Stock certificates were printed and distributed to shareholders who then assumed responsibility for safekeeping and transferring the certificate. The loss or destruction of a certificate meant the loss of an investment and stock transfers were a time-consuming, administrative process. Owners generally held their certificate for a long time in order to earn a satisfactory profit from dividends and growth of the stock’s price. Speed trading was unheard of before today’s methods of electronic bookkeeping and online trading platforms. Now, a responsible custodian maintains all records of stock ownership on behalf of the investor.  Confirmation messages and periodic statements provided by the investor’s brokerage firm serve as proof of ownership.

The reason that investors buy stock is to earn a profit by accumulating dividends and selling shares. Investors can protect their interest by voting on corporate matters such as board membership and executive compensation. In case the company files for bankruptcy, the proceeds from liquidation are theoretically distributed equally among stock holders according to the number of shares they own. In fact, the court-ordered company must first pay its debts, which means that corporate bondholders have priority over stockholders in receiving repayments of debt. Then owners of preferred stock have priority over common stock holders in receiving the residual funds.

Preferred stock is a hybrid form of bond and stock. The bond portion represents corporate debt to be repaid with guaranteed fixed-dividends and the stock portion represents an equity opportunity to earn capital gains without the privilege of voting rights.  Common stock represents an equity opportunity without guaranteed dividends but with voting rights. Preferred shareholders typically earn more dividends and common shareholders typically earn more capital gains.


Rates of return

March 20, 2015

Preview

The simple rate-of-return ( R ) is a measure of your investment’s profitability for any chosen time interval.  By comparison, the CAGR and IRR are rates of return that measure your investment’s profitability as if it were an orderly process with respect to time.  CAGR is the acronym for “compound annual growth rate”.  It is the constant rate at which an investment’s market value grows every year in a cumulative fashion.  IRR is the acronym for “internal rate of return”, which describes the performance of all cash flows in a financial project such as the individual investor’s program of dollar-cost-averaging or an investment club’s program of portfolio management.  IRR is an annualized rate-of-return when all time intervals are measured in years.

Return

Any profit from your investment is called a return.  There are 2 types of return: realized and unrealized.  Realized returns are cash payments from dividends, interest, and sales.  Unrealized returns are the market values of reinvested dividends and unsold holdings.

return = market value – cost  [equation 1]

Example 1: Suppose you invested $100 and held the stock for 5 years until its market value grew to $201.  From equation 1, you determine that your return is $101.  If you sell it, it’s a realized return; otherwise, it’s an unrealized return.

Simple rate-of-return

The simple rate-of-return ( R ) is a measure of your investment’s profitability for any chosen time interval, but time is not an essential factor in the calculation (equation 2).

 R = return/cost [equation 2]

R is reported as a decimal number or a percentage.

Example 2: The cost of an investment was $100 and 5 years later the return was $101.  From equation 2, R = $101/$100 = 1.01.  Multiply the answer by 100 to find the percentage.  R = 100×1.01 = 101%.

CAGR

The CAGR is a rate-of-return that measures your investment’s profitability as a growth rate.  Time is a factor in the calculation of CAGR (equation 3).

rate = (final/initial)(1/N) -1  [equation 3]

N is the number of events or time periods between

the initial and final values.

Example 3, simple R versus CAGR: The cost of an investment was $100 and 5 years later its final value was $201.  We know from example 2 that the simple R is 101%.  Using the growth rate formula from equation 3, we find that the CAGR is 15%.

Significance: CAGR is the acronym for “compound annual growth rate”.  It is the constant rate at which an investment’s market value grows every year in a cumulative fashion.

MATH: CAGR is a growth rate that describes the ‘future’ (or final) value of a single cash payment.  In contrast, the discount rate devalues a cash flow.  Both rates represent a common ratio that generates a geometric series of points aligned to a smooth curveref 1. Chart 1 illustrates the geometric series of an inflated and devalued investment.

 Chart 1.  Geometric series.

geometric series

In chart 1, the black circle represents a single investment.  The blue curve is a series of theoretical values related to the investment by a common ratio called the discount rate or the growth rate depending on the particular application.  The discount rate devalues the investment to lower values as a function of the time-period N.  The growth rate inflates the investment to higher values.  Both rates are calculated by the formula in equation 3.

IRR

Equation 3 is also used to calculate the IRR, an acronym for the “internal rate of return”.  The IRR is used to measure the profitability of investments with multiple cash flows.  It is a discount rate that balances all devalued cash flows in a financial project.

MATH: In the field of Finance, a devalued cash flow is called the present value.  The present value is found by revising equation 3 to calculate the initial value for time period N at a given discount rate.  The net present value of the project is the sum of all present values.  The IRR is the discount rate that sets the net present value to zeroref 2.  It is the best-fit discount rate found by an iterative process of trial and error.  The significance of the IRR will be discussed after working through example 4.

Example 4, IRR:  An investor paid $100 each year for 4 years to purchase and accumulate shares of a particular stock.  After 5 years the market value of all shares was $735.  Since the purchases were multi year cash flows, the IRR is a good choice for analyzing this investment.  In this example, the trial discount rate is 13.1%.  Table 1 (below) illustrates the analysis:

Table 1.  IRR analysis of the investment in example 4.

IRRanalysis

Row 1, N displays the time period in years for factor N of equation 3.  Row 2, ACTUAL is the series of investments that began with a $100 payment at time 0.  Additional $100 payments were made at the end of years 1 through 4 for a total cash outflow of $500.   The total market value of the investment was $735 at the end of the 5th year.  To determine the IRR, the present value ref 2 of every cash flow was calculated with the trial discount rate of 13.1% after rearranging equation 3 to solve for the initial value.  Row 3, DISCOUNTED is the series of present values for each cash flow in row 2.  Notice that the total present value of all cash outflows equals the discounted cash inflow of $396.65.  Therefore, the net present value is $0 and the 13.1% discount rate is the investment’s IRRRow 4, PROJECTED is the final value for each present value in row 3.  The final value is predicted by rearranging the terms of equation 3 and using the IRR’s 13.1% as a growth rate for the remaining time.  It’s no accident that the sum of final values in row 4 equals the $735 cash inflow in row 2.  Chart 2 (below) illustrates the growth curves for projected values.

Chart 2. Projected values for every cash outflow in example 4.

IRRinterpretation

In chart 2, N is the time period in years.  Each black square depicts an investment of $100.  Each blue curve shows the predicted growth of the investment.  Every point on a curve is a future value and the endpoint at year 5 is the final value.  The final values are listed in row 4 of table 1.  They decreased as the years progressed because there was less time remaining for growth.

Significance:  The IRR is a rate-of-return that describes the performance of all cash flows in an investment.  The IRR is an annualized rate-of-return when all time intervals are measured in years.

Time distortion

A positive CAGR or IRR always shows a profit.  Conversely, a negative CAGR or IRR always shows a loss.  Higher CAGRs and IRRs imply more profitable investments, but beware that those with short holding periods may grossly misrepresent the long term performance of an investment.

Example 5, time distortion:  Suppose that four different $100 investments grew to $200 apiece.  From equation 1, we know that the return was $100 for every investment.  If the holding periods were 10, 5, 1, and 1/5th years, what were the annualized rates of return?

Table 2.  Annualized- and Simple Rates of return

for different holding periods

TimeDistortionOfCAGR,IRR

Legend.  Equation 3 is used to calculate the annualized rate-of-return when the unit of time is in years.  For this equation, the “Holding period” is the value of N and “Final/Initial” is the quotient of $200 divided by $100.  The 4th column is the annualized rate-of-return calculated by equation 3.  The 5th column is the simple rate of return calculated by equation 2.

High annualized rates are desirable, but don’t feel exuberant about an exceptionally high annualized rate-of-return.  As shown in table 2, the annualized rate-of-return might temporarily be inflated by a brief holding period.  It’s unlikely that a short term investment could sustain the 3,100%, or even 100%, annualized rate-of-return in the long run.

Significance:  The passage of time decreases an annualized rate-of-return when cash flows are static.  ANY increase in the CAGR or IRR over time indicates a profitable increase of cash inflow relative to cash outflow.  It’s always wise to verify this impression by checking the payout of the project.

Conclusions

In the investment world, rates of return are measurements of profitability.  Positive rates indicate profits and negative rates indicate losses.  All rates of return are sensitive to the volatility of market prices; they rise and fall with the market.  The annualized rates of CAGR and IRR are exquisitely sensitive to short time periods; don’t get exuberant about high annualized rates before checking the time period and potential payout.  In the long term, annualized rates tend to decline unless supported by dividend payments and capital gains.  An IRR that is holding steady during the passage of time is revealing an underlying growth in market value.

Copyright © 2015 Douglas R. Knight

References

  1. Donna Roberts, Geometric sequences and series. Copyright 1998-2012.  http://www.regentsprep.org/regents/math/algtrig/atp2/geoseq.htm
  2. A. Groppelli and Ehsan Nikbakht. Barron’s FinanceFifth Edition.  2006, Barron’s Educational Series, New York.

The internal rate of return (IRR) of a portfolio

December 18, 2014

Summary

Since investment portfolios have multiple cash flows, their performance is typically measured by the internal rate of return (“IRR”)refs 1-3.  IRRs are widely used to plan and analyze financial projects.  The planning process called capital budgeting won’t be discussed in this article.  The purpose of this article is to describe the analytical use of IRRs in evaluating profitability.  Generally speaking, the positive IRR reflects a profit and the negative IRR reflects a loss.  Higher IRRs infer more profitable investments, but the analyst is cautioned to examine the investment’s return as well as its IRR refs 1-2!!  There are three steps to computing an IRR.

  1. calculate the present value of every cash flow
  2. find the net present value
  3. find the IRR (the IRR is a specific discount rate that sets the net present value to 0).

[Click on this link –calculate_IRR– to download an IRR calculator.]

Present value

Analysts evaluate the history of multiple cash flows by finding the time value for each cash flow.  Time value is measured by converting the future value of each cash flow to its present value.  In hindsight, the present value is the initial cash payment and all future values are subsequent cash flows.  Equation 1 shows how one present value is estimated from one future value over the time span labeled N.  The present value depends on its discount rate, R.

present value = future value/(1+R)N                    Eq. 1

Discount rate

The process of discounting an item means to reduce its price or market value.  In equation 1, the discount rate (R) is the rate at which the known future value reverts to its theoretical present value.  The practical significance of the discount rate depends on its intended use.  In financial planning it reflects the risk of an investment as influenced by interest rates, inflation, and the uncertainty of time ref 2.  In the hindsight analysis of a portfolio, the discount rate represents the rate of return for a given cash flow.

Net present value (NPV)

The sum of all present values in a portfolio is the theoretical cash balance called net present value (NPV)refs 2-3.  The positive NPV reveals a profit and the negative NPV reveals a loss.

Internal rate of return (IRR)

The IRR is a specific discount rate that sets the net present value to 0.  As such, it represents the time value of all cash flows in a portfolio.  It also reflects the rate of return of the portfolio.  The IRR is calculated by a trial-and-error process of computing net present values for different discount rates.  In the appropriate set of trial discount rates, net present values will vary from negative to zero to positive or positive to zero to negative depending on the cash flows.

Example

Suppose $1,000 was invested every 6 months and the stockbroker charged a $7 trading fee each time.  After 21 months, the total market value grew to $4,436.46.  Was the IRR 10%?

Time span in years (N) Item  Cash flow
0 Investment + trading fee -1,007
0.5 Investment + trading fee -1,007
1 Investment + trading fee -1,007
1.5 Investment + trading fee -1,007
1.75 Market value 4,436.46

 

NPV = sum of present values

= (PV at N=0) + (PV at N=0.5) + (PV at N=1) + (PV at N=1.5) + (PV at N=1.75)

= (-1,007/(1+.10)0) – (1,007/(1+.10)0.5) – (1,007/(1+.10)1) –( 1,007/(1+.10)1.5) + (4,436.46/(1+.10)1.75)

= -1,007 -960.79 -915.75 -873.51 +3,757.05

= 0

Yes, the IRR was 10%.  The NPV was $35.13 at 9% IRR, $0 at 9.985% IRR, and -$35.18 at 11% IRR.

Applications

Periodic reports.  The IRR increases when cash inflow increases, cash outflow decreases, and time is compressed ref 1.   The passage of time will decrease the IRR when all cash flows are static.  Consequently, any increase in IRR over time indicates a profitable increase of cash inflow relative to cash outflow.  It’s always wise to verify this impression by checking the payout of the project.

Comparisons.   Be cautious about using the IRR to compare different investments ref 1.   For one reason, higher IRRs don’t always identify higher returns.  Two projects with different cash flows may have the same IRR, yet one project yields a higher return at the time of comparison.  For another reason, the compression of time tends to raise the IRR and promote a false sense of security.  Project A’s exceptionally high IRR for a brief time period may not be sustainable in the long run.  Project B’s lower IRR over a longer time period may be sustainable.  Be sure to examine the payouts as well as the IRRs when comparing investments ref 1!!

U.S. Tax Code

The calculation of IRR is indifferent to tax rules for reporting an investment’s cost basis.  The LIFO and FIFO rules have no effect on calculations of IRR.

Miscellaneous

IRR vs CAGR.  Both the IRR and CAGR measure an investment’s rate of return.  The CAGR measures an initial and final cash flow over one time period.  The IRR is a more flexible measure due to its capability of analyzing multiple cash flows over time ref 4.

ERR.  The IRR is sometimes called the economic rate of return (ERR)ref 3.

IRR computation.  The trial-and-error determination of IRR is applicable in all situations, but it can be simplified to a single step when all cash flows are constant ref 2.

Two IRRs.  For mathematical reasons, an investment project with delayed cash outflows may have two IRR’s of widely different values ref 1.   The practical significance of the higher IRR is uncertain.

References

  1. Baker, Samuel L. Perils of the internal rate of return.  Economics interactive tutorials, University of South Carolina.  12/5/2009.  ©2000.
  2. A.A. Groppelli and Ehsan Nikbakht. Barron’s FinanceFifth Edition.  2006, Barron’s Educational Series, New York.
  3. Grayson, Linda.  Internal Rate Of Return: An Inside Look.  © 2014, Investopedia, LLC.
  4. Fuhrmann, Ryan C.   What are the main differences between  compound annual growth rate (CAGR) and internal rate of return (IRR)?  © 2014, Investopedia, LLC.

April, 2014, I joined an investment club

May 15, 2014

I enjoy seeking short term returns from stocks. Active trading gives me the excuse to place crafty trading orders and check the market every day. The goal is to realize a profit from every stock in less than a year, resulting in a portfolio turnover rate of at least 100%. Read the rest of this entry »


%d bloggers like this: