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HEY! DID YOU KNOW…

 

  • The median age in the U.S. is 36.8
  • The median income in the U.S. is $51,939
  • The average 401k match is $1 for $1 up to 6%

A 36.8 year old investing 10% of their $51,939 income with a $3,116.34 match:
With just average stock market returns of 10% would have $1,114,479.31 by retirement.

Join 7,200+ other readers who have learned how anyone, even beginners, can easily make this desire a reality. Download the free ebook: 7 Steps to Understanding the Stock Market.

DCF Valuation: How to Use It Wisely

Discounted Cash Flow (DCF) valuation is one of the fundamental models in value investing. The model is used to calculate the present value of a firm by discounting the expected returns to their present value by using the weighted average cost of capital (WACC).

How to perform a DCF valuation

There are certain steps in performing a DCF valuation. These are:

  1. Calculate the WACC

The weighted average cost of capital is fundamental to the capital asset pricing model (CAPM). The WACC is calculated as the weighted average of a firm’s cost of debt and cost of equity.

Assuming that you have invested in Novartis (NYSE: NVS), the steps for the calculation of WACC are the following:

dcf valuationa) The first step is to find the cost of debt and the cost of equity.

The cost of debt is derived as follows:

The company’s total debt is $16.33 billion and the interest expenses are $655.0 million. The interest expenses will save Novartis $655 x 30% (tax rate) = $196.50 million. So, the after-tax cost of debt Rd = ($655.0 – $196.5) / $16.33 = 2.81%

The cost of equity is calculated using the formula Rs = RRF + (RPM * b), where,

  • RRF: the risk-free rate
  • RPM: the return that the market expects
  • b: the stock’s beta (systemic risk)

Therefore, for a risk-free rate of 5.00%, an expected market return of 5.10% and a b=0.75, the cost of equity is:

Rs = RRF + (RPM * b) = 5.00% + (5.10% x 0.75) = 8.83%

b) The second step is to calculate the weights of debt and equity

First, you need to find the Market value added (MVA) of the company, which represents the difference between the current market value of a firm and its book value. Novartis is currently trading at $75.21 and the number of shares outstanding is 2.37 billion. Therefore, the company’s market value is $75.21 x 2.37 = $178.25 billion. Given the company’s book value per share (BVPS) of $31.57, its book value is $31.57 x 2.37 = $74.82 billion. Therefore, the market value added is market value – book value = $178.25 – $74.82 = $103.43 billion.

Now that you know the MVA and the total debt, you added them to derive the weights of debt and equity. Therefore:

The book value of debt + MVA of equity = $16.33 + $103.43 = $119.76. Therefore, the weight of debt Wd = $16.33 / $119.76 = 13.63% and the weight of equity We = $103.43 / $119.76 = 86.37%.

c) The final step is to calculate the WACC

The formula for WACC is (Rd*Wd) + (Rs*We). Therefore:

WACC = (2.81% x 13.63%) + (8.83% x 86.37%) = 0.38% + 7.62% = 8.00%.

[click to continue…]

High Dividend Stocks: The Risks and Double Compounding Potential

A stock that can grow their dividend payments over time consistently provides compounding like no other opportunity. Naturally, investors try to maximize this compounding by searching for high dividend stocks. It’s a great idea but it comes with some hidden dangers.

Let’s be clear. It doesn’t take much reading of this site to figure out how strongly I feel about dividends. I push for dividends and only buy stocks that pay dividends. To me, it’s not really investing unless you are getting paid a steady stream of income over time.

high dividend stocks

Also, many good dividend growth picks of the past had a double compounding effect for the investors. Companies like $KO, $PG, $WMT, $MO and others, were able to not only increase their share price by 10s of percent per year but also sustain double digit dividend payment growth.

Some of the best investing stories come from ordinary people who bought a couple good dividend stocks and held them for the long term, letting the company do all of the work for them. I’m talking about 10s of thousands of dollars turning into 100 of thousands or millions.

Let me tell you one quick example.

The Dividend Stock Widow

This is true story about investing told by hedge fund manager Joe Ponzio.

He met a woman named Rose who tells of the time her husband Fred died in 1966. Now, Fred was a successful businessman and left the family with good life insurance. However, they still had one child left in an expensive med school problem.

And Rose was left without an income or any means to make an income.

It just wasn’t possible for a mid 40s woman with no experience to get a job in that time period. Luckily, she knew about the income generating stock market.

Rose didn’t know too much about investing. So she bought the big names– like Coca Cola, Johnson and Johnson, and Pepsi. She didn’t bother with trying to time the market… after all she needed the income from these dividends to pay for all her expenses. So she couldn’t sell them.

Instead of “going to work”, Rose would go to the library and read annual reports. She had her brother help her calculate the intrinsic value of these companies so she’d know at what price to buy them.

Rose started in 1966 with $10,000. By 2001, her portfolio was worth $200,000+. By 2008… she had a portfolio of over $2.5 million.  [click to continue…]

The Substantial Opportunity Cost of Retained Earnings for Investors

When a company creates profits, it has a decision to make. It’s all between how much of the earnings they should pay back to shareholders as a dividend, and how much they should reinvest in the business. Keeping the earnings is known as retained earnings.

retained earnings

Many investors can be led astray by the deceitfulness of retained earnings because on the surface it sounds like a great idea.

Warren Buffett is a proponent of retained earnings, after all, his company Berkshire Hathaway retains all of its earnings. His argument is that the company can compound the retained earnings at a much higher rate than the investor can if it was instead paid out as a dividend.

In fact, the better a company is at this– evidenced by high efficiency ratios such as return on assets, return on equity, etc– the stronger the argument for retained earnings tends to become.

Many of the “growth stocks” of today, those that are popularized by the media that usually have high rates of earnings growth, don’t pay out a dividend and use the excuse of retained earnings quite frequently. It’s almost expected by growth investors that their companies won’t pay a dividend.

The logic is this. If a company can utilize earnings and return 20% on that money, meaning create 20% more profits for the company, then that’s a superior compounding rate than an investor can expect to get in the market. And it’s true, investors can’t expect 20% returns in the market most of the time.

So then investors should be in favor of retained earnings most of the time, right?

Not so fast.

There’s several reasons why I disagree. It’s not that I don’t agree with the base level logic. I do, I get it. But you have to look deeper than that, and really examine the implications. Look at all possible outcomes of when a company does this.

Let’s not just blindly follow successful investors like Buffett. After all, his company Berkshire implements this standard for their own company– but look at many of Buffett’s past and present investments. They tend to pay great dividends or have high levels of dividend growth, indicating a stock that retains less of its earnings.

Valuations Matter, Alot

The first and most easiest point to understand is the valuation effect. I mentioned earlier that many growth stocks tend to be the biggest perpetrator of retaining earnings. They also tend to carry high valuations.

For beginners, a high valuation means a stock is expensive. And the higher a valuation you pay for a stock, the less of a positive effect retains earnings has on your results.  [click to continue…]

How the Stock Market Cycles like the 4 Seasons

Like winter, spring, summer and fall… the stock market cycles. Now if you are aware of this phenomenon, you can better prepare your investments to reflect this reality. Being unaware of stock market cycles, on the other hand, can make you panic when things don’t go your way.

stock market cycles

One of the most important concepts about the stock market is this feature of moving in cycles. Like the seasons that fluctuate repeatedly, the stock market moves between periods of extreme optimism and pessimism. This is where the terms bear and bull market originate from.

The interesting thing about strong bear or bull markets is that they aren’t readily apparent until after the fact. While general prosperity or low stock market returns are occurring, most investors are consumed with issues inside the current season, unaware that a new season might be and often is just around the corner.

This is one of the reasons why being a contrarian is so profitable. It’s also a factor in why value investing works so well. Value investing depends on investor sentiment and emotions wildly mis-valuing securities beyond its logical value. The difference of undervaluation becomes the margin of safety that value investors chase.

There’s two ways to look at the stock market. One is a very black and white approach. Either you buy a stock and it makes you money or loses you money. This is a very frustrating mindset to have, because you have no control over the situation. Anything can and does happen in the markets, and you’re just hoping that you come out ahead this time. It’s a short term and limited approach.

The other way is to recognize that the stock market moves like the seasons. Other than bankruptcy, nothing is permanent and things are changing all the time. Instead of trying to directly profit from our trades, you’re trying to hold for the long term and generally buy companies that are undervalued. This allows you to hold through less advantageous times and see opportunities where others don’t.

One glance at any stock chart will show you how much more the stock price fluctuates than the actual value of the business does. The ability to identify this value and capitalize on it is a major part of finding success.

Another major key to success is staying conscious of what season the market is in and making investment decisions based on this. Let’s examine some key characteristics behind the 4 seasons of the stock market.  [click to continue…]

Value Investors Love to Sell When Reaching Intrinsic Value. I don’t.

Like most things investing, it seems like I am constantly taking a contrarian approach. Value investing, at its core, is based on comparing a company’s fair market value with the way you’ve calculate its intrinsic value and closing that gap. Graham, Klarman, and others call it a margin of safety.

margin of safety focus

By closing that gap, I mean waiting for the company’s share price to catch up with its intrinsic value. Buying with a margin of safety simply means buying a stock at a discount to its intrinsic value. The thought is that emotions and perceptions on a company are temporary, and stocks out of favor in the market will eventually trade back at its intrinsic value over the long term.

An approach like this actually lowers the risk rather than increases it. You get less exposure to risk because the more of a discount you get, the less likely it is the share price will decrease further.

Because although many see the market as a voting machine, where all it takes is to buy stocks before they get popular, prudent investors see the market as a weighing machine—with an underlying business behind it. Analyze the business, not the share price potential.

A major risk to buying depressed stocks is that many will have pessimistic views on themselves precisely because their business is struggling. A more complete overview is needed to ensure that isn’t the case.

The danger in relying on a particular intrinsic value calculation is that most intrinsic value calculations only concern themselves on a focused portion of the financial statements.

That’s exactly why I take an approach to span all 3 financial statements in my “buy low” approach. To me, it’s like the difference between security cameras all around your house vs. just one high powered 4k HD camera at your front door. Many value investors place their one narrow viewpoint HD camera and think they are protected with their calculated margin of safety.

Now, back to the matter at hand. [click to continue…]