Weighted Average Cost of Capital

Students who graduated from the WA08 class, if you can still recall, Conrad showed us this site where you can key in the stock symbol and the site will automatically compute the intrinsic value of the stock for you. For those who cannot remember, you can click on this link Online Intrinsic Value Calculator. I have also added the link to heading under Investment Related Sites.

If you have used the calculator for your stock valuation, you will notice there is this entry known as the Company WACC (%). So what is this company's WACC? WACC is actually an acronym for Weighted Average Cost of Capital for that company. If you understand about the capital budgeting process of a company that involved the discounted cash flow analysis, this is actually the discount rate that company used to discount its future cash flow. This rate is also known as the marginal cost of capital.

On the right (liability) side of a firm's balance sheet, we have debt, preferred stock, and common equity. These are normally referred to as the capital components of the firm. Any increase in a firm's total assets will have to be financed through an increase in at least one of these capital accounts. The cost of each of these components is called the component cost of capital.

The WACC is given by:

WACC = (wd)(kd)(1 – t) + (wps)(kps) + (wce)(kce)

where:

• wd = The percentage of debt in the capital structure
• wps = The percentage of preferred stock in the capital structure
• wce = The percentage of common stock in the capital structure
• kd = The rate at which the firm can issue new debt. This is the yield to maturity on existing debt. This is also called the before-tax component cost of debt.
• kd(l - t) = The after-tax cost of debt. Here , t is the firm's marginal tax rate. The after-tax component cost of debt, kd(l - t), is used to calculate the WACC.
• kps = The cost of preferred stock.
• kce = The cost of common equity. It is the required rate of return on common stock and is generally difficult to estimate.

How a company raises capital and how they budget or invest it is considered independently. Most companies have separate departments for the two tasks. The financing department is responsible for keeping costs low and using a balance of funding sources: common equity, preferred stock, and debt. Generally, it is necessary to raise each type of capital in large sums. The large sums may temporarily overweight the most recently issued capital, but in the long run, the firm will adhere to target weights. Because of these and other financing considerations, each investment decision must be made assuming a WACC which includes each of the different sources of capital and is based on the long-run target weights. A company creates value by producing a return on assets that is higher than the required rate return on the capital needed to fund those assets.

The WACC as we have described it is the cost of financing firm assets. We can view this cost as an opportunity cost. Consider how a company could reduce its costs if it found a way to produce its output using fewer assets, say less working capital. If we need less working capital, we can use the funds freed up to buy back our debt and equity securities in a mix that just matches our target capital structure. Our after-tax savings would be the WACC based on our target capital structure, times the total value of the securities that are no longer outstanding.

For these reasons , any time we are considering a project that requires expenditures, comparing the return on those expenditures to the WACC is the appropriate way to determine whether undertaking that project will increase the value of the firm. This is the essence of the capital budgeting decision. Since a firm's WACC reflects the average risk of the projects that make up the firm , it is not appropriate for evaluating all new projects. It should be adjusted upward for projects with greater-than-average risk and downward for projects with less-than average risk.

The weights in the calculation of WACC should be based on the firm’s target capital structure. In the absence of any explicit information about a firm’s target capital structure from the firm itself, an analyst may simply use the firm’s current capital structure as the best indication of its target capital structure. If there has been a noticeable trend in the firm’s capital structure, the analyst may want to incorporate this trend into his estimate of the firm’s target capital structure.

Alternatively, an analyst may wish to use the industry average capital structure as the target capital structure for a firm under analysis.

What Kind of Trader or Investor are you?

Conrad mentioned this in the WA08 workshop and I thought it was kind of cute to classify traders and investors to the characteristics of the animals and hence I did a search on Investopedia to see what they really mean?

1. The Turtle Trader or Investor
2. The Pig Trader or Investor
3. The Ostrich Trader or Investor
4. The Lemming Trader or Investor
5. The Sheep Trader or Investor
6. The Barefoot Pilgrim Trader or Investor

Turtle - A nickname given to a group of traders who were a part of an 1983 experiment run by two famous commodity traders, Richard Dennis and Bill Eckhardt. The goal of the study was to prove whether being a great trader was a genetic predisposition or whether it could be taught. Dennis believed that a person could be trained while Eckhardt thought it was an innate skill.

Pig - An investor who is often seen as greedy, having forgotten his or her original investment strategy to focus on securing unrealistic future gains. After experiencing a gain, these investors often have very high expectations about the future prospects of the investment and, therefore, do not sell their position to realize the gain.

Ostrich - A slang term given to investors or other market participants who ignore important pieces of information or situations, which have the ability to impact them or the market in which they operate. The reasons behind type of action can include risk aversion and bias.

Lemming - The act of following the crowd into an investment that will inevitably head for disaster.

Sheep - An investor who lacks a focused trading strategy and trades on emotion and the suggestions of others, including friends, family and financial gurus. This type of investor often makes rash investments without reviewing their financial viability. The behavior of sheep contrasts with that of bulls and bears, who have focused views about the market.

Barefoot Pilgrim - Slang for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market.

Which kind are you?

Yield Curve for Bonds

For those students who graduated from WA07 class, if you still remember Conrad mentioned about the Inverted Yield Curves for year 2006 and 2007 and their implication to the economy, you may be wondering what Conrad is trying to get across to us. I'll try to explain what causes the shape of the yield curve in this post.

There are three theories to describe the term structure of interest rates that affect the shape of the yield curve. They are

1. Pure Expectation Theory
2. Liquidity Preference Theory
3. Market Segmentation Theory

So what does each theory say? The pure expectations theory states that the yield for a particular maturity is an average (not a simple average) of the short term rates that are expected in the future. If short term rates are expected to rise in the future, interest rate yields on longer maturities will be higher than those on shorter maturities, and the yield curve will be upward sloping. If short term rates are expected to fall over time, longer maturity bonds will be offered at lower yields.

Proponents of the liquidity preference theory believe that, in addition to expectations about future short term rates, investors require a risk premium for holding longer term bonds. This is consistent with the fact that interest rate risk is greater for longer maturity bonds.

Under this theory, the size of the liquidity premium will depend on how much additional compensation investors require to induce them to take on the greater risk of longer maturity bonds or, alternatively, how strong their preference for the greater liquidity of shorter term debt is.

The market segmentation theory is based on the idea that investors and borrowers have preferences for different maturity ranges. Under this theory, the supply of bonds (desire to borrow) and the demand for bonds (desire to lend) determine equilibrium yields for the various maturity ranges. Institutional investors may have strong preferences for maturity ranges that closely match their liabilities. Life insurers and pension funds may prefer long maturities due to the long-term nature of the liabilities they must fund. A commercial bank that has liabilities of a relatively short maturity may prefer to invest in shorter-term debt securities. Another argument for the market segmentation theory is that there are legal or institutional policy restrictions that prevent investors from purchasing securities with maturities outside a particular maturity range.

A somewhat weaker version of the market segmentation theory is the preferred habitat theory. Under this theory, yields also depend on supply and demand for various maturity ranges, but investors can be induced to move from their preferred maturity ranges when yields are sufficiently higher in other (non-preferred) maturity ranges.

The pure expectations theory by itself has no implications for the shape of the yield curve. The various expectations and the shapes that are consistent with them are:

1. Short-term rates expected to rise in the future -> upward sloping yield curve
2. Short-term rates are expected fall in the future -> downward sloping yield curve
3. Short-term rates expected to rise then fall -> humped yield curve
4. Short-term rates expected to remain constant -> flat yield curve

The shape of the yield curve, under the pure expectations theory, provides us with information about investor expectations about future short-term rates.

Under the liquidity preference theory, the yield curve may take on any of the shapes we have identified. If rates are expected to fall a great deal in the future, even adding a liquidity premium to the resulting negatively sloped yield curve can result in a downward sloping yield curve. A humped yield curve could still be humped even with a liquidity premium added to all the yields. Also note that , under the liquidity preference theory, an upward sloping yield curve can be consistent with expectations of declining short term rates in the future.

The market segmentation theory of the term structure is consistent with any yield curve shape. Under this theory, it is supply and demand for debt securities at each maturity range that determines the yield for that maturity range. There is no specific linkage among the yields at different maturities, although, under the preferred habitat theory, higher rates at an adjacent maturity range can induce investors to purchase bonds with maturities outside their preferred range of maturities.

Conrad showed us to this site where you can learn more about bonds. You can click on the link here.

Sam Stovall

I first heard about Sam Stovall, who is the Chief Investment Strategist at Standard & Poor's, from Conrad Alvin Lim when I attended the Wealth Academy workshop. Sam Stovall wrote a book on Sector Investing. Conrad had used his model and showed us a demonstration on how this model works till today even though Sam Stovall wrote the book back in 1996. What Conrad had shown really impressed me a lot. I have always been a stock centric person and never really take the times to understand how the money flows from the one sector to the other. Hence after learning what Conrad had taught me, I decided to find more information regarding sector rotation, sector investing etc.

I found this very good article in Investopedia which you may be interested to take a look. I also found a research written by Sam Stovall. I have provided the links of the article and the research here. You can simply click on the links.

1. Article about Sector Rotation
2. Demystifying Stock Research

Nineteen Common Mistakes Most Investors Make

This is a continuation of my yesterday post on the CAN SLIM acronym by William J. O’Neil book, "How to Make Money in Stocks A Winning System in Good Times or Bad - Third Edition". One of the chapters in the book mentioned about the nineteen common mistakes most investors make. I have consolidated and posted them here.

Even the most experienced investors often make the same classic mistakes that limit their profits or cause steep losses. Here are the 19 mistakes you must avoid:

1. Stubbornly holding on to losses when they are very small and reasonable. Instead of getting out cheaply, many investors hold on until the loss gets so large it costs them dearly. Without exception, cut every loss at 7 to 8 percent.
2. Buying on the way down in price, thereby ensuring miserable results. A declining stock seems to be a real bargain. But remember: With few exceptions a stock’s price is high or low for good reasons.
3. Averaging down in price rather than up when buying. If you buy a stock at $40 and then buy more at $30, and average your cost at $35, you are following your losers and putting good money after bad.
4. Buying large amounts of low-priced stocks rather than smaller amounts of higher priced stocks. When you invest, buy the best merchandise available, not the cheapest. Low-priced stocks cost more in commissions and are more volatile, usually to the downside.
5. Wanting to make a quick and easy buck. Wanting too much, too fast, without the proper preparation, can lead to big losses.
6. Buying on tips, rumors, split announcements, and other news events, stories, advisory service recommendations, or opinions you hear from supposed market experts on TV. Trust what you have learned through hard work, not rumors and tips, which usually aren’t true.
7. Selecting second-rate stocks because of dividends or low price earnings ratios. Dividends and P/E ratios aren’t as important as earnings per share growth. In many cases, the more a company pays in dividends, the weaker it may be.
8. Never getting out of the starting gate properly due to poor selection criteria. Many people buy highly speculative, risky stocks that have questionable earnings and sales growth; inevitably, they get what they deserve.
9. Buying old names you are familiar with. Many of the best investments will be newer companies that, with a little research, you could discover and profit from before they become household names.
10. Not being able to recognize and follow good information and advice. Friends and relatives can give bad advice. So can some stockbrokers and advisory services, because every profession includes a small minority who are top performers, many who are mediocre, and some who are truly awful.
11. Being afraid to buy stocks that are going into new high ground in price. A stock that reaches a new high may be on its way to much greater highs.
12. Cashing in small easy to-take profits, while holding the losers. You should do the opposite: Cut your losses short, and let your profits grow.
13. Worrying too much about taxes and commissions. The money to be made by selecting the right stocks is enormous in comparison to the cost of taxes and commissions.
14. Focusing on what to buy, and not understanding when the stock must be sold. Timing your exit is as important as planning your entrance.
15. Failing to understand the importance of buying quality companies with good institutional sponsorship.
16. Speculating too heavily in options and futures because they’re thought to be a way to get rich quick.
17. Rarely transacting "at the market" and preferring to put price limits on buy and sell orders. By quibbling on an eighth of a point, they miss the stock's larger and more important movement.
18. Not being able to make up your mind when a decision needs to be made. This invariably points to lack of a plan.
19. Not looking at stocks objectively. Relying on your emotions or only on your opinion is a recipe for failure.

I'll share more information of the book again. Cheers.

How to Make Money in Stocks - A Winning System in Good Times or Bad

I guess some of you may have come across this book, "How to Make Money in Stocks - A Winning System in Good Times or Bad". This book is written by William J. O’Neil. For those who have heard of the acronym CAN SLIM, it actually came from this book. I have briefly summarise what does the acronym CAN SLIM means? Remember the simple acronym CAN SLIM. Each letter stands for one of the seven basic fundamentals of selecting outstanding stocks.

Most successful stocks share these seven common characteristics at emerging growth stages, so they are worth committing to memory.

1. C equals Current Quarterly Earnings per Share: They must be up at least 18 or 20 percent. The higher, the better. Also, quarterly sales must be accelerating or up 25 percent.


2. A equals Annual Earnings Increases: Require significant growth for each of the last three years and a return on equity of 17 percent or more.


3. N equals New Products, New Management, New Highs: Look for new products or services, a new senior management team, or significant changes in industry conditions. Buy stocks as they begin to make new highs in price.


4. S equals Supply and Demand: It doesn't matter whether a company has a large capitalization or a small cap, as long as it fits all of the other CAN SLIM rules. Look for big volume increases.


5. L equals Leader or Laggard: Buy market leaders and avoid laggards. Buy the No. 1 company in its field. Most leaders' Relative Price Strength Rating will be 80 or 90 or higher.


6. I equals Institutional Sponsorship: Buy stocks with increasing institutional ownership and at least a few sponsors with top-notch recent performance records.


7. M equals Market Direction: Learn to determine overall market direction by accurately interpreting daily market indices' price and volume movements, and the action of individual market leaders. This can determine whether you will win or lose. By using this simple, proven, and extremely powerful method, you can make money in stocks in any type of economy.

The reason that CAN SLIM continues to work, cycle after cycle, is because it is based solely on the reality of how the stock market actually works, rather than personal opinions, including those of the experts on Wall Street. Further, human nature at work in the market simply doesn't change. So CAN SLIM does not get outmoded as fads, fashions, and economic cycles come and go.

I would seriously recommend investors to borrow or buy the book if you wish to know more about how CAN SLIM can work for you. The 3rd edition also includes a chapter on "Nineteen Common Mistakes Most Investors Make".

What are futures?

I guess many of us might have come across this term, "Futures". You may have heard of "Forwards" before as well. Simply put it, futures are simply forwards but they are regulated and are backed by clearing house.

A futures contract is a legally binding agreement between a buyer and seller to receive (in the case of a "long" position) or deliver (in the case of a "short" position) a commodity or financial instrument sometime in the future, but at a price that's agreed upon today. These contracts mature at a particular point in the future and are identified by reference to that date - for instance, a Nov 2007 Wheat futures contract or a December 2005 S&P 500 stock index futures contract. The ability to make or take delivery of the underlying commodity at expiration creates a strong tendency for cash and futures prices to move in the same direction by roughly equal amounts. It will take two options to replicate a future contract.

For those who wish to know more, Wikipedia provides very good information about futures and its difference between forwards. Click here for more information.