Notes from finance books

Table of Contents

Warren Buffet's three favorite books

A guide to "The Intelligent Investor", "Security Analysis", and "The Wealth of Nations"

On Stocks

  • Purchasing a stock = Buying part of a real business
  • Buy stocks during recession
  • During bull markets, risky and least profitable time to buy stocks

Bonds

  • Purchasing a bond = providing a loan
  • During recession - least profitable and most risky to buy bonds
  • During bull market - least risky and most profitable to buy bonds
  • Longer the bond (e.g. 30 year bond), higher the expected interest rate
  • If the graph for 30 year bond is decreasing, assume stocks are in bull (inverted yield curve)
  • As interest rates increase, if bond doesn't pay as much, it's value decreases
  • As interest rates decrease, and bond pays more, value of bond increases

10 year Treasury note

  • Considered gold standard of zero risk investment which other investments are measured against.
  • Your risk profile is your rule of thumb:
  • E.g. I do not consider any investment that doesn't return x% vs 0 risk investment

Valuing of Stock

  • Market price of a stock is never equal to intrinsic value of a stock.

1863 french economist Jules Regnault's "Efficient Market Hypothesis" which says the price of any financial instrument will be priced efficiently by the market over time is not accurate.

At any given moment, if only a small number of people (volume) in relation to the total number of stockhodlers are determining how much a stock is worth - is that a an accurate represenatation?

4 rules of valuing a stock

  • Must be managed by vigilant leaders
  • Must have long term prospects
  • Must be stable and understandable
  • Must be undervalued

Managing debt (Debt/Equity Ratio)

Equity = what the company is worth right now.

If you sold everything and paid bills, what's left over.

Measure it using D/E ratio

Lower the D/E ratio, the better. E.g. a D/E ratio of 5 means, it has 5 times the debt compared to equity

  • Rule of thumb: D/E ratio < 0.50

Current Ratio (Current Assets/ Current Liabilities)

Tells you if the the business needs to take on debt in next 12 months

Provides a good glimpse into short term outlook

  • Current ratio of 1 means company won't owe/earn capital
  • Never consider a business with current ratio < 1.0.

    It means the company won't be able to pay it's bills in the next 12 months.

  • Ratings on the bond it issued B/c bonds are rated on the company's ability to pay back debt, it's a great way to examine a company's financial health.

    Usually this info is available on the company's investor relations website.

Calculate Intrinsic value

To calculate the intrinsic value of a stock - you need estimate future cash flow earnings and divident payments.

  • Use the DCF method to determine the present value of future cash flows.

Estimating the future cash flows of a business

  • Future Cash flow (10 yr period) = Book Value Growth + Dividend payments
  • [estimated future BV (in 10 years)] + [sum of divident payments over 10 years]
  • Then discount the cash flow by the current 10 year federate note
  • Book value = Equity per share
  • Total Equity / Total Shares Outstanding

What can a company do with it's earnings:

  • Pay shareholders via dividends
  • Invest or pay debts ==> More or Less Equity

To analyze a stock

  • Get it's book value for last 10 years
  • Is it increasing? Slow or fast?
  • What rate? Is it stable and predictable?
  • Exercise: plot book value over time
  • Average annual book value growth (%) = Present BV - Previous Years BV / Previous year's BV

    Repeat for all previous 10 years to get book value growth rate

  • Sum of book value growth / total number of figures = average book value growth
  • Book value of a stock: FV = PV (1+i)n

    FV = future book value

    PV = Present Book value (or Current Book value)

    i = Book Value Growth Rate

    n = number of years into future

  • EPS = Earnings per share

    Net Income / Total number of shares outstanding

    To get precise number, calculate diluted earnings per share

  • Diluted EPS = Net Income / Diluted Weighted Average Shares

Johnson and Johnson end of 2011

  • JNJ Book value: $20.95
  • JNJ Avg Equity Growth: 12.1% (avg from 2003-2012)
  • JNJ Diluted EPS: $3.49

Compare company's divident payment to EPS

If dividend payment per share / EPS = ? %

Can the company afford to pay such a high dividend?

Is it sutainable?

If a company is making a high dividend payment every year, it's BV or EPS will stay constant or decrease in value year after year

DCF the future value back to current value by using the DCF method

If the DCF FV of stock is $x

It means if you invest $x today, over next 10 years you'll earn equiv interest of risk free investment.

Compare that to the stock value it's trading today.


Money Ratios

Capital to Income Ratio

Assumption that your money will return, on average, 8% a year. If that's too optimistic, keep a higher “times” number.

E.g. $50,000 a year (in total income before taxes) Farrell argues that you need to have $600,000 saved for retirement. Then, each year, you would withdraw $40,000 (80% of your salary) of that $600,000 and leave the rest invested. In order to maintain the same balance of $600,000, your investment would have to earn 7.15% – and, ideally, it would earn a little bit more than that to help you keep pace with inflation.

Savings Ratio

Save 12% of your income (if you’re 45 or under) 15% (if you’re over 45).

Where to Save Your Money

As you sock away money to meet that “twelve times” goal from the first chapter, your priority should first be to your 401(k), then to your IRA, then to other investing options. You need this savings to be automatic.

Debt Ratios

Borrowing for a mortgage is pretty much the only significant debt an adult should acquire.

Get rid of car payment

The Investment Ratio

Farrell recommends 50/50 stock/bond split if under 60 Shift to bonds as you get older.

Stocks and Bonds 101

Your stock investments should be spread across lots of different companies, including international ones, big ones, and small ones.

Your bond investments keep in government bonds, but diversified Rebalance annually - move money between the stocks and bonds to restore the overall 50-50 balance described earlier.

Ignoring Wall Street

Don’t spend your time worrying about what Wall Street is saying. They’re often worried about the short term – the next few years. You’re worried about the long term, something rarely discussed on TV

The Disability Insurance Ratio

Recommends getting coverage equal to 60% of your income, which will roughly amount to your current income after taxes.

The Life Insurance Ratio

Your life insurance should be a term policy that pays out 12 times your salary minus your capital-to-income ratio (discussed earlier). So, for example, if you make $70,000 a year, your total of your capital and your life insurance benefit should be $840,000 per year. As you save more - you should need less life insurance.

Long-Term Care Insurance Ratio

Looking into long-term care insurance in your mid-fifties. Before that, the risk is so low - not worth the cost. After that, your risk goes up - cost might be prohibitive.