Investing, Personal Finance 

What is a Stock Worth? Part 5: Stocks versus Index Funds

This is a five part series written by Trent of Stock Market Beat and each part will be published this week. In Parts 1 through 4 we showed how an investor can determine the value of a stock. All of the same guidelines can be used to value a stock index. For many investors, especially those just starting out, indexes offer many advantages:

  • When you buy an index fund you just pay one commission rather than one for each stock you buy.
  • An index fund gives you diversification into many stocks. If any one stock goes bankrupt or is manipulating earnings, it will get smoothed out by the better ones.
  • When you buy a stock you should know it very well: its business, its competitors, its financial metrics, and so on. If you buy an index, all of these things get smoothed out.

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Sennheiser’s Warranty Is Great

About a year and a half ago I bought a pair of Sennheiser HD 202 Headphones for a cool $20 that I could wear at work to listen to music. Overall, the sound quality was good and I was satisfied with its performance until a month or so ago when one of the ear’s stopped producing. Now, I’m pretty sure it was just the wire coming loose but I didn’t really want to break open the ear piece and try to sodder it back on. Since the Sennheiser HD 202 Headphones come with a two year warranty, I just printed out a letter, the invoice, and sent them back at a cost of like $4.00.

One week later, Sennheiser had sent me a brand new pair of my el cheapo $20 headphones no questions asked. I doubt they even checked that the originals were busted in the first place. I give them a thumbs up for customer service!

 Investing, Personal Finance 

What is a Stock Worth? Part 4: Discounted Cash Flow Models

This is a five part series written by Trent of Stock Market Beat and each part will be published this week. In Part 1 we showed how to calculate the present value of a cash flow that is expected to be received in the future: divide it by (1 + r)n. In Part 3 we concluded by saying the value of a stock is the present value of all the dividends the shareholder will receive, plus the present value of whatever it will be worth when the investor decides to sell it. Simple, eh?

Sure. Until you consider that an investor may hold the stock for many years (we used 35 years as an example in Part 2) and both the dividend and the stock price will grow at an uncertain rate in the future. For our investor, that means first forecasting each dividend for the next 35 years, as well as figuring out what the stock price will be in 35 years, then calculating their present values as follows:
D1/(1+r) + D2/(1+r)2 + D3/(1+r)3… + D35/(1+r)35 + (Ending Stock Price)/(1+r)35. At this point, you are probably thinking “never mind. I’ll take my chances with the lower return on bonds.”

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What’s $50 Per Month Worth In Long-Term Savings?

One mindset that is crucial to increasing your wealth is to stop thinking linearly and thinking in “compound” terms. Previously, I’ve discussed how it’s easy to believe that saving $50 or $100/month is not much and thus not worth doing. But that is thinking linearly. Let’s look at saving $50/m over 10 years, using a variety of investment vehicles. Fifty dollars becomes a lot more than you’d think. No amount is too small to save, and fifty dollars is a lot easier to save than a hundred, if you’re struggling. Or undisciplined.

Here’s the general plan: stop thinking linearly and save at the highest rates you can find, without paying ridiculous service fees or penalties. Pretty simple plan, right?

Sure, 10 years X 12 months a year X $50 per month is only $6,000. That’s still $6,000 you wouldn’t otherwise have saved but if you leverage your savings by using online savings accounts, money market accounts or funds, CDs, index mutual funds, and maybe later on, stocks or DRiPs (Dividend Reinvestment Plans), you’ll have more than $6,000 saved in the same time period. Or you could eat that $6,000 in extra donuts and coffee every day for the next ten years. You choose.

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Almost Free Movie Ticket to An Inconvenient Truth

Fandango is giving away tickets to an An Inconvenient Truth if you use the promotion code AnInconvenientTruth3, there is a $1.00 service charge for Fandango’s service. If it’s playing at a local AMC, you can also try on a pair of jeans at American Eagle and get a free ticket that way too. If you’re curious what it’s about, visit the Inconvenient Truth homepage (at least I think that’s the homepage).

Update: Some people were not charged a service fee, I’d try this out myself except I’m in Lake Tahoe now and I’m not going to a movie.

 Personal Finance 

Appearances and Reality, Part 1

This is a guest post by Figure Eight, who apparently looks younger than she is (lucky!), and she blogs over at Figure Eight (blog has since been removed).

I’m someone who looks quite a bit younger than I am. Not long ago, I was pulled over by a traffic cop after I misread a sign and made an ill-advised left turn.

He took my license and registration back to his car, and when he came back to my car, he was laughing. “You must get carded all the time,” he said. He went on to tell me that he was in the business of sizing people up, and he was rarely wrong. “But I looked at you,” he said, “and I thought: 22, maybe 24 tops.”

He let me off with a warning–partly, I think, out of surprise.

I guess I can’t help the fact that I look young. I think it has something to do with the long hair, minimal make-up, and casual clothes. I would say it’s my genes, except for the fact that my younger sister—who is eight years younger—has been taken as older than me since she was 13.

Not long ago, I went to Home Depot for a kitchen redesign. I paid $60 for someone to come out and measure my kitchen, then sat down with a designer to decide what we would do. Before long, I got the sense that his heart wasn’t really in it. After every small decision we made, he would say: “Well, let’s find out what that costs.” And he would calculate the cost and then look at me, as if he expected me to panic or flee. I made three separate trips to Home Depot before we finalized the design, and he was supposed to send it out for a labor quote, but that never happened. The designer left the store, and things fell between the cracks, and after a few misbegotten attempts to resurrect the process and order something, I called the manager and got my money back. I’m now repeating the process (with slightly more success) with Lowe’s.

I’m finding out that the kitchen design center at all the major home improvement stores are massively understaffed. And yet I can’t help but wonder if the kitchen designer looked at me and thought I was too young to be a serious customer. If so, it was his (expensive) mistake. But it was also a waste of my time. Still, short of marching in and announcing, “I may look young, but I’m quite flush and I’m planning to pay cash for this kitchen renovation” I’m not sure how to go about correcting the impression. Thoughts?

Figure Eight is a New England-based writer and editor who’s been reading financial blogs almost as long as they’ve existed. She was recently inspired to start her own blog, which covers financial subjects, but from the perspective of finding out how to cultivate an enjoyment of what you already have.

 Investing, Personal Finance 

What is a Stock Worth? Part 3: Sources of Cash Flows

This is a five part series written by Trent of Stock Market Beat and each part will be published this week. In Part 1 we demonstrated how to calculate the future value of a dollar today, or the present value of a dollar in the future. In Part 2 we explained why investors in stocks want more dollars in the future than investors in bonds. Now we get to the nitty gritty: where do the dollars come from when you buy a stock?

The most common thing people look at is the company’s earnings, which can be divided by the number of shares outstanding to get Earnings per Share (EPS). Very often people refer to Price to Earnings (P/E) multiples when looking at stock values. The long-term average P/E multiple for the stock market (and also the present multiple) is about 16x. That means that a stock with $1.00 of EPS is trading, on average, for $16.00.

You can also turn the P/E multiple upside-down to get E/P, which is also called the earnings yield. Using the same example, a P/E of 16x equates to an earnings yield of 1/16, which equals .0625 or 6.25%. The Federal Reserve did a study one time that showed that the earnings yield on stocks has historically been followed the yield on 10-year government bonds. Gabe Harris created a chart of the relationship:

Fed Model

At the very least, it offers a basis for comparison. You can look at the 6.25% yield on stocks and compare it to the 5% yield on a CD to decide whether the extra return is worth the extra risk of owning a stock.

But didn’t we say that on average stocks have paid 4% to 6% more than risk-free assets? How can that be if the earnings yield on stocks is the same as the yield on bonds? The reason is that, in addition to any current payments, stocks also tend to grow in value over time. So the total return on the stock is the current yield plus any growth in the value of the stock over time. In essence, the Fed Model shows that it is that growth that compensates for the additional risk of stocks.
This brings us to the fact that earnings might not be the best measure of cash flow. If you buy a stock and the company earns $1.00 per share, they don’t give you $1.00. Usually they keep some or all of their earnings to invest in their growth.

Even if you ask for it, they won’t give it to you. Even though by owning a share you are part-owner of the company and “entitled” to your fair share of the earnings. Although they can be useful when comparing the value of companies, or the ability of companies to grow and return money to shareholders, they might not be appropriate to determine the money a shareholder can expect to receive.
From the shareholder’s perspective, the two sources of cash flow from a stock are the growth in value and any dividends the company pays. Dividends are similar to the interest payments on a bond. They are usually paid out on a quarterly basis and quoted as an annualized yield.

For example, Verizon pays out a dividend of $0.405 per share per quarter, or $1.62 per year. At the recent share price of $32.24 this equates to a 5.0% yield, similar to that available in government bonds.

So now we can get to the heart of what a stock is worth to an investor. It is the present value of all the dividends the shareholder will receive, plus the present value of whatever it will be worth when the investor decides to sell it.

William Trent, CFA has been a securities analyst since 1996. Since March
2006 he has been the editor of;.
Prior to that he was Senior Equity Analyst for New Amsterdam Partners LLC,
which manages $6 billion for pension funds, endowments and other
institutions. His experience covers all market-cap sizes and is primarily
within the TMT (Telecom, Media and Technology) and Transportation sectors.

 Frugal Living, Personal Finance 

Festival of Frugality In Limerick Form

Yeah, you read that right, Penny Nickel of Money and Values put together the thirty-second Festival of Frugality in Limerick Form. It’s absolutely amazing and it must have taken a lot of time, if you have any time do please visit and marvel at the hard work Penny’s put in.

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