Investing Basics October 6, 2008

Why do we invest? Capital Preservation Building Wealth, Retirement Take Advantage of Time and Compounding Savings Rate

Compound Interest  Investor A: Starts contributing $2,000 annually to an IRA at the age of 26.  Investor B: Contributes $2,000 per year to an IRA beginning at age 19 and ending at age 25.  Earn 10% per year.  Who ends up with more more at age 65?

Investor B Ends up with More Money than Investor A Adapted from Richard Russell: L.nsf/htmlmedia/body_rich_man__poor_ man.html

Morals of the Story  Start saving and investing as early as possible.  At a young age, savings rate is probably the most important factor in building wealth (although investing responsibly helps too).  (The moral isn’t necessarily to stop investing after age 25. Consider that a hypothetical investor C who started investing $2,000 annually at age 19 would have ended with nearly $2 million.)

Growth of $1 Since 1926

Active vs. Passive Management Definitions Advantages and Disadvantages Investing in Funds

What do these terms mean?  Active Management  The use of an active means such as stock selection or market timing in an attempt to outperform the market.  Passive Management  Matches the return of a given market index by owning all (or substantially all) the securities in the underlying index.

Active Management  Incentive Problems:  Fee structure.  Risk.  Higher fees in general.  Higher turnover and lower tax efficiency.  Most actively managed funds underperform passive indexes over time.  It’s also hard to pick funds that will be long term winners.

Advantages of Index Funds  Guaranteed market rate of return.  Diversified. Eliminates idiosyncratic risk.  Low expenses.  Usually tax efficient.  Easy to build a portfolio based on your risk tolerance.

Exchange Traded Funds (ETFs)  Advantages of Index-Tracking ETFs:  Low ERs.  No minimums.  Traded on an exchange like stocks.  Pay same commission as a regular trade.  Examples of Index-Tracking ETFs:  VTI – Vanguard Total Stock Market (0.07%)  IVV – iShares S&P 500 Index Fund (0.09%)  VEU – Vanguard FTSE All World Ex-US (0.25%)

Index Mutual Funds  Higher minimums.  Better for small, frequent purchases (DCA).  Only priced and traded at the close of the day.  Vanguard (generally $3,000 minimum).

More on Investing in Funds Next Week…

Investing Basics Business Analysis Accounting Analysis Financial Analysis Valuation

Business Analysis  Remember last week?  Procter & Gamble  Competitive advantages?  Brand names?  Ability to raise prices with inflation?  Economic moat?  Industry and type of product?  Consistency?

Accounting Analysis  Do the firm’s accounting policies reflect the business reality of the firm?  If not, we must make adjustments.  More on accounting analysis later. Yes, it needs its own week (or two..).

Financial Statements  Balance Sheet: A list of the things owned and owed by the firm and the difference between the two.  Income Statement: A list of the resources acquired and consumed by a firm over a period of time.  Cash Flow Statement: A list of the flows of cash in and out of a company over a period of time.

Basic Accounting Terms  Balance Sheet  Assets: Probable future benefits owned or controlled by a firm.  Liabilities: Probable future sacrifice of benefits.  Equity: The difference between total assets and total liabilities.  Income Statement  Earnings: The increase in net assets (equity) resulting from operations over a period of time.

Balance Sheet for P&G

Things to Remember  The Balance Sheet Equation:  Assets = Liabilities + Equities  Equity is the residual left over for shareholders after a company’s other creditors (represented by liabilities) have been satisfied.  One of the best sources of information is the company itself and its management.  This means reading annual and quarterly reports, which can be found on SEC.gov or on the company’s website.  We still need to be cognizant of management’s incentives and biases.

Value Line Accessible via OSU libraries and ccig.osu.edu.

Reminders About Value Line  Good starting point.  Usually a reliable source for objective data aggregated in a consistent format.  It’s generally a good idea to ignore Value Line’s predictions (or any analyst predictions for that matter).

The Basics of a Stock  Share of Stock: A security representing fractional ownership in a firm and a claim on its net assets and earnings.  Shares Outstanding: The total number of shares issued by a company.  Market Capitalization (Market Cap):  The total market value of a company based on the share price and number of shares outstanding.  Share Price x Number of Shares Outstanding.

Market Cap $67.28 x 3,033 m = $204 bn

Implications  Share Price  One share of P&G costs $  Shares Outstanding  There are about 3 billion shares outstanding, so if you buy one share, you’re buying 1 / 3 billionth of the company.  Market Cap  The total market value of P&G (based on the share price and shares outstanding) is $204 billion.

Earnings  Definition Again: The increase in net assets (equity) resulting from operations over a period of time.  Earnings per Share (EPS) = Earnings / Number of Shares  Price to Earnings Ratio (P/E Ratio) = Share Price / Earnings per Share  Earnings Yield = Earnings per Share / Share Price

Earnings per Share EPS = Earnings / Shares Outstanding

P/E Ratio P/E Ratio = Share Price / EPS

Earnings Yield Earnings Yield = EPS / Shares Outstanding

Implications  P/E Ratio  You’re paying $18.10 per dollar of P&G’s earnings.  Depends on factors such as expected growth and industry.  Earnings Yield  The initial yield you’re earning on your investment is 5.5%.  Since the earnings yield is the reciprocal of the P/E ratio, a lower P/E ratio results in a higher earnings yield.  Note: You might run those calculations and end up with numbers slightly different than those reported by Value Line because they use a weighted average of shares outstanding.

Dividend  Definition: A distribution of earnings to shareholders.  Dividend per Share: Amount paid per share (usually per year).  Dividend Yield: Dividend per Share / Share Price  Payout Ratio: Dividend per Share / Earnings per Share

Dividends Payout Ratio = Dividend per Share / EPS

Implications  Dividends in General  Considered to be indicative of stability.  Earnings not paid out as dividends can be reinvested.  Dividend per Share  The amount paid to you by the company (in cash) per year.  Dividend Yield  The amount of the dividend relative to the share price.  The yield (extra return) you will receive from the dividend.  Payout Ratio  Tells us how much of the company’s earnings are being paid out as dividends.  The remainder (1 – payout ratio) is reinvested in the business.

Book Value of Equity  Refers to the value of equity recorded on the balance sheet.  Also interchangeable with equity, remember:  Equity = Assets – Liabilities  Book Value per Share = Book Value / Number of Shares  Price to Book Ratio (P/B Ratio) = Share Price / Book Value per Shares

Book Value P/B Ratio = Price / Book Value per Share

Implications  Book Value  Broadly refers to values assigned to various entries on a firm’s balance sheet.  Sometimes requires adjustments (for example, book value of equity often requires the deduction of intangible assets that cannot be readily priced and sold).  P/B Ratio  Above 1 indicates that the firm is priced at a value greater than the book value of its net assets.  Most firms trade at a market value above book value.  Intangibles and other advantages can result in a higher P/B ratio.  High or low P/B ratio does not necessarily make something a good or bad investment.

Measuring Return on Investment (ROI)  Return on Equity (ROE) = Net Income / Book Value of Equity  Return on Assets (ROA) = Net Income / Total Assets  There are a few more, but we can save those for later.

Return on Equity ROE = Net Income / Book Value of Equity

Implications  Return on Equity  A (relatively) comprehensive measure of how profitable a firm is in relation to money invested by shareholders.  We prefer an above-average ROE.  Return on Assets  Measures a firm’s profitability relative to its total assets.  Differences Between ROE and ROA are generally caused by leverage, which can enhance a firm’s ROE.  We will break down these ratios later.

More on Valuation Later…

Don’t Feel Overwhelmed.  We covered a LOT of material today.  It takes time for these concepts to sink in.  After a few more meetings and some outside reading, you’ll catch on quickly.  This PowerPoint will be posted online for future reference and review.  Outside of meetings, ask questions on the Forum!

Some Recommended Reading for the Mean Time  The Wall Street Journal  The Superinvestors of Graham-and-Doddsville by Warren Buffett  The Dhandho Investor by Mohnish Pabrai  The Intelligent Investor by Benjamin Graham  Margin of Safety by Seth Klarman

Next Week  Getting Started  Choosing a Broker  Account Types  More on Investing in Funds  Starting the Club Portfolio  Look at Core-Mark (CORE)

ccig.osu.edu October 6, 2008