The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition) [Benjamin Graham, Jason Zweig, Warren E. Buffett] on Amazon.com. *FREE* shipping on qualifying offers. This classic text is annotated to update Graham's timeless wisdom for today's market conditions... The greatest investment advisor of the twentieth century
Purpose All businesses require capital equipment (fixed assets) such as machinery, premises and vehicles. The purchase of such assets is known as capital investment and is undertaken for the following reasons: To replace existing equipment which is out-of-date or obsolete To expand the productive capacity of the business To reduce the production costs per unit (i.e. to achieve economies of scale) To produce new products and, therefore, break into new markets Capital investment, like all other business activities, involves an element of uncertainty, because expenditure is incurred today in order to produce some benefit in the future. Investment appraisal techniques are designed to aid decision-making regarding such investment projects. There are 3 methods which can be used to appraise any investment project: The Payback method The Average Rate of Return (A.R.R) method The Net Present Value (N.P.V) method. Payback Method This is the simplest method of investment appraisal and is usually preferred by small businesses because of its simplicity. Larger businesses may use it as a screening process before embarking on one of the more complicated techniques. The payback period is the time taken for the equipment, (machinery etc.), to generate sufficient net cash flow to pay for itself. For example: A manufacturing firm is considering investing £ 500,000 in new machinery. The equipment is expected increase the firm's cashflow by £ 150,000 per year. How long is the payback period ? After 1 year, the cashflow will be £ 150,000. After 2 years, the cashflow will be £ 300,000. After 3 years, the cashflow will be £ 450,000. The firm will need £ 50,000 (or one third) of the cashflow from year 4 in order to reach the payback point. Therefore, the payback period is 3 1/3 years (or 3 years, 4 months). Firms can use this technique in one of two ways: Firstly, a firm could set an upper limit on the time allowed for payback, and any project which is not expected to payback within this period is rejected. Secondly, when faced with a choice of projects, the payback method can be used to rank projects according to the speed at which they payback. However, the payback method ignores the following two important factors: The total return on the investment project (i.e. the earnings after payback). The timing of the return prior to payback. The payback method clearly discriminates against projects which produce a slow but substantial return, resulting in the danger that highly profitable projects will be rejected because of the delay in producing a return (yield). Example: Each of the three alternative projects below involve an initial cost of £ 1 million, and produce net cash flow as shown: PROJECT YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 A £ 0m £ 0.5m £ 0.5m £ 0.5m £ 0.5m B £ 0.5m £ 0.5m £ 0.5m £ 0m £ 0m C £ 0m £ 0m £ 0.5m £ 1m £ 1m Project A pays back in 3 years (£ 0 in year 1 + £ 0.5m in year 2 + £ 0.5m in year 3). Project B pays back in 2 years (£ 0.5m in year 1 + £ 0.5m in year 2). Project C pays back in 3 1/2 years (£ 0 in year 1 + £ 0 in year 2 + £ 0.5m in year 3 + half of the £ 1m in year 4). Using 'The Pay-back Method' to decide between these projects, project B would be selected. But if you looked at the total revenue over the full life of each project, project C actually brings more cash into the business and would be the better project to select. Average Rate of Return (A.R.R.) Method This method takes the total return (yield) over the whole life of the asset into account and therefore overcomes one of the defects of the payback method. In order to understand the arithmetic, consider an item of capital (e.g. a machine) which will cost £ 1 million to purchase, is expected to last 5 years, and will produce an annual net cash flow of £ 0.5 million. The total return (yield) is: 5 x £ 0.5 million = £ 2.5 million If we now deduct the initial cost of investment (£ 1 million) we are left with a total return (yield), net of the initial capital outlay, of £ 1.5 million. Annually, this works out at: When we express this annual figure as a percentage of the original capital outlay we get the Average Rate of Return for the project: To recap, the 4 steps for calculating the A.R.R. are: Add up the total forecasted net cash flow Deduct the capital outlay from this Divide the resulting figure by the expected life (in years) of the capital Express this annual figure as a percentage of the capital outlay As with the Payback method, we can use the A.R.R. in two ways. Firstly, the firm might set a predetermined level and reject any project which has an expected A.R.R. less than this percentage. Secondly, when faced with a choice of alternative projects, then the projects can be ranked by their A.R.R. Further examples. A firm is considering three alternative investment projects. The maximum life of each asset is three years and the capital outlay is £ 100,000 in each case. The table below depicts net cash flow in each of the three years: PROJECT YEAR 1 YEAR 2 YEAR 3 A £ 50,000 £ 50,000 £ 50,000 B £ 100,000 £ 20,000 £ 0 C £ 0 £ 50,000 £ 140,000 Project A: Total forecasted net cash flow = £ 150,000 Total forecasted net cash flow - capital outlay = £ 50,000 £ 16,666.67 (this is the amount of profit per year) 16.67%. Project B: Total forecasted net cash flow = £ 120,000 Total forecasted net cash flow - capital outlay = £ 20,000 £ 6,666.67 (this is the amount of profit per year) 6.67% Project C: Total forecasted net cash flow = £ 190,000 Total forecasted net cash flow - capital outlay = £ 90,000 £ 30,000 (this is the amount of profit per year) 30% The great defect of the A.R.R. method of investment appraisal is that it attaches no importance to the timing of the inflows of cash. A.R.R treats all money as of equal value, irrespective of when it is received. Hence, a project may be favoured even though it only produces a return over a long period of time. The more sophisticated methods of investment appraisal take the timing of the cash inflows into account, as well as the size of the inflows. A sum of money in one year's time is worth less than that same sum of money now (i.e. inflation will erode the real value of that sum of money over the year). This is where the notion of present value is used. Net Present Value (N.P.V.) Method The return on an investment comes in the form of a stream of earnings in the future. The N.P.V. method of investment appraisal takes into account the size of the cash inflows over the life of the equipment, but also makes adjustment for the timing of the money. A greater weighting (or importance) is given to the inflows of cash in the earlier years. The weighting can be calculated from the following formula: A = the actual sum of money concerned r = the rate of discount (called the 'Discount factor') n = the number of years This enables us to calculate the present value of money, net of operating costs, to be received in a certain number of years. Hence, £ 1000 in two years time, at a 3% rate of discount, has a present value of: In examinations you will usually be given the discount factor, so that you do not have to work it out! The present value of each year's cash inflow are then aggregated (this is called the discounted cashflow, or D.C.F) and this figure is compared with the initial capital outlay. If the sum of present values (minus the capital cost) is positive, then it is worthwhile proceeding with the project. If the resulting figure is negative, then the project should not be undertaken. Example: In appraising a £ 300,000 investment project, a firm uses a discount rate of 5%. The equipment will produce a cash inflow (net of operating costs) of £ 75,000 per year, over a five year period. At the end of the five years, the firm expects to sell the equipment for £ 10,000. What is the Net Present Value of the project? Year cashflow Present Value 0 -£ 300,000 -£ 300,000 1 +£ 75,000 +£ 71,428.57 2 +£ 75,000 +£ 68,027.21 3 +£ 75,000 +£ 64,787.82 4 +£ 75,000 +£ 61,702.69 5 +£ 85,000 +£ 66,599.72 Year 0 is the present day (i.e. when the initial capital outlay is spent). The cashflow of £ 75,000 in year 1 has a present value of: £ 71,428.57 The cashflow of £ 75,000 in year 2 has a present value of: £ 68,027.21 The process continues for the remaining years. The discounted cashflow is the sum of the present values for the 5 cash inflows (i.e. from year 1 to year 5). This figure is £ 332,546.01 The net present value is found by deducting the initial capital outlay from the discounted cashflow. In other words: £ 332,546.01 - £ 300,000 = £ 32,546.01 Since this result is positive, then it is advisable for the firm to go ahead with the investment project. If the result had been negative, then the investment project should not be undertaken. Other Influencing Factors There are many other factors that a business will need to take into consideration when appraising an investment project, other than the financial (quantitative) factors. Qualitative factors such as the objectives of the business must be considered at all times, as well as the effect upon the employees of new machinery, new working practices and changes to their working conditions. The external environment needs to be considered before any decision can be taken regarding a proposed investment project. These factors include the state of the economy (e.g. it may be dangerous to attempt to expand during a recession, because demand for products may be falling), pressure group activity, the level of technological progress in the industry (e.g. competitors may already be using the new machinery), and any legislation (e.g. restricting the use of certain materials, components). The effects of the actions of the business on the environment must also be taken into consideration, since any external costs (e.g. pollution) will have a detrimental effect on the image and reputation of the business. Finally, as with any investment decision, the business will also need to consider the amount of finance that is available for expansion, and the effect that any borrowing to raise extra finance will have on the gearing ratio.
Young people are going about investing all wrong. The most basic (and important) decision you make as an investor is your allocation between major asset classes—primarily stocks, bonds, and cash. Here is how millennials’ portfolios look in 2014, according to a recent research report from UBS.
This allocation screams caution, worry, and distrust of the stock market. Why are millennials investing this way? Mainly because they have had two very sour experiences with the stock market: the technology crash between 2000-2002 and the more dramatic financial crisis between 2007-2009. Both times, the market collapsed 40% or more. The only other time that happened twice in one decade was in the 1930’s in the midst of the Great Depression. Millennials don’t trust Wall Street (all four major banks among most hated brands by millennials), and one of our most famous authors is saying the stock market is rigged.
With all this in mind, it makes sense that millennials are so cautious. But the choices they are making with their investments are backwards. Millennials think cash is safe, but its actually dangerous. They think that stocks are risky, but in fact stocks are the safest means to secure long-term financial prosperity.
The problem is that we tend to think of “risk” as a fixed concept—that is, stocks are riskier than cash and bonds…period. But risk can only be accurately assessed in combination with a time horizon. If you are 25 and saving for retirement, you have at least a 40 year time horizon, which drastically changes what is risky and what is safe. Millennials are making decisions as if they were 60 years old, on the verge of retirement—and it could cost them huge amounts of wealth.
The Potential of Every $1
I find it easiest to think about potential investments in terms of individual dollars. What returns are you likely to earn over certain time periods on every dollar you invest? What are the best and worst case scenarios? Let’s start with stocks—the most hated investment choice among millennials.
Obviously we want every dollar we invest to be worth as much as possible when we retire. The first figure below lists theaverage result for $1 invested in the stock market at various ages. It shows what each dollar will be worth by age 65 depending on when you start investing in the stock market (earlier if obviously much better). This assumes the market grows at the same real rate it has since 1926 (6.9% per year). “Real” means after accounting for inflation, which reduces your returns. For the reasons I lay out in a separate piece on the history of money, inflation is a crucial consideration when evaluating investment options.
One important note: I am basing this analysis on data back to the 1920’s for stocks, bonds, and cash (bills) because it allows us to include events as diverse as the Great Depression, World War II, runaway inflation, booms, busts, panics, and so on. Everything short of a 100% breakdown is covered.
Note that the earlier you start, the more potent each dollar is. If you start at 22, then each dollar would be worth nearly $18 when you retire…but if you procrastinate, even until you are 40, each dollar would only be worth $5.30.
Millennials care more about risk than anything else, so let’s look at the worst case scenario alongside the average. These numbers represent the worst possible times to be invested (again starting at various different ages) between 1926 and 2014.
Sure enough, stocks are risky as hell in the short-term. Look at the worst-case scenario for the value of a dollar invested by people 50 years or older (who have between 5-15 years until retirement). It would be terrible to invest in the stock market at age 50 and have each dollar worth just 70 cents 15 years later. That’s a scary 30% decline over 15 years.
But look at the worst case scenarios if you start younger. If you start at age 22, the worst result for a dollar invested was growth to $4.80. This would have happened if you invested at age 22 in 1966 and retired in February 2009 at the exact market bottom of the second worse collapse in the stock market’s history. It also would have included the crash in 2000 and the miserable period for stocks between 1968 and 1982 when the market went nowhere. Even through three tumultuous markets, you’d still have $4.80 for every dollar you invested.
You can see why risk cannot be assessed independent of time. Stocks can be very risky in the short term, but have been extremely safe over the long term, which is all that should matter to millennial investors.
Bonds and Cash
What about the “safe” options that millennials prefer? Here are the average and worst case scenarios for bonds and cash (t-bills).
For both bonds and bills, the worst case scenarios are scary across all time periods. Even if you start investing when you are in your 20s, there is a chance that each dollar you put into bonds or bills will be worth less than 50 cents in real terms come retirement. For bonds and bills, inflation is the silent killer. Bonds and cash (bills) seem so safe because they preserve thenumber of dollars you have. But what good is preserving $100 until 2050 if a sandwich costs $80 at that point in the future? Purchased power is what matters, not the number of dollars you have. Judged this way, stocks are the runaway winner.
Think back to the current millennial investor’s allocation. More than 50% is in cash, an asset that seems safe, but can be very dangerous over the long-term. Meanwhile, millennials have just 28% in stocks, which even under the worst-case scenario have delivered strong long-term real returns.
What If The Sky Isn’t Falling?
I’ve focused on worst-case scenario because millennials are so sensitive to risk…but the best case scenarios are also worth considering. Here is the best case scenario for each dollar invested at different ages for all three assets: stocks, bonds, and cash.
If you start investing in the stock market in your 20s, there is a chance each dollar ends up being worth much more than the $4.80-worst-case scenario or $18-average. There was one period where each dollar grew to $52 over 40 years. In sharp contrast, the best case over 40 years for bonds and bills was $6.70 and $1.90, respectively.
When Safe Isn’t Safe
Millennials are right to be cautious, but if their current investment allocations are any indication, too many millennials are thinking about short-term risk when they should be thinking about very long-term risk. When risk is reframed, stocks have always been the safest long term asset. The bottom line is that you should start investing now. Even if the initial amounts are very small, the long-term benefits are can be huge. But you have to start young and remember that what seems risky is in fact safe.
Monthly real returns for stocks, bonds and bills from Roger Ibbotson. Stocks = S&P 500, Bonds = Long Term U.S. Government Bonds, Bills = T-Bills
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