Month: March 2014

It’s About Time (Value of Money)!

Since in my last post I discussed inflation and why people invest in the stock market, I decided that a natural next concept to introduce would be something called time value of money or TVM for short. This concept is the basis for most everything in finance. Stock investing, private equity, venture capital, bond investing, savings and loans, capital budgeting and much more hinge on the concept of TVM so I’ll try to explain it as clearly as possible.

At the base of it, time value of money means that 1 dollar today is worth more than 1 dollar in the future, and conversely 1 dollar today is worth less than 1 dollar one year ago. It may be tempting to attribute this to inflation but that is not the reason that this is true. The reason that a dollar today is worth more than the same amount in the future is because a dollar today can be invested until next year at which point it that dollar plus the return from investing would be more than just the one dollar being given to you one year from now. If this does not make sense to you, that’s okay, the followinf example will help clarify.

You have two people James and Sally. I tell them each that I’ll give them $100, they can receive it now(March 29, 2014) or they can receive it exactly one year from now (March 29, 2015). Naturally Sally takes her $100 now, James decides that he would rather receive his $100 exactly one year from now. Sally goes home and puts her money in her bank account which we’ll say pays 5% interest compounded annually. On March 29 2015, one year from the starting point, I give James his $ 100 dollars and he puts it in his bank account. At this point Sally has $105 in her account while James has only $100. Time value of money is true because any money that a person receives today can be invested and earn returns.

In the case of James and Sally, we would say that the presesnt value of both James and Sally’s money was $100. We would also say that the Future Value of James’s money was $100, while the Future value of Sally’s money was $105 because she earned interest on her money.

In order to further understand this concept we must consider the TVM formulas. OH NO MATH!!!!! Relax, there is no reason to panic when it comes to this math, it’s really easy to understand and it applies the same way across all areas of finance.

The future value formula is as follows.

The Future Value of Money Formula

The Future Value of Money Formula

FV is your future value and in the case of this formula, the number that we are trying to find. PV is the present value of money, as I said before this is the amount of money that you have right now, or in other words the amount of money is being invested. The variable is your interest rate if you are lending money or your rate of return if the money is invested in stocks. The variable is the number of compounding periods per year, which means the amount of times you take the returns you’ve made and reinvest them. Finally, the variable  is the number of years that you are keeping your money invested.

In the case of Sally if we substitute in the appropriate numbers into the formula we get the result shown below.

FV sally

And of course when we work this out we do get $105.

The other formula used in TVM is when we are told what our future value will be and we have to figure out what that would be worth toady. For that we would use something called the present value formula which is shown below.

 

As you can see all I did was use algebra to isolate the PV variable from the previous formula. Suppose we knew that Sally had $105 in 2015 and that her bank paid 5% interest compounded annually and we wanted to find out how much she started with. All we’d have to do is fill out the formula.

PV sally

The Present Value of Money Formula

And when this is simplified we do get our $100 starting amount.

I understand that all of the math in this might come off as boring now, but it is a necessary evil and it will come in use when I discuss things like dividend discount and discounted cash flow valuation techniques for stock valuation. It will also come in use when learning what it means to beat the market or to beat a benchmark.

If you have any questions please post them in the comments below and I will attempt to get back to you.

As always, thanks for reading!,

Mohit D. Patel, Author

 

Disclaimer:

The author is a student, not an attorney at law or finance professional. As such, this article is not intended to constitute legal or finance advice and is offered as is for purely educational purposes. The author is not liable for any decisions a reader makes based on the content this article.

If you have any questions please post them in the comments below and I will attempt to get back to you!

 

 

 

Why Invest in Stocks? An Introduction to Inflation and Investment

In last week’s post I explained what the three main forms of business ownership are: sole proprietorship, partnership and corporation and I explained that a stock is a share of corporate equity or basically a piece of ownership in a corporation. So why do people invest in stocks? There are all sorts of things out there that people believe about the stock market. Some believe that that the stock market is practically a casino since stock prices change randomly, others believe that stocks are controlled heavily by big business and that its none of their business to be involved in in them, yet other people believe that they can simply do without stock investment simply because they don’t care about finance or business. All of these things are simply untrue. The stock market is not a casino because an intelligent investor can grow their money safely by buying stocks below their intrinsic value and holding them for the long term. As for the second assertion it is true that businesses do have a direct effect on their stocks but the idea that the management officials in a company somehow work for their own benefit is completely without base. The managers of a corporation must act in the best interest of the corporation’s owner, that is, the stockholders, and not just the institutional ones according to the law, because they are considered agents of those owners. Though I cannot cite any specific source I’m certain that lawsuits have occurred where stockholders have sued their corporation’s mangers for not acting in their best interests. The third reason that people avoid that stock market is the one that I seek to explain most thoroughly.

Simply not being interested in stock is not a valid reason to avoid stock investments. The first step to understanding why is inflation. Most people know inflation as a general rise in prices in the economy, which is true. It is more important for anyone who has saved any significant amount of money is that inflation also corrodes the amount of “stuff” that their money can buy. For example let’s say that I have $100 dollars and as of right now in 2014 the price of one gallon of milk is $10 then say that over ten years inflation occurred such that the price of milk is $20 in the year 2024. In 2014 at the price of $10  I could buy 10 gallons of milk. After the ten years pass and the price of milk changes to $20 if I still have my $100 under my mattress, I would now only be able to buy 5 gallons of milk. On average each year for this to work about 7% inflation would have had to occur. If I had invested my money in stocks, bonds, certificates of deposit, or anything else and earned a return of 7%, I would still have the buying power to buy 10 gallons of milk. The effects of this effect on a larger scale say on money being saved for retirement savings can be devastating, since more money and a greater number of years exist in which inflation can act. The only way to completely or partially counteract this effect is through intelligent investment practices. Thus our purpose as investors is not to get rich quick, but rather to mitigate the effect of inflation and the decrease in buying power of money.

Why can’t I just invest in bonds or put my money in a bank? In the long run stock outperform bonds by a long shot. In the last 12 months the Standard and Poor’s 500 stock market index had returns of 17.78 percent while the Barclays Aggregate Bond market Index had returns of 0.50 percent within the same period. The rate of inflation for this year was 1.5%.  Bonds would not have cut it and bank accounts would not even have come close. The only investment that couldn’t shielded against inflation was the stock.

To recap, investment is performed to allow a person’s savings to maintain their buying power in the face of inflation. While there are many types of investment choices out there, stocks are the ones that are most likely to provide an investor returns above the level of inflation in the long run.

Disclaimer:

The author is a student, not an attorney at law or finance professional. As such, this article is not intended to constitute legal or finance advice and is offered as is.

If you have any questions please post them in the comments below and I will attempt to get back to you!

 

Starting at the Beginning: What is a stock?

So, I realized that I might’ve made a mistake just jumping into this blog, a blog which I intended to be for beginners in the world of stock investing and given an analysis which was both too hard to understand and incompetent in its analysis of the company and I apologize. With this post, I hope to rectify my mistake and to start at the very beginning of teaching what I know of stock investing.

-Mohit D. Patel

Anyhow, to start off we must answer a rudimentary question: what is a stock? Now many people will say many things about what stocks and stockholders are, and that is natural seeing as finance and politics are nearly inseparable. In order for me to best explain this I have to explain the three main forms of ownership for a business; they are proprietorship, partnership, and corporation. It perfectly alright if you have no idea what these terms are, I’ll explain all of ’em; on the other other hand if you do already know, you’re ahead of the game.

A proprietorship is when an individual person for legal purposes is considered to be the business. In order to form this type of business, a person does not have to file any forms with the government, all they have to do start doing business. In the case of a business like this the person who starts the business reports all of the money that they make on their own tax form. This type of tax form is called a form 1040. If a proprietorship business owes money or has a lawsuit filed against it the owner, who started the business must answer to the suit or pay back the loan and the government will seize their personal property if it has to in order to pay off the debt or settle the law suit. The fact that the government can do this is what a lawyer would call unlimited liability. Additionally while one person is considered to own and be the business, they can hire employees to work for them and then they would pay them a salary.

The second form of ownership is a partnership. This form of business is very similar to a proprietorship except that instead of one owner legally being the business, there are two or more persons who own the business. The laws apply the exact same way and the unlimited liability concept described above extends to all of the partners. One of the few differences between a partnership and a proprietorship is that a partnership formed by a group of people signing a contract called a partnership agreement which outlines how the partnership will function. Normally a partnership will dissolved if any of the partners die, file bankruptcy, or leave the business unless the agreement says other wise. In order for a person to be allowed to invest in this type of business they must be made a partner which would require the partnership agreement to be amended and for the investor to take on all of the risks of being a partner including having to pay back to the partnership’s debts and taking on any law suit that may be filed. For this reason many large businesses find this structure of ownership to be too burdensome and opt to choose the next structure instead.

The next form of business ownership is the one that is of utmost importance to a potential stock investor. It is a corporation. Many people talk a bout corporations without actually know what they are. Corporations inherently have very little to do with business, instead they are a purely legal construct. A corporation is created by filing a form with any state government, called a certificate of incorporation or sometimes articles or incorporation and receiving approval. Once a corporation has been successfully been created, in the eyes of the law it is its own person. A corporation can file law suits, have suits against it, it must pay taxes, and it can enter into contracts. Within the legal structure of a corporation there are two groups of people: directors and shareholders. When a corporation is created it is given the right to issue a certain number of shares of equity. In accounting the word equity means ownership of the business. Once the shares are issued the holders of the shares are owners of the company. A corporation unlike a partnership unlike a proprietorship or partnership has what in the field of law is called limited liability. What this means is that the shareholders cannot be sued directly for an action taken by the corporation, and they cannot be forced to pay the debts of the corporation. This is the opposite of unlimited liability and you guessed it; it’s called limited liability. The group of people we mentioned are the directors. The directors are responsible for the day to day running of the company on behalf of the shareholder. The directors are what are called agents of the of the shareholders. This means that legally they must do whatever they believe would most benefit the shareholders of the corporation. In most large business corporations, the directors don’t all actually manage the business, instead they hire a group management officials to do. The titles of these officials are those that most people used to hearing when they talk about big businesses i.e. President, Exeutive VP, Chief Executive Officer, Chief Marketing Officer, Chief Counsel, etc. It should be noted that in each corporation the specific roles of both directors and shareholders are spelled out in a document called the corporation’s bylaws, which like the partnership agreement in a partnership explains how the corporation is to be run and governed.

So, if you’ve actually read this far you be wondering, when is he actually going to tell me what a ‘stock’ is. I’ll get to that right now. A stock is a share of corporation’s equity as we mentioned before that is easily traded by people through broker/dealer firms and/or one or more clearing houses. There are many requirements that have to be met for a corporation to trade its shares publicly as stock. The individual requirements depend on what brokerage or clearing house, the corporation wants to be listed on. The New York Stock Exchange has the most strict requirements, OTC Pink, which used to be known as the Pink Sheets very little requirements to be listed.

This article is provided on an as is basis and is not meant to constitute legal or finance advice. The author is a student, not an attorney or finance professional.

If you have any questions please leave them in comment section below!