Novice Investing - Getting Started in Investing

Date: Tuesday 13th 2008f May 2008 02:53:32 PM

Different types of Investment Vehicles

Vehicles in this case refer to the way investors achieve their goals. What is the goal of investors? Growing their capitals, of course. There are ways to do this, both effective and ineffective. Let’s dissect them one by one.

Knowing investing jargon

When you buy a car, you need to know about the jargons that the pushy salesman uses such as MSRP, ABS, warranty, EX-LX-DX, coupe, 4-door and so forth. When buying clothes, you need to know the types of clothes (coat, suit, sweater, jeans, corduroy, khakis), the size, how to wash them and so forth.

As with buying a car and clothes, it is good to learn about the basics investing jargons. We will provide the list of important investing jargons in the near future. Please be patient. It will absolutely help you more in understanding our stock analysis.

Investing is risky. Investors can lose part and even all of their money in investing in stocks. For more about risk, please click here. How about the ultimate goal of investing? The goal of course is to make money. And the way we do that is to buy undervalued companies and sell it at a fair price.

What is a fair price?

Wouldn't it be nice if we can buy undervalued securities and sell it when it is overvalued? That requires luck as well as skills. Therefore, we will just dwell on a much easier question. Even then, it is still extremely difficult to answer. When are stocks fairly valued?

The answer is different for each investor. You might be scratching your head and wonder what do we mean by fair price. The primary reason is that because investors use different methods of determining a stock's fair value. (Some don't even bother ) Another reason is that when investors use the same method, they have varying skills. Determining a fair value for a company requires making lots of predictions. The more experienced investors normally make more accurate predictions.

To illustrate the point, here is an example. Every investor know what the risk-free interest rate is at the moment from the wallstreetjournal or other publications. Currently, it is around 4.5%. So, what will be the risk-free interest rate a year from now? Five years from now? You will get varying answers, I am sure. How about the net income of the company? Some investors will predict $1.00 of EPS, some will predict $1.50 of EPS. As you can see now, fair price is different for everybody.

Simple valuation tools

My job is to let investing simple. So, I will now let everything simple. Let's assume that we all make the same predictions about everything. A year from now, we predict interest rate to be 6.5%. Furthermore, we feel that we need to get a 3.5% additional return for taking the extra risks of investing. That means, we require a 10% yield for our investment.

Currently, we are looking at MRK as a possible investment. After doing some research, EPS for MRK is predicted to be $2.60 next year. So, what is the fair value or MRK? We require 10 % of yield for investing and therefore MRK is fairly valued at a P/E of 10. Now, what is the price of MRK? Is it the price of the stock? Not quite. P in the P/E ratio here is the 'real' price of MRK.

Real price = stock price - (cash+ short-term investment)+ long-term debt.

To illustrate our point, let’s assume you are buying your friend’s wallet for $10. In it, there is a one $5 bill and two $1 bills and nothing else. How much are you actually paying for the wallet? The answer is $3. Just pluck in the formula and we will get $3 as our answer.

Real price of wallet = $10- $7+ $0 = $3

This makes sense, doesn't it? Companies with larger debt are more risky and therefore it is more expensive in terms of its 'real' price. Therefore, we subtract cash & short-term investment while adding long-term debt to get our 'real' price. As of 30th Sept 04, MRK has $6.95 Billion in cash and short-term investment while long-term debt stood at $4.4 Billion. Changing these figures into per-share basis, MRK has $3.13 cash per share and $1.98 long-term debt per share.

Earlier, we figure that a P/E of 10 is the fair value for MRK. With EPS of $2.60, the fair value of MRK is $26. Now, remember that this $26 is the 'real' price. Therefore, using the equation earlier, the fair value for MRK's stock price is $27.15/share.

Voila! $27.15 is the fair value of MRK using a fairly simplified method. Hope it helps.

Every investment analysis is derived from the simple valuation tools above, whether you are investing in Google or Pfizer. The next step is to refine our predictive tools. There will be more reading ahead, folks, so we suggest you take another round of arm stretching. Don’t forget to congratulate yourself for making it thus far. You are that much closer in becoming millionaires. When you are fresh and ready, click here to continue.

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