The Stock Price Tag being Dictated by Your Required Rate of Return

Stock Price Tag. The price a rational investor pays for a
stock would have an implied rate of return. Because the 
price one pays dictates his rate of return. Or put in another 
way, one's required rate of return dictates the fair price to pay. 
A price tag is not appraised just for the sake of it.

When someone appraises a stock and assigns a fair price tag for it, what exactly does that imply? To most of us, it's fairly intuitive: it just means that it should be bought at or below that price. Simple enough, isn't it? But let's say you are indeed able to buy it at that price, what's next? What should be the expectation?

My criticism of simply appraising a stock for the sake of it is that it loses track of why one is appraising it in the first place. My personal view is: a fair price should be appraised based on an expected rate of return. I cannot further stress the importance of this point.

A rational investor and capitalist buys a stock because first and foremost, he expects a certain rate of return from it. So yes, that is where it should all begin. A rational investor, even before buying into a stock position, should have a set required rate of return. This is the very basis of stock appraisal. Because the price one pays dictates his rate of return. Or put in another way, one's required rate of return dictates the fair price to pay.

Capital Preservation and Rational Potency of Earnings

This is Part 2 of a Series. Go to Part 1: On Discount Rates, Required Rate of Return, and Conservative Purchase Price.

The idea behind capital preservation is defensively allocating capital in a safe investment position (thus, preserving your money’s worth) but at the same time exposing it to the prospect of profits (or capital gains)—Simply, it is earning without risking losing money. The cardinal concern shouldn’t really be profits—it should first be preserving capital. Profits only come secondary after making sure we don’t lose money. If we start concerning ourselves on this primary consideration, then we’d undoubtedly be diligent and be very cautious in our allocations.

Earning without risking losing money. Capital preservation should remain top priority, with earning profits only being an afterthought.

So if that be the case, then why not just easily opt to hold hard cash, you may think? Well that’s hardly the solution. Complacently leaving your cash lying in the room or under your bed or pillow would diminish its worth because of that value-sucking animal called inflation—the real enemy. Capital preservation is therefore achieved only through placements in value-enhancing instruments which, at the least, beats inflation.

In the realm of stocks, capital preservation can be ascertained by banking on very conservative assumptions of underlying value. Why underlying value? Because that can only be your best bet towards consistency and predictability. If you rely on market value, you’d be subjecting yourself to the whims, emotions, and ups-and-downs of the market. And that would certainly not preserve capital. (An aside though: take note that this is only true if we exempt arbitrage plays; in arbitrage scenarios, the pursuit of value is not found on the underlying business, but rather on the difference between prevailing market price and the publicly declared market tender offer—the arbitrageur viewing the discrepancy as his source of value gain). Nonetheless, certainty is key.

On Discount Rates, Required Rate of Return, and Conservative Purchase Price

Why do we discount something? We discount a future value because we want to know the right price to pay now to achieve that discount rate as our required rate of return. Or maybe we don't necessarily want to accurately achieve our target rate; we just want, at least, to estimate a conservative purchase price that will preserve capital and put some potential earnings exposure, leaving most of the actual returns to chance... Just maybe.

This is Part 1 of a Series

Discount rates often seem too complicated when they should be not. Because the idea behind them is similar to an interest rate. Interest rates, for most of us, are easier to comprehend because of their familiarity in everyday practical use. Say we have Php100 and a bank deposit placement offers a 10% interest rate per annum. Should we decide to put it there and hold it for a year, our Php100 will be Php110 [Php100 x (1+10%)]. It’s very straightforward and helps to answer the question: How much money will we get in the end? Or algebraically, the unknown being sought is FV (future value):

FV = PV x (1+i)^n

By contrast, if what is known and offered to us, instead, is a future value amount, the question now is: How much are we willing to pay for it now? Algebraically, after transposing the variables, our unknown this time is PV (present value):

PV = FV / (1+i)^n

So if we are offered Php110 and we want to achieve a 10% rate of return after a year, we should be paying Php100 [Php110/ (1+10%)]. The interest rate and discount rate are thus one of the same nature. The difference can be attributed to the circumstance—that is, the term interest rate is used if we’re talking about finding the future value of a principal amount we would want to invest now. The term discount rate, on the other hand, is spoken if we’re talking about finding a present value we would be willing to pay now provided we know what the future value outcome would be.

Intrinsic Value and Bond Valuation

This is Part 1 of a Series

The intrinsic value of an asset is only worth the sum of the present values of all the future cash flows it provides. This is the assumption of bond analysis and valuation. When you buy a bond, you are offered interest or coupon payments which you receive in varying intervals (e.g. monthly, quarterly, semi-annually, annually, etc.). You pay upfront for the principal, receive interest payments, and finally receive that principal you initially paid for upon maturity (i.e. expiration date of the bond).

Coupon Bonds. In bond analysis, a bond is only worth the sum of the present values of all its coupon payments and principal upon maturity.

What is Present Value? It is the discounted value of a cash you’d be receiving in the future. It is based on the premise that as rational capitalists, we give more value to cash we can hold, spend, or invest now (at the present time) than the same cash amount we would receive in the future. It does make sense if we observe an extreme example: were you offered a million pesos, would you rather have it now or have it 10 years later? Most definitely, that Php1M is worth more to you now than it is (at the same amount) 10 years after!

How about Discounting? Discounting is a technical, finance-slang term akin to your more familiar, layman’s interest rate. Say you have a Php100 and you offered it to me as a loan with 10% interest per annum. After a year, assuming I stay true and make good our original terms, your Php100 would be worth Php110.

FEU’s Cash Hoard. And They Said School is Boring...

This is Part 3 of a Series. Go to Part 2: So Where Have All Those Free Cash Flow Gone?

Majestic Campus. FEU is one of those few quality businesses that routinely produce and hoard free cash for the wealth enrichment of its owners.

I can’t blame anyone who thinks school is boring. Be it on what one may have experienced back in high school or college (e.g. boring classes and teachers/professors), or in stocks (i.e. boring, illiquid issues that hardly move in the market). But let’s take on the shoes of a prospecting investor interested in the fundamental cash-generating dynamics of a school as a business.

Disclosure: I'm currently a shareholder of Far Eastern University—yes, it is listed in the Philippine Stock Exchange (PSE: FEU).

Grasping the core business model of a school seems easy. Schools teach and prepare students for the real world, and in return collect tuition fees for this education service. As many are aware, they collect these fees upfront; before a student can walk into a classroom to learn, he must first pay the registrar a visit and write the accounting department a check. Not mentioning its other sidelines (such as leasing certain properties owned and deploying excess cash into other non-core business investments), that's how a school primarily makes its money.