Breaking Down Capital Markets - Part 1
Part 1 - Introduction to Stock valuation, Bonds, and Investments
Principles of Investing
Although Part 1 will serve as the initial building block for its successors, I believe this information to be critical in understanding investments in more detail, and making educated decisions. Consequently, Part 2 will use this information and deal more granularly with building a portfolio, smart investments, and risk management. For many, this will be new information, and I hope having it broken will make it seem that much less intimidating.
The Financial Mosaic (Beginner)
The mention of stocks seems to have taken on an interesting development across this generation within my observations. Upon mention, the conversation often turns rather facetious, agonizingly serious, or even expressly indifferent; I find the lattermost as disconcerting as the one preceding it. To avoid the repetition of what has already been said across many mediums, my plan for this series is to develop a gradual base of more practical knowledge instead, to facilitate intelligent decisions rather than make them for you.
With that said, I should not need to discuss the merits of investing early, with this picture displaying the significance of maintaining consistency and timeliness.
It should also be clear that the intelligent investor need not be the most keenly knowledgeable on stocks themselves in order to generate consistently substantial returns through their lives. In the illustrations above, the differences in portfolio value are comprised of many factors, for one, the amount of contribution, i.e) a $19,500 annual contribution to lead to differences in the millions of dollars. Although an 11% annual return is historically high, there is no reason to believe an soundly constructed portfolio cannot generate around 7% in annual average return without onerous levels of risk.
As I alluded to above, we should first take a step back and consider the details of the components of the portfolio in order to better be fitted to make economically intelligent decisions. Knowing how stocks and bonds price and what drives their movement is incredibly informative in order to make intelligent decisions, or said otherwise, generating incremental returns without taking on an extreme burden of risk.
Definitions and Explanations
Before I begin, I will likely be using financial vernacular that may be unfamiliar. Within my best efforts, I list them here and define them so they are more easily understood, feel free to skip this and come back. Please reach out with any requests for definitions and terms as I will continually be updating this
Definitions of Components: Stocks / Bonds
Equity / Equities / Stocks / Shares / Securities / Common Stock / Equity Securities: These are all essentially synonymous. Simply put, a stock or a share is a term you've likely heard all too often. Other than the eponymous representation of the company i.e.) APPL (otherwise known as the ticker) for Apple, the more granular definition is that it is a single claim on the company's ownership, e.g) owning a single share of Apple stock means you own 1 divided by 16.79 billion of the company (total shares that the company has issued to the public, this # can be easily googled). Congrats! The components are simple, it's just the price:
$APPLE, Apple Inc - $121.94 USD
Bonds / Debt Securities / Fixed Income / Coupon Instruments: Bonds are the less-understood counterpart of equities. Think of these as like an I.O.U (liability) from whomever issues them. Together, the total bond and stock market make up what we call the "Capital Market." You will likely see them referred to as Fixed Income securities as well. All this denotes is that they pay a coupon, or a fixed payment, per quarter, annual or semi-annual period. The components of a bond are as follows:
Par / Face Value : $1,000
Market Value / Price : $990
Coupon Rate : 10% or (10% x Face Value) = $100
Yield / YTM: The % return an investor in a bond will realize if held to maturity and rates do not change.
Maturity (Years) = 10
Don't be intimidated, when broken down, this is quite simple. In this example, an investor (you) purchases a bond from a company or the government at the price of $990. You have essentially lent the issuer or borrower (the company or government) money, which you obviously want back. As such, the issuer promises to pay you the coupon rate, or 10% of the face value on a given time basis, let's assume annually. In addition to that, if you hold the bond for the full maturity (10 years), the issuer will pay you the coupon rate and the face value in full, ($1,000 + $100). So, you have effectively earned $100 coupons every year and then the face value of $1,000 on the last year for your initial investment of $990. There are obviously some intricacies here, but that is all a bond is. You will often seen them quoted in terms of Yield, which represents the theoretical annual % return you will earn if held until maturity at the current price. So intuitively, yields are higher if prices are lower.
Government bonds are considered safe investments, because you are essentially promised the obligation as they have infinite disposal to taxation and money printing in case they cannot pay it off. As such, during periods of uncertainty, investors will usually buy bonds and sell stocks. Following the law of demand, all else equal, this will lower the price of stocks, and increase the price of bonds, reducing their yield. Remember, price and yield move opposite to each other for bonds.
Financial Market Concepts
Time Value of Money: Possibly the most critical theory in finance that forms the cornerstone of all theories of valuation, and past its ridiculous forms of names, is quite shockingly simple. Consider this hypothetical scenario:
You are offered a free $1,000 today, or $1,100 in exactly one year. Which one do you choose?
Not completely clear right now, right?
Let's add another layer of information. Let's assume you have a magical machine that, without fail, spits out 15% more money than you put in exactly one year after you insert it.
The decision should be obvious. You could take the $1,000 and turn it into $1,150 by the time you would have received the $1,100. What I'm trying to imply is that the $1,100 is not worth $1,100, at least not in present terms. If we assume this magic machine exists, then this $1,100 is only worth ~$956.5217391 dollars to you today, or ($1,100) / (1 + .15) ^ 1. All this equation is calculating is the PRESENT VALUE of the investment. In other words, investing ~$956 right now in the machine would yield $1,100 in one year, which means that this question could also be worded as :
You are offered a free $1,000 or $956, which one do you choose?
The 15% that is offered by the magic machine is the discount rate in this scenario and is representative of the time value of money, which essentially implies that a dollar today is worth more than a dollar tomorrow. Although we obviously have no real life magic machines that spit out larger amounts of money, we are able to approximate these rates through various means. Keep this is mind as we discuss more granular numbers.
Unsystematic Risk / Risk / Standard Deviation / Variance / Volatility: Whenever we refer to any financial securities like stocks or bonds, we often hear them quoted in terms of risk or return, and rightfully so. As investors, we should consider being risk-adverse as the most economically sound approach, especially as we get older.
Consider these two scenarios:
You are given two choices with $100:
Choice A: A coin flip in which you have a 50% chance to win $200, or a 50% to lose everything
Choice B: Walk away and keep your $100.
Although the expected return is the same for both scenarios, the risk or standard deviation is quite different. A quick refresher on basic statistics below:
Economics Definitions
Inflation rate / Inflation / CPI Increase:
Inflation is likely a term that has crossed the conversation of most individuals’ experiences. Simply put, inflation represents an increase in the overall price level of the economy based on a base year. How is inflation caused? By two functions economists call Demand-Pull and Cost-Push Inflation.
Demand-pull inflation is the result of an elevated level of consumer demand for overall goods that overtakes supply. As overall supply dwindles, prices are pushed upwards as consumers bid higher and higher for ownership (sound familiar?). This usually occurs during periods of economic expansion and low unemployment, when confidence in the market and spending levels are high. Some believe the period following COVID-19 may accelerate COVID as millions of people consumer all the goods and services they could not prior. To estimate this, the government / economists will compile a basket of consumer goods that are supposed to approximate the average consumer’s spending habits, and call this the Consumer Price Index (CPI). This basket of goods will have it’s weighted price calculated and indexed as 100, or 1. Each subsequent year’s basket of prices will then be compared to the base year’s price. If 2017 was the base year , and 2021’s CPI measured 110, this would imply inflation of (110/100) - 1, or 10%. In other words, all else equal, prices rose by 10%. This has many implications across the broader financial market down to the minutiae of our lives.
Cost - Push inflation is caused when higher input prices for businesses cause them to pass on the extra cost to the consumer. For instance, rising labor or raw material costs will likely be transferred to the consumer, all else equal, with the same level of demand. For producers (businesses) the equivalent of the CPI is the Producer Price Index (PPI), which measures prices for fuel, chemicals, metals, etc.
Altogether, higher inflation reduces or erodes your returns. For instance, making an average return of 10% of the market would only net you a real return of 5% with a 5% inflation rate. This can also create a vicious cycle where employees demand for wages for higher prices, which in turn can create another loop of rising prices. On a normal basis, inflation runs around 2%, although it has ran historically low at the 1-1.5% for the last several years. Stocks were historically thought to be inflation-proof, which has turned out not to be case. However, they have shown to be more largely protected than bonds. While stock prices can be more fluid and react to new information, bonds are fixed-income or fixed-payment instruments that pay the same coupon rate repeatedly. Consider a bond that pays a 2% coupon per year in a 2% inflation environment. You essentially make 0% real money when adjusting for inflation. The reasons above are partially why the optimal portfolio contains a strong allocation to both equities and bonds, and both have risk / return characteristics that complement each other.
Intermediate Financial Terms
Discount Rate / Cost of Capital / WACC: The “opportunity” cost or hurdle rate that should be supposed when estimating the present value of money
EBITDA: Earnings Before Interest, Taxes, Depreciation & Amortization: (E-BIT-DA): A proxy for unlevered cash flow of the business. A company’s revenue minus their expenses to operate the business and adjusting for items that are expensed on the income statement but not necessarily impacting cash. From an accounting perspective, certain items are considered expenses in the year/period but do not actually incur an outflow of cash (depreciation of equipment, etc). This derivation meant to be very easy to calculate and comparable among all companies, hence why we do not subtract taxes and interest. This metric is meant to be usable and comparable across all companies with varying tax and debt structures, which are technically not components of the core business. For instance, if I am a business that generates 50 million dollars of revenue it costs me 35 million dollars to make it, my core business is doing 50 million minus 35 million dollars. To get to my net profit, I will then subtract, interest expense on any debt I have, corporate taxes, etc.
Principles of Stock Prices (All Levels)
Across my experiences, I have heard many different ways of approaching stocks and their prices.
Although definitive statements are impossibly incompatible with life, I can still categorically state that are incorrect ways to do approach them, which can be inferred through statements like these:
"I think the stock is too high (low), it should go down by $XX"
"It was at $XX before, so I’ll keep holding it"
"It shouldn't go higher than $XX, or lower than $XX"
"XX is so big, its everywhere! Of course the stock is going to go up."
To caveat, let's assume these statements were made after just only looking at the chart of the stock price and not based on any sort of reasoning.
For the more experienced investor, there are often some misconceptions that can lead to downfall
“It’s relatively cheap (expensive), so Its undervalued (overvalued)”
“They have a great management team, so they should get through it”
“The market is valued at XX multiples, so this is how (this stock) should be valued”
Consider this example below:
The burgeoning Marijuana industry has been sweeping North America for the last decade, as the fall-outs of the War on Drugs and increasing public support for legalization has put pressure on governments to decriminalize marijuana. Estimated demand for the total market including Black Markets is around ~55 billion dollars. Legalization in certain states like in California, Colorado, Seattle, Oregon, Washington, etc, have proved that on the legislative level, federal governments are hesitant to stop state-level legalization, despite not being nationally legalized.
Consider a population of 300MM U.S. citizens, with ~200MM over 18 years old. On average, over 50% have tried its use, and around 10-20% continue to use or actively smoke. With an ounce of marijuana costing between an average of $266 nationally, if just 10% of the adult population of 20MM purchase a conservative estimate of one ounce per year, the total market would then be estimated at $266 * $20M of $5.3BN, excluding different qualities and costs per state and the use of medicinal, etc.
Consider the company Tilray, a producer of marijuana / marijuana products in North America. The legal marijuana industry is both hard to break into as a newcomer, with extensive government regulation and costs of developing farms, etc. If we believe marijuana will only become increasingly more legal, why would you not purchase this stock? In fact, you should be purchasing this stock immediately, right?
Consider the following picture below:
It seems hundreds to thousands of people came to the same spurious conclusion that I have facetiously reached above. In roughly 2018, Tilray’s stock hit around $150, amid the craze for legalization after some positive news on passed legislation came out. Herein lies the issue with future forecasting and getting swept up in the craze and FOMO. We come to the same conclusion we have prior, that social significance / prevalence does not imply economical significance. Many probably made the mistake of predicting that the company’s sales would grow at wildly optimistic exponential rates, or worse yet, even continually to just blindly buy the stock because “marijuana is going to be big.” Unfortunately, different complexities came into play severely crimping the heightened optimism that plagued the stock prior, and shortly after, the price declined over 80% and still trades in the low double digits.
How many do you think fell for the same fallacious logic when Tilray was at $100, $150, or $50 - or when Cisco was at $80? I am not making any statements on whether or not these stocks are actually worth the amounts that they are, but rather make them as an examination on the behavior of the market. For one, past prices do not signify future results. What the lesson should be is that even mythical levels of intelligence do not necessarily favor good stock picks, but neither do instinctual reactions. Gut instincts have served our species for thousands of years, and I do not question their usefulness. However, when considering the (mostly) mechanical nature of stocks, it is hard to prescribe the same optimism. Stocks are priced in a manner that make such "gut checks" like the ones described above as inefficient.
Of course, the one caveat is that the agents participating in the market (humans) are inherently flawed, and there have been cases of irrationalism in the market. However, these are relatively few in nature, and impossibly difficult to predict or monetize without taking on immense levels of risk.
What is significant in a societal sense does not imply economic or financial significance. In other words, everybody owning a car does not mean you will make money buying car stocks. You can see a similar story with Tilray (Marijuana) and Cisco (Internet / Communications).
Basics of Stock Pricing / Valuation
To those wishing to know how stocks are exactly priced, I fear you may be veritably disappointed. Knowing how stocks are priced implies that is therefore possible to identify MISpriced stocks, which is a tenuous position at best. However, it is possible to know the the factors that influence the prices.
Stock prices, in their simplest form, are an intersection of supply and demand, similar to anything in life. You may be wondering, then, how the specific prices are agreed on by so many different market participants?
Stocks are valued in three main mannerism:
Valuation Methodologies
1.) Relatively (Present looking) : Comparing a stock to other similar stocks. Consider this example
Company A has total sales of $100 and has a total of 100 common shares in the public. The current stock price is $50.
Company B is in a similar industry and of similar size, has sales of $200 and total common shares of 50.
What would you pay for Stock B if these companies both had no debt?
Company A: Sales per share = $100 / 100 = $1. Stock Price = $50, or 50x (50 times) sales per share.
Company B: Sales per share = $200 / 50 = $4. Implied Stock Price = $4 * 50 = $200.
The ease of this valuation methodology goes to show exactly how unintimidating stocks can be when broken down. Obviously, this is incredibly simplified. For one, this valuation methodology is PRESENT focused. In other words, it captures current market sentiment but fails to accommodate any historical or future information. If Company A was projected to have sales of $400 next year, while Company B was projected to have $150, you would be unlikely to pay the same for both.
2.) Intrinsically (Historical + Future looking): Estimating how much cash a company will make each year in the future, and discounting it to see its present value. Consider this example:
Company A has total sales of $100 this past year and has a total of 100 common shares and 0 debt. Historically, they have turned 50% of their sales have turned into cash, meaning that after paying all their expenses, the company earned $50 of cash last year.
How much would you pay for this company's stock?
Assuming that for the next 5 years, they will continue to turn 50% of their sales into cash like they have historically, and assuming they grow sales at a 5% rate every year, their future cash flows will be as follows:
Year 1: .5 * 105 = 52.5
Year 2: .5 * 110.25 = 55.125
Year 3: .5 * 115.7625 = 57.88125
Year 4: .5 * 121.550625 = 60.7753125
Year 5: .5 * 127.6281563 = 63.81407813
Total = 290.0956406
Discount Rate = 10% (See definitions above if you are unsure what discount rate represents, 10% is an arbitrary number created for this example's purpose)
Present value of $290 = 290 / (1.1)^5 = 180.67 (We normally will discount each year after the first by the respective year, and not discount the whole sum of the 5 years by 5, this is just a simplified example)
Common shares outstanding = 100
Implied price = 180.67/ 100 = $1.867 (We divide the cash flows by the total amount of shares to determine what one share should be worth)
As you can see, this valuation takes into account potential growth as well as historical factors. However, you should hopefully see the issues with relying on such factors.
Although you take potential future growth in account, you are assuming that 1.) you are correct in your assumptions, and 2) historical patterns will hold. For this example, if the company suddenly stopped growing at 5%, or began to hold generate 40% of their sales to cash instead of 50%, your initial calculation will be far off. It wouldn't be an exaggeration to say that being able to predict the future would render your need for stock forecasting as trivial. Most practitioners, as a result, use a table of sensitivities to display a range of possible values based on different conditions.
Now that we have established two different ways that people price stocks, it is far easier to understand why making gut checks for stock prices can be so limiting, and why applying spurious rational can lose you lots of money. In the case of Tilray that I outlined above, the increasing pace of the legalization of weed in the U.S. led people to falsely believe the future growth rate of the company would skyrocket. However, predicting the future is as hard as it sounds, and there are many more complexities involved.
The focus for Part 1 was to demystify the process of stocks, which represents the core of investing. Now that've done the boring stuff, part 2 will focus on how we can leverage this knowledge to build your net worth through smart investments, and how to start. Stay tuned! Reach out with any questions.
