DCF Analysis - the analysis of article

Andy and Shashi have left some comments on the first part of my article on DCF analysis - saying that they have not understood anything and they also feel comfortable with the simple plus/minus calculations.

They are ABSOLUTELY RIGHT - though it is simple mathematics, even then the majority of investors (including IT engineers who are supposed to know maths to a good extent) find it difficult to understand. If they do understand, they dont have time to make calculations - they probably want to shield themselves from the bad news.

But unfortunately, the bitter truth is that method listed in this article is the truth and this is the correct way of calculating profit and loss.

In all my articles, I've always stressed about the ignorance that people have in understanding the calculations. All they end up doing is making ignorant bets in the market. Even if they are in loss, they don’t realize it. They just look at 1 or 2 profitable trades and believe that they are in big profit. I was also one among them before my finance studies – I was working as a programmer, also betting on stocks and making incorrect plus/minus calculations and thinking that I am earning extraordinary money – all thanks to the bull run in the Indian stock markets. Under the same false impression of making good profits, I left my well paid job thinking that I can make enormous money in the markets, did a very costly masters course - just to realize that we cannot really make any returns better than what is offered by risk-free bank accounts.

My articles are aimed at providing the true picture. That's the reason I include every fine detail in my articles (including formulas and examples)

If the readers still want to ignore the things - it is left upto them. Sometimes, I feel what is this euphoria game going on? People invest or trade to earn more – but do not want to learn even the basics of how to calculate profits and losses.

Here is another example:

Casinos are legal business in US and US citizens, visitors, tourists, etc. are frequently visit casinos. Despite knowing very well that no one can make any money from betting in Casinos, they still go there and loose money.

The reason - they go there for leisure time and do not mind loosing money. Nobody is knowledgeable about the mathematics of how and why casinos are always in profit and why the people visiting casinos are always the loosers. (It’s actually due to rules set by casinos and due to a probability law called “Law of large numbers”).

Today, information is available for free. Blogs like mine, and other sites have enough details about the how and why of profit making calculations. Still people are not willing to accept the basic facts and learn. Is the situation any better than visiting the casino and loosing money?

To me, it seems even worse than the casino. Atleast in a casino, you visit occasionally, and loose only a limited sum of money. With access to internet and phone - people bet with stocks day and night. Hardly anyone knows whether they are doing right or wrong - whether they are in profit or loss.

All they want to do is live under the false impression that they are making better profits than what is offered by bank accounts.

Anyways, I publish articles with an aim to expose the true colors or the stock market, and I will continue doing so. I attempt to include true examples and historical data to backup my explanations. I have been through that ignorant stage before my masters studies, so I know that it is difficult to digest these contrarian views. I am honest here because before my finance studies I also used to read only the goody-goody articles and ignore the things that occasionally used to come up telling me that there is no way one can make extraordinary money. I also use to bet my money in stocks, calculate the profits using simple plus and minus and keep myself happy with the false impression of making better returns than bonds and banks accounts.

Anyways, It is left to the readers to realize it or not. At the depth of my heart, I know that everyone has a businessman inside us and this businessman inside us will never allow us to realize the truth. That's why I always say, we are doing nothing better than betting in the stock market like people visiting casinos and willing to loose money. Lucky if they win, leisure if they loose.

Keep betting, Choice is yours!

All the best!

Have questions, please read the comments and post your views and queries in the comments section which helps in open discussion and avoids duplicity of questions.

You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.

DCF Analysis – an example - I

Stock traders and investors – a simple question to ask yourself: Do we really know how to make calculations of our profit and loss in the stocks and trading business?

Few days back I again got into a discussion with one of my friends.

His claim: Over past 5 years, I’ve invested 200,000 in the market. Today, I have booked profits amounting to 300,000. So I am in a 50% profit overall.

My Question: You invested 200,000 over a period of 5 years. Sometimes you invested 10,000, then after another month you may have invested 40,000, then after two months you may have booked profits of 15,000. So your investment was split across 5 years and at with different amounts. Are you taking the time value calculation of your money?

Response: I don’t get into all this high complex terms and mathematics. I simply do plus and minus. Minus for buying and plus for selling. At the end, if my net value is positive, I am in profit and I’m happy that I am making money in stocks. 50% return is much better than that offered by bank account.

I had attempted to give an answer to this situation of calculating profits in my very first article of my blog: Are your really making money in the stock market?. But that was very basic and a comparative method, where the returns from your overall investment were compared with those of the market indices, and with the returns from bonds or saving bank account FD (over the same period).

In this article, I’ll explain a much more realistic scenario and more practical way of calculating returns and hence profit and loss values.

The most important concept when calculating profit and loss from any investment is with the “Time Value of your money”.

Let’s take an example:

Case 1: Suppose, my bank offers me a banking account (like fixed deposit) with the following condition: Invest your money for a period of 6 years (lock-in period) and your money will double. I invest say, 10,000 in this scheme and at the end of 6 years get double of my money i.e. 20,000. Hence, my profit is (20K-10K)/10K = 100%.

Case B: I invest in a stock today, same 10,000. And in 2 months, it doubles in value. The return is again 100%.

Are the two investments A &B – which are yielding same returns – exactly the same??? No, they are not. Because in first case, the investment horizon is 6 years, and in the other, it is only 2 months. That’s why it is important to make time value calculations like DCF or Discounted cash flow analysis – instead of doing simple plus and minus.

So let’s carry on with a simple example of DCF analysis:

Suppose you buy and sell different stocks at different timings over a 3 year long period – from 1st January 2005 to 31st December 2007.

So, lets say you begin trading on 1st Jan 2005 and buy Microsoft by investing a total of 1000. Please note that the price of stock is not considered here – only the total amount that is invested is considered. Since it’s a buy, means you put in the money, so it can be taken as negative value. Similarly, for a Sell, we will take it as a positive value.

Then, on 3rd March 05, you buy Goldman Sachs Stock, by investing 200. Again negative, as it is a Buy. On 1-dec-05, you buy Google stock, by investing a total of 4000.

Then, on 10th February 2006, you sell Microsoft for total of 1200. This will be taken as positive, as it is a sale and you get money.

Similarly, you carry on your trading activities over the 3 years and we have the following table. Remember, all BUYS are taken NEGATIVE and all SELLS are taken as POSTIVES. Also, we DO NOT consider individual stock prices – we only consider the total money you pay and receive (offcourse, after deducting the brokerage charges).

For simplicity, I’ve named the columns as A, B, C, etc.

Start Date

01-Jan-05

Investment Period

3 years

End Date

31-Dec-07

Interest Rate

9%

Present Value of

A

B

C

D

E

F

G

Date

Stock

Buy

Sold

Annualized time

PV-Buy

PV-Sold

01-Jan-05

Microsoft

(1,000.00)

-

(1,000.00)

-

03-Mar-05

GS

(200.00)

0.17

(197.14)

-

01-Dec-05

Google

(4,000.00)

0.92

(3,696.68)

-

10-Feb-06

Microsoft

1,200.00

1.11

-

1,090.57

11-Jul-06

Exxon

(5,000.00)

1.52

(4,384.89)

-

13-Sep-06

Amazon

(2,000.00)

1.70

(1,727.65)

-

19-Sep-06

AMX

(3,000.00)

1.72

(2,587.81)

-

28-Dec-06

GS

600.00

1.99

-

505.49

05-Jan-07

AMX

3,600.00

2.01

-

3,027.19

09-Jun-07

Google

(5,000.00)

2.44

(4,053.34)

-

10-Oct-07

Google

12,000.00

2.77

-

9,449.58

11-Oct-07

Exxon

5,500.00

2.78

-

4,330.03

31-Dec-07

Amazon

2,100.00

3.00

-

1,621.97

Total

(20,200.00)

25,000.00

(17,647.52)

20,024.82

Net (Sold-Buy)

4,800.00

2,377.31



The same can be plotted as in the below graph as postive and negative over the period of time





Continue to Part II

DCF Analysis – an example - II

This is part II of the article DCF Analysis – an example. Please read the article from the first part before continuing with this one

Start Date

01-Jan-05

Investment Period

3 years



End Date

31-Dec-07

Interest Rate

9%

Present Value of

A

B

C

D

E

F

G

Date

Stock

Buy

Sold

Annualized time

PV-Buy

PV-Sold

01-Jan-05

Microsoft

(1,000.00)


-

(1,000.00)

-

03-Mar-05

GS

(200.00)


0.17

(197.14)

-

01-Dec-05

Google

(4,000.00)


0.92

(3,696.68)

-

10-Feb-06

Microsoft


1,200.00

1.11

-

1,090.57

11-Jul-06

Exxon

(5,000.00)


1.52

(4,384.89)

-

13-Sep-06

Amazon

(2,000.00)


1.70

(1,727.65)

-

19-Sep-06

AMX

(3,000.00)


1.72

(2,587.81)

-

28-Dec-06

GS


600.00

1.99

-

505.49

05-Jan-07

AMX


3,600.00

2.01

-

3,027.19

09-Jun-07

Google

(5,000.00)


2.44

(4,053.34)

-

10-Oct-07

Google


12,000.00

2.77

-

9,449.58

11-Oct-07

Exxon


5,500.00

2.78

-

4,330.03

31-Dec-07

Amazon


2,100.00

3.00

-

1,621.97

Total


(20,200.00)

25,000.00


(17,647.52)

20,024.82

Net (Sold-Buy)



4,800.00



2,377.31

Column A contains Dates, B contains Stocks that we buy/sell, C contains amount invested when we BUY the particular stock, D contains amount we receive when we sell a particular stock. For the moment, let’s ignore the columns E to G.

Now, if we take a simple plus and minus game, then we observe that the net TOTAL amount of money we invested is 20,200 and the net TOTAL amount of money we received from selling is 25,000. Hence, our profit is 25,000 – 20,200 = 4,800. So in terms of % calculations, we have (25,000 – 20,200)/20,200 = 23.76% profit. Very good performance!

However, what we have ignored is that our total investment was split over a period of 3 years and at any given time, we did not invest the total 20,200. Instead, the money we invested was also split in smaller amounts. So what we are ignoring here is the time value of money.

Now let’s take the time value of money into consideration and make some realistic calculations – columns E to G.

The way DCF or discounted cash flow works is explained very well in this article on Wikipedia. Do read it before proceeding further with this article, and it will give you a clear picture of DCF and the mathematics involved.

So, for every amount we spend or receive in the table above, we make the PRESENT Value calculation (using the below formula):

Present Value = (Net Amount Received or Spent / ((1 + interest rate) ^ annualized time)

Annualized time is calculated with respect to your start date – which in this case is 1-Jan-05.

So, for item no. 3 in the table, i.e. Google BUY of 4,000, the date is 01-Dec-05.

Annualized time = (No. of days from 01-Jan-05 to 01-Dec-05) / 365

= 334 / 365

= 0.92

Hence, the present value of our investment of 4000 is calculated as

PV = Amount / ((1 + interest rate) ^ Annualized Time)

= - 4000 / (1 + 9%) ^ 0.92

= - 3696.68 (as mentioned in column F in the table)

Similarly, we do the PV calculations for all the remaining items in the table (columns F and G) and at the end SUM them up together.

We see that the net PV of our BUYS is - 17,647.52 and all SELLS is + 20,042.82.

Hence, the NET value that we get is 20042.82 – 17647.52 = 2,377.81

In terms of percentage = 2377.81/20042 = 13.47%

Therefore, what appeared to be a profit of 4,800 by simple plus/minus calculations (and a 23.76% return), is actually only 2377.81 (and a % return of 13.47% only).

Continue to Part III


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