DCF Analysis – an example - I: Finance Trading Times

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

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3 Comments: Post your Comments

Andy K said...(on 28 September 2007 at 01:47 )  

Hi Shobhit
Frankly speaking i didn't understand a word from this article. I will take the total profit as 50% like the guy said. common man will understand that much only..how much he put in the market and at the end of the day how much Extra he got on his principle. that's all. Whatever you have written here is fine piece of return calculation might be used buy Fund houses or big financial companies.

But thanks for the efforts you have taken to present this stuff.

Keep posting
Aniruddha

Sachin said...(on 28 September 2007 at 02:09 )  

Really a nice article.
Thank God I don't do just a plus and minus :-)

Additionally I got something to learn about my type of analysis of profit and loss in market.

Appreciate your efforts in coming up with such great articles from time to time.

shashi said...(on 29 September 2007 at 05:53 )  

Hi Sobhit,
Regret to add that for the first time I found an article which was not clear in its motive. May be because we are used to reading wonderful articles written with a definite purpose.
I must say I felt similar to what andy k felt.
Thanks anyway.

Wish you all happy and fruitful trading and investing activities with safety! = = = Post a Comment

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