DCF Analysis – an example - III: Finance Trading Times

DCF Analysis – an example - III

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

This return of 13.47% was accumulated over a 3 year period. Hence, to make a comparison, we should annualize it.

To understand how annualization works, take this example.
You invest an amount of 100 for 3 years at the rate of 10% and don’t withdraw anything in between. How much money will you get at the end of 3 years?

First year principle = 100
Your first year income = 100 * (1+ interest rate) = 100 *(1+10%) = 110
Second Principle = First year principle + First year interest income = 110
Second year income = 110 *(1 +10%) = 121
Third year principle = second year principle + second year income = 121
Third year income = 121 * (1+10%) = 133.10

Hence, at the end of 3 years, you get a total of 133.1
Actually, the simple way to calculate this is the following formula:
Final Value = Initial Principle * (1+ annual interest rate) ^ no. of years
= 100 * (1+10%) ^3
= 133.10

Hence, if we know final value, then we can calculate the effective annual interest rate in reverse calculation as follows:

Final Value = Initial Principle * (1+ annual interest rate) ^ no. of years
So annual interest rate = (Final Value/Initial Principle) ^ (no. of years) – 1

Now, for 13.47%, the annual interest rate comes out to be 4.3% only.
To cross-check : 100 * (1 + 4.3%) = 113.467 = 13.46%, which matches the value exactly.

On the other hand, for simple plus-minus calculations, we received a profit of 23.76%. Corresponding calculations give an annualized return of 7.36% - which is incorrect as compared to the correct figure of only 4.3%.

Hence, if you take the realistic time value calculations, you will observe that the simple plus minus calculation will always give a highly bloated and incorrect value for profit calculations. We MUST understand this very clearly.

---Modified after comment from Nilesh-----
The reason why I gave a detailed example here was because the 4.3% annual return that you are actually generating on your RISKY stock market returns (over and above the risk free rate of 9%), is this extra percentage justifiable with respect to what is offered by the RISK FREE bank accounts or bonds?

Secondly, We have considered all the investments with POSITIVE RETURNS. Not a single stock investment has been assumed to give negative or loss making returns. The moment we take negative returns even for 1 or 2 stocks, the 4.3% will come down drastically.

Thirdly, this article is not only to compare your returns with those Bank accounts and bonds, but to actually learn to compute the right way of profit/loss.
---Modification Ends -----

That is why I always insist on making correct calculations and then see what you have done in the past, what your positions are in the present and would you be interested in avoiding these mistakes for the future.

Tomorrow, I’ll continue with some more parts of options trading tutorial.

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.
Have Comments or Questions? Please post them as comments using "Post our Comments" link below. Your queries will be responded for free in 24 hrs!

10 Comments: Post your Comments

Anonymous said...(on 28 September 2007 at 01:49 )  

Dear Shobhit,
Very good article and really an eye-opener for all the investors. New thing I learnt today. Thanks once again for your efforts.
Best Regards

Anonymous said...(on 28 September 2007 at 02:56 )  

this statement is wrong.

>>>> The reason why I gave a detailed example here was because the 4.3% annual return that you are actually generating on your RISKY stock market returns, is much lower than what is offered by the RISK FREE bank accounts or bonds.

had you invested this money in bank deposit giving 9% return and then do this DCF calculation, your return would have come 0%. if your Fixed deposit is yielding less than 9%,

what i mean to say is this 4.3% return is above 9% return u get. so overall return is 13.3%.

Anonymous said...(on 28 September 2007 at 03:07 )  

putting example
you buy bond of 10000 on 1-Jan-05
and sell this bond for 12950 on 31-Dec-07 (9% ananulized).

PV of buy 10000
PV of sell 12950/(1+9%)^3 = 10000
return = PV of buy - PV of sell = 0Rs

Waller said...(on 28 September 2007 at 03:46 )  

Fanatastic Article!! The next thing I am going to do is apply the same onto my portfolio returns over the last 3 years.

Would you be able to share your knowledge and expertise on Home \Loans or points to watch out for when choosing a home loan vendor.

Many Thanks,

Shobhit said...(on 28 September 2007 at 03:49 )  


Thanks for quoting the example.

The sentence that i missed to include is that the 4.3% is above the risk free rate. AND I also forgot to mention that the returns are always assumed to be POSTIVE.
Also have a look at the data that I've included in the table.
All the stock investments have been taken as POSITIVE returns - none of them are negative. Postives are also high values.
Hence, the 4.3% that you see is just a figure for the an assumption that consistently you make money on all your investments.

Just change one or two of the SELL values to lower than the BUY values and you will see that the annualized return percentage will come down even below the risk free rate.

I attempt to take the best and profitable examples, and tell how the investments even for the best and profitable cases are not worth taking the risk.
Thanks for your contribution - it really helps.


Anonymous said...(on 28 September 2007 at 04:33 )  

Excellent work Nilesh. Even I was not convinced with Shobhit's arguments when I read this article today. However, your comment clarifies it all.
Shobhit - I hv been a silent follower of your articles but can't find enough time to read consistently. Most of your points are valid but sometimes you provide a very grave picture. Could you kindly add the valuable stuff like the one pointed out by Nilesh and it to your series so that blind followers are not mislead.
Thanks for all your efforts.

Anonymous said...(on 29 September 2007 at 01:22 )  

anonymous, i agree Shobhit is little pessimistic or should i say he is over cautious about stock markets.

i am also regular reader of this blog and find it good to keep myself down to earth in this general euphoria abt the market.

on your comment mentioning "blind followers", i think Shobhit also emphasizes not to blindly following anyone (he does not mention it explicitly but that includes him as well).

Unknown said...(on 29 September 2007 at 22:35 )  

Investors are interested in the money they get at the end of a period of investment. Most people will be more benefitted in knowing where and how to invest by virtue of which they will get more returns in terms of money and not in terms of rate(percent) of return. Simply put it in lay man terms - where can you double your money in less time?? That is - where risks are fewer and returns grossly outweigh the risks.

Unknown said...(on 29 September 2007 at 22:40 )  

Two - three years retrospectively, can you compare investments in secondary markets in select sensex shares vs. etf/ifs.
we are looking forward to your further tutorials on futures and options.
Thanks a lot for your articles.

Anonymous said...(on 30 September 2007 at 22:27 )  

Mr. Anonymous,

The way you've left your comments, it seems that you were just waiting for Shobhit to make a mistake, so that you can come out and make noise about it.
So Sick and sad of you.

What were you doing so long, when there are regularly good articles being published for last few months. Should I again call it the SICK INDIAN MENTALITY. No appreciation for good work, and unnecessary noise for alleged mistakes that are not actually mistakes.

You mention that you've been a silent follower of the articles - but dont have enough time to read consistently. What exactly are you trying to say?
Spotting mistakes is easy - very easy. Try and write a good article on any topic you have expertise and we will be more than happy if it is atleast to the level of clarity that is reflected in Shobhit's article.

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

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