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Buyback Versus Dividend

Sep 26

Posted by admin in Finance, Investing, Stocks Mutual Funds

There are two ways company can give out its profit to shareholders. One is to give out dividends. The other is to buy back its own stocks. Which one is more appropriate? This article will explore the topic further.

The American tax law give a slight edge to stock buybacks. It is taxed once before the company decide to use its profit for stock buyback. (Every profit in a corporation is normally taxed). Dividend payment meanwhile is taxed twice. Once when the corporation reports a profit. Twice, when the shareholders receive it as an income. Most recently, investors receiving dividend income are taxed at rate of 15%.

So, does stock buy back is always advantageous to dividend payment? No, not really. It really depends on what price the company buys its own stock. If a company buys back its stock when the stock price is relatively overvalued, then it is better to distribute it as dividends. Shareholders can then appropriately invest it in undervalued investments.

So, at what point will dividend make much more sense? This all goes back to the fair value of the common stock itself. In a 4.5% interest rate environment, stock trading at a fair value is yielding 7.5% ( a Price Earning Ratio of 13.3 ). This assumes a 0% growth in earning. Therefore, it is desirable for companies to buy back its stock at a P/E of 13.3 or less.

But, wait. Since, dividend is taxed at a 15% rate, company that buys back its own stock at fair value will still saves shareholders 15%. Therefore, buyback still reward shareholder even when the common stock is 15 % overvalued. Based on this, company should continue buying back its stock only when the stock is trading at a P/E of (115% x 13.3) = 15.3. For a 0 % growth, it makes no sense for management to insist on buying back its stock that is trading at a P/E higher than 15.3.

One recent example is Intel Corporation (INTC) which initiates a $ 25 Billion intelligent stock buyback on Thursday Nov 10th 2005. At current price of $ 26.16 and $ 2.24 positive net cash on the balance sheet, Intel is buying back its stock at a forward P/E of 16.72. While this is a high P/E to buyback stock for a company that is not growing, Intel is not a 0% growth stock. Analysts generally expect Intel to grow its earning by 15.5% for the next five years.

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Writen By : Hari Wibowo

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The Power Of Stock Buybacks

Sep 26

Posted by admin in Finance, Investing, Stocks Mutual Funds

Company with excess cash flow has two options to return the money to shareholders. One is to give out dividends. The other one is to initiate a stock buyback program.

Stock buyback is a program where a company use its cash to buy back its own stock at an open market. The purpose is to reduce the amount of shares outstanding and thus causing the remaining shares to be more valuable. Company initiating a stock buyback program will be able to grow revenue more rapidly and afford to pay bigger dividends. Let\’s use an example to illustrate. Ready? Please write it down on a piece of paper if you must.

Company A is trading at $ 20 per share with 100 Million of shares outstanding. It earns $ 2 per share at recent years and it is giving out $ 1 per share of dividends. If you do the math, this translates into $ 200 Million of annual profit and $ 100 Million of dividend payments. Now, let\’s assume that company A is distributing all its profit to shareholders. With $ 100 Million used for dividend payment, management decide to use the rest of $ 100 Million to buy back its own shares. Meanwhile, the company manages to grow its profit by 5% in the following year to $ 210 Million. What is the effect of the buyback? The following table will illustrate. (The table can be viewed at http://www.noviceinvesting.com/Research71.php)

Looking at the result, stock buyback obviously increases the growth in earning per share. In an actual basis, earning grew from $ 200 Million to $ 210 Million, or a 5 % growth rate. Earning Per Share (EPS) however, grew at a much faster rate. It grew from $ 2.00 to $ 2.21 representing a 10.5 % growth rate. Meanwhile, dividend payment shrank due to the shrinking number of shares outstanding. The company still gives $ 1 per share dividend but it costs them $ 5 Million less now.

Do it over a longer time frame and the EPS increase will be much larger, assuming that the stock price remains stagnant at $ 20 per share.

There is several lessons that we can learn from stock buyback. One is that investors won\’t have to worry if the stock price remains stagnant. The company can keep buying back its shares, reduce its share count and increase Earning Per Share even faster.

The second lesson is that stock buy back will reduce the cost of distributing dividends. As less shares are available, the company can afford to increase its dividend per share even when the total dividend distributed remains constant.

The third lesson is that the cheaper a stock price is, the larger amount of shares the company can buy back. This is positive for shareholders! If the company buy more shares at a low price, the effect of EPS increase will be higher with the same amount of dollars. Thus, investors often applaud companies that initiate stock buy back when their stock price is depressed.

What kind of companies can afford to buy back its own stock while initiating dividend? These are mainly companies that require less capitals to fund its ongoing business and they should be profitable. In other words, they have excess cash. Buying companies with positive net cash also helps. Management may decide to buy back its own stock when they cannot find better use of its cash.

Investing Idea is now Free. You can get it at commentary section of our website at http://www.noviceinvesting.com

Writen By : Hari Wibowo

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Buying Company That Is Down

Sep 26

Posted by admin in Finance, Investing, Stocks Mutual Funds

I hope you know how to differentiate a company that is out and a company that is down. We have discussed these in the past and you are welcomed to check it out at our commentary section. Today, though, we are going to talk more about reasons to buy company that is down.

Why should we as investors buy companies that are down? Why don\’t we buy company that is out or company that is doing fine? Here are several reasons why:

Cheap. Company that is down usually sells at a discount. A company announces bad news and then the share price will drop as a result. If the company is solid and your long term picture has not improved, then the company that is down can be bought at a cheaper price than other similar companies.

Dividend. Company that is down normally has a long history of profitability. If the company is not in danger of going out of business, then it can continue paying its dividend to shareholders. Buying company that is down will give you higher dividend yield due to the drop in the share price. On the contrary, company that is out cannot afford to pay off dividend to shareholders.

Take Over Potentials. Companies would love to scoop up other companies at a low valuation. Company that is down normally have depressed share price while its core business remains intact. This is appealing to potential competitors. A lot of big investors and companies buy company on the cheap. For example, Carl Icahn the fame investor, bought Time Warner Inc. (TWX) cheap and he is trying to unlock values for the company.

High Potential Return. This is one reason investors should invest in companies that are down. The depressed share price will have a chance to recover once its short-term problem is sorted out. Company that is down normally have a low P/E ratio, many in the single digits.

It is crucial to know whether a company is down or out. There are a lot of companies selling at single digit P/E ratio, giving dividends and yet their survival is in question. These are companies that is out and not down. While, it might be difficult to identify, I can give you several examples of companies that are down: pharmaceutical companies, banking industry and companies selling hard drives. The demand for their business remains intact despite the short term downturn in the industry. However, each company within an industry is different as well. Please use the guidelines mentioned on the past article to differentiate company that is down and out.

Investing Idea is Free ! You can get it at our commentary section at http://www.noviceinvesting.com

Writen By : Hari Wibowo

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The Folly Of PEG Ratio

Sep 26

Posted by admin in Finance, Investing, Stocks Mutual Funds

Price Earning Growth (PEG) Ratio is the ratio of a company\’s P/E with its growth rate. A lot of analysts have concurred that a stock is fairly valued when its PEG ratio equal one. This means that if a stock has a P/E of 10 with a growth rate of 10%, then the stock is trading at fair value.

How many of you have seen this kind of statement? I have seen it plenty of times and I think it is silly. This is a relatively simple reasoning. Let\’s think of it for a second. If a stock will grow its earning for 8%, then to reach fair value, the stock has to trade at a P/E of 8. How about a stock with growth rate of 5%? Its fair value is a P/E Of 5. How about a company with 0% growth? Oh, right. According to this theory, the company should have a P/E of 0, or worthless. Does this make sense? Heck, no. But there are a lot of articles regarding this PEG theory. Here are several sources of commonly misunderstood PEG ratio:

http://www.moneychimp.com/glossary/peg_ratio.htm
http://www.fool.com/School/TheFoolRatio.htm
http://www.investopedia.com/articles/analyst/043002.asp

For a 0% growth company, the fair P/E ratio for the company is not 0. Rather, it is a few percentage above risk-free interest rate or a ten year treasury bond. If a ten year bond is yielding 4.6%, then the fair value of a common stock is at 7.6% yield. Inverting this yield, we get a P/E ratio of 13.2.

Anything else is wrong with using PEG ratio to determine the fair value of a common stock? PEG assumes infinite growth rate in earning per share. No company can grow at the same rate forever. If we assume company A will grow at 10% rate for the next five years and then growth slows to 2% indefinitely, what is the fair value of the common stock using PEG ratio? The answer is it can\’t do that. PEG ratio is way too simple to single-handedly assign a fair value for a common stock. It is misleading and simply wrong to use PEG ratio for our fair value calculation.

Common sense dictates that a stock with higher growth rate should be valued at a higher P/E ratio. There is nothing wrong with that. But using a simple PEG ratio of one as a fair value of a common stock is simply wrong. I don\’t have an accurate way to calculate this but an estimation can be read on other articles entitled Calculating Fair Value with Growth and Fair Value with Negative Growth.

Get your free investing idea today by visiting our commentary section at http://www.noviceinvesting.com. No String attached.

Writen By : Hari Wibowo

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Sane Prediction

Sep 25

Posted by admin in Finance, Investing, Stocks Mutual Funds

The reasonable way to find undervalued investment is to find the fair value of the common stock. This requires us to predict into the future. The stock that seems cheap on the trailing basis will not rise if future earning is in jeopardy. An example of this is General Motor Corporation (GM) which had been trading at a trailing Price Earning (P/E) Ratio at single digits for years. Nobody rush to buy GM because investors realize that the future of GM is still shaky. Cost is high while revenue per vehicle is $ 3500 less than its Japanese competitors, Toyota Motor (TM).

To find undervalued investment, we therefore need to have a good predictive tools. This is mainly a quest of learning by doing. The more you do, the better your prediction power would be. Experience can teach you a lot of things about the proper way of predicting future earnings. Aside from that, you can follow the guidelines below to improve your earning prediction.

Be Conservative. Lean on the cautious side. After all, not all predictions are accurate. We would like to be in the position where our investment would not lose money even when the performance of the company misses our expectation.

Be Realistic. Let?s assume the company has a gross profit margin of between 40-45% for the last three years. If you are predicting a gross profit margin of 75% next year, do you think it is realistic? Nope. Unless the company is changing its line of business entirely, I don?t think such drastic change is possible within a year. For example, if Walmart Stores Inc. (WMT) is expected to be in the retail business, it is unwise to predict a significantly higher gross profit margin even when it branches out to higher margin industry such as credit card or insurance. Its profit margin might be up but it will not be shooting up from 30% to 60% in one year.

Be Reasonable. Use a reasonable judgment to justify your prediction. For example, you need to justify the cause of your forecasted gross margin of 40%. Perhaps, the company is moving its production to places where the cost is significantly lower. Perhaps, the company will see increased pricing pressure due to new competitions in the marketplace. Whatever it is, every elements in the pro-forma income statement should have some justifications behind it.

Be simple. There are a lot of uncertainties in pro-forma income statement. By simplifying the elements of income statements, it will be easier to decide whether a stock is a good investment or not. For example, if a company is paying different taxes rate at different states, it is better for us to simplify it and use the combined average tax for our calculation purpose.

Get your free investing idea by visiting our commentary section at http://www.noviceinvesting.com

Writen By : Hari Wibowo

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It Pays To Be Stingy

Sep 25

Posted by admin in Finance, Investing, Stocks Mutual Funds

We all know the importance of savings for the future. A dollar a day would have grown into $ 508,000 after 50 years. This assumes a 10.5 % annual return.

There are other ways to boost our retirement account other than cutting your expense by a few dollars a day. But first, you have to understand the importance of boosting just one percentage of your return. 1% does not seem much. After all, if you have saved a dollar a day, after the first year, your savings would have grown larger by $ 3.65. So, why bother, right? Wrong.

If you take your time to whip out your calculator and compute, the one percentage difference is a BIG deal. Instead of 10.5 % annual return, you can assume that you now achieve an annual return of 11.5%. While saving a mere $ 1 a day, how much your money would have grown after 50 years? The amount now is $ 730,000. 1% return will have given you $ 230,000 in extra money. Assuming that you will spend $ 100,000 per year on your retirement day, this extra 1 % will give you 2 more years of comfortable life.

Knowing that an extra one percent return is significant to your retirement account, here is several ways to achieve that.

Using a Limit Order. We are not day traders. But, that does not mean we should buy a company using market order. With lots of program trading out there, using market order might give you the highest price of the day. Looking at any publicly traded companies, it can fluctuate 1 – 2 %. in a given day. Furthermore, using limit order does not cost you extra. At Scottrade, both market and limit order costs you $ 7 per trade. There are several excellent broker comparisons website out there.

Learning Technical Analysis. Sure, this is the tool that are mostly used by day traders. But, in the short term, it has its use. There is no guarantee that you can buy at the absolute lowest price. But at the very least, you won\’t buy at the top. In general, it always pay to buy at major support and sell at major resistance. If you are not sure about this definition, you are welcomed to discuss it at our discussion forum.

It pays to be stingy. An extra 1 % would probably buy a new car by the time you reach retirement. Now, this is just a conservative estimate. I believe you can save more than 1% with all the volatile stocks out there.

Do you have any bright idea on how to improve investment performance? Please go to our forum at http://www.noviceinvesting.com

Writen By : Hari Wibowo

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Positive Net Cash

Sep 24

Posted by admin in Finance, Investing, Stocks Mutual Funds

Every investor\’s goal is to find undervalued investment and then sell it when it reaches fair value. To find the fair value of a common stock, we need to predict the profits generated by the stock over a period of time. This prediction may not be accurate. After all, nobody can know the future with 100% certainty. When things unexpectedly turn ugly, investors need to guard themselves against capital losses. The way to reduce this risk is by investing in companies with positive net cash.

Net Cash is the difference between cash

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