Musings of a (Financially) Illiterate Father

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Musings of a (Financially) Illiterate Father Page 6

by Anand Saxena


  MUSING 12: AM I ON TRACK FINANCIALLY?

  SOME IMPORTANT FINANCIAL RATIOS

  Assuming that one starts to earn at the age of 25 and retires at 60, there is a 35-year investing period. This 35-year period has to take care of nearly 25 years of retirement (either of the spouses may live till 85 or so.) It thus becomes extremely important to be able to periodically track whether one is on course towards achieving one’s financial freedom. I can suggest a few markers along the way which can assure us that we are on track, financially.

  Net Worth: A must-read book by Thomas J Stanley and William D Danko, titled ‘The Millionaire Next Door’ gives a nice rule of thumb to check one’s financial fitness, which is by tracking one’s net worth. The authors define net worth as the current value of one’s assets less liabilities. They also introduce terms like ‘Prodigious Accumulator of Wealth (PAW), Under Accumulator of Wealth (UAW) and Average Accumulator of Wealth (AAW)21.’

  Net Worth=Annual pretax income*Age (in years)/10.

  PAW: If the net worth is twice or more than the level expected as per above equation.

  UAW: If the net worth is half or less than the level expected as per above equation.

  AAW: Anyone in between UAW and PAW.

  Now we get our first real financial marker that we can track. Taking the example of Anshreya, if at the age 30, her annual pretax income is ₹10 lakhs, then she should aim for her net worth to be ₹30 lakhs ((10*30)/10). However, if her net worth is less than ₹15 lakhs, Anshreya should feel concerned.

  For first five years of earning don’t get into net worth calculation as you would be building up your ‘breathing fund,’ taking care of your insurance needs, accumulating funds for your marriage and house and so on. Hence in this example, I have taken the age of Anshreya to be 30 though she started to earn at 25.

  Initially, one should aim for becoming only an AAW. The reason is that as one accumulates assets, they will take time to give compounded returns, may be up to and beyond five years. “Good investments like excellent cheese and wine need to be aged22.” Over time, however, one should aim for becoming a PAW.

  Calculate your net worth once every quarter. It is easy once you transport the figures onto an excel sheet. Choosing an important day like birthday or marriage anniversary would be helpful in remembering this important activity.

  Another way to look at and track your wealth could be by calculating the number of days you will survive if you stop working today? This will obviously depend upon the income that is being produced from your income-producing assets like stocks, bonds, mutual funds and real estate (remember the musing on assets and liabilities?) For example if the monthly expenditure of Anshreya is ₹50,000 and the monthly cash flow being generated from her assets is ₹25,000, she can only survive half a month without earning. She must endeavour to increase her assets so that the cash flow generated from them reaches ₹50,000 per month. At this point, she could be called wealthy. The corollary would be that if she wants to increase her expenses from ₹50,000 to say ₹60,000, she must first increase her assets so that the income from them increases to ₹60,000. Always remember that “Rich people focus on their net worth. Poor people focus on their working income.23”

  In addition to net worth, there are some other important financial ratios that one must track once in every quarter to ensure that one’s financial growth is not lopsided and one has adequate liquidity and cash flow.

  Current Ratio: Current Ratio=Current Assets/Current Liabilities.

  o Current assets are liquid assets that one can draw upon quickly like cash, savings bank account, fixed deposit (FD) and recurring deposits (RD).

  o Current liabilities are those which need to be serviced in the current year.

  o Target figure is between 1 and 2. A figure of less than 1 means that current liabilities are more than assets (alarm bells should ring) while a figure of more than 2 means that there is idle money lying which could be better invested.

  Debt Ratio: Debt Ratio=Total liabilities/Total Assets

  o Target less than 0.4.

  o Should be worked out for next two years in advance.

  o It is a good marker to have if one wants to take a new loan.

  Savings Ratio: Savings Ratio=Annual savings/Annual Gross Income.

  o Target between 10 and 20 percent.

  o Closer to 20 percent is better.bullet

  Liquidity Ratio:

  Liquidity Ratio=Cash or cash equivalents/Monthly committed expenses.

  o Should be between 3 and 6.

  o Already covered under ‘breathing fund’ in earlier musing.

  Wealth Ratio This is an interesting ratio which is obtained by adding the ‘passive income and portfolio income24.’

  o Passive income is generally income from real estate, royalty income from patents or for use of your intellectual property such as songs, books, or other objects of intellectual value.

  o Portfolio income is generally income from paper assets such as stocks, bonds, and mutual funds.

  o Your passive and portfolio income should equal or exceed your total expenses.

  o Wealth ratio should be tracked on a quarterly basis and all-out efforts should be made to increase one’s portfolio and passive income.

  Once you start earning, create an excel sheet to monitor your net worth and other financial ratios. Let me say, even at the cost of repetition, it is futile to track one’s income. Instead, track one’s net worth, which should keep growing towards AAW and then to PAW. Many free excel software for net worth tracking are available on the internet. You can explore and use which one works best for you.

  TOWARDS BEING A BETTER INVESTOR

  MUSING 13: TEST THE WATER BEFORE TAKING THE PLUNGE

  A STOCK MARKET PRIMER

  Like any other pursuit in life, investing is also likely to accrue long-term benefits if one is adept at basic fundamentals. Before taking the plunge into the deep blue waters of equity investing, it is good to check the depth of water by understanding some basics. By no means am I encouraging you to be an active stock picker but instead coaxing you to improve your financial IQ by this short reading.

  The engine of a country’s economy and indeed of its economic growth is its businesses which contribute to different sectors of the economy. It is these businesses that boost up the GDP of a country as a whole by generating profits.

  Equity and Shares

  Equity or equity shares represent part ownership of a business. So, if a business is worth ₹1 lakh and it has 10,000 shares outstanding (meaning that the business has been divided into 10,000 smaller and equal parts so that common people can buy these shares and the business owner can raise the capital for setting up or expanding his business,) then each share is worth ₹10 (₹1 lakh/10,000). If you own 100 shares, you own 1 percent equity of the business or in other words, you are 1 percent owner of this business. Obviously, if the business does well, you are going to partake in the profits generated (that’s the reason you bought the shares.) But, if the business goes into loss, you end up suffering loss as well. In an extreme case, if the business just folds up being too much into losses, you suffer almost the total loss of your investment of ₹1,000 paid for buying 100 shares of that business.

  The shares can be bought in two ways, firstly through the primary market, when a business (company) goes public to raise capital. These are called Initial Public Offerings (IPO) and represent direct trading between the company and buyer of the share. Shares bought through IPO, cannot be sold back to the business owner. Once the company goes public; it is listed on the stock exchange (BSE or NSE in India, details follow) and its shares can be traded (bought or sold) on secondary market. Thus an investor, who had not bought the shares through the IPO route, can buy through the stock market. Obviously, he can only buy shares, if some owner of those shares (who bought them through the IPO route/stock market) is willing to sell them. That’s the reason it is called the secondary market.

  And why would a holder of the
shares want to sell them? There could be two main reasons: first that he fears that the business is not going to make profit in the manner he had anticipated. The second reason could be that he wants to recover not only his original investment but also his ‘future anticipated earnings’ that would have accrued to him if he had held his shares. In the first case, he may not find a buyer or be forced to sell his shares at a loss. In the second case, he is going to demand a premium for letting go of his shares and sell them at a price higher than he bought them for. Obviously, a buyer who is willing to buy these shares at these inflated prices expects to earn even greater profit over a period of time.

  The Bombay Stock Exchange (BSE), established in 1875, is the world’s 11th biggest stock exchange with more than 5500 publicly listed companies on it. All the trading for the stocks of these companies takes place on BSE. Sensex or BSE 30 is the market index for BSE consisting of 30 well-established and financially sound companies belonging to different sectors of the economy. The movement of the Sensex reflects the general movement of the companies listed on the BSE. Please understand that the upward/downward movement of Sensex doesn’t reflect the similar movement of all the companies contained in it, much less of all the 5500 listed companies.

  The National Stock Exchange (NSE,) established in 1992, is the world’s 12th biggest stock exchange with more than 2000 listed companies. Nifty or Nifty 50 is the market index of NSE consisting of 50 top companies belonging to 24 sectors of the economy. Like in the case of Sensex, the movement of Nifty doesn’t reflect movement of all its constituent stocks in the same direction as also of all the 2000-odd listed companies.

  Both the market indices can’t be said to reflect the overall state of the Indian economy, though they betray the general sentiments of the investors. The economy in a way does well if companies grow and make more money as it creates wealth for all the participants—businesses and investors: domestic and foreign, individual and institutional.

  It is a must to understand how equity investment gives profits. When you own a business for a long time, you earn in two ways: firstly, the initial ‘dividend yield’25(partaking of profit made by the business) and secondly, the ‘future growth rate of the dividends.’ Obviously, the future dividend yield will increase only if the business keeps on doing well and growing and hence the projected or the anticipated growth rates become important. Some businesses, however, especially in their initial growth period, may not distribute the dividends but instead reinvest it in their business to grow their business further. This is not bad for the investors as their future stream of dividends will be that much larger. So, the total anticipated profit to an investor in equity (over the long-term) can be calculated by adding current dividend yield (which is known, say 4 percent) and future growth rate (which is easily available, say 6 percent,) making it a total of 10 percent.

  Dividend pay-out is such an important factor that there are strategies which focus on building a portfolio entirely consisting of dividend paying stocks26. For this, stocks with at least 10 years old history of dividend payment are selected, with a current dividend yield of 3.5 percent. Another factor to look at is the ‘dividend pay-out ratio’ which is the percentage of earnings the Company pays out as dividends. This figure should be between 50 and 75 percent, preferably closer to the higher figure. I am not endorsing this strategy as I am against the very concept of individual stock picking, however, if you find this idea interesting you can partake of this strategy by investing in ‘dividend yield mutual funds.’ We shall cover the same in our musings on mutual funds.

  There are three more important terms to understand. First is the Earnings per Share (EPS) which is nothing but a division of a company’s net income by its total shares outstanding. In other words, it shows how much of part of total profit is being given to holder of one share of the company. The higher the EPS, the better and more profitable the business is. EPS shows the financial health of a company and should show an upward trend over last few quarters.

  EPS alone however may give a false picture and needs to be seen in conjunction with another financial ratio called the price-earnings or ‘PE ratio,’ which is obtained by division of the share price of one share by EPS. A PE ratio of 10 means that the investor is paying a price of ten rupees to obtain a one rupee profit of the company or in other words, the investor will recover his investment in 10 years. Does it mean that a higher PE ratio is bad? Not quite. Large growth companies will have higher PE ratios as more and more investors buy into their shares hoping for a larger and longer stream of future income. Beyond a point, however, the PE ratios tell that the company is too overvalued. PE ratios could be trailing PE (last 12 months data used) and forward PE (forecasted next 12 months data used). Obviously, trailing PE ratios are more robust yardsticks.

  The EPS and PE ratios apply to both individual stocks of a company as well as to the stock market as a whole. The rule of thumb for evaluation of PE ratios for the Sensex is as follows27. Below 12: grossly undervalued, 12-16: slightly undervalued, 16-20: fairly valued, 20-24: slightly overvalued and PE above 24: grossly overvalued. Remember the dictum, “A great company is not a great investment if you pay too much for its stock28.” Incidentally, the average trailing PE ratio of the Sensex has been in the region of 18.6. While it touched a high of 29 during the dotcom bubble in 2000, it hit a low of 12 in 2008 during the subprime crisis29. In a nutshell, investors are likely to get best returns if they invest between market PE of 16 and 20.

  PE is also applicable to equity mutual funds wherein it shows the weighted average PE of all the stocks held in the portfolio. A higher PE ratio of fund indicates a growth style whereas a lower PE ratio indicates a value style of the fund manager. We’ll cover this issue in greater detail in a subsequent musing.

  Another important financial ratio to understand is ‘Earnings Yield’ which can be used to calculate the anticipated rate of return from an equity investment the way we do for a fixed income instrument. The earnings yield is nothing but an inverse of PE ratio i.e. 1/PE ratio. To take an example, suppose a share is trading at ₹25 and its PE ratio is 10, then the earnings yield will be 10 percent (1/PE ratio*100.) How to use this in real life? Well, the father of “value investing,” Benjamin Graham, had this to say, “Investors should never buy a stock that had a PE ratio higher than the sum of the earnings yield plus the growth rate.” So taking our ongoing example, if the expected growth rate of this company was 5 percent, then an investor can buy stocks in this company till a PE ratio of 15 (10 percent earnings yield + 5 percent growth rate,) and he will have a reasonable chance of earning profit over long-term.

  The final point which needs attention is that every time one makes a transaction on the stock market (buys or sells) some costs are incurred. These are called ‘Transaction costs’ and consist of brokerage (commission taken by the broker,) Securities Transaction Tax (STT), stamp duty, service tax and other charges and may total upto 0.46 percent of the transaction value30. By no means is it an insignificant percentage and can cause a sizeable drain on returns if done frequently.

  This is the reason that the market will keep urging you to trade frequently, the more you do that the more you fill the coffers of others. You will get tips on daily, weekly and monthly stock movements and how you can make a quick profit. Buy and sell therefore is a dumb strategy as compared to buy and hold. Remember our exposition on how profits are made in stock market given earlier in this musing and once you buy a stock (or mutual fund) hold it for really long time.

  So, do yourself a favour and stop watching financial news channels and stop reading financial news magazines and websites, you will avoid motion based on emotion. As Benjamin Graham says in his legendary book ‘The Intelligent Investor,’ “A defensive investor runs-and wins-the race by sitting still.”

  MUSING 14: WHERE DO YOU INVEST?

  THE ASSET CLASSES

  It’s time now to bite the bullet and decide where you should invest your savings bucket (20 percent) as also the s
inking fund (to buy your wants or needs.) Before we can make an informed decision on this all-important issue it will be worthwhile to learn as to where all can we look for saving/investing?

  Basically, these investment vehicles are called ‘Asset Classes,’ each with a peculiar characteristic making it more suitable depending on one’s financial goal, risk appetite, age and time horizon. Tony Robbins in his book ‘Money— Master the Game’ divides these instruments under safety/security and risk/growth buckets, a classification which I personally like as it declutters the technical jargon and comes down to the basic investment needs of any investor. After all, one needs both a Rahul Dravid and a Virender Sehwag in the cricket team to hedge against all kinds of opposition or pitch conditions. Two terms, however, must be covered right here before we proceed further: debt and equity.

  Debts signify a loan, so if I take a car, home or any other loan from a bank or financial institution, I become their debtor (I owe them) and they become my creditor. Similarly, I can also loan money to a bank in the form of a FD or even to the government in form of bonds in which case, the bank or the government becomes my debtor. A debtor promises to pay the capital (the original loan amount) along with some previously defined interest on that principal, periodically or on termination of the loan term. As is obvious, debt has the inherent safety of your principal (subject to certain caveats) but lower rates of return as compared to equity. In periods of high inflation, however, value of debt (bond) goes down.

  Equity, on the other hand, signifies a partnership in a business or venture. Here you buy stocks of a business and then partake in the profits that business generates over time. However, as is obvious, there might be upsides or downsides in any business, at least in the short term and hence one should be prepared to lose a significant part of even the principal amount, leave aside any gains. Over long periods of time, equity has always outperformed debt and should form a major chunk of your long-term investments. We will devote a significant part of this book to the nuances of equity investment.

 

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