Wednesday, July 4, 2012

Irving Fisher, Valuing Investments, Ridding Yourself of Emotion... an Investment Rant.

In the early twentieth century, the economist and mathematician Irving Fisher helped pioneer the wider adoption of statistical models and quantitative analysis in the fields of investment and finance. If widely adopted and blindly followed, any model that attempts to eliminate the subjective nature and qualitative side of security valuation and stock price movements is prone to failure and can lead to massive losses, which was witnessed recently during the 2008-2009 financial crisis.

One aspect of Fisher's work, however, that can be very valuable to the Intelligent Investor and armchair investment analyst, and this is his general insistence on finding some dollar valuation of a security based on its present day value of future income payments. Far too often investors can forget that the true underlying value of any investment most often lies in its ability to return a stream of income payments over time back to the owner. For a bond, this stream of payments would be the present value of interest payments added to the present value of the principal payment being returned at maturity. Thus, if one was evaluating a bond, they would need to decipher what the value of all inflation adjusted interest payments would be, in addition to the inflation adjusted value of the principal when it is returned at maturity. If inflation is high, the value of the security is less, and vice versa.

For a bond, the above thought process is almost always entered into by the investor, but for a stock, it is often absent. Emotion plays far too large a part into the psychology for why the average investor buys or sells an equity. For a stock, an investor should be able to decipher, albeit with a lot of assumptions, the present value of the dividend payments, and the present value of the shares if the equity had to be redeemed at a future date in time. If the corporation, let us call it Canadian Steel, is valued at $100,000, and it pays $5,000 in dividends per year, that is a cash return to us of 5%. Now, let us also assume that Canadian Steel retains $4,000 per year in income and uses it to acquire land and machinery to grow its business and, hopefully, its future dividend payments, that also must be taken into account by us as a 4% return on our investment. For most, this would be a reasonable investment if its future could be determined as somewhat stable and predictable. However, what if we re-name Canadian Steel... International Solar Power, and its name was plastered all over the Globe and Mail as a hot new business of the future? This should mean nothing to us unless we can, with a high degree of certainty, determine that it will be returning dividend payments, or utilizing its retained earnings for growth, from which it will pay us higher dividends in the future.

Essentially, follow the cash. Read the balance sheet and cash flow statements, look for rising cash and asset balances or increasing payments of dividends to shareholders; analyse the income statement for steady and stable earnings flows; look for declining or low liability levels. Try to eliminate the white noise of the media and make informed and rational decisions. Think, if I had to own all of this company for the next 5 to 10 years, how much cash would be in my pocket after expenses? And how certain can I be of that?

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