Demystify the math of investing
Sameer Bhardwaj November 13, 2008
For every conscientious investor who nurtures his portfolio by the book and pores through valuation tools with practised ease, there are a dozen others who are stumped by the jargon and frazzled by the formulas. So even if they are aware of the risks that can skim off their returns, they don’t know how to calculate these and limit their losses. Michael C. Thomsett must have had such investors in mind when he penned The Stock Investor’s Pocket Calculator. Teeming with mathematical and financial formulas and their interpretations, the book covers most of the basic and advanced quantitative concepts. More importantly, it manages to dejargonise the theory of investment mathematics and helps the readers to crunch the numbers on their own.
Snipped off neatly into four sections, the book begins with the basics of investment mathematics, explaining the importance of quantitative analysis and rate of return. The author lists important adjustments of dividends, taxes and inflation in the rate of return that are necessary for determining the real worth of investments. Consider Jindal Steel, which gave an absolute rate of return of 22% between September 2007 and 2008. The company declared dividends of Rs 1.5 per share in February 2008 and Rs 2.5 per share in September. After adjusting for dividends and inflation (9%), the real return works out to 12.3%. So the investment in Jindal Steel has grown by 12.3% in terms of purchasing power.
The concepts of compounding and discounting, which are of utmost importance in investment analysis, are also covered in this section. Simple numerical examples are used to compute the maturity value of a fixed deposit and show the effect of different compounding frequencies (monthly, quarterly). For example, Rs 10,000 at 8% per annum will grow to Rs 14,693 after 5 years through annual compounding at an annualised yield of 9.39%, whereas the same amount invested at 8% per annum, with quarterly compounding, will grow to Rs 14,860 after 5 years with an annualised yield of 9.72%.
The second section looks at the financial concepts used in company analysis. As there are serious shortcomings in the accounting systems (treatment of contingent liabilities, employee stock options, non-core revenue and expenses), the book suggests a thorough quantitative analysis to understand the true financial health of a company. Take Kotak Mahindra Bank and Yes Bank, whose contingent liabilities were 12.8 times and 11.3 times their respective total assets in March 2008. If contingent liabilities are not listed in the balance sheet, adjustments are required in the key reported financial parameters like EPS and profits. In most cases, contingent liabilities are significant and firms must make provisions for losses arising from these.
The penultimate section explains key ratios and indicators used in fundamental and technical analysis. The former covers the basics of balance sheet and operating statement, and almost all ratios like working capital ratios, inventory ratios, solvency ratios and accounts receivable ratios. Take the solvency ratio (debt-equity ratio) of Jet Airways, which has been consistently rising for the past two years— from 2.02 in March 2006 to 4.57 in March 2008. Rising debt can create problems for the company due to fixed interest costs. So, in case of Jet Airways, the increased ratio is not a good indicator. The author stresses on trend analysis of revenues and expenses to judge the operating efficiency of the organisation.
The Bank of Baroda’s total income has grown by 78.65% in the past three years, whereas its total expenditure has grown by just 5%. On the other hand, in the past two years, IOL Netcom’s total income has grown by 123.8% compared with its expenditure, which grew by 310.5%. The other part of this section, technical analysis, which lists technical indicators along with formulas, is not adequately covered. It lists mostly traditional indicators like advance decline ratio and short interest ratio, whereas advanced indicators like rate of change, relative strength index and standard deviation, which are very useful in predicting market direction, are missing.
The final section stresses on the use of both fundamental and technical analysis for stock selection and lists indicators that combine both. These include price to earnings ratio, price to book value, price to revenue and price to cash ratio. The author considers P/E ratio as one of the best indicators that combines fundamental and technical analysis, but also warns of the disadvantages associated with this ratio due to the time lag between current price and reported earnings.
Acting as a guide and tutorial, the book is sure to help readers interpret and understand the reports of mutual funds and brokerage houses and their claims on forecasted returns. Important Website links on loan calculators, technical charts, US inflation data, etc, provide additional help.
All concepts and formulas are explained using examples in simple and clear language. So the book is bound to be of immense value to investors, analysts and students of quantitative finance.
Read our review of the book: Guide to Investing Success “Advice during volatility”