Moneywise24 Personal Finance

I know, most of you would have expected me to dig into the financials of a company first. However, I have explicitly chosen to write the first article on fundamental stock analysis about the P/E ratio. The P/E ratio stands for Price-to-Earnings Ratio, and might is also referred to as PER.

The P/E ratio measures the price paid per share relative to the earnings on that share, or the Earnings Per Share. The P/E ratio is expressed in years. As such, having a P/E ratio of 8 means that if I would buy 1 share, it would take me 8 years to earn back my investments on that share; A P/E ratio of 30 means that if I would buy 1 share, it would take me 30 years to earn back my investments on that share. Thus, the formula is:

P/E ratio = Price per Share / Annual Earnings per Share

The P/E Ratio can also be expressed in percent:

• A P/E ratio of 8 resembles an annual return 12.5% (becuase 8 times 12.5% is 100%),
• A P/E ratio of 30 resembles an annual return of 3.33%.

From the above examples, it is easy to conclude that a lower P/E ratio means higher annual returns. However, since the Earnings Per Share is related to the actual income of a company, it also makes a statement as to whether the share is relatively inexpensive or expensive considering the company’s current economical situation. Generally said:

• Share with a P/E ratio below 10 is considered as inexpensive,
• Sahre with a P/E ratio above 20 is considered as expensive.

P/E ratios should never be considered alone, but always in the context of the performance of the company. One reason the P/E ratio of a company is low might be simply due to the fact that the company has been somewhat ‘forgotten’, although the company is performing well. However, another reason might be, because the company’s performance is very poor and investors have been selling the shares massively.

Some internet platforms offer the possibility to select shares according their P/E ratio, such as Yahoo! Finance; this allows you to select the more inexpensive shares, and work from there. But you will definitely want to conduct further research as to the company’s future.

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I consider long-term investing in stocks/shares as a crucial element of building wealth; in fact, you will most probably find this confirmed by most personal finance blogs on the internet. This also brings a number of interesting questions, such as how we can pick the best investment opportunities, and on what do we base our investment decisions. In the next few weeks, I intend writing a number of articles, focussed on how to analyze company stocks and investment pportunities.

Currently, there are two main methodologies for analyzing and possibly predicting the future value of a stock or share. These are:

• technical analysis
• fundamental analysis

Technical Analysis

The basic principle of the technical analysis, also called chart analysis or market analysis, is to identify potential buying or selling signals, and generally predict the future development of a stock price by its historical price and volume data. While doing this, the actual company data (e.g. annual reports, strategies, developments) as well as other economic factors are are not being involved in the technical analysis. Technical analysis is based on the fact, that particular price and volume patterns in the past have frequently been followed by a particular price and volume movement. Technical analysts attempt to identify these patterns, via the calculation of many different indicators, aiming at identifying buying and selling signals.

Technical analyses can be conducted using different time frames; long-term, mid-term, or short-term.  Additionally, technical analysis is largely based on the fact, that a stock’s price is largely determined by supply and demand of investors, irrelevant to what the actual company is worth. However, many technical analysts combine their technical findings with current macro and micro economic trends, in order to find whether these are in line with each other or not.

The topic of using technical analysis as a stock analysis method is quite controversial, as it does not attempt to involve the actual company’s performance. Many analysts swear by the technical analysis, others prefer using fundamental analysis methods.

Fundamental Analysis

The fundamental analysis is based on researching the fundamentals of the economy and the company. The fundamental analysis includes analyzing the annual reports of companies, specific ratios, the strengths and weaknesses of a company, potential development opportunities or threats, as well as macro economic developements. Fundamental analysts assume that generally the stock price reflects a company’s real performance, keeping in mind that sudden micro or macro economic news, market fluctuations, or sudden panic might let the stock deviate from its course. The fundamental analyst therefore attempts to identify which stocks are undervalued, overvalued, yearly earnings, and future potential.

Fundamental analysis is adopted by many large financial institutions, who publish their mid- and long-term view on a particular stock’s development. Also Warren Buffett used the fundamental analysis to select his stocks, or why do you think that the book “Warren Buffett and the Interpretation of Financial Statements” is about a company’s financials rather than technical analysis?

Each person will have his or her own preferences. Myself, since I aim to invest with a long-term vision and also share the idea that generally a stock will move in the direction of a company’s performance or potential, tend to adopt the fundamental analysis as my main investment strategy.

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Every now and then I have been thinking what I would do if I would win a few million in a lottery, or in the casino. I am sure most people have, perhaps you have. I have been discussing all possible scenarios with my friends, and often we ended up talking about expensive sports cars, yachts, luxurious estates and world travel. Honestly, if this is really how I would spend my millions, I would probably be instantly in debt.

I watched a documentary the other week, in which they were looking at what people had done with the millions they had won in a lottery, and as it became obvious, most people had spent their money very stupidly. A psychologist was asked about this phenomenon, and he claimed that it is only logical; these lottery winners were not at all used to thinking in dimensions of millions. They were literally thrown out of their own reality, which caused them to make irrational decisions.  This particular documentary set me to think: how would I handle that much money.

Keep my job

Okay, I have to admit, it really depends how much I won. But at least at first, I would definitely keep my job. Especially if I can not live off interest and maintain a good standard, what is the point in quitting my job? Besides that, I love my work. I might quit at a later time, but first I want to see how things are developing.

Cash Savings

Before I would do anything with the money, I would put some part of it on a savings account. Call it an emergency account if you want to, the money is intended for emergency situations, and in case I would lose everything. This money should allow me to start all over again just in case things go wrong. I would probably put aside about two years of my current salary.

Real Estate

Currently, I am renting an apartment, this might be one of the first things I want to get rid of. I would probably buy something bigger and more central than what I have now, but I do not see the point in buying a luxurious estate, which would vaporize most part of my money. A nice 2- or 3-bedroom condo in the city center will do, nicely furnished, a place where I feel good and comfortable. Besides, I am conscious of the fact that the bigger and more luxurious the estate, the more tax and other yearly expenses I will have. Real estate offers me the benefit of lowering my monthly expenses (my monthly rent) while making a long-term investment. Alternatively, I might purchase more than only one object, which I would rent out if I am not using them. This way, the incoming rent will compensate for my expenses I have on the real estate, and I am investing money with a long-term focus.

Long-term investments

At least half of my winnings, if not more, I will invest long-term on the stock markets. Firstly, I want my money to grow over time and it to gain value. Secondly, I want to obtain dividend payouts. If these dividends are high enough, they could even substitute for my current job, either partially or completely. But until I have reached a certain threshold, I would keep my job.

Business

If I feel entrepreneurial, I would perhaps start a business. However, I will do this with great caution. I do not have great experience with running businesses, so I will start small, even though I have the necessary funds to start big. By gaining experience, I can build my business from there, and engage into bigger businesses over time. The documentary I was writing about earlier showed a man, who invested most of his money in a bigger type of manufacturing business, which went bankrupt due to his inability to run that business. By the way, the guy ended up broke, and his wife left him. So did many of his friends.

Education

I am a fan of life-long learning, whether it is a new language, an MBA, or something else which I find interesting. I consider education an important part of my personal development.

Something needs to be spent, right?

Good, I have to admit; of course I will spend some of that money. I might buy some fashion, perhaps travel the world, buy a more fancy car, or take my flying license. I will definitely give myself some treats, but I will do this in a dimension I understand. I would hardly start to buy business suits worth 5,000 Dollars, as this is a dimension of spending I am not familiar with, and which I do not need either. The same goes for my world travel: I might fly business class on long distance flights, but I don’t see the use of paying 8,000 Dollars or so for flying first.

I am in charge of my money

I recognize the fact, that once I win the lottery I will probably be approached by many so-called consultants, who would recommend me to invest my money here or there. But I will, at all cost, remain fully in charge of my own money. I might consult someone I really trust, who may give me advice of specific trends and market developments, while at the same time I make my own decisions.

Honestly, I have never been in a situation of winning millions. However, I believe that becoming suddenly rich can be quite problematic for many people. And even if I am gaining wealth slowly over time, I will cherish the above points, in search for long-term growth, development, and a stress-free life.

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I know, it’s a bit awkward that I am writing a post on option trading, while on the other side my website is about long-term financial development. Nevertheless, I remember being very active in options trading as a student, just like most of my fellow-students, and actually it did earn me some money. In addition, options can be a great strategy to use as an insurance, in combination with shares. In this post, I am mainly referring to European options. Also, please keep in mind that not in every country option tranding is possible for individuals.

Options are much like insurances: they give the buyer the right to buy a specific item, during a certain period, for a certain price. Options exist for many items, perhaps one of the most well-known is real estate. Consider the following example:

Your are considering buying a nice holiday home in France. You see a nice real estate you like for 300,000 Euros, but you are not quite sure about the purchase. In addition you need to clarify some formalities with your bank, such as whether or not you will be granted a mortgage. Knowing that this process might take 2 months, there is a risk that someone else buys the real estate and takes away this opportunity from you, and there is a risk of rising real estate prices; In 2 months time the real estate might be worth 330.000 Euros. By buying an option, you will obtain the right to buy that house (also called the underlying value) during a certain period, for a pre-set price of, let’s say, 300,000 Euros. As such, even if the real estate price has increased to 330.000 Euros, you will still be able to buy the object for 300,000.

As with real estate, you could buy options on stocks. Stock options come in two forms: call options give the right to buy specific stock for a certain price (strike price) before a pre-defined date (expiration date), and put options give the right to sell specific stocks for a strike price before the expiration date. Now, being able to exercize that right does not mean you have to. With a changing price of the underlying value, the option price will change too, and you can simply trade in options, aiming at making profits from it. There are actually three things you can do with an option:

1. You can buy an option and sell it at a profit later.
2. You can buy an option and at a later point exercize your right to buy or sell the underlying value (when selling the underlying value, you need to possess it).
3. You can buy an option and let the option expire at the expiration date: the option will end worthless and will be taken from the market.

Apart from purchasing options, you could issue them. This is a highly risky business, since issuing an option would result in a limited profits (the price that the buyer has to pay for the option) and a theoretical unlimited loss, as opposed to buying options, where the risk is to lose the money invested in that option, but profits are theoretically endless. If you are just getting acquainted with stock options, I’d recommend to focus on buying options only, and with smaller amounts.

How options are listed

Options are listed in a specific way. Look at the following examples:

ING C 0912 9.00 lists a call option (note the C) on the stock ING, expiring on december 2009* with a strike price of 9.00 Euros.

ING P 1003 11.00 lists a put option (note the P) on the stock ING, expiring on march 2010* with a strike price of 11.00 Euros.

*Note: the expiration date in any given month is usually the third friday of that month.

This is how options work

How options work exactly can best be explained by the following example:

Let’s take the ING call option example from above. The strike price of the option is 9.00 Euro, and the stock itself closed at a price of 9.53 Euro today (19 november 2009). This means, that if I would would have the ING C 0912 9.00 option, I could buy the ING stock at a price of 9.00 Euros, although the real price of the stock today is 9.53. As a result, the stock price must at least cost 0.53 Euro; if the option would cost less, I could make an immediate profit by buying the option and immediately exercizing my right. This difference is called the intrinsic value. In addition, there are also option series with an intrinsic value of exactly 0, and there are option series with a negative intrinsic value.

Suppose the stock price would tomorrow increase from 9.53 to 9.69 Euros, which is an increase of 1.65%, the option price must increase to at least 0.69 Euros (else someone would be able to make immediate profits). But look at what happens: from 0.53 to 0.69, that’s an increase of 23.1%.

Put options work exactly the other way around; they are rights to sell stocks, and thus if the stock price decreases, the value of the option would increase. This is one feature what makes options so interesting; it allows for making profits in both increasing and decreasing markets.

Note: options are bought per contract, 1 contract includes the option to buy, for example, 100 shares. So, if an option is priced at 0.53 and you would buy one contract, you would actually invest 53.00 Euros.

This example shows the leverage effect of options, that everyone is talking about. But be cautious: whereas there is a leverage effect on profits, the same leverage effect applies on losses!

The options’ price structure

As we saw in the above example, the intrinsic value of the above option is one element of the options’ pricing. However, if we look at the real value of the INC C 0912 9.00 series, we see saw that this option is currently being traded for 0.83 Euros.

There two important elements, which influence the pricing of an option. This is one of the reasons why options are so risky:

• Time value: the more time is left until the expiration date, the higher the time value of an option. The reason is that more time equals a higher chance (or expectation) that the stock will move in a certain direction. If I look at the price of the same option, but with an expiration date in january 2010, the price is 1.10 Euros.
• Expectation value: if a stock is very volatile, or if there is a high expectation that it will develop in a specific direction, this might add up to the expectation value of the stock price.

Considering the pricing of an option, the worst thing that can happen is to own an option on a stock, which is stable; a stock’s stability is the stock trader’s enemy, since expectations and the time value will become less and less. This is what makes options risky: although you would not have gained or lost anything on the stock, the option is becoming worth less, and you are losing money over time.

Get professional advice

This article explains some of the basic principles of options. There are so many different types of options and option strategies, that I would highly advise to read in-depth material and consulting a specialist before attempting to trade in options yourself. Option trading bears a very high risk.

This post is in no way a subsitution to professional advice and should not be seen as such. Moneywise24 can not be held responsible for any personal decisions. Please also refer to our disclaimer at the bottom of this page.

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I have a few questions for you: Do you know your monthly net wage? Do you know how much money you spent on groceries last week? If you consolidate all of your accounts, including checking accounts, credit cards, and investments, how did your assets and liabilities develop per month during the past 6 months?  

These may seem some tricky questions perhaps, but how can you maintain a grip on your finances if you are not able to see how your finances develop over time, or if you can’t match your budget with your actual expenses? Making your finances transparent and visible is perhaps one of the first essential steps in gaining financial control.

 Doing your very personal bookkeeping means making your finances transparent. Bookkeeping does not need to be as boring as many people imagine it to be. Actually, it can be great fun, since you are actually seeing how, for example, specific changes in purchasing behaviour have a direct impact on your financial strength. Generally, Bookkeeping requires nothing more than a piece of paper (or a pre-printed book of household accounts) and a pencil. You will require separate columns for the following information: 

• Date of the transaction
• Credit amount, or the amount you received
• Debit amount, or the amount you spent
• Transaction category (e.g. groceries, real estate, living, automotive. You can define your own categories as you see fit).
• Payee
• Description / further comments

Alternatively, you can use a programme such as Microsoft Excel. Microsoft Excel offers the benefit, that you are able to set filters easily and create statistics. For example, if you would like to gain an insight on how much money you spent on automotive last month, you can set the appropriate filters and Excel will calculate this information.

If you are looking for an all-round solution, which allows you not only to do your daily bookkeeping, but also assist you in evaluating the results, you may want to consider purchasing a product such as Microsoft Money or Quicken. These programmes are specifically designed for personal finance purposes. They allow you to create multiple accounts, categories, budgets, and to enter all your transactions. In the background the programme will evaluate the data, and the programme may supply you with all the information you need.  Additionally, such programmes often allow its users to do research on companies and shares, and to plan possible future scenarios.

 The benefit of using personal finance software is tremendous; if administered regularly and precisely, you will know exactly where your money is coming from and where it is going to. Once you have your finances visible, it will allow you to make changes to how you handle money and the success over time.

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