Message to readers: Most of the readers of my blog have commented that it is bit difficult to follow the complex topics. hence I have decided to make these blogs simpler. If you think otherwise, please put in your comment and I will take more liberty to write more complex things...
--------------------------------------------------------------------------------------
Yes, globally we are in correction (I don't prescribe to recession, but to correction...) for long now. And all the analysts keep non saying the there is shortage of money supply. But before the correction started, everything was good. Then where did all the money go?
Let us start with understanding role of central banks and macro economic fundamentals. Lets say there are only 2 persons in the economy. They transact using money (or cash bills). As per my earlier post, what ever they pay for is for the effort that they put in. That effort will be converted into cash equivalent based on need and supply. (called demand and supply in a larger context).
Lets say now there is also central bank to control inflation, growth and many more factors. Lets say both these persons have $100 each. that is $200 in the economy. Person A deposits his $100 in the bank. Now bank has $100 to be lent to someone who wishes to start a business. lets say Person B takes that $100 on loan from bank to start his business. Now in economy there are total of $300 ($100 of person A which bank has liability to pay. Person B's $100 and $100 given to person B as loan) In other words now person B has purchasing power of $200, and A with purchasing power of $100.
Lets say person B starts producing goods. He is going to get paid for the efforts. Lets say for some products that person A buys from B, person A pays $50 to person B. Now since bank has to pay $50 to person A, that is typically done by printing new $50 bills (in real world where transactions are mostly bank transfers, central banks dont even need to print money). Now person B can repay his loan of $50 or can reuse the $50 for more business. If he repays his loan, the total cash in economy becomes $250.
This sounds so simple!!!
But a logical question is how does central bank control inflows and outflows in the money market? there is concept of CRR (cash reserve ratio) this basically control the lending % of the banks. So the banks cannot lend all the money which is deposited with them. then the interest rate (repo, reverse repo rates) which defines cost of capital. In today's world I may not be comfortable taking loan at 10% interest. But in booming economy when I have surety of job etc. I may actually take loan at high interest rates.
In times when people are not very optimistic, they tend to repay the loans and not to take more loans and not to spend a lot. All these things siphen away liquidity from the economy
Things can get as complex as you can think with multiple banks, foreign exchanges, multiple people taking decisions based on it and natural issues like earthquakes. If readers ask for, I will talk about more complex things.
Monday, February 23, 2009
Thursday, February 19, 2009
Traffic and Personal finances
Most of us who believed that equity investment is the only best way to beat the inflation, are not in very good shape. Of course I know a few who have made millions by going short. Or saved losses by getting out of the market at the right time. However, most of us are not in a very good shape. Today I try to see what makes us take wrong decisions or right decisions at wrong time.
I want to talk about stock market but not about fundamentals nor about technicals on stock market. Imagine you are driving in the crowded street and the car next to you want to overtake you. You of course dont want him to overtake you so you try to come on his/her way. He will try to come as close as you as to make you believe that he may hit you to give you indication that you need to give him a way. At the same time being scared of hitting you. On the other hand you also know that you run a risk of him hitting you but at the same time being just enough cautious you want to block his way.
In Stock market, lets say there are 2 people who have same stock. Both of you want the price of the stock to move up. But at the same time, you want to sell your stocks just before the other guy as he selling before you may take down the price. And you selling will definitely reduce price for him. Now both of you have same interest of stock price to go up. But at the same time he is your competitor when it comes to selling the price.
Now lets talk about information asymmetry. In real market there are hundreds and thousands of traders, investors. Everyone waiting for the right time to buy and right time to sell. Your decisions are based on information. No matter what you follow - fundamental analysis or technical. You want to be ahead of the curve to sell/buy before others take the same decision. at the same time, you dont want to be a loner. After buying a stock, you want others to imitate you to take the price in your favour for you to sell it at the right time. all those who have power of knowledge, will try to use the knowledge to their advantage before disseminating the knowledge to others. and if the chain is huge, by the time the last guy gets the knowledge, first guy would have already started liquidating his stocks.
And this all happens in a very methodical manner. Just like the traffic situation, the big guys want to make money in market - more than others. And at the other end, they need the smaller players to make making money (or at least feel that they are making) because these smaller guys are the ones who lack cutting edge information/knowledge.
Its human to be selfish. But we always try to strike right balance of being social at the same time...
I want to talk about stock market but not about fundamentals nor about technicals on stock market. Imagine you are driving in the crowded street and the car next to you want to overtake you. You of course dont want him to overtake you so you try to come on his/her way. He will try to come as close as you as to make you believe that he may hit you to give you indication that you need to give him a way. At the same time being scared of hitting you. On the other hand you also know that you run a risk of him hitting you but at the same time being just enough cautious you want to block his way.
In Stock market, lets say there are 2 people who have same stock. Both of you want the price of the stock to move up. But at the same time, you want to sell your stocks just before the other guy as he selling before you may take down the price. And you selling will definitely reduce price for him. Now both of you have same interest of stock price to go up. But at the same time he is your competitor when it comes to selling the price.
Now lets talk about information asymmetry. In real market there are hundreds and thousands of traders, investors. Everyone waiting for the right time to buy and right time to sell. Your decisions are based on information. No matter what you follow - fundamental analysis or technical. You want to be ahead of the curve to sell/buy before others take the same decision. at the same time, you dont want to be a loner. After buying a stock, you want others to imitate you to take the price in your favour for you to sell it at the right time. all those who have power of knowledge, will try to use the knowledge to their advantage before disseminating the knowledge to others. and if the chain is huge, by the time the last guy gets the knowledge, first guy would have already started liquidating his stocks.
And this all happens in a very methodical manner. Just like the traffic situation, the big guys want to make money in market - more than others. And at the other end, they need the smaller players to make making money (or at least feel that they are making) because these smaller guys are the ones who lack cutting edge information/knowledge.
Its human to be selfish. But we always try to strike right balance of being social at the same time...
Monday, February 9, 2009
Debt and Equity
In one of business meetings I attended last week, we came to conclusion that for a high debt industry, it is fine to have low margins as what really matters is return of Equity. After meeting, I found out that it is not as straightforward as it looks, hence this post on my thoughts...
--------------------------------------------------------------------------------------
For ease of understanding let me first define the terms. (not because I think I know more than you, but just to make sure that we are all at the same level of understanding. My knowledge is more from practice and not from books as much hence would like to be corrected if any of my definitions are faulty)
Equity - deployed capital by the investors who expect profits from the venture to be shared.
Debt - Loan taken for doing business. Debtor expects interest gains no matter how good or bad the business is doing.
RoE (Return on equity) - return on equity - profits made by business per $ invested in equity.
RoCe (Returrn on Capital employeed) - return on all the capital (equity + debt) deployeed.
Liability - all returnable/payable amount (Debt, interests, payments to be made etc...)
Profit Margin (margin) - profit per $ of revenue
-------------------------------------------------------------------------------------
Lets take case of a business. A Business is a venture undertaken to improve value for every stakeholder. For Investors what really matters is returns he gets for every $ he invests int he venture. In other words it is nothing but RoE that investor is concerned about. In old times when banks, financial institutions, stock markets were far less active, one would invest his own cash to do a business expecting pure returns on the capital.
With time, theories came to have break even point of about 5 years. This has duel meaning. If you consider human life span of about 40 - 50 years of work time, I would like no investments going more than 10% of my life. An intelligent businessperson puts maximum of 20% of his wealth in any business and hence he expects 5 years of breakeven (5 year cycle of starting new venture every year)
with time, businessmen wanted to have as high RoE as possible with shorter and shorter time to break even. Firstly to see ways to increase your margins thereby increasing returns. another way is to look at increasing revenue itself. To increase revenue, one of the chosen path is to go debt way. If with $100 I have, I can make $100 or revenue, Can I raise debt of $100 on top to make revenue of $200? Lets look at the math -
Assuming I have 10% margins. Earlier I was making $10 with RoE of 10%. In the second scenario, I am making RoE of 20%!!! Sounds great!!! If I can fool my DEBTOR and raise $1000 in stead ($100 from me and $900 from DEBTOR), I make RoE of 100% :) Now as I have such huge gains possible, can I get into business giving less margin? Lets say even if I make 5% margin, my RoE if whooping 50%...
Too good to believe....
After doing little argument with self, I figured out an anomaly in this calculation. firstly, I did not consider all the liabilities while calculating. For instance, interests. Lets say I can raise money at 10% interest (which is the minimum in my area), What ever debt I raise, I end up paying all my excess profits only as interest and I am unnecessarily taking risks.
Lets talk about Risks. Risk is unexpected (+ve or -ve) outcome of any task, venture etc. When I talked about those the expected numbers in terms of revenue, margin etc. All were mere assumptions. these assumptions are mostly called estimates to make it sound more scientific. And in a business venture, many things can affect to change the assumptions. even if I am in a business as stable as healthcare, I may see a sudden drop in number of patients to have much lesser revenues or dip in profit margin. Even if the probability is low, there is a probability and when this happens, I have to pay the interest from my base profits...
Lets say, for some reason, I can only make revenue of $100 in stead of $200, Then my RoE is zero and if it were to fall below, I will have to accept erosion of my capital which will lead me to a downward spiral.
And that is exactly happened couple of years back. there were businesses which were making huge profits with over leverage. Showing the RoE and such indications, they raised more debt. All was good till the economy was growing. (Was is really growing?) But when all of a sudden the spending pattern of customers change, the first organizations to hit were the once who were over leveraged. And even those who were marginally leveraged had difficult time because of the downward spiral.
It was a double edged sword for low margin organizations as they could not even reduce price points as reduced margins at reduced revenue hit them from both sides...
For a healthy business I strongly believe to have 0 debt (max to 50% of equity). and high profit margins. and there is nothing like having cash (& cash equivalent) on your balance sheet by which you could afford to have -ve margin to stay in business or even take over your competitors who have working capital issues.
Cheers...
--------------------------------------------------------------------------------------
For ease of understanding let me first define the terms. (not because I think I know more than you, but just to make sure that we are all at the same level of understanding. My knowledge is more from practice and not from books as much hence would like to be corrected if any of my definitions are faulty)
Equity - deployed capital by the investors who expect profits from the venture to be shared.
Debt - Loan taken for doing business. Debtor expects interest gains no matter how good or bad the business is doing.
RoE (Return on equity) - return on equity - profits made by business per $ invested in equity.
RoCe (Returrn on Capital employeed) - return on all the capital (equity + debt) deployeed.
Liability - all returnable/payable amount (Debt, interests, payments to be made etc...)
Profit Margin (margin) - profit per $ of revenue
-------------------------------------------------------------------------------------
Lets take case of a business. A Business is a venture undertaken to improve value for every stakeholder. For Investors what really matters is returns he gets for every $ he invests int he venture. In other words it is nothing but RoE that investor is concerned about. In old times when banks, financial institutions, stock markets were far less active, one would invest his own cash to do a business expecting pure returns on the capital.
With time, theories came to have break even point of about 5 years. This has duel meaning. If you consider human life span of about 40 - 50 years of work time, I would like no investments going more than 10% of my life. An intelligent businessperson puts maximum of 20% of his wealth in any business and hence he expects 5 years of breakeven (5 year cycle of starting new venture every year)
with time, businessmen wanted to have as high RoE as possible with shorter and shorter time to break even. Firstly to see ways to increase your margins thereby increasing returns. another way is to look at increasing revenue itself. To increase revenue, one of the chosen path is to go debt way. If with $100 I have, I can make $100 or revenue, Can I raise debt of $100 on top to make revenue of $200? Lets look at the math -
Assuming I have 10% margins. Earlier I was making $10 with RoE of 10%. In the second scenario, I am making RoE of 20%!!! Sounds great!!! If I can fool my DEBTOR and raise $1000 in stead ($100 from me and $900 from DEBTOR), I make RoE of 100% :) Now as I have such huge gains possible, can I get into business giving less margin? Lets say even if I make 5% margin, my RoE if whooping 50%...
Too good to believe....
After doing little argument with self, I figured out an anomaly in this calculation. firstly, I did not consider all the liabilities while calculating. For instance, interests. Lets say I can raise money at 10% interest (which is the minimum in my area), What ever debt I raise, I end up paying all my excess profits only as interest and I am unnecessarily taking risks.
Lets talk about Risks. Risk is unexpected (+ve or -ve) outcome of any task, venture etc. When I talked about those the expected numbers in terms of revenue, margin etc. All were mere assumptions. these assumptions are mostly called estimates to make it sound more scientific. And in a business venture, many things can affect to change the assumptions. even if I am in a business as stable as healthcare, I may see a sudden drop in number of patients to have much lesser revenues or dip in profit margin. Even if the probability is low, there is a probability and when this happens, I have to pay the interest from my base profits...
Lets say, for some reason, I can only make revenue of $100 in stead of $200, Then my RoE is zero and if it were to fall below, I will have to accept erosion of my capital which will lead me to a downward spiral.
And that is exactly happened couple of years back. there were businesses which were making huge profits with over leverage. Showing the RoE and such indications, they raised more debt. All was good till the economy was growing. (Was is really growing?) But when all of a sudden the spending pattern of customers change, the first organizations to hit were the once who were over leveraged. And even those who were marginally leveraged had difficult time because of the downward spiral.
It was a double edged sword for low margin organizations as they could not even reduce price points as reduced margins at reduced revenue hit them from both sides...
For a healthy business I strongly believe to have 0 debt (max to 50% of equity). and high profit margins. and there is nothing like having cash (& cash equivalent) on your balance sheet by which you could afford to have -ve margin to stay in business or even take over your competitors who have working capital issues.
Cheers...
Subscribe to:
Posts (Atom)
