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Frequently Asked Questions (FAQS);faqs.338 The other common option is the PUT. If you buy a put from me, you gain the right to sell me your stock at the strike price on or before the expiration date. Puts are almost the mirror-image of calls. ----------------------------------------------------------------------------- Subject: P/E Ratio From: egreen@east.sun.com, schindler@csa2.lbl.gov P/E is shorthand for Price/Earnings Ratio. The price/earnings ratio is a tool for determining the value the market has placed on a common stock. A lot can be said about this little number, but in short, companies expected to grow and have higher earnings in the future should have a higher P/E than companies in decline. For example, if Amgen has a lot of products in the pipeline, I wouldn't mind paying a large multiple of its current earnings to buy the stock. It will have a large P/E. I am expecting it to grow quickly. P/E is determined by dividing the current market price of one share of a company's stock by that company's per-share earnings (after-tax profit divided by number of outstanding shares). For example, a company that earned $5M last year, with a million shares outstanding, had earnings per share of $5. If that company's stock currently sells for $50/share, it has a P/E of 10. Investors are willing to pay $10 for every $1 of last year's earnings. P/Es are traditionally computed with trailing earnings (earnings from the year past, called a trailing P/E) but are sometimes computed with leading earnings (earnings projected for the year to come, called a leading P/E). Like other indicators, it is best viewed over time, looking for a trend. A company with a steadily increasing P/E is being viewed by the investment community as becoming more and more speculative. PE is a much better comparison of the value of a stock than the price. A $10 stock with a PE of 40 is much more "expensive" than a $100 stock with a PE of 6. You are paying more for the $10 stock's future earnings stream. The $10 stock is probably a small company with an exciting product with few competitors. The $100 stock is probably pretty staid - maybe a buggy whip manufacturer. ----------------------------------------------------------------------------- Subject: Renting vs. buying a place to live From: mincy@think.com, lott@informatik.uni-kl.de This note will explain one way to compare the monetary costs of renting vs. buying a home. It is extremely predjudiced towards the US system. SUMMARY: - If you are guaranteed an appreciation rate that is a few points above inflation, buy. - If the monthly costs of buying are basically the same as renting, buy. - The shorter the term, the more advantageous it is to rent. - Tax consequences in the US are insignificant. The three important factors that affect the analysis the most: 1) Relative cash flows; e.g., rent compared to monthly ownership expenses 2) Length of term 3) Rate of appreciation The approach used here is to determine the present value of the money you will pay over the term for the home. In the case of buying, the appreciation rate and thereby the future value of the home is estimated. This analysis neglects utility costs because they can easily be the same whether you rent or buy. However, adding them to the analysis is simple; treat them the same as the costs for insurance in both cases. Computation of present value is reasonably straightforward and is explained elsewhere. Programs to compute present and future value as well as for loan amortization (pv, fv, loan) are also available from Lott. Opportunity costs of buying are effectively captured by the present value. For example, pretend that you are able to buy a house without having to have a mortgage. Now the question is, is it better to buy the house with your hoard of cash or is it better to invest the cash and continue to rent. To answer this question you have to have estimates for rental costs and house costs (see below), and you have a projected growth rate for the cash investment and projected growth rate for the house. If you project a 4% growth rate for the house and a 15% growth rate for the cash then holding the cash would be a much better investment. Renting a Home. * Step 1: Gather data. You will need: - monthly rent - renter's insurance (usually inexpensive) - term (period of time over which you will rent) - estimated inflation rate to compute present value (historically 4.5%) - estimated annual rate of increase in the rent (can use inflation rate) * Step 2: Compute the present value of the cash stream that you will pay over the term, which is the cost of renting over that term. This analysis assumes that there are no tax consequences (benefits) associated with paying rent. (The 'pv' program can help here.) Long-term example: Rent = 990 / month Insurance = 10 / month Term = 30 years Rent increases = 4.5% annually Inflation = 4.5% annually For this cash stream, present value = 348,137.17. Short-term example: Same numbers, but just 2 years. Present value = 23,502.38 Buying a Home. * Step 1: Gather data. You need a lot to do a fairly thorough analysis: - purchase price - down payment & closing costs - other regular expenses, such as condo fees - amount of mortgage - mortgage rate - mortgage term - mortgage payments (this is tricky for a variable-rate mortgage) - property taxes - homeowner's insurance - your tax bracket - the current standard deduction you get Other values have to be estimated, and they affect the analysis critically: - continuing maintenance costs (I estimate 1/2 of PP over 30 years.) - estimated inflation rate to compute present value (historically 4.5%) - rate of increase of property taxes, maintenance costs, etc. (infl. rate) - appreciation rate of the home (THE most important number of all) * Step 2: compute the monthly expense. This includes the mortgage payment, fees, property tax, insurance, and maintenance. The mortgage payment is fixed, but you have to figure inflation into the rest. Then compute the present value of the cash stream. (The 'pv' program can help.) * Step 3: compute your tax savings. Roughly you should multiply your tax bracket times the amount by which your interest plus property tax expenses exceeds your standard deduction. No fair using the whole amount because everyone gets the standard deduction for free. Must be summed over the term because the standard deduction will increase annually, as will your property taxes. Note that late in the mortgage your interest payments will be be well below the standard deduction. I compute savings of about 5%. (The 'loan' program can help.) * Step 4: compute the future value of the home based on the purchase price, estimated appreciation rate, and the term. Once you have the future value, compute the present value of that sum based on the inflation rate you estimated earlier and the term you used to compute future value. If appreciation > inflation, you win. Else you lose. (The 'pv' and 'fv' programs can help.) * Step 5: Compute final cost. All numbers must be in present value. Final-cost = Down-payment + S2 (expenses) - S3 (tax sav) - S4 (prop value) Long-term example #1: * Step 1 - the data: Purchase price = 145,000 Down payment etc = 10,000 Mortgage amount = 140,000 Mortgage rate = 8.00% Mortgage term = 30 years Mortgage payment = 1027.27 / mo Property taxes = about 1% of valuation; I'll use 1200/yr = 100/mo (which increases same as inflation, we'll say) Homeowner's ins = 50 / mo Condo fees etc = 0 Tax bracket = 33% Standard ded = 5600 Estimates: Maintenance = 1/2 PP is 72,500, or 201/mo; I'll use 200/mo Inflation rate = 4.5% annually Prop taxes incr = 4.5% annually Home appreciates = 6% annually (the NUMBER ONE critical factor) * Step 2 - the monthly expense, both fixed and changing components: Fixed component is the mortgage at 1027.27 monthly. Present value = 203,503.48 Changing component is the rest at 350.00 monthly. Present value = 121,848.01 Total from Step 2: 325,351.49 * Step 3 - the tax savings. I use my loan program to compute this. Based on the data given above, I compute the savings: Present value = 14,686.22. Not much at all. * Step 4 - the future and present value of the home. See data above. Future value = 873,273.41 and present value = 226,959.96 (which is larger than 145k since appreciation > inflation) Before you compute present value, you should subtract reasonable closing costs for the sale; for example, a real estate brokerage fee. * Step 5 - the final analysis for 6% appreciation. Final = 10,000 + 325,351.49 - 14,686.22 - 226,959.96 = 93,705.31 So over the 30 years, assuming that you sell the house in the 30th year for the estimated future value, the present value of your total cost is 93k. (You're 93k in the hole after 30 years ~~ you only paid 260.23/month.) Long-term example #2: all numbers the same BUT the home appreciates 7%/year. Step 4 now comes out FV=1,176,892.13 and PV=305,869.15 Final = 10,000 + 325,351.49 - 14,686.22 - 305,869.15 = 14796.12 So in this example, 7% was an approximate break-even point in the absolute sense; i.e., you lived for 30 years at near zero cost in today's dollars. Long-term example #3: all numbers the same BUT the home appreciates 8%/year. Step 4 now comes out FV=1,585,680.80 and PV=412,111.55 Final = 10,000 + 325,351.49 - 14,686.22 - 412,111.55 = -91,446.28 The negative number means you lived in the home for 30 years and left it in the 30th year with a profit; i.e., you were paid to live there. Long-term example #4: all numbers the same BUT the home appreciates 2%/year. Step 4 now comes out FV=264,075.30 and PV=68,632.02 Final = 10,000 + 325,351.49 - 14,686.22 - 68,632.02 = 252,033.25 In this case of poor appreciation, home ownership cost 252k in today's money, or about 700/month. If you could have rented for that, you'd be even. Short-term example #1: all numbers the same as Long-term example #1, but you sell the home after 2 years. Future home value in 2 years is 163,438.17 Cost = down&cc + all-pymts - tax-savgs - pv(fut-home-value - remaining debt) = 10,000 + 31,849.52 - 4,156.81 - pv(163438.17 - 137,563.91) = 10,000 + 31,849.52 - 4,156.81 - 23651.27 = 14,041.44 Short-term example #2: all numbers the same as Long-term example #4, but you sell the home after 2 years. Future home value in 2 years is 150,912.54 Cost = down&cc + all-pymts - tax-savgs - pv(fut-home-value - remaining debt) = 10,000 + 31,849.52 - 4,156.81 - pv(150912.54 - 137,563.91) = 10,000 + 31,849.52 - 4,156.81 - 12,201.78 = 25490.93 Some closing comments: Once again, the three important factors that affect the analysis the most are cash flows, term, and appreciation. If the relative cash flows are basically the same, then the other two factors affect the analysis the most. The longer you hold the house, the less appreciation you need to bet renting. This relationship always holds, however, the scale changes. For shorter holding periods you also face a risk of market downturn. If there is a substantial risk of a market downturn you shouldn't buy a house unless you are willing to hold the house for a long period. If you have a nice cheap rent controlled appartment, then you should probably not buy. There are other variables that affect the analysis, for example, the inflation rate. If the inflation rate increases, the rental scenario tends to get much worse, while the ownership scenario tends to look better. Question: Is it true that you can usually rent for less than buying? Answer 1: It depends. It isn't a binary state. It is a fairly complex set of relationships. In large metropolitan areas, where real estate is generally much more expensive then it is usually better to rent, unless you get a good appreciation rate or if you are going to own for a long period of time. It depends on what you can rent and what you can buy. In other areas, where real estate is relatively cheap, I would say it is probably better to own. On the other hand, if you are currently at a market peak and the country is about to go into a recession it is better to rent and let property values and rent fall. If you are currently at the bottom of the market and the economy is getting better then it is better to own. Answer 2: When you rent from somebody, you are paying that person to assume the risk of homeownership. Landlords are renting out property with the long term goal of making money. They aren't renting out property because they want to do their renters any special favors. This suggests to me that it is generally better to own. ----------------------------------------------------------------------------- Subject: Shorting Stocks From: ask@cblph.att.com Shorting means to sell something you don't own. If I do not own shares of IBM stock but I ask my broker to sell short 100 shares of IBM I have committed shorting. In broker's lingo, I have established a short position in IBM of 100 shares. Or, to really confuse the language, I hold 100 shares of IBM short. Why would you want to short? Because you believe the price of that stock will go down, and you can soon buy it back at a lower price than you sold it at. When you buy back your short position, you "close your short position." The broker will effectively borrow those shares from another client's account or from the broker's own account, and effectively lend you the shares to sell short. This is all done with mirrors; no stock certificates are issued, no paper changes hands, no lender is identified by name. My account will be credited with the sales price of 100 shares of IBM less broker's commission. But the broker has actually lent me the stock to sell; no way is he going to pay interest on the funds from the short sale. (Exception: Really big spenders sometimes negotiate a full or partial payment of interest on short sales funds provided sufficient collateral exists in the account and the broker doesn't want to lose the client. If you're not a really big spender, don't expect to receive any interest on the funds obtained from the short sale.) Also expect the broker to make you put up additional collateral. Why? Well, what happens if the stock price goes way up? You will have to assure the broker that if he needs to return the shares whence he got them (see "mirrors" above) you will be able to purchase them and "close your short position." If the price has doubled, you will have to spend twice as much as you received. So your broker will insist you have enough collateral in your account which can be sold if needed to close your short position. More lingo: Having sufficient collateral in your account that the broker can glom onto at will, means you have "cover" for your short position. As the price goes up you must provide more cover. Since you borrowed these shares, if dividends are declared, you will be responsible for paying those dividends to the fictitious person from whom you borrowed. Too bad. Even if you hold you short position for over a year, your capital gains are short term. A short squeeze can result when the price of the stock goes up. When the people who have gone short buy the stock to cover their previous short-sales, this can cause the price to rise further. It's a death spiral - as the price goes higher, more shorts feel driven to cover themselves, and so on. You can short other securities besides stock. For example, every time I write (sell) an option I don't already own long, I am establishing a short position in that option. The collateral position I must hold in my account generally tracks the price of the underlying stock and not the price of the option itself. So if I write a naked call option on IBM November 70s and receive a mere $100 after commissions, I may be asked to put up collateral in my account of $3,500 or more! And if in November IBM has regained ground and is at $90 [ I should be so lucky ], I would be forced to buy back (close my short position in the call option) at a cost of about $2000, for a big loss. Selling short is seductively simple. Brokers get commissions by showing you how easy it is to generate short term funds for your account, but you really can't do much with them. My personal advice is if you are strongly convinced a stock will be going down, buy the out-of-the-money put instead, if such a put is available. A put's value increases as the stock price falls (but decreases sort of linearly over time) and is strongly leveraged, so a small fall in price of the stock translates to a large increase in value of the put. Let's return to our IBM, market price of 66 (yuck.) Let's say I strongly believe that IBM will fall to, oh, 58 by mid-November. I could short IBM stock at 66, sell it at 58 in mid-November if I'm right, and make about net $660. If instead it goes to 70, and I have to sell then I lose net $500 or so. That's a 10% gain or an 8% loss or so. Now, I could buy the IBM November 65 put for maybe net $200. If it goes down to 58 in mid November, I sell (close my position) for about $600, for a 300% gain. If it doesn't go below 65, I lose my entire 200 investment. But if you strongly believe IBM will go way way down, you should shoot for the 300% gain with the put and not the 10% gain by shorting the stock itself. Depends on how convinced you are. Having said this, I add a strong caution: Puts are very risky, and depend very much on odd market behavior beyond your control, and you can easily lose your entire purchase price fast. If you short options, you can lose even more than your purchase price! One more word of advice. Start simply. If you never bought stock start by buying some stock. When you feel like you sort of understand what you are doing, when you have followed several stocks in the financial section of the paper and watched what happens over the course of a few months, when you have read a bit more and perhaps seriously tracked some important financials of several companies, you might -- might -- want to expand your investing choices beyond buying stock. If you want to get into options (see FAQ on options) start with writing covered calls. I would place selling stock short or writing or buying other options lower on the list -- later in time. ----------------------------------------------------------------------------- Subject: Stock Index Types From: susant@usc.edu There are three major classes of indices in use today in the US. They are: A - equally weighted price index (an example is the Dow Jones Industrial Average) B - market-capitalization-weighted index (an example is the S&P Industrial Average) C - equally-weighted returns index (the only one of its kind is the Value-Line index) Of these, A and B are widely used. All my profs in the business school claim that C is very weird and don't emphasize it too much. + Type A index: As the name suggests, the index is calculated by taking the average of the prices of a set of companies: Index = Sum(Prices of N companies) / divisor In this calculation, two questions crop up: 1. What is "N"? The DJIA takes the 30 large "blue-chip" companies. Why 30? I think it's more a historical hangover than any thing else. One rationale for 30 might be that a large fraction of market capitalization is often clustered in largest 50 companies or so. Does the set of N companies change across time? If so, how often is the list updated (wrt companies)? I suspect these decisions are quite judgemental and hence not readily replicable. If the DJIA only has 30 companies, how do we select these 30? Why should they have equal weights? These are real criticisms of the DJIA type index. 2. The divisor is not always equal to N for N companies. What happens to the index when there is a stock issue by one of the companies in the set? The price drops, but the number of shares have increased to leave the market capitalization of the shares the same. Since the index does not take the latter into account, it has to compensate for the drop in price by tweaking the divisor. For examples on this, look at pg. 61 of Bodie, Kane, & Marcus, _Investments_ (henceforth, BKM). Historically, this index format was computationally convenient. It doesn't have a very sound economic basis to justify it's existence today. The DJIA is widely cited on the evening news, but not used by real finance folks. I have an intuition that the DJIA type index will actually be BAD if the number of companies is very large. If it's to make any sense at all, it should be very few "brilliantly" chosen companies. + Type B index: In this index, each of the N company's price is weighted by the market capitalization of the company. Sum (Company market capitalization * Price) over N companies Index = ------------------------------------------------------------ Market capitalisation for these N companies Here you do not take into account the dividend data, so effectively you're tracking the short-run capital gains of the market. Practical questions regarding this index: 1. What is "N"? I would use the largest N possible to get as close to the "full" market as possible. BTW in the US there are companies who make a living on only calculating extremely complete value-weighted indexes for the NYSE and foreign markets. CMIE should sell a very-complete value-weighted index to some such folks. Why does S&P use 500? Once again, I'm guessing that it's for historical reasons when computation over 20,000 companies every day was difficult and because of the concentration of market capitalization in the largest lot of companies. Today, computation over 20k companies for a Sun workstation is no problem, so the S&P idea is obsolete. 2. How to deal with companies entering and exiting the index? If we're doing an index containing "every single company possible" then the answer to this question is easy -- each time a company enters or exits we recalculate all weights. But if we're a value-weighted index like the S&P500 (where there are only 500 companies) it's a problem. Recently Wang went bankrupt and S&P decided to replace them by Sun -- how do you justify such choices? The value weighted index is superior to the DJIA type index for deep reasons. Anyone doing modern finance will not use the DJIA type index. A glimmer of the reasoning for this is as follows: If I held a portfolio with equal number of shares of each of the 30 DJIA companies then the DJIA index would accurately reflect my capital gains. BUT we know that it is possible to find a portfolio which has the same returns as the DJIA portfolio but at a smaller risk. (This is a mathematical fact). Thus, by definition, nobody is ever going to own a DJIA portfolio. In contrast, there is a extremely good interpretation for the value weighted portfolio -- it's the highest returns you can get for it's level of risk. Thus you would have good reason for owning a value-weighted market portfolio, thus justifying it's index. Yet another intuition about the value-weighted index -- a smart investor is not going to ever buy equal number of shares of a given set of companies, which is what index type a. tracks. If you take into consideration that the price movements of companies are correlated with others, you are going to hedge your returns by buying different proportions of company shares. This is in effect what the index type B does and this is why it is a smarter index to follow. One very neat property of this kind of index is that it is readily applied to industry indices. Thus you can simply apply the above formula to all machine tool companies, and you get a machine tool index. This industry-index is conceptually sound, with excellent interpretations. Thus on a day when the market index goes up 6%, if machine tools goes up 10%, you know the market found some good news on machine tools. + Type C index: Here the index is the average of the returns of a certain set of companies. Value Line publishes two versions of it: * the arithmetic index : (VLAI/N) = 1 * Sum(N returns) * the geometric index : VLGI = {Product(1 + return) over N}^{1/n}, which is just the geometric mean of the N returns. Notice that these indices imply that the dollar value on each company has to be the same. Discussed further in BKM, pg 66. ----------------------------------------------------------------------------- Subject: Stock Index - The Dow From: vision@cup.portal.com, nfs@princeton.edu The Dow Jones Industrial Average is computed from the following stocks: Ticker Name ------ ---- AA Alcoa ALD Allied Signal AXP American Express BA Boeing BS Bethlehem Steel CAT Caterpillar CHV Chevron DD Du Pont DIS Disney EK Eastman Kodak GE General Electric GM General Motors GT Goodyear Tire IBM International Business Machines IP International Paper JPM JP Morgan Bank KO Coca Cola MCD McDonalds MMM Minnesota Mining and Manufacturing (3M) MO Philip Morris MRK Merck PG Procter and Gamble S Sears, Roebuck T AT&T TX Texaco UK Union Carbide UTX United Technologies WX Westinghouse XON Exxon Z Woolworth The Dow Jones averages are computed by summing the prices of the stocks in the average and then dividing by a constant called the "divisor". The divisor for the industrial average is adjusted periodically to reflect splits in the stocks making up the average; the divisor was originally 30 but has been reduced over the years to 0.462685 (as of 92-10-31). The current value of the divisor can be found in the Wall Street Journal and Barron's. ----------------------------------------------------------------------------- Subject: Stock Indexes - Others From: jld1@ihlpm.att.com, pearson_steven@tandem.com, jordan@imsi.com, rajiv@bongo.cc.utexas.edu Standard & Poor's 500: 500 of the biggest US corporations. This is a very popular institutional index, and recently becoming more popular among individuals. Most often used measure of broad stock market results. Wilshire 5000 Includes most publicly traded shares. Considered by some a better measure of market as a whole, becuase it includes smaller companies. Wilshire 4500 These are all firms *except* the S&P 500. Value Line Composite See Martin Zweig's Winning on Wall Street for a good description. It is a price-weighted index as opposed to a capitalization index. Zweig (and others) think this gives better tracking of investment results, since it is not over-weighted in IBM, for example, and most individuals are likewise not weighted by market cap in their portfolios (unless they buy index funds). Nikkei Dow (Japan) I believe "Dow" is a misnomer. It is called the Nikkei index (or the Nikkei-xx, where xx is the number of shares in it, which I can't quote to you out of my head). "Dow" comes from Dow Jones & Company, which publishes DJIA numbers. Nikkei is considered the "Japanese Dow," in that it is the most popular and commonly quoted Japanese market index, but I don't think Dow Jones owns it. S&P 100 (and OEX) The S&P 100 is an index of 100 stocks. The "OEX" is the option on this index, one of the most heavily traded options around. S&P MidCap 400 Medium capitalization firms. CAC-40 (France) This is 40 stocks on the Paris Stock Exchange formed into an index. The futures contract on this index is probably the most heavily traded futures contract in the world. Europe, Australia, and Far-East (EAFE) Compiled by Morgan Stanley. Russell 1000 Russell 2000 A small cap stock index. Russell 3000 NYSE Composite [options on index] Gold & Silver Index [options on index] AMEX Composite NASDAQ Composite Topix (Japan) DAX (Germany) FTSE 100 (Great Britain) Major Market Index (MMI) [ Compiler's note: a few explanations are still missing. Can anyone supply a few? ] ----------------------------------------------------------------------------- Subject: Stock Splits From: egreen@east.sun.com, schindler@csa2.lbl.gov, ask@cblph.att.com