Investing Feeds

In all of the theory which I have covered in my articles I have often referred to a perfect market, or perfect conditions. It is important that potential investors understand what is meant by Perfect Market in relation to theory. A perfect market has two sides, first the companies or entities involved in the market would behave in a mathematically perfect way in terms of investment and financing, they would all utilize NPV analysis to make decisions and would subscribe to Fishers normative function of maximizing shareholder wealth. Secondly Investors would act in a perfect way by also utilizing NPV to make decisions about investing and financing decisions. [Read more]

Following on from the article on ‘Valuing a company from Public Records’, presents me with the perfect opportunity to introduce the concept of ‘Goodwill’. Goodwill is the amount of value the market places onto a company that represents the intangible worth of that company. To illustrate let us consider the following data:

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Irving Fisher’s Separation Theorem is the bedrock of modern financial theory. Essentially it asserts that in the modern, listed, business entity there is a divestiture of ownership (Shareholders) and control (The Board) and as such, this separation produces the need for the control to maximize the present value (see article on NPV) regardless of the market opportunities of the owners. In simple terms, the interests of the owners of a firm are always served by utilizing NPV as a tool of investment appraisal. It’s main assumptions are therefore that:

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Net Present Value (NPV) Part Two

Before the worked examples, it is important that you read the first part of NPV, as the underlying concepts, and their limitations, are very important. To utilize NPV as a tool for ranking Investments it is important to arrive at a rate at which to discount the estimated future cash flows. In terms of Share purchases, future cash flows are either dividends paid, or increase in share value. The following is a highly simplified example, and care should be taken when arriving at estimates of growth and dividend payments, as well as the rate at which those estimates are discounted.

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If you invest in a firm, you want to hope they utilize NPV as a tool for vetting potential projects, as this method is the only mathematically correct measure of the Economic Value Added (EVA) to a company (which should then equate to Market Value Added (MVA), or an increase in share price.) NPV is a method of discounting future revenue to arrive at a dollar figure which is the present value of that revenue today (or as Economists say, at time period 1.) [Read more]

In what I hope will be a longer series of tutorial style blogs, this article is designed to give an overview of the history and current developments in Investment Theory. Investment Theory is really a subset of Economics, utilizing, at times, quite complex mathematical concepts to represent the behavior of the Markets. What is important to understand right from the start is that whilst theory is useful, and used extensively by analysts in interpreting the markets, it models itself on what is commonly held to be a perfect world, in which little or no uncertainty exists. Of course in the real world, and in real markets, plenty of uncertainty exists, and no market behaves in a perfect way. This is because investors do not act in a mathematically rational manner (looking at statistical information of takeovers in the UK for, say, fifty years will suggest that the majority of the takeover valuations were over priced and therefore not rational investment decisions) People invest for reasons other than maximizing wealth, for a sense of power, because acquisitions have more benefits than financial or just because they are badly informed. If all of the investment decisions were made by the careful application of econometrics, and those econometrics were perfect in every way, then the markets would behave in a ‘perfect’ way, and predicting the outcomes of investment decisions would be (comparatively) easy.

The most cutting edge theorists and analysts utilize Chaos Theory (see E.E. Peters, Chaos and Order in the Markets, for a good introduction to this subject), and a derivation of the Nash Equilibrium or ‘game theory’ is also popular at the moment. These subjects do require a deep understanding of the underlying mathematical concepts, and therefore a Degree in Mathematics. There are, however, many other resources, which although do require the use of mathematics, are far simpler, and are based on widely held theoretical principals. Chief amongst these is the use of Net Present Value (NPV) to vet potential investments. In this series I will be explaining the theory and practice of NPV as well as introducing the classic theories of Finance, from Fisher’s Separation Theorem (1930), The Gordon Growth Model (1960) and the work of Modigliani and Miller.