The price/earnings ratio (P/E) tells us how much an investor in a particular company’s stock pays for each dollar of earning. In other words, the lower the P/E, the better the deal an investor gets and the studies indeed demonstrate that buying stock at lower P/E usually results in higher long-term returns. Even though P/E is usually calculated for earnings in the past, it can also be calculated on the basis of expected earnings in the future. Since a company is affected by factors external to it, the P/E ratio is also affected by external factors. P/E is usually higher when overall stock market is doing well and vice versa. It is also important to compare P/E of a company with that of the competition or the industry in which the company operates. But P/E has limitations and is not always a useful tool in choosing investment candidates. What I have read about value investors, higher P/E may be acceptable for companies with strong competitive position or who have a long-term track record such as some of the blue-chip companies. I also believe that P/E on the basis of future expected earnings should be used as infrequently as possible because humans tend to be poor predictors of future events.
Another way to decide upon investment candidates may be valuation of companies through free cash flow method. The free cash flow method involves taking the present value of all future free cash flows as well as terminal value to arrive at enterprise value. The free cash flow method excludes noncash expenses such as depreciation. Another step in determining enterprise value through free cash flow method is to choose a discount rate which reflects the risk inherent in the business. I like this method because it takes into account the most liquid of all assets but I am not very confident that this method works for most for the simple reason that it is extremely difficult to predict future cash flows, especially in the age of globalization where competitive dynamics and companies’ competitive positions change quickly and same is also true for corporate risk. There are numerous examples that demonstrate the difficulty of predicting future. After all, who could have predicted Apple’s current problems or the decline of Microsoft or even Yahoo.
As far as financial asset management is concerned, the most important investment decision is probably asset allocation because it has a huge impact on the overall investment returns. Asset allocation basically refers to dividing portfolio among different investment securities such as stocks, bonds, and real estate etc. There are several factors that are taken into account when deciding upon asset allocation such as one’s risk tolerance, time horizon, country risk, and stage in career. Asset allocation strategies usually evolve over time and also change when certain assets in the portfolio become cheaper or expensive. The basic idea behind asset allocation is diversification or not putting all eggs into one basket. There are differences among different assets regarding expected returns but higher returns usually come with higher risks. At earlier stages, one can afford to invest heavily in higher risk, higher return assets but as the retirement age comes close, the right thing is to move to safer assets. Similarly, it is also important to take a disciplined approach and not be overly influenced by the market sentiments. Safer assets like bond are also better investment in an environment of high inflation. In addition, active asset management is not always the best option because of high turnover which only leads to higher fees. This article basically says the same thing that most investment article say that one should aim for high return assets when one is just starting or retirement age is quite far away. I am convinced after reading the article that most people should go for ETF because we are living in increasingly volatile times and not only investment vehicles like ETF will generate higher returns due to less-frequent asset turnover but may also help us become more disciplined investors by resisting market sentiments in times of boom and bust.
Islamic finance has been getting attention lately and some funds have demonstrated it is possible to earn profits while complying with Islamic laws. One fund is Amana Mutual Funds Trust which only invests in companies that do not violate any principles of Islamic faith. This means it avoids companies that manufacture products forbidden in Islam such as alcohol, gambling, and banks (banks generate income through interest). Amana’s Growth Fund takes value investing approach by investing in companies with good long term prospects. Amana’s Income Fund usually targets companies that usually pay dividend because they tend to be stable. Amana’s Developing World Fund targets companies with significant operations in developing economies and/or markets. Amana also calculates Zakah on its investors’ holdings and deduct it. This is an interesting article and shows that Islamic Finance is practical because there are countless ways to earn income or invest. But it is also apparent that Islamic Financing tries to achieve a balance between material wealth and faith and the expected income for investors who follow Islamic principles may not be as high as an average investor who follows western investing principles.
Issuing IPO is one way of raising capital for companies. IPO refers to listing stock on a stock exchange or the process of going public. In order to go public, a company has to meet certain requirements put forward by SEC and in addition, stock exchanges such as NYSE and NASDAQ have their own requirements. Companies that decide to go public hire the services of law and accounting firms and also assemble a board of directors. The company’s underwriters help the company develop terms and structure of offering and also connect with potential major investors including institutional investors. The company hopes that the buyers of initial stock offering will hold the shares for the long term and take steps to ensure the buyers are in strong financial health and do not intend to immediately flip shares on first day of trading. The performance of company stock on first day of trading is also dependent upon several factors including demand from investors. As far as I am concerned, I believe a wise investor may avoid IPO because high demand means share prices may be inflated as Facebook’s example show. In addition, the company has no previous financial record, thus, any investment is more a speculation than an educated investment.