Personal Money Management 101 Blog

Picking stocks can seem a bit like choosing your lottery numbers, so many choices and no guarantee of success. At least with stocks there is ample information to make your choice easier, so much so it can be hard knowing where to start!

Stock picking is not an exact science, but each stock has some crucial numbers that can shed some light on the process.

Earnings per Share (EPS) = Profit Before Tax / Number of shares in issue

Quite simply this is the amount of profit earned for each share. Its main use is as an input to the

Price-Earnings (PE) ratio = Share Price / Earnings per Share

This tells you how cheap/expensive a share is. The PE ratio should be viewed in the context of the average for the market, and in particular for the average of the sector for the stock under consideration. You should also ask why the market has priced the stock as it has. A low PE ratio could mean a bargain, or (more likely) suggest some perceived problems. A high PE ratio could mean the stock is overpriced, or that the market thinks highly of it. A related indicator is the

PEG ratio = PE ratio / Expected annual growth of Earnings (%)

A low PEG ratio (<1) can indicate a bargain. A problem with PEG is that the “Expected annual growth of Earnings” is just a forecast (guess).

Yield = Dividend per Share / Share Price

A very significant number if income is important to you.

The next two numbers indicate how well the firm is able to meet its debts.

Current Ratio = Current Assets / Current Liabilities

The higher the better. If less than 1 the firm would be unable to meet all its liabilities at this time.

Quick Ratio (Acid test) = (Current Assets – Inventory) / Current Liabilities

Similar to above but excludes inventory, leaving only assets, which could quickly be converted, to cash. This should not be significantly less than the sector average.

Net Asset Value (NAV) per Share = Net Assets / Number of shares in issue

Theoretically how much each share would receive if the business were wrapped up and its assets sold. The higher the NAV the safer the investment, but too high a figure suggests the firm itself adds little value.

Return on Investment = Operating Profit / Owner’s equity

A measure of management efficiency. The higher the better.

The following two measures give an indication of risk.

Debt-to-Equity Ratio = Total Liabilities / Owners’ Equity

A measure of leverage or gearing. Since payment on debt is unrelated to earnings, the higher this number the more common stockholders stand to gain from an increase in profit. It is effectively magnified. On the other hand the more stockholders lose in the event of a downturn.

A stock’s beta coefficient reflects its volatility in relation to the market as a whole. A beta of 1 indicates the stock moves in line with the market, less than 1 that it moves less than the market, and more than 1 that it is more volatile. Obviously beta is calculated on past behavior, which may not be continued in future.

The higher the risk, the higher should be the (expected) return.

Remember:

• the numbers are calculated on past performance, and as the small print of every piece of investment literature states – past performance is no guarantee of the future;
• supporters of perfect market theory say looking at this data is pointless, because the market as a whole has already looked and adjusted prices accordingly;
• these numbers are inputs to the decision process, they alone should not make your decisions for you.

Don’t know stocks from bonds? Not sure how mutual funds compare to ETFs?  Money can be confusing, but you can’t afford to stay confused.

When in doubt many people turn to a professional advisor. There is certainly no shortage of people willing to tell you what to do with your money, financial advice is one of the growth professions of the new millennium, though its reputation often fails to inspire confidence. This article helps you make the most of the mass of advice available.

There are various types of advisor.

Tied advisors work for a particular institution and only advise on that institution’s products. Tied advisors will not necessarily advise on the best deals available (unless they just happen to be provided by their employing institution). If (and it’s a big if) you use tied advisors, be sure to compare quotes from 3, 4 or however many you have time to go to.

Independent advisors advise across the whole spectrum of available products. They should find the very best deal for your needs.

Independent advisors are paid in 2 ways: 

• Commission based – advisor earns commission from products they recommend 
• Fee based – client pays advisor’s fee, advisor refunds part/all commission to client

Commission based advisors charge nothing for their time, but they may have ulterior motives (ie higher commissions) for recommendations.

Important points in making your choice:

• Is the advisor licensed? 
• Does s/he belong to the relevant professional bodies? 
• Is s/he bound by any code of practice? 
• How long has he/she been in business?
• Has he/she been recommended by trusted friends/associates?
• Can he/she provide references?

Ask around. The effectiveness of a financial advisor is difficult to gauge until some time after their advice is given. Do your friends recommend a particular advisor? Why?

Advisors can assist in the financial planning and investment process, but always remember it’s YOUR money at stake. The best advice is not to delegate your money management decisions to a (disinterested) 3rd party. Instead make just a little time and effort to acquaint yourself with the available choices. And – should you choose to use one – do this BEFORE consulting a financial advisor, ie you should have a pretty good idea of what you’re looking for before the meeting. Ask your advisor difficult questions – and lots of them.

Avoid signing up for anything there and then. Always sleep on decisions, even if that means the opportunity is lost. There are few opportunities so golden that they won’t exist next morning.

Some advisors are guilty of “blinding with science.”  Don’t invest in anything you don’t understand. The advisor’s job is to advise. Your job is to listen carefully and then make YOUR decision.

What do Dutch tulips, dot-coms and English real estate have in common?

In 17th century Netherlands a craze developed for the buying and selling of tulip bulbs. Bulbs were traded for ever-higher prices with some speculators making fortunes from the market. Unsurprisingly (with hindsight) the fad proved unsustainable, and in 1637 panic selling ensued resulting in many sustaining huge losses.

In the late 20th – early 21st century a craze developed for investment in Internet businesses. The Internet was seen as breaking the mould of traditional business. Existing business models were cast aside as dot-com stocks were traded for ever-higher prices with some speculators making fortunes from the market. Unsurprisingly (with hindsight) the fad proved unsustainable, and panic selling ensued resulting in many sustaining huge losses.

Dutch tulips and dot-coms were both bubbles that burst, but what of English real estate? Let’s review the facts…

Real estate has undergone a lengthy period of rapidly rising prices. Nationwide data [http://www.nationwide.co.uk/hpi/historical.htm] reveals that in quarter 1 of 1997 the average UK house price was £55,810. By quarter 2 of 2007 (10.25 years) that figure had risen to £181,810, a rise of more than 3 and a quarter times, or an average annual increase in excess of 12%, far outstripping price and earnings inflation.

The Daily Mail Aug 15th 2007 [http://www.dailymail.co.uk/pages/live/articles/news/news.html?in_article_id=475396&in_page_id=1770] reports the typical mortgage taken by first-time buyers has reached a record 3.37 times annual salary. The number of repossessions has recently jumped 30% and the number of first-time buyers in June 2007 was the lowest for two years.

Why? Possibly one or more of the following factors:

* The UK operates an extremely lenient immigration policy. According to migrationwatchuk.org net foreign immigration reached 292,000 in 2005, excluding illegal immigrants of whom some 50,000 are detected each year.

* The rise in the number of single households means more homes are needed overall.

* Reduction in availability of affordable rented housing. Since 1980 many council tenants have taken advantage of legislation allowing them to buy their homes at substantial discounts. The number of homes sold under this scheme far outweighs the number of additional properties available for rental, thus more people need to buy.

* Growth in purchases for rental investment has restricted supply of housing for owner-occupation.

* Recent years have seen sustained periods of historically low interest rates, thus allowing buyers to borrow more, but without increased supply prices have just increased.

It all adds up to demand rising faster than supply, and when that happens economics says prices will keep rising. The government has recognized as much with incoming PM Gordon Brown pledging to build 3 million new houses by 2020 (though he’s unlikely to be in office long enough to see it fulfilled).

So, what next? Is the boom sustainable, will it gently peter out, or will the bubble burst just like the tulips and dot-coms?

Well, if I knew the answer with certainty I’d rush out and put my house on it. But let’s see what’s most likely.

The only likely trigger for a crash is out and out recession, but that seems unlikely. Figures from National Statistics [http://www.statistics.gov.uk] show the number in work rising, the jobless rate falling and annual GDP growth at a healthy 3%.

Housing isn’t discretionary. Pretty tulips and dot-com stocks might be nice to have, but shelter is one of life’s necessities. Those that can live with their parents will do so for longer. Others may rent privately, but will soon realize it makes more sense paying their own mortgage than someone else’s. That’s why price growth has remained strong despite recent interest rises.

Figures published yesterday show inflation falling. Combined with world stock market volatility it’s unlikely the Bank of England will rise interest gain any time soon.

So my guess is that fears of a housing market crash are greatly exaggerated.

These days we’re all encouraged to take more care over our health by eating sensibly, taking exercise etc. But how many of us take equal care over our financial health?

Our financial profile consists of our income, outgoings, assets and debts. For many this profile is either something that’s just happened piecemeal, or it was planned at one time but has not been reviewed since.

Everyone should have a financial health check at least once a year. The holiday season might be a good time if you find yourself at a loose end. However, be careful not to review your finances too often, lest it lead to “churning” (moving investments unnecessarily) and the associated fees.

DIY vs. Advisor

You can either conduct your financial health check yourself, or you can hire a financial advisor to do it for you. The best bet is to spare the time and effort to do it yourself. After all it is your hard-earned money, and no one else is going to care for it as you do.

If you do decide to use an advisor, make sure you choose one you can trust. Personal recommendation is a good guide. Allow the advisor to advise, but make sure that you make the final decision. If you use a commission-based advisor be particularly careful that their advice is in your best interests rather than theirs. A golden rule is that if you don’t understand it, don’t do it!

Know your goals

Reconsider your financial priorities. Why are you saving/investing and have those reasons changed since you constructed or last reviewed your portfolio. In general, the closer you get to an objective the more conservative (risk-averse) you ought to become.

Spending

Look over your bank statements. You should already be taking the time each month to reconcile these with check stubs, ATM receipts etc. Are there any direct payments that are no longer needed? eg insurances that are no longer appropriate, memberships or subscriptions you no longer require…

Do your bank statements highlight any changes you could make to spending habits, eg do you buy stuff daily in the convenience store that you could get cheaper at the supermarket?

Investments

Do you have any investments? Stocks, mutual funds, real estate? If so, ask yourself 2 questions – are they performing to your expectations? and are they still the most appropriate place for your money?

In deciding whether to move your money you need to consider the most likely future performance of potential choices, the costs of any move (exit charges for currents plus entry charges for the new), whether the alternative(s) better fit your objectives.

Are you comfortable with the risk level of your portfolio? In general, the longer the term the greater the risk you can stand. But risk is also a personal thing. If you’re losing sleep over your portfolio, it’s time to decrease risk. Alternatively if you want more of a gamble, then go for it.

Remember, on average managed funds don’t beat the market, and those that do probably do so by chance. Tracker funds offer lower fees and (on average) better performance. Is now the time to switch to tracker funds? And if so, which index(es) do you want to track?

Mortgage

For many people their mortgage represents a significant portion of their outgoings. If you have a mortgage are you getting the best deal? There is no shortage of competition among those wanting to lend you money. It may be worth consulting an independent advisor, or using one of the online comparison sites.

Be sure to read the small print before switching. You need to consider not only your monthly payments, but also any up-front costs, and exit costs (both on your current and proposed mortgage)

Insurance

We probably all need insurance of some form or other, on our home, our car, our health, our life… And it’s worth checking periodically both that you have the cover you need, and that you’re getting the best deal for it.

Taxation

For most of us taxes are a necessary evil. But we can all make sure we’re not paying a cent more than we need to.

Make sure you’re claiming all the allowances you’re entitled to. If you work wholly or partly from home, maybe the heating, lighting, power, phone etc used in respect of your work are tax deductible. Or if you need to travel can you claim for fuel or fares?

Take advantage of any tax breaks on savings and investment offered by your government. But only if those savings or investments are appropriate for your particular needs.

Couples should take advantage of the individual tax position of each partner. EG if the wife doesn’t pay tax then the couple’s savings should be held in her name to avoid it being taxed.
Each partner is usually entitled to their own set of tax breaks.

Not a nice thought, but some planning ahead can also minimize or eliminate inheritance tax.

The tax system is complex, perhaps it is designed so in order to confuse. The key point is to understand the system and the rights you have. This may mean a visit to the library or an afternoon reading the rules and regulations online. It might be worth paying a visit to a reputable accountant or tax advisor.

Pension Provision

It’s never too early to start saving for a pension. Are you on track to have sufficient income after retirement?

Employer’s schemes are usually a good deal as the employer often makes a considerable contribution. “Final salary” schemes are particularly worthwhile, but these days are becoming rarer than hen’s teeth, in England anyway.

Alternatively you have the option of joining a designated pension scheme or building up your own investments to see you through old age. Recognized schemes often provide significant tax advantages, but may carry substantial fees and involve entrusting your money to a fund manager. Pension laws vary from country to country, but perhaps you have the option to take out a self-managed pension plan with tax benefits but without the fees of a managed fund.

You may just decide to go it alone, but whatever you do, do not neglect your pension.

Keep watching the diet and taking daily exercise and you’ll live a long life. Remember to keep a check on your financial health too and you’ll have the money to enjoy it!