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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.

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Subject: P/E Ratio
From: [e-mail], [e-mail]

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.

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Subject: Renting vs. buying a place to live
From: [e-mail], [e-mail]

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.

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Subject: Shorting Stocks
From: [e-mail]

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.

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Subject: Stock Index Types
From: [e-mail]

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.

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Subject: Stock Index - The Dow
From: [e-mail], [e-mail]

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.

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Subject: Stock Indexes - Others
From: [e-mail], [e-mail], [e-mail],
    [e-mail]

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? ]

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Subject: Stock Splits
From: [e-mail], [e-mail], [e-mail]