I'd like to continue along the line of Bill's excellent Tuesday and Wednesday articles, starting with a couple of random comments. First, when I read yesterday's article, I didn't remember what a "coupon" was, so I fired up my favorite search engine to find out. This is how I discovered investorwords.com, which seems extremely cool so far. Just thought I'd pass along the tip.
Secondly, Bill ended his talk about the Federal Reserve -- a topic I've also written about in the past -- with a warning that companies drinking from the debt or equity troughs would be most affected by the recent rate hike, but it shouldn't be as painful to many of our low- and no-debt Rule Makers like Cisco (Nasdaq: CSCO) and Microsoft (Nasdaq: MSFT). As I've written before, Cisco and Microsoft DO depend heavily upon the equity market to fund their option programs, and for large cash tax refunds derived from their option programs. A man named Bill Parish has covered this topic in more depth than anyone else I know, although he sometimes manages to make even me look unbiased by comparison. (You have been warned.)
So, on Tuesday Bill started to talk about discounted cash flow analysis (DCFA), a name which clearly indicates that investment professionals are quite capable of inventing big words to make what they do sound impressive.
As Bill explained, DCFA is a useful tool for putting potential investments in context by telling you if one set of assumptions would make a better investment than another set of assumptions. Think of a share of stock as an IOU of sorts with a certain amount of assumptions built into the current price. You can use DCFA to figure out how much a promise of future payments is worth in today's dollars by comparing the payout from the IOU with how much you'd have if you invested the money at a fixed interest rate (in bonds, CDs, a savings account, etc.) until the IOU comes due.
Expert investors like Berkshire Hathaway's (NYSE: BRK.A) Warren Buffett use DCFA to price stocks, by combining a company's estimated future per-share earnings and the rate of return they think they could get investing the money elsewhere. Plugging in the numbers and doing the math results in a share price at which the shares are as good an investment as the theoretical alternative. Below this price the stock is an even better investment, and above this price the alternative is the better investment, assuming the estimates used to calculate that share price turn out to be true. (That last bit is why we don't use it much here. Garbage in, garbage out.)
Discounted cash flow analysis is also the basis for calculating the internal rate of return (IRR) of a portfolio. This is the XIRR function on most spreadsheets, which I've mentioned before. What IRR does is figure out the discount rate you need to plug into your discounted cash flow analysis calculation for a given series of cash flows in order to make the current value of the whole thing equal to zero. When you find the rate that makes your initial invested cash match the cash you got back out, your discount rate exactly matches the actual performance of your investments.
A computer finds this rate by rapid trial and error. It guesses, and if the guess is too high it tries a lower number, if it's too low it tries a higher number, and it gradually zeroes in on it. This is why you don't want to do this calculation by hand -- it would take a LONG time.
The problem with this method of tracking portfolio returns is that it accurately annualizes short-term gains, which turns out to be a bad thing. If I buy one share of a stock at $10, and the next day it's trading at $12, my annualized return is simply insane! If my $10 investment increases 20% each day, I'm more than doubling it every four days! In 140 days, I'd be a millionaire! By the end of the year, I'd surpass America's richest man -- Oracle (Nasdaq: ORCL) CEO Larry Ellison (heh heh).
You know this isn't what's really going to happen. I know this isn't what's really going to happen. But mathematically speaking, if I ask a computer to annualize short-term results, it believes what I tell it. The problem here isn't with the IRR method, it's with the concept of annualizing. Projecting short-term results into the future by expecting them to consistently repeat themselves for the rest of the year simply doesn't work.
The frustrating thing is that for investment periods of a year or longer, internal rate of return gives mathematically perfect results. Except for the short-term annualizing problem, IRR is the best method for tracking portfolio returns, and we'd like to use it.
For the first year of this portfolio, we simply didn't annualize our returns. The cash-in/cash-out method we're using now effectively assumes that all the stock we've ever purchased in this portfolio -- up to and including last month's $500 purchase of Yahoo! (Nasdaq: YHOO) -- has been held for the entire life of the portfolio. We're assuming that we've held stock longer than we actually have, which understates our returns. We're willing to live with that for now.
As the portfolio ages, the distortion of our returns will get worse, and we'll have to improve our tracking method again. Probably, we'll wind up with some kind of hybrid method of IRR, perhaps by extending all holding periods less than a year to a full year to avoid the unpleasant side effects of short-term annualizing.
If you'd like to suggest what we should do, or comment on how you track your portfolio returns, the Rule Maker Strategy discussion board is waiting.
-- Oak
