Cost of capital

So, what’s this all about? Are things changing? Is it a load of bear or a load of bull?

Published on: 15 Aug 2013

The major stock markets around the world have been bear markets for the last couple of years but with the end of the recession looking like it’s here we should soon see a switch to a bull market.

Analysts around the world will be arguing one way or another on the timing of the recovery but where do the terms “bear market” and “bull market” come from?

There are two main views on the origin of these terms.

The first view is based on the methods with which the two animals attack.  A bear for example will swipe downwards on its target whilst a bull will thrust upwards with its horns. A bear market therefore is a downwards market with declining prices whilst a bull market is the opposite with rising prices.

The second view on the origin is based around the “short selling” of bearskins several hundred years ago by traders. Traders would sell bearskins before they actually owned them in the hope that the prices would fall by the time they bought them from the hunters and then transferred them to their customers. These traders became known as bears and the term stuck for a downwards market. Due to the once-popular blood sport of bull and bear fights, a bull was considered to be the opposite of a bear so the term bull market was born.

Whatever the actual origin of the terms though I’m sure most people will be relieved when we return to a bull market.

Are the young ones always smaller?

Published on: 18 Nov 2011

I’m willing to bet that nearly all of you have used a Microsoft product. Probably an equally high proportion have used Google and a reasonably significant number of you will own an Apple product.

What about LinkedIn? Most of you have no doubt heard of it and a number of you will be registered with the website.

But did you know that Microsoft currently has one of 9.40, Apple has one of 13.61, Google has one of 20.30 and LinkedIn has one of well, … well, you’ll just have to wait a moment to hear the figure as it’s rather impressive.

So, what figures am I talking about?

The figures mentioned above refer to the PE ratio or the Price Earnings ratio.

In an attempt to astound you with my knowledge, the Price Earnings ratio measures… (wait for it)… the ratio of Price to Earnings (a round of applause please for that brilliant explanation).

In other words, the share price of Microsoft for example is such that the market is currently prepared to pay 9.40 times the earnings to own it.

The PE ratio is also sometimes known as the “price multiple”, “earnings multiple” or simply “multiple” and whilst share prices can be affected by a number of different things, a high PE ratio generally implies that the market is expecting earnings to rise in the future.

If we round up the PE ratios of the companies above we get:

Microsoft: 9

Apple: 14

Google: 20

That other tech giant on the market, LinkedIn currently has a PE ratio of 1,498 (yes, 1,498).

Wow – that’s not bad is it?

So hang on. A PE ratio this high implies that the market has factored in an expectation of significant growth in earnings for LinkedIn.

This really is an expectation of pretty significant growth as at the moment for every $1 of current earnings an investor gets he or she has to pay $1,498.

So, for the sake of the LinkedIn shareholders let’s hope that in the future more people become linked in.

Would you criticise me if I spent ALL of YOUR bonus on alcohol?

Published on: 01 Jun 2011

One of the ways that governments around the world have tried to kick start the economy during the recent recession has been through the reduction of interest rates.

10 years ago the Bank of England base rate was 11.38%.

Today, the current rate is 0.5%.

If individuals have variable rate loans or mortgages on their home and the interest rate falls, their interest payments will also fall.

As a result these people will have more money in their bank account and in theory this additional money should make them feel more relaxed about buying goods. If these additional goods are purchased then the economy is stimulated.

Lower interest rates may also encourage individuals and organisations to take out new loans. This money can then in turn be used to buy products which again should stimulate the economy.

Now, whilst low interest rates are good for people that are borrowing money, they are not so good for people who are investing money and looking to receive interest on the cash they’ve invested.

Certain parts of the population are more reliant on interest received as part of their income than others. Pensioners for example, who are no longer working can be hit particularly hard as they often rely on interest income.

I’ve just had a quick look at the internet bank Egg.

Egg was established in 1998 and 4 years ago was bought by Citigroup (Citi). It’s one of the top internet banks around and offers good interest rates when compared to some of their competitors.

But what sort of interest rate do you get?

The Egg site today includes the following text:

“Egg Savings Account – watch your money GROW.

Get 0.60% gross pa/AER variable and watch your savings grow.

Includes a fixed 12 month introductory bonus rate of 0.10% gross pa/AER from the date your account is opened on balances from £1 to £1 million.”

The accountant in me likes to play with figures so let’s just think about this for a moment.

If you open an account with Egg with a £1,000 deposit, after the first year you’ll receive a bonus of £1.

Yes, a whole £1.

My favourite drink is London Pride beer and a pint will set me back £3.50.

Just think, in one year’s time if I invested £1,000 in the Egg savings account I could blow the bonus on just over a quarter of a pint of beer.

Then again, I couldn’t actually buy a quarter of a pint as I’d have to pay tax on the £1 bonus received…

If you found this interesting you may also like:

You can raise your profile on LinkedIn but will LinkedIn raise $175 million?

Published on: 28 Jan 2011

The professional networking site LinkedIn yesterday announced plans to raise up to $175 million (£110 million) by way of a public offering.

Many of you may well be members of LinkedIn and in terms of registered users it has been very successful since it started back in 2002.

Financial information about the company though has historically been difficult to obtain as such information was kept away from the public domain.

The IPO document released yesterday however provides some interesting figures.

For example, LinkedIn gains a new member every second and now has more than 90 million total members worldwide.

Although the majority of LinkedIn users are subscribers that sign up for the free version the company does generate significant income. It was able to double its 2009 revenues to $161 million in the first nine months of 2010. The $161 million can be broken down as follows:

  • Hiring solutions (job listings): $66 million (41% of revenue)
  • Marketing solutions (advertising): $51 million (32% of revenue)
  • Premium subscriptions: $44 million (27% of revenue)

2010 was the first year that LinkedIn was profitable with a net income after tax of $10 million.

Cash at hand as at 30 September 2010 was $90 million whilst total assets were $197 million.

The IPO document also has to provide details of shareholders with more than a 5% stake.

The founder and chairman, Reid Hoffman owns 21.4% of the company together with his wife whilst 3 venture capital firms own approximately 39% between them.

The shareholders should do very well out of the IPO and indeed Mr Hoffman is no stranger to successful e-businesses having previously been an executive at PayPal.

If you’ve got a relaxed day at the office and a love of detail then the full document submitted to the US Securities and Exchange Commission can be found here.

A bank run? Don’t worry, it’s only a bit of fun…

Published on: 15 Nov 2010

It hardly seems possible that the bank run on the UK bank Northern Rock happened over 3 years ago but last week some people thought that there was a similar run on the Spanish bank BBVA.

A bank run occurs when a large number of people with deposits at a particular bank head to branches of the bank to get their money out as quick as possible.

It often follows a rumour about problems with the bank and can lead to a self fulfilling prophecy.

Large numbers of people withdraw money. This can cause liquidity problems at the bank which in turn causes more concern which leads to more people rushing to withdraw their money which leads to liquidity problems with leads to….. and so on until a vicious circle develops.

A bank makes its money from lending.

If it just keeps depositors money without using the deposits to generate revenue by for example lending to borrowers then the bank is in effect just a safe deposit box for the deposits.

In the great depression of the 1930s sudden withdrawals by panicky depositors caused liquidity problems to such an extent that a number of healthy banks were forced to close.

Nowadays, as long as the bank is solvent, any short term liquidity problems should be resolved by borrowing cash from its central bank as a “lender of last resort”.

Bank runs can still happen though and last week the queues of people outside of BBVA bank in Madrid caused rumours that resulted in the share price falling sharply.

It took a while for the markets to identify what was going on and it wasn’t so much a bank run that was causing the queues but rather a “fun run”

There was a 10km fun run sponsored by BBVA and joggers were queuing up to get their race numbers and t-shirts from the bank for the run on the Sunday.

Unfortunately rumours quickly spread around the financial markets that there were large queues outside the bank and in the jittery post financial crisis atmosphere the share price plummeted by nearly 4%.

Luckily a hour or so later the markets realised that the bank withdrawals were race t-shirts rather than cash and the share price recovered.

Finally, to test your knowledge of the financial markets there are two pictures in this blog entry. One shows a bank run whilst the other shows a fun run. Can you tell the difference…

Forget the sunshine, the beaches and the fantastic food – if you live in Australia sell your house and move to America…

Published on: 11 Aug 2010

Asset valuation is a tricky business.  It is, however, a skill that accountants are often commissioned to use.  It’s also a useful one to have when making personal decisions, such as whether to buy a home or not.

Some people would argue that a major driver of the current economic slump in many countries is the collapse of house prices.

In a number of countries, house price bubbles were enormous.  There are lots of motivations for buying a home; principally as a place to live, a store of value for the future; certainty come retirement (when the mortgage is paid off so housing costs drop only to be maintenance).

Another motive has been speculation.  In my opinion, speculation in house prices is a bad thing, since it drives up house prices.  This means that new houses are not affordable for the young.  The more that house prices go up, the greater the transfer of wealth from the economically active young to the less economically active old.

Unsustainably high house prices cause uncertainty in an economy and when a crash eventually happens, it can cause people to be locked into homes with loans greater than the value of the asset (negative equity).  As well as a source of human misery, negative equity reduces labour mobility, which is bad for the economy as whole.

The Economist newspaper tracks house prices in different countries, using a method based on rental yields.  The assumption here is that rental markets react more readily to underlying supply and demand conditions.  If one had $500,000 to invest, would one use it to buy a house which could then be rented out, or buy other investments such as bonds?  If the rental yield (rent / initial value x 100) is less than the yield on bonds, then the house price is overvalued.  It’s a simple enough methodology that can give some revealing results.

A couple of years ago, this analysis suggested that UK property prices were 35% overvalued.  A crash followed.  There have been property crashes and recession in many countries where speculation is a big motive to buy property.  The alarming thing is that a recent analysis (Economist 10 July, page 75) revealed that properties are under and overvalued in certain countries:

UK: 33.8% overvalued (following a hard-to-explain recovery in house prices)
USA: 6.5% undervalued
Spain: 50.4% overvalued
Australia: 61.1% overvalued
Germany: 14.5% undervalued
Ireland: 15.7% overvalued.

This may be poor news indeed for the economy of countries with very overvalued property.  With these sorts of valuations, mortgages may become unaffordable the moment that interest rates rise to above the rock bottom levels we have at the moment.  This could release very big downward forces in the economy and dampen out any economic recovery.

On the plus side, the USA looks to have reacted quickly, albeit brutally, to the changed economic circumstances and it might be a good time to sell your home in Australia (cash out your investment while it’s arguably overvalued) and buy somewhere in America.  If you can get a visa.  Oh, and a mortgage!

Do you know your cost of capital?

Published on: 26 Sep 2009

The other day I was talking to a few local business owners and I asked them if they knew what their cost of capital was. I got a few blank stares.

When we discussed the issue further, people started to warm up to the idea that the cost of capital can be viewed in terms of opportunity costs:

1. One owner said his cost of capital was the interest rate on his bank loans. I suppose he was 100% debt financed and probably not planning to refinance any time soon! Good luck to him!

2. A second owner said he took out all his savings from the bank and put it into his business. Since the bank deposit rate was so low, he figured his opportunity cost was pretty low as well. He has a point, though he must realize that he has moved into a higher risk category by withdrawing his money from the bank and investing it in a start-up business.

3. Another business owner said he started his company by borrowing from his relatives. Since they haven’t asked for it back he assumes its cost is zero. But he does pay a price, I suppose: at family gatherings he gets dirty looks from his relatives and his wife gives him constant grief. He suspects that the relatives complain about him to his wife.

Since all three owners want to expand their businesses, they asked me if I could recommend new sources of finance. I thought of sending them to our P4 candidates (after the exam!).

The ExP Group