FYI:Amazon.com Inc. (AMZN)https://www.stock-analysis-on.net/NASDAQ/Company/Amazoncom-Inc/DCF/Present-Value-of-FCFF
Present Value of Free Cash
Flow to the Firm (FCFF)
In discounted cash flow
(DCF) valuation techniques the value of the stock is estimated based upon
present value of some measure of cash flow. Free cash flow to the firm (FCFF)
is generally described as cash flows after direct costs and before any
payments to capital suppliers.
Look for a
quality rating that is average or better. You dont need to
find the best quality companiesaverage or better is
fine. Benjamin Graham recommended using Standard & Poors
rating system and required companies to have an S&P Earnings and Dividend
Rating of B or better. The S&P rating system ranges from D to A+. Stick
to stocks with ratings of B+ or better, just to be on the safe side.
VALUE CRITERIA #2:
advised buying companies with Total Debt to Current Asset ratios of less than
1.10. In value investing it is important at all times to invest in companies
with a low debt load. Total Debt to Current Asset ratios can be found in data
supplied by Standard & Poors, Value Line, and
many other services.
VALUE CRITERIA #3:
Current Ratio (current assets divided by current liabilities) to find
companies with ratios over 1.50. This is a common ratio provided by many
VALUE CRITERIA #4:
four is simple: Find companies with positive earnings per share growth during
the past five years with no earnings deficits. Earnings need to be higher in
the most recent year than five years ago. Avoiding companies with earnings
deficits during the past five years will help you stay clear of high-risk
VALUE CRITERIA #5:
Invest in companies with price to earnings
per share (P/E) ratios of 9.0 or less. Look for companies that are
selling at bargain prices. Finding companies with low P/Es usually eliminates
high growth companies, which should be evaluated using growth investing techniques.
VALUE CRITERIA #6:
companies with price to book value (P/BV) ratios less than 1.20. P/E ratios,
mentioned in rule 5, can sometimes be misleading. P/BV ratios are calculated
by dividing the current price by the most recent book value per share for a
company. Book value provides a good indication of the underlying value of a
company. Investing in stocks selling near or below their book value makes sense.
VALUE CRITERIA #7:
in companies that are currently paying dividends. Investing in undervalued
companies requires waiting for other investors to discover the bargains you
have already found. Sometimes your wait period will be long and tedious, but
if the company pays a decent dividend, you can sit back and collect dividends
while you wait patiently for your stock to go from undervalued to overvalued.
last thought. We like to find out why a stock is selling at a bargain
price. Is the company competing in an industry that is dying? Is the company
suffering from a setback caused by an unforeseen problem? The most important
question, though, is whether the companys problem
is short-term or long-term and whether management is aware of the problem and
taking action to correct it. You can put your business acumen to work to
determine if management has an adequate plan to solve the companys current problems.
For class discussion:Times have changed. Mr.
Granhams book about value investing
was published sixty years ago. Do you think the criteria in his book are
still working in todays
For class discussion: Why do interest rates
change daily? Who determines interest rate?
interest rates are determined by the
Federal Open Market Committee (FOMC), which consists of seven governors of the
Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC
meets eight times a year to determine the near-term direction of monetary
policy and interest rates.
Interest rates are the cost of borrowing
money. They represent what creditors earn for lending you money. These
rates are constantly changing, and differ based on the lender, as well as
your creditworthiness. Interest rates not only keep the economy functioning,
but they also keep people borrowing, spending, and lending. But most of us
don't really stop to think about how they are implemented or who determines
them. This article summarizes the three main forces that control and
determine interest rates.
Interest rates are the cost of borrowing money and
represent what creditors earn for lending money.
Central banks raise or lower short-term interest rates to
ensure stability and liquidity in the economy.
Long-term interest rates are affected by demand for 10-
and 30-year U.S. Treasury notes.
Low demand for long-term notes leads to higher rates, while
higher demand leads to lower rates.
banks also control rates based on the market, their business needs, and
Interest Rates: Central Banks
In countries using a centralized banking model, short-term
interest rates are determined by central banks. A government's economic
observers create a policy that helps ensure stable prices and liquidity.
This policy is routinely checked so the supply of money within the economy is
neither too large, which causes prices to increase, nor too small, which can
lead to a drop in prices.
In the U.S., interest rates
are determined by the Federal Open
Market Committee (FOMC), which consists of seven governors of
the Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC
meets eight times a year to determine the near-term direction of monetary
policy and interest rates. The actions of central banks like the Fed affect
short-term and variable interest rates.
If the monetary policymakers
wish to decrease the money supply, they will raise the interest rate, making
it more attractive to deposit funds and reduce borrowing from the central
bank. Conversely, if the central bank wishes to increase the money supply,
they will decrease the interest rate, which makes it more attractive to
borrow and spend money.
The Fed funds rate affects the prime ratethe
rate banks charge their best customers, many of whom have the highest credit
rating possible. It's also the rate banks charge each other for overnight
prime rate remained at 3.25% between Dec. 16, 2008 and Dec. 17, 2015, when it
was raised to 3.5%.
Interest Rates: Demand for Treasury Notes
Many of these rates are independent of the Fed funds rate,
and, instead, follow 10- or 30-year Treasury note yields. These yields depend
on demand after the U.S. Treasury Department auctions them off on the market.
Lower demand tends to result in high interest rates. But when there is a high
demand for these notes, it can push rates down lower.
If you have a long-term fixed-rate mortgage, car loan, student
loan, or any similar non-revolving consumer credit product, this is where it
falls. Some credit card annual percentage rates are also affected by these
These rates are generally lower than most revolving credit
products but are higher than the prime rate.
Many savings account rates are also determined by long-term
Rates: Retail Banks
banks are also partly responsible for controlling interest rates.
Loans and mortgages they offer may have rates that change based on several
factors including their needs, the market, and the individual consumer.
For example, someone with a lower credit score may be at a
higher risk of default, so they pay a higher interest rate. The same applies
to credit cards. Banks will offer different rates to different customers, and
will also increase the rate if there is a missed payment, bounced payment, or
for other services like balance transfers and foreign exchange.
Normal Yield Curve
When bond investors expect the economy to hum along at normal rates of growth
without significant changes in inflation rates or available capital, the
yield curve slopes gently upward. In the absence of economic disruptions,
investors who risk their money for longer periods expect to get a bigger
reward in the form of higher interest than those who risk their money for
shorter time periods. Thus, as maturities lengthen, interest rates get
progressively higher and the curve goes up.
Economy is improving
Typically the yield on 30-year Treasury bonds is three percentage points
above the yield on three-month Treasury bills. When it gets wider than that
and the slope of the yield curve increases sharply long-term bond holders
are sending a message that they think the economy will improve quickly in the
Inverted Curve Recession
At first glance an inverted yield curve seems like a paradox. Why would
long-term investors settle for lower yields while short-term investors take
so much less risk? The answer is that long-term investors will settle for
lower yields now if they think rates and the economy are going even lower
in the future. They're betting that this is their last chance to lock in
rates before the bottom falls out.
or Humped Curve
To become inverted, the yield curve
must pass through a period where long-term yields are the same as short-term
rates. When that happens the shape will appear to be flat or, more commonly,
a little raised in the middle.
Unfortunately, not all flat or humped curves
turn into fully inverted curves. Otherwise we'd all get rich plunking our
savings down on 30-year bonds the second we saw their yields start falling
toward short-term levels.
On the other hand, you shouldn't discount a
flat or humped curve just because it doesn't guarantee a coming recession.
The odds are still pretty good that economic slowdown and lower interest
rates will follow a period of flattening yields.
Inflation and interest rates are often linked and frequently
referenced in macroeconomics.
Inflation refers to the rate at which prices for goods and services rise. In
the United States, the interest rate, or the amount
charged by a lender to a borrower, is based on the federal
funds rate that is determined by the Federal Reserve
(sometimes called "the Fed").
By setting the target for the federal funds rate, the Fed has
at its disposal a powerful tool that it uses to influence the rate of
inflation. This tool enables the Fed to expand or contract the money supply
as needed to achieve target employment rates, stable prices, and stable economic
There is an
inverse correlation between interest rates and the rate of inflation.
In the U.S, the
Federal Reserve is responsible for implementing the country's monetary
policy, including setting the federal funds rate which influences the
interest rates banks charge borrowers.
when interest rates are low, the economy grows and inflation increases.
Conversely, when interest rates
are high, the economy slows and inflation decreases.
The Inverse Correlation Between Interest
Rates and Inflation
Under a system of fractional
reserve banking, interest rates and inflation tend to
be inversely correlated. This relationship forms one of the central tenets of
contemporary monetary policy: Central banks manipulate short-term
interest rates to affect the rate of inflation in the economy.
The below chart demonstrates the inverse correlation between
interest rates and inflation. In the chart, CPI refers to the Consumer
Price Index, a measurement that tracks changes in prices. Changes
in the CPI are used to identify periods of inflation and deflation.
In general, as interest rates are reduced, more people are
able to borrow more money. The result is that consumers have more money to
spend, causing the economy to grow and inflation to increase.
The opposite holds true for rising
interest rates. As interest rates are increased, consumers tend to
save as returns from savings are higher. With less disposable
income being spent as a result of the increase in
the interest rate, the economy slows and inflation decreases.
To better understand how the relationship between inflation
and interest rates works, it's important to understand the banking system,
theory of money, and the role interest rates play.
The world currently
uses a fractional reserve banking system. When someone deposits $100 into the
bank, they maintain a claim on that $100. The bank, however, can lend
out those dollars based on the reserve
ratio set by the central bank. If the reserve ratio is 10%,
the bank can lend out the other 90%, which is $90 in this case. A 10%
fraction of the money stays in the bank vaults.
As long as the
subsequent $90 loan is outstanding, there are two claims totaling $190 in the
economy. In other words, the supply of money has increased from $100 to $190.
This is a simple demonstration of how banking grows the money supply.
Quantity Theory of Money
In economics, the
quantity theory of money states that the supply
and demand for money determines inflation. If the money
supply grows, prices tend to rise, because each individual piece of paper
becomes less valuable.
Hyperinflation is an
economic term used to describe extreme inflation where price increases are
rapid and uncontrolled. While central banks generally target an annual
inflation rate of around 2% to 3% as an acceptable rate for a healthy
economy, hyperinflation goes well beyond this. Countries
that experience hyperinflation have an inflation rate of 50%
or more per month.
Interest Rates, Savings, Loans, and
The interest rate acts
as a price for holding or loaning money. Banks pay an interest rate on
savings in order to attract depositors. Banks also receive an interest rate
for money that is loaned from their deposits.
When interest rates
are low, individuals and businesses tend to demand more loans. Each bank loan
increases the money supply in a fractional reserve banking system. According
to the quantity theory of money, a
growing money supply increases inflation. Thus, low interest
rates tend to result in more inflation. High interest rates tend to lower
This is a very
simplified version of the relationship, but it highlights why interest rates
and inflation tend to be inversely correlated.
The Federal Open Market Committee
The Federal Open
Market Committee (FOMC) meets eight times each year to review
economic and financial conditions and decide on monetary
policy. Monetary policy refers to the actions taken that affect
the availability and cost of money and credit. At these meetings, short-term
interest rate targets are determined.
indicators such as the Consumer
Price Index (CPI) and the Producer
Price Indexes (PPI), the Fed will establish interest rate
targets intended to keep the economy in balance. By moving interest rate
targets up or down, the Fed attempts to achieve target employment rates,
stable prices, and stable economic growth. The Fed will raise interest rates
to reduce inflation and decrease rates to spur economic growth.
Investors and traders
keep a close eye on the FOMC rate decisions. After each of the eight FOMC
meetings, an announcement is made regarding the Fed's decision to increase,
decrease, or maintain key interest rates. Certain markets may move in advance
of the anticipated interest rate changes and in response to the actual
announcements. For example, the U.S. dollar typically rallies in response to
an interest rate increase, while the bond
market falls in reaction to rate hikes.
December's inflation rate was the lowest since
Analysts said it raised the chances of a rate cut,
with inflation below the Bank of England's target of 2%.
"Very soft UK inflation data for December
leaves the door wide open for a Bank of England rate cut on 30 January,"
said Melissa Davies, an economist at stock broker Redburn.
The Bank's main interest rate is used by banks and
other lenders who set borrowing costs.
It affects everything from mortgages to business
loans and has a big effect on the finances of individuals and companies.
who spend their working lives trying to anticipate moves in interest rates
are convinced of it today: the Bank of England is likely to cut the official
interest rate when it meets later this month. Market indicators suggest a 60%
chance of it happening.
Here's the thinking: at 1.3%, the official measure of consumer price
inflation in the year to December was lower than expected and well below the
2% target. With the economy barely growing (even shrinking if you are
prepared to rely on the official November estimate of a 0.3% contraction)
there's little sign of inflationary pressure in the near future.
Granted, there was a sharp rise in the price of
crude oil - a barrel was up 4.9% in the month and 17.4% on the year. But in
spite of that, producers were still paying slightly less for their raw materials
and supplies than they were last year.
The assumption has been that the November
contraction was a temporary period of weakness induced by pre-election
political uncertainty - and that there will be a recovery as businesses and
consumers regain a new-found confidence to spend and invest.
The risk the MPC will have to contend with is
that that hoped-for post-election recovery does not materialise.
Wednesday, Michael Saunders, one of the rate setters on the Bank's Monetary
Policy Committee (MPC), reiterated his view that borrowing costs should be
"It probably will be appropriate to
maintain an expansionary monetary policy stance and possibly to cut rates
further, in order to reduce risks of a sustained undershoot of the 2%
inflation target," he said.
Last week, two other rate setters and Bank
governor Mark Carney also suggested that rates could be cut, depending on how
the economy performs.
members of the MPC could take the latest inflation figure with a pinch of
salt, said Samuel Tombs, chief UK economist at Pantheon Macroeconomics.
"Half of the decline in the headline rate
was driven by a sharp fall in volatile airline fares inflation," he
He expects inflation to rise to 1.6% in the
first three months of 2020, and this could mean enough MPC members will
decide to wait rather than voting to cut rates.
Emma-Lou Montgomery, associate director for
personal investing at money manager Fidelity International, said the
inflation data painted a bleaker picture for the UK economy than before.
"Today's UK CPI figures simply add to the
growing sense of unease many feel when considering the outlook for the UK
economy, with the rate of inflation continuing to lag well below the Bank of
England's target of 2%."
A cut would ease the finances of borrowers, but
create a tougher environment for savers, she added.
Chapter 6 Interest rate Part II: Term
Structure of Interest rate
theory attempts to predict what short-term interest rates will be
in the future based on current long-term interest rates. The theory suggests
that an investor earns the same amount of interest by investing in
two consecutive one-year bond investments versus investing in one two-year
bond today. The theory is also known as the "unbiased expectations
Understanding Expectations Theory
expectations theory aims to help investors make decisions based
upon a forecast of future interest rates. The theory uses long-term rates,
typically from government bonds, to forecast the rate for short-term bonds.
In theory, long-term rates can be used to indicate where rates of short-term
bonds will trade in the future (https://www.investopedia.com/terms/e/expectationstheory.asp)
By CHRIS B.
MURPHY Updated Apr 21, 2019
Example of Calculating Expectations Theory
Let's say that the present bond market provides
investors with a two-year bond that pays an interest rate of 20% while a
one-year bond pays an interest rate of 18%. The expectations theory can be
used to forecast the interest rate of a future one-year bond.
first step of the calculation is to add one to the two-year bonds interest rate. The result is 1.2.
next step is to square the result or (1.2 * 1.2 = 1.44).
the result by the current one-year interest rate and add one or ((1.44 /
1.18) +1 = 1.22).
calculate the forecast one-year bond interest rate for the following
year, subtract one from the result or (1.22 -1 = 0.22 or 22%).
In this example, the investor is earning an equivalent return
to the present interest rate of a two-year bond. If the investor chooses to
invest in a one-year bond at 18% the bond yield for the following years bond would need to increase to 22% for this investment
to be advantageous.
Expectations theory attempts to
predict what short-term interest rates will be in the future based
on current long-term interest rates
The theory suggests that an investor
earns the same amount of interest by investing in two
consecutive one-year bond investments versus investing in one two-year
In theory, long-term rates can be
used to indicate where rates of short-term bonds will trade in the
Expectations theory aims to help investors make
decisions by using long-term rates, typically from government bonds, to
forecast the rate for short-term bonds.
Disadvantages of Expectations Theory
Investors should be aware that the expectations
theory is not always a reliable tool. A common problem with using the
expectations theory is that it sometimes overestimates future short-term
rates, making it easy for investors to end up with an inaccurate prediction
of a bonds yield
Another limitation of the theory is that many
factors impact short-term and long-term bond yields. The Federal Reserve
adjusts interest rates up or down, which impacts bond yields including
short-term bonds. However, long-term yields might not be as impacted because
many other factors impact long-term yields including inflation and economic
growth expectations. As a result, the expectations theory doesn't take into
account the outside forces and fundamental macroeconomic factors that drive
interest rates and ultimately bond yields.