DCF Analysis continued – II

This is part II of the article DCF Analysis continued – I. Please read the article from the first part before continuing with this one

Now, let’s be a bit more practical. All your investments can never be positive. Hence, let’s introduce some negative returns also, but ONLY in 2 of the stocks.

Start Date	01-Jan-05	Investment Period		3 years
End Date	31-Dec-07	Interest Rate		9%	Present Value of
A	B	C	D	E	F	G
Date	Stock	Buy	Sold	Annualized time	PV-Buy	PV-Sold
01-Jan-05	Microsoft	(1,000.00)		-	(1,000.00)	-
03-Mar-05	GS	(200.00)		0.17	(197.14)	-
01-Dec-05	Google	(4,000.00)		0.92	(3,696.68)	-
10-Feb-06	Microsoft		800.00	1.11	-	727.05
11-Jul-06	Exxon	(5,000.00)		1.52	(4,384.89)	-
13-Sep-06	Amazon	(2,000.00)		1.70	(1,727.65)	-
19-Sep-06	AMX	(3,000.00)		1.72	(2,587.81)	-
28-Dec-06	GS		600.00	1.99	-	505.49
05-Jan-07	AMX		3,600.00	2.01	-	3,027.19
09-Jun-07	Google	(5,000.00)		2.44	(4,053.34)	-
10-Oct-07	Google		6,000.00	2.77	-	4,724.79
11-Oct-07	Exxon		5,500.00	2.78	-	4,330.03
31-Dec-07	Amazon		2,100.00	3.00	-	1,621.97
Total		(20,200.00)	18,600.00		(17,647.52)	14,936.51
Net (Sold-Buy)			(1,600.00)			(2,711.01)
Net % Return			-7.92%			-15.36%
Annualized % Return			-2.71%			-5.41%

As you can observe, the two stocks Microsoft and Google are now having negative returns -EVERYTHING else is exactly the same. For Microsoft and Google as well, the returns are negative to the same extent – only the sign is changed from positive to negative (as can be seen from the table below):

	Buy	Sell	% Profit
Microsoft	-1000	800	-20.00%
GS	-200	600	200.00%
Google	-9000	6000	-33.33%
Exxon	-5000	5500	10.00%
AMX	-3000	3600	20.00%
Amazon	-2000	2100	5.00%
TOTAL	-20200	18600	-7.92%

Hence, in conclusion:

When the returns are negative even with one or two stocks, the overall profit percentage goes down. We see that the annualized DCF profit percentage has come down to -5.41%. This means that your highly diversified portfolio has performed worse than the risk free bank accounts. If the bank account offered 9% return, your diversified portfolio has offered you only (9% - 5.41% = 3.59% only). If such is the case, then you are better off investing in bank accounts and savings accounts, instead of creating a diversified portfolio of stocks.

Continue to Part III

DCF Analysis continued – III

This is part III of the article DCF Analysis continued – I. Please read the article from the first part before continuing with this one

Third part: Let’s increase the investment horizon as well. Initially, we were having a 3 year investment horizon 1-jan-2005 to 31-Dec-2007. Now, let’s make it 31-Dec-2008 and all the investment from year 2 onwards are shifted a year further (as follows):

Start Date	01-Jan-05	Investment Period		4 years
End Date	31-Dec-08	Interest Rate		9%	Present Value of
A	B	C	D	E	F	G
Date	Stock	Buy	Sold	Annualized time	PV-Buy	PV-Sold
01-Jan-05	Microsoft	(1,000.00)		-	(1,000.00)	-
03-Mar-05	GS	(200.00)		0.17	(197.14)	-
01-Dec-05	Google	(4,000.00)		0.92	(3,696.68)	-
10-Feb-07	Microsoft		1,200.00	2.11	-	1,000.52
11-Jul-07	Exxon	(5,000.00)		2.52	(4,022.83)	-
13-Sep-07	Amazon	(2,000.00)		2.70	(1,585.00)	-
19-Sep-07	AMX	(3,000.00)		2.72	(2,374.14)	-
28-Dec-07	GS		600.00	2.99	-	463.75
05-Jan-08	AMX		3,600.00	3.01	-	2,777.24
09-Jun-08	Google	(5,000.00)		3.44	(3,717.79)	-
10-Oct-08	Google		12,000.00	3.78	-	8,667.29
11-Oct-08	Exxon		5,500.00	3.78	-	3,971.57
31-Dec-08	Amazon		2,100.00	4.00	-	1,487.69
Total		(20,200.00)	25,000.00		(16,593.58)	18,368.06
Net (Sold-Buy)			4,800.00			1,774.48
Net % Return			23.76%			10.69%
Annualized % Return			5.47%			2.57%

Everything else is same except for the trading activities from 2^nd year onwards have been shifted down a year further, so that the effective investment horizon is 4 years.

As we can see, the effective annualized rate of return has come down to just 2.57% as compared to 4.3% with our initial figure. Hence increasing the horizon also reduces the effective net return.

Then, what is the point in telling that we only look at the amount of money we get on our investment (and forget about the time value of money)? Increase the investment horizon to 5, 6 years and beyond, the same return value will come to negative.

If you have to forget the time value of money, then why not consider the bank accounts in which the money is doubled in 7, 8 or 9 years that too risk-free? Why are we playing around in the risky stock markets for speedy returns if we have to ignore the time value of money?

The fact is that investments or trading should be analyzed in real perspective. You cannot ignore the effective annual rate of return and time value of money.

Have questions, please read the comments and post your views and queries in the comments section which helps in open discussion and avoids duplicity of questions.

You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.