The Motley Fool: Every Sunday, useful tips on investing
Q: What does the “time value of money” mean?
A: It refers to how money’s value changes over time. Imagine being offered a dollar today or a dollar in 10 years. Naturally, you’d prefer the dollar today.
You could invest it and it would grow to more than a dollar in 10 years. Or you might buy a loaf of bread with it. In 10 years, owing to inflation, a dollar will probably buy only a few slices of bread.
Stock analysts consider the time value of money when they use fancy “discounted cash flow” (DCF) analysis to estimate the value of companies. (Warning: This is complicated, but useful to know.)
They create DCF models, estimating how much cash a firm will generate over time. Future earnings are then “discounted,” at a rate that can be tricky to determine.
As a simplified example, imagine that a company will earn $5 next year and you’re discounting that at 10 percent. Take 1 and add 0.10 (for the 10 percent), getting 1.10. Now divide $5 by 1.10 and you’ll get $4.55. So the “present value” of those future earnings is $4.55.
Q: Do strategies such as selling in May and reinvesting in October make sense? Rules of thumb like this confuse me, as I have a long-term focus.
A: What you’re describing is a form of market timing, which can be risky. After all, there’s no way to know exactly when to get out or get in, and you might miss a big run-up while on the sidelines.
Instead, stick to that long-term focus and aim to hang on to great companies for many years.
Dear Fool: I would call Extreme Networks my dumbest investment. Why? Well, while working for a telecom carrier, I came in contact with their products (Ethernet network switches) and found them to be very advanced.
Based on my experience in the field, I bought in on Extreme — my first stock purchase, ever.
The stock didn’t do much for about half a year, so I sold 90 percent of my holdings for a mere 2-cent gain per share.
Shortly afterward, the announcement came that Extreme Networks purchased Enterasys. The stock skyrocketed. The remaining shares are now the best performing ones in my portfolio.
The Fool responds: You were smart to seek promising investments within your field of familiarity, but investing success often requires patience, as well.
When a stock is stalled, but you still have confidence in the company’s health and long-term growth prospects, hanging on is often the best.
It can sometimes take a while for a stock’s current value to catch up to its intrinsic value. If you doubt a company’s future, though, it’s smart to seek alternative investments in which you have more faith.
Social media darling Twitter (NYSE: TWTR) debuted on the stock market via an initial public offering (IPO) on Nov. 7. Interest in it has been great, but is it a stock to buy now? Opinions differ.
Twitter is attractive to many for its growth prospects. It has been growing its revenue (mostly from advertising) at triple-digit rates lately, and its profit margins are growing.
Its business is rather capital-light, too, as it can expand without building expensive new factories or stores, or having to hire gobs of new workers.
Hopes are high for international expansion, although the majority of Twitter’s users already come from abroad and contribute only about a quarter of its revenue.
On the other hand, keep in mind that Twitter is still unprofitable, and that its recent valuation is quite lofty. Rapid growth rates do decline over time, and its growth in U.S. users is already slowing. Much of its potential lies in how well it monetizes its users.
A sensible approach with Twitter, as with many freshly minted stocks, is to wait for the dust to settle, as high-flyers often come down to earth, at least for a while. Aim to buy only when the stock seems to be valued at significantly less than you think it will be worth in the future.