Tuesday, August 9, 2016

What Is Dollar Cost Averaging?

When you buy shares at different prices on various dates the result is an amazing thin called the 'Dollar Cost Averaging' having a profound impact on your portfolio and returns on your investments.

Dollar cost averaging is a nice sounding term for a simple concept of weighted average cost. let us see the example from our educational portfolio 'Portfolio 2K15'.

The ‘Dollar Cost Averaging’ is done only a way of Reporting. Your port folio shows the average holding cost at a glance for your convenience. However when you click on the name of the scrip the detailed page opens showing the various purchases on the various dates at various prices. Therefore I would say that the actual data and records remain intact and only in the report the holdings are dollar cost averaged.

If we examine my favourite scrip NMDC Ltd., in April 2016 we are holding 444 shares at weighted average holding cost of Rs.107.58. If we go deeper into the detailed purchases on various dates it will look as shown in the following table:

We can see that beginning with a price of Rs.130.48 in March, 2015 when the market was high, we were able to buy the shares at as low a price as Rs.81.35.

The beauty of dollar cost averaging is that over a very, very long period of time of say three to four decades, one is able to purchase the scrips at various levels, from very low and the weighted average cost is optimal, making timing the market, which is extremely difficult, irrelevant.

The second advantage is one can achieve spectacular dividend yield through dollar cost averaging. NMDC is quite generous in paying dividends and the yield is generally 10%, which on a tax free basis is simply superb. Suppose after 20 years the price of the share is Rs.800 and the dividend yield at that time is 10% it means the company paid a dividend of Rs.80 per share. Such a dividend on the 444 shares purchased at an average cost of Rs.107.58 is yield of 74.36% per annum. If you consider the capital appreciation, your 444 shares bough at and average Rs.107.58 are valued Rs.800 apiece, giving a return of 643% in twenty years. 

From the above it becomes clear how Riches are built on stock markets through prudent investments over long periods of time through dollar cost averaging. 

What are the rules of thumb for investing a lump sum amount into a mutual fund?

There are only two rules for selecting the right mutual fund and one rule after investing, as follows:
Rules for selecting the right mutual fund are:
  1. The fund shall be sponsored by a large and well established organisation that one can reasonably be sure of to be existing for the next hundred years without becoming bankrupt.
  2. The total fund management charges should be as small as possible.
After you have invested your money, the only rule you MUST follow is just the leave the investment undisturbed for the next thirty to fifty years. You may make further investments but should never sell.
If you cant think of such long term horizon please do not call it investment; call it justsavings. Further, for the purpose of savings, mutual fund is not the right instrument. A fixed deposit with the bank is the right option.
Any mutual fund investment can give stellar results only after a very, very long period. Why so? Please read the important Is the Stock Market a Place to Make a Fast Buck?.

How to Find the Fair Price of Stock?

Value Investing is about determining the fair price of stock, comparing the value with the stock price and trying to buy the stock below its intrinsic value when the markets are depressed or not very enthusiastic about that specific stock. So, this is the short answer to the question, "how to find the fair price of stock?"

There are Three Essential Ingredients in Determining the Fair Price of Stock as follows:

  1. Earnings Per Share: Reducing the earnings (net profit) of the company to the level of a single share.
  2. Book Value Per Share: Bringing down the net assets of the company again to the single share.
  3. Current Market Price (CMP) of the Share: This is the price at which the share is presently trading in the stock market.

Three ingredients to determine fair price of stock

Three Golden Ratios to determine Fair Value of Stock

 Therefore, from the above-described three ingredients, we can derive three valuable ratios or proportions for determining the fair value of stocks, as follows: 
  1. Price to Earnings (PE) Ratio: This ratio indicates at how many times the earnings the share is trading in the market. A positive number of up to 15 is reasonable and fair.
  2. Price to Book Value (P2BV) Ratio: This ratio reveals how many times the net assets of the company are trading on the stock exchange. I recommend a P2BV ratio of 1.50. This means that you can pay a maximum of 1.5 times the net assets as the price.
  3. Combined PE*P2BV Ratio: You obtain this ratio by multiplying the PE and P2BV ratios. Benjamin Graham recommends the number below 22.5 (15*1.5). Any positive number below 22.5 is fair.

three golden ratios to determine fair price of stock

Fixing the Fair Price of a Stock:

We have already determined the fair value of the stock. What remains is deciding what price to pay for the stock. It is quite obvious that once we know the value, deciding the price is quite easy; we simply would like to pay the lowest possible below the fair value, if the stock is available or someone is willing to sell at such a price.

What if the market price of the stock is above its fair value?

There are two possible scenarios as follows:
  1. The price of the share is slightly higher than its fair value - the PE Ratio is 16 or the P2BV Ratio is 1.65 - this means the stock is trading at a slight premium
  2. The price of the stock is steeply higher than the intrinsic value - this means the share is expensive.
What investment decisions should we make in the present situation?
Let us examine the following live example of stocks of two companies:

table showing calculation of fair price of stocks, three in number

All the three companies, SJVN and MOIL and Gillette India are excellent companies and worth buying. However as on 14th July 2017,  you can buy SJVN shares at a fair price, MOIL is slightly expensive and Gillette India shares are highly expensive. You can buy SJVN shares without any hesitation, MOIL share with the crib as it is slightly pricey and Gillette India, though is a wonderful company, its shares are highly expensive and should not be bought.

Suggested Further Reading


Valuation of shares is both an art and a science. The answer to the question, "How to Find the Fair Price of Stock?" is closely linked to the share's intrinsic value. You will never find stock prices exactly matching their intrinsic value. But if the price is at par or below or slightly above the inherent value the price is fair.  If the price far exceeds its intrinsic value, the stock is expensive. It is important to buy stocks only at a fair price.

Is the Stock Market a Place to Make a Fast Buck?

I have met in my long consulting career of about three decades many people who believe that the ‘Stock market’ is the place to make a fast buck – a place where one can become rich quickly. I have also met an equal number of people who is convinced that stock market is the most dangerous place on the earth, and that it is meant solely for gamblers and speculators and certainly not for investors. I can state with conviction that both the extreme views are far from the truth.

Playing the stock markets is certainly not the get-rich-quick solution. On the other hand those who enter with such a notion are sure to burn their fingers. Of course there are a few exceptional examples of individuals who have consistently made successful bets on stocks, currencies and commodities, but these examples do not hold good for most of the large number of speculators indulging in day trading. Those who had made quick gains a few times should attribute the success only to pure luck; they are bound to run out of lady luck soon and are face the unpleasant consequences.

Stock market is also a place where through prudent, disciplined and sustained investments, spectacular wealth can be built over very, very long periods of time, spanning two to four decades.

Why is it that there are no shortcuts to wealth creation? What are the essential ingredients of wealth creation?

Essentially there are two key factors behind wealth creation: natural growth in companies and secondly by the operating of the compounding effect.

Natural Growth:
Companies that supply goods and render services in an innovative and efficient manner are bound to prosper and consequently the long term investors owning the shares of such companies are also bound to prosper through regular dividends received during the long period of investment and appreciation in the market price of the shares, on the back of growth in the ‘Earnings Per Share (EPS)’.

The amazing results of compounding were discovered and propounded by Albert Einstein. The ‘Miracle of Compounding’ works only over long periods of time and especially the spectacular results start occurring at the fag end of the very long period. Being a natural law like any other law of physics it operates at its own pace as per its own nature – there are absolutely no shortcuts.

To conclude, one cannot consistently make a fast buck playing on the stock markets, but through disciplined investments one can build significant wealth over very long time.