A firm's capital expenditures (capex) are funds that it requires to spend in order to maintain or grow its business operations. This includes, for example:

• Maintenance or upgrades to physical property: This is the amount of money which the firm is required to spend to prevent property degradation or indeed improve the quality of its store locations.
• Investment Projects: This is money which the firm spends to grow its business operations in the future. Investment projects may include the construction of warehouses, new stores, technological innovation or the building of stores.
• Expansion plans: The firm may spend money establishing joint ventures or working with business partners in different parts of the world to grow its business.

Importance of Capex

It is important to calculate how much a firm will spend on capital expenditure as this will impact its free cash flow. A firm's free cash flow is the money which it can distribute to owners after all expenses have been paid. The formula to calculate free cash flow is:

= Net income Depreciation & Amortisation – Capital Expenditures.

The amount of money of which the firm spends on capital expenditures will have a major impact on the firm's 'actual' earnings. One of the most determining factors that affect how much a firm is required to spend on capex is the industry in which it operates.

Firms which are in the credit card industry or beverage industry are considered to have low ongoing capital expenditures. There is minimal maintenance required to keep their business going. Online service businesses tend to fall into the same category, whether they provide cloud-based accounting tools, crypto casino VPN access, or digital media subscriptions. However, firms which operate in the utilities sector or oil and gas, have extremely high capital expenditures as they need to outlay large sums to maintain their business. Such businesses are generally more vulnerable to downturns in the business cycle.

Nuances related to Capex

The amount that is generally subtracted for capital expenditures is the capital expenditures required for the maintenance of the firm's operations. Investment and expansion projects will grow the firm's future earnings and are therefore not deducted as general capital expenditures. Usually, business owners will take an average of the maintenance capital expenditures in the last 4-5 which the company has incurred and subtract that from net income, depreciation & amortisation.

The post Investing tips: What is capital expenditure (Capex)? appeared first on The Motley Fool Australia.

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Depreciation is a tax deduction which takes into account the decrease in the value of an asset over time due to wear and tear and through general usage. Depreciation aims to allocate the costs of assets to periods which the assets were used i.e. over the lifespan of an asset. Businesses use depreciation for tax purposes and it reduces a business's net income, allowing it to pay lower taxes.

As depreciation reduces net income, through the loss of value of an asset over a period of time, it does not impact a business's cash flow. There is no cash involved in a depreciation charge. Depreciation is therefore often added back to calculate a firm's exact cash flow for a period.

Firms which record large depreciation charges usually operate in industries that have large capital expenditures and assets that lose significant value over time. For example businesses in the real estate industry as the quality of the building decreases significantly over time and firms which operate in the oil & gas industry as machinery experiences wear and tear and record significant depreciation charges over time.

How to calculate depreciation?

There are three methods which firms can use to calculate depreciation. These methods include:

• Straight-line depreciation: This is when an asset is depreciated in equal amounts over the course of its life-cycle. It is generally considered the most common method for recording depreciation. The formula for calculating straight-line depreciation is: (Cost-Salvage value) / useful life
• Reducing balance: This occurs as depreciation expense decreases over the life-cycle of an asset. This method enables greater levels of depreciation to be charged in the early stages of an assets life cycle.
• Sum of the years': This involves depreciating an asset as a fractional part of the sum of its years of useful life.  Similar to the reducing balance method, the sum of the year's method allows higher depreciation levels of an asset in the early years of an asset's life. This method is generally therefore only used with more valuable assets.

Conclusion

Depreciation is a key way for businesses to depreciate the assets of their useful lives. For you as an investor, it is crucial to understand exactly how firms are computing depreciation, to have the most precise and informed picture of the state of the company, which is practically possible.

The post How to calculate depreciation as an Investor? appeared first on The Motley Fool Australia.

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If you are planning for retirement or need to have some cash liquid, you might want to consider buying bonds. There exists a very large number of bonds on the market which can be purchased. The manner which returns are paid out to bondholders varies significantly. The most commonly traded bonds include:

Regular Bond Category

• Inflation-indexed bonds: These are bonds whose payments are indexed to keep up with inflation. Owners of these bonds are protected from sharp increases in the cost of living.
• Secured bonds (covered): These bonds are backed by underlying assets such as property (mortgage backed securities) and collateralized debt obligations.
• Government bonds: These are bonds issued by national governments to fund government spending such as infrastructure projects. US Treasury bonds are considered the 'safest' investments as their value is backed by the full faith and credit of the United States government.
• Municipal bonds: These are issued by states, territories or local governments for the same purpose as government bonds. Some of municipal bonds may be tax exempt.
• Fixed Rate bonds: These are 'standard' bonds which have constant coupon payments throughout their lifetimes. They are however exposed to interest rate risk and should interest rates increase the value of the bond decreases. Conversely, should interest rates decrease, bond values will increase accordingly.

Common Bond Variations

• Zero Coupon bonds: These are bonds which are issued at a discount to their face value (value at maturity) and the owner receives a premium of the purchase price at maturity. As opposed to regular bonds, there are no regular interest payments and the only gain is the capital gain. This is generally beneficial for the owner as taxes on capital gains are substantially lower than taxes on regular income.
• High yield bonds: These are otherwise known as 'junk bonds'. Bonds which are rated 'junk' have debt which is considered high risk and have a greater probability of default. These bonds are rated below investment grade by credit organisations such as Moody's/ Fitch and are not considered appropriate investments for individuals who have a low tolerance for risk. To compensate for their risk profile, these bonds offer significantly higher yields.
• Convertible bonds: These allow bondholders to exchange their bonds for a number of shares of common stock. These bonds combine debt and equity.

Conclusion

There are major variations between the different types of bonds which corporations can issue. Understanding the discrepancies between these bonds can help you as an investor to make to most informed decision possible and pick the investment bond that suits you best and helps you plan for your future.

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As an aspiring investor, it is crucial for you to learn the different types of accounting standards used globally and how they will impact your company valuation. Here are some of the differences in accounting for inventory between Australia and the United States.

Two of the most popular methods of conducting inventory accounting are the First in First Out method (FIFO) and the Last in First Out method (LIFO). The FIFO method is generally associated with International Financial Reporting Standards, while LIFO is exclusively permitted in the United States under GAAP accounting standards (https://www.ifrs.com/updates/aicpa/ifrs_faq.html question 11).

The following table demonstrates a number of the key differences between these two inventory accounting systems.

Advantages of each system

Under the FIFO method, the ending inventory is based on most recent purchases which is a better approximation of the current cost. Should the inventory purchased be subject to high levels of inflation, FIFO accounting will understate the cost of goods compared to the current base. Earnings may, therefore, be overstated and overestimate a company's 'real' income.

Under the LIFO method, as the item purchased most recently is assumed to be the first item sold, in an inflationary environment the cost of goods sold will be higher than under the FIFO method and earnings will be lower. Lower earnings enable the company to pay fewer taxes and increases the company's net cash flow. Since ending inventory is valued using the earliest costs, in an inflationary environment LIFO ending inventory is less than the actual current cost.

Why are there different inventory accounting methods?

When firms purchase and sell inventory, the cost of their products sold must be reported in the income statement under 'Cost of goods sold'. If the cost of a firm's inventory were to remain constant over time, determining the firm's cost of goods sold would be easy! However, since the cost of inventory changes over time a firm must select a cost flow formula to allocate inventory costs. Firms do have the flexibility to select more than one inventory method; however, they must select an inventory method for items of similar nature and usage.

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Bitcoin has been the subject of almost no serious analysis despite its popularity in recent years. This guide aims to explore various issues raised by virtual currency schemes including the creation of monetary value, lack of legal basis and oversight and volatility of virtual currencies.

Issues

Creation of Monetary Value

Monetary value is based on trust – if people trust something is valuable then it will have value. People's trust is linked to how credible it is that a currency is valuable and accepted as a medium of exchange.

Enduring and stable traditional currencies are credible because they are linked to things that people trust and value – Commodity money is considered intrinsically valuable, commodity-backed money is redeemable for bullion, fiat money is tied to the credibility of the central authority, and law guarantees that electronic funds are redeemable for central bank currency.

Virtual currencies are less credible. None of the preceding mechanisms exists to induce people to trust their value. The value of a virtual currency is based only on the trust gained by the virtual currency issuer.

Lack of Proper Legal Basis and Oversight

Virtual currency schemes have no framework legislation and the rights and obligations of different parties are not clear. They are not subject to regulation, oversight or supervision by central authorities. This is clearly unacceptable and creates significant risks to users as well as opportunities for criminals and money launderers.

It will be difficult for central authorities to ban or effectively regulate virtual currencies. States have uncertain jurisdiction over global virtual communities and authorities encounter difficulties even identifying the location of the owners, creators and users of these schemes. It is difficult to target crime and money laundering because online transactions are anonymous and very difficult to trace.

Volatility

 Virtual currencies tend to be volatile and prone to collapse because:

• Real currencies are affected by the performance of the real economy to which they are linked. This moderates fluctuations in their exchange rates. In contrast, the price of virtual currencies is determined solely by demand and supply in exchange markets and is more likely to fluctuate.
• Virtual currency schemes are not particularly credible. As argued above, trust in them is not supported by connection to institutions that people trust.
• They lack legal certainty and users' rights are unclear.
• They are prone to security breaches.
• They are immature.
• Low volumes of virtual currency are traded. Fluctuation can occur based on purchase or sale by only a few users.
• Some virtual currency schemes, most notably Bitcoin, are particularly volatile especially insofar as they are a vehicle for speculation.

Monetary policy in the virtual economy can be used to moderate or control the volatility of these currencies. By manipulating the supply of Linden Dollars in the market, Linden Lab manages to maintain the stability of Linden Dollars. Without such interventions, significant volatility of virtual currency seems unavoidable.

Risks Associated with Virtual Currencies

Risks for Users

 Virtual currencies have characteristics of traditional money – they act as a medium of exchange and unit of account in a virtual community. However virtual currencies are not a safe store of value and entail significant risks to users because:

• They tend to be volatile and susceptible to collapse.
• Issuers of virtual currency rely only on their own creditworthiness and are not privy to the last-resort loans of central banks.
• There is no guarantee that users can convert virtual funds to real currency. Virtual currencies have no intrinsic value – if they cannot be converted to real currency they are worthless.
• Virtual currency schemes and their creators are not subject to proper oversight and prudential requirements
• There is no proper legal basis for virtual currency schemes and accordingly, users bear all the risks of holding virtual currencies.

Potential Implications for the Real Economy

At present, virtual currencies do not impact the real economy because they are traded in limited volumes and users are spread around the world. However, these schemes are expected to continue to grow due to increasing use of the internet, virtual communities and electronic commerce. If virtual currencies were sufficiently grown to challenge traditional currencies as a medium of exchange, they could substantially impact the real economy in the following ways:

Fluctuations in virtual currencies could be transmitted via the exchange markets into the real economy. This could be a source of potential financial instability if virtual currencies were traded in substantial volumes.

If a virtual currency became widely used as a medium of exchange, they could affect central banks' ability to implement monetary policy and maintain price stability. Widespread use of virtual currency could cause the following consequences:

• The amount of central bank money required for transactions would be significantly reduced. Therefore central banks' ability to influence short-term interest rates would be diminished.
• It would be difficult for central banks to accurately measure money aggregates and the money supply and effectively target inflation.
• Transmission of central bank interest rate decisions through the economy could change which could reduce central banks' control of money and credit development.

Competition to the Central Bank Monopoly on Money Issuance

Dangers

If a virtual currency such as Bitcoin was to operate alongside national currencies in significant volumes, it could undermine the benefits of having a "single unit of account as a common financial denominator for the whole economy" Multiple units of account send multiple, possibly conflicting price signals and complicate transaction for economic decision makers. This effect is worsened insofar as exchange rates for virtual currencies are volatile.

 Theoretical Justifications

Bitcoin is designed as a challenge to central bank monopoly on money issuance. As such, Bitcoin highlights a wider theoretical debate about the nature of the monetary system. Bitcoin has theoretical foundations in two arguments of the Austrian School of Economics:

(1) The supply of Bitcoins does not depend on the monetary policy of a central bank. New Bitcoins are created through "mining" (a technical process of validating transactions by solving complex algorithms that rewards "miners" with new Bitcoins when they solve an algorithm). They are created at a predictable, decelerating pace and the supply of Bitcoins is ultimately limited to 21 million.

Austrian Economists and Bitcoin supporters argue that business cycles arise from monetary interventions of central banks. These interventions lead to an excessive increase in the money supply through the fractional reserve banking money creation process. The excessive money supply pulls down interest rates causing overinvestment and widespread imbalances in the economy. Eventually, the economy enters into recession as firms liquidate investments and change their production to match consumer preferences. The Australia School advocates a return to the gold standard arguing that the limited supply of gold would curb monetary interventions and excessive money creation. Bitcoin's limited supply is theoretically justified by analogy to the gold standard. Of course, the fixed supply of Bitcoins could also be designed to drive up its price allowing its creators, who presumably hold Bitcoins, to make super profits.

(2) Bitcoin is a starting point to undermine the central bank monopoly on money issuance. According to the economist Hayek, there should be no such monopoly and private banks should be able to issue currency. Competitive forces would eliminate unstable currencies and "a highly efficient monetary system would emerge where only stable currencies would coexist".

Despite the arguments of Bitcoin's supporters, various Austria School Economists have criticised Bitcoin's validity in the Austrian schema. They argue that Bitcoin, unlike gold, has no intrinsic value and does not have roots in a commodity expressing purchasing power. Therefore, Bitcoin does not provide the stable foundation for the monetary system that the gold standard does.

The post Bitcoin: The definitive guide appeared first on The Motley Fool Australia.

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The Cost of Capital is known as the cost of financing for a business. It is the rate at which the business can obtain capital to grow its operations and maintain its business stable. The cost of capital is usually divided into the cost of equity (through the issuing of common stock) and the cost of debt (through issuing bonds, preference shares or taking out a loan). The overall source of the cost of capital for a firm is known as its weighted cost of capital. The firm's overall cost of capital is extremely important as its operations must be able to generate returns that exceed the firm's cost of capital in order to be profitable.

Factors which influence a firm's 'Cost of Capital'

There are a number of important factors which impact the cost at which a firm will be able to obtain funding to grow its business. These include:

• The firm's credit rating: This is a credit rating provided by firms such as Moody's & Fitch which provides an objective evaluation of the company's ability to repay debt. Businesses which have a good credit rating will certainly have a lower cost of capital than those which have a bad credit rating.
• Profitability ratios: Firms which have a robust operating margin, low levels of debt and a high-interest coverage ratio, will generally have a cost of capital significantly below firms which have tighter margins and a high level of debt. This is because they are considered to be less risky to creditors and have more flexibility to meet their repayments even if the business experiences a slight downturn.
• firm's operating history: Businesses which have long histories and have been profitable for longer periods of time generally have lower costs of capital than recently established firms. A proven track record of success gives lenders confidence.
• Nature of the business: Firms which are stable rather than cyclical are generally able to obtain a lower cost of capital. This is because their operations are not seasonal or subject to regular fluctuations.

Conclusion

A firm's cost of capital is extremely important as it will impact profitability levels. Additionally, businesses which have a low cost of capital usually experience favourable operating conditions which allow them to grow the business.

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A firm's return on invested capital is a profitability ratio, which measures a business' efficiency in reinvesting profits which it has earned through its business operations. The return on the invested capital ratio is extremely important because it illustrates how effective the firm is at allocating capital and compounding profits. Using the metric of return on invested capital is particularly useful when investing for the long term as the investor can understand how effectively a business is able to generate profits on an ongoing basis.

A business with high returns on invested capital will usually be able to grow profitability over time, while businesses that have low returns on invested capital will generally be mediocre investments over the long run. Businesses which generate large amounts of free cash flow and are able to profitability reinvest funds into the business are very high-quality businesses that create large amounts of wealth for their owners. Owners of business which have a high return on invested capital are generally willing to hold their stakes for long periods of time as their wealth increases progressively.

The formula for calculating return on invested capital is:

Net income- dividends / debt + equity.

For example, a firm which lists $100,000 as net income, pays $20,000 in dividends has debt of $300,000 and equity of $80,000 has a return on invested capital of 21%.

Generating high returns on excess capital

There are a number of factors which impact a firm's ability to generate a high return on additional capital:

1)     The percentage of earnings which can be reinvested into the business: This will be impacted by the scope of the business operations and the ability which a business has to grow. How scalable are business operations? Can the business be grown in an intelligent manner?

2)         Return on investment (ROI): What are the returns that a business achieves when it reinvests into its business? Can the firm achieve returns above 15% sustainability and even increase its return.

3)         Allocation of excess capital: If the business cannot intelligently reinvest into its current operations how can it continue to create value. Could it potentially acquire other business, pay higher dividends or repurchase its own stock? This is crucial for businesses that are in a stage of maturity are reinvesting less than 100% of their retained earnings.

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A company's operating cash flow is the amount of cash which has been generated from its regular business operations. This serves as an excellent measure of the performance of the company's core business strength and how it is evolving over time. The company's operating cash flow is vital as it represents a company's ability to generate profitability, fund expansion and capital expenditures and purchase inventory going forward.

A company which is generating significant operating cash flow, usually also does not need to incur large amounts of debt as it has enough free cash flow to support its business requirements. Here are some crucial factors to understanding operating cash flow:

• Operating cash-flow includes various non-cash charges which are not counted in terms of calculating net income. This includes stock-based compensation, depreciation & amortisation and other expenses.
• Operating cash flows concentrate on cash generated by a company's main business activities. This includes selling and purchasing inventory or changes in the value of the inventory. Operating cash flows are also generated by the company's investments and accounts payable.

Importance of Operating Cash flow

There are a number of fundamental reasons why operating cash flow is extremely important in terms of calculating a firm's intrinsic earning power. These include:

• Removing accounting charges which do not accurately represent the earning power of a business. For example, adding back depreciation and amortisation helps to provide a more accurate depiction of the quality of business operations.
• Removing extraordinary earnings/losses. These are not representative of the normalised earning power of a firm and may distort the firm's net income for a given period, providing an inaccurate analysis of the business. As operating earnings measure the firm's recurring income, investors can have confidence in the ability of a firm to continue to generate significant amounts of cash flow in the future.
• Comparing revenue generated to expenses incurred. This enables a clearer picture to be developed regarding how the firm is able to generate free cash flow, which can then be distributed to shareholders.

When operating cash flow is analysed in conjunction with the firms investing and financing activities, a complete picture is able to work out how the business will evolve over time. Additionally, referring to the discussion from management provides more precise insight than simply looking at the income generated.

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A firm's interest coverage ratio reflects how easily the firm can service its interest expenses on its outstanding debt. A high-interest coverage ratio means the firm can comfortably service its debt, while a lower ratio means it is under greater pressure to meet repayments. The interest coverage ratio is calculated using the following formula:

Earnings before interest and taxes/ interest expense

The amount of debt which a firm should generally take on and the 'acceptable' interest coverage ratio depends on a number of crucial factors. These include:

• The cyclical nature of the industry: Firms which operate in industries that are highly cyclical, for example, the auto-industry/industrial goods may have a harder time serving their short-term debt during times of sustained economic downturn. Consequently, it is generally advisable that these firms take on lower levels of debt and have more manageable interest coverage ratios.
• The industry in which the firm operates: Certain industries such as the oil & gas sector have very high costs at the beginning, which gradually decrease as operations are set up. This is because large costs are often incurred with exploration, pipelines built for transport and opening refineries. However, costs decrease dramatically once operations are in 'full swing'. For these firms, the interest coverage ratio generally starts off low and increases gradually.
• The size of the firm: Larger firms do not generally require large amounts of debt to grow their operations. They usually have large cash reserves/are generating regular cash flow. Larger firms are also usually at a more mature stage in the business cycle. On the other hand, smaller firms may require taking on larger amounts of debt to promote their products and grow their business. Borrowing rates may also be higher for smaller firms. As a consequence, their interest coverage ratios may be higher and gradually decrease over time.

It is crucial for a firm to meet its short-term borrowing obligations. Not being able to service its debt may even put a very high-quality firm out of business, simply as a result of a short-term downturn. It is, therefore, crucial to undertake an in-depth analysis of the firm's interest coverage ratio and determine whether or not it is appropriate, depending on the sector it operates/the requirements and size of the firm.

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Inventory is the amount of stock a firm has of its own products. Managing inventory levels is extremely important for businesses for to maximise efficiency levels. Having either too much or too little inventory can compromise the effectiveness of the business.

Businesses which have excess inventory, for example:

• Have cash tied up in inventory which could otherwise be used to invest in other areas of the business, such as marketing & promotion or research and development.
• Are usually required to spend extra funds paying for storage, as well as maintenance of their warehouses to ensure the quality of their products.
• Risk inventory degradation and lack of demand for their existing inventory. This can be a serious problem for technology firms or businesses which store products that are very cyclical or highly sensitive to consumer tastes.
• May engage in aggressive discounting in order to clear their excess inventory. This lowers their profit margins and does not bring as much money in.
• May be required to write-down the value of their inventory as business needs evolve and the net-worth of the firm's products declines.

Conversely, businesses which have a lack of sufficient inventory face a number of serious problems including:

• Not being able to satisfy consumer demand. A lack of sufficient inventory may drive consumers to competitor products as they are unable to procure the product they desire.
• Lower confidence in the business as potential buyers are frustrated that they cannot find the correct item.
• Overpaying for current inventory. Firms which purchase inventory in very small quantities may spend proportionally more money than firms which purchase large amounts of inventory in bulk.

So what is the right level of inventory?

Generally, business inventories should increase incrementally alongside sales growth. For example, should a business forecast that sales will increase 30% in the following year, inventory levels should increase by a corresponding 30%. Firms can also engage in a number of inventory management methods, including:

• Back ordering: This involves purchasing inventory, only once an order has been placed for them.
• Just in time shipping: This involves putting orders through for new stock just before it is needed. This, however, requires highly sophisticated business operations, to ensure that there is no delay in the production.

Conclusion

Managing inventory is tricky and requires a significant amount of experience and expertise.  However, ensuring that the firm keeps an appropriate amount of stock on hand is highly beneficial for profit levels.

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• NetEase has an extremely strong business model and robust games pipeline. The company operates in an extremely consolidated sector and is perfectly positioned to profit from the secular growth in the gaming market in China.
• NetEase has strategic partnerships with Activision Blizzard, Mojang (AB) in addition to a great in-house development team. It has more diversified operations than ever and is no longer dependent on just a couple of major titles.
• NetEase has begun to develop a very strong E-Commerce business through its platforms Kaola and Yanxuan. These are still in the early stages of growth, yet the market is basically assigning no value to them.

BUY NetEase on the Pullback

NetEase is a Chinese tech company which is still unfamiliar to most in the West. This is unfortunate, as I believe NetEase is probably one of the greatest companies in the world. Its core operations revolve around video games and online advertising, though the company has also launched two E-commerce platforms, Kaola and Yanxuan which import high-end consumer goods, targeted at China's growing middle class. Finally, the company offers a range of online services and is even China's largest email provider, with over 850 million Chinese citizens using its email service.

The company is an entrenched player in the Chinese market and Ding Lei, its founder was the very first Chinese tech billionaire. What makes NetEase such a great company? Well firstly, the company has compounded its earnings at 30% annually in the last ten years. NetEase earns around 30 percent on equity while maintaining a pristine balance sheet. The company barely has debt and has actually been returning value to shareholders through periodic share repurchases and stock buybacks. I have personally owned the company's stock for the last 12 years and taken advantage of pullbacks in the market to up my stake as much as possible.

The Future Looks Bright

NetEase is fortunate enough to operate in an extremely favourable sector in one of the world's most video-game crazed markets. There are a number of fundamental reasons which explain the company's success and why the company has been such a great investment over the long run.

• NetEase has operating leverage: Most of the companies spend is the cost of developing new video games. Once a game is developed, there are basically no variable expenses which act as a burden on the bottom line. That means for NetEase, selling a million copies of a game costs basically the same amount as selling ten thousand copies.

Now you could argue that this is the same situation for all gaming companies. You would be correct in making that observation. The difference, however, is the fact that NetEase has direct access to 1.3 billion Chinese citizens, many of whom have only recently joined the middle-class. This is a massive advantage which almost no other company in the world has. NetEase is perfectly positioned to capture the Chinese middle class.

• Pricing Power: NetEase earns its money from customers through two different revenue streams, an item-based model and a time-based model. NetEase currently charges just RMB0.60 (US$0.10) for time-based games, which is still extremely cheap. The company is able to charge such low prices because it operates on such a large scale and has a massive amount of operating leverage. Over time though, as the Chinese middle classes' wealth increases, a minor increase in price will still impact the bottom line in a very positive way. The item-based model also gives NetEase the opportunity to increase the incremental spend per client, if there were to be even a slight increase in price.

Additionally, a large proportion of Netease's revenues come from monthly subscriptions. That benefits the company because it first provides a steady flow of money that can be reinvested or paid out in dividends. Subscribers are generally exceptionally loyal and this makes the entire NetEase eco-system more 'sticky'.

• High return on equity: At the time of writing, NetEase has earnt a 30 percent return on equity using barely any borrowed money. This is despite the fact that the company is still in a massive growth phase and is still far away from maximizing its economies of scale. This is outstanding for a company with a ~$36 billion dollar market cap.
• A flourishing E-Commerce platform: NetEase has launched the Kaola and Yanxuan platforms that sell high-end products directly to consumers. These platforms have grown very fast and will be a formidable source of revenue in the future, despite not making money today. I believe that the market is valuing NetEase almost entirely off its video game business, which seems too conservative. There doesn't seem to be any reason to doubt that NetEase will be able to make a significant profit in E-commerce in the future and I don't think this is priced into the security at all. In the future, this could easily be a $50 billion dollar business.

Source: NetEase Quarterly Earnings Release

• NetEase has operated in an industry with high barriers to entry. The company is 'protected' by the Chinese government. Foreign companies are limited in their ability to enter the Chinese market given government restrictions, which prevents international rivals from entering directly. Major Western companies such as Activision Blizzard, Zynga and Google, therefore, license their games to Netease which then distributes them to the Chinese market. For example, Microsoft gave Netease the license to distribute Minecraft in China, one of the most popular games of all time.

As for domestic rivals, 70 percent of the market is dominated by NetEase and Tencent, with NetEase actually having increased its market share year after year for the last 3-4 years. Despite this amazing business model and all these competitive advantages, Netease shares trade at a current price to earnings ratio of only 18, this basically implies minimal future growth: this seems very unlikely.

Conclusion

NetEase's shares have dipped in recent months, given a slight sequential decline in video game sales last quarter. However, for investors with a long-term orientation, it seems clear that the future growth of Netease is definitely not priced in the stock. Shares are a fraction higher than what I would recommend paying. In my opinion, NetEase is a Buy if the stock reaches $250 or less.

The post Should you consider NetEase on its recent price decline? appeared first on The Motley Fool Australia.

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Firm's issue debt because they think the return on their future investments will exceed their cost of borrowing. Firms invest across a range of areas, which they feel will be able to create long term, value and boost long-term earning power. Here are some of the primary reasons for issuing debt.

1. Business Expansion: Entering new markets is generally quite costly and incurs a large amount of fixed costs during the early stages of expansion. Firms may therefore issue debt in order to grow beyond their home markets and improve the long-term prospects of the business. Money spent to enter new markets is generally be recouped as firms are no longer required to outlay large amounts of money to establish themselves in the marketplace. As a business becomes familiar with a new market and grows its sales, economies of scale develop and a solid return can be earned.
2. To complete a merger/acquisition: A business might decide that acquiring a competitor or firm in a similar industry may allow it to create significant long-term value and boost its earning power, competitive operates and scope of operates. In this case, it would generally choose to issue debt in order to complete the acquisition. It is rare that firm's would have enough capital to fund an acquisition solely through equity, should the transaction be significant.
3. To fund capital expenditures/research expenses: Firm's which operate in industries that have large capital expenditures such as a the oil & gas industry or pharmaceutical industries may often issue debt to fund their capital expenditures during industry downturns, whereby they lack sufficient funding to undertake these operations. In this instance, the usage of debt is absolutely essential; otherwise the business will be unable to undertake its core activities which allow it to generate income.
4. To repurchase shares: Businesses which feel that their shares are significantly undervalued may decide to issue debt in order to repurchase their shares. Issuing debt has the advantage of being tax deductible, which means that firms are also able to profit from having a lower tax base. This strategy is most commonly used by very mature firms, with very solid business prospects.

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Return on equity is a measure of profitability, which calculates the return which a company is able to generate with its shareholders equity (cash).

It is widely considered one of the most important metrics to determine company performance and a firm's continued ability to generate satisfactory returns. Return on equity can be calculated using the following formula:

Net Income/ Shareholders Equity

A firm earning $10,000 per year with $100,000 shareholders capital invested would be earning 10% on equity.

Why is return on Equity Important?

A high return on equity means that a business is able to reinvest funds into the business to grow operating earnings without requiring additional equity (cash) from their shareholders. It means that the business will be less dependent on borrowing money as they earn consistent high returns on their initial investment. The return on equity metric enables an investor to gain insight into the performance of a company as it can be seen how a company manages its money, including every year's prior savings (retained earnings). It also enables an investor to assess how successful the firm is at investing its money into other business segments, which often deviate from its core business.

Businesses which have high returns on equity

An exhaustive study of American businesses by Dr J.B Farewell, present extensive evidence that businesses which are able to earn high returns on equity, earn materially higher returns than the market in general. There is significant evidence to suggest that there is a correlation between return on equity and returns as a whole. The top 8 firms in the Dow Jones Industrial average by return on equity, returned a compounded 18.4% per year over a 20 year period, compared to firms with an average return on equity, who returned just 12%.

It should be noted however, that some firms may earn very high returns on equity, due to having very large debts outstanding and consequently low net equity. Returns on equity, should therefore be analysed in context with a firm's return on assets.

Conclusion

This easy to calculate metric is one of the most effective measures of a firm's performance over time. Firms which continually earn high returns on equity tend to grow their owner's earnings consistently over time and (often) have superior money management teams.

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A firm's accounting book value is the difference between its total assets and total liabilities. This is otherwise known as Shareholders equity. Tangible book value refers to the company's total equity minus intangible assets such as patents and goodwill. Both of these measures can be calculated from the Balance Sheet.

Book value serves as a reference for a number of key reasons:

1.  Accounting book value is the value that shareholders would receive if the firm was to be liquidated.
2.  It can be used to measure the company's ability to consistently achieve a return on their shareholders equity.
3.  Book value serves as a reference point for companies who are expanding their economic footprint, for example as they open new stores and acquire new logistical facilities.

Book Value versus Market Value

While book value refers to the accounting measure of a firm's net worth, the company's intrinsic value may differ substantially from its tangible worth. This depends on a number of factors, such as the company's returns on equity, return on assets, growth prospects, liabilities and operating sector. Generally firms which earn high returns on equity who are seen to have favourable future prospects will trade substantially above book value, while firms who earn lower returns and are seen to have uncertain futures may trade below book value. Companies that trade at their book value are considered to have earning power only equal to their assets.

Book value is essentially what has been invested into the firm, while a firm's net income is its ability to generate earnings from what has already been invested. Since most companies are expected to grow their earnings over time, firms generally trade above book value. Growth companies for example, may trade as high as 10 times their tangible book value. Using book value is a more useful metric to evaluate companies who are growing slowly or expecting to sell their assets.

Conclusion

Book value is a useful reference point for managers looking to assess the net worth of their firm. The importance of firm's book value depends on its ability to generate returns and the industry in which it operates.

The post What is a firm's book value? appeared first on The Motley Fool Australia.

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Investors in bitcoin are taking more heavy losses as the price of bitcoin plunged to below $7,000 last week. Cryptocurrencies in general have been in freefall. There seems to be no direct explanation for why Bitcoin has suffered such heavy losses, apart from the fact that there are fears of a global trade war between China and the United States.

I have previously warned on the risks of buying bitcoin and maintain that one of the reasons it is so difficult to invest in a speculative currency like bitcoin is simply the fact that there is no way possible to calculate the coin's exact intrinsic value. Compared to investing in a business which has earnings, dividends and business prospects, investors in bitcoin are simply gambling that someone will come around and pay more for their bitcoin than their purchase price. It is essentially a game of greater fools, until the music stops.

While bitcoin has even been touted by some experts as a potential reserve currency I don't see how this could possibly ever take place. One of the most important components of a currency is surely pricing stability. Imagine going to the supermarket to buy milk and having the currency amount changing on a daily basis? That is exactly what would happen if bitcoin were to become a global reserve.

In reality that won't happen and the best thing investors could do with bitcoin would be to avoid it.

The post Bitcoin (BTC) was crushed last week appeared first on The Motley Fool Australia.

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Ah! The famous "Price to earnings ratio". This is viewed as the ultimate measure by most as to what a stock is actually worth.

The PE ratio is simply the price of a stock relative to its earnings per share. This is a common metric used by investors to analyse what they should pay for a stock. It is used as a measure to interpret how much money a firm is currently earning relative to its valuation and how much the company expects to earn in the future, relative to what the business is expected
to be worth.

For traditional "value investors" companies which had high PE ratios are generally viewed as being expensive, while those with lower ratio's often provide greater levels of value. Firms which have a high price to earnings ratio are generally considered to:

• Have above average business prospects and potentially in a phase of rapid expansion/growth.
• Have the ability to generate significant amounts of free cash flow (money) on an ongoing basis.
• Have captured high levels of investor confidence and demonstrate an ongoing sustainability to their business. This potentially includes companies who aggressively repurchase their own shares or have paid increasing dividends on a yearly basis.
• Be positioned in a highly favourable industry which may have above average business prospects, such as e-commerce or technology.

On the other hand firms which have a low price to earnings ratio are considered:

• To have below average growth prospects and may potentially experience contractions in their business.
• To be unable to generate excess funds for their shareholders, potentially being forced to reinvest all of their earnings in the business to sustain their operations.
• Have very low levels of investor confidence. This includes firms which have potentially missed their earnings forecasts on several occasions and have potentially cut their dividend payments.
• Be positioned in an industry which is considered to be highly unfavourable for business, such as the aviation industry or heavy industrials.

Forward Price to Earnings Ratio & Yield

The price to earnings ratio is calculated on a forward basis, particularly for firms which are experiencing rapid levels of growth. For example, a firm which has a current price to earnings to ratio of 30 and is growing earnings at 40% per annum is generally considered to be highly undervalued as its current earnings will grow significantly. On the other hand, a firm which has a price to earnings of 15 and stagnant earnings is often considered to be fairly valued.

A firm's price to earnings ratio is one important metric used in valuation. It is particularly useful when utilizing the future prospects of the firm. Remember that a company's PE ratio depends entirely on the state of the business, so you may often wind up with exactly what you paid for!

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Recently, there has been a trend in stock investment which recommends passive investing. This involves putting money away in index funds to gain exposure to the entire market, rather than picking individual stocks. As a passive investor you aim to largely keep your fees low, minimize portfolio turnover and benefit from secular growth trends over time. But is this really the best strategy for you as an investor?

Enter the Efficient Market Hypothesis (EMH)

The EMH suggests the stock market is efficient. The EMH suggests that existing share prices incorporate and reflect all relevant information in stock prices, making it very difficult to pick individual investments. There are three different forms of the EMH that are largely discussed in academic circles.

1. Strong-form EMH: This theory suggests that stocks are always fairly valued and a it is impossible to buy undervalued stocks without being lucky. This theory also suggests that it is impossible to time the market and that future returns cannot be predicted in any way by looking at past performance.
2. Semi-Strong EMH form: This theory suggests that the price of a stock incorporates all public information and as new information becomes publicly available, the marketing instantly reacts and prices in the stock market adjust accordingly. Investors therefore cannot beat the market without having access to more information.
3. Weak-EMH form: This suggests that all public information may or may not be available to investors and not all variables are incorporated into the price, rather only historical price is available. This argues that technical analysis or studying graphs of stock prices is completely useless.

Are markets really efficient?

George Soros developed the conceptual framework of reflexivity to explain why markets are not efficient. The core principals of the theory are:

•  Objectivity: These are facts which are true regardless of what the market thinks.
• Subjectivity: These are subjective realities which are affected by what people think about them.

George Soros argues that since perfect information is not available, it is impossible to determine what causes movements in stock valuation. To Soros collective thinking means that reality affects reality itself (i.e. people invest into a company which is making little money because they believe in its prospects and are reassured by others who believe in its prospects, creating a group-think).

Soros believes that opportunity is created when the market prices a distorted view of reality which allows the rational investor to take a contrarian stance and profit from fundamental errors in valuation.

Berkshire Hathaway & Efficient Markets

Founded by legendary investors Warren Buffett and Charlie Munger, Berkshire Hathaway (1962) has achieved a 1,826,163% increase in stock price, majorly outperforming the stock market. It is difficult to believe that if markets were perfectly efficient such a return would be possible. Clearly, neither Buffett nor his partner Charlie Munger believes in the theory.

In fact, Berkshire Hathaway demonstrates that markets are generally much less efficient than most people think.

What this means for you as an Individual Investor

For the individual investor passive investing is a great way to invest, without having to actually put in any work! It's clear that over time you will be able to achieve a moderate return on your investment and plan for your retirement.

However, if you believe that you are skilled enough to value individual companies, it is clear that the EMH is false. The experience of investors such as Warren Buffett, George Soros and Charlie Munger has shown that it is possible to become extremely rich identifying market inefficiencies. However, remember that this requires putting in a lot of work and a tremendous skill-set. For you as an individual investor, you should decide which approach works best for you, based on your individual circumstances.

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Ah! Dividends! Those famous checks which hit your bank account every couple of months. Investors seem to have a major crush on companies that pay dividends as they create passive income which you can easily live-off. But do you really know why most companies pay dividends?

Dividends (cash payments by the firm to their shareholders) are paid out for a number of key reasons. These include:

1)     The firm is not able to reinvest all of its earnings. When a firm is in its initial phase of growth, the company usually requires as much capital as it can get to grow the business. Companies then reinvest earnings back into the business to further grow and expand into the future. However, once companies reach maturity, this is no longer possible. An example of this would be firms such as Apple or Coca-Cola who have grown to the point that they have excess funds and don't need all the money they have to grow the company. As a consequence these firms pay dividends.

2)     Stability: Firms who are able to pay dividends usually have stable earnings which have grown over time and continue to trend upward. The ability of a company to pay dividends usually puts a floor on its share price and provides a degree of confidence to investors who are able to identify a guaranteed yield. In low-interest rate environments, firms with a generous dividend policy are extremely well viewed.

3)     Low Capital requirements: Firms which pay out dividends are often located in industries which are not very capital intensive and do not require large amounts of ongoing investment. For example, it is easier for a firm such as Coca-Cola to pay dividends once they have established their operations compared to a business such as Amazon which is constantly required to innovate in order to seek alternative streams of growth and operates in a fiercely competitive environment.

The negative side of Dividend Payments

While the constant cash flow provided by dividends is advantageous to investors, there are a number of downsides for firms who choose to pay dividends, including.

• The 'Double taxation'. This refers to the fact that companies are taxed on their earnings and investors are then taxed on their dividends received. This is a 'double tax' when compared to capital gains tax, where only the investor is taxed. This can be avoided if you invest in certain Australian companies which allow you to 'frank' dividend payments.

• Slower growth: Firms who pay dividends are usually mature companies and therefore expected to grow at a substantially slower rate than firms who do not pay dividends.

There you have it! Now you know why some companies pay dividends while others don't.

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Should a public business go bankrupt and stop all operations to go out of business, a trustee will be appointed to liquidate the company's assets. The remaining funds will be used pay off creditors and reimburse investors as much the company can. Here is how funds are divided between investors following a bankruptcy situation:

• Secured Creditors: These are the investors who took the lowest level of risk and are the first to be paid. Secured investors, for example usually have their credit backed by collateral such as a mortgage or company assets.
• Unsecured Creditors: This might include bondholders/banks. These have the second claim to the assets of the firm as firms have a legal requirement to pay debtors before stockholders.
• Stockholders: Stockholders have the last claim to the assets of the firm and will only be paid after both secured and unsecured creditors have been paid. In a bankruptcy situation stockholders will often receive nothing.

Should the business operate as a partnership/sole trader, the individuals are liable for the debt of the company and may have to declare personal bankruptcy.

Preventing a business from going bankrupt

Should a business be heading toward bankruptcy, the best thing to do is to implement measures that prevent insolvency. These include:

• Restructure: This may include selling-off some parts of the business to raise funds. Non-essential capital projects may be abandoned/postponed for cost saving.
• Refinance: This includes coming to an agreement with creditors which might enable business owners to delay payments or pay interest back over a longer period of time.
• Recapitalize: Businesses may look to financial markets and sell more shares in order to raise capital. This has the effect of diluting ownership and is generally very badly received. It may be the only option for firms in severe distress.

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There are many ways for a business to develop a competitive advantage that will enable it to outgrow and outlast its competitors. If a company has an economic moat it can solidify its place in the market relative to competitors, build a brand in the mind of customers to make them obsess over the company's products and profit from growth trends.

The most important thing for a company to concentrate on is effectively positioning themselves in relation to their competition. Michael Porter (1980) showed that there are three main generic strategies which firms can utilize to build their competitive advantage:

• Overall cost leadership: This involves targeting customers, based on offering them the lowest possible price. For this strategy to be effective a company must have a sustainable cost advantage and economies of scale which enables it to maintain its position as a cost-leader in the marketplace. Firms pursuing cost leadership often have generic products and highly efficient distribution networks to maximise efficiency.
• Differentiation: This involves winning customers through factors other than price such as a higher product quality or superior service. To effectively pursue a differentiation strategy, a firm must differentiate itself favourably compared to its
  competition. Firms pursuing a differentiation strategy seek to match their competition in areas which do not differentiate it and provide a superior offering in the areas they differ.
• Focus: A firm seeks to focus on just a few very specific segments of the industry. This may involve specialised 'know-how' or offering a particular service which competitors do not offer. Focus involves concentrating on winning a smaller number
  of customers but creating an excellent 'value proposition' which makes the firm dominant in its niche.

Quality vs Quantity

Porter tells us that a firm does not need to have a high market share to maximise profitability. In fact, many firms who have a small market share have very high levels of profitability as they focused on targeting a small and profitable sector of the market.

On the flip side, Porter reflects that firms who fail to position themselves effectively in the marketplace can essentially become 'stuck in the middle' and are vulnerable to attacks from the competition who targets specific characteristics of the target market and provide a superior offering.

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