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What is a Derivative?



Efraim Landa is president of Effi Enterprises which assists entrepreneurs and emerging companies create value. The company offers growing companies hands-on executive management and leadership and helps them discover various ways of securing finances. They offer options such as introducing businesses to angel money, marketing strategies and divestures among many other options. Effi Enterprises works with emerging companies to help find the best solution for their particular situation. This may include stock options for employees, future contracts or any number of other strategies. Future contracts, options, and warrants are all common derivatives.

What is a derivative?

A derivative’s value is based on a contract between parties who are agreeing on an underlying financial asset, security or index. Some of the most common underlying instruments are bonds, currencies, market indexes, stocks interest rates and commodities. Some common derivatives are warrants, swaps, options, forward contracts and futures contracts. Basically, a derivative is an instrument which derives its price from another variable or financial asset. A stock option derives its value from that of a stock; and a swap gets its value from the interest rate index. A derivative obtains its value form an underlying asset and the derivative’s price will rise or fall along with the underlying asset’s value. The derivative’s value is based off of the price of the instrument and the payoff will mirror that of the instrument that they are based on.

A derivative is a contract on an underlying asset. There are many different derivatives but options are the most common type. When an owner purchases an options contract they have the right to purchase or sell the asset at a certain price prior to a pre-set date. The most common underlying assets for which contracts are purchase are stocks, commodities, bonds, currencies, market indexes and interest rates.

Basically, a derivative is a contract between a buyer and a seller. Unlike traditional investments, there is a pre-set expiration date. This time is established at the time the contract is purchased. Payoff is typically determined at the expiry most of the time. Occasionally there is no exchange of money when the contract is made.

Some very well established exchanges trade derivatives. The New York stock Exchange, the Chicago Board of Trade and the French CAC are three. Trades such as these are called exchange-traded derivatives which mean that the terms and features are highly standardized. The advantage to these is that they are regulated which is just an extra safeguard for investors.

Other types of derivative instruments like swaps, forwards and other exotic derivatives are traded over-the-counter. These have very flexible terms and a large number of underlying assets and combinations which can be purchased. These types of financial dealers can customize the derivatives for specific clients and their needs.

Why Derivatives?

The largest thing that makes derivatives appealing to businesses is that they allow a certain amount of leverage. This is a financial term which refers to the increase that occurs when a small quantity of money is all that is used to control another item which is of a larger value. An example is a mortgage. A person can gain control of a highly priced piece of property for a smaller amount of money. Derivatives can give this same type of leverage, or multiplication as a mortgage can. An investor can actually control company stock which has a large value by using a small amount of money. An investor has the opportunity to make more money than the company who is reaping the benefit of the investment.

However, if derivatives take a turn for the worse they can be very costly for a business. In 1995, trader Nick Leeson traded derivatives but the trades were not profitable and because of the leverage the losses were so huge for the Barings Bank of England that they ended up in bankruptcy. Warren Buffet, who is a very successful investor, is against using derivatives and he sees them in a very negative light. However, just like any investment there are always risks involved. Derivatives are a form of investing which have been part of business finance for many years and will likely remain an integral part for many years to come.

What is a P/E ratio?

One of the primary objectives of Effi Enterprises is to help a company realize value. There can be many means through which the valuation of a company is achieved. Efraim Landa is a venture capitalist who is intent on helping emerging companies and entrepreneurs learn how to successfully manage the finances of the business. This includes helping businessmenconsider all available options including venture capital, IPO’s or strategic alliances or joint ventures. One thing that is commonly discussed among businessmen and investors it the P/E ratio.

P/E ratio

P/E ratio

What is the P/E Ratio?

The P/E Ratio is a proportion that can be used to learn about a company’s earnings and its value. P stands for Price, and E represents earnings. The price is relatively easy to find as it can be found through any vendor. The trading price for stocks is easily accessible through online resources. As an example, if a company’s stock is trading at $42 per share and the earnings for the last year was $1.55 per share, then the P/E ratio is found by dividing $42 by $1.55. The P/E ratio for the company’s stock would be 27.10. The earnings per share (EPS) is generally obtained by looking at the last four quarters but some prefer to take it from the estimates of what is expected over the upcoming four quarters or the projected P/E. Other companies will use the sum of the previous two quarters and the estimate of the upcoming two quarters.

What does the P/E Mean?

Generally a higher P/E will indicate to investors that they should expect an increased growth in earning in the future if it is compared to companies which have a lower P/E. But you cannot look solely at the P/E ratio. Typically, the P/E ratio is compared among companies in the same industry. It may also be compared to the overall market value or to the company’s previous ratios. It would not make any sense to compare a utility companies P/E ratio to one of a technology development company. In comparison the technology company would far surpass the utility company if based on the P/E ratio alone.

What the P/E ratio is used for is for investors to decide how much they are willing to pay per dollar of earnings. To interpret this let’s say a company is currently trading a multiple P/E at 20 which means that the investor would be willing to pay $20 for each $1 of earnings. For example’s sake we can say that Google is trading currently at $400 a share and the EPS is $13.31. That means that an investor can expect to earn $13.31 for each share that is available. But if Google only has 315 million shares which are outstanding shouldn’t they be available for $13 a share? No, simply because an investor plans on holding on to stocks for an extended amount of time, and they expect for the company’s stocks to increase in value during that time. That means that they will willingly pay a premium now hoping that they will get a higher return later. With a P/E ratio of about 30, an investor will pay 30 times more per share in Google.

The important thing for investors to note is that the P/E ratio is not the only influencer for making decisions. The P/E ratio has a higher quality based on the quality of the underlying earnings value. This is only one of the factors used to decide where to invest monies. Remember that investments are typically long term and after the initial purchase it is a game of waiting to see how much the price will increase until a profit is made.