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What is a Derivative?

Derivatives

Derivatives

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.

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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.

What is a Hedge Fund?

Hedge Funds

Hedge Funds

Hedge Funds are types of partnership investment opportunities. Sometimes these are formed as a limited partnership or a limited liability company just in case the company goes under or bankrupt, creditors will not be able to try to get more money from the investors than the amounts they contributed to the hedge fund. These are a very risky type of investment which many shy away from while others flock to it. Some feel that the greater the risk the higher the return can be in the end. A hedge fund manager will use money that has been deposited with his company by investor and use it to invest in another company looking for a profitable return on the funds.

The main purpose of a hedge fund is to capitalize on the market and be able to make money whether the market is increasing or decreasing.  This type of private investing is a way to sort of outperform the market. This type of private investing is not like mutual funds which are run by large public corporations; therefore they are not regulated by entities such as the Securities and Exchange Commission (SEC). This lack of regulations is what makes them be so risky, but is also one thing that makes them more attractive to investors. This is just one type of private investing opportunities which companies such as Effi Enterprises helps locate for start up businesses or struggling companies.

What does a manager do?

Managers of a hedge fund get compensated by earning a percentage of the returns. This is more appealing to many investors since they do not get just a “fee” as a return on their investment. The managers stand to make a lot more profit since the compensation structure can yield a return that is above market value. Without the standard types of regulations, hedge funds can yield a very high return; even though much of the investment is based on speculative results initially. Managers are excellent at using derivatives, like futures contracts or options. These allow a manager to bring in a profit whether or not the stock market goes up or down. Many times they have the option of selling the stocks short which basically means they can use a small amount of money as leverage and remain in control of large quantities of commodities or stocks. And they can select a particular time frame in which they will pay out. This means that they can use timing along with leverage to make a huge return if they correctly predict if the market is going to rise or fall.

New Regulations on Hedge Funds

Recently, there were some new regulations put into place regarding hedge funds. If the hedge fund is valued over $150 million it must be registered with the SEC. The Dodd-Frank Wall Street Reform Act which was enacted in 2010 set up a Financial Stability Oversight Council which watches for this type of private investing that begins to grow too large. Once it is deemed that they are “too large to fail” the Council may recommend the regulating of these funds by the Federal Reserve. The Dodd-Frank Act also set limits for how much a bank can invest in a hedge fund. Hedge funds can only be used by banks on behalf of customers and not simply to boost the corporate profits of the bank.

What happens if the investment is lost?

The hedge fund is very risky for investors. If the investment pays off everyone gets paid, but what happens if the fund loses money? Does the manager still get paid? Absolutely not; they will not get paid if there is a loss. The manager is somewhat protected while it is the investor that stands to lose. However this type of investment is protected from fraudulent activity but many feel that there are not enough regulations in place that can help protect the private investor.

Risks of IPO Investing

stock Market

Stock Market

There was a day when any kind of IPO investment in the technological world was all but guaranteed a huge profit. Some investors grabbed up public stock in companies like VA Linux and had some great first day gains. Those who invested and then sold did very well and made investing look like a very easy process. But investors were disappointed in the long run as they watched values plummet.

Risk Factors

It is important to realize that there is no investment that is a guaranteed, sure thing. There will always be risks associated with investing. Companies like Effi Enterprises are aware of the risk factors and carefully consider the high tech companies that they offer venture capital or private investing options to. The biggest lesson many investors have learned is that the IPO market leveled out and there are not the same extreme gains to be had simply from flipping stocks. IPO’s have a huge set of very unique risks which makes them different from trading in average stock. A good example right now is the Facebook IPO. Many people grabbed up public shares and invested in the top social networking company. Stocks have risen somewhat from their initial drop but they are still about 13 percent down from where they were a short time ago. That’s not actually a bad drop compared to many companies such as Zeltiq Aesthetics who is sitting on a 65 percent decline from its initial IPO price.

Facebook’s IPO

People thought they could buy up some Facebook shares and watch the prices soar immediately. Basically, they took a risk and lost. IPO’s are not the best option for most investors. When a company goes public one of the main risk factors is that there has not been a trading history and so there are no analytical reports to examine. Trying to obtain information on a company that is going public is going to be difficult. Most of the time companies have traded publically and so there are lots of analysts which have done their homework. These reports can at least reveal some of the problems they have encountered.

Purpose of an Underwriter

Many times a company which is going public does not have a strong underwriter. This of course, does not mean that investment banks never produce a dud, but generally quality brokerages will be bringing only quality companies public. It is very risky to choose companies who are represented by smaller brokerages because they are many times willing to underwrite any company at all. A larger investment firm can be more selective about which companies it underwrites than a small underwriter can. However, the smaller broker can make it a lot easier for private investing since it’s much easier to purchase IPO shares.

Read the Prospectus

It is important to read a company’s prospectus. But keep in mind that this is not done by an outside party, it is written from within the company so it is not necessarily as reliable as a third party analysis. You will need to note the risks and opportunities as they are presented by the company. You will want to know why they are going IPO. If the money raised by IPO is going to repay loans or to buy equity from private investing, stay clear. However, if it is going toward marketing, expansions or research it is usually a good sign.

This does not mean that IPOs are all bad. There have been many success stories over the years. There are some very successful companies that go public every single month, however, it can be very difficult to sift through it all and find the investment opportunities with the most potential. Efraim Landa works with companies who are going public to help ensure each party’s success.