Where Did The Perception That Banks Were Good Investments Come From?

There is no question that if you look at banks historically you can see the factors that investors promote when looking for a "good" investment. My friend that encouraged me to invest at the time was waiting for a huge market correction. That was back in 2006 and he was already more then half cash. One that he mentioned he wanted to pick up was HSBC, and his price was in the $65 range. The reasons, years of growing dividend, expanding into emerging economies, steady in their years of showing growth, etc. There is a list somewhere, I am sure.

He also talked about how dividend stocks tend to bounce back better after a downturn, at least that's what happened with the last down turn.

There is no question that banks had a very good run, but I doubt what was known to be true historically is going continue to be true moving forward.

When I look at where the increasing profits came from a see a sector that will have years upon years of disappointment to investors that fail to think this through.

You have the maestro idiot who for more than a generation gradually stepped interest rates down. So, what exactly does that do for bank profits? Consider that the dollar value of loans have been increasing over the years much more then wages. Banks are increasing their profits as that dollar value of loans increased. This has gone on since the 80s. It has enabled some troubled borrowers to refinance at lower rates and avoid the messy businesses of defaults, and of course there is an enormous fee that goes with this. Heck, there were borrowers that weren't in trouble that refinanced and just paid the penalty. I did so twice as it was in my interest to do so, and there was up to 3 months interest penalty on my mortgage each time.

Banks also added those fancy securitization products which they made a bundle on.

Well, now that there is a rate reversal in progres, so just what are all the ways that banks will lose out on in terms of how they were increasing their profits?

Loans aren't going to be getting bigger. Wages will finally have to catch up. Just how many years do you think this will take? A decade or two would not surprise me. Moving forward banks will have decreasing values of loans. Trying to increase profits through increasing rate spreads will simply increase this effect. So years of declining loan values is a given.

And, now that interest rates pretty much went as low as they could go, well, just how are those troubled borrowers going to refinance? I suppose those with massive credit card debt at high rates might be able to, but what about troubled mortgage borrowers? Or over extended big car loan borrowers? Now some of the defaults that were traditionally avoided by refinancing aren't going to be avoided. I suspect it will be years of higher defaults then historically. There will be a large wave to start and then a much higher steady stream as life's challenges hit people that were doing their best but had no room for those life's challenges -- relationship break-up, job loss, unexpected pregnancy, illness, natural disaster and so on... So, years of higher defaults for banks is a given.

You think the securitization of debt market is ever going to be as profitable again? I don't. So years of reduced profits from secutitization is a given.

Then of course there is the massive dilution of stock as banks work to raise capital. So, you have this declining profit environment on this growing equity base.

It seems to me that there is going to be a move to less debt in this environment, so not only will loan values be smaller, people will go back to the "old fashioned" way of making purchases, saving a good portion before borrowing. If you think it through what the stepping down of rates did to housing, well, it increased the loan amount that people qualified for and the responsible saver who wanted 20 or 25% down was forever finding that out of their reach. It lead to the masses jumping in early in terms of saving for a down payment because you could never earn in wages what you'd lose in equity as home values went up. They watched the market go up for 2-3 years they were wanting to buy and finally jumped in. It is what happens to young people.

Generations just young enough to miss this massive bubble will learn from the financial hardships they see around them. Many will wait and they will save for a proper down payment.

So, where do I see banks? I think loan values will cut in half and raising equity to cover losses will double the number of shares out there.

I can't see the business sector of banks doing much better.

And then there is the investment side of it. I think so many people are going to be hit hard by the markets there will be a trend back to safer investments. My idiot investment advisor argued with me over an investment I wanted to make and then I was charged $400 on the one trade. This garbage is already on the decline. Look at all the competition for $10 trades now.

So, no kidding banks were a good investment. There many things happening in their favor that whoever was running them would have to be worse then Bush to screw it up. But now the reversal comes and it isn't just reach a bottom and go back to business as usual. Moving forward the business environment is going to have those things that worked in banks favor working against them, and it is going be years of challenges and little opportunity for profit growth.

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I'll Bite, I'll Blog About It

A line in the song suggested blogging about it...



While I'm at it, another wonderful song, Bubbleman:

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Backroom Deals

Calculated Risk has a post about a back room deal BoA is trying to get taxpayers to fund.

According to the proposal $739 billion in mortgages are at moderate to high risk of defaulting. So, tax payers buy the mortgages at deeply discounted prices and pay to forgive the debt above current market value and tax payers pay the difference to refinance these borrowers at lower rates.

The marketing strategy to the public is that you present this as a bailout of homeowners, not the bond market or the banks. At all costs steer away from the fact that the banks get off scot-free for their gross negligence and are immediately able to line the pockets of their executives again and that the bond owners get their money back.

Additionally, completely steer away from the fact that taxpayers would then be on the hook for even more should the mortgage market decline further and these people simply walk away anyways.

Gotta hand it to the banks, "We believe that any intervention by the federal government will be acceptable only if it is not perceived as a bailout of the bond market."

I am sure their information processing psychologists were coaching, "the way you present this thing is that it has nothing to do with you, it is about the bond holders and the home owners. Keep it along the line that you are the Robin Hood for home owners and bond holders alike. Do not answer any questions about the banks and bring the focus first to the homeowners, and if necessary, the bond holders."

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Where Are The Regulators?

I was reading an excellent piece by Nobel Prize winer Joesph Stiglitz on his thoughts on the World Economic Forum.

One of the things that he said that is proving to be a lesson that Wall Street sociopaths, morons, idiots, scam artists, con men, swindlers bankers refuse to acknowledge (or perhaps once a swindler always a swindler) that Stiglitz said is:

Bankers – and the rating agencies – believed in financial alchemy. They thought that financial innovations could somehow turn bad mortgages into good securities, meriting AAA ratings. But one lesson of modern finance theory is that, in well functioning financial markets, repackaging risks should not make much difference.

If we know the price of cream and the price of skim milk, we can figure out the price of milk with 1% cream, 2% cream, or 4% cream. There might be some money in repackaging, but not the billions that banks made by slicing and dicing sub-prime mortgages into packages whose value was much greater than their contents.

It seemed too good to be true -– and it was.

These are supposed to be intelligent people. US and European banks are working together to try and "shore up" the the mortgage insurers. I can't help but think this anything but smoke and mirrors to delay the day of reckoning when the risk comes home. I can not help but believe it is perpetuating a further fraud on the markets.

From my understanding of what I read in a letter from one of the largest share holders of one of these companies many of these insurance contracts have time limits. They expire and new insurance contracts will not be written.

Give the appearance that everything is ok and that the nay sayers really don't know what they are talking about and more get suckered into taking this junk off the banker's hands, or get suckered in to believing that a discount is a deal when without the appearance they are insured in fact the junk may be worth zero.

Naked Capitalism thinks that the worst thing happening here is that the bankers are spending money shore the insurance companies up when they will lose their AAA rating later.

I have more sinister beliefs, they are trying to delay the inevitable for either personal interests or because of cost is less than if it enables them to get rid of more of their junk.

So, where are the regulators and how did they let this happen?

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Gooooogle Grooooowth

I am of the opinion that Google is full of hype that has sent its share price beyond reasonable valuations. No question the growth story is good, but investor expectations go far beyond reality.

I have done a couple posts looking at Google and tried to demonstrate how this growth rate stuff for pricing investments is increasingly nonsense as the growth rate get higher. The example I used previously is:

	Daily rate	Compounded rate
A	8%	10,000,000,000%
B	8.1%	13,000,000,000%
B minus A	0.1%	3,000,000,000%
C	0.0%	0%
D	0.1%	27%
D minus C	0.1%	27%

The difference in the rate being compounded each day of the year in the two examples is a mere o.1% difference yet with the high rate the magnitude of the difference at the end of 240 compounding periods is enormous, 3 billion percent versus just 27 percent. As the growth rate become large the numbers you get back a equally nonsense and this is the basis of the theory people have used in justifying Google's price because of "growth."

So, lets have a look at Google's eps:

Quarter	Earnings/ share	1% increase over last Quarter	2Annualized Quarter Growth	3Annual Growth to Q4/04
Q4 2003	0.10	n/a	n/a	n/a
Q1 2004	0.24	140%	3218%	3218%
Q2 2004	0.30	25%	144%	800%
Q3 2004	0.19	-36.7%	-83.9%	135%
Q4 2004	0.71	274%	19400%	610%
Q1 2005	1.29	81.7%	990%	674%
Q2 2005	1.19	-7.8%	-27.6%	421%
Q3 2005	1.32	10.9%	51%	337%
Q4 2005	1.22	-7.6%	-27%	249%
Q1 2006	1.95	59.8%	553%	274%
Q2 2006	2.33	19.5%	104%	252%
Q3 2006	2.36	1.3%	5.3%	216%
Q4 2006	3.29	39.4%	278%	220%
Q1 2007	3.18	-3.3%	-12.7%	190%
Q2 2007	2.93	-7.9%	-27.9%	163%
Q3 2007	3.38	15.4%	77.1%	156%
Q4 2007	3.79	12.1%	58.1%	148%

1This is a quarterly rate of return (loss). 2The rate must be taken to the 4th power to get the annualized rate. 3This is what the annualized rate of return is if it was constant back to Q4 2003.

The rate of growth is clearly declining, as this graph shows.



The rate of growth in the chart looks enormous, but that is partly because it is being compared back to when eps was 10c. The bolder second line is a smoothed trend line. The growth rate in earnings over time has been declining rapidly.

If the growth rate per year is looked at, you get less overall volatility as "events" are averaged in over a year rather than a quarter.

Year	Earnings	Percent Growth
2003	0.41
2004	1.46	256%
2005	5.02	244%
2006	9.94	98%
2007	13.29	33.7%

The increase in earnings last year was $3.35, the year before was $4.92 and the year before $3.56. The absolute earnings growth for 2007 has been less than both 2006 and 2005. If you were to assume the same rate of growth for next year, according to PEG theory $13.29*33.7 gives $448 as a fair price. It means that the earnings per share needs to increase to $17.77 or $4.48/share for 2008. Given that the earnings growth has only increased that much one year, it is a tall order.

The other thing that makes Google a bad investment, imho, is the gross level of stock based compensations. Within their expenses they have $1.6 billion of stock based compensation, or 38% of the 2007 earnings. They've increased their employment numbers by 57% over the past year. If I take the average of 2006 and 2007 number of employees, I get 13740 employee for the average for the year. Averaging the stock based compensation over the number of employees comes to a whopping $116k per employee, more than 3 times the starting salary for a teacher in BC, I might add. They are returning an enormous amount of

Another way to put this into perspective, it is $5.06 per share. Heck, that kind of stock based compensation can completely obliterate the true growth rate.

Interesting, when I add up the stock based compensation figures from their consolidated statement of income, I get $1.6 billion, but when I read it on their website it gives $869 million. From their website stock based compensation more than doubled from 2005 to 2006 and then almost doubled again in 2007. Employee increases are considerably less than the stock based compensation.

The fully diluted number of shares has gone from 273 million at the end of 2004 to 318 million at the end of 2007, or a growth rate of 5.2% over the 3 years.

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World Economy Slow Down

I am looking forward to the next stream of financial and annual reports that will be coming soon. I predict that the press releases will focus on the annual earnings and completely gloss over the 4th quarter earnings, which I expect will not be rosy for any base metal company. However, the 4th quarter earning are probably more representative of the company's next quarter earning potential rather than looking at the full years.

In a recent post I was asking if base metals would fall off a cliff. There were many indicators that economic growth was slowing.

The US is of particular concern. According to Nobel economist Joseph Stiglitz the US has been drawing down home equity at a rate of $700 to $800 billion per year.

That's a lot of unsustainable US economy. Further, the US consumption economy is about $9.5 trillion. The home equity borrowing has been 7-8% of the consumption US economy. Now that lending standards have tightened, and home equities have declined, that borrowing is not likely to continue at anywhere near the same rate. It has to be a strong US slow down in the economy and the trickle down effects can not possibly be pretty.

Emerging markets are not likely to make up the slack. China's consumption economy is a mere $1 trillion, so $700 billion is 70% of their economy. Anyone who thinks China will pick up the slack is smoking something pretty strong.

This can't possibly be good for base metals. There are a lot of base metals that go into consumer goods. Additionally, commercial construction is rapidly declining as well, and municipal budgets that might do big capital projects that require base metals are in trouble because municipal budgets are in trouble due to declining revenue from declining home prices in the US. Cities are demanding all departments cut budgets.

Mining projects in the process of being developed do not just stop in the middle of hundreds of millions of dollars being committed to them, so increases in supply tend to strongly lag changing economic conditions. Data showing slow downs for material usage tends to be lagging rather than leading. In the US housing starting were going full throttle as late as last March, and all of the materials that go into housing would have continued to be used until some time in the fall or winter, yet by then housing starts had plummeted, but the actually declines in demand from that reduction will not be fully showing up in financial reports until the end of Q1, and it should be significant. So far Q4 earnings are down about 20% for companies that have reported Q4 earnings. That's gigantic and it is crazy to not think that that isn't have an effect on commodity demand.

Base metals have had enormous leverage of earnings from record commodity prices and they've been bid up in price, valuing the base metals stocks like a coca-cola stock, only base metals are at far more risk to supply and demand price fluctuations that demand a low P/E when prices are strong. When the market looks good and the company has good growth prospects I'd never give a second look to a base metal stock with a P/E of 12 or higher. It has room built in for down side risk and a opportunity to exit without wiping you out should the market turn, which it appears to have done.

There are numerous examples now of how the downward leverage affects earnings. From Q2 07 to Q3 07 FNX mining's revenues declined 28.3%, but earnings declined 64.3% despite the fact that "the total tons of ore, pounds of nickel, pounds of copper and ounces of precious metals produced and sold was were higher ... than in any previous quarter," according to the Nov 1, 2007 news release. According to google finance the current P/E is 21.7, but that has earning of $12.5 million (the last report), $35 million, $30.2 million and $19.7 million included. Go four quarters forward based on last quarter and you get $50 million per year of earnings compared to the current last four quarters of $97 million. It means the P/E for last quarter reported is about 43. Average nickel price was $11.65/lb and copper price was $3.57/lb. FNX is still richly valued despite being down 37% from its high. The $24.87 shares earned 15c/share last quarter. Even if you believe they can double earnings, the shares seem richly valued.

Teck Cominco's earnings declined from $2.01/share to $1.16/share for the same two quarters, only Teck Cominco did not get so insanely valued. Their revenues were down about 1/3rd yet earnings were down 42%. Their loss of leverage of earnings was not nearly as drastic as FNX. Teck's current P/E is 6.46 and forward P/E is 10.63. It is down 40% off its high. The $32.51 shares earned $1.16/share last quarter.

It is likely any base metal company examined will show a higher decline in earnings than revenue because of the leverage and it is also likely that all established companies will experience a significant decline in earnings due to the declines in commodity prices, which are at risk to decline further due to the economic slow the entire world seems to be experiencing.

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BHP - RIO -- Merging Bubbles

I play CAPS and I am losing on my BHP call and barely holding on my RIO call. I believe both these companies to be highly bubbled values and BHP is courting RIO.

BHP has a market cap of about $190 billion and I believe BHP has been artificially sending its share price higher with its share buy back program. I simply see no value for long term shareholders, as I have previously written.

I think share buy back programs are gross violations of shareholder interests as ultimately they tend to line the pocket of the executives with stock options at the detriment of the company and shareholders. A share buyback creates a temporary increase in demand which increases price. Mish has a very good example of a share buy back that fell apart. I can't see the BHP buyback being much different.

Ouch, isn't this going to be good, look at some of the largest shareholders:

Company Citicorp Nominees Pty Ltd	Shares 440,460,280	% 13.12
HSBC Australia Nominees Pty Ltd	377,638,519	11.25
J P Morgan Nominees Australia Limited	372,983,700	11.11
UBS Nominees Pty Ltd	20,861,621	0.62
HSBC Custody Nominees (Australia) Limited	18,369,730	0.55
ARGO Investments Limited	6,422,411	0.19

Aren't those companies related to companies already in trouble because of subprime?

So, BHP has been making record profits, but when you look at their liabilities, they have increased from $17 to $28.5 billion. There is no question that equity has increased nicely, from $12.8 to $29.7 billion, but price to book is over 7x. Additionally, P/E is around 17-18. Say earning cut in half, then the P/E is about 35, and earnings cutting in half is highly realistic.

The problem is that many commodity prices have gone down and with weakening demand, and they are likely to decline further.

Take a look at BHP's earnings over the past six years:

Year	Total Income (billions)
2002	$1.25
2003	$1.58
2004	$2.72
2005	$6.32
2006	$9.75
2007	$13.16

BHP's business segments (and relative share of 2007 profit) are petroleum (16.4%), aluminium (9.9%), base metals (31.5%), diamonds and specialty products (1%), stainless steel (20.1%), iron ore (14.6%), manganese (1.4%), metal-lurgical coal (6.8%), energy coal (1.4%), and eliminations (-3%).

Take a look at the 5 year spot price for aluminium, some base metals and nickel, of which 60% of segment profits are dependent.







For Aluminium the profit before taxes was 31%, $1.8 billion out of $5.9 billion. The year ended in June and spot price graph shows a full year of strong price when the US dollar was on average about 15% stronger. A rough estimate of where the 2008 price will be with both spot price and currency declines is about 25% less. That comes off revenue and costs stay relatively the same, so expecting to see revenue decline to about $4.5 billion for 2008 for aluminium is highly realistic. Well, $4 billion was costs, so the aluminium segment declining to $0.5 billion in earnings isn't unrealistic, or $1.3 billion shaved off earnings.

There are a few base metals, but they all have strong prices so an estimate can be made just by looking at copper. The revenue was $12.6 billion and profit was $5.8 billion, or 43% of revenue. Copper had a 2-3 month period for 2007 with a strong price decline in the winter/spring so average copper price for 2007 looks to be around $3.20ish. Copper is currently 10% less and with the G7 economies all slowing down it is not likely to have the same kind of price support. So copper revenue down 20% for 2008 is not unrealistic. That would shave $2.8 billion off earnings.

Steel is nickel and nickel price is indeed scary. BHP caught the entire unsustainable nickel price spike in 2007. Whoo-hoo, no wonder it had a race to the bank 310% EBIT increase over the previous year. It looks like the average 2007 price was about $17-18/lb. Nickel is under $12/lb and there is about a 15% currency decline to consider. Expecting to see 2008 revenues will be down in the range of 40% is not unrealistic. That would be $2.8 billion off revenue and would take profit from $4 billion to $1.2 billion.

Looking at just 60% of the market segments of BHP and considering commodity and currency declines there is a feasible estimate of $7 billion decline in operating profit, or about 37% gone. For this year the energy earnings look sustainable, and could be up, but I would expect energy to decline as the gross over supply of housing used a lot of energy and that part of the demand is already declining as manufactures that supplied the housing boom are finding their inventories increasing and are cutting production.

For the merger with RIO they need $70 billion, $40 billion to restructure Rio's debt and another $30 billion for a share buy back. Their existing long term debt is about $9.3 billion, so they are looking to increase debt about 9-fold. They had $13 billion in earnings for 2007 and Rio had $7 billion. Wouldn't it be reasonable to expect debt servicing costs on $80 billion to be about $8 billion? With the kind of unsustainable record earnings of the past 5 years wouldn't you expect zero debt on the books?

This is the wrong time to increase debt. With $80 billion in debt, and say earnings go down 25% overall, would result in increased costs by about $7 billion and decrease income by $5 billion, and combined $20 billion in earnings would decline to $8 billion. Scraping the share buyback would reduced the debt burden by $3 billion so earnings would only decline to $11 billion.

But, overall, I would anticipate more like a 50% decline in earnings by the time the next year or two play out without increased debt costs.

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Is Zinc Deleveraging?

An article, Shanghai Exchange More Than Doubles Zinc Price Limits, describes how the margins for zinc contract have been increased and how price controls have been relaxed, if my understanding of the article is correct.

To enter a contract you needed 5% down, but that changed on November 19th to 9% down and it is increasing to 14% on November 22. That is almost three times the margin requirement and three times the amount of money down.

The price control limited the change in any single day to 6% and that has been raised to 13%.

The changes to margin are enormous.

Frank Veneroso has maintained that metal prices increased beyond reasonable levels partly due to hedge funds buying metals without ever planning to take possession of metal. With a 5% margin requirement, they could tie up 20 times the deposit on any commodity trade. Increasing the margin dropped the leverage to 11 times and the final increase drops the leverage to 7 times. Essentially traders now require about 3 times the money to enter a contract. If hedge funds are indeed responsible for the huge increases in price, that leveraging has got to fall apart pretty quickly with such enormous increases to the margin.

Zinc exports from China increased by 47% during the first 10 months of this year, which really doesn't say much unless you have an idea of how much of the world zinc market they produce and how much they export. Data from the US Geological survey suggests that China produced about 25% of the world production, about 3 times what the US produces. This certainly suggests China is a big enough producers of zinc to be dramatically influencing the price down with such huge increases in exports.

The price declines will result in enormous downward pressure on zinc stocks I've previously followed.

When I looked at Zinifex in July the P/E was around 8.6. The metal values per ton of their Rosebury mine that they were mining was about $610/ton, but the reserves for future mining were a higher grade at about $800/ton. Having a higher grade coming up, and not an outrageous P/E to start gave Zinifex room for downward pressure from prices. The downward pressure on zinc prices have been enormous, however, at today's prices that higher grade reserve still has metal values of over $650/ton. The Century mine also had higher grade in reserves to be mined. Costs are in Australian dollars. The higher grades to be mined are protective, however, zinc prices have come down enough to be cautious with this one now.

I didn't care much for Tamberlane, Breakwater or Acadian. Tamberlane only had one deposit out of the 34 that had very nice revenue potential and that would only last 1-2 years and the other deposits were questionable. Breakwater's best mine had metal values of about $410/ton and those are now below $300/ton. The metal values in El Toqui are down to about $230/ton. El Mochito's values are down to about $275/ton and Myra Falls about $320/ton. Myra Falls is showing $1.10 per pound cash costs last quarter. With zinc below that the mine doesn't look very good at all. Toqui has $0.76 cash costs per payable zinc sold. The costs appear to have gone up enormously, from $0.39 per pound payable in 2005. There has been share dilution to bring the fully diluted count from about 395 million to 461 million. Acadian estimates 8 million pounds of zinc and 3.5 million pounds of lead. The costs are estimated to be $12 million. They estimated $13 million of revenue, but the price declines of just the past days brings that down to $12.3 million. At best that might give just under a penny per share for full year production. It might even run at a loss.

Hudbay minerals looked to be valued at about 2-3x the valuation of Blue Note when I looked at them together. Today Hudbay's earning look to me like they are heading to the 50c/share for a full year range, and that won't show up on the next quarter, but Q1 2008 would have earnings in the 10-13c/share range based on today's metal prices and exchange rates. Q4 already has some better metal prices rounded into the quarter. I saw some serious reasons to see earnings declines when I reported on this stock and they have shown up and further declines will likely happen.

Blue Note's metal values are down to about $315/ton. They have have not met 2007 production goals, and there has been more dilution. Production costs are supposed to be in the $66 million range. The gross revenue potential is still in the $190-200 million per year, but that up to 4c/share earning potential in a quarter is mostly likely gone. The numbers still look like it has the potential for 1-2c eps for their first full quarter of production, but the first full quarter of production is not likely until 2008 due to problems getting the zinc circuit functioning.

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Gold – What’s in a Currency?

Whether a currency is weak or strong seriously affects buying power. Being Canadian, I have traveled the US when it took $1.50-1.60 to buy one US dollar. It keeps the cost of imports expensive. It helps export businesses and it helps tourism as people from countries with strong currencies see tremendous value in their vacations.

Gold is not a currency, but it does act like a form of money, and it preserves wealth in countries experiencing currency devaluation. It can work the opposite for countries whose currency is gaining strength.

We think we have cost of living issue, have you checked out Zimbabwe? According to this May article, Zimbabwe inflation in May, the cost of living double last April/May. It is predicted to be as much as 100,000% over this year, Zimbabwe inflation up more. The official exchange rate is very different than the black market rate where when converted to US dollars teachers make $100/month at the official rate and $6/month at the black market rate, Zimbabwe teachers on strike. Clearly demanding pay in grams of gold would protect buying power. Check out the video on life in Zimbabwe, Zimbabwe living in hyper-inflation. Currently, foreign currency is king.

Zimbabwe is experiencing hyperinflation. Check out their stock market and the graph goes straight up. Check out the early warnings, as this 2001 article shows, Zimbabwe 2001 decsions and one starts to see that the burden of debt and the inability to attract foreign dollars as investors did not see that the interest rate offered would protect their investment from currency devaluation. Life has gotten very bad, indeed, Zimbawe lifestyle lost to hyper-inflation.

Canada’s weakened dollar through the 80s and 90s was due to debt. Few Canadians appreciate the debt of gratitude Canadians owe former Prime Minister Brian Mulroney and finance minister Michael Wilson. They took over a Trudeau government that had program spending exceed tax revenues by $39 billion per year, never mind the cost of debt servicing. By the time Mulroney left office program spending match revenue. Canada still had a deficit in that tax revenue still did not cover debt servicing, but the changes they made during their tenure was outstanding.

Anyone who says other has a poor understanding of calculus, which tells us that if a graph is concave down, the rate of increase is coming under control. The graph for Canada debt was concave down for the entire time this team worked together. The graph of increasing debt under Trudeau is concave up, straight up. Many older Canadians look back at the Trudeau years as the glory years, but he left a burden of unsustainable program spending and debt that many Canadians blame the Prime Minster’s that were left to deal with the problem. No kidding the times feel very good indeed when fair share of taxes are not paid and the burden of paying for yesterday's lifestyle is passed on to future generations.

To that end, Mulroney and Wilson harped on and on about our debt problem and they set the stage for Canada to control debt and eventually move to surplus budgets, $13.8 billion for 2006-2007, Canada surplus budget, Canada budget highlights.

The US has increased debt, and they have increased it to levels that I believe are worse than Canada ever faced. And US currency is devaluing because of it and US congress is asking to increase the level of debt a few times per year. You can see that US debt was under control with Clinton, but out of control with Regan, Bush and Bush, graph of US debt. Last month the US Senate Finance Committee approved increasing the limit on debt to $9.8 trillion. Canada’s debt is $587 billion. With roughly 1/10th the population it means that the US level of debt per person at the federal level is about 1.7 times as high, and unlike Canada which currently has surplus budgets, there is no evidence that US government spending is coming under control, yet another increase to US debt.

Gold has protected wealth for Americans as government has continued out of control. With lowering the Federal Reserve rate last month from 5.25% to 4.75% the US government has chosen to devalue the US currency. The US dollar lost about 6% buying power in September alone in contrast with Canadian currency.

Gold has strongly outperformed many investments for US investors because of currency devaluation, but has not been nearly the performer for Canadian investors.



Over five years gold is up 41% for Canadian investors, or about 7.1% per year annualized. For US investors gold is up 126% over 5 years, or 17.7% per year annualized. Over a shorter term, say 6 months, gold has not been a good investment for Canadians.



Gold is down 6.1% for Canadians and up 8.3% for Americans. Gold is offering some protection of wealth from currency devaluation for Americans. If I were American I would consider owning some gold bullion as part of a diversified investment strategy. The Canadian dollar has had the fundamentals to strengthen the currency through debt management for a long time and it is showing up in a stronger Canadian dollar, from about $1.60 to by a US dollar five years ago to par today.



Surely, if the US government reduces the Federal Reserve rate, the US currency will devalue more and gold will increase in price in US dollars. It may or may not increase in price in Canadian dollars. If the Canadian dollar gets stronger relative to the US dollar, it is likely gold will decline in Canadian dollars.

If Americans panic about preserving wealth from a declining currency and do it through buying gold, gold will likely skyrocket and even currencies gaining strength relative to the US dollar would see gold increase. Should this happen gold will also be a very good investment for Canadians.

Gold behaves like a master currency against all currencies, gaining when a currency declines, and losing when a currency gains. It is subject to the same market forces that lead to selling-off and under valuation and speculation leading to over valuation, which makes the contrast to currencies relative to how gold is valued in the market as a whole. But it is ultimately a master currency. Gold stocks are not bullion and have very different fundamentals that need to be looked at one at a time. A gold stock with costs in foreign currencies will see costs going up due to currency devaluation and will not necessarily see a leverage of earnings that investors expect. Some gold stocks have very strong leverage of earnings expectation built into their price, completely ignoring the explosive cost increases due to currency devaluation.

Currently gold stocks tend to sell off all of their gold, trading it for the very fiat currency their philosophy claims to abhor.

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Long Live the Credit Bubble!

Today Bush announced plans to essentially bail out irresponsible lenders, developers, borrowers, brokers, basically anyone involved with the subprime mortgage mess, as this news release outlines.

There are a number of responses, critical as in Mish's post, and I do think Mish is right on with his analysis.

I am not sure what to make of "Parting the Bankrupt Sea." He points out that those hurt by this move are those who correctly assessed that these were bad investments and there would be a crash. I simply don't get the part of this post that says:

This is a good move by our government (unless Bush does something really odd during his speech later today or Bernanke usurps President Moses Bush with comments that are at less than positive and supportive)

I don't see at all how it can be a good move to bail out highly irresponsible activities. Governments role is to regulate highly irresponsible activities, not dip into taxpayer's pockets to make irresponsible activities ok. At best, it is a short term solution that allows the wealth to cut their losses.

Another post, just a graph, shows the degree to which US debt has risen relative to that which makes a nation strong. The graph screams to me the degree to which today's promise is short term, unsustainable and further cannibalizes the future.

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Declining grade of Gold – Are the cost disadvantages linear?

This is an analysis that I have been meaning to do for a while that simply looks at how mining a declining ore grade affects costs. This is a particularly important analysis for investors of gold stocks as my sense of the market is that the grades of gold being mined are declining faster than any other commodity, and additionally, replacement reserves for gold companies are grossly lower quality than reserves that are currently being mined.

The markets were awful while I was away on vacation, and some of the market fears from the subprime mortgage market spilled over into commodities. These fears as well as fears of stagflation or hyper-inflation are part of what is driving gold prices and gold stocks. The idea is that gold will hold wealth better than paper currency that is simply printed at will.

Figuring out what gold bullion is “worth” is very easy, just go to Kitco.com. If you think the price of gold will double, well, just buy the bullion and your investment will double.

Figuring out what a gold stock is “worth” is a very complicated thing and nothing about how a company is run is in your control. Proper evaluation of a gold stock requires an enormous amount of time. A simple linear extrapolation that if they double production they double earnings is proving to be false due to increases in costs that would be best described as a hyperinflation of costs, as in the Goldcorp 2004 project of costs for 2006 of $70/oz that ended up 179% higher at $195/oz. Gold stocks also have a propensity to issue equity at will, highly diluting wealth as well.

My suspicions are that gold producers are mining off their higher grades at a rate that leaves drastically reduced grades left to be mined and they have drastically lower grades in replacement properties so new mines do not have any chance of coming close to the profitability of historical mines despite higher gold prices.

The question I want to answer is how does the declining grade affect costs. I suspect that costs do not increase linearly with declining grade, but exponentially and if I am correct, many investors are going to find themselves in serious trouble with their gold stock investments, even if the price of gold doubles.

As the purpose of this investigation is to simply understand what happens to costs when all things are equal except the grade declining, I will make some very simple assumptions. First, assume there is a part of the processing linked to the cost of grinding the ore and extracting the gold. For this analysis assume the cost is fixed per ton of ore. I will assume a cost of $25/ton of ore, as you might have for an open pit operation. At the end of this will be a gold concentrate that requires more processing to extract the pure gold. The second part of the process assumes a fixed cost per ounce of gold. I will assume a fixed cost of $10/oz of gold.

Further, I will look at how a 0.5 g/ton decline affects costs from 100 g/ton down to 1 g/ton. The last assumption will be that 32 grams of gold must be extracted to get one ounce of gold. Recovery is never 100% and using this number works out to 97% recovery. My educated guess as a chemist is that the overall percent recovery would also decline with declining grade, so more than likely this analysis will understate the increasing costs with grade.

I set up a simple spread sheet at http://spreadsheets.google.com/pub?key=pHy7hQjBLOcqL73eztsvRaQ. It shows that with the costs used a half-gram decline in grade when the grade is over 30g/ton is utterly marginal to costs. The follow graph is the percent increase in cost as the grade increases.



This graph demonstrates beyond my wildest expectations that costs hyper-inflate for low grades of ore. The prices I used would be for a low cost open pit operation. The graph does not explain how Goldcorp’s projected costs ended up being 179% higher over a two-year period.

When I put a cost of $175/ton of ore for processing for underground mining my model gives costs of $80/oz when the grade is 79.5g/ton, reasonably close to Goldcorp’s $80/oz when they were mining a grade of 77g/ton. At 30g/ton the model gives a cost of $187/oz, very close to the $195/oz they had around that grade. Interestingly, the model shows that it would cost $5,600/oz to mine underground grades of 1g/ton, and double that, $11,200, for a grade 0.5g/ton.

This is a very simple model, but the lesson it shows is something that every gold investor ought to understand. Below is the graph reproduced for grades 6 grams and less, showing the increased percentage cost for a grade decline of 0.5g/ton, and I reversed the director of the x-axis so you can see the out of control, concave up, shape of the curve.



This graph should have investors of companies with low-grade reserves feeling utterly ill. I would suggest that what it means is that anyone signing their name saying that a low-grade reserve is economically viable is either incompetent, unethical or they think investors are truly gullible and stupid.

I have worked as a chemist in a lab and the entire economic viability of the feasibility study rests on the accuracy and extrapolation of the assay results. The lab I worked in we used to regularly send out samples to other labs as a crosscheck on our results and there would typically be up to a 30% variation in results. To test where the problem in results lay, I sent out duplicate samples labelled differently and carefully prepared and tested standards and the results returned were out by 30%.

This graph is showing that when grade declines from 6g/ton to 5.5g/ton, costs increase by almost 10%. A half-gram decline at 3g/ton has cost increases of about 20%. At 2g/ton the same decline results in a 30% increase in costs, and at 1g/ton the decline results in about a 100% increase in costs. When you consider the potential error in assay results, the margin of error in these feasibility studies on low-grade deposits is potentially so enormous; these kinds of investments simply are not investments, but truly a form of gambling.

Conclusion:

The cost increases in low-grade deposits are not linear, but exponential and imitate a hyperinflation of costs as grade declines. In high-grade deposits errors in feasibility studies due to errors in grade or small declines in grade are relatively small and have a minor effect on investment decisions. Feasibility studies on low-grade deposits are highly suspected for huge errors due to the grossly different economics of low-grade deposits from small errors in assumptions and data. Using these studies for investment decisions resembles gambling more than investing.

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Exploring Declining Grade

In 1905 the Bingham Canyon mine opened mining a copper grade of 2%. Last year the grade they mined was 0.63% and the reserves they have left to mine have a grade of 0.54%. In 2003 Goldcorp’s Red Lake mine mined a gold grade of 77.5 g/ton, and 28 g/ton in 2006. These are a couple examples of a trend of declining grade in individual mines and within the industry as a whole as the best deposits tend to be mined first. This post looks at declining grade in a single mine. I suspect that declining grade affects costs exponentially rather than linearly, and I will examine that next post.

There is no question that grade is related to profitability. Looking back to Goldcorp’s 2003 financial reports, when it was much simpler company with just two gold mines, Wharf and Red Lake, it is absurdly easy to see the contrast in the two mines. For 2003 the Wharf mine had an operating profit of $100,000 and on the $24,900,000 in revenue, it left an operating margin of 0% reported on the financial reports. The average grade mined for the year was 0.9 g/ton. Red Lake had an operating profit of $153,000,000 on $224,000,000 in sales, or a monstrous 68%!

Indeed, in 2003 Goldcorp reports that from the 602,845 ounces it produced, 532,028 from Red Lake and 70,817 from Wharf, earnings were $85.7 million with an average gold price of $364. At a price of $600/oz, assuming 40% of the increase goes to taxes, at this rate you’d expect 600,000 oz of gold to earn about $170 million, or each 100,000 oz of gold produced to earn just over $28 million. If you correct for the fact that the Wharf ounces contributed nothing to earnings -- all $85.7 million in earnings came from Red Lake’s 532,028 ounces – Red Lake would have earned about $30 million per 100,000 oz had gold been $600/oz. Goldcorp actually earned more that year by selling off stockpiled gold, but that is an independent action in terms of individual mine’s profitability.

In 2006 Goldcorp’s Red Lake produced 665,600 oz, had an average price of $609 and contributed $177.1 million to the earnings. That is below the $203 million one would expect if Goldcorp had remained as profitable assuming 40% going to taxes. In fact, only 32% went to taxes and controlling interests, so with 32% used instead, one would expect $216 million towards earnings. The calculation I did here was:

($30 million +(($609-364)/oz)*(1-0.32)*100,000oz/$1,000,000)*(665,600oz/100,000oz))

where the $30 million per 100,000 oz was calculated above, the $609-364 is the increase in gold price realized, the 1-0.32 gives the 68% that should go to earnings, the 100,000oz/$1,000,000 converts the number to millions of dollars per 100,000 oz and the 665,600oz/100,000oz corrects the number of ounces to what Red Lake actually produced.

To put this change of how much more Red Deer ought to have earned based on how well it did in 2003, use the calculation $216/$177 -1 = 22%. There would be 2-3% inflation per year, but overall, profitability per ounce at Red Lake declined at a rate of 6.8% per year.

But even that does not include Goldcorp’s vision for 2006. They write in their summer 2004 Outlook:

It is December 2006, and the winter freeze has already engulfed Ontario’s northwest, but operations at Goldcorp’s Red Lake Mine are running at a feverish pace with the completion of a new 7,150-foot shaft that now gives greater access to the world’s richest gold deposit.

The $100 million project, which was completed on schedule and within budget, has increased production from 510,000 to 700,000 ounces per year and lowered costs from $80 per ounce to $70 per ounce. What’s more, the shaft has been constructed with excess capacity so that when ongoing exploration uncovers additional reserves, production will be able to increase accordingly. This will help achieve Goldcorp’s ultimate goal of increasing the company’s annual production to 1 million ounces.

Their vision was to reduce cash costs by $10/oz, which at that 32% tax rate should add even another $6.80*665,600/1,000,000 = $4.5 million, or, ignoring that they missed their production target by 5%, earnings ought to have been $220 million, or 24% more than they achieved.

Missing their production goal by about 5% is a relatively minor problem. But their cash costs of $195/oz are 179% above there vision!

How can a vision go so wrong?


In 2003 they mined 242 thousand tonnes of ore and in 2006 they mined 769 thousand tonnes of ore, a 218% increase, but because of the decline in ore grade they only mined an extra 25% more gold.

The costs are given per ounce of gold produced, but the numbers may make more sense trying to look at them as cost per ton.

So, in 2003 the grade was 77.5 grams per ton, or 77.5/31.1 = 2.49 oz per ton. With costs of $80/oz, $80*2.49= $199/ton. So the cost per ton of ore processed was $199.

In 2006 the grade was 28grams per ton, or 28/31.1 = 0.90 oz per ton. With costs of $195/oz, $195*0.90= $175/ton, or a decline of almost 14%, almost identical to the 14% decline in costs outlined in Goldcorp’s vision.

In this example, the rising price of gold has completely hidden perilously increasing costs due to declining grade and enabled a healthy profit margin to be maintained, but it is a rapidly declining margin relative to production, cost per oz of gold increased 179%!

Goldcorp’s remaining proven and probable reserves average 22.24 g/ton. They have 1.55 million ounces at a grade of 41.48 g/ton, and then the probable grade declines to 18.57 g/ton for 3.64 million ounces. If we use the $175/ton of ore processed, the cost per ounces for mining a 41.48 g/ton gold ore grade would be (31.1/41.48)*175 = $131 per ounce of gold. The 18.57 g/ton would have a cost (31.1/18.57)*175 = $293 per ounce of gold, and considering the average of the grade, 22.24 g/ton you get cost per ounce of gold of $245.

What this means to investors is that failing to pay attention and assess the quality of the reserve grade and whether it is maintaining, improving or declining could cost you dearly in your investments. It means that you absolutely cannot look at a gold stock, or any other metal for that matter, and mentally calculate that if they are doubling their production profits should double. It also means that the values of assets in the ground are highly dependent on grade. This simple look suggests that Goldcorp’s 1.55 million ounces of proven reserves in Red Lake are worth about $160/oz more than the probable reserves of 3.64 million ounces, and by the time Goldcorp starts mining the reduced grade, gold will need to be about $830/oz to maintain profits at Red Lake, not improve profits.

It is utter nonsense to add up the reserves and resources of grossly different metal grades and come up with some kind of valuation without correcting for the grade quality.

Many things affect profitability, but declining grade seems to be is the most ignored or unrecognized source of implosion of value and earnings.

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Fantasy Girl Revist - Google Googlplexed

In the fall I was writing my blog over on Stockhouse and I wrote this 10 part series which I titled Fantasy Girl and a subtitle for each post. Half the posts were taking detailed look at why Google's earnings would not keep up, as in the news story Google's Profit Falls Short, Shares Drop. The other half were looking at Goldcorp and the serious valuation problems with that one for investors. Those parts I worked on polishing up further and turned it into my post, How I Discovered the Gold Bubble.

For the Google related part of the series I intended my posts to show how when growth rates are unreasonable large applying that PEG dogma is nonsense by starting with an absurd rate of interest and hoped people would make the connected that their expectations from Google were also absurd.

I like Google's products and services and use the all the time, however, when too many people get on a boat it sinks. Here's my original analysis of Google from November 2006.

Fantasy Girl - Up 10,000,000,000 % Part I

Have you ever had a day where you could say you were up 10,000,000,000%?

Are you sure?

Just what kind of daily percent would you have to make each trading day to make 10,000,000,000% in a year?


Compounding interest is a wonderful thing. I do this math thing where my spreadsheet calculates my percent change for the day, and my annualize change if I did that percent each of the 240 trading days of the year.

The formula if you let D be your day's earnings, O be your day's open is:

Annualized rate of return = (1 + D/O)^240 - 1

The D/O gives you your percent increase for the day, and taking it to the power of 240 compounds it much the same way you might to a simply compounding interest calculation for 10 years.

So, what percent?

Well, I found out yesterday, and wow, what a lesson on compounding interest. 10 billion percent it said, and I went to correct my error, only there wasn't an error. At that point my portfolio was up 8%, and wow, the annualized rate of return if you could do that everyday is 10 billion percent! And a different stock, with a small holding, went up, so I changed it, and wow, up 13 billion %, and up more, and then 33 billion %.

But wait, that's not a lot of extra dollars causing that jump. Huh? I looked at the percents, 8.1% gets you 13 billion, and 8.5% gets you 33 billion, and well, 10.1% gets you over a trillion %.

In absolute terms, the increases are small compared to compounding effects. By comparison, to go from 0%, to 0.1%, the same absolute difference, as 8% to 8.1% the annualized rate goes from zero to 27%, a small percentage difference compared to from 10 billion to 13 billion %.

And herein lies part of the problem in how we can get ourselves into enormous trouble with our portfolio when past growth rates of a company are used to project future valuation. The bigger the growth, the company experienced, ie, already had, the harder it is to ever meet that crazy expectation.

In the next few posts I'll examine the financial difference between using past growth numbers and future growth numbers, and how some of the those past growth numbers are setting investors up for financial ruin.


Fantasy Girl - 300 Billion! Part II

The main idea from the first post in the first Fantasy Girl series was that as the rate gets higher, the magnitude of the difference in compounding increases dramatically with tiny increases in the rate use. The two examples have a mere 0.1% difference in rate. Compounded rate = (1 + daily rate)^240 - 1

	Daily rate	Compounded rate
A	8%	10,000,000,000%
B	8.1%	13,000,000,000%
B minus A	0.1%	3,000,000,000%
C	0.0%	0%
D	0.1%	27%
D minus C	0.1%	27%

The tiny increase in rate in these two examples is 0.1%, but the absolute difference becomes unimaginable as the rate gets absurd.

But, what would happen if you did that 0.1% per trading day for say, 12 years?

Year	Total interest
0	0%
1	27%
2	62%
3	105%
4	161%
5	232%
6	322%
7	436%
8	581%
9	766%
10	1001%
11	1299%
12	1679%

Well, if you started with $10,000, in 12 years you'd have $177,88, and $167,880 of "wealth" has been created.

But, just how did that wealth get created?

There are many paths to that wealth. Some will create wealth that will be sustainable, and some could be described as lying in wait for nuclear melt down.

How about taking a look at say ... Google (GOOG), and later, a much smaller company.

Google's market cap is $153 billion dollars. Google's share price is up about 33% in two months. About $38 billion dollars of market cap.

And just what is the annualized rate of growth if you increase by 1/3rd in 3 months?

(1.33^6 -1) = 213%

Oh boy, if we keep going like this, we should see $1100/share by next summer and a market of $300 billion. What a great company... And wow, this company is everywhere, it can do anything...

But....

Part III a closer look at what Google's financials are saying...


Fantasy Girl - Googlplex 10^100^10 - Part III

Googolplex - 1 followed by a googol of zeros

Recap:

• As growth rates increase even marginally, they have exceptionally larger effect on the end numbers.
• Google has a market cap of $153 billion and its share price is up 33% in two months, creating $38 billion of market cap.
• To continue at the current growth rate, Google would be up 210% by the end of the year.
  

Oct 19, 2006
EXTRA, EXTRA READ ALL ABOUT IT
Google Revenues increase 70%

The PEG Ratio says that if price/earning is less than the growth rate, you've got an undervalued stock, although the Motley Fool suggests it should be 0.5 or less to be undervalued (http://www.fool.com/Pegulator/pegulator.htm). For correct use, the PEG is dependent on an expectation of 5 years of growth at the rate used for the earnings per share.

So, just what have Google's earnings per share been?

Quarter	Earnings/ share	1% increase over last Quarter	2Annualized Quarter Growth	3Annual Growth to Q1/05
Q1 2005	1.29	n/a	n/a	n/a
Q2 2005	1.19	-7.8%	-27.6%	-27.6%
Q3 2005	1.32	10.9%	51%	4.7%
Q4 2005	1.22	-5.5%	-20%	-7.2%
Q1 2006	1.95	59.8%	553%	51%
Q2 2006	2.33	19.5%	104%	48%
Q3 2006	2.36	1.2%	5.3%	41%

1This is a quarterly rate of return (loss). 2The rate must be taken to the 4th power to get the annualized rate. 3This is what the rate of return is if it was constant back to Q1 2005.

The headline said 70% growth, where is it in the earnings?

Seriously, time to apply the PEG ratio, using the 5 year standard that it was based on. So, being optimistic, lets say that overall annual rate of 41% will be continue over the next 5 years. Keep in mind that a 41% annual growth rate means we are looking for 1.41^5-1 = 457% over the next five years. If you don't appreciate why we are looking at 457% growth over the next 5 years, go back and read www.stockhouse.ca/blogs.asp?page=viewpost&blogID=459&postID=6959.

So P/E = $505/(2.36+2.33+1.95+1.22) = 64.2

Hmmm, 64.2 is not less than 41. 457% of sales growth over the next 5 years will not be enough. 64.2/41 = 1.56

Double hmmmm. At 1 - 1.3 the Motley fool is saying a stock is overvalued. At 1.7, it is saying short!

But, there is something even more serious to notice here, the gross rapid decline in the quarterly growth rate in 2006. The decline in that growth rate is like a nuclear melt down.

And seriously, 1.642^5-1 = 1094%. To force the PEG to be one, we need 1094% in growth of earnings over the next 5 years. And that's for the current share price to catch up to itself, without growing at this absurd rate of 450% per year. We need even more growth in real sales and real wealth if the stock continues to create market cap out of thin air.

But, given this, I predict the next headline will read an even great rate of growth. Next post I'll explain how the numbers can be used to show this, and I'll even predict when the nuclear meltdown will occur.

And even more seriously, earnings per share are 1.6% of the share price. You can do better in the bank and your money is safe.

Fantasy Girl - Googlplex^Googlplex - Part IV

Googol - 10^100

This is the 4th post in a series on valuation and growth when growth rates are big.

Recap

• Google's 2 month growth rate on share price ($380->$505) is 210% annualized.
• Correct use of PEG says earning must be expected to increase by 1094% in the next 5 years without any further increase in share price.
  
• Quarterly data on earnings per share show dramatic declines in growth.
  

Perceptions of Growth - Google's Next Quarterly Report

The last quarterly headline read "Revenue Up 70%." And the next report will probably read something like "Earnings up 90%." Remember the 3 billion percent difference in annualize return between 8 and 8.1% from part 1? Yet it didn't seem so extreme using 0% and 0.1%. A large past growth rate easily hides rapidly declining growth. Here's how.

First, we need to look at earnings per share and increases in earnings per share over the previous quarter, and the quarter one year ago.

Quarter	Earnings/ share	% increase over last Quarter	% increase over Quarter 1 year earlier	Quarter increase annualized
Q4 2004	0.71	n/a	n/a	n/a
Q1 2005	1.29	82%	n/a	997%
Q2 2005	1.19	-7.8%	n/a	-28%
Q3 2005	1.32	10.9%	n/a	51%
Q4 2005	1.22	-5.5%	72%	-20%
Q1 2006	1.95	59.8%	51%	552%
Q2 2006	2.33	19.5%	96%	104%
Q3 2006	2.36	1.3%	78%	5.3%

If you just compared Q3-06 to Q3-05, you'd see a 78% growth in earnings, and that's exceptional. But, where in the news was the headline:

Google's Growth in Q3 Earnings Decline by 94%

(1-1.3/19.5) * 100% = 94%

We are playing with exponential growth here, so it is fundamentally important to consider the exponential growth consequences.

But, lets look at how the headlines will read for Q4, based on 3 projections I got from MarketWatch, a low estimate of $2.31, a mean of $2.72, and a high of $3.13. Notice earnings in Q4 2005 were down. That's going to be great for punching the numbers to make things look good... Might even be able to get away with increasing projections to $1000 per share!

Q4 2006 Estimate	% increase over $1.22	% increase over $2.36	Annualized Growth Rate	PEG = one @
2.31	89%	-2.1%	-8.2%	$795
2.72	123%	15.3%	76.5%	$1150
3.13	156%	32.6%	209%	$1500

So, there you have it, the next headline:

Q4 - Google's Earnings up 89%

And the red elephant hides in plain view. PEG wrongly used supports share prices at a low of $800 and a high of $1500, creating an additional $90 to 300 Billion in market cap, out of thin air. I need one of these money trees in my back yard.

But what of Q1 - 2007? Notice that jump from $1.22 to $1.95 between Q4 and Q1? That's going to play havoc with the numbers. MarketWatch estimates are a low of $2.10, a mean of $2.98 and a high of $3.28

Q1 2007 Estimate	% up over $1.95	% up over $2.31	% up over $2.72	% up over $3.13	Annualized Rate Over $2.32	Annualized Rate Over $2.72	Annualized Rate Over $3.13	PEG = one @
$2.10	7.7%	-9.1%	-23%	-33%	-32%,	-65%	-80%	$73
$2.98	53%	29%	9.6%	-4.8%	176%	44%	-18%	$550
$3.28	68%	42%	20.6%	4.8%	307%	111%	21%	$725

There's a lot more red elephants in that chart, and the growth over the same quarter in the previous year is much smaller than what Q4 projects. I predict there's going to be a lot of pain right about here.

One more thing, that by looking at the PEG calculation between three estimates and 2 quarters and finding a share price valuation that varies by a magnitude of TWENTY ($73 vs $1500) simply says the PEG is grossly misused and is best left for Voo Doo economics.

Part V, a different kind of valuation...

Fantasy Girl - Scrooged - Part V

"But you were always a good man of business, Jacob." Ebenezer Scrooge

Recap

• Google's market cap: $153 billion, $38 billion created in past two month.
• Q4 PEG could support $800-$1500 share price, creating up to $300 billion more market cap.
  
• Q1/07 PEG could suggest a share price as low as $73, destroying $130 billion in market cap.
• Oops, easy come, easy go, $6 billion of market cap gone today 11/27/06.
  

How does your bank treat you?

Ultimately, sound investment is about a company's ability to generate earnings relative to the investment. Sure, there is tons of money to be made on greed, fear, and speculation, but that isn't realistic or fair valuation.

Your bank:

• Wants security for 6%
• Good credit rating for 10%
  
• Has legal recourse against you
  

Google, earnings per share from the last 4 quarters comes to a mere 1.6% of share price, you have no legal recourse and you are risking your savings. By banking standards, for fully secured, earnings per share needs to be in the $30/share range $7.50 per quarter at the very minimum. Currently, Google's earnings per share aren't even keeping up with the rate of inflation!

So, just how much do you expect Google to grow to reach market staturation? At some point all companies reach maturity and have limited growth prospects. Where is that for Google, and how many years?

Say the company grows to earnings of $50 per share in 10 years to reach market maturity, and at that point because Google is a big secure company, that's about where earnings will stay. This is a highly optimistic quarterly growth rate for earnings of 4.3%.

Lets examine 3 examples:

1. You want 6% return on your money and you are confident Google can to it.
2. For that kind of speculation, you want 10% return on your investment today.
3. You think growing to earnings of $50/share is highly unlikely, and you want 15% because of the high risk you are taking because it is highly unlikely.
   

For $50/share earnings to be 6%, the share price would be $833.

% return wanted (r)	(1+r)^10	Present Value of Shares
6%	1.79	$465
10%	2.59	$321
15%	4.04	$206

So, with a low expectation of return (6%), and highly optimistic growth projections (>400%), a fair share prices would be $465. But wouldn't bonds be safer?

With a 10% expected rate of return, and a highly optimistic growth projection, $321 would be a fair share price.

And finally, if you don't think it is likely, and want 15% return because of the high risk of not making it, $206 is a fair share price.

Some created wealth is sustainable, but some is simply waiting for nuclear melt down. So Barrons called Google richly valued today.

Can we say Google Bubble?

Next a little gold dust fantasy.

www.forbes.com/2002/09/13/400fictional_5.html

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