David Hillier's Finance Classroom

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How to Value Firms: The Market Valuation Approach

How to Value Companies Part One: The Market Valuation Approach

In this four-part series on valuation, I will describe different approaches to valuing a firm.

My advice is to start off with the methods given in this post, adapt them to the specific industry and corporate conditions, and then come to a consensus view based on all four approaches.

The Four Valuation Methods:

  1. Market Valuation, where actual market information is gathered on the debt and equity of a firm.
  2. Free Cash Flow to the Firm, where the present value of future cash flows to the firm are calculated.
  3. Asset Approach, where the company’s assets are valued.
  4. Valuation Multiples, where information is used on peer firms in the same industry to arrive at a valuation of the firm.

To show valuation in action, I will use the global pharmaceutical firm, AstraZeneca plc, as an example.

The Market Valuation Approach   

The Market Valuation method takes data from the stock market to value a firm.


  1. Find Equity Value: Visit any financial webpage (such as FT.Com, Yahoo! Finance, etc.) and find the market capitalization of equity. I went to FT.Com’s webpage for AstraZeneca plc and got the information below: AstraZeneca Market Capitalisation Figure 1: Summary data on AstraZeneca, 26 November 2016 (source: FT.Com)

The Market Capitalisation of equity is £54.30 billion.

  1. Find Debt Value: In most countries, corporate debt is traded irregularly. This means that the prices you get from financial pages can be out of date by a long way. The fastest way to find the value of a company’s debt is to get the total value of its liabilities from the most recent set of accounts. Don’t worry about any bond issues or loans issued since the most recent report because the cash raised will be reflected in the equity market capitalization.


Figure 2: AstraZeneca Balance Sheet (Source: AstraZeneca 2016 Q3 Results)

From Figure 2, the value of the Debt is equal to total liabilities = $48.31 billion.

At an exchange rate of $1.2478/£ (source: XE.com, 26 November 2016), AstraZeneca’s debt is worth £38.72 billion.

The total value of AstraZeneca plc according to the market valuation method is £93.02 billion.

Value of Equity + Value of Debt = £54.30 billion + £38.72= £93.02 billion.

Strengths and Weaknesses

The strengths of the market valuation method are as follows:

  1. Share prices contain all available information in the stock market including future growth prospects, intangible assets and the quality of a firm’s management, among other factors.
  2. The information you are using is the most up to date out of all the valuation approaches. Other methods use figures that can be many months old.
  3. The method makes no theoretical assumptions and is based entirely on observed market valuations.


  1. Market prices may not reflect value fundamentals. This can occur if a firm is the target of a takeover and the price has responded to the potential bid.
  2. If the company is not publicly traded there will be no market prices. Most valuations are carried out for private companies with no share price, which makes it impossible to use this method.
  3. The company may be small and traded infrequently leading to stale market prices. Out of date information can cause as many issues as poorly estimated information.

If a company is large and traded on the stock market, the market valuation method can be used quickly and easily to arrive at a firm value.

In my next post, I will explain the Free Cash Flow to the Firm method, which is also known as the income approach to corporate valuation.

Strathclyde Business School 2016

Strathclyde Wins Business School of the Year!

I am absolutely delighted that Strathclyde Business School has won the Times Higher Education Business School of the Year.  This is a great reflection on all the staff and students, past and present, of my great institution.

The Times Higher Education Awarding Panel announced:

An innovative programme that boosted the external business engagement of Strathclyde Business School was a substantial reason for its being named as winner of this award.

Under the Growth Advantage Programme (GAP) – launched in June 2015 in conjunction with Santander bank and the first of its kind in Scotland – leaders of businesses turning over at least £500,000 attend four workshops tackling areas critical to business growth, such as resource, market, operations and leadership advantage. GAP helps business owners to improve growth as well as providing them with relationship-building opportunities.

Along with this and Strathclyde Business School’s growing number of company-specific MBAs – including the Weir MBA, Babcock MBA and Iberdrola MBA – the judges were “particularly impressed” with the school’s level of external engagement, a central feature of Strathclyde’s agenda.

Strathclyde also garnered praise for its academic success. It was rated first in Scotland and in the top 10 business schools in the UK for its research in the 2014 research excellence framework. The results showed that, in particular, its research was strong in terms of impact. Additionally, the REF rated the research environment, for both academic and doctoral student communities, as joint first in the UK. A report that reinforced the business case for employers to adopt the living wage had particular impact.

“Strathclyde Business School has been innovative since its inception 50 years ago, responding to business and technological developments,” the judges said.

“We were particularly impressed with its level of external engagement… and the research project of the case for the living wage also impressed.”

Stock Market Investment in 2017

7 Key Equity Characteristics for 2017

It may seem as if the world has never been stranger nor more uncertain.  We’ve had Trump and Brexit in the second half of 2016. Who knows what will happen in Italy’s referendum or the elections in France and Germany in 2017?  Sterling has collapsed and the UK stock market has surged (although it has been relatively flat since August 2017).

The global economy appears just as risky.  Will Russia run out of money in 2017? Will the Middle East flare up further or will it calm down? How will China respond to the fracturing of Western political structures? What part will emerging markets play in global economic growth? Will the Gulf Region adapt to the low oil price regime?

Although it appears as if the risk facing financial markets in 2017 rivals that of the 2008 global financial crisis, the data doesn’t show this to be the case.  Consider the CBOE VIX Volatility Index (source: Google), which is a good proxy for uncertainty in the financial markets:

VIX Volatility

The risk at the tail end of 2008 was four times greater than today.

Saying that, we’re looking into a new period of protectionism and slowing economies.  In the UK, Brexit is contributing to a major suspected slump in growth and I wouldn’t be surprised if this is replicated over the next year in Europe as well.

With all this uncertainty, you may be thinking it’s not worthwhile to invest in the stock market in 2017.  However, if you take a long-term investment strategy (I never recommend short-term investments of fewer than 5 years in equities), there may be some good opportunities available.

Key Equity Characteristics to Look For

I’ve been thinking about the different equity characteristics one should consider in 2017 and have come up with seven key pointers.  These will help with the investment decision to buy, sell or hold over the next 12-24 months in any country or region.

Clearly, it will be difficult to identify companies that satisfy all 7 of my criteria, but I recommend that all good investments should have, at the very minimum, four of the below:

  1. Low Price-Earnings (P/E) stocks compared to industry norms. Research has shown that P/E ratios revert to the mean industry P/E ratio over time.  If a company has a low P/E ratio, it may be that the stock is underpriced. You can find Industry and company P/E ratios from Reuters (for example, check out current Oil & Gas P/E Ratios).
  2. Large Market Capitalisation. When the market is going up, smaller companies do very well and when it is going down, smaller companies tend to be hit worse. Stick to larger companies if you think the market is going to be bearish. Using the UK as an example, assuming that the FTSE 100 has fully anticipated the effect of a depreciated sterling on corporate profits, then I wouldn’t anticipate it growing by too much in 2017.
  3. Stick to Industries that have stable continuous demand or do well in downturns. This is a low-risk strategy because sectors such as retailers (especially discount companies like Aldi and Lidl) will perform consistently well during the bad times.  Strangely enough, firms that sell tobacco and gambling firms do better in downturns and these may be good areas to consider. Finally, Pharmaceuticals and Healthcare companies are solid players irrespective of the state of the economy.
  4. Low leverage firms Companies that have a lot of debt struggle to pay off interest when earnings drop. A permanent drop in cash flows leads to increased risk when interest payments need to be met.  Stick to companies that have low debt ratios if you think the economy is going to slow down in 2017.
  5. High operating efficiency During uncertain periods, only the most efficient companies can respond well to challenging external conditions. Look for high ROCE (Return on Capital Employed) compared to other firms in the same industry. Return on Investment (ROI) is another good ratio to consider (see Reuters for Oil & Gas ROIs)
  6. Stable recent performance This is a bit controversial, but I like the look of companies that have stable Net Income over the previous 24-36 months. When the future is uncertain, the drivers of very strong past performance may change dramatically and this could tip the earnings figures down.  Stable performance (irrespective of market conditions) is linked to my point (3) because it suggests that the company has a low-risk business model.
  7. Good cash balances More and more companies are hoarding cash (much more than twenty years ago) and, as a result, there is liquidity in the market. Ensure that your investment has good cash levels as credit may dry up in poor market conditions.


Taken together, The 7 characteristics will lead you to invest in undervalued companies with stable operating performance and lots of liquidity. They won’t provide you with stellar returns but would hopefully keep you financially safe if things don’t go well on the geopolitical arena. At a portfolio level, diversification is important, so invest in several companies rather than only one or two stocks.  Even better, think about Exchange Traded Funds or other investment funds.

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How to Estimate Equity Growth Rates

Equity Valuation: Why do Firms Grow?

In this second video of my Equity Valuation series, I ask two questions:

  1. Why do firms grow?
  2. What determines the return investors earn from equity investments?

This video is still in the theoretical space and I use the Dividend Growth Model to derive a simple expression that captures why firms grow. I then decompose investor returns into two components: Dividend Yield and Capital Gains Yield.  I am not working with real data at the moment as I need to ensure the basics are understood first.

Two Practical Insights:

  • Companies can change their dividend payout policy to ensure share price growth. This has no impact on the overall returns to investors (because they receive dividends and share price profits) but it can look like the company is performing well to unsophisticated or inattentive investors.
  • The key factor to ensure your company grows is to reinvest your earnings in good projects.  Any time you remove money from your company (such as through unnecessary expenses, high salaries, dividends), you are eating into future cash flows and reducing today’s firm value.   Controlling your expenses early and introducing discipline into your investments can have a massive impact on future cash flows.

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You Should Use Payback Period

Three Important Reasons Firms should use Payback Period

Over the past two years, I have grown more and more in favour of using Payback Period for making investment decisions.  This is based on engagements with a number of large and small firms who have raised their challenges with investment appraisal.

As you can see below (from Chapter 6 of my book, Corporate Finance), Payback Period is used in many large companies across the world.  In fact, it is the most common investment appraisal technique used by large firms in the UK.

Survey of Capital Budgeting Methods

The troubling issue for academics is that, compared to other methods like Net Present Value and Internal Rate of Return, Payback Period has so many theoretical weaknesses.

I will now show you how to calculate Payback Period and discuss its weaknesses. I will then explain why (despite its failings), it is one of the best methods for investment decision-making.

How to calculate Payback Period

When you calculate payback period you ask how long it will take to get your money back.  It’s as simple as that.

A basic example:

You invest £1,000 and receive £400 every year for the next 6 years.  The Payback Period will be between 2 and 3 years depending on when the cash flows occur during the second and third year.

Companies will have target payback periods beyond which they will refuse to invest in a project.  So, if your company had a target payback period of 3 years or more in the previous example, you would go ahead with the investment decision.  This is because the project payback period of between 2 and 3 years is less than the maximum Payback Period (3 years) the company is willing to consider.

Theoretical Weaknesses in the Payback Period Method

There are a number of theoretical and conceptual issues with Payback Period, which make it unattractive to academics.

  1. It doesn’t differentiate between cash flows that occur early in the project life cycle from those that occur later on.
  2. Payback ignores all cash flows beyond the company target payback period. In the previous example, the project may have a very large negative (or positive) cash flow in year 6.  This would be deemed irrelevant by the Payback Period approach and ignored.
  3. Target Payback Periods are subjective targets thought up by corporate management.  There is no theory justifying any particular target.

Three Important Payback Period Strengths.

  1. The Payback Period’s main attraction is its simplicity. Academics may forget that many corporate managers are creative entrepreneurs with skills in other areas like Marketing or Technology. In my experience, many businesspeople feel uncomfortable with concepts like Net Present Value or Time Value of Money. Payback Period simply tells you when you are likely to get your money back – providing insights into future liquidity and project flexibility.
  2. Although Payback Period does not explicitly consider cash flow risk, by ignoring future cash flows beyond a certain threshold period it is effectively reducing the present value of those cash flows to zero. This is comparable to a very high discount rate. High discount rates may be appropriate when firms face considerable future cash flow uncertainty.
  3. Forecasting cash flows beyond two years can be difficult, especially when a new product is introduced.  To arrive at a net cash flow for a specific year, one must predict market size, market share, sales price, variable costs and fixed costs.  These will all be predicted with error, and the errors grow in magnitude the further away the prediction. The best way to visualize this is to think of the prediction error below:

Prediction Errors in future forecasts

When viewed this way, it’s clear the theoretical strengths of methods that incorporate all cash flows (NPV, IRR, etc) may actually be weaknesses. Forecasts of long-term future cash flows will contain so much noise that the output figure (NPV, IRR) may be nonsense.  By ignoring later cash flows, Payback Period removes this prediction issue.

The Best Way to Use Payback Period

Payback Period is best used in combination with another method (IRR and/or NPV).  Only if the project is increasing wealth (has a positive NPV) and returns the initial investment within an acceptable period, is it worthwhile.

Use a hybrid investment appraisal method that combines more than one decision rule (for example, IRR and Payback, NPV and Payback). This is the optimal approach and dominates the use of any single method.

In fact, this is what many companies use in practice.


Equity Valuation

Video: A Brief Introduction to Equity Valuation

This new video series is in response to a number of requests from viewers to discuss how to value equities. I’ve already written a fairly detailed post on how to value equities with real data, but I want to go back to the fundamental concepts so that anyone can understand the main ideas underlying valuation.

I’ll repeat what I said in my earlier post: valuation is almost 100% about predicting the future.  If your predictions are inaccurate, there is a good chance your valuation estimate will be in error.

Valuing Equities during Volatile Periods

Because the financial markets are so volatile at the moment (Brexit and Trump presidency in the space of 6 months!), equity analysts will find it incredibly difficult to make good predictions of future cash flows.

What can you do in this environment?

  1. You can carry out a sensitivity analysis of your main assumptions relating to future dividends, discount rate and growth rate.
  2. Undertake a scenario analysis of different outcomes re: Brexit and US trade policy.
  3. Run a monte carlo analysis on your valuation model.

To find out more about these methods, check out my Risk and Sensitivity Analysis videos on YouTube:

In future videos, I’ll dig deeper in where we get the estimates for growth and discount rate.  Enjoy!

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How to write Brilliant Essays in an Exam

How to Write Perfect Essays for an Exam

If you are at university or college it is almost 100 per cent certain you will be asked to write an essay in an exam.  Fortunately, it doesn’t matter what subject you study, as the principals of essay writing are the exact same.

How to write brilliant essays is one of the most common questions I am asked by students.  This is a particularly worrisome issue for those who speak English as a second language and can mean the difference between a good degree qualification and failure.

Before the exam you need to fully prepare for essay questions and there are a number of things you can do to ensure you are well placed to write a killer essay that will attract a very good mark.


  1. Study past exam papers for essay topics and question structure. There are only so many essay questions that can be asked in an exam, and there is usually a predictable structure to the questions.  Are the questions open-ended? Do you need to discuss a statement? Do you need to explain a concept?  Write down all variations of past exam questions.
  2. Create your own essay questions. You’ll be amazed at how difficult it is to write a truly original exam question.  For every topic or lecture, create 3 exam questions: a) open-ended; b) discuss a statement; c) explain a concept.  If you do this for every topic, you will have an excellent bank of potential questions to practice.
  3. Practice your Essays. An examiner will expect you to write about an A4 page every 10 minutes.  So if you have to answer a 40-minute question, expect to write four pages (normal handwriting!).  This will be extremely difficult at first but I assure you, with practice, you can do it.
  4. Research how to apply the theory/concept/method. One thing that distinguishes excellent essays from run-of-the-mill attempts is showing you know how to apply the theory/concept/method in a practical setting.  For each topic, devise a practical example or brief case study.
  5. Independent Reading. For each topic, find two or three articles that research or critique the theory/concept/method.  This is another distinguishing essay characteristic examiners look for.  If you can show you have done your own reading, you will really impress the examiner.
  6. Memorise your lecture notes. This is the bare requirement for a pass.  Use mindmaps, flashcards or other memory aiding methods. For each theory/concept/method, ensure you can: a) describe it in detail; b) compare it to other theories/concepts/methods; c) know its strengths and weaknesses.

The Exam

  1. Read. Read the exam question carefully and highlight the important words in each sentence.
  2. Brain Dump. Do a brain dump of all the things you know about the topic. This should be half a page. List everything possible, including real-life application and references.
  3. Structure your Essay – The Beginning. An essay should have a beginning, middle and end.  The beginning sets the scene and structure of your essay. State what you are going to talk about and list the different sections of the essay. This should be one paragraph at a minimum but could be longer if the exam question is a big one.
  4. Structure your Essay – The middle. This is the core part of your essay and where you will get the most marks.
    1. Show you fully understand the main theory/concept/method.  This is essentially you rewriting the lecture notes.
    2. Give a worked quantitative example if appropriate.  By going through a calculation, you show you understand how to use the method.
    3. Give an example of how the theory/concept/method is used in practice.  This is your case study and should be a minimum of one paragraph but more is better.
    4. Refer and discuss to academic articles or other literature.  This part of the question shows you have undertaken independent reading and have gained more knowledge than what was provided in class.
  5. Structure your Essay – The End. You need to close off your essay by restating your main points and providing succinct conclusions.

Tips for Different Question Types

  1. Open-Ended Questions. These are the easiest questions because there is frequently no single answer.  For these questions, follow the structure as given above. Finance Examples include:
    1. Explain what is meant by the Dividend Growth Model and show how this can be used in Emerging Markets. 
    2. Explain what is meant by the payback period of an investment and discuss how the use of payback is related to the objectives of the company.
    3. Discuss the advantages and disadvantages of the use of the internal rate of return as an investment criterion.
  2. Statement Discussion Questions. For this question, you will be given a statement and asked to critique it.  An examiner is looking for you to show your understanding of the issue and so you should always make sure you present both sides of the argument: For and against.  Then you should present your position and justify it. The same general essay-writing principles apply. Finance Examples include:
    1. “Dividend Policy is Irrelevant.” Discuss.
    2. “NPV is completely useless in emerging markets because nobody can estimate a discount rate with any accuracy.” Do you agree with this statement? Discuss.
    3. “The only objective a financial manager should consider is shareholder wealth maximisation.” Is this a valid statement? Discuss.
  3. Compare and Contrast Questions. These are very similar to Statement Discussion Questions.  Present each theory/concept/method in turn and then discuss their strengths and weakness.  Show how each can be applied in practice and provide evidence of independent reading. Finance examples include:
    1. Review the strengths and weaknesses of the NPV and IRR investment appraisal methods.  In what situations (if any), would IRR be preferred to NPV?  Explain your answer using practical examples.
    2. Review the international parity conditions. In the context of Brexit, which condition is most likely to be violated? Which one is least likely to be violated? Explain.
    3. Compare and contrast CAPM with APT.  Is CAPM simply a subset of APT? Explain.

Marking Guidelines

It’s difficult to explain exactly how essays are marked because each examiner looks for different things. However, if you follow the guidelines given above, include evidence of independent reading, and know how to apply your knowledge in practice, you are sure to massively increase the chances of a good mark.

Best of luck and I hope my advice helps you in your exam preparations.


How to Value Equities in Under Five Minutes

One of the most requested topics I’ve received for my video series is Equity Valuation.  I have already recorded a video on how to value bonds (this is in the Corporate Finance playlist on YouTube), so it makes sense for me to look at equities.  To close things off, I also plan do one or more videos on total firm valuation.

Equity valuation is one of those topics where you can spend a lot of time considering complex models, equity risk premiums, stochastic discount factors, and  other academic concepts.

However, one has to realise that all of these techniques require very good predictions of future cash flows, as well as decent risk estimates.  Without these, it doesn’t matter how complex or fantastic your valuation model is, you are going to end up with a poor valuation.

In finance, we say, ‘Rubbish in, Rubbish out‘, and that maxim is very true when it comes to valuing equities.

Rubbish In, Rubbish Out

In my industry facing work, I have undertaken a number of commercial valuations and found that in most cases, you don’t lose much from going with a simpler, more general, model.  This is especially true in emerging markets.

Do you believe me?

If not, consider the following analyst forecast summary for Pfizer, inc, from 1 November, 2016.  I chose Pfizer simply because they were in the news, no other reason.

Twenty analysts follow Pfizer and you would think, given their full-time job is to value firms, that the price forecasts would be quite similar.  According to FT.Com, the forecast estimates were as follows:

Pfizer Analyst Forecasts FT.Com (1/11/2016)

Today’s price is $31.13 (They are actually down 1.19 per cent on the day), and the 12-month predictions range between $33 and $54, with an expected price in one year of $38.

In terms of capital gains yield, the expected percentage change in price is (38-31.13)/31.13 = 22.07 per cent.

However, the highest forecast return was (54-31.13)/31.13 = 73.46 per cent!

How can analysts who use the same publicly available information get such different answers?

It all comes down to predictions of the future, and clearly the $54 forecast is exceedingly optimistic about Pfizer’s operations.

A Simple Valuation of Pfizer

In the video series I will discuss equity valuation in a lot more depth, but let’s jump ahead and do our own valuation of Pfizer using real data. I am going to use the growing perpetuity model [PV = C1/(r-g)] to value Pfizer (if you want to know more about this model, please check out my video on Discounted Cash Flow Valuation Shortcuts)

According to FT.Com, Analysts expect Pfizer to pay a dividend of $1.19 next year. The estimated growth rate for the next twelve months is 6.34 per cent.

Pfizer Dividend Growth FT.Com 1/11/16

I did a quick google search on ‘Cost of Equity Pfizer’ and was directed to Gurufocus.com.  They use CAPM and calculate Pfizer’s cost of equity as 9.21 per cent.


We can now use the simple Dividend Growth Model to arrive at an estimate for Pfizer’s price: Price = Div1/(r-g) = 1.19/(.0921 – .0634) = $41.46.

Our estimate of the correct Pfizer price is $41.46 compared to the actual price of $31.13, so we would predict the price will increase over the next twelve months.

The range of analyst forecasts for the next twelve months is between $33 and $54, so we are definitely within the prediction interval of professional analysts.


I could, if I wanted, have taken a lot more time building a complex valuation model but I’m not convinced our prediction would have been much different from the very simple approach given above.

In addition, since we are predicting the future, we don’t actually know what is going to happen and can only say that (if the above figures are realistic), Pfizer appears undervalued.

Will Pfizer’s share price increase to $41.46? Will it increase to $54?  Nobody knows and only time will tell.

If you want to understand Equity and Firm Valuation, be sure to watch my upcoming video series on YouTube.

If you wish to subscribe to the Finance Classroom Newsletter, please supply your e-mail address at the side of the page (or the bottom if you’re using a mobile phone or tablet) and click the ‘subscribe’ button.  You will receive an e-mail notification each time a new article has been posted and exclusive posts based on subscriber requests.




Three Steps towards Financial Health for New Graduates

The best time to plant a tree was 20 years ago.  However, the second best time is today – Japanese proverb

Many new graduates believe they should wait until their earnings are high enough before they make a conscious effort to pay off debt accumulated over their university years. Wrong wrong wrong!

One of the most important pieces of advice I can give to new graduates is to pay off all your debt as quickly as possible.  I repeat this statement many times in today’s post because it is so important.

Going to university is like any strategic corporate spend. You make an upfront investment in your degree (that will likely require external financing) and expect a positive return from incrementally higher earnings over the rest of your working life.

In my previous post on personal finances, I showed that corporate finance principles can be easily applied to personal finances.

New graduates, by their nature, are similar to new companies, and it is this similarity I draw upon in the guidelines presented below.

Without further ado, the three-step guide to improving your personal finances for new graduates:


Step 1: Pay off all personal debt

Student debt can be enormous.  A combination of fees, student loans, and personal credit card debt may lead new graduates to leave university owing substantial sums.  Unlike corporate debt (which has tax advantages), personal unsecured debt is largely all bad.

Worse, it permanently lowers your discretionary spending until the debt is paid off.  Given the large amounts of debt some have, many graduates take the maximum amount of time to pay off loans. However, this is not advisable because of compound interest (you can check my 6 minute youtube video on compounding for more information).

So before you buy your first car, rent your first apartment, or take your annual holidays, you need to eradicate your debt first.


Upon graduation, you have a £10,000 credit card debt that has slowly grown over your years as a student.  The annual rate of interest is 6 per cent (assume it is a student credit card – normal credit card rates are much higher).  The minimum annual payment is £1,358.68 (this is the annual amount required to pay off the loan over 10 years), which is roughly equivalent to a monthly payment of (£1,358.68/12 = ) £113.22.

If you follow this payment plan, you will have spent £13,586.80 (10 x £1,358.68) to pay off £10,000 debt.  The £3,586.80 interest is a whopping 35.87 per cent of the original amount!

Instead of paying the minimum amount of £113.22 per month, you could opt to double the payment. If you then paid £226.44 (2 x £113.22) a month, your loan would be fully repaid in just over 4 years and total interest would be only £1,634.96, equivalent to only 16.34 per cent of the original amount.

Suggested Actions
  1. Postpone all big expenditures until you have paid off your debt.
  2. Your number one priority is to get rid of all your debt as quickly as possible, so focus on paying off the highest interest debt first to minimise total interest paid.


Step 2: Create and follow a budget

I’ve already advised on how to minimise expenditure so you can pay off your debt quickly. Strict budgets are almost impossible to stick to in personal financing because of the number of unexpected events that occur in any month or week, so you have to be flexible in how you approach your monthly spending.

As a new graduate, you won’t have a time series of spending records, so I advise you to follow a much simpler variant of my 3-step guide to improving your personal finances. The big difference between my earlier post and below is  you substitute loan repayments for savings.

The interest you pay on loans will almost definitely be higher than the interest you earn on savings and so it is suboptimal to choose savings over loan repayments.

Suggested Actions
  1. List out all your different spending categories and make these categories broad. Typical examples include:
    1. Loan repayments (Number 1 in your list!);
    2. Food (learn to cook to minimise grocery costs);
    3. Travel (I advise bus and train travel until you pay off your loans);
    4. Bills (Rent, Electricity, etc);
    5. Discretionary (clothes, entertainment, socialising) and unexpected spend.
  2. Calculate your discretionary spend amount.  This is equal to your take-home pay minus (Loan Repayments + Food + Travel + Bills).  Aim to spend only 80% of the discretionary budget and keep other 20% for emergencies.
  3. Try your best to stick to your budget and review/monitor performance every month.

I repeat: I recommend you put as much money into paying off your loans as possible.  Believe me, it will have a massive impact on your future standard of living.


Step 3: Improve your credit score

Students are notorious for being bad payers and many end up having poor credit scores that plague them for years.  This can be rectified slowly and should be done during your period of loan repayments.

If you follow my guidelines, you will avoid any large purchases and focus only on repaying your debt.  Since you won’t be taking out any new loans, you will not need a credit score and so you can use this period to repair it.

Suggested Actions
  1. Ensure all loan payments, credit card payments, and bills are paid on time.  Set reminders or direct debits so you never forget a payment.
  2. Stop spending on your credit card.  In fact, cut it up if you can and only concentrate on paying the account off (you can always order a new one when you have no debt).  Further, don’t take out any new credit cards.
  3. Check your credit score once every six months (A good company is Experian, but there are many more out there).

Religiously follow these actions and your credit score will steadily improve.  It will take 3-5 years if you have really bad debt, but you have to start at some point.


Getting back on track

It can be easy to look at your personal debt and think it impossible to pay off.

It isn’t.

You need to prioritise and choose between consumption today and consumption in the future.  By repaying your loans as quickly as possible, your future standard of living will be much higher.

Once you’re out of debt, achieved a good credit score, and have a sustainable budget, it is time to move into equilibrium and follow the sustainable personal finance plan.

Start your financial recovery today and before you know it, you will be debt free.

Best of luck!

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A Simple Three Step Guide to Improving your Personal Finances

I know I focus on Corporate Finance, but a surprising number of people have asked if they can use what I teach to improve their personal finances. Without a doubt, the concepts applied to business can be extended to individuals, as well as non-profit organisations.

In this article, I draw upon standard Corporate Governance principles to create an objective framework for personal spending.  In the principles below, I focus on optimising financial decisions, maintaining financial discipline, enhancing transparency of your decisions, and monitoring performance.

Key Corporate Governance Principles

(If you want to cut straight to the three steps, just skip this section. Academics like to explain the theory underlying their recommendations, so please indulge me!).

The principles I draw upon are the following:

  1. There should be an effective framework for financial decision-making;
  2. Resources are employed to maximize the wealth of all shareholders (i.e. you);
  3. Stakeholder (i.e. your partner/family) interests should be reflected in all decisions;
  4. All decisions are completely transparent;
  5. Managers (i.e. you) are held accountable for their decisions.

You’ll be surprised at how easy it is to adapt these to the personal level.

In the following 3 steps, I propose a structure for personal financial decision-making that replicates the business decision framework seen in modern corporations.

I have steadily iterated and improved on these 3 steps since 2012 (four years ago) and can attest to their effectiveness. If you think you can improve on these further, please let me know.


The Three Steps

Step 1: Create a savings plan and spending targets for the next month

In personal finance, strict budgets don’t work.  Unanticipated events regularly destroy the best plans and it’s impossible to keep to very strict spending limits.  In the corporate world, businesses keep a cash float to deal with unexpected liquidity shocks and building up a cash reserve is essential.

Calculate Recurring Spend, Savings, Discretionary Spend and Emergency Fund for Month:
  1. At your monthly spending review, subtract all fixed recurring expenditure (such as mortgage, rent, car loan, etc) from your total income.
  2. Of the remaining funds, choose how much you want to save over the coming month and transfer that amount into a separate savings account.
  3. What you now have left is for unexpected and discretionary spending. Aim to spend only 80% so that 20% of your remaining money is left for emergencies.
  4. You’re now at the end of the month and hopefully there has been no emergency.  Whatever you have left, put into an emergency fund to deal with any one-off spending shocks (replacement central heating, car repairs, etc.) that may occur in the future.

Your take home pay is £2,000 and your fixed recurring spend is £1,400 (this is your mortgage, telephone, rates, grocery budget, etc.).  You have £600 left for savings, discretionary and unexpected spend.  You plan to save £200, leaving you £400 for discretionary/unexpected spending. Target  80% of this amount (£320) is for discretionary spending.  The residual amount (£80) should be kept aside for emergencies.

Tip: Calculate your total annual vacation costs (flights + hotels + taxis + spending money), divide by 12, and include this amount in your fixed recurring spend so you have enough when holiday time comes around.


Step 2: Each month identify one of your repeating expenditures and shave 5% off the spend

Companies continually seek efficiencies and the same should be done with personal finances.  In any one month, choose one of your spending categories and cut a permanent 5% from the recurring monthly spend. This may entail renegotiating terms with your suppliers, switching suppliers, or cutting down/back on usage.

Recommended accounts to target:
  1. Mortgage
  2. Car Loan
  3. Insurance (home, car, buildings, life, mobile phone, travel, or dental)
  4. Utility Bills (electricity, gas, water)
  5. Phone (home, mobile)
  6. Credit Card Interest
  7. Car Fuel
  8. Satellite or Cable Subscriptions
  9. Groceries
  10. Home (Furnishing, maintenance, garden)
  11. Internet spending
  12. Clothing
  13. Dining
  14. Entertainment
  15. Music
  16. Food Carry Outs


Step 3: Carry out a Monthly Spending Review

Reviewing and monitoring your monthly spend is one of the most important tasks one can do. At your monthly spending review, objectively assess spending performance over the previous month against each spend category (i.e. mortgage, groceries, eating out, etc.). Identify spending requirements for the coming month (including one-off expenditures) and target one spend category for a 5% efficiency. Always look to create efficiencies where you can.

Checklist for Monthly Spending Review:

Important: Only choose from one of the questions listed below each month.  Cycle through the questions so you revisit each area every six months.

  1. Did you spend money on goods/services you didn’t really require?
  2. Did you throw out food? What did you buy too much of? What is your monthly/weekly/daily food bill?
  3. Is your mortgage/rent too high? Can you get a better rate elsewhere?
  4. Are you paying too much for electricity and gas? Can you get a better deal elsewhere?
  5. What is the total cost of your car (monthly car payment + monthly fuel cost + monthly road tax cost + monthly car insurance + monthly maintenance/servicing)? For some of these, find the annual spend and divide by twelve to get the monthly amount. Is it substantially cheaper to take public transport/hire taxis?
  6. Is your spending balanced across all areas of your life?

That’s it!

Example Monthly Spending Review

Let’s finish off with a detailed example.  You have £2,000 net monthly income and have worked out your recurring monthly costs are £1,400.  You plan to save £200 this month, leaving you £400 for discretionary spend/emergencies.

Monthly Checklist

Let’s choose the first option from our monthly checklist (remember to do a different item each month).

Did you spend money on goods/services you didn’t really require?

Using your spreadsheet, itemise everything you bought/spent over the previous month and allocate to a spend category (e.g. groceries, mortgage, mobile phone, media and TV).  Tally these up and calculate the cumulative amount you spent for each category.  Look at each transaction and ask yourself if it was urgent AND necessary.  If it was both, then fine.  However, if this wasn’t the case, then it was discretionary spend and could have been postponed or avoided completely.

Make a commitment to reduce, avoid or postpone spending in one category over the next month.

Spending Review

Next we pick an account to target 5% spending efficiencies.  The first one I would choose is groceries as it is easiest to change and control.  Assume your average total monthly groceries spend  is £800.  Since 5% of £800 is £40, you should look to reduce your grocery spending to £760 over the next month.  This is equivalent to cutting back by £10 a week, which is definitely achievable.


After carrying out the Monthly Spending Review, you would have committed to the following:

  1. Reduce/Avoid/Postpone spending in one of your key spending categories as identified in the review;
  2. Aim for 5% reduction in grocery spend.

Try it out yourself

By going through these simple steps each month and consistently applying financial discipline, your money situation will definitely improve over time. It doesn’t take long at all to do the Monthly Spending Review and you will certainly see improvements in your personal finances within months.

Happy saving!

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