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Home > Weekend Investor > Weekend Investor: Scoping The Second Derivative

Weekend Investor: Scoping The Second Derivative

October 29th, 2011 Leave a comment Go to comments

Remember math in school? OK, I think most people want to forget, but math was a strong subject for me. I’ve forgotten a lot of that math while other key concepts I’ve kept and used over the years. There are fewer math topics more important and memorable than the derivative. My instructors of the day said that it was important because it is used in all sorts of fields. They were right.

And so it goes for investing. It’s helpful here too.

Here’s a painless and quick way to understand it. A derivative is a measure of the change in something. For example, if the Department of Labor says that the labor market is expanding at 10K jobs per week, that’s the first derivative.

It gets better. How can we tell if the labor market is improving? The 10K number won’t tell us much. What we want to know if how fast it is increasing over time. So, then we want to know how much the labor market is expanding over time, or the rate of change in the expansion. Let’s say that each week the number goes up 1K (from 10K -> 11K -> 12K, etc each week). This rate of increase is called the second derivative.

Another way of looking at this is that the first derivative is how fast the car is going and the second derivative is how fast it is accelerating.

This second derivative is useful in investing because it can provide an answer as to why a stock that looks expensive (from it’s P/E ratio, Price to Earnings) is being bought up by the market. The answer may not be in its current valuation but by an indication by the market that it is in a growth explosion.

A couple of examples here. One is NASDAQ:Netflix, which until recently was growing very fast in earnings and revenue. Investors love stocks like Netflix because as it expands it can leverage even higher profits because margins are so high. Or a company like NASDAQ:Amazon gets a huge valuation not because its profits are expanding fast (they aren’t) but due to the fact that its revenues are growing like gangbusters (investors likely think that the profit will come later). So in each case the earnings or the revenue are accelerating.

So when you value your own investments keep in mind the second derivative.

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