I started investing or shall I say gambling in the stock market roughly 17 years ago, just after starting my first job out of college. Money was coming in and I desperately wanted to grow it. Ever since then, I have been continuously learning. Similar to just about everything in life, the more you know, the more you realize you don't know.
If there is truth to the saying that "you must pay to learn", then I paid enough to be able to teach thousands on how to become a stock trading expert. 🙂
That was a joke. There is no such thing as a stock trading expert. By this, I mean that nobody can consistently outperform the market. If you need further validation on this statement, read The Quest for Alpha by Larry E. Swedroe. It's a very simple read that tells it like it is. (Alpha is a risk-adjusted measure of the so-called active return on an investment... Take the price risk of a mutual fund and compare its risk-adjusted performance against the index. The excess return of the fund compared to the index is the fund's alpha.)
When it comes to picking stocks, it is always better to be lucky than good. Therefore, for the sake of this post, I will focus on providing a basic understanding on critical terms and definitions that I think you should know, as opposed to trying to make you good at catching rainbows.
If you work for a publicly traded company, then you should have a decent understanding of what your CFO reports in meetings each quarter. I'm amazed by the number of eyes I see that are glazed over on such occasions. Sure, most of the folks in Finance get it, but that's a small percentage of the overall company.
I worked in the life sciences industry where the CFO actually held a session on how to read the Income Statement, Balance Sheet and Statement of Cash Flow. The company was performing very well at the time and he wanted to be sure that everyone knew it. A brilliant move! Educate the audience, so employees know how to appreciate the strong performance of the company. Sessions like these should be recorded and posted to the internal website for new hires and existing employees to reference.
The greatest pet peeve that I have is around those who do not understand the concept behind a company's stock price and market cap. I worked with colleagues who believed that our company was inferior to a competitor because our stock price was $5 per share and our competitor's was $20. They were completely oblivious to the number of shares outstanding and that ours was 20x greater than the competitors.
For example, if I created a company called Carmine's Candy Cones and it had a stock price of $10 with 1,000 shares outstanding, then the company would have a total share value of $10,000. Meanwhile, Sam's Sugar Cones, a fierce competitor, could be trading at only $2 per share but have 50,000 shares outstanding. The total share value of Sam's is $100,000; which is 10x greater than Carmine's. This is a very basic concept that I hope all new entrants to the business world grasp.
Listed below are some key definitions that will help to provide a better understanding on how to evaluate a company's financial strength and performance. I will also include some of the formulas, as reviewing those may help to learn the concept. It is imperative to evaluate all of these data sets and more before ever making a stock purchase. Do not purchase individual equities without having at least these definitions mastered.
1. Market Cap- The total dollar value of all outstanding shares. (This is what we determined in the Cone scenario above). Market Capitalization is a measure of company size. Formula: Current Market Price Per Share x Number of Shares Outstanding
2. Enterprise Value- EV is a measure of theoretical takeover price... answering how much would someone have to pay to buy this company? Formula: Market Cap + Total Debt - Total Cash & Short Term Investments
Note: A company could be considered trading at a good value when the Market Cap is less than the Enterprise Value. The Market Cap ignores debt while the EV incorporates it.
3. Forward P/E Ratio- A valuation ratio calculated by dividing the current market Price by projected 12-month Earnings Per Share. Formula: Current Market Price / Projected Earnings Per Share. Note: P/E ratios could be trailing as well.
4. Operating Margin- A good measure of profitability. It's a ratio used to determine a company's pricing strategy and operating efficiency. Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. For example, if a company has an operating margin of 15%, this means that it makes $0.15 (before interest and taxes) for every dollar of sales. Formula: Operating Income / Net Sales
5. The Income Statement- Shows how the companies revenues and expenses are transformed into net income for a certain period of time. These are some of the items on the Income Statement:
Revenue (Sales) Per Share- Formula: Total Revenues / Weighted Average Shares Outstanding
Quarterly Revenue Growth- The growth of Quarterly Total Revenues from the same quarter a year ago. Formula: [(Qtrly Total Revenues - Qtrly Total Revenues (yr ago)) / Qtrly Total Revenues (yr ago)] x 100
Gross Profit- Formula: Total Revenues - Cost of Revenues
EBITDA- The accounting acronym EBITDA stands for "Earnings Before Interest, Tax, Depreciation, and Amortization." Formula: Revenue-Expenses (excluding interest, tax, depreciation, and amortization)
6. Balance Sheet- Provides a summary of the company's financial balances on a certain date (unlike Income Statement and Cash Flow Statement). A Balance Sheet is often describes as a snapshot of the company's financial condition. Listed below are some of the key things found on the balance sheet:
Total Cash- The Total Cash and Short-term Investments on the balance sheet as of the most recent quarter.
Total Cash Per Share- This is the Total Cash plus Short Term Investments divided by the Shares Outstanding at the end of the most recent fiscal quarter.
Total Debt- The Total Debt on the balance sheet as of the most recent quarter. Formula: Short Term Borrowings + Current Portion of Long Term Debt + Current Portion of Capital Lease + Long Term Debt + Long Term Capital Lease + Finance Division Debt Current + Finance Division Debt Non Current
Total Debt / Equity- This ratio is Total Debt for the most recent fiscal quarter divided by Total Shareholder Equity for the same period. Formula: [(Long-term Debt + Capital Leases + Finance Division Debt Non-Current + Short-term Borrowings + Current Portion of Long-term Debt + Current Portion of Capital Lease Obligation + Finance Division Debt Current) / (Total Common Equity + Total Preferred Equity)] x 100
7. Statement of Cash Flow- The cash flow statement is concerned with the flow of cash in and out of the business for a given period. It reflects the company's liquidity and can show whether or not the business generates enough cash to pay its bills.
Operating Cash Flow- Net cash used or generated in operating activities during the stated period of time. It reflects net impact of all operating activity transactions on the cash flow of the company. Formula: Net Income + Depreciation and Amortization, Total + Other Amortization + Other Non-Cash Items, Total + Change in Working Capital
Levered Free Cash Flow- The free cash flow that remains after a company has paid its obligations on its debt. The levered cash flow represents the amount of cash left over for stockholders and for investment after all obligations are covered. The levered cash flow can be negative while the operating cash flow is positive if the amount of cash paid to cover obligations exceeds the cash that comes from operations.
8. Beta- A measure of the volatility (risk) of a security or a portfolio in comparison to the market as a whole. In other words it would compare the price change of Apple against the price change of the NASDAQ.
A beta = 1 means that the security's price will move with the market.
A beta < 1 means that the security will be less volatile than the market.
A beta > 1 means that the security's price will be more volatile than the market.
If a stock's beta is 1.5, it's theoretically 50% more volatile than the market. Many utilities stocks have a beta of less than 1. To the contrary, most high-tech stocks have a beta of greater than 1, posing more risk but possibly leading to a higher rate of return.
9. Share statistics- Key terms
Shares Outstanding- This is the number of shares of common stock currently outstanding—the number of shares issued minus the shares held in treasury. This field reflects all offerings and acquisitions for stock made after the end of the previous fiscal period.
Float- This is the number of freely traded shares in the hands of the public. A company may have a large number of shares outstanding, but a fairly limited float. Meaning that owners, insiders and institutions own most of the shares. Since stocks trade on supply and demand, the float of a stock is important to know.
Shares Short- This is the number of shares currently borrowed by investors for sale, but not yet returned to the owner (lender).
Short Ratio- This represents the number of days it would take to cover the Short Interest if trading continued at the average daily volume for the month. It is calculated as the Short Interest for the Current Month divided by the Average Daily Volume.
Short % of Float- Number of shares short divided by float. As a rule of thumb, you should never invest in companies where this number is greater than 10%. I do not always follow this rule. The last time that I did, it prevented my from purchasing Tesla at $38 per share. The company's short interest at the time was north of 40%. A short squeeze occurred and sent the price much higher. SQNM and MNKD are two risky equities that I currently own with short interest greater than 20%.
10. Dividends and Stock Splits- Definitions
Dividend- A distribution of a portion of a company's earnings in cash or stock, decided by the board of directors, to its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share). If a company's share price does not move much, the issuance of a dividend will make up for this.
Stock Splits- A corporate action in which a company divides its existing shares into multiple shares. You may know that Google recently performed a 2 for 1 stock split. There are two reasons for this. First is that it halves the stock's trading price; which makes a lower price attractive to more investors. Second is that the extra amount of shares outstanding can improve a company's liquidity and help increase trading. Companies can also undergo reverse stock splits. This will do the exact opposite. Companies with a really high float and low stock price may look to do a 10 to 1 reverse stock split to drive the price up; which gives the illusion of more value.
Learning the definitions above is enough to wet your beak and help you to perform your own due diligence on a company. But it should not provide you with enough confidence to jump into the game and gamble your hard earned money. For now, invest in your 401k and continue to educate yourself in this dynamic field. (As I state in Welcome to the Big Leagues, ETFs are a much safer alternative).
If you are having trouble grasping these concepts, get engaged and speak to colleagues who can help. You'll find many who are passionate about the subject and willing to share what they know. Start by assessing the financial strength of your current company and then go off and evaluate the performance of a competitor. This will help to increase your awareness on the industry and provide further insights on what it takes to compete within the sector.
In the long run, it is your competence in finance that will lead to successful investing and financial stability. Best of luck to you.
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