I did an investing primer for my wife, who wanted to know what I did for a living. I’ll post it here for anyone who feels they could learn from it or has a relative or friend who could learn from it. It’s only 9 pages. I never actually finished it so it ends rather abruptly, but what’s there is very clear and useful.
Difference between Stocks and Bonds
Bonds: If you “buy” a bond, it means you actually lend money to the company. You receive interest payments for the term of the bond and then get your money back at the end of the loan.
For example, if you buy a thousand dollar, 5.6%, 20-year bond from GM, that means GM owes you a thousand dollars which they will pay back in twenty years from the issue date, and will pay 5.6% per year interest in the meanwhile ($56 per year).
Bonds trade on exchanges on Wall Street, just like stocks, so if you want to sell the bond and get your cash before the due date you can sell it just like a stock. The price will vary though and won’t always be exactly $1000.
For example if interest rates are very low (like now), and all you can get from the savings bank is 1% or less, that 5.6% can look very good to someone who is interested in income.
She might say to herself “I’d be willing to pay $1040, $1050, or even $1080 for that bond. It still has 18 years to run, and I’ll get $56 per year in interest. That’s $46 per year more than I’ll get from the bank. I know that I’ll only get $1000 back in 18 years when the bond matures, but even if I pay $1080 I’ll more than make the difference back within the first two years.”
On the other hand, if interest rates are high, at 7% or 8% for a fully guaranteed treasury bond, for example, the same person might say, “I’m not willing to pay $1000 for a GM bond paying 5.6% when I can get a better rate from the Treasury. I’m only willing to pay $920 for it. That way the $56 per year I get will actually be 6.1% on the money I’ve invested. It’s less than I’d get on a 7% bond, but when the bond matures, I’ll get a full $1000 back and make $80 profit.
Also if there is any question that the company may fail, the value of their bonds will fall in value, because they may not be able to pay you back that $1000.
Note that if it’s closer to the maturity date, the price that people will pay will be closer to $1000, because they are about to get $1000 for the bond.
A new company starting out, or one whose finances are shaky, in order to interest people in lending them the money, will have to offer their bonds paying a higher rate of interest, than say a company like General Electric, for example. The question is “Is this company sure to be able to pay back the $1000 in 20 years?”
I NEVER buy bonds. You have no chance of profiting in the success of the company, but all the risk if the company fails or goes out of business. In twenty years the company’s stock could be worth 50x what it is now, but the bond is just a loan, and you’ll just get back what you loaned them ---- which will be worth only a small fraction of what you actually loaned them due to INFLATION.
My father called bonds “guaranteed confiscation”, because the money was guaranteed to lose value over time.
Stocks: about which we will talk at length, are ownership of a piece of the company. If the company has a million shares and you own one hundred shares, you own one ten thousandth of the company. If the company is successful and increases in value, your shares will go up proportionally.
If a company has 1 million shares of stock and each share happens to be trading today for $80, the company is valued by the market at $80 x 1 million, or $80 million. This is called the Market Cap, which is short for market capitalization.
Since the market sets the price of the stock, the price, and thus the Market Cap, can be more, or it can be less, than what you think it’s worth. It varies from day to day and can go up or down depending on how people estimate the company’s chances for success, or just for irrelevant reasons such as a big mutual fund deciding to buy the stock or sell it, or even because a large holder of the stock decides to buy an apartment in New York, and thus sells $1.5 million worth of shares.
Several factors go into how the public values a stock. One is growth, another is profit, a third is how much publicity a company gets, and a fourth is how much the company is in the public eye.
Let me touch on these:
Growth is very important and people will almost always pay more for a company that is growing rapidly, even, usually, if it isn’t yet making money. (That is, they’ll value the company higher for a certain amount of sales and earnings than they will another company with identical sales and earnings but which is not growing. They value the first company higher because they figure it will be worth more next year).
I generally won’t buy a company until it’s profitable, but I do make exceptions (for example, Solar City).
Profitability. A company can be quite profitable, but can be making the same nice amount of money each year, or be growing very slowly. In this case it won’t be valued as highly as a rapidly growing company. Its P/E ratio will be lots lower. (More on P/E ratios later)
Publicity is important because people have to hear about a stock before they can buy it. The stock is like a product that needs advertising. For example, if a newsletter recommends a stock, or if a brokerage house like Morgan Stanley recommends a stock, the price will go up because more people will be bidding for the same supply of stocks after the recommendation. There are even newsletters which make paid recommendations (recommendations for a fee)!
Public Eye. Everybody knows Google, for instance, and Amazon, so they will sell for higher multiples than a company like Ellie Mae, which automates the mortgage origination business. Everyone in the mortgage origination business may know Ellie Mae but that is a tiny fraction of the number of people who are familiar with Google or Amazon.
Another factor, which can be important, is the size of the company. In general, smaller companies can grow faster and therefore often sell for higher valuations in relation to the size of their sales and earnings. In other words, they often sell at higher PE ratios.
Part of the reason is “The Law of Large Numbers”. A little company, say with $20 million in sales, which is doubling each year but controls only a 1% share of its potential market, can double again next year, and the year after, and the year after that, and still have only an 8% share of its potential market. Maybe even less, if the potential market has grown in the meanwhile.
On the other hand, a big company with $20 billion in sales, which controls, say, a 40% share of its market, will have a very difficult time doubling its sales even once. (It’s hard to find $20 billion in new sales, and it’s almost impossible to go from a 40% share of the market to an 80% share).
Note that you can easily find a small company that has no room to grow. If it sells widgits and has $20 million in sales, but there are only $30 million in worldwide sales of widgets, where’s it going to go? Or if it has nothing special about its widgets, how is it going to get more sales, etc.
Similarly, a larger company with $5 billion in sales, may be facing a $200 billion worldwide opportunity, and thus have plenty of growing room. Rules about size are not hard and fast.
Each company in their quarterly report gives a rundown of its quarterly results, and usually compares them to the same quarter a year ago.
This starts off with their Revenues or Sales (the money they brought in from selling things.
This is followed by the Cost of Sales, which is how much it cost to make and ship whatever they are selling. What is left is their Gross Profit and their Gross Margin (or Gross Profit Margin), which is what percent their Gross Profit made up of total revenue.
(In other words, if they had $80 million in sales and their cost of sales was $30 million, their gross profit was $50 million, and their gross profit margin (or gross margin, for short) was 50/80 or 5/8 or 62.5%. It’s usually listed as a percent).
Then they list Operating Expenses, which are the cost of running the business, and are usually listed in categories like:
R&D – which stands for Research and Development and means pretty much what it says: the cost of research and of developing new products or improving the old ones.
SG&A – Which stands for Sales, General and Administrative, and includes everything from salesmen’s commissions to electric bills, legal and accounting expenses, and right through to the CEO’s salary.
Depreciation and Amortization – This is an accounting thing: If they bought or built a factory five years ago, they may be depreciating the cost over twenty years. That means they didn’t count (“write down”) all the expense in the year they built it (which would drop earnings that year enormously and not give a true picture of the business). Instead, they take 5% of the cost each year for 20 years for accounting purposes. This would be considered the “useful life” of the factory.
Other – This is miscellaneous. For example they sued someone for infringing on one of their patents and they received a payment. Or someone sued them, etc. Or they paid interest, or made interest on money the company had in the bank or had invested. It’s really “other”, and it’s usually minor.
Note that a lot of this is considered “fixed costs”. That is to say that doubling sales won’t require a much increase of salary expenses, or legal expenses, or accounting fees, or electricity in the home office. It won’t change depreciation or amortization, and probably the company will just increase research expenses marginally. That means that an increase in revenues can often increase profits by a larger percentage, once fixed costs are covered.
What’s left after you subtract operating expenses is Operating Profit, or Operating Income. The importance of this number is that one year the company could have a tax loss carryover and have lower taxes, and another year pay full taxes. Operating profit gives the amount that the company actually makes in running the business. It’s sometimes referred to as profit before taxes.
The percent that operating profit is of total revenue is Operating Margin. (In other words, operating profit divided by total revenue and expressed as a percentage. For example, if they had $80 million in revenues and $20 million in operating profit, their operating margin was 25%).
(Another useful side-figure that is often referred to is EBITDA. That stands for earnings before interest, taxes, depreciation and amortization. As you can see, it’s useful because it tells you how much money the actual business is making, and year to year comparisons can add to your understanding of the company’s business.)
If you subtract taxes from Operating Income, you get Net Income, which is what’s left at the end. This is a very important figure. Net income divided by the number of shares gives you Earnings Per Share, or EPS.
The above covers the majority of the basic terms you need to understand. I’ll talk about two other terms, adjusted earnings and diluted EPS below, but they are just modifications of the basics.
For example: Basic EPS is Net Income divided by the total number of shares outstanding. However there may be additional potential shares that are not currently outstanding.
For instance, consider if employees have been granted options to buy an additional 100,000 shares, and the company sold someone else warrants to buy 50,000 shares more, you have to add that additional 150,000 shares to your outstanding share count to get the number of Fully Diluted Shares.
Then Diluted EPS is the net income divided by the fully diluted share count. Diluted EPS is usually a smaller number than basic EPS because the earning are divided among more potential shares.
The company will always list Basic EPS and Diluted EPS (as well as basic shares outstanding and fully diluted shares), but when people refer to Earnings per Share, they are almost always referring to diluted EPS.
Adjusted earnings are another important term. The accountants preparing the quarterly reports have to follow what are called GAAP rules, which stands for “generally accepted accounting principles”. The problem is that some of the rules distort the true picture of how the company is doing, and others are just stupid.
Therefore, many, many companies give non-GAAP or “adjusted” results alongside the GAAP results. If the company had a large one-time expense or windfall, a legal expense or suit settlement, for example, they would remove these from the calculations to get adjusted results.
Also stock-based compensation, or option grants must be counted as an expense by GAAP rules, although there is no cash expense, and in spite of the fact that they are already counted by an increase in the diluted shares. Almost all companies remove this double counting expense in figuring adjusted earnings.
I ignore GAAP results almost entirely, and almost always use adjusted results, which usually make more sense and are more useful.
Now lets talk about the price earnings ratio, or PE. (The terms “PE” and “PE ratio” are used interchangeably). The PE tells you how highly the market is valuing the company for the amount of earnings that they have. Simply, it tells you how many times the price of the stock (the price of one share of stock), is of the EPS (the earnings for that one share of stock).
You get the PE ratio by dividing the price of the stock that day, by the earnings per share over a full year. If you base it on the previous four quarters (which is a common method), it’s called the trailing PE. On the other hand, if you base it on what you think it will be this year, or the next four quarters, it’s called the forward PE.
For example, if the stock is selling today at $80 per share, and the company made $4.00 per share last year, their trailing PE is 80/4 = a PE of 20.
Note that I specified that it’s the price today, because the PE changes from day to day according to the price of the stock. If tomorrow or next week the price of the stock has gone up to $88, the PE will be 88/4 = 22. Thus higher PE’s mean the stock is more expensive.
Let’s go back to that stock with earnings of $4.00, a price of $80, and a trailing PE of 20. If you think that next year their earnings will be up 25% to $5.00, you can say that their forward PE is $80/5 = 16, which is quite reasonable for a stock growing at 25%.
A company’s PE can be quite different for the same earnings, depending on what the expectations are for the company and how fast it’s growing and what industry it’s in. For example a high-flying internet stock making $4 per share, that people expect to be increasing its earnings by 50% per year for the next five years, could have a PE of 50 instead of 20, and be selling at $200 per share instead of $80 per share. And a stodgy company that makes electric lawn mowers and makes about the same $4 every year, with maybe 5% growth, might be selling at $40 per share, which gives it a PE of 10.
Companies with very high PE ratios (like 100 or more, because people have very high expectations for them) often don’t turn out well as investments, although the company itself may do well. That’s because it takes a long while for the company to grow into its stock price. These are often called “story stocks” because they have a great exciting story, which makes investors bid up the price of their shares.
Some companies keep growing like that though and end up making a lot of money for investors. The trick is to know which ones.