When I first started out with investing I didn’t know anything at all about investing and financial metrics.
The company that I was working for was a startup in a highly specific scientific field and of course I bought into the idea that we would all become rich eventually.
Unfortunately that did not pan out the way that I had planned and I lost money together with all the others.
So instead I began to research the best way to invest my money. It turned out that the approach that I had taken was akin to betting at the lottery.
Sometimes you win, but because the odds are stacked against you, in the end you will lose your money.
So it was clear that I needed to do something different.
My research led me to the classic value investors, but they were embroiled in a language that I did not understand.
What that meant was that I needed to go deeper in my research to really understand the concepts and terms involved in value investing.
So in this series of articles I will try to elucidate what some of the “value” terms really mean.
I will begin with the metrics mentioned above and I start off with working capital:
The first thing that you need to do is to download your favorite company’s annual or quarterly report.
Either you can find this on the company’s web page or you can download it from EDGAR website (because all companies trading om the US stock exchange are forced to release their numbers publicly).
If you then go to the Balance Sheet of your favorite enterprise, you will find the assets and the liabilities.
These are then further divided into current assets and liabilities and total assets and liabilities (Figure 1).
The current proportion of the assets is what the company has in cash or can turn into cash within short notice.
The current proportion of the liabilities is the debt that the company needs to pay within a year.
The working capital is then calculated as current assets minus current liabilities.
What it means is how much money the company has to pay its bills during the year.
If this number is negative then the company somehow needs to raise cash during the year.
That can happen either by an Initial Public Offering (IPO) or by a direct investment from external sources.
You can also calculate a working capital ratio as current assets divided by current liabilities.
If this ratio is greater than 1 then the company has enough money to cover its bills.
If it is less than 1 then they need external financing.
A negative working capital, or a ratio below 1, is most of time a warning signal for a conservative investor.
The second metric that you hear a lot in the financial press is the free cash flow.
So what is the FCF and why is it important?
To calculate the FCF you will need to go to the cash flow statement of the company that you are interested in.
You will see that it is divided into three different sections:
The FCF is then defined as the operational cash flow minus capital expenditures (CAPEX).
So what is CAPEX and where can I find it?
Under the Cash flow from investing activities you will find a section called “Additions to operating assets and facilities” (or something equivalent).
This is CAPEX and it represents the cash that the company pays out in order to maintain or expand its productive assets.
So in effect, the free cash flow is the cash the company generates after paying its bills on its productive assets.
The FCF is the cash that the company can use for paying dividends or share buybacks. In other words measures to increase shareholder value.
If the Free Cash Flow is negative the company does not generate enough money to pay its dividends. It therefore needs to borrow the money from someplace else in order to stay afloat.
What is net income and how is it calculated?
To find the net income you need to go to the Income statement in the annual report.
There you will different item like the Total revenue which is the total amount of sales that the company generated for the period.
The next thing that you will find is the Total expenses. These are deducted form the Total revenues in order to get the Net income.
Thus the Net income is a measure for the profit the company has made during the reporting period.
What does the ratio between the Net income and Total revenue tell me?
It’s a measure of the profitability. For a manufacturing company, the ratio between the two is usually an indication of its comparative strength and weakness.
I would consider a figure above 5 percent satisfactory.
What is then the Return on equity, what does it say and how is it calculated?
This is a measure of the return on the invested capital or in other words the company’s profitability.
The number is calculated by taking the Net income and dividing by the Book value.
The Book value is turn calculated by taking the Total assets minus Intangible fixed assets (goodwill and patents) and Total liabilities.
A high Return on equity usually goes along with a high annual growth rate in earnings per share.
Today I’ve been looking at the working capital and tried to give a definition of what it means.
A positive working capital tells the investor that the company can pay its bills for the year while a negative working capital says that it cannot pay its bills.
I’ve also gone through Free cash flow which is the money generated by the company when all bills on productive assets have been paid.
I have also talked about Net income to Total revenue and what it means for the profitability of the company.
Today I want to answer a question about only having limited funds to invest. “I only have $500 to invest. How do I make the best of it?”
You buy an index fund. The positive thing about those is that they are reasonably cheap and you get exposed to all the stocks in that index all the time. That way you don’t have to worry about “beating the market” or “picking the right sectors”. The fund performs as the index – that is the whole idea.
The only real downside that I can see with an index fund is that they are boring. You will never be able to tell your friends how well your stocks are performing, because they perform just as well as the index itself.
If we assume that the stock market will return 7 percent a year, which is not unreasonable, over 20 years you will have doubled your money twice ($500 => $2000).
However, over the years the cost advantage will bear fruit and you will be able to see your investment grow substantially. Hold it over 25 years, add new money each month and you will be wealthy in the end.
Today I’ve been talking about investing only limited funds. My conclusion is that it is best to buy an index fund. They are cheap and you get exposed to the over all stock market like this.
Do you ever wonder how some people somehow seem to building wealth without putting any effort into it?
They have the means to carry out all sorts of things without being stretched financially.
It turns out that you don’t have to be a genius to figure this out. Anyone with a basic understanding of simple math can do it.
It comes down to two very simple formulas:
It basically means that you should save a certain amount of your earnings each month.
Of course not so much that it infringes on your basic necessities, but still a significant part of what you earn should be put aside. Each month. All the time.
This means that you need to look into each part of your economy and identify unnecessary spending to try to cut down on it.
Of course there are things that you need, but then I’m sure there are other expenses that can be labeled as “discretionary” and sometimes downright “silly”. Try to cut down on those.
Each dollar saved is a dollar earned.
There are some very good websites out there that can help you, but here are three of my own favorite money saving tips:
When buying groceries try to buy several months’ supply so that there is always an extra pack of sugar or flour in the cupboard no matter what.
This tip is obviously limited to products with a long shelf life, but it is amazing how much money you can save by just sticking to this.
An essential part of having your finances under control is to have a budget.
This ideally lists all your income and expenses as well as gives you space for an occasional treat.
Of course there are many ways to do this, but personally I prefer to use a spreadsheet where everything is labeled accordingly.
A car is one of the biggest expenses in a household and having one is of course great.
However, many families also have a second car out of convenience. Try to skip this and get a bike instead.
A bike is an extraordinary way to get around in town where you quite frankly very seldom need a car.
In the rare cases where a second car is necessary there is always the possibility of taking a taxi. There is a lot of money to be saved.
There are many kinds investments that you can choose from. In this section I will briefly try to outline a few of those:
For a beginner a good way is to invest in an index tracker.
An index fund is a fund that owns all the stocks in an index, all the time, without the pretense of being smarter than anyone.
An index fund is cheap – you only pay about 0.2 percent of your invested capital in annual fees.
Index funds only have one drawback – they are boring. They will perform as the overall market – no better, no worse.
This behavior is inherent in an index fund, but because index funds are so cheap their cost advantage will only accrue over time.
My suggestion would be to keep your index fund part of the equity proportion (discussed below) at least to 50 percent.
If you just leave your stock picking to chance, you will be out of luck quickly.
That said, if you would like to join the excitement of investing in stocks, you will need to do some research.
One important metric is price (i.e. how much do you pay for the stock) and another one is the return that you will get out of it.
The first one should be as low as possible in relation to the companies’ earnings and the second should obviously be as high as possible.
Another thing to watch is the companies’ financial situation where the company should have a sufficiently amount of assets in relation to liabilities.
To invest in debt is fundamentally different from investing in equity.
The company or the treasury borrows investors’ money in return of interest that they will pay back over a long time.
The most fundamental question an investor asks himself is the proportion of stocks and bonds in his or her portfolio.
My advice would be never to go below 20 percent of either.
That way you make sure that your at least some of your money will be protected against inflation.
Stocks fluctuate in value all the time and there is always the possibility that your investments will go down in value.
Therefore it is important that you know why you bought your securities in the first place.
In the words of famous value investor Benjamin Graham “you are never forced to sell or buy securities just because they have gone up or down in value”.
If you are inclined to sell in a bear market chances are that you would be better off not having your securities quoted in the first place.
This is important in all kinds of markets, but especially important in a bear market.
This all boils down to what I call “sanity checking your investments”.
If the fundamentals of the security change then there is reason for the decline, but often declines just come from unfounded rumors and hearsay.
Therefore never sell a security just because its value has fallen.
This post tries to explain the simplicity of getting rich. In essence it boils down to two simple things: 1./ Make more money than you spend, and 2./ Invest the surplus wisely and see it grow. That’s all you need to think about.
As a beginner, doesn’t it suck not being able to reap the rewards of the stock market?
I know when I started out, I thought that I would make a killing straight away.
But then I started to talk to people who had been trading for a while and they told me that it wasn’t that easy and that I needed experience in order to thrive.
In hindsight it turns out they were right. In order to consistently make money in the stock market you need to know when to trade and when not to. To be able to spot a good opportunity you need to have done it for a while.
It comes down to chart work and knowing the ins and outs of the patterns that present themselves all the time.
So the first thing that you need to learn is technical analysis. If you don’t find any other introductory text on technical analysis you can do that here.
What separates a good trader from the novice is that the good trader almost always win while the novice only sometimes win.
But then you also need to put real money at stake because if you don’t do that you will never learn. A demo account is just that: A demo account.
There is nothing that beats seeing that candlestick moving up or down.
The only way to learn is to lose your hard earned cash and then come back stronger.
Once you’ve decided to put real money on line, you can begin slowly.
But don’t get too excited if you see that things are going your way.
Even if you are unexperienced, you need to expect a few gains.
One of the most important rules of trading – and one that I’ve personally have learnt the hard way – is always to use a stop-loss.
When you consider a move in the market, up or down, there is always the possibility that you will be wrong.
Therefore it is very important to set a stop for each trade where you say “The buck stops here”.
It’s far easier to get back into the game if you have been stopped out than to see yourself lose significant money day after day for weeks in a row.
To earn a living from the stock market is not for the faint of heart. You need to be mentally prepared for the ups and downs and that you may lose a significant portion of your wealth at any time. But in the end it can be a very profitable business if you apply a system where your losses will be limited.
Knowing Microsoft Excel is great.
Knowing finance is even greater.
But when you can do BOTH?
That’s when you call yourself Superman!
…because there’s nothing stopping you!
Today I am going to talk to you about Microsoft Excel so that you feel like you have Excel superpowers.
I am going to give you insanely actionable Excel tools to use for corporate and personal finance.
To kick things off I am going to start with an introduction of Excel.
1. Introduction to Microsoft Excel
Most people think that Excel is overly complicated and would like some guidance on how to use it properly.
So it definitely pays off to go back to the old definition of what Excel actually does. Excel essentially does three things:
a. Calculations, which include things like adding a column or calculating a total monthly loan payment. We can add some numbers, or find a minimum of some values or simply subtract numbers from each other.
b. Data analysis. That’s when you look at raw data, you organize it in some way and then come to a conclusion. A very simple example of this is illustrated in the figure below (1). If we for example have many interest rates and we would like to find the lowest we can do that with Excel.
c. Excel also stores raw data, but that is out of the scope for this article.
Excel is a two-dimensional grid where you have different columns horizontally and rows vertically.
The intersection between a column and a row is called a cell. If we for instance highlight the green cell to the right of the numbers and below the Add-cell, you can see that cell is called I3.
That is the heart of Excel because as you will see in this series you can reference a specific cell to make formulas.
A range of cells is when you choose a number of cells in order to make a calculation. In the example above we can highlight F3, G3 and H3 to select this range.
What about all the cells?
That is called a worksheet.
A sheet tab is shown below:
What you can do here is to double click on it and change the name of the sheet.
To change between the different worksheets you can use the shortcuts CTRL + PgUp or CTRL + PgDn which is very useful.
When I use Excel I always have my Ribbons open so that I have easy access to the functions.
It looks like this:
Now, if you want to close the ribbons for whatever reason you can just right click on your mouse and select the “Minimize the ribbon”-option when you hover over the Home tab.
We then have the Quick Access Toolbar which looks like this:
What the Undo button does is that it undo:s the last action and the Redo button undo:s the Undo.
If you have a particular task that you like and use often, you can put it in the Quick Access Toolbar by right clicking your mouse and scroll down to the “Add to quick access toolbar” option.
Sometimes in this article series I am going to show you large tables. The way to navigate up and down in these is by clicking on the scroll arrows or pulling the scroll box.
There will be separate articles on this concept, but just to give you foretaste I will show you how it works:
Let’s say that I want to subtract 85 from 98. How do I go about doing this?
In order to do that you’ve got to know how to tell Excel that what it wants is a formula in I9.
If you just type an equal sign in I9, you’ve just to Excel that what is coming is a formula.
What you do next is that click on G9 for the first number.
Then you type a minus sign on your keyboard and click on H9 for the second number.
When you then hit Return you will get your answer in I9.
2. Formulas and functions
In this chapter we are going to go a little bit deeper into the formulas and functions that we discussed last time.
First of all let’s repeat what I talked about in the last chapter. The way to tell Excel that you want to input a formula is by typing an equal sign (=).
For the sake of argument, let’s say that we have an interest rate of 8.4 percent (C3) and this has to be paid twice a year.
To figure out how much you have to pay each time we then have to divide the number in C3 with 2, which is the number in C5.
Instead of taking each cell the way we described above, many people type the numbers directly. This of course gives the same result, like so:
The problem comes if we want to update the rate. Then the C5 is updated automatically whereas C6 stays the same. You can see what I mean in this picture:
There are three reasons for why you want to update your data dynamically like that:
To calculate the sum of different numbers, there’s a nifty shortcut to use: Alt + =
When you type the keyboard shortcut, Excel will guess which numbers you want to add together and there will be “marching ants” around these.
When you are done selecting the numbers you want, just hit ENTER and the formula will automatically update.
What you don’t want to do is to type =sum and then click on D2, D3, D4 and D5. The reason for this is that a range (as we have in Figure 8) is dynamic. This means that you can insert or remove numbers to your liking, whereas if you insert numbers into a formula with only clicked numbers, the final sum will not update.
We are going to look at a few more formulas and we will begin with an average or a mean:
What I do is that I type in the start of the formula and Excel then give you suggestions of what to choose based on what you have typed. Then you can select the corresponding correct formula and press the Tab key to select. As always Excel then guesses which numbers you want to choose.
We then want to calculate a loan function.
What I want is my yearly interest payment. First of all I click in C5 to activate the cell. Then I click the fx in the upper center of Figure 10. Then I begin to type “Loan payment” in the dialog box where it says “Search for a function”.
You will then get a list of a number of different functions that you can use, like so:
Then you have to read the description to figure out exactly what the formula does. In my case the description of PMT seems fine so I click OK.
I then get this dialog box:
Here it says that I’ve come to the Function Arguments box.
What is then an argument?
It’s a mathematical term of the individual parameters within a formula. In my example there are three different arguments that I want to insert and they are highlighted in bold.
The first argument being the rate so I go back and click on C3 to insert the rate.
The next argument is the number of periods and because I have annual rates in my example, I simply click on C4 for the number of years.
The last argument is the Present Value which in our case is how much the loan is worth right now. So I click C2, like so:
What you see to the right of the dialog box in Figure 13 are the actual numbers of the cells that I’ve entered. Down below you will see the unformatted result of the formula.
Down to the left I get the formatted result which has parentheses. These are financial numbers so parentheses mean that the number is negative. The reason for this is that if you have borrowed that amount of dollars at that rate you will get a negative number because the money will come out of your wallet.
One other thing that I will talk about is screen tips. When you have done these numbers for a while you will be fluent. Once you are fluent, you can just type =PMT( and you will see that the formula pops up in the screen:
These screen tips allow you to see which value to enter next. You can between the different values by typing a comma on your keyboard.
3. Math Operators and Orders of Operation
I now want to turn your attention math operators and orders of operation. In this part of the article I will talk about all operators below:
In Figure 14 you can see how you can type the different operators.
Let’s see some math examples:
If you want to add two numbers together the easiest way is to type Alt + = in the result cell. In my example that is B5. That way you will get a formula of =SUM(B3:B4) and if you hit enter Excel will calculate that addition for you, like so:
To subtract a number from another I type an equal sign in C5 and then I use the mouse to click in C3 (or the up arrow twice on my keyboard). Then I type a minus sign on the number pad and click in C4:
The result is then shown in C5.
There are two ways to multiply numbers in Excel. The most common is to type an equal sign and then click the individual numbers, like so:
You can also use the PRODUCT function, like so:
To divide two numbers we first type an equal sign and then click on the individual numbers. In this case E3 is called the numerator and E4 is called the denominator:
If the numerator is greater than the denominator, the result will be a number that is bigger than 1 (E5):
Similarly, if the nominator is less than the denominator then the resulting number will be less than 1 (F5):
If I want to take the number in cell G3, which in my case is 5, squared, I first have to type an equal sign. Then I have to click in G3 to get the number in G3. Then I have to type Shift + 6 to get to the caret symbol. Then I can click in G4:
That means that the base is 5 and the exponent is 2. The result is then shown in cell G5, like so:
I will now show you how to use logical formulas. If I want to check if two numbers are equal, I click the first cell and then the second:
It may come as a surprise, but when I hit Enter now I see that I get the Boolean value “False” in B5.
Why is that?
It comes from that Excel does not always show you everything. In this case if I click in cell B3, you can see that the value is not 5, but really 5.02:
How can that be?
This comes from the number formatting in Microsoft Excel. If you look up in the formula bar you see that the number in B3 is actually 5.02 and not 5.
How do you go about changing this?
The answer is that you change the number of displayed decimals simply by clicking the Increase Decimals or Decrease Decimals box like so:
I then want to check if a number is greater than another number.
Is the value in C3 greater than the value in C4? I do that with a greater than symbol.
And of course if I hit Enter:
I get the Boolean value TRUE in cell C5.
The next thing that I will talk about is the order of operations. In particular I will focus on the question if 2+2*4^2 is 256 or 34:
If I calculate from left to right, the first calculation is 2 + 2 which is 4. Then the next is times 4 which would make 16. If I then take that number squared I would end up with 256.
But that is not the way calculations work. The parenthesis always come first followed by exponents, multiply and divide follow and addition and subtraction come last.
If we then type in the formula in the example into Excel we will see this:
So Excel knows in which order to do the calculations and it does it automatically.
The correct way of calculating is first to look for any parenthesis, but in this case I don’t have any. Then I see that I have look at exponents where I have 4 raised to the second. This turns out to be 16. I then have to multiply that number with 2 which gives 32. Finally I have to add 32 with 2 which gives a result of 34.
There is a neat acronym to memorize the order of operations:
Please Excuse My Dear Aunt Sally.
If, on the other hand, I want to have 256 as a result I have to put parenthesis around the number, like so:
If I hit enter I will get the result 256 in cell C9.
In this section I want to show you how to evaluate a formula.
What I do is that I go up to the formulas ribbon where I first click “Formulas” and then “Evaluate formula” as shown in the picture:
When I click on “Evaluate Formula” I get a dialog box, like so:
Then when I click on “Evaluate” Microsoft Excel will calculate the underlined value for me. This comes in handy when you want to check your formula and you don’t know the order of operations.
4. Number formatting
The next thing that I will talk about is number formatting. The reason for me to do this is there are a lot of people who get it wrong and that we want to avoid.
If I for instance want to change a naked number to a number with a comma and two decimals I first highlight the numbers, like this:
If I then click “Ctrl” and “1” at the same time I open the Format Cells dialog box. Now if I click on “Number” I will get this:
Here I can decide how many decimals I want to show. I this case I go for zero and I click the box that says “Use 1000 Separator (,)”:
Next thing that we want to look at are the numbers in A3 to A5. They all say $67.35 but if I look closer I see that what it really says is $67.351383489, like so:
If I want to get rid of the number formatting in A3 to A5, I type Ctrl + Shift + ~ and I get get this result:
If I then jump to Currency in column D, you can see that by pressing Ctrl + Shift + 4, I get the currency formatting that I want:
If you then check with Ctrl + 1, you can see that the Format Cells dialog box has indeed chosen Currency.
What is the difference between Currency and Accounting?
If I highlight cells E3 to E5 and click on Accounting in the format drop down-menu, like so:
What happens when you click Accounting is that all the numbers that you are working with will align so that you can compare them directly.
I will be talking about loans and cash flow later on where you will have to do math on those dates.
Let’s say thatI have a loan that is due on a specific date and today is another date and I want to know how many days the loan is behind:
In the cells there are dates written, but behind the scenes Excel consider these as numbers. That means that there is an actual number there where Excel can do calculations.
You can check which actual numbers Excel uses by changing the formatting drop down to Text. First I highlight cells F7 and F8 and then change to Text:
You can then see that Excel use the numbers 42675 and 42712. If you want to know the difference between those you can write a formula:
First of all I’m typing an equal sign, then I click on the later date (F8), I click on the earlier date (F7) and hit Enter.
The result is 37, like so:
If you get a date as a result, it’s because the formatting is set to date. Just change to General (Ctrl + Shift + ~) and you will see the number.
The keyboard shortcut for today’s date is Ctrl + ; so if I for instance would like to add today’s date in cell F3, I first activate the cell by clicking in it and then type Ctrl + ; like so:
If I then want to increment my dates I click in the bottom right corner of cell F3 to get the crosshairs. Then I can simply drag it down:
If I then click on the Fill options handle I can choose to increment months or years instead of days. That is going to be handy when we want to analyze cash flows.
If we now want to know which numbers Excel use behind the scenes, you can highlight the dates that I just used (F3 to F5) and click General:
In Figure 49 I went from a date to a number so let’s do the opposite instead. I cells G3 and H3 I have written 1 and 2:
How do I make these numbers into dates? I type Ctrl + 1 to bring up the Format Cells dialog box. Here I choose the option “Date” and the format 3/14/01:
The result then becomes 1/1/00 where 00 is short for 1900:
As a sidenote I will now discuss how dates and text are differently treated by Microsoft Excel:
By default, Excel align numbers to the right and text to the left. From Figure 53 it is obvious that our dates are aligned to the left. That means that I have made something wrong in the formatting:
What has happened here is that we have started the date in cell C3 with an apostrophe and in C4 I’ve formatted the date as “Text” in the number formatting.
The reverse of converting dates to numbers can also be achieved. I have some numbers in cells I3 to I5:
Then I go to the number formatting drop down menu and choose “Short Date”:
Then I click and I get these dates out:
You can also find the maturity date of a loan that is issued on a specific date:
In this case the Loan Issue Date is in cell C3 and the Loan Length In Days is in cell C4. When I then type =C3+C4 I get the maturity date in cell C5.
5. Percent Number Format
In this section I will talk about Percent Number Format, Percent and Percent Change.
One of the biggest mistakes made in Excel with the Percent Button:
If I then type 0.02 in cell B2 and I click the Percent Button above I get the following:
The 0.02 is then transformed into 2%. On the other hand if I click the Percent Button with the value 2 highlighted in cell C2, I get the following:
That is an example of Number First, Then Format. The other way to do it is by first formatting and then typing. Here I highlight the cells B3 and C3 before I click the Percent Button:
If I then type the number 3 in cell B3 I get the result that I want (which in my case is 3%).
But when I type 0.03 in cell C3 I also get 3.00% so it doesn’t matter if you use 3 or 0.03:
I don’t know why this has been programmed this way, but it’s the way Microsoft Excel works.
Sometimes you have just one interest rate and then you can just type for example 3% in cell B4:
You will then get the result 3.00% when you hit enter.
Then I am going to talk about Percent and Percent Change. A Percentage is calculated as a Part of the Total. In Figure 66 I am comparing the Cost Of Goods Sold to the Total Revenue:
The result in cell B9 is of course the following:
Then we have the concept of Percent Change. This is calculated as (End – Beginning)/Beginning:
The result is of course as follows:
Microsoft Excel is a very powerful tool for doing calculations and data analysis. It is very often used in finance and we will dive deeper into the topic in later articles.
Today I have only gone through the basics of Microsoft Excel to whet your appetite.
I hope you come back for more.
Here are the ten rules of wealth building that we have discovered throughout the years. Don’t consider these principles absolute rules, but more of a guidance to how to think about your wealth in order to accumulate it. The principles are:
Today we have been talking about the ten principles of wealth building and how they relate to your personal fortune. They are more of a guidance on how to think about money and not absolute rules.
If you are interested in investing you should check the site Quora out. There anybody can ask whatever they want and you get insightful answers from qualified people. It’s a good way of getting more informed.
This is what the person is asking: “I’m interested in investing. I’m young, no debts, budget ~5k. I wanted to know whether I should opt for more low-risk options or go for day trading. Not really trying to get rich quick. I won’t need to spend any money for at least a few years, and I’m thinking more in terms of long-term, for retirement or house funds.”
First of all, forget about day trading. In order to a day trading operation successfully you need much bigger funds than those you have at your disposal. In a decent day traders world your whole budget is looked upon as small change and not anywhere near what you would need to be successful.
What I suggest that you do is to take a “value” approach where you honor the power of compound interest. What this means is that you will reinvest your dividends into the same stock and over time you will increase your wealth significantly. As an example, an interest rate of 10 per cent (which is not unthinkable in the stock market, price appreciation and dividends combined) will double your money in seven years.
What kind of stocks you invest in depends on your temperament. If you are so inclined you can look into small-cap stocks and find really cheap ones based on their recent earnings. Here it gets a little bit tricky because the free financial web pages only give out a momentary price to earnings (P/E) ratio – while what you are really looking for is consistency in earnings and cash flow. The only way to really figure this out is by going to the annual reports and write down the numbers either in a spreadsheet or in an old-fashioned notebook with a pen.
Otherwise I would stick to the bigger companies and make sure that I do not pay too much for what I get. The argument about the P/E ratio above also holds here. In order to make sure that the earnings of the company that you are interested in are consistent, you can go to your local library and pick up a recent edition of Value Line and figure this out.
Welcome to the exciting world of investing!
In this guide we will lay out the basics of why you want to invest your money based on the value that you get from your investment and why an approach like Warren Buffet’s almost always outperform in the long run. We will talk about value investing in the broad sense as well as the traps you want to avoid. We will not get too deep into technicalities like return on equity and working capital although we will briefly mention them. We will especially talk about how you as an investor can manage your money for the better and how you can build your nest egg – slowly.
(Note: If you would like to know more about the financials of Tesla Motors please read this article.)
To invest your money is both easy and hard at the same time. If you just want to invest somewhere you can do that with the click of a button, but if you want to invest wisely it’s a little bit harder. To invest wisely you have to go through the financial statements that are found in the quarterly or annual reports of the companies that you are interested in. When that is done, you need a framework for telling if the stock is worth buying or not.
When we first started investing many years ago and then sold our holdings at a profit, we thought that we ruled the world. There was nothing stopping us from making a killing in the stock market. We bought shares like there was no tomorrow. The only question that was relevant to us was how much money we could possibly deploy for our next speculation.
But then something happened. The market fell.
When it did there was no bottom to our losses. Everything that we had gained during the previous years was now lost and then some.
Wise from our experiences we laid out another strategy, one that was based on value instead of spectacular growth. One where a steady cash flow was more important than spikes in earnings.
This is why we write this guide. To prevent others from making our mistakes and to teach them how to be prudent with their hard earned money. This is especially true if you like sleeping well at night without any financial worries.
We caution you to take a more prudent approach with your cash and do your due diligence before you buy or sell any security. Never buy securities without asking for advice from a qualified adviser. You should always ask yourself if the investment decision you are about to make is justified by the fundamentals. If it is then go ahead, if it’s not then wait until it is.
There are many examples of occasions where the market has been severely wrong. We see them almost every day. These occasions ultimately create good buying and selling points for every shrewd investor out there. But you have to remember being patient.
Here we are going to talk about allocating your portfolio. What proportion of stocks to bonds you should keep and how to deal with the urge to speculate.
There is nothing giving you more thrill than seeing the ball fall at the right number when you’re at roulette table at the casino. This feeling of exhilaration is very strong and also very addictive. But it deceives you. The next time you will not be that lucky and when looking at it objectively, you have the odds stacked against you. After all, that is how the casinos around the world are making their money, by making sure that they will win more times than they will lose.
The same is true for investing. You can see a speculative stock go up two or three times in price over a short period of time. But to believe that you are consistently able to time the market so that you always buy low and sell high is just unrealistic. Sure you may be able to have a few quick wins, but they will almost invariably be accompanied with losses that exceed your gains.
You therefore have to have a system in place that prevents you from speculating. Keep a proportion of your portfolio – the smaller the better – aside for your speculation, but never mix money you gain from speculation with money for investment. What we suggest is keeping a proportion of 10 per cent or less aside for speculation. That way you can participate in the excitement, but you will never let it overtake your life.
Furthermore, there is a misconception out in the public that says that investing is like betting in the casino. We would like take a different view. Where betting is ultimately dependent on luck, the same cannot be said about investment. Investing is about putting money to work and getting a reasonable reward in return.
The safer this return is the better.
Regarding portfolio allocation it depends on the where in the market we are. In normal times the prices of bonds are the opposite of the prices of stocks. Therefore you should try to keep an equal balance between the two.
However, at times the prices of stocks are depressed while the prices of bonds are high. In such a situation it makes sense to increase the stock proportion in your portfolio. We suggest that you never exceed 90 per cent stocks when they are undervalued and that you don’t exceed 90 per cent bonds when stocks are overvalued. That way you will keep an even balance in your portfolio at all times.
Ultimately it depends on how high corporate- and treasury bond yields are compared to the average yield on stocks. As we write this interest rates are chillingly low. In fact they are so low that treasury bonds do not correspond to our of a good investment. Instead you have to look into the world of investment grade corporate bonds. These are rated by rating agencies according to how likely they are to continue paying out their return. An investment grade bond has at least a rating of BBB.
Here we will discuss what to do when the market plummets and the need to resist any urge to sell good investments just because the market has been going down. Similarly, we will also discuss the psychological urge to buy more stock when prices have been going up.
When the market goes up it is very easy to buy more securities in the hope that they will continue to go up. That may very well happen for a while. But then reality sets in and the security that you bought for dear money will sense gravity and eventually fall to the ground.
The lesson learned over and over again is that there is always a fair price of the securities that you buy. This means that it is wrong to look at a rising price in the market as a vindication of having made the correct decisions regarding a security. If anything, a rising price signify that what you are about to buy has become more expensive and that you will get less value out of it in the long run.
In the same way, a falling price signify a cheaper security and gives you the opportunity to buy more of the stock than before. The only reason to buy or sell any security is if the fundamentals of that security have changed. If they have then, by all means, go ahead and buy or sell. If the fundamental situation does not change then you are better off holding onto your securities.
The financial media is to blame for much of the hype that has surrounded the stock market in recent years. Often media don’t reflect that investing in essence is a rather boring activity. This is especially true when we are talking about value stocks.
The average investor would actually be better off had the securities in his or her portfolio been unquoted. That way he or she would be sure not to fall into the mass hunt that has proliferated in the financial media. The media often portray the business of investing as a kind of safari where it is all about killing big animals.
The true business of investing is very different. It is not a question about winning against the pros, it is about beating yourself in your own game. If you take a long term view and buy stock at a regular basis and reinvest your dividends in a disciplined manner, you are almost certain to succeed.
That is not to say that you should forget about the ups and downs of the stock market all together. If you see that your stock plummets, you need to sit down and harshly once again check the fundamentals. Are the steady earnings constant or are they slipping? Has the company taken on more debt? Does it finance its dividends with borrowed money? If it does then the market is right and you have to sell, but if it isn’t then you should take advantage of the low prices and buy more stock.
This is why we recommend holding on to your stocks for at least 5 years. That way with the dividends reinvested you should see a real accretion of your wealth during this period.
To sum this up: the more the market falls, the more value you will get out of your securities. Do not fall into the trap of selling just because everybody else is selling.
Here we will discuss the merits of mutual funds and index funds and how they can help the lay investor to grow his/her wealth.
One of the most common ways of investing is to leave the hassle of finding investment-worthy stocks to others. There were more than nine thousand different mutual funds in the US alone in 2014. As an aggregate they are almost perfect, but only just. Their biggest drawback is that they charge a hefty fee for the sake of looking after your money. You can pay anywhere from 0.25 percent all the way up 1.5 percent depending on what type of mutual fund it is.
This brings us to another aspect of stock picking which is that past performance almost never is a good guide for future rewards. A mutual fund may start out small, but inevitably, as the fund grows in size, it will attract more money. When the fund attracts more money it has a set of bad decisions to make:
Thus, there simply are no good options for the money managers who manage big accounts. So what they tend to do is that they indulge in the process of “herding” which means that most mutual funds buy the same kinds of stocks and at similar proportions as everyone else.
Another thing that may affect the long-term performance of the fund is that a top stock picking manager may be recruited to a competing fund. Good managers with good track records are almost always sought after, which is another reason that these are paid so well.
For the lay investor there is another possibility which is to buy an index fund. The upside to these is that management fees are low – it is not very complicated to buy equal amounts of the S&P 500, for instance. Another positive is that the fund will always follow the index – no worse or no better – which is good because it is fiendishly difficult to beat the index over time. Another plus is that you will always receive the aggregate dividend yield that the index pays. For somebody who is not very interested in stocks this is an almost ideal solution.
The downside is of course that they are boring. You will be able to look at the performance of the index to tell yourself how much money you have made recently. There will be no excitement when a stock finally takes off and you see that its price increases by the day. Likewise you will probably not see your stocks go down too much in value either. If you just want to participate in the stock market without doing the extra work it takes to analyze individual stocks, this may be the solution for you. As we shall see, the work of a financial analyst is very different.
In this chapter we will look into what determines the value of a security. How the operational cash flow, the assets on the balance sheet and the debt ultimately decides what kind of return you will get from your security.
If you have ever seen an annual report you will see that it contains a lot of information. If it’s a retail company you will likely find sales volumes in different regions of the company, if it’s a mining company there are many pages about reserves and resources and if it is a technology company there are probably discussions about their recent technological advances.
But what we are interested in as investors are the financial statements. You will see that they are divided into three parts:
The income statement is about how much money the company has made in the period (1) and how much money it has paid in taxes (2). When you subtract (2) from (1) you end up with the Earnings that the company has made in the period.
This Earnings number is then divided by the total number of shares to find the Earnings per share during the reporting period.
When you then look at the current price of the stock and divide it with the Earnings per share, you will get the price to earnings ratio or the P/E ratio. If you on the other hand are using last year’s P/E number you are in effect calculating the trailing P/E ratio and similarly if you are using an estimate of analysts expectations of next year’s earnings, you are determining the forward P/E ratio.
What this all boils down to is that it tells you something about about how much profits a share in the company will buy. A common share in a company is nothing but a stake in the profits.
There is a problem with P/E ratio however and that is that the number does not take into account the earnings over time. To do that we have to calculate an average over the past years’ earnings and adjust for inflation. Then we can use this average number just as we did when we calculated the real P/E-ratio. This is called Cyclically Adjusted Price to Earnings (CAPE) ratio and was introduced by the economist Robert Shiller in his book Irrational Exuberance from 2000.
The balance sheet is where the company is stating all its belongings and debts. The belongings are called Assets and are further divided into Current- and Non-current assets where the current assets are assets that can be sold over the next 12 months and the non-current assets cannot. On the one hand you have the assets (a) and on another you have the liabilities (b). Then you subtract the liabilities from the assets to end up with the Shareholder’s equity which is precisely defined as the Total assets minus the Total liabilities.
Then we prefer to divide the short-term liabilities, the long-term liabilities and the total liabilities with the shareholders equity to figure out if the debt is sustainable or not. If it is not then the company runs the risk of seeing the debt eat in to their earnings due to amortization. This will of course create a vicious circle.
When is the debt too much?
The debt levels vary significantly across different sectors. Some types of businesses are very capital intense and therefore highly leveraged (or running on borrowed money). Other businesses don’t need so much money, but can rather start to churn out money with a laptop computer from home. So it’s difficult to make a definitive statement about much debt is too much. For a mining company or a shipping company which are very capital intensive may see debt levels (i.e. total liabilities to shareholders’ equity) of more that two whereas a startup tech company may have very low debt levels.
The cash flow statement is where the cash that has goes in and goes out of the company during the reporting period is reported. The statement is divided into three different categories. These are usually divided into cash flow from Operational activities, Investment activities and Financing activities. The free cash flow is the money that the company can use for discretionary purposes, i.e. paying out dividends to shareholders.
The free cash-flow is defined by subtracting Investment in plants and equipment (CAPEX) under Investment activities from the Operational cash flow. The formula looks like this:
Another thing that is important is how much the company pays out in dividends, i.e. the dividend yield. You want to look for companies that pay a good dividend, but also has a history of increasing that dividend over time. Most companies that are doing well in this respect also has good cash flow coverage of their dividend. It makes sense, otherwise they would not be able to sustain their dividends.
A warning here is in place. Just because the company has a high dividend does not mean that the dividend is safe. For instance, the major oil companies nowadays almost exclusively has a high dividend yield, but that is more a reflection of the risk that you are running when investing in those companies. One way to check this is to make sure that the dividend is fully covered by the free cash flow.
The lower the P/E-ratio and the higher the dividend yield is, the more value you will get out of your investment. In mature companies this may be difficult, but in the small-cap space finding so-called “double-sevens” is most definitely feasible. A “double-seven” is a a company with a P/E ratio of 7 as well as a dividend yield of 7. The trouble here is that the cash flow is not as stable for a small-cap stock and may vary a little bit more than for more bigger companies, but anyway they are worth looking into.
We also want to mention the Return on equity or the ROE. The ROE is defined as the companies’ net income over the period divided by the shareholders’ equity. This is a measure of how much profit the company makes per dollar of shareholder investment. For a good profitable business an ROE of at least 17 percent should be sought after.
The last thing that we want to mention is the net net working capital. The net net working capital has been popularized by legendary investor Benjamin Graham who figured out a good way of valuing stocks in the stock market. The method involves taking the Working capital (current assets less current liabilities) and then subtracting any additional debt.
We can then divide the net working capital with the total number of shares to end up with a number for the intrinsic value of the shares. In the 1920’s and 30’s these numbers were at times surprisingly close to the quoted value and extraordinary bargains could be found. In today’s stock market these extreme values are seldom found because, let’s face it, a stock that is priced for its net working capital is priced for liquidation. In today’s market liquidations are rare and the costs associated are huge. They also take a long time to unwind.
The upside of this is of course that if you buy a stock that is priced by its Net Working Capital you are protected by their assets value (like plants and buildings) which effectively puts a floor beneath the price.
To conclude we would like to emphasize that what matters is the consecutiveness of the earnings in relation to their price. We would therefore propose the following list when we select a stock:
This chapter will contain a few real life examples of what we are teaching. We will in particular look at some of the stocks that we picked out in our small-cap screen at the end of last year.
We will compare two small-cap stocks that trade on the New York Stock Echange: “The Buckle” (BKE), an apparel company and “Cummins Inc.”, a company that manufactures natural gas engines.
What we did here was that we used data from the annual reports, Yahoo and Morningstar to come up with this:
Figure 1. Financial data and key ratios of The Buckle (BKE). For illustration purposes we have limited ourselves to three years of data.
What is clear from the data is that the earnings are pretty constant over the three years. They are decreasing slightly, but not so much that it justifies the stock to go from 53.39 USD in December of 2014 to 24 USD on this Friday the third of October. That is a good sign.
If we then calculate the cyclical P/E ratio we see that the averaged earnings over the last three years puts cyclically adjusted price-to-earnings ratio (CAPE) at 7.32. We see that the dividend yield is OK and we have a good free cash flow to pay for the dividends.
In all, when we are analyzing the stock we conclude that the market has weighed too much importance to the decreased earnings in 2015. The prudent thing would therefore be to buy more of the stock rather than selling. Therefore our recommendation for this stock is BUY.
If we then look at Cummins Inc. instead we see this:
Figure 2. Financial data and key ratios of Cummins Inc (CMI). For illustration purposes we have limited ourselves to three years of data.
What we see here is that the earnings are increasing over the years, but are they increasing too much? We see that the price has gone from 89 USD to 128 USD over the last year while the earnings have increased from 3.70 USD per share to 4.5 USD per share. The increased earnings do not reflect such an explosive increase in the price and the cyclical P/E ratio is much higher today than at the beginning of the year.
Taken altogether we do not recommend buying this share at this point. It is simply too expensive. If you already own it, by all means keep it, and reinvest your dividends so that you will receive a higher dividend next time. Another possibility would be to take some profits so that you can invest in other companies. In the small-cap space there are plenty of stocks with sufficiently low P/E ratios at all times. Therefore, if you look at a sufficiently low P/E ratio and a good dividend yield, you will always be able to find good investment options in this field.
In this guide we have been trying lay out the basics of value investing. We have been trying to answer the questions of what a good investment is, what constitutes value in an investment and how to deal with your non-discretionary spending whilst investing them in the market.
Value investing is not something that will make you rich quickly, but rather a technique for the turtles. The power of it comes from the “compound interest” that you will experience when you reinvest your dividends in the same stock. If you have bought shares in a good value company with a steady earnings, you will see that your wealth increases exponentially with time.
To the questions of what to buy and when to buy we have given real life examples which makes it easier for you to follow along.
In today’s post I will try to answer the question above and flesh out the reasons why I don’t think it’s a good idea. Personally I never limit my budget.
One day you may find yourself in financial trouble. That’s just part of life. It can be that you have fallen ill and have expensive medical bills or that you have just lost your job. These are all circumstances that normally force you to look into your personal finances and take a hard look. In the end you may come to the conclusion that you don’t really need all those restaurant dinners or coffees at Starbucks.
To cut back on low-hanging fruit like that does not do you any harm – it may even be a positive for your economy – but I still seldom do. Why is that? It’s because I have made a budget that allows me to lead a certain lifestyle. That lifestyle is then non-negotiable which means that I simply don’t compromise on the things that I’m doing. For instance, I love biking in the nearby hills and even if I had been unemployed I would still enjoy doing that. Now you can say that going on a bike is not the most expensive of things, but even so it still costs a fair amount each month. So what do I do?
The answer to question may seem to obvious. When my resources are not enough for the month’s expenses I simply increase my income. That is what I suggest that you do too. An extra income will allow you to maintain your lifestyle so you don’t have to cut back on the things that you enjoy the most.
Today we have been talking about personal finance and what to do when there are unexpected expenses. Do I limit my budget? No. I try to increase the money coming in.
The first thing that you need to consider when you want to learn the basics of investment is that almost every investor is a saver down below. You will never be rich by spending your money on lattes at Starbucks. The only way to become rich is to begin to save regularly at an early age – the earlier, the better. In this article we will therefore lay out the basics of investment and give you a few tips on books to read to begin with.
If you have trouble with spending money spontaneously and want to learn the basics of investment here’s a little tip that you can use:
If you are going out shopping, decide in advance what you want to buy and estimate the approximate cost of the things you want to buy. Then bring that money along plus a little extra, but don’t bring your credit card. Leaving your credit card at home will prevent you from shopping many unnecessary things.
When that is all out of the way, let’s get into some of the specifics.
Sure, you can be rich by speculating, but chances are that you won’t. Successful speculation involves buying and selling securities at the exact right time and that is very difficult to do consistently. Therefore, what I suggest is to look into companies with a steady cash flow and a good dividend yield. The cheaper you can get them, the better it is.
How cheap a security is, is determined by the price to earnings-ratio. If, for instance, you have a company that cost 100 $ while at the same time earning 10 $ then the P/E-ratio is 10.
If you want to buy apples on your local market, you know that the cheaper it is, the better. Somehow that quality does not apply when people are buying securities. Instead the more a stock falls, the more people tend to sell it instead of taking advantage of the opportunity. The facts are indisputable, the cheaper you buy a security, the more value you get. Similarly, when prices have gone up it means that you receive less value for your purchase.
Therefore, always look at the predictability of the cash flow. Are the company’s earnings something that you can count on or do they fluctuate? Is the dividend yield increasing over time? If it is it is generally a sign that the company does have enough cash to pay out to shareholders. Otherwise you can go in and look at the company’s free cash flow – which is defined as the operational cash flow minus CAPEX-spending – and see if they generate enough. The free cash flow is the money that is readily available to the company to pay out dividends. Otherwise they have to borrow money, which disturbs their debt structure.
The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor by Howard Marks. This book is full of praise for defensive investing which may prove to be the soundest piece of advice that you can get.
This is a short top three list of our own favorite financial books in order to learn the basics of investment. Don’t just read them, but also try to learn the wisdom that they are teaching. That way you are almost guaranteed to become wealthy one day.