The Only Ten Terms You Need to Know
Let’s dispel the myth that investing is too intellectually demanding for the normal person to understand. Of course, the financial professionals would love you to think you can’t get along without them; but it’s in your best interest to know the truth—that you certainly can.
Financial professionals have gone through the educational mill and, as with any other profession, have learned a whole lot of stuff you and I don’t know. Most of what they have learned represents things that business managers must know in order to run their companies successfully. And, indeed, those tools can be pretty complex. But, do you have to know them to invest successfully? No.
I’m fond of saying “You don’t have to know what’s going on under the hood to drive to the store!” And that’s quite true. You don’t have to know the spark plug gap or the viscosity of your oil to get from here to there. You have only to know how to start the engine, steer and shift gears, and stop.
Investors need to look at the results of management’s work. They don’t need to know all the things a manager knows to get those results—any more than a CEO needs to know the details of how his managers reach their individual results. Enlightened executives don’t micro-manage their management teams. They base their judgments on the results they get, and so should we.
Putting aside all of the arcane information, there are only ten terms you must know to be successful. They are: stock, sales, expenses, earnings, earnings per share, assets, liabilities, equity, book value per share, and price:earnings ratio or P/E.
A Share of Stock – You must understand and embrace the fact that a share of stock is not something that has any intrinsic value. It’s not like a baseball card that can be traded or sold for its own worth. Its value lies in the fact that it represents a part ownership of a business. Though it’s a small share, it nonetheless has one prime quality that makes it especially valuable: it can increase (or decrease) in value, depending upon the success of the operation of the company that issued it.
Because your ability to select quality companies relies on data about those companies, the next eight terms come from the financial statements issued by those companies. This data is readily available and can be conveniently “massaged” and displayed with the software products that are currently available.
A company puts out two primary kinds of reports. The first is an income statement (not one of the required terms) which tells you about that company’s performance during a period of time. The second is a balance sheet, which tells you about the company’s condition at the end of that period. You need only to learn four things from each. And those things are similar, though not the same. Whether we talk about General Electric or Lucy’s Lemonade Stand, the terms basically mean the same thing.
From the Income Statement: Sales, Expenses, Earnings, Earnings Per Share.
Sales (more properly called Revenue) – How much money the company takes in for the goods and services it produces.
Expenses – How much money it cost to bring in those sales.
Earnings (or Profit) – How much money there was left from the sales after expenses were paid.
Earnings per Share (EPS) – How much profit there was for each share of stock outstanding.
General Electric’s income statement would include line after line for each of these entries, showing all sources of income, broken down in various categories. It would also show each individual expense item. But, since we’re not managers, we’re interested only in the totals of each of the above elements. Lucy’s income statement, on the other hand, might consist of “Last week I made $50.”
From the Balance Sheet: Assets, Liabilities, Equity, Book Value per share.
Assets – Includes everything the company owns, from its money in the bank to the factories it has built. The primary purpose of assets should be to generate revenue or reduce costs.
Liabilities – Includes all the company owes.
Equity – The company’s value, after the liabilities have been paid.
Book Value per Share (or simply, Book Value) – As with the EPS, how much equity there is for each share of stock outstanding.
Both the earnings and the equity are divided by the number of shares outstanding to arrive at the per-share values. Each of these values must be reduced to a per-share value to provide a unit value. You can tell no more about the price of a tank of gas or container of coffee without reducing it to its unit cost—gallons and pounds—than you can about a company’s earnings or equity. By reducing it to the per-share value, you can compare it with other companies or values.
Thus it is with the last term: the Price-Earnings Ratio, a term which links the value of the share of stock with the earnings of the underlying company. Another unit value, this tells you what price is being paid for each dollar of a company’s earnings per share. Where the price per share, by itself, is as meaningless as the price of a tank of gas would be without knowing the cost of a gallon, the share price can’t be evaluated or assessed intelligently without knowing the cost of a dollar’s worth of the underlying company’s earnings.
You now know all the terms necessary for you to be that successful investor.