Notes for a Beginning Investor pt 1

We recently had a birthday party for my two middle sons.  They share the same birthday three years apart.  To celebrate we invited close family to swim and relax, my parents, brothers, and their families.  While floating in the pool my sister-in-law mentioned she is interested in investing, but didn't know where to start.  I told her I'd help her.  I gave her a few good beginning books, and said I'd help her understand what she's doing.  After reflecting on my offer I also decided to build out a guide for beginners.  Casey, this post is for you!  If you are a beginning investor, or know someone who is interested in investing basics start with this post.

The act of investing is committing some of your capital (money) to another business.  You can either invest directly, or invest in a secondary market.  Regardless of what you do, you are always investing in a business.  Every business shares the same goal.  They offer a product or service to a customer that is value enhancing to the customer personally, or as a business and in exchange receive a small amount as compensation.

Let's get to basics.  What is a business?  At the bare bones a business is a collection of people or products that solves a problem for someone or something.  Here is a simple example.  Imagine you are lost in the woods and are out of water.  Would you as a thirsty individual be willing to pay a guide a token amount to lead you to water?  Of course you would!  If you didn't pay the guide you would likely die of thirst.  Paying a guide to lead you to water in unfamiliar terrain seems like a simple exchange.  You pay the guide, and they provide something of far greater value, continued life.  That is the essence of most businesses.  Their goal is to provide something to their clients that far exceeds the price they charge for the product or service.

Ok, so we recognize what a business is, but how can we invest?  And what is it worth?

You're probably familiar with stock quotes.  These are numbers that float on a screen.  Some companies are worth $14.67 and others $1467.  What's the difference?  And does it matter?

To understand this let's back up and understand what an investment is.  When a company is formed an amount of initial capital is required.  This is the money founders and initial investors put in to fund initial operations.  For the sake of this post let's use a fictional lemonade stand.  Someone wants to create a lemonade company and they're looking for investors.

In considering our lemonade company we have a few startup costs.  We'd need a table, some materials to make a sign, and of course lemons, sugar and water.  Maybe we need $100 all-in to start our stand.  But unfortunately we only have $10.  At this point most people just give up.  They need $100 and have $10, it seems futile.  But there is a path forward!

We take our $10 and solicit friends and family for the other $90.  Our family is generous and contributes $90 but tells us "I want a return on my money."  We get started and setup our stand.  We spend $100 funding our stand and initial lemonade inventory.  Lucky for us the stand is right at a busy intersection with lots of traffic.  We're able to sell cups of lemonade for $1 apiece with ease.  At the end of the day we've sold $40 worth of lemonade and are excited.  After tallying costs we spend $100 to build our stand and buy ingredients.  Our $40 in sales represents a 40% return on investment (the initial $40 divided by the $100 in initial capital.)

Unfortunately we need to spend $20 of our $40 to buy ingredients for the next day.  But the next day we hit the pavement and make another $40, and it continues like this for a while.  We are able to make a profitable return on our initial investment.  Our family will be happy with their investment.

The initial investors paid in $100 in capital.  Because we're legal minded we formed a corporation and issued 100 shares.  Each investor will receive $1 for each share, and our company will have 100 shares outstanding.  Each share represents a 1% ownership in our lemonade stand. 

If our stand is open 100 days a year we'd make $2,000 in profit on that initial investment.  Maybe we decide to pay that out as a dividend.  Each owner would receive $20 for each share they owned.  The math is this, 2000 divided by 100 shares is $20 per share.

This stand is a spectacular investment.  Initial family invested $1 and received $20 back their first year.  But let's imagine that we want to expand.  Instead of a single stand we want an empire of stands.  We decide we need more investors.

The next investors won't be investing at $1 per share because this company is already throwing off $20 per year in dividends.  If we wanted to raise additional capital, say $1000 to expand we might offer equity based on our current profits.  If the company did $20 per share in earnings maybe new investors might be willing to wait five years for a return of their capital.  This means they might pay $100 per share for that $20 in earnings.  After five years they get their money back and anything beyond is gravy.

If we can sell new shares on this basis we can raise our $1000 by selling 10 new shares for $100 per share.  Remember when we had nothing we were selling our shares for $1 per share, now they're $100 per share based on our earnings.  Our share count would expand from 100 to 110.  From here we grow larger and continue to expand.

The lemonade stand example is simple, but proves two points.  It shows the value of earnings to a company, and also shows that as earnings grow the value of the company grows. 

But understanding earnings and growth is a small part of investing.  It is the "meta" to investing, but there are a few other nuts and bolts pieces that need to be understood.


There is a saying that "accounting is the language of business."  This saying is largely true.  To understand a business is to understand their accounting.  

When I was in college there were plenty of people who were failing out of accounting left and right.  It was a dark art of business.  If you couldn't hack accounting 101 you were destined for an Anthropology Major.  Accounting was seen as scary and difficult.  Accounting is neither scary nor difficult.

Accounting is a way to describe how a business functions using numbers, and the numbers represent the money flowing through a business.  If a business isn't generating revenue it isn't much of a business, it's more of a hobby or idea.

A real business earns money via sales (called revenue).  This revenue is used to pay expenses.  After expenses are paid the company pays taxes.  What's left after taxes is called profit or net income.

In most businesses the majority of revenue is spent trying to make the next dollar, equipment, salaries, office supplies.

There are three financial statements that describe the operations of the business.  The balance sheet, the income statement, and the cash flow statement.  For a publicly traded company they are required to file all of these statements quarterly on the SEC's website.  You can search for a given company at this link.

Let me break down the financial statements.  The easiest way to think about them are this:

The income statement shows a company's ability to price their products over their costs.

The cash flow statement shows if they're lying.

The balance sheet is a snapshot of this process at a point in time.

Let's start with a company's balance sheet.  A balance sheet is showing a company's accounts, sometimes called their assets (what a company owns) and their liabilities (what they owe).

At the top of a balance sheet are things called current assets.  These are things a company owns that are either cash, or can be turned into cash within the next year.  Below current assets are longer term assets.  These are things a company owns that can't be liquidated within a year.  A long term asset might be a building, land, or machinery used to create product.

Under liabilities are both current and long term liabilities, just like long term assets.  A short term liability might be money owed to suppliers or payments due on short term debt.  Longer term liabilities are things like long term loans and lease agreements.

A company's assets minus their liabilities equity their equity.  The equity is what shareholders own.  If a company has little equity and a lot of debt the company is effectively controlled by their bankers.  A company's equity is last in line of ownership.  Bank debt has first lien on a company's assets.  If a company were to run into trouble assets are sold to satisfy liabilities.  If assets fall short of liabilities then a company's equity becomes worthless.

A company's balance sheet can be used to evaluate the staying power, or strength of a company.  Are they laden with debt and reliant on perfect business conditions?  Or do they generate ample cash and have enough to make it through a rainy day?

While a balance sheet is important in most cases it isn't as important as the two other financial statements, the income statement and cash flow statement.

The income statement shows the flow of money coming in and where it's paid out.  At the top of the income statement is a company's revenue.  This is money earned from selling products or sales.  Below revenue is the cost of sales.  This is the amount that it cost to create the products or services that a company is selling.  

Revenue minus cost of sales is something called "gross profit" and is often expressed as a percentage.

Below this is salary costs, research and development, taxes and other company expenses.  Before taxes are paid a company pays interest on their debt.  What's left after expenses, interest and taxes is called net profit.  This is what shareholders are entitled to.  A company can either reinvest this amount, or pay it out directly to shareholders as a dividend.

The company's net profit divided by the number of shares outstanding is called "earnings per share".  This is often a value used when discussing companies and their performance.  It's a representation of the profit shareholders are entitled to per share of ownership.

The last statement is the cash flow statement.  Both the balance sheet and income statement are based on accrual accounting.  This is probably a 200 level topic, but in short accrual accounting recognizes money flow based on contractual timing of money flow, not when money actually changes hands.

The cash flow statement shows the company's accounts in terms of actual cash flow, not accounting flows.

In the US the cash flow statement starts with the company's net income and adds and removes a variety of items such as depreciation and inventory flows.  The end result is operating cash flow.  This is the actual cash generated from operations.

One thing to watch out for is when a company claims they are profitable on their income statement, but then don't generate any cash.  Alternatively some companies claim they don't earn much of a profit, but have substantial cash flows.

This has been a whirlwind tour on the basics of a company and their financial statements.

In part two I'll cover the basics of valuation.

Best of luck!

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