Back to the Basics: 8 Simple Metrics That Beginner Investors Should Know

21:41Andrew:I guess most investors, the way I look at it is anything under a 20, I consider cheap. Anything under 15 is really cheap. And then once you start creeping above 25 to 35, that's starting to get expensive, kind of depending on the business and generally anything above 35 to 50, particularly anything above 50 is like, forget it. That's crazy talk. And so when you see those kinds of numbers thrown around for really, really expensive businesses, think of Palantir. I have no idea what the PE ratio is, but 220 is probably a number I've probably seen out of that. Those are kind of crazy. And this number may not mean much to you, but think about this.

22:36Andrew:If you go and buy a car, would you pay 220 times more for a Tesla than what the dealership is offering it for? Well, no, you wouldn't. So it's kind of the same rule would apply when you're investing. You want to try to find companies that are in a range that are going to give you a good return. And so anything above, once you're pushing 25, 30, 35, depending on the business, you're starting to get into nosebleed territory.

23:06Dave:So why do, and we won't sit on this too long, but why do people pay high PEs?

23:14Andrew:some people are I think the easy way to say it is I feel like some people are willing to take bets on companies that they feel like there's way more growth that's not baked into the price of the company and that they're going to get a better return over a longer period of time based on that future growth that they're expecting for that business. The hot stocks right now are the space companies, for example, Rocket Labs and ASTS and things like that. I've seen a lot of those on social media. And those trade a very, very high multiples because people are expecting them to grow very, very quickly.

23:59Andrew:And so they're willing to, air quote, pay up for that growth. And that's why they will pay for that. And it's not a game I like to play. That's just too rich for my blood, personally.

24:16Dave:It's risky, for sure.

24:18Andrew:Yes.

24:19Dave:Yes. Part of the reason why people like to buy lower PE stocks is because you kind of know what you're going to get. You know what the business is doing. and so there almost is like a floor to the stock where if it gets cheap enough, enough people are going to say, well, I could get a dollar of earnings for 10 bucks for one of the great companies. There just tends to be a floor there where you don't see the same kind of thing for a high flying stock. Their floor is a lot lower.

24:59Andrew:Yes, for sure. And that's the last thing I guess I'll say in this week and move off this mountain. But recently, in the last few years, Meta fell to a... It generally traded at a much higher PE ratio, 25, 35, 40. It's not a company I follow closely, so please don't hold me to those numbers. But it generally traded at a higher PE ratio. And then before the year of efficiency, when everybody was bashing on Meta, And it had gotten down to probably a PE ratio of 14, 15, somewhere in that range. And so then it became what everybody would refer to as a value stock. So generally, companies that have a lower PE ratio are referred to as more like value stocks.

25:43Andrew:And companies that maybe carry a higher PE ratio can sometimes be lumped in with what you would call gross stocks. So it kind of depends and whatnot. And you will see companies move in and out of these ranges all the time. Google was just in the air quote of value stock range not too long ago. Microsoft has been there, was there for a long time. So companies will go in and out of that. Someday NVIDIA may come back to that. Who knows?

26:12Dave:Who knows? If they keep going, they're going to hit the moon at some point.

26:16Andrew:Right, exactly. Which they may well.

26:18Dave:I mean, some of these got to get to the moon again soon, right?

26:21Andrew:Right, exactly. Exactly. Elon better hurry so he can get there ahead of them. Yeah. I'm here for that. Yeah, right. Me too. All right. Let's talk about 10-year CAGR.

26:34Dave:Yeah. Okay. CAGR. Think of the acronym. It's CAGR, compounded annual growth rate. And the reason why we want this number is because when you have returns year after year after year, it compounds on itself. And so if I earn, let's say I earn 11 % per year every year, 11, 11, 11, 11, 11. At the end of like 10 years, it's not just 11 times 10, and that's your return. It's actually a much higher return because when you factor in the power of compounding, you've had extra growth that continues building on itself like a snowball that's rolling down a hill. The bigger the snowball gets, the more and more snow it attracts.

27:25The more growth you have for a company and a stock, the more and more your total will grow. That's why when you look at stock charts, you'll see this is just math,

27:38Dave:but basically you'll see them kind of rocket ship higher. They have this exponential growth rate. It looks like a rocket ship kind of going up. And it's because of that compounding effect. And then if you change the numbers,

27:55Dave:the curve will be steeper or not as steep. But that's a conversation for a different day. You can go dive into log charts and stuff like that to figure out why. Why does 1986 look so small and 2025 look so large? It's actually similar growth. It's just the way that it's a chart thing. So as investors, we want to know what the CAGR is and we want to know what the 10-year CAGR is because that will give us a good sense of what's been the actual wealth that has been generated from a stock. and a lot of investors like to look at what has revenue done over a 10-year CAGR and what have earnings per share done over a 10-year CAGR.

28:41Dave:Because again, another reason for this, I'll just quickly say, if you were to look at a 10-year return or a 10-year growth rate of revenue or earnings, you would see like 1 ,200 % or 657%. That doesn't tell us anything. These are just obnoxiously huge numbers. But when you go CAGR, 11 % annually versus 13 % annually, we can conceptualize that. We can understand the difference. And so because Wall Street looks at things on a yearly basis anyways, they'll do an earnings call and they'll say, oh, revenue was up 7 % year over year. Everything's in year terms anyways. And so when we go to a CAGR, that helps us because it takes that big compounding number and squishes it down to an annual number that makes it really easy to understand.

29:40Andrew:That's a great explanation. And I hate it when you're reading about Buffett and his track record and they throw out, if you bought the company in this timeframe, in this time, it would have earned this kind of return. And you go, I mean, it's a huge number, right? And you're like, I can't, my brain can't conceive of that. But then, you know, then either the smart person will do it or somebody will calculate it for you and it'll say, you know, oh, it was 19.85%. Oh, okay. That makes sense. I can wrap my head around that. That makes sense. But yeah, those, those crazy big numbers. If you'd bought this company at, you know, at a thousand dollars in IPO, it would be worth, you know, Amazon.

30:20Andrew:If you'd bought it at Amazon, went at IPO, it'd be worth this much. and I'm like, okay, that doesn't tell me anything. So yeah, it's super important to understand.

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32:03Dave:It matters where you stay. Book now at Hilton.com. Hilton, for this day. yeah so if you can learn the metric and the more you see it the more you'll learn it next metric on the list is position sizing how do you look at position sizing what's the definition let's let's start with that position sizing is probably one of the more

32:33Andrew:undiscussed, very important ideas related to investing. And what it means is it tells you how big a investment you're going to make in comparison to the overall total of your portfolio. So to use easy numbers, if you're going to buy, if your total portfolio has 20 stocks in it, or let's say 10 stocks, and you buy one position, you make an investment in Google, and you want to make that an equal position, then you would have to buy 10%. You would have to make a 10 % investment in Google to have a 10 % equal size to the other nine companies or investments that you have in your portfolio. And so depending on how you have your portfolio set up and how many companies you have or want to have, that will have a bearing on how big the position size is.

33:29Andrew:So you'll hear people throw around numbers like I started this at a 3 % position size, or I bought 2 % and then I added another 3%. What they're talking about is they're using numbers to compare to the overall size of the portfolio to give you a sense of how big an investment they made comparatively to the position size. Now, sometimes you're not going to know exactly how big their portfolio is. And that in and of itself is not necessarily important. It's more important. It gives you a sense of how much conviction they have in a particular investment. You'll hear people say throughout terms, like I did a starter position, which generally means they bought a very small position, a very small size, a very small slice of the pie, if you will, to go back to Andrew's pizza analogy.

34:15Andrew:They bought a very small slice. They bought one of my squares from my pizza that I got gypped on. That's a starter size. A full size would be the regular size pizza. And if you wanted to buy half the pizza, that would be maybe a full position, depending on how you define it. You'll hear people throw out numbers like 1 % for a starter position or smaller, maybe 3 % to 5 % for a full position, maybe 5 % to 10 % for a very large position. And if you really got a lot of guts, you could do the Warren Buffett and have 50 % as he did in Apple. That's just crazy talk, but it will leave the genius for another day.

34:56Andrew:So that's kind of the basic lowdown on what a position size is. It's very important because it has a huge impact on the returns that you get. Because the more that you put into a company, then the better it does, the larger that position will grow in your portfolio and the larger size will give you a faster compounding return. Like we talked about with the CAGR, it'll give you a faster return on that particular investment.

35:27Dave:Yeah. And I mean, it's kind of probably doesn't need to be said, but I'm just going to say it anyways, because it helps my brain. Like if you have a 2 % position size and you have a 20 % position size, that 20 % position size is going to affect your portfolio 10 times more than that two position size so if that if that stock moves five percent that would have been like the same as your two percent position size moving 50 percent it's a very important decision yeah and um very important in the world of like give me the next stock pick give me the next stock pick like you're saying it is not discussed enough and it makes a huge impact.

36:08Andrew:Yeah, it definitely does. And it also goes to what kind of portfolio, how big of a portfolio do you want to have? A lot of people will have 15 to 20. That's very common. But you have outliers like a Joel Greenblatt that has hundreds. Or you have Charlie Munger who has four or had four. So there's all different levels and you can slice the pie however you want, but the position size will have a very big impact as Andrew just explained on your returns. And it'll also have a very big impact on the conviction that you have going into that company. So you could be the greatest stock picker in the world.

36:48Andrew:And if you put 1 % into all your best ideas and 20 % into your worst idea, you're not going to get a great return. So it definitely has an impact and it's something you should understand and try to wrap your brain around. It's hard. It's very hard. It's probably one of the hardest things to do in investing because there's no concrete way to do it and there's no concrete guidelines to do it, to do this, do this, do this kind of thing. It's very much, it's more open-ended, which makes it more challenging.

37:19Dave:Yeah. Or endlessly fun, depending on how you want to look at it.

37:23Andrew:Right? Yes, for sure. It's something people debate a lot, for sure. All right. We've talked a lot about the income statement. Let's talk a little bit about the balance sheet. So what about the current ratio?

37:38Dave:Yeah. Current ratio is going to give you a sense of how liquid a company is. And that's not really important most of the time. But for those few times when there is market uncertainty, when liquidity dries up, it happens once every 10, 20 years, maybe even a little bit more frequent. But when those stresses in the economy happen, and they always happen, they have happened for decades and decades and decades, you want to be confident that the companies that you own in your portfolio have that kind of liquidity and that cushion to be able to survive something freaky. And there are companies that have not done that.

38:21Dave:and I've said them over and over again. You can look up the blog post if you want. You can go on our blog, investingforbeginners.com and search up Circuit City. And that was a very, very good example of a company that wasn't actually completely liquid, even though it appeared to be on the surface. But current ratio, you just calculate it. Current assets divided by current liabilities. The higher, the better, because that means the higher number of liquid assets they have. anything above a one is generally considered like pretty liquid and then anything like below point five is starting to get a little concerning and you really won't see too many companies start to go that low except for like grocery stores or things where uh they're getting like steady cash flow all the time and they don't need to stay as liquid so um you know like grocery stores, people are just always going to go get their bananas.

39:20Dave:But Circuit City, people weren't always going to go get computers. So there is a little bit of swaying, a little bit of movement one way or the other, depending on what kind of industry you're in. But in general, you probably don't want to be in the most illiquid company with the worst financials, the worst growth. Those are the type of stocks that you can use the numbers to identify. And those are the ones that at least over the longterm, you probably want to stay away from.

39:54Andrew:That's very good advice. Very, very good advice. All right. I have nothing else to add. Let's move on to the free cash flow. This is a little more advanced. So we're going to talk about this one for you.

40:09Dave:Yeah. Do you want to take this one? Sure.

40:11Andrew:So free cash flow is probably one of the more important metrics to understand and know. Free cash flow is what drives the growth of every business. Earnings are generally opinion, but free cash flow is a fact. This represents the actual dollars, the cash that a company has in its account, bank account. So think of our checking account. It's the money that goes in and out of the account. That is our free cash flow. So calculating free cash flow, it involves two numbers, and it's looking at the cash flow statement. So the cash flow statement is broken up into three components. We're going to be looking at the top component, which is the cash from operations or cash flow from operations.

40:55Andrew:Companies will refer to it as different terminology, but it's all the same. So we look at the bottom number of that section, which will say cash from operations. and that's subtracting all the different inflows and outflows of cash throughout the quarter. And what's left over is the operating cash flow. So that's the money that the business has made from the operations of the business. So Walmart selling all of its inventory and comparing it to buying all of its inventory, for example, and then also depreciating or paying for all the stores in simplified terms. So then what we're going to do is we're going to take that number and we're going to subtract capital expenditures or investments in property, plant, and equipment.

41:40Andrew:Those terms are kind of interchangeable. And we're going to subtract that from the operating cashflow. And the number that's left over is called free cashflow. And this is the money that the company can use to reinvest in the business. They can pay down debt. They can buy more shares. They can pay a dividend, or they could go out and buy Andrew and I's ice cream shop. Please hurry. And so that is what they can do with free cash flow. It's a very easy metric to calculate once you know where it is. Like anything else, the higher, the better. And you can also do all kinds of other fun things with it, which we'll probably talk about in the future.

42:17Andrew:But it's a really important metric to understand. And the bigger the number and the more it's growing, the better that is for the business because then they can use that money to grow or return capital to us as shareholders.

42:30Dave:Yeah, great breakdown. And that is 100 % how you do it. Look at the cash flow statement. One of the ways I guess you could look at it, and I'm not throwing shade because I've had a student loan. I've been there. But if you were working part-time and then also going to school and having a student loan, you might get 20 grand from the government to go to school and that might go into your checking account, but that's not free cash flow because you borrowed to get that money in your checking account. Your actual free cash flow would be whatever you're making, working at the furniture store or something like that.

43:07Dave:And so that's important for investors to know too, because maybe companies can take advantage of low interest rates and so they borrow a bunch of money, or maybe they're taking advantage of investors who are really excited and they're able to raise capital. But that's not telling you the actual operations of the business, their actual earning power. And that's what, as investors who are trying to be a little more risk averse and trying to look at what are the facts today, what's something that's maybe more reliable than a hope and a dream down the future, that's why you look at free cash flow.

43:46Dave:And that's why that metric is kind of organized the way it is. Yeah.

43:52Andrew:Yeah. It's very important. And of all the ones that we've talked about so far, this is one you really want to wrap your head around for sure. All right. So let's wrap up with our last return metric. This is return on equity. Yeah. Return on equity. Warren Buffett's most favorite metric, I believe.

44:13Dave:Yeah. Yeah. Yeah. And I would call it maybe the predecessor to ROIC. I think of ROIC as the more sophisticated metric. If you've ever seen the Winnie the Pooh meme, do you know what I'm talking about? Yes, I do. To me, that's ROIC versus ROE. But they measure pretty much the same thing. So ROE is trying to tell you how capital efficient a business is. if we had our ice cream shop, if it took us$100 to open a store and we earned$20 in profit from the store, that's pretty good, 20 % ROE. If we opened a store and we only earned$1 in profit every year, and so now your ROE is 1%, man, we're going to have to open a lot of stores to get to$20.

45:10Dave:so companies that have high ROEs are just going to have easier paths to growth because their money that they're investing is more efficient and that's really what the whole reason for calculating the metric is is you're trying to find those businesses that can grow so we have our ice cream shop an ice cream shop down the street which doesn't use sugar so we're obviously going to be a better ice cream shop than them. If our ROE is twice as big as theirs, it's not hard to see us outpacing them over the long term and being the more profitable and bigger business. So that's why I use ROE. And there's many ways you can use it, but that's kind of the first steps there.

45:59Andrew:The formula is actually quite easy to calculate. You take the earnings that we discussed earlier. So for earnings per share, you take that same number, which is also referred to as net income. which you'll find at the bottom of the income statement. And then we're going to divide that by the shareholder's equity or the book value of the company, which we will find at the bottom of the balance sheet. And so you just compare those numbers and that will tell you what the return on equity for the business is. So it's a very easy metric to calculate. And again, with something like the PE ratio, you can quickly communicate to people.

46:37Andrew:This has a PE ratio of 15 and it has a return on equity of 22%. That tells investors a lot that it's potentially cheap and it's doing a really good job of investing their capital to grow. And so it can communicate a lot of things very quickly. And that's why it's a very popular metric. And it's useful across a lot of different industries. One caveat to the return on equity, do not compare return on equity to Microsoft to Wells Fargo. That will not be a favorable comparison, especially if you're interested in investing in Wells Fargo. um so make sure make sure that you look at it on a uh a company like a industry to industry comparison don't don't look at fast growing industries to you know something that's super capital extensive uh intensive and slower growing that will not be a fair comparison especially if you're interested in these slower growing ones yeah just stick your head in the

47:38Dave:and then everything will be okay.

47:40Andrew:Yes, exactly. That's the best way to fly always. All right, folks. Well, with that, that'll wrap up our conversation on some beginning metrics for you to explore, especially if you're newer to the stock market. These can be very helpful for you to start analyzing companies and looking through companies and kind of understand what it is that you're seeing and also understand the lingo that people are throwing at you if you're listening to podcasts like ours or other shows. So with that, we'll go ahead and sign us off. You guys go out there and invest with a margin of safety, emphasis on the safety.

48:13Andrew:Have a great week and we'll catch you next time.

48:17Dave:We hope you enjoyed this content. Seven Steps to Understanding the Stock Market shows you precisely how to break down the numbers in an engaging and readable way with real life examples. Get access today at stockmarketpdf.com. Until next time, have a prosperous day.

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