Essential Metrics for Analyzing Stocks: A Beginner's Guide

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1:56tuned in to the Investing for Beginners podcast. Led by Andrew Sather and Dave Ahern. Step-by-step premium investing guidance for beginners. Your path to financial freedom starts now. Starts now.

2:19All right, folks. Welcome to Investing for Beginners podcast. Today, Andrew and I are going to have a little fun. We're going to talk about some metrics and a few different things you can use to analyze companies, give you a quickie start, if you will. So if you're newer to investing, these are some simple metrics that you can use to start analyzing any company, whether it be NVIDIA, which is in the news today, or it could be TSMC or Intel, which was in the news recently as well, any company you want. So these are great starting points to start giving you, I guess, a good heads up or leg up on investing in companies.

2:57So with that, I'll go ahead and list out all five that we're going to talk about today. And then we'll kind of break each one down as we go through. So we have the cashflow statement overview. We're also going to look at gross versus operating versus net margin income margins. We're also going to look at the current ratio, understanding debt to equity and return on equity. Now, if you are new to investing and you're like, I don't understand what this cowboy goop is. We are going to explain each one as we go along. So don't be afraid. Stay with us. We got you. We're going to hold your hand through all this.

3:30All right. So let's start with a cashflow statement overview. What does that mean to you? And why is this important to take a gander at? Yeah. Cashflow statement, income statement, these are financial statements telling you about the big picture of a business. Income statement, it's kind of obvious profit and loss, right? Like is the business making money cash flow statement? Similar thing. Is the business generating cash flow? One of the big differences between those statements though is that the cash flow statement lays it out nicely in the way it's sectioned. So the way the cash flow statement is sectioned off, you have three sections, cash from operations, cash from investing and cash from financing.

4:13And those three things are three major categories that help tell you what kind of cash flow is coming from where and doing certain things for the parent company for the entire business. So I'll turn it over to Dave to talk through some of those and give context to why each of those sections are important. Yeah. So I think if you can kind of think about what they're telling you, each section is telling you, it helps break down a little bit why it's important to think about. So cash from operating activities, for example, makes sense. It's the money that is spent on the business to operate the business.

4:56So to pay for the things that they need. So, for example, if a company needs to pay for inventory to buy Nike shoes to sell in their stores, then that's money that they're going to spend on inventory. And that comes out of the cash flow of the business. Net income is the bottom line from the income statement, which connects to the cash flow statement at the top of the cash flow statement. And that feeds all the rest of the activities for the operations. So you have things like depreciation and amortization. you have changes in working capital, which means that you'll have accounts payable, accounts receivable, inventory, maybe deferred taxes, maybe deferred revenue, different things that'll be in there that'll indicate monies going in and out of that account.

5:41An easy way to think about this is it's like the checking account for a business. So that's an easy way to think about cash from operations. The next section is cash from investing. So this is where the company will use those monies that they generate to reinvest in the business. So things like investments in PP &E or CapEx, which is where they will use money to, let's say, pay for a factory or buy more computers or maybe pay for software. Those kinds of things will be part of investing activities. You also see things like acquisitions. So if companies are buying other businesses, this is where you'll see money going in and out.

6:20A lot of companies invest, so they will buy investments. Maybe they'll buy like Amazon buys Rivian. You'll see that kind of thing in this section. And then the next, the last section is the cash from financing. And so this is where they use the money to raise money to invest in the business. So you have free cash flow, which is generated from the operations of the business, less any reinvestments. Then you have the money that they would generate from things like raising debt. So if a company wants to generate money, let's say Microsoft needs to pay for a big project and they want to do it without using cash flow, they would go out in the market and sell their bonds in the open market and people would pay for those bonds.

7:05And then that would be raising debt that they could use to buy another company, for example. Other ways that they could do it is they can sell stock on the market or they can raise money by doing that by selling their stock in the market. Other things that you'll see in the financing section is also things like capital return to us as investors. So dividends, when you see it when a dividend is paid, this will be in that section. Or if they're repurchasing stock, or buybacks is another way to refer to that. And a lot of people will refer to those things, and that could be a real easy way for them to return capital.

7:41And so those are kind of the three major sections that you'll see in the cash flow statement. If I could just piggyback on that, just to give some kind of more context, if a company has that last piece, if a company has cash from financing, and if there's more cash, if there's more cash leaving from cash from financing versus cash being added from cash from financing, that tells you what growth stage a company is in. and that's just not that's not just my opinion that's what michael mobison said and i apologize i don't have the paper like in front of me i can't remember off the top of my head but that's a really great way to look at it you can take each of the three sections and he kind of laid it out because i think he he broke it out into like four four different life cycles four or five but every combination of life cycle.

8:37Like for example, if a company is losing a ton of money, it could be in the decline phase. But that kind of inflection point between whether a company is in the growth phase or they're in the profitability, optimizing profit stage, I think he just calls it growth and mature. That is based on whether are they raising a bunch of capital or are you getting it back in buybacks or dividends. And he has numbers all about how those perform. So I think it's good to know. Yeah, it's very good to know. And that's a great way. The cash flow statement probably, I would argue, doesn't get enough love. It's probably one of the more important.

9:16They're all important, but the cash flow statement can tell you a lot about a business and a lot about the management of the business and what they're trying to do. And so it is a really good place to look beyond just the obvious free cash flow metric that everybody wants to calculate and look for, which is obviously critical and very important. But to Andrew's point, the other sections can tell you a lot about the company as well. Yes. So let's talk about one that maybe gets a little more love. Income statement? Yeah, it gets a lot of love. What are you looking at with the income statement and what metrics?

9:51There's three main things you need to think about when you're looking at the income statement. Those would be the margins of, I guess, the three main sections. There's four sections to the income statement, but the three that we're most concerned about are going to be the gross margin, the operating margin, and the net income margin. And all right, so when we think about the gross margin, the gross margin tells us how much money the company would make after paying for the cost to produce the thing that they sell. This is not the bottom line. This is only the profit that this is before all the other expenses have to be figured into the business.

10:38So this is the gross profit that they make. So the cost that they would be required to make whatever it is they're selling compared to the revenue that they generate from selling that thing. So if they sell widget A for$5 and the gross cost of goods sold or the cost of goods sold for that would be$2, then their gross profit before other profits, before other expenses would be$3. So we still have a little bit of ways to go before we figure out how much we as shareholders make, but the company has made$3 on selling widget A. Yeah, that's perfect. so the next piece of that would be the operating margin and so you take out some of the other expenses that the company would need to run the business they probably needed a sales team to get widget A into the hands of stores and then maybe they needed some lawyers along the way to hold a hand or two so maybe if that costs a dollar we've now gotten operating margin down So gross profit was what was it?

11:47You said$3? Yeah,$3. So gross profit's$3. You take out$1 for SG &A, and now you're at$2. Now we're at operating margin, which still doesn't get you to the full profit that shareholders would get, but we've gotten one level further. And a lot of times when Dave and I talk about the core operations of a business, we're talking about this operating margin because we've included all of the costs for selling, not only selling, but making and selling widget A. And then that's all locked in operating margin. And then the last piece is Uncle Sam needs to take his cut and some of the other loose ends, interest and things like that, loose ends that are required for having a business, but the operations are covered by operating margin.

12:40So recap, it's margin after how much does it make to cost to make widget A. Then how much does it cost to sell widget A. Both of those combined give you operating margin. And then the last piece is... Net income margin or earnings. Yeah. So this is the coup de grace. This is what everybody in Wall Street talks about is earnings or net income margin. Don't get confused by the terminology. They're exactly the same thing. Different people will refer to them differently. When we're looking at the income statement, the net income margin or the net income is the bottom line. It's the final straw on the income statement.

13:24It's the last thing that you will see. And this is the result of all the costs to produce widget A, all the expenses to sell widget A, as well as all the gobbledygook taxes and other things that are required to run the business. And what's left over is the net income or earnings. And that is the money that we as shareholders have, air quote, earned from our$5 sale all the way at the top of the income statement. And the way that we would measure that is we would look at the earnings or the net income and compare that to the revenue. And that would give us a margin percentage. And then we could tell how profitable our business was.

14:06So let's say the bottom line is we had$1 left of earnings after selling$5. So that means that we divide the one by the five and that gives us a 20%. And so we have a 20 % income margin for our selling our widget A. So that's actually a pretty good profit. So that's kind of how the income statement is set up and works. And that's how you can start to analyze it. And I think, like I said before, try not to look at it in stasis. It's all fine and dandy to look at it for one quarter or one year, but look at it over longer periods and compare it to others in the same industry. Please do not compare Wells Fargo to NVIDIA.

14:44That's going to be a very poor comparison, but it's okay to compare Costco and Walmart together or even Target. All three of those would be a really good comparison. So try to think of like to like as opposed to opposites attract. And that's a good way to start looking at the income statement. Yeah, I mean, if I throw a dart at the wall and I pick what was the net income margin for 2022, it doesn't tell me a thing. But if I'm looking at a five, 10-year period, I can see how it's moving. And that trend can give me an indication on the health of a business. Is it getting better? Is it getting worse?

15:18Is it staying the same? And that tells you how is it rocking and rolling. Are profits rocking and rolling or are we hitting a rough patch? You can see them in the margins over time. I'm not going to lie. Running a small business has been stressful lately, swamped in paperwork, different state agencies, and got all these expenses to track and everything. And it's hard to have visibility on these things. But I've stumbled on a better solution, kind of like a one-stop shop for my bookkeeping, my expenses, my P &L, my banking, my contractor payments, all of the messy pieces. It's called Found. It's for business owners like you and I.

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18:03Join at functionhealth.com slash beginners and use gift code beginners 25. What's the best way to get started in the market? Download my ebook for free at stockmarketpdf.com. Yep, exactly. All right, so let's move on to the balance sheet. So this is a metric that we would use to measure the health of the balance sheet. And this is called the current ratio. Would you like to tell our fine listeners what the current ratio is and how we calculate it? Yeah, pretty simple. Half of it's in the name, current. So current ratio, current assets divided by current liabilities. And those are the things, there are assets, there are liabilities.

18:44I think a lot of us can kind of intuitively understand those two concepts. but in a balance sheet so now we've moved on we've hit cash flow we've hit income statement now the balance sheet the one that nobody wants to talk about the one that's so neglected neglected the most except by bank analysts and Mike Mayer he's like the only one who looks at balance sheets the balance sheet is separated into two parts you have the short term assets and the long term assets same for liability short term and long term and they define short term as one year or less and long term as one year and greater. So the idea of the current ratio is it's telling us what are that current assets, current liabilities, what is the short term picture of what the company owns versus what they owe.

19:35And that can give you a viewpoint. If that number gets really, really low, then a company might have, let's say a company has like 300 ice cream shops. But if they come through a rough point where it's the middle of December and nobody wants to buy ice cream, but they still have to make payroll and pay everybody at every 300 stores, that could be a problem. And if you combine that with a recessionary market or some market panic where you're not able to raise money quickly, that's how companies go bankrupt. It doesn't happen very often, but it definitely has happened. And as investors, we want to try to avoid that.

20:16as much as we can. So that's why current ratio is important and that's kind of the context behind calculating it. Do you have thoughts on it? Yeah, a couple thoughts. Number one is, again, it's really important to look at current ratios over longer periods of time. Again, when you're in stasis, I'll tell you a little bit, but not a lot. And so looking at it over a longer period is a really good idea. Also, comparing it to others in the same industry is also a really good idea. And you also probably want to look closely at what contributes to the assets and the liabilities. So does a company have maybe a lot of cash and not a lot of other current assets?

21:14and likewise does it have a lot of debt and not a lot of other current liabilities. And in and of itself, those things aren't good or bad, but it's things to understand about the business. Like if it has a lot of cash and it has a lot of debt and doesn't have a lot of other things, it could be early stage company. And so you wouldn't expect it to have as much inventory as Walmart or Costco, right? So those kinds of things make sense. But you do want to just kind of glance at those things to have a little better insight into what's contributing to the current ratio, good or bad. So you have some sense of where that's going.

21:51And then I guess the last thing I would say is that I think Warren Buffett said in his last shareholders meeting that he spends the most time looking at the balance sheet, which is contrary to what most people do, including sometimes myself. And I think that is a good reminder that the balance sheet can be a very, very useful thing to look at and we shouldn't just ignore it for the glory of the income statement. No. All right. So let's move on to the next one. So this is debt to equity. So this kind of stays with the balance sheet. And this is another way that we could kind of measure the health of the business.

22:33So what is the debt to equity and what should we look for with that? Yeah. Again, you can hear the ratio to get clues as to how to calculate the ratio. Debt to equity is going to be debt divided by equity. So you have long-term debt divided by equity. You could have total debt divided by equity. Long-term debt tends to be more used as the ratio there. But it gives you a sense for the companies that are more capital intensive, meaning they have more assets on their balance sheet, gives you a better sense of their ability to be solvent. So in the first case with the current ratio, we were talking about the short-term, the current situation with the current ratio.

23:22This one's more of a long-term thing. Okay, is there a ton of debt just in general, which leaves a lot less margin for error? maybe interest expenses are going to be really really high so even if the business does pretty good all that money is not going to go to shareholders because they're paying interest on debt or maybe that does turn into a wow we're really struggling to pay debt here and so we're going to have to raise a bunch of capital through dilution and now you've got a reverse split where your stock is now basically split into tens or something, which has happened and does happen. So understanding what the debt-to-equity picture is can help you avoid some of those situations with the caveat that asset structure matters and business, how assets drive a business's profitability also matters.

24:27Could you explain that a little bit? yeah let's go back to the ice cream example if i were to make an ice cream business that would be pretty capital intensive because i would need to commit to either buying the real estate or renting the real estate for a long period of time and along with that comes the building and the costs and the maintenance and and all those things are those are all long-term asset the buildings and the land. Something like that is going to be a big expense and it shows up as an asset on the balance sheet. Compare that to a software company where it costs 30 bucks in AWS fees a month to run our little website.

25:20There's not going to be a lot of assets on the balance sheet. So it's really just based on the way accounting works today. If you're making huge capital commitments, those tend to show up on the balance sheet. If you're just hiring a bunch of people to make something like software, it's not really going to show up on the balance sheet unless somebody acquires you, buys your business, and then that valuation is on the balance sheet. So I know it's weird. It doesn't really make sense. And I agree with you, but that's just the way it is, so we have to deal with it. Bitcoin is one of those really divisive topics.

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27:58You have to look at it in relation to how the company has done in the past. Longer periods of time are good to look at because they can give you an indication. For example, let's say a company goes out and buys another business and they use a lot of debt to help finance that payment, but they only do that once every 10 years. Well, depending on where you are in that cycle, you may see a huge debt-to-equity number and that may be out of character for them. Let's say they normally run lower debt-to-equity numbers and then all of a sudden you see this huge spike. Well, that in and of itself, if you see it in that one-year period, you may think, oh my goodness, forget this.