How To Determine The True Value Of A Stock For Yourself
One of the things that makes The Rich Dad Company so different from other financial educators is that we do not tell you what to buy or what to invest in. Instead we teach why an opportunity is good and we show you how many different things there are to invest in.
Real estate may be a good fit for many investors but it’s not a great fit for all investors. Stocks may make a lot of sense to most people, but certainly not all. A good investment vehicle (stocks, real estate, business, commodities) needs to fit with your lifestyle, your personality, and your philosophies. There is no investment vehicle that is one size fits all.
Today, I’m going to talk about stocks. Most people believe that stock investing is at odds with the Rich Dad philosophy of investing for cash flow. The reason people believe this is because they think stocks are simply buying low and selling high.
An educated stock investor knows how to cash flow with the stock market, not just invest for capital gains.
Price vs. Value
Simply put, price is what you pay and value is what you receive.
Warren Buffett is famous for talking about the “intrinsic value” of stocks. But while many people parrot this phrase, few know what it really means.
The good news is that once you understand intrinsic value, you may better understand why some investors make more money than others. You might also realize that you can find intrinsic value in investments other than stocks, such as real estate.
When the average investor thinks about making money, he or she usually thinks about buying low and selling high. For example, an investor buys a stock for $10 and sells it when (and if) it reaches $20.
This leads many investors to check their stock prices immediately first thing every morning; their day gets off to a good start if the price has gone up, and a bad start if the price has gone down. Many of these investors become addicted to watching their stocks rise and fall throughout the day.
Warren Buffett doesn’t do this, and neither do I. While the price of an asset is important, it’s not something we watch on a daily basis. Buffett owns businesses rather than stocks, and pays close attention to price only when he buys one. After that, he isn’t really concerned if the share price goes up or down, nor does he care if the stock market is open or closed.
In very simple terms, Buffett looks for well-managed businesses that grow more valuable over time; consequently, he often refers to a business’s value “compounding,” or accelerating in value. This is its intrinsic value, and being aware of it is one of the differences between an amateur investor and a professional one.
You become a better investor by training your brain to “see” what your eyes can’t—the real value (or lack of value) in any investment, regardless of whether it’s a stock, bond, mutual fund, business, or real estate. This is its intrinsic value.
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Create Your Criteria
When you create your criteria, you are taking the emotion out of investing. If you have a plan and you stick to it, you can’t be lured into making an uninformed decision.
My advisor on stocks, Andy Tanner, uses the business’ financials as a key criteria when choosing a stock.
For example, in school, your report card is the marker for success. In business, your financial statements are. If you want to be successful in business, you must know how to read a financial statement and how to draw fact-based conclusions about the health and potential of a business.
When it comes to reading a financial statement, there are various levels of sophistication. As a baseline, you should be able to understand income, expenses, assets and liabilities, as well as the relationship between these and your cash flow.
But to become a sophisticated business owner and investor, you need to grow your knowledge base and understand even more advanced financial concepts to know the health of either your business or one you’re planning on investing.
When it comes to understanding the health of a business, there are key ratios that you can use to determine the financial health of a business.
As Investopedia defines them, “Key ratios take data from the subject company’s financial statements such as the balance sheet, income statement and statement of cash flows. Items on these statements are compared with other items to produce ratios that represent key aspects of the company’s financial picture such as liquidity, profitability, use of debt and earnings strength.”
These key ratios are not difficult to calculate, but many people don’t know them.
Key financial ratio #1: Gross margin percentage
Calculation: Gross margin percentage = Gross margin / sales
Gross margin is sales minus the cost of goods sold. So, if you sell $100 in bananas and they cost you $75, your gross margin is $25.
Gross margin percentage is the gross margin divided by sales, which tells you what percentage of sales is left after deducting the cost of the goods sold. In this example it would be $25/$100, which equals a gross margin percentage of .25 or 25%.
Key financial ratio #2: Net operating margin percentage
Calculation: net operating margin percentage = EBIT / sales
This ratio tells you the net profitability of the operations of a business before you factor in your taxes and cost of money, which are out of the business owner’s control.
Earnings Before Interest and Taxes (EBIT) is your sales minus all the costs of being in business, not including capital costs (interest, taxes, and dividends).
Key financial ratio #3: Operating leverage
Calculation: operating leverage = contribution / fixed costs
Every business has fixed costs that must be accounted in the overall cost structure.
The percentage of fixed costs relative to all costs is called operating leverage, and is calculated by dividing contribution, which is the gross margin (sales minus cost of goods sold) minus variable costs (all costs that are not fixed costs that fluctuate with sales), by fixed costs.
Key financial ratio #4: Financial leverage
Calculation: financial leverage = total capital employed / shareholder’s equity
Almost every business needs to borrow money in order to operate.
Financial leverage is a key financial ratio that refers to the degree a business uses borrowed money. Total capital employed is the accounting value of all interest-bearing debt plus all owners’ equity.
Key financial ratio #5: Total leverage
Calculation: total leverage = operating leverage x financial leverage
Total leverage is calculated by multiplying the operating leverage (key ratio #3) by the financial leverage (key ratio #4).
If you are the business owner, and therefore on the inside, you have at least partial control of your company’s total leverage.
Key financial ratio #6: Debt-to-equity ratio
Calculation: debt-to-equity ratio = total liabilities / total equity
This one is pretty self-explanatory. It’s the measure of the portion of the whole enterprise (total liabilities) financed by outsiders in proportion to the part financed by insiders (total equity). Most businesses try to stay at a ratio of one-to-one or below.
Key financial ratio #7: Quick and current ratios
Calculation: quick ratio = liquid assets / current liabilities
Calculation: current ratio = current assets / current liabilities
Quick and current ratios are both designed to tell you whether or not the company has enough liquid assets to pay its liabilities for the coming year.
Key financial ratio #8: Return on equity
Calculation: net income / average shareholder’s equity
Return on equity is often considered one of the most important key financial ratios. It allows you to compare the return a company is making on its shareholders’ investments compared to alternative investments.
Rich dad taught to always consider at least three years of these figures. The direction and trends can tell you a lot about a company and its management, and even its competitors.
Many published company reports do not include these ratios and indicators. A sophisticated investor learns to calculate them when they aren’t provided. However, these cannot be used in a vacuum. They are indicators, but they must be considered in conjunction with analysis of the overall business and industry. By comparing three-years’ worth of data with that of other companies in the same industry, you can quickly determine the relative strength of a company.
While the ratios may appear complicated at first, you will be amazed at how quickly you can learn to analyze a company. One fun exercise is to download the financial statements of public companies and run these ratios yourself. Learn how to find the information you need and see what you can learn.
Remember, these ratios are the language of a sophisticated investor. By educating yourself and becoming financially literate, you too can learn to “speak in ratios.”
One Word of Caution
No investment is good or bad. There are no such things as bad investments, just bad investors.Your investment is only as good as you are. Before you get in the stock market you need to get educated.
There are so many ways to get going with your education. You can take online courses, attend local workshops, or read a bunch of books.
But please, do not go into stock investing without first investing in yourself and your education.
Editor, Rich Dad Poor Dad Daily