Learning to invest is like learning to speak new language. Many people find investing and personal finance confusing because of the confusing investing terms.
No need to panic, it won’t be this way for long. You can learn to speak this language of investing fluently in no time. That’s why I’m going to break down some of the essential financial terms every investor needs to know to invest money wisely. So breathe, relax, listen up, and watch these videos on investing terms.
1. Margin of Safety
You’re going to hear Margin of Safety a lot. So what is it?
Margin of Safety is how we provide room for error when we invest. There is the sticker price that a business is going for in the market. Let’s say this business is going for twenty dollars.
Then there’s the price it’s actually worth. Let’s say that’s fourteen dollars. Then there’s how much we want to buy it for. The difference between the sticker price and how much we want to buy a business for is the Margin of Safety.
For Rule #1 investing, we use a fifty percent margin. That means whatever a business is worth, we want of buy it for half of that price. So in this example, we want to buy this business for seven dollars. We never make purchases at the sticker price.
2. Return on Invested Capital
Another term you’ll always hear is Return on Invested Capital or ROIC.
ROIC is the percentage return you get back from the cash you’ve plowed into your business…
One way to calculate this is to subtract dividends from net income. Then… divide that number by total capital.
For example, let’s say your kids finance a lemonade stand for two-hundred dollars to get it up and running. That is their “investment capital.”
After a week, they’ve made three-hundred dollars. Subtract the invested capital of two-hundred dollars, they made a hundred dollar profit.
You divide the dividend, one-hundred dollars, by the total capital, two-hundred dollars. That gets us a fifty-percent ROIC, which is a pretty amazing return!
ROIC is a measure of how effectively a company uses the money invested in its operations.
As Rule #1 investors, we want to see at least ten percent ROIC per year and we don’t want to see it on a downward trend.
3. Dollar Cost Averaging
It’s the practice of buying a certain number of shares with the same amount of money in a given stock periodically, regardless of the price per share.
Investors do this because it allegedly helps reduce their risk of investing a large amount in a single stock at the wrong time.
For example, you buy one-hundred dollars worth of shares in a business every year, no matter what the price is.
So when the price is down, you end up buying more shares with your allotted money. And when the price goes up, you end up buying fewer shares.
The idea is you’re making the average cost per share of stock smaller, minimizing your investment risk.
But instead of trusting DCA, Rule #1 investors already know the value of a wonderful business and buy it when it’s undervalued. We buy one dollar for fifty cents and repeat. We never buy when the price is up.
4. Payback Time
Payback Time is the amount of time it takes before you get the return on your invested capital.
In Rule#1 investing, our payback time goal is eight years or less.
If a business makes a million dollars a year, you want to know how long it would take you to get your money back in eight years or less at whatever price you were to buy it for.
Once you earn all that money back, you have no risk. You’re just playing with house money.
How do you calculate Payback Time? I have a calculator you can use. But essentially you divide your investment by the amount of money the business makes a year. Now let’s see how Payback Time and Rule #1 investing all tie together to earn you more money.
Assume that you find a business you really understand with a great Moat and Management you can get behind. Assume it has a conservative value of twenty dollars a share, it’s selling for a Margin of Safety price of ten dollars, and it has a Payback Time of eight years.
You have ten thousand dollars to invest and you buy one thousand shares.
Six months later you’ve managed to save another ten thousand dollars and are looking for something to invest in, so you reconsider this business you love.
But now it’s priced at twenty dollars, with a Payback Time of thirteen years. Nothing has fundamentally changed in its long-term value, but it no longer has the Margin of Safety or Payback Time we’re looking for.
That means that you can’t buy any more shares with your ten thousand dollars because we don’t use Dollar Cost Averaging to buy it at any price. At the end of five years, the stock price is still at twenty dollars, and if you decide to sell, you’ve doubled your money and made a fifteen percent annual return on your one thousand shares. Nice!
Assets are items that have value in the market. Resources controlled by a company from which future economic benefits are expected to be generated. In a business, an asset is something the business owns that has a dollar value. (An asset in general, is anything of value that can be traded.)
An intangible asset is an asset that has a dollar value but may not be worth anything unless the business is successful. Typically this is an asset that was acquired through buying another business. The price paid in excess of that business’s net worth is often called “goodwill” and is treated as an asset for GAAP purposes.
6. Sticker Price
The sticker price is the intrinsic value of a business. The value of a business, despite the selling price on the market. Rule #1 investors seek to buy businesses at 50 percent of their Sticker Price, when they are undervalued. Sticker Price is determined by performing calculations on the Four Growth Rates (see definition).
7. The Stock Market
Stock is ownership in companies that are public – meaning they have sold off chunks of their company.
Together as a group, this collection of companies is known as the stock market. The key to success in the stock market is buying a good business that will survive for 10-15 more years. And buy it on sale!
It is a myth that the stock market is constantly going up with time. The compounded average return in the stock market over the last 120 years is 5%.
Make sure the business is durable and has a CEO with integrity.
8. The S&P 500
The S&P 500 is an index compiled of the 500 best stocks currently in the market.
In general, the S&P is a measure of how the stock market is doing. I want you to disregard the S&P 500 when it comes to making money.
Focus on your absolute return – how much money are YOU making every year? Don’t compare yourself to any index.
9. Index Funds & Mutual Funds
An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the S&P 500.
Mutual funds are doing the same thing that index funds are doing, except they charge higher fees. Both diversify your portfolio across hundreds of stocks.
Index funds are just very specific to the index that it’s tracking.
10. Earnings Per Share
Earnings per share are the net earnings of the company divided by the number of shares in the company.
EPS, also known as profit per share, is used to calculate the value of a business.
Make sure the cash flow of the company is as good as its earnings per share.
11. 401(k) Plans
The 401(k) is a retirement account created by taking a portion of your salary pre-tax each month. This is also known as a defined contribution plan.
There is a defined amount of money that you can put in your account each month. Once you retire, you pay taxes to the federal government. Today, however, if the stock market goes down, your retirement fund decreases. I recommend getting a self-directed 401(k) plan from management so you can invest the money where you want to.
12. 10-K Reports
A 10-k is a financial report. Every public company has to file a 10-k annually. In it, you’ll find a full explanation of the company. It includes things such as risks, numbers, and anything else about the business. The CEO and CFO have to fill it out properly and sign it, risking jail time if the information is false or inaccurate.
Use 10-k’s to your advantage when investing. Read them and gain knowledge about companies and their competitors.
13. Roth IRA
It is a wonder the federal government has not discontinued the Roth IRA yet. It produces a phenomenal retirement fund!
The beauty of it lies in the fact that you put money into a Roth IRA after you pay taxes. Once you put the money in, it never gets taxed again. This also includes all of the money that grows on top of it. I recommend all new investors get one NOW.
Are there any other investing terms you’d like me to go over? Let me know in the comments. Learn how to invest like the best investors in the world from my free Transformational Investing webinar.
Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.