2-The Magic of Compounding
2008.3.28
09:14
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102-The Magic of Compounding [come from Morning Start]
Course 102:
The Magic of Compounding
When you were a kid, perhaps one of your friends asked you the following trick
question: "Would you rather have $10,000 per day for 30 days or a penny that
doubled in value every day for 30 days?" Today, we know to choose the doubling
penny, because at the end of 30 days, we'd have about $5 million versus the
$300,000 we'd have if we chose $10,000 per day. Compound interest is often
called the eighth wonder of the world, because it seems to possess magical
powers, like turning a penny into $5 million. The great part about compound
interest is that it applies to money, and it helps us to achieve our financial
goals, such as becoming a millionaire, retiring comfortably, or being
financially independent.
The Components of Compound Interest
A dollar invested at a 10% return will be worth $1.10 in a year. Invest that
$1.10 and get 10% again, and you'll end up with $1.21 two years from your
original investment. The first year earned you only $0.10, but the second
generated $0.11. This is compounding at its most basic level: gains begetting
more gains. Increase the amounts and the time involved, and the benefits of
compounding become much more pronounced.
Compound interest can be calculated using the following formula:
FV = PV (1 i)^N
FV = Future Value (the amount you will have in the future)
PV = Present Value (the amount you have today)
i = Interest (your rate of return or interest rate earned)
N = Number of Years (the length of time you invest)
Who Wants to Be a Millionaire?
As a fun way to learn about compound interest, let's examine a few different
ways to become a millionaire. First we'll look at a couple of investors and
how they have chosen to accumulate $1 million.
1. Jack saves $25,000 per year for 40 years.
2. Jeff starts with $1 and doubles his money each year for 20 years.
While most would love to be able to save $25,000 every year like Jack, this is
too difficult for most of us. If we earn an average of $50,000 per year, we
would have to save 50% of our salary!
In the second example, Jeff uses compound interest, invests only $1, and earns
100% on his money for 20 consecutive years. The magic of compound interest has
made it easy for Jeff to earn his $1 million and to do it in only half the
time as Jack. However, Jeff's example is also a little unrealistic since very
few investments can earn 100% in any given year, much less for 20 consecutive
years.
TIP: A simple way to know the time it takes for money to double is to use the
rule of 72. For example, if you wanted to know how many years it would take
for an investment earning 12% to double, simply divide 72 by 12, and the
answer would be approximately six years. The reverse is also true. If you
wanted to know what interest rate you would have to earn to double your money
in five years, then divide 72 by five, and the answer is about 15%.
Time Is on Your Side
Between the two extremes of Jeff and Jack, there are realistic situations in
which compound interest helps the average individual. One of the key concepts
about compounding is this: The earlier you start, the better off you'll be. So
what are you waiting for?
Let's consider the case of two other investors, Luke and Walt, who'd also like
to become millionaires. Say Luke put $2,000 per year into the market between
the ages of 24 and 30, that he earned a 12% aftertax return, and that he
continued to earn 12% per year until he retired at age 65. Walt also put in
$2,000 per year, earned the same return, but waited until he was 30 to start
and continued to invest $2,000 per year until he retired at age 65. In the
end, both would end up with about $1 million. However, Luke had to invest only
$12,000 (i.e., $2,000 for six years), while Walt had to invest $72,000 ($2,000
for 36 years) or six times the amount that Walt invested, just for waiting
only six years to start investing.
Clearly, investing early can be at least as important as the actual amount
invested over a lifetime. Therefore, to truly benefit from the magic of
compounding, it's important to start investing early. We can't stress this
fact enough! After all, it's not just how much money you start with that
counts, it's also how much time you allow that money to work for you.
In our first example, Jack had to save $25,000 a year for 40 years to reach $1
million without the benefit of compound interest. Luke and Walt, however, were
each able to become millionaires by saving only $12,000 and $72,000,
respectively, in relatively modest $2,000 increments. Luke and Walt earned
$988,000 and $928,000, respectively, due to compound interest. Gains beget
gains, which beget even larger gains. This is again the magic of compound
interest.
Why Is Compound Interest Important to Stock Investing?
In addition to the amount you invest and an early start, the rate of return
you earn from investing is also crucial. The higher the rate, the more money
you'll have later. Let's assume that Luke from our previous example had two
sisters who, at age 24, also began saving $2,000 a year for six years. But
unlike Luke, who earned 12%, sister Charlotte earned only 8%, while sister
Rose did not make good investment decisions and earned only 4%. When they all
retired at age 65, Luke would have $1,074,968, Charlotte would have $253,025,
and Rose would have only $56,620. Even though Luke earned only 8 percentage
points more per year on his investments, or $160 per year more on the initial
$2,000 investment, he would end up with about 20 times more money than Rose.
Clearly, a few percentage points in investment returns or interest rates can
mean a huge difference in your future wealth. Therefore, while stocks may be a
riskier investment in the short run, in the long run the rewards can certainly
outweigh the risks.
The Bottom Line
Compound interest can help you attain your goals in life. In order to use it
most effectively, you should start investing early, invest as much as
possible, and attempt to earn a reasonable rate of return.
3. Investing for the Long Run [Morning Star]
2008.3.31
10:39
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103-Investing for the Long Run
Course 103:
Investing for the Long Run
In the last lesson, we noticed that the difference of only a few percentage
points in investment returns or interest rates can have a huge impact on your
future wealth. Therefore, in the long run, the rewards of investing in stocks
can outweigh the risks. We'll examine this risk/reward dynamic in this lesson.
Volatility of Single Stocks
Individual stocks tend to have highly volatile prices, and the returns you
might receive on any single stock may vary wildly. If you invest in the right
stock, you could make bundles of money. For instance, Eaton Vance EV, an
investment-management company, has had the best-performing stock for the last
25 years. If you had invested $10,000 in 1979 in Eaton Vance, assuming you had
reinvested all dividends, your investment would have been worth $10.6 million
by December 2004.
On the downside, since the returns on stock investments are not guaranteed,
you risk losing everything on any given investment. There are hundreds of
recent examples of dot-com investments that went bankrupt or are trading for a
fraction of their former highs. Even established, well-known companies such as
Enron, WorldCom, and Kmart filed for bankruptcy, and investors in these
companies lost everything.
Between these two extremes is the daily, weekly, monthly, and yearly
fluctuation of any given company's stock price. Most stocks won't double in
the coming year, nor will many go to zero. But do consider that the average
difference between the yearly high and low stock prices of the typical stock
on the New York Stock Exchange is nearly 40%.
In addition to being volatile, there is the risk that a single company's stock
price may not increase significantly over time. In 1965, you could have
purchased General Motors GM stock for $50 per share (split adjusted). In the
following decades, though, this investment has only spun its wheels. By May
2005, your shares of General Motors would be worth only about $30 each. Though
dividends would have provided some ease to the pain, General Motors' return
has been terrible. You would have been better off if you had invested your
money in a bank savings account instead of General Motors stock.
Clearly, if you put all of your eggs in a single basket, sometimes that basket
may fail, breaking all the eggs. Other times, that basket will hold the
equivalent of a winning lottery ticket.
Volatility of the Stock Market
One way of reducing the risk of investing in individual stocks is by holding a
larger number of stocks in a portfolio. However, even a portfolio of stocks
containing a wide variety of companies can fluctuate wildly. You may
experience large losses over short periods. Market dips, sometimes
significant, are simply part of investing in stocks.
For example, consider the Dow Jones Industrials Index, a basket of 30 of the
most popular, and some of the best, companies in America. If during the last
100 years you had held an investment tracking the Dow, there would have been
10 different occasions when that investment would have lost 40% or more of its
value.
The yearly returns in the stock market also fluctuate dramatically. The
highest one-year rate of return of 67% occurred in 1933, while the lowest
one-year rate of return of negative 53% occurred in 1931. It should be obvious
by now that stocks are volatile, and there is a significant risk if you cannot
ride out market losses in the short term. But don't worry; there is a bright
side to this story.
Over the Long Term, Stocks Are Best
Despite all the short-term risks and volatility, stocks as a group have had
the highest long-term returns of any investment type. This is an incredibly
important fact! When the stock market has crashed, the market has always
rebounded and gone on to new highs. Stocks have outperformed bonds on a total
real return (after inflation) basis, on average. This holds true even after
market peaks.
If you had deplorable timing and invested $100 into the stock market during
any of the seven major market peaks in the 20th century, that investment, over
the next 10 years, would have been worth $125 after inflation, but it would
have been worth only $107 had you invested in bonds, and $99 if you had
purchased government Treasury bills. In other words, stocks have been the
best-performing asset class over the long term, while government bonds, in
these cases, merely kept up with inflation.
This is the whole reason to go through the effort of investing in stocks.
Again, even if you had invested in stocks at the highest peak in the market,
your total after-inflation returns after 10 years would have been higher for
stocks than either bonds or cash. Had you invested a little at a time, not
just when stocks were expensive but also when they were cheap, your returns
would have been much greater.
Time Is on Your Side
Just as compound interest can dramatically grow your wealth over time, the
longer you invest in stocks, the better off you will be. With time, your
chances of making money increase, and the volatility of your returns
decreases.
The average annual return for the S&P 500 stock index for a single year has
ranged from negative 39% to positive 61%, while averaging 13.2%. After holding
stocks for five years, average annualized returns have ranged from negative 4%
to positive 30%, while averaging 11.9%. Finally, if your holding period is 20
years, you never lost money, with 20-year returns ranging from positive 6.4%
to positive 15%, with the average being 9.5%.
These returns easily surpass those you can get from any of the other major
types of investments. Again, as your holding period increases, the expected
return variation decreases, and the likelihood for a positive return
increases. This is why it is important to have a long-term investment horizon
when getting started in stocks.
Why Stocks Perform the Best
While historical results certainly offer insight into the types of returns to
expect in the future, it is still important to ask the following questions:
Why, exactly, have stocks been the best-performing asset class? And why should
we expect those types of returns to continue? In other words, why should we
expect history to repeat?
Quite simply, stocks allow investors to own companies that have the ability to
create enormous economic value. Stock investors have full exposure to this
upside. For instance, in 1985, would you have rather lent Microsoft money at a
6% interest rate, or would you have rather been an owner, seeing the value of
your investment grow several-hundred fold?
Because of the risk, stock investors also require the largest return compared
with other types of investors before they will give their money to companies
to grow their businesses. More often than not, companies are able to generate
enough value to cover this return demanded by their owners.
Meanwhile, bond investors do not reap the benefit of economic expansion to
nearly as large a degree. When you buy a bond, the interest rate on the
original investment will never increase. Your theoretical loan to Microsoft
yielding 6% would have never yielded more than 6%, no matter how well the
company did. Being an owner certainly exposes you to greater risk and
volatility, but the sky is also the limit on the potential return.
The Bottom Line
While stocks make an attractive investment in the long run, stock returns are
not guaranteed and tend to be volatile in the short term. Therefore, we do not
recommend that you invest in stocks to achieve your short-term goals. To be
effective, you should invest in stocks only to meet long-term objectives that
are at least five years away. And the longer you invest, the greater your
chances of achieving the types of returns that make investing in stocks
worthwhile.
4.What Matters and What Doesn＇t
2008.4.1
13:14
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104-What Matters and What Doesn't [Morning Start]
Course 104:
What Matters and What Doesn't
Different people have different notions of what stock investing is all about.
Before we go any further, we want to put things into focus and set you on the
right path.
Investing Does Not Equal Trading
Your perception of stock investing may involve highly caffeinated, frantic
traders sweating in front of a half dozen computer screens packed with
information, while phones ring off the hook in the background.
Feel free to dump these images from your mind, because solid stock investing
is not about trading, having the fastest computers, or getting the most
up-to-the-second information. Though some professionals make their living by
creating a liquid market for stocks, actively "day trading" is simply not how
most good investing is done by individuals.
Beyond having to expend an incredible amount of effort to track stocks on an
hour-by-hour basis, active day traders have three powerful factors working
against them. First, trading commissions can rack up quickly, dramatically
eroding returns. Second, there are other trading costs in terms of the bid/ask
spread, or the small spread between what buyers are bidding and sellers are
asking at any moment. These more hidden frictional costs are typically only a
small fraction of the stock price, but they can add up to big bucks if
incurred often enough. Finally, frequent traders tend not to be tax efficient,
and paying more taxes can greatly diminish returns.
Just as someone can be a great racecar driver without being a mechanical
engineer, you can be a great investor without having a clue about how the
trades actually get executed in the market. How your orders flow from one
computer system to the other is of little consequence.
Just remember that investing is like a chess game, where thought, patience,
and the ability to peer into the future are rewarded. Making the right moves
is much more important than moving quickly.
Investing Means Owning Businesses
If the mechanics of actual trading mean little, what does matter? Do charts of
stock prices hold the answers? We've said it once, and we'll say it again and
again: When you buy stocks, you are buying ownership interests in companies.
Stocks are not just pieces of paper to be traded.
So if you are buying businesses, it makes sense to think like a business
owner. This means learning how to read financial statements, considering how
companies actually make money, spotting trends, and figuring out which
businesses have the best competitive positions. It also means coming up with
appropriate prices to pay for the businesses you want to buy. Notice that none
of this requires lightning-fast reflexes!
You should also buy stocks like you would any other large purchase: with lots
of research, care, and the intention to hold as long as it makes sense. Some
people will spend an entire weekend driving around to different stores to save
$60 on a television, but they put hardly any thought into the thousands of
dollars they could create for themselves by purchasing the right stocks (or
avoiding the wrong ones). Again, investing is an intellectual exercise, but
one that can have a large payoff.
You Buy Stocks, Not the Market
We've all seen the prognosticators on television, predicting where the market
is going to go in the future. One thing to remember when listening to these
market premonitions is that stock investing is about buying individual stocks,
not the market as a whole. If you pick the right stocks, you can make money no
matter what the broader market does.
Another reason to heavily discount what the prognosticators say is that
correctly predicting market movements is nearly impossible. No one has done it
consistently and accurately. There are simply too many moving parts, and too
many unknowns. By limiting the field to individual businesses of interest, you
can focus on what you can actually own while dramatically cutting down on the
unknowns. You can save a lot of energy by simply tuning out market
predictions.
We established in the previous lesson that stocks are volatile. Why is that?
Does the value of any given business really change up to 50% year-to-year?
(Imagine the chaos if the value of our homes changed this much!) The fact is,
"Mr. Market" tends to be a bit of an extremist in the short term,
over-reacting to both good and bad news. We will talk more about this
phenomenon later, but it is nevertheless a good fact to know when starting.
Competitive Positioning Is Most Important
Future profits drive stock prices over the long term, so it makes sense to
focus on how a business is going to generate those future earnings. At
Morningstar, we believe competitive positioning, or the ability of a business
to keep competitors at bay, is the most important determining factor of future
profits. Despite where the financial media may spend most of its energy,
competitive positioning is more important than the economic outlook, more
important than the near-term flow of news that jostles stock prices, and even
more important than management quality at a company.
It may be helpful to think of the investing process as if you were planning a
trip across the ocean. You cannot do anything about the current weather or the
tides (the current economic conditions). You can try to wait out bad weather
that might sink your ship, but then you are also giving up time. And as we've
already covered, time is a precious resource in investing.
The main thing you can control is what ship to board. Think of the
seaworthiness of a ship as the competitive positioning of a business, and the
horsepower of the engine as its cash flow. Some ships have thick, reinforced
metal hulls, while others have rotting wood. Clearly, you would pick the ships
that are the most seaworthy (with the best competitive positioning) and have
the most horsepower (cash flow).
Though the ship's captain (company management) certainly matters, the quality
of the ship is more important. On a solid vessel, as long as the captain does
not mess up, there is not much difference between a good and a great captain.
Meanwhile, there is nothing the best skipper can do if the boat's engine is
broken and the boat is constantly taking on water (poor business). To relate
this to stocks, business economics trump management skill.
It's also worth noting that all ships will experience waves (volatility). And
though it is true that a rising tide lifts all ships, the tides have nothing
to do with the quality of the boats on the sea. All else equal, a better ship
is still going to arrive faster, and a company with the best competitive
positioning is going to create the most value for its shareholders. We will
talk about exactly how to spot the best ships in later lessons.
The Bottom Line
It is very easy for new stock investors to get started on the wrong track by
focusing only on the mechanics of trading or the overall direction of the
market. To get yourself in the proper mind-set, tune out the noise and focus
on studying individual businesses and their ability to create future profits.
In the coming lessons, we will begin to build the skills you will need to
become a successful buyer of businesses.
5.The Purpose of a Company
2008.4.1
13:16
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105-The Purpose of a Company [Morning Start]
Course 105:
The Purpose of a Company
It's worth repeating that when you hold a stock, you own part of a company.
Part of being an owner is understanding the financial underpinnings of any
given business, and this lesson will provide an introduction.
The main purpose of a company is to take money from investors (their creditors
and shareholders) and generate profits on their investments. Creditors and
shareholders carry different risks with their investments, and thus they have
different return opportunities. Creditors bear less risk and receive a fixed
return regardless of a company's performance (unless the firm defaults).
Shareholders carry all the risks of ownership, and their return depends on a
company's underlying business performance. When companies generate lots of
profits, shareholders stand to benefit the most.
As we learned in Lesson 101, at the end of the day, investors have many
choices about where to put their money; they can invest it into savings
accounts, government bonds, stocks, or other investment vehicles. In each,
investors expect a return on their investment. Stocks represent ownership
interests in companies that are expected to create value with the money that
is invested in them by their owners.
Money In and Money Out
Companies need money to operate and grow their businesses in order to generate
returns for their investors. Investors put money--called capital--into a
company, and then it is the company's responsibility to create additional
money--called profits--for investors. The ratio of the profit to the capital
is called the return on capital. It is important to remember that the absolute
level of profits in dollar terms is less important than profit as a percentage
of the capital invested.
For example, a company may make $1 billion in profits for a given year, but it
may have taken $20 billion worth of capital to do so, creating a meager 5%
return on capital. This particular company is not very profitable. Another
firm may generate just $100 million in profits but only need $500 million to
do so, boasting a 20% return on capital. This company is highly profitable. A
return on capital of 20% means that for every $1.00 that investors put into
the company, the company earns $0.20 per year.
The Two Types of Capital
Before discussing return on capital further, it is important to distinguish
between the two types of capital. As we mentioned above, two types of
investors invest capital into companies: creditors ("loaners") and
shareholders ("owners"). Creditors provide a company with debt capital, and
shareholders provide a company with equity capital.
Creditors are typically banks, bondholders, and suppliers. They lend money to
companies in exchange for a fixed return on their debt capital, usually in the
form of interest payments. Companies also agree to pay back the principal on
their loans.
The interest rate will be higher than the interest rate of government bonds,
because companies generally have a higher risk of defaulting on their interest
payments and principal. Lenders generally require a return on their loans that
is commensurate with the risks associated with the individual company.
Therefore, a steady company will borrow money cheaply (lower interest
payments), but a risky business will have to pay more (higher interest
payments).
Shareholders that supply companies with equity capital are typically banks,
mutual or hedge funds, and private investors. They give money to a company in
exchange for an ownership interest in that business. Unlike creditors,
shareholders do not get a fixed return on their investment because they are
part owners of the company. When a company sells shares to the public (in
other words, "goes public" to be "publicly traded"), it is actually selling an
ownership stake in itself and not a promise to pay a fixed amount each year.
Shareholders are entitled to the profits, if any, generated by the company
after everyone else--employees, vendors, lenders--gets paid. The more shares
you own, the greater your claim on these profits and potential dividends.
Owners have potentially unlimited upside profits, but they could also lose
their entire investment if the company fails.
It is also important to keep in mind a company's total number of shares
outstanding at any given time. Shareholders can benefit more from owning one
share of a billion-dollar company that has only 100 shares (a 1% ownership
interest) than by owning 100 shares of a billion-dollar company that has a
million shares outstanding (a 0.01% ownership interest).
Once a Profit Is Created...
Companies usually pay out their profits in the form of dividends, or they
reinvest the money back into the business. Dividends provide shareholders with
a cash payment, and reinvested earnings offer shareholders the chance to
receive more profits from the underlying business in the future. Many
companies, especially young ones, pay no dividends. Any profits they make are
plowed back into their businesses. One of the most important jobs of any
company's management is to decide whether to pay out profits as dividends or
to reinvest the money back into the business. Companies that care about
shareholders will reinvest the money only if they have promising opportunities
to invest in--opportunities that should earn a higher return than shareholders
could get on their own.
Different Capital, Different Risk, Different Return
Debt and equity capital each have different risk profiles. Therefore, as we
showed in Lesson 103, each type of capital offers investors different return
opportunities. Creditors shoulder less risk than shareholders because they are
accepting a lower rate of return on the debt capital they supply to a company.
When a company pays out the profits generated each year, creditors are paid
before anyone else. Creditors can break up a company if it does not have
sufficient money to cover its interest payments, and they wield a big stick.
Consequently, companies understand that there is a big difference between
borrowing money from creditors and raising money from shareholders. If a firm
is unable to pay the interest on a corporate bond or the principal when it
comes due, the company is bankrupt. The creditors can then come in and divvy
up the firm's assets in order to recover whatever they can from their
investments. Any assets left over after the creditors are done belong to
shareholders, but often such leftovers do not amount to much, if anything at
all.
Shareholders take on more risk than creditors because they only get the
profits left over after everyone else gets paid. If nothing is left over, they
receive nothing in return. They are the "residual" claimants to a company's
profits. However, there is an important trade-off. If a company generates lots
of profits, shareholders enjoy the highest returns. The sky is the limit for
owners and their profits. Meanwhile, loaners keep receiving the same interest
payment year in and year out, regardless of how high the company's profits may
reach. By contrast, owners keep whatever profits are left over. And the more
that is left over, the higher their return on capital.
Return on Capital and Return on Stock
The market often takes a long time to reward shareholders with a return on
stock that corresponds to a company's return on capital. To better understand
this statement, it is crucial to separate return on capital from return on
stock. Return on capital is a measure of a company's profitability, but return
on stock represents a combination of dividends and increases in the stock
price (better known as capital gains). The two simple formulas below outline
the return calculations in more detail:
Return on Capital: Profit / (Invested Capital)
Return on Stock: Shareholder Total Return = Capital Gains Dividends
The market frequently forgets the important relationship between return on
capital and return on stock. A company can earn a high return on capital but
shareholders could still suffer if the market price of the stock decreases
over the same period. Similarly, a terrible company with a low return on
capital may see its stock price increase if the firm performed less terribly
than the market had expected. Or maybe the company is currently losing lots of
money, but investors have bid up its stock in anticipation of future profits.
In other words, in the short term, there can be a disconnect between how a
company performs and how its stock performs. This is because a stock's market
price is a function of the market's perception of the value of the future
profits a company can create. Sometimes this perception is spot on; sometimes
it is way off the mark. But over a longer period of time, the market tends to
get it right, and the performance of a company's stock will mirror the
performance of the underlying business.
The Voting and Weighing Machines
The father of value investing, Benjamin Graham, explained this concept by
saying that in the short run, the market is like a voting machine--tallying up
which firms are popular and unpopular. But in the long run, the market is like
a weighing machine--assessing the substance of a company. The message is
clear: What matters in the long run is a company's actual underlying business
performance and not the investing public's fickle opinion about its prospects
in the short run.
Over the long term, when companies perform well, their shares will do so, too.
And when a company's business suffers, the stock will also suffer. For
example, Starbucks has had phenomenal success at turning coffee--a simple
product that used to be practically given away--into a premium product that
people are willing to pay up for. Starbucks has enjoyed handsome growth in
number of stores, profits, and share price. Starbucks also has a respectable
return on capital of near 11% today.
Meanwhile, Sears has languished. It has had a difficult time competing with
discount stores and strip malls, and it has not enjoyed any meaningful profit
growth in years. Plus, its return on capital rarely tops 5%. As a result, its
stock has bounced around without really going anywhere in decades.
The Bottom Line
In the end, stocks are ownership interests in companies. We can't emphasize
this fact enough. Being a stockholder is being a partial owner of a company.
Over the long term, a company's business performance and its stock price will
converge. The market rewards companies that earn high returns on capital over
a long period. Companies that earn low returns may get an occasional bounce in
the short term, but their long-term performance will be just as miserable as
their returns on capital. The wealth a company creates--as measured by returns
on capital--will find its way to shareholders over the long term in the form
of dividends or stock appreciation.
6.Gathering Relevant Information
2008.4.1
13:46
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106-Gathering Relevant Information-
Course 106:
Gathering Relevant Information Now that you know the definition of a stock and the purpose of a company, how
do you go about finding more information about a firm you may be interested
in? Because knowledge truly is power when it comes to investing, your success
as a stock investor depends on your ability to locate information and
determine its importance. In this lesson, we'll point you in the right
direction and tell you where to concentrate your efforts.
Sorting Out the Public Filings
At first, public filings may look like alphabet soup, but when researching a
company, they are some of the most important documents you will read.
If a company has a stock on a major exchange like the New York Stock Exchange
(NYSE), it is required to file certain documents for public consumption with
the Securities and Exchange Commission (SEC). The SEC imposes guidelines on
what information gets published in these filings, so they are somewhat
uniform. Finally, companies are required to file documents in a timely
fashion.
Among the public filings available, the most comprehensive and useful document
is the 10-K. The 10-K is an annual report that outlines a wealth of general
information about a company, including number of employees, business risks,
description of properties, and strategies. The 10-K also contains the
company's audited year-end financial statements. In addition to possessing
crucial facts and figures, the 10-K also includes management's discussion and
analysis of the past business year and compares it with preceding years.
We suggest making the 10-K the first stop in your journey to researching a
company. How do you find a firm's 10-K? Just visit the SEC Web site, click on
"Filings & Forms," and then "Search for Company Filings." After plugging your
company's name into the "Companies & Other Filers" search, you can pick the
10-K out of the list of forms. Morningstar.com also has links directly to the
SEC Web site. Just enter a company's name or ticker into the search box, and
choose the "SEC Filings" link on the left. What about all those other forms? Some of them are worth a read. For instance,
the 10-Q contains some of the same data that you'll find in the 10-K, except
that it is published on a quarterly basis. Although it's a little less
comprehensive and the financial statements are typically unaudited, the 10-Q
is a good way to keep tabs on a company throughout the year.
Another important document is the annual proxy statement, also called DEF 14a.
In the proxy, you will find detailed information about executive compensation,
the board of directors, and the shareholder voting process. The proxy is a
must read for gaining better insight into the corporate governance of the
company you're researching and determining your rights as a potential
shareholder.
If you're interested in a recent event, typically associated with an earnings
release or major company announcement, you can find the details in the most
recent 8-K. Also, you may want to occasionally peruse the Form 4's to see if
insiders have been trading company stock. Every time company insiders make a
transaction in company stock, they are required to file the Form 4, allowing
you a peek into whether they are buying or selling shares. While an insider's
trading activity may be no smarter than your own, it can at least reveal if
management's investment behavior is consistent with its tone.
Making the Most of a Company Web Site
Another source of information is the company itself. Just plug the name of the
company you want to research into the search engine of your choice. You should
find the company Web site near the top of your results.
The investor section of a company's Web site can offer a variety of
information. Copies of the public filings are usually available in more
flexible, downloadable formats--such as PDF, Microsoft Excel, or Microsoft
Word. Also, you can sort through the firm's press releases and examine the
latest investor presentations (typically in PDF or Microsoft Power Point
formats).
It's definitely worth a visit to the company Web site. It doesn't take long,
and reading the press releases will give you some of the most up-to-date
information available. Also, it may be useful to see how a company does
business on the Web.
Setting Up a Watch List
After you've researched your first batch of companies (read the public filings
and visited company Web sites), it's time to set up a watch list. How do you
do this? Fortunately, Morningstar offers these services for free:
1. Go to the Morningstar.com and click on the tab labeled "Portfolio."
2. In the Portfolio Manager window, under "Create a Portfolio," click "New
Portfolio."
3. You'll see a box labeled "Step 1." It's automatically set up to build a
watch list, so click "Continue."
4. Pick a name for your portfolio, or just call it "watch list." Then, plug in
the ticker symbols of the companies you want to watch. Click "Done."
5. In the following window, you'll see a list of updates, alerts, and tips
that Morningstar will send you daily for the companies in your watch list.
Click "Done" again.
6. Now you have a watch list that you can visit anytime by clicking the
Portfolio tab on Morningstar.com.
By creating a watch list, you'll be able to keep tabs on company news and
easily find stock price information. Among other things, you can set alerts to
notify you when a stock price has met or exceeded a particular threshold.
Thus, your watch list will eventually become an integral tool in helping you
make buy and sell decisions, stay organized, and keep informed.
Seeking Out Expert Opinions
After you've become a bit of an expert yourself by sifting through the
information we've already discussed, you may want to read what other analysts
and investors have to say about a particular company. While your investing
decisions are yours to make, you might be able to gain a new insight or angle
by reading others' research. Obviously, we think a subscription to
Morningstar.com's Premium Membership service, which would allow you to read
our analysts' opinions, is one worthwhile resource.
Avoiding Information Overload
You shouldn't feel bad if you can't read every article from every source that
comments on a company you're researching. In your journey to becoming an
informed stock investor, you'll almost inevitably feel overwhelmed from time
to time by the vast amounts of information available. Fortunately, you don't
need to read it all to be successful. In fact, some information may actually
harm your performance by taking your focus away from what's truly important.
That's why we've highlighted the key pieces of information you will need to
make an informed decision.
Here's a quick step-by-step guide to becoming informed about a company:
1. Obtain the firm's 10-K and really try to give it a thoughtful read. Don't
feel bad if you spend a lot of time on this step. (Give it a couple of days to
digest.)
2. Read through the 10-Qs when they are released each quarter. These are
usually much shorter than the 10-K and shouldn't require more than an hour or
two of your time.
3. Set up a watch list to organize the steady flow of news on all the
companies that interest you.
4. Poke around on the company's Web site. This takes less than a half hour.
5. When time allows, visit relevant industry Web sites and catch up on some of
the industry trends.
The Bottom Line
If you follow these steps, you'll be able to form a foundation of
understanding about a company in about a week. Over time, you can build on
your foundation and gain a much deeper understanding. Further, you'll be able
to weed out the news that just isn't worth your time. All told, if you stay
the course, you could be surprised how your knowledge will grow by applying
this simple process.
7.Introduction to Financial Statements
2008.4.1
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107-Introduction to Financial Statements
Course 107:
Introduction to Financial Statements
Although the words "financial statements" and "accounting" send cold shivers
down many people's backs, this is the language of business, a language
investors need to know before buying stocks. The beauty is you don't need to
be a CPA to understand the basics of the three most fundamental and important
financial statements: the income statement, the balance sheet, and the
statement of cash flows. All three of these statements are found in a firm's
annual report, 10-K, and 10-Q filings.
The financial statements are windows into a company's performance and health.
We'll provide a very basic overview of each financial statement in this lesson
and go into much greater detail in Lesson 301-303.
The Income Statement
What is it and why do I care?
The income statement tells you how much money a company has brought in (its
revenues), how much it has spent (its expenses), and the difference between
the two (its profit). The income statement shows a company's revenues and
expenses over a specific time frame such as three months or a year. This
statement contains the information you'll most often see mentioned in the
press or in financial reports--figures such as total revenue, net income, or
earnings per share.
The income statement answers the question, "How well is the company's business
performing?" Or in simpler terms, "Is it making money?" A firm must be able to
bring in more money than it spends or it won't be in business for very long.
Firms with low expenses relative to revenues--and thus, high profits relative
to revenues--are particularly desirable for investment because a bigger piece
of each dollar the company brings in directly benefits you as a shareholder.
Revenues, Expenses, and Profit
Each of the three main elements of the income statement is described below.
Revenues. The revenue section is typically the simplest part of the income
statement. Often, there is just a single number that represents all the money
a company brought in during a specific time period, although big companies
sometimes break down revenues in ways that provide more information (e.g.,
segregated by geographic location or business segment). Revenues are also
commonly known as sales.
Expenses. Although there are many types of expenses, the two most common are
the cost of sales and SG&A (selling, general, and administrative) expenses.
Cost of sales, which is also called cost of goods sold, is the expense most
directly involved in creating revenue. For example, Gap GPS may pay $10 to
make a shirt, which it sells for $15. When it is sold, the cost of sales for
that shirt would be $10--what it cost Gap to produce the shirt for sale.
Selling, general, and administrative expenses are also commonly known as
operating expenses. This category includes most other costs in running a
business, including marketing, management salaries, and technology expenses.
Profits. In its simplest form, profit is equal to total revenues minus total
expenses. However, there are several commonly used profit subcategories
investors should be aware of. Gross profit is calculated as revenues minus
cost of sales. It basically shows how much money is left over to pay for
operating expenses (and hopefully provide profit to stockholders) after a sale
is made. Using our example of the Gap shirt before, the gross profit from the
sale of the shirt would have been $5 ($15 sales price - $10 cost of sales = $5
gross profit). Operating profit is equal to revenues minus the cost of sales
and SG&A. This number represents the profit a company made from its actual
operations, and excludes certain expenses and revenues that may not be related
to its central operations. Net income generally represents the company's
profit after all expenses, including financial expenses, have been paid. This
number is often called the "bottom line" and is generally the figure people
refer to when they use the word "profit" or "earnings."
The Balance Sheet
What is it and why do I care?
The balance sheet, also known as the statement of financial condition,
basically tells you how much a company owns (its assets), and how much it owes
(its liabilities). The difference between what it owns and what it owes is its
equity, also commonly called "net assets," "stockholder's equity," or "net
worth."
The balance sheet provides investors with a snapshot of a company's health as
of the date provided on the financial statement. Generally, if a company has
lots of assets relative to liabilities, it's in good shape. Conversely, just
as you would be cautious loaning money to a friend who is burdened with large
debts, a company with a large amount of liabilities relative to assets should
be scrutinized more carefully.
Assets, Liabilities, and Equity
Each of the three primary elements of the balance sheet is described below.
Assets. There are two main types of assets: current assets and noncurrent
assets. Within these two categories, there are numerous subcategories, many of
which will be explained in Lesson 302. Current assets are likely to be used up
or converted into cash within one business cycle--usually defined as one year.
For example, the groceries at your local supermarket would be classified as
current assets because apples and bananas should be sold within the next year.
Noncurrent assets are defined by our left-brained accountant friends as, you
guessed it, anything not classified as a current asset. For example, the
refrigerators at your supermarket would be classified as noncurrent assets
because it's unlikely they will be "used up" or converted to cash within a
year.
Liabilities. Similar to assets, there are two main categories of liabilities:
current liabilities and noncurrent liabilities. Current liabilities are
obligations the firm must pay within a year. For example, your supermarket may
have bought and received $1,000 worth of eggs from a local farm but won't pay
for them until next month. Noncurrent liabilities are the flip side of
noncurrent assets. These liabilities represent money the company owes one year
or more in the future. For example, the grocer may borrow $1 million from a
bank for a new store, which it must pay back in five years.
Equity. Equity represents the part of the company that is owned by
shareholders; thus, it's commonly referred to as shareholder's equity. As
described above, equity is equal to total assets minus total liabilities.
Although there are several categories within equity, the two biggest are
paid-in capital and retained earnings. Paid-in capital is the amount of money
shareholders paid for their shares when the stock was first offered to the
public. It basically represents how much money the firm received when it sold
its shares. Retained earnings represent the total profits the company has
earned since it began, minus whatever has been paid to shareholders as
dividends. Since this is a cumulative number, if a company has lost money over
time, retained earnings can be negative and would be renamed "accumulated
deficit."
The Statement of Cash Flows
What is it and why do I care?
The statement of cash flows tells you how much cash went into and out of a
company during a specific time frame such as a quarter or a year. You may
wonder why there's a need for such a statement because it sounds very similar
to the income statement, which shows how much revenue came in and how many
expenses went out.
The difference lies in a complex concept called accrual accounting. Accrual
accounting requires companies to record revenues and expenses when
transactions occur, not when cash is exchanged. While that explanation seems
simple enough, it's a big mess in practice, and the statement of cash flows
helps investors sort it out.
The statement of cash flows is very important to investors because it shows
how much actual cash a company has generated. The income statement, on the
other hand, often includes noncash revenues or expenses, which the statement
of cash flows excludes.
One of the most important traits you should seek in a potential investment is
the firm's ability to generate cash. Many companies have shown profits on the
income statement but stumbled later because of insufficient cash flows. A good
look at the statement of cash flows for those companies may have warned
investors that rocky times were ahead.
The Three Elements of the Statement of Cash Flows
Because companies can generate and use cash in several different ways, the
statement of cash flows is separated into three sections: cash flows from
operating activities, from investing activities, and from financing
activities.
The cash flows from operating activities section shows how much cash the
company generated from its core business, as opposed to peripheral activities
such as investing or borrowing. Investors should look closely at how much cash
a firm generates from its operating activities because it paints the best
picture of how well the business is producing cash that will ultimately
benefit shareholders.
The cash flows from investing activities section shows the amount of cash
firms spent on investments. Investments are usually classified as either
capital expenditures--money spent on items such as new equipment or anything
else needed to keep the business running--or monetary investments such as the
purchase or sale of money market funds.
The cash flows from financing activities section includes any activities
involved in transactions with the company's owners or debtors. For example,
cash proceeds from new debt, or dividends paid to investors would be found in
this section.
Free cash flow is a term you will become very familiar with over the course of
these workbooks. In simple terms, it represents the amount of excess cash a
company generated, which can be used to enrich shareholders or invest in new
opportunities for the business without hurting the existing operations; thus,
it's considered "free." Although there are many methods of determining free
cash flow, the most common method is taking the net cash flows provided by
operating activities and subtacting capital expenditures (as found in the
"cash flows from investing activities" section).
Cash from Operations - Capital Expenditures = Free Cash Flow
The Bottom Line
Phew!!! You made it through an entire lesson about financial statements. While
we're the first to acknowledge that there are far more exciting aspects about
investing in stocks than learning about accounting and financial statements,
it's essential for investors to know the language of business. We also
recommend you sharpen your newfound language skills by taking a good look at
the more-detailed discussion on financial statements in Lessons 301-303.
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