Essential Investing Terms You Need To Know

Why It Matters

I learned a lot of things in the Marines, but the deepest lesson I learned was that there’s a simplified version of everything. This goes for warfighting, investing, and everything in between.

In this article I’ll get at the heart of the language of investing and the terms you need to know to get started. (And without the jargon!)

Let’s dig in:

1 Dollar

It’s important to note upfront that one dollar signifies a problem solved for the customer. The more problems solved, or the more difficult the problem, the more money a company can make.

Local companies solve a local problem. Most US public companies solve a problem at scale, across the nation or the world.

But there’s always a problem solved.

Most people that refuse to invest cannot get past this first rule.

Shares and Stock

(For ease, I’m going to use these terms interchangeably.)

Every public company issues shares of its company, like a piece of a pie.

pie

Let’s say we take our lemonade stand public. We want everybody to be able to invest in our wonderful little business. Let’s say we have a total of 100 shares of our lemonade stand. Thi is equivalent to cutting up our business into 100 equal-sized pieces.

If our friend buys 3 shares of our lemonade stand business, then they own three hundredths, or 3%, or the business.

That means they own 3% of the revenue, debt, profit, dividends, and everything else in the business. That friend is now in business with the lemonade stand. This is where most people trip up in investing. When they buy stock they think they are just buying imaginary numbers that hopefully go up in the next week, month, or year. However, when you start a business, or buy into a business, you own some of that business. You’re not looking at the next week or month, but you’re playing the long game of providing maximum value to your customers with the best dang cup of lemonade on the planet, and in turn making a profit. Everybody wins (hopefully).

In one sentence: shares are slices of a business.

Stock Price

Everybody knows this one but it’s important to note anyway. Stock price is what you’re paying for each slice of the company. You can google right now “Apple stock price” and see what each share is trading at. Here is Apple:

Per Share Metrics

Now that we know what shares are, let’s talk about per-share metrics.

Let’s say our friend that bought 3 shares of the lemonade stand business is here, and that business made $100. Let’s split that up equally into the 100 total shares: that’s $1 per share.

Per-share metrics are one of my favorites, because you can tell what you’re getting today when you buy.

Note: You’re getting a little of everything in the business when you buy a share like debt, dividends, revenue, and cash flow. (I’ll explain these later)



Revenue

Revenue is the money generated from normal business operations. If our lemonade stand sells 100 cups of lemonade for $1 each, then we have $100 of revenue.

Many small businesses mistake revenue for profit but it is just the beginning.

Our lemonade stand still has to buy more materials to make more lemonade and to keep business going. If all goes to plan, our lemonade stand makes enough to expand into a second location, or to improve quality of lemonade. It all starts with revenue.

Expenses

An expense is the cost of generating revenue for our business. In our lemonade stand its’ the cost of things like cups, water, lemons, sugar, advertising, and wages.

Larger businesses can have more complex expenses, but the concept is the same.

Earnings

Earnings are a companies after-tax net income. It is the bottom line, or profit, a company makes. This is where most of wall street gets their kicks. Headlines like “Intel reports their quarterly earnings this morning” are all too common in investing.

SEC Filings

The SEC is the U.S. Securities and Exchange Commission. Their mission is to “protect investors; and facilitate capital formation. The SEC strives to promote a market environment that is worthy of the public’s trust.”

The great thing about the SEC is that they require filing s from companies that are available to the public and are the main tool for investors to use in learning about the internals of any public US company.

Here’s the filing types listed by importance:

  • 10-K: Annual Financial Report. Contains information on the business, risk factors, selected financial data, management discussions and analysis, and official financial statements with supplementary data. This is the bread and butter for most professional investors. 10-Ks are audited, another major bonus.
  • 10-Q: Quarterly Report. Shorter, contains quarterly financial performance of the company. 10-Qs are not audited, however.
  • 8-K: Announcement. The SEC requires that a company files an 8-K whenever major events unfold that might impact shareholders.
  • Proxy Statement: View the salaries and perks of company management. (Look for incentives here!)
  • Forms 3, 4, and 5: Ownership of the company. It’s nice to see leaders in the company with a high % of net worth in the company. It’s called Skin In The Game (SITG) and is a good signal.
    • Form 3: Initial filing disclosing ownership.
    • Form 4: Changes in ownership.
    • Form 5: Annual summary of form 4.

Most time spent in filings should be spent in the 10-K. Once I invest in a company I will subscribe to the rest of these filings on the company investor relations website.

Everyone should read a complete 10-K from front to back at least once.

Bullish / Bearish

We’ve all heard of the bulls and bears, but what does it mean? Basically, if someone is “bullish” on something then they are saying that they think it is going to perform well. “I’m bullish on the lemonade stand. That’s why I bought 3 shares of it!”

Conversely, if someone is “bearish” it means they think it will perform poorly. “I am bearish on Dale’s Discount Lemonade. That’s why I’m not buying any shares.”

These are interchangeable with “long” and “short”. Long = bullish. Short = bearish.

I hardly ever use these terms, but they are extremely common so it’s good to know them.

Free Cash Flow

By far my favorite metric, Free Cash Flow (FCF) is the cash available to investors after all necessary expenses are paid for.

A company can do a few different things with FCF:

  • Reinvest into the company (equipment, property, etc)
  • Pay dividends to the investors
  • Repurchase shares (decreasing the number of total shares available to investors, a good thing for shareholders)
  • Pay down debt
  • Acquisitions (buying other smaller companies that support the overall business)

It’s good to keep in mind that a business owner goes into business to generate Free Cash Flow. If Free Cash Flow is negative, the business will go under after an amount of time, otherwise it is a charity.

Here’s the thing: many companies manipulate their earnings, but it’s very difficult to manipulate free cash flow. That’s why I like it so much. I valuate companies by their Free Cash Flow (FCF) and their ability to grow the amount of FCF generated.

Assets

There’s lots of boring definitions for an asset, but what it boils down to is this: an asset solves a problem.

  • Tools
  • Housing
  • Cash (can be used to purchase assets in the future)
  • A business (including a piece of a business, like a stock)

Equity

Equity is ownership of an asset.

To say “I have equity in this lemonade stand” means “I own some of this lemonade stand.”

Ownership of a business is through shares, as we talked about before. “I own equity in the lemonade stand” means we own some of that lemonade stand business.

Debt

Debt is owing someone else money. The most common form of this is home loans, auto loans, and credit cards.

Businesses take out loans for many reasons, like purchasing more equipment or inventory.

A good example is our lemonade stand. Let’s say we want to make more lemonade faster, so we get a loan so we can buy a lemonade juicer to make twice as much lemonade in half the time. Sounds good, right?

This is a good use of debt, assuming all goes to plan.

However, nothing ever goes to plan. Things can go sideways. It turns out our juicer lowers the quality of our lemonade, and people stop buying. Oh no! Now we have a bad juicer and a loan to repay with less money coming in because our lemonade is now subpar.

This is the problem with debt. Nothing ever goes exactly to plan.

Note: many CEOs are experts in not falling into debt traps, and this is a simplified and extreme example, but the lesson still remains.

When I look at businesses I make sure they are not laiden with debt.

Profit

There’s a lot of definitions out there about what profit is.

Profit is money available to owners of a business after all mandatory expenses have been paid.

Many small business owners confuse revenue with profit. Remember: Just because our lemonade stand sold 100 cups of lemonade for $1 each doesn’t mean we made $100. We still need to buy replacement cups, lemons, water, and pay down the debt we took our for our new lemon juicer.

Every business defines profitability in their own terms, and sometimes terrible businesses that lose a lot of money make it look like they are profitable. Watch out!

Refer back to Free Cash Flow to weigh a companies true profitablity today.

Margins

Margins are the measure of profitability.

If it costs us 50 cents to produce 1 cup of lemonade and then we sell it for $1, then we have a 50% margin. (Pretty good!)

Some businesses spend $2 to make their lemonade then sell it for $1. Not kidding.

Cash

Cash is money available right now.

A lot of analysis dances around with different metrics and making things more complicated than they need to be. A good way to boil things down is look at Cash Flow.

Cash Flow is looking at the cash coming in vs the cash going out. It’s as simple as that.

Cash is king.

Opportunity Cost

“If you buy this, you can’t buy that” I explain to my son as he’s browsing the toy aisle with is hard-earned dollars. This is the core of opportunity cost.

I see opportunity cost play out the most when deciding what business to buy. We only have so many dollars, so we can’t buy every single neat business that we see.

Compounding

Compounding is described as the 8th wonder of the world, and for good reason.

Compounding combines time and incremental successes to do some truly amazing things. Check this out:

If we took a chess board and put one grain of rice on the first square, then 2 on the second square, then doubled it every square, we’d have a lot of rice!

First two rows of the rice-chess problem.

Here’s how much rice we would have at the end of this problem: eighteen quintillion, four hundred forty-six quadrillion, seven hundred forty-four trillion, seventy-three billion, seven hundred nine million, five hundred fifty-one thousand, six hundred and fifteen, over 1.4 trillion metric tons, “which is over 2,000 times the annual world production of wheat, which in the period 2020-21 was an estimated 772.64 million metric tonnes.”

This is why we invest. Investing takes the power of compounding and gives it to the patient investor.

The cool part: it’s free to everyone.

The most improtant part about compounding is the time it takes. On the very last square of the chess board lies the most rice.

Diversification

“Don’t put all your eggs in once basket”

In investing, this means owning more than once business in case one of those business collapses. No business lasts forever.

Risk

The cost of compounding is risk. There is risk inherent in everything, even walking outside. We all weigh risk without thinking about it: some ride motorcycles, others walk.

Some work a 9-5 for a large corporation, others start small business, and still others start an online resource to help new investors like us.

Our lemonade stand might fail, and that’s the risk we take with owning that business.

When investing your own hard-earned money it’s important to not take unnecessary risk. The best way to do this is to own real pieces of businesses that solve real problems for people. Not by buying the latest cryptocoin in hopes that the price goes up.

Conclusion

This is what I consider the bare essentials to get started in investing. As with anything, the best way to learn is to start. If you’re human, you learn as you go, not just from reading.

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