*This is a follow up to my original article: “Introduction to the Stock Market”. If you haven’t read that one yet, I suggest you check it out before reading this one (unless you already have substantial knowledge of what the market is, how it works, etc.)
In our first article we ran through active vs. passive investing (stocks. Vs mutual funds/ETFs) and talked about a few of the different aspects of a business to analyze before making an investment. (Revenue, Expenses, Income, Assets, Liabilities)
Now we are going to dive a bit deeper and actually look at how we can compare stocks to each other when making investment decisions.
Remember - all investment decisions should be made as a comparison.
“Should I be saving or investing?”
“Should I hold cash in a savings account or buy this house?
“Should I buy that house or buy stocks?
“Should I buy stocks in the technology sector or the financials sector?”
All good financial decisions will involve an element of our brain that makes comparisons (this or that).
The people who struggle financially are the ones that do not have the ability to choose. They want it all - so they end up borrowing to fulfill all of their wants right now.
We won’t do that here. We make educated decisions about the risks, potential enjoyment/profits, and opportunity costs of our money decisions. This affords us a much greater probability of not only getting rich, but staying wealthy. (Which is much harder!)
That being said, it is easy to see why comparing businesses to similar competitors is one of the most fundamental parts of investing. That is in addition to comparing across sectors, like technology vs utility companies as a whole. Then ultimately choosing asset classes and asset allocation, like what % of your portfolio you want to be invested in stocks vs. bonds vs. cash vs. real estate vs. venture capital vs. commodities vs. foreign currencies vs…….
You can see how this can be overwhelming for newcomers.
The easiest way to tackle this would be to step back and create a plan along with a few cornerstone analytical tools that will help us look at ANY investment and see if it is of any value to us. Then we will be able to compare that value to other choices.
Asset allocation (stocks vs bonds vs.......) is another article all together and will be talked about at length soon.
On the other hand, to analyze an investment, let’s use what we learned in the first stock market post and leverage those insights to create metrics.
Remember these 5 aspects of a business we mentioned (can also use these for other assets as well):
Then factor in these key points when analyzing an investment:
Is this a business? A shiny metal? Or a piece of paper promising cash in the future?
What are you buying?
It is a simple question that I don’t think most people actually ask themselves. When you are purchasing stocks, you are REALLY purchasing a piece of a business. So you should be focusing on THE BUSINESS.
Another good example is buying a bond. Most people don’t know what bonds really are, they think that bonds are always low risk investments that won’t lose money.
Bonds can be just as risky, if not more risky, than stocks. That is because a bond is just an IOU piece of paper saying that the government/company/municipality will pay you back. (What happens if they break their promise?)
So really understand what it is that you are buying, and ask the common-sense questions that will help us in the next steps. (Cost, income, etc)Here is an intro article on Stocks Vs Bonds
How much money do you have to put out when you buy a house? Conventional wisdom says typically between 10-20% and then the mortgage as a carrying cost.
What Most people fail to include are the closing costs, taxes, homeowners insurance, PMI, maintenance, and other fees in their calculation.
It is VERY important to understand the full amount of money you have to shell out when analyzing an investment opportunity. This is critical, and this is also where most people go wrong.
When buying real estate, don’t forget to calculate the extra costs mentioned above, they add up! Also, I do not consider your personal residence to be an investment. Check out this article for a bit more color on that!
Buying financial assets is a bit different, because they usually don’t have those carrying costs. (Unless you purchase them on leverage with borrowed money!)
Therefore you can expect to pay whatever the asking price is in the market for those securities at the time. (Whether that is a GOOD price will be looked at in the next few paragraphs)
When you buy a rental property, this would be the rent, laundry income, etc.
What would it be for a stock?
Well, when you are purchasing a share of stock, the income you own is based on your % ownership in the company. So if you own 1 out of 100 shares (simplified example), you own 1% of the company.
If that company makes an income of $100/year, your portion would be $1. (This does not actually get laid out to you in cash, but it is the portion of the business you own)
How much would you pay for that right now? That’s the eternal question of the stock market!
This ratio (Known as the Price to Earnings Ratio) is a hot topic, and there is a whole blog post on it, linked HERE!
Now factor in your dividends, which is money you will actually receive in cash from the company, and that is how much of the business’ income you own.
By Comparing financial ratios across investments, you will naturally lean into buying things that provide you more income per dollar that you throw down! Which is a very useful metric to know before you buy, no matter what you are buying.
You should also look at the amount of debt a company has, what the interest on that debt is, and contrast that to the asset’s income to determine if it is in a healthy position. (This is called the Debt to Income ratio!)
Some investments will naturally have a higher debt associated with them. For example, financial companies are basically all run on high levels of debt because they use other people’s money to invest and create a return. The return they make minus their cost (the interest on the debt) is essentially their profit. This is called the spread.
If you just look at the amount of debt a company has without understanding the business model it could throw you off! So be aware. The same applies when looking at the assets a company has! Some companies (like manufacturers) hold a LOT of real assets. Think plants, equipment, office real estate, etc.
Other companies, think software-techy types, will hold little to no real assets. Most of their assets will be intangibles like intellectual property or goodwill.
So be sure that you are comparing apples to apples!
Whew! That was a lot. I hope you took some value away from this post, and we will be working on a part 3, so stay tuned! If you still don’t feel comfortable, here is an amazing guide to stocks by JL Collins (legendary author of The Simple Path to Wealth. It is easy to follow along! If you have any questions (something like, how does my order to buy get filled? Or how do I calculate my profit/loss?) feel free to reach out :)
If you thought this was helpful, terrible, or somewhere in the middle, please leave me feedback in the form of a Direct Message on instagram @MakeDollarsAndSense, or feel free to send me an e-mail/text to the information on my Home Page. I truly appreciate constructive criticism and opposing views, so bring em on!
P.S. New blog posts coming your way every Monday!
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