You may have searched many sites trying to figure out how to invest in stocks. However, what you will find mostly are how and where to open brokerage accounts, or perhaps some generic investment ideas.
Here we will share with you exactly how to interpret businesses and its numbers!
No doubt investing in stocks requires constant learning. To us it is more than buying a paper asset. We treat it like owning a piece of the business we are investing. It is unlikely for one to be great in assessing all types of businesses across all industries and geographies. Moreover, there are numerous metrics and values to examine, which will probably take a 4-year degree to go through.
So what we will do here is to share with you some key financials and how to interpret them. We want to equip you with the know-how to assess businesses so that you can kick start your investment journey.
Note that we will refer to stocks investment as the common shares that we understand trading in the stock exchanges. We will not go into other financial instruments such as preferred stocks or options that can change the expected risks and returns.
Ok, let’s dive in on exactly how to invest in stocks!
How To Invest In Stocks: Sources of Profit
In order to provide a comprehensive overview, we need to work out the potential profits from investing in stocks.
How To Invest In Stocks: Profit From Dividends
The first thing you should find out is whether the particular company you are investing in is distributing dividends. Some companies practise giving out periodic dividends. Others either give out dividends irregularly or don’t distribute at all.
Let’s take a look at The Coca-Cola Company (KO), which is known to be distributing dividends historically.
Data Source: Yahoo Finance / The Coca-Cola Company (KO) – Chart By Carepital
As you can see from the historical trend, KO has been giving out regular dividends over the years. In fact they have been increasing the per share dividends as well. So how does it translate to your returns?
So assume that you purchase the KO at $50 a share. Also, assume that the dividends for the coming year will remain the same as 2019 which was $1.60 a share. Dividing $1.60 by $50 will give us a dividend yield of 3.2%.
Although the price of KO stocks had been rising, it does not mean that dividend yield had decreased. Its per share dividend distribution has been rising as well.
The dividend yield has been hovering consistently at about 3% although you may be purchasing at higher prices over time.
Data Source: Stockrow / The Coca-Cola Company (KO) – Chart By Carepital
A caveat is that the company should be doing better to justify distributing more dividends over the years. If the company has been increasing its payout without attaining higher earnings, then it might not be so great.
The aim here is not to go into a detailed analysis of Coca-Cola. Rather, we seek to provide an understanding that dividends distribution form an important component of your overall expected returns. So make sure to check out the dividend distribution records of any companies that you are interested to invest in.
How To Invest In Stocks: Profit From Capital Gains
The second thing to think about is a potential capital gain in the future. Here capital gain will mean an increase in share price of the company you have invested in.
Going back to Coca-Cola, you can observe that the company’s share price has increased steadily over the years.
Source: Yahoo Finance / The Coca-Cola Company (KO)
Let’s say you have invested a share back in 2010 for around $30 a share. Then, sell it at $50 today, you would have attained a $20 capital gain. This will translate to an average return of 6.7% or a compounded annual growth rate (CAGR) of 5.2%.
Add this to the dividends you received over the past 10 years. It should give you an average return of about 10% a year or a CAGR of 7.5%. While not an extremely high return, it’s quite a stable one. You may wish to find out more about The Coca-Cola Company here.
Now, the question is why has the company’s share price been increasing over the past years? Well, if the business is experiencing growth in its earnings, then of course the share price should increase accordingly. Because this will mean that the company can distribute more of its earnings to their shareholders.
Before we get into the details of the business, there’s one element you need to know that will affect the share price. That is share repurchase or buyback.
This is an alternative form of distributing earnings back to the shareholder. Instead of giving cash back, the company will purchase its own shares from the market to boost its value.
In essence, it reduces the number of outstanding shares in the market. The shareholders will now enjoy a bigger pie each. This will improve the per share metrics of the business, and in turn cause its stock price to climb. We will discuss the metrics in more detail later.
Just a quick illustration here. Since there’s lesser shares in the market now, the same total dividends distributed will result in higher dividends per share. As a result, dividend-sensitive investors will be attracted by the higher dividend yield.
The increase in demand for its share will in turn push up its stock prices. The stock price will evenutally equilibrate to the original level of dividend yield. Indirectly, the management is actually distributing its earnings back to their shareholders. They repurchase shares to create capital gain effect in their stock price.
Share Repurchase: Coco-Cola
Source: Stockrow / The Coca-Cola Company (KO) – Cash Used For Equity Repurchase
Coca-Cola has been spending about $2 – $3 billion to repurchase its shares from the market over the past decade. This is part of the reason why we see the steady climb of its share price over the years.
Now that you have a better idea of where your profit sources are, we can now examine a business deeper. To do that we need to understand how to read financial statements, made up of 3 statements. They are the income statement, balance sheet and cash flow statement.
Again, our aim is not to train you to be an accountant. Rather, we want to provide you with a quick overview of what the financial reports tell you. And from there, extract some key metrics to help you do a quick assessment of a business. Thereafter, you can decide whether to skip or dig deeper into the business. If you are ready, let’s go!
How To Invest In Stocks: Income Statement & Key Metrics
The first statement you will usually find is the income statement. It tells you how much is the company generating as well as the related expenses. The income statement usually comes in a quarterly, half-yearly or annual format. It depicts all the income and expenses that occurred during these defined periods of reporting.
Quick Overview of Income Statement
Source: Yahoo Finance / The Coca-Cola Company (KO) Income Statement 2016 – 2019
If you look at the income statement, it will generally start with the company’s revenue which means the sales that it has made for the fiscal year. After deducting the cost of goods sold (COGS), it will give us the gross profit.
However, running a business involves more than the cost of making the products. There will be operating expenses related to depreciation of machineries, marketing, wages, shipping, utilities etc. These are typically classified as Selling, General and Administrative Expense (SG&A). Deducting these operating expenses from the gross profit will give us the operating income.
In addition, there are other non-operating income and expenses the company has to account for. Typically, non-operating income involves interests and profits earned from investment in short-term debt instruments and securities respectively. Whereas non-operating expenses will include interest expense that the company is obligated to pay back on its debt. After adding non-operating income and deducting non-operating expenses from the operating income, we can get the pretax income.
Finally, after deducting the tax provision from pretax income, we can arrive at the net income.
Note that different companies can have different accounting practices and items in their financial reports. Here we just want to give you an idea of the flow in the income statement.
Earnings Per Share
While the absolute earnings figures are important, per share earnings can help investors assess companies more readily.
Earnings per share (EPS) = (Net Income – Preferred Dividends) / Common Shares Outstanding
Understand that the shares that we know as are called common shares. But companies can issue preferred shares as well. And usually it is required pay preferred dividends to preferred shareholders first before common shareholders are considered. However, generally the number of preferred shares is much smaller than the common shares.
Well it’s obvious if the company is earning more, it will translate to higher EPS. But one thing you should note is that share repurchase, as discussed earlier, will drive up the EPS as well.
The first ratio many investors will take note of is the price-to earnings ratio. It is also what we call the P/E ratio.
Price-to-earnings (P/E) = Market share price / Earnings per share
In essence, market share price is the principal sum of your investment. While EPS doesn’t translate to actual cash returned, it is what the business is earning for each of the shareholders.
Hence if P/E = 20, you are in effect paying 20 times what the business will be earning for you.
Data Source: Stockrow / The Coca-Cola Company (KO) – Chart By Carepital
Going back to Coca-Cola, we can see that the EPS is about $2 a share for FY2019. Assume you bought the share at $50 back in 2019, it will translate to a P/E of 25 times. Looking at it the other way round, divide EPS by market share price, you will get 1/25 or 4%. Effectively your investment is generating you 4% return.
In general, a stable business should expect to have a stable P/E ratio as well. Hence, when the market expects the company’s earnings to grow, there may be temporary distortion to the P/E ratio. Investors will push up the market share price, causing the rise in P/E ratio because the EPS would still reflect the previous reporting figures.
This is why the market is obsessed with tracking and estimating the earnings growth of companies. As you now know, earnings growth should directly affect the stock price, hence the potential capital gain from your investment.
Similarly, when management announces a share repurchase programme, we will expect higher EPS as discussed earlier. Since P/E should hover at similar values for stable business, the price of the share should increase eventually.
EBIT And EBIT Margin
EBIT stands for earnings before interest and taxes. This is a common term that we should know as investors. Different companies have varying capital structures taking up different amounts of debt. They are also operating in different tax regimes. Thus, companies in the same industry can incur vastly different interest and tax expenses. As such, to compare the profitability accordingly across different companies, we can compare their EBIT margins, derived from dividing EBIT by revenue.
How To Invest In Stocks: Balance Sheet And Key Metrics
As we have seen, the income statement reveals the company’s operation for a defined period of time. On the other hand, the balance sheet provide a snapshot of the company’s financial health at a point in time.
Quick Overview of Balance Sheet
Source: Yahoo Finance / The Coca-Cola Company (KO) Balance Sheet 2016 – 2019
The fundamental equation you need to know here is:
Total Assets = Total Liabilities + Shareholders’ Equity
In essence, it tells you what a company owns (assets), owes (liabilities) and invested (equity). Imagine, if Coca-Cola wants to purchase a bottling plant for $100 mil. However, given the substantial amount, the company invests $60 mil and takes up a loan of $40mil from the bank.
Here the $100 mil will be reported as the asset. The $40 mil will be the liability that the company is obligated to pay back the bank. Finally, the $60 mil will the shareholders’ equity that was used to invest in the bottling plant.
Of course, this is a simplified version. The actual balance sheet consists of a myriad of items condensed together. Generally assets and liabilities can be classified into current and noncurrent.
Current assets consist of assets that can be used or sold within a year or normal operating cycle. If it takes longer than that, then the asset will be classified as noncurrent assets.
Similarly, current liabilities are obligations that are due within a year or normal operating cycle. If the obligations are due over a long time frame, then they will be classified as noncurrent liabilities.
To illustrate, see below diagram for a big picture understanding of what a typical balance sheet is made up of.
[Copyright] Carepital, 2020 Balance Sheet / Assets = Liabilities + Equity
Current Ratio = Current Assets / Current Liabilities
This ratio helps us to assess the liquidity of the company. In short, it helps to check if they have enough resources to fulfill its short-term obligations. A value of more than 1 indicates that the company has more current assets than current liabilities. And that the current assets can be converted to cash within a year or less. This means that it will be sufficient to satisfy its current debt obligations and payables.
However, note that if current ratio is too high, it can also imply that management is not allocating its assets efficiently.
Interest Coverage Ratio
Interest Coverage Ratio = EBIT / Interest Expense
This ratio tells whether earnings from the company is sufficient to fulfill its interest obligations from its outstanding debt. Similar to the current ratio, it reveals the ability of the company to service its debt.
You need to be wary if you see a declining ratio over the years, as it could mean that potentially the company is taking on more debt. Or perhaps their earnings have declined. It helps us understand the short-term financial health of the company. As with other ratios, you will need to examine other metrics in order to understand the long-term financial health of the company.
Debt-To-Equity (D/E) = Total Liabilities / Total Shareholders’ Equity
This is effectively a leverage ratio. It tells you how much debt the company is undertaking out of the total equity it has. Therefore, higher D/E can potentially signal higher risk to the shareholders. However, understand that D/E ratio can be quite different across different industries. So, compare D/E of competing firms in the same industry to cross-examine their level of leverage. You will then be able to tell if there is any company that is highly leveraged compared to others.
How To Invest In Stocks: Cash Flow And Key Metrics
As you dwell deeper into the income statement, you will realize that the earnings reported usually do not translate to cash earnings. There’s many items on the income statement that are non-cash in nature. Thus, it is important to see how cash is actually flowing in and out of the company.
Quick Overview of Cash Flow Statement
Let’s use Coca-Cola consolidated statements of cash flows to help us understand what we need to know.
Source: The Coca-Cola Company (KO) 2019 Annual Report – Cash Flow Statements
The cash flow statement is broken down into namely 3 sections as below:
- Cash flow provided by operating activities. This is the main cash generated from the business operations. It is usually reported as the net income and adjusted with noncash components to derive the actual cash generated during the reporting period.
- Cash flow provided by investing activities. The cash outflow here in Coca-Cola’s case includes the cash used for purchases of investments, acquisitions of businesses as well as purchases of property, plant and equipment. At the same time, the disposal of assets from time to time will result in cash inflow as well.
- Cash flow provided by financing activities. Cash can be obtained from issuing of debt or stocks. At the same time, payment of debt and share repurchase results in cash outflow. Similarly, distributing dividends is a cash outflow activity.
Free Cash Flow
As mentioned in the beginning of this section, reported earnings can sometimes be distorted due to multiple noncash items. As such, investors should keep an eye on the actual cash the company generates as well. This is a key metric that legendary investors like Warren Buffet look at when determining how to invest in stocks.
More than just operating cash flow, free cash flow (FCF) aims to define how much cash the company generates after deducting cash required to maintain operations and capital assets. It measures the profitability of the company in terms of cash. Compared to reported earnings, non-cash expenses such as depreciation and amortization are excluded in FCF. At the same time, we need to deduct capital expenditure (capex) from reported income. Any increase in working capital will have to be deducted as well.
There are many variations around the definition of FCF. There’s also different ways of deriving it. Warren Buffett defined FCF as earnings plus depreciation, amortization, and other non cash charges, less the average annual capex required to maintain the company’s operation and competitive position.
Don’t worry if you feel lost in all the financial and accounting terms here. Just understand that FCF tells us how much cash the company generates to pay its creditors and shareholders, after setting aside the amount required to maintain operations.
How To Invest In Stocks: Other Key Financials
So far we have gone through a brief rundown of the various financial statements that you should familiarize yourself with. We also explained some key terms and ratios. These will be handy when assessing the financial health and investment prospect of a company. Now, we will highlight some key metrics remaining that should help you better assess a business.
How To Invest In Stocks: Return On Equity
Return On Equity (ROE) = Net Income / Average Shareholders’ Equity
As you can see from the formula, ROE tells us how profitable the company is with respect to the shareholders’ equity. Great companies tend to be able to produce consistently high ROEs over the years. A good gauge is to look for companies generating ROEs above 12%.
Refer to the chart below. You can see that Coca-Cola has been generating high ROEs of above 20% over the years, less FY2017 when it was hit by a one-time $3.6 billion tax charge. Overall, it is indicating that the company is generating high returns with respect to shareholders’ equity. This is a plus point for investors to consider researching further.
Source: Stockrow / The Coca-Cola Company (KO) Return On Equity
How To Invest In Stocks: Return on Invested Capital
Return On Invested Capital (ROIC) = Net Operating Profit After Tax (NOPAT) / Invested Capital
NOPAT = EBIT x (1 – Tax Rate)
Invested Capital = Equity + Debt (Long & Short-Term) – Cash (Include Short-Term Investments)
ROIC tells us how efficient is the management allocating the capital to generate good returns for its shareholders. Similar to ROE, great companies should yield a high ROIC consistently. And a good gauge is to look for companies generating ROICs above 12%.
Refer to the chart below. Similarly, you can see that Coca-Cola’s ROIC has been averaging about 15% over the past decade. This means that the company’s management has been allocating its capital pretty well over the years. Definitely a positive signal to add the stock to your watchlist.
Source: Stockrow / The Coca-Cola Company (KO) Return On Equity
Good job! You made it all the way till the end!
From understanding how to estimate your profits to assessing the financial health of a company, by looking at key values and metrics from financial statements, you are now in a solid position to find your first or next investment idea.
Again, there are so many more things to learn in the world of investment. Our hope here is to help kick start, solidify and refine your investment journey. Ultimately, we want to enhance your success rate with investing.
There’s a lot of variables in the investing work. So, maintain an independent mind and always invest with a margin of safety. As what Warren Buffett says, “Price is what you pay; Value is what you get.”
Continue to learn how a good business looks like both quantitatively and qualitatively. When the opportunity presents itself, have the confidence to make the move. While we need to be prudent with our investments, try not to be paralyzed by over-analyzing.
Hope you managed to learn some useful and actionable investment knowledge. Start researching about companies that you are interested in and decide whether they are good investments or not. Continue to expand your knowledge on how to invest in stocks.
Keep learning and happy investing!
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