How Do You Start in the Stock Market (Part 1)

The stock market can be a daunting place for beginner investors. It can also be a demolition derby for seasoned investors who are on the wrong side of trades. Whether you are a beginner or expert, the fundamentals of business apply. When you disregard the fundamentals eventually you will lose.

This article will focus on beginner investors. It's tempting for a beginner investor to sign up for an account like Robinhood, upload some funds then start investing. The purchase of any asset is the most critical decision you will make in your investing journey, and it's only 1% of all the investing actions you will take. Investing in the market is dangerous because purchasing a stock is extremely easy with our current technology platforms. Think about the last thought for a second. The most crucial decision is also the easiest decision in terms of effort. Anyone can invest at any time. In this article, my goal is to Guide You through My Foundational Approach to Investing so you have some tools to make a sound decision when you decide to purchase a stock or other assets. In this article, we will discuss Recommended Material to Study, How to Find a Potential Stock, How to Evaluate a Stock Further, A Deep Dive into Dividends, How to Examine the Brand, and Finally Assessing the Management Team.

Recommended Study Material

So, where do you start? You have thousands of companies and endless online investing platforms to choose from online. Don’t start with the markets; in fact, avoid the markets like you would avoid a smelly dumpster. The markets are merely an area where individuals exchange shares. They are not where the meat of investing lies. Investing starts with good ole fashioned accounting. Most individuals avoid accounting when investing in a business, and they ponder why they can never pick a company that performs well. Choosing solid performing businesses is essential to success in investing. How do you determine the performance of a business? You evaluate it using accounting and finance principles.

Let’s define performance. Performance is how effective a business is at earning revenue, then how effective they are at retaining cash off that revenue, the cash flow. Certain companies are more effective at keeping more cash flows off of their revenue than other businesses. We will discuss why this occurs later in the article. Accounting will tell you the effectiveness of a business. When you start your investing journey, study Accounting A & B. These courses will teach you how to evaluate the 3 most important statements of a company; the Balance Sheet, the Income Statement, and the Cash Flow Statement. Also, taking a beginner course in Finance is essential as it will teach you Discounted Cash Flows, Future Value of Money, Present Value of Money, and other critical financial metrics and ratios. The accounting statements provide the business numbers, and financial analysis tells you how healthy a business is. Before you invest a single penny, take these 3 courses, in my opinion. These three courses will teach you how to look at and evaluate the performance of a business.

Now that you have the basics, the next course of action is to read 2 books by Benjamin Graham, Warren Buffet’s Mentor, the Intelligent Investor, and Securities Analysis. The Intelligent Investor is an essential book for the beginner. It teaches the importance of an investment vs. speculation which is the most crucial sector in the book. If you can differentiate between investing and speculating, you will set yourself up for success across your investing career. Security Analysis is a deep dive into anything you ever wanted to know about securities. It is a massive book so tread lightly. Once you have acquired these two books, I advise you to read Howard Marks and Warren Buffet's memos. These are decades of investing experience from the best investors in the world. Look at Benjamin Graham, Warren Buffet, and Howard Marks as your mentors.

SEC requires companies to file an Annual Report each year. A company will file its Annual Report at different times of the year depending on its fiscal year. The majority file their reports on 31 December, and some file on 31 March or 30 June. Filing dates may confuse you if you are looking for the company's Annual Report on 1 January, yet they have not filed their report. You will have to wait until the Spring, Summer, or Fall to see the new Annual Report. Within these Annual Reports, you will find descriptions of the business, potential risks, the 3 Accounting Statements (Cash Flow, Income & Balance Sheet), and other info that clarifies the accounting statement. Read one report at a time. They are usually 200 pages long and packed full of information. Take it slowly and read it over and over again until you see the structure of the document. You will usually find the three accounting statements 2/3rd's of the way down the document. If you feel overwhelmed, that's normal. Read, re-read, re-read until you feel comfortable reviewing it.

Investing in stocks requires evaluation and patience (we will talk about this later). It starts with studying the fundamentals of Accounting and Finance, then learning how the best investors apply these fundamentals to assessing and evaluating a business. Once these investors have completed their underlying analysis, which is 99% of the work, they set a price for which they are willing to purchase the asset. They then patiently wait until that asset reaches their price and they buy. Speculators jump directly into the market and purchase assets based on euphoria, excitement, and other emotions. Their evaluation is their emotions.

How to Find a Potential Stock

Once you have learned accounting, finance 101, and how the best investors think about buying companies, now it's time to develop your investing strategy. I will share mine with you as an example of an investing strategy you could create. Then I will describe how I employ it in the markets.??

My investing strategy is straightforward. I look for businesses with a 20% Operating Margin or better that pay you a dividend (pay you to own them). I look for companies with a track record of paying their dividends consistently over time. I also look for resilient brands that are powerful and durable in the world. These are just a few of the requirements for which I look.

How do I execute my strategy? I start with one metric, the Operating Margin. You can find the Operating Margin on the Income Statement. Let's look at a fictional lemonade stand to explain how to calculate the Operating Margin. Below are our calculations:

Total Revenue 2020?

$100,000

Gross Expenses (Cost of Lemons, Water and Sugar)

-$30,000

Gross Income

$70,000 ($100,000 - $30,000)

Sales, General, and Administrative Expenses (Employees, Stands, Vehicles, etc.)

-$40,000

Operating Income (This is the income you make after paying off all your operating expenses)

$30,000 ($70,000 - $40,000)

Operating Margin (Operating Income / Revenue - $30,000 / $100,000)

30%

*Remember we are looking for businesses that generate a 20% Margin or Better. The lemonade stand passes the mark at 30%

Now that you have your baseline Operating Margin, how do you find these businesses on the stock exchanges? Start by going to Yahoo Finance or similar financial site and search for the stock tickers of the companies you know and like. On each company page, in yahoo finance, find the Operating Margin. If it's 20% or higher, mark it as your favorite, and if it isn't, disregard it and move on to the next company. Here is the caveat, it's your choice where you set your baseline Operating Margin. Your baseline Operating Margin is the first part of your stock screening process. As you review 100s of companies, you will notice trends emerging, such as certain businesses in specific sectors always seem to have higher margins. In comparison, other groups of companies have lower margins—the physical form of this business are more cash-intensive to operate (add link)

How to Further Evaluate the Potential Stocks on Your List

Now that you have your list of stocks, let's look at how we will evaluate them further. I will share with you how I assess stocks. Different investors will have different methods they use to evaluate a business. It's your responsibility to establish your ways of valuation.

Free Cash Flow Margin

I use this ratio because it provides an accurate and authentic statement of how much cash went into the bank account at the end of the year. You can find the numbers to calculate this margin in the Income Statement and the Cash Flow Statement. To calculate this ratio, search for the Cash Flow from the Operations number on the Cash Flow Statement and the Total Revenue on the income Statement. Below is the calculation:

Cash Flow From Operations / Total Revenue

26,000 / 100,000 = 26%

This ratio tells you what percentage of cash from the total revenue the company retained. Cash is the lifeblood of the business, so a keen investor will look for how much cash the company puts in its bank accounts at the end of every accounting cycle. I look for businesses that have Cash Flow margins that are similar to the Operating Margin. IE. Company A has a 30% Operating Margin and a 26% Free Cash Flow Margin.??

Enterprise Value / Cash Flow from Operations

Investopedia defines Enterprise Value as "a measure of a company's total value, often used as a more comprehensive alternative to?equity market capitalization. EV includes in its calculation the market capitalization of a company but also short-term and long-term debt as well as any cash on the company's balance sheet. Enterprise value is a popular metric used to value a company for a potential takeover."

To calculate this ratio, we first calculate the Enterprise Value:

Total Market Capitalization (Total Shares Outstanding x Current Stock Market Price = Total Market Equity)?

+ Short Term & Long Term Debt?

- Cash (Liquid Assets of a Company)?

We then divide the Enterprise Value by:

/ Cash Flow From Operations.??

Why do we add the Total Amount of Market Equity and the Total Debt? It is because this is what the company owes other individuals. Total Market Capitalization assumes you re-purchased all the shares at the current market price trading in the public markets. The Total Debt is all the loans, accounts payable, and any other liabilities the company owes to others. You subtract cash because that is what the company owns. If you took that cash and paid down as much debt and purchased as many shares as possible until the company ran out of money, the liabilities and the equities left over would be what the company is worth. When you divide what the company is worth by the cash flow, you get a multiple on how much that debt and equity are producing. The multiple tells you how many years it would take the company to pay back all the debt and re-purchase all the shares until it didn't owe anyone anything. Enterprise Value / Cash Flow from Operations is a robust calculation.

Part 2:

A Deep Dive into Dividends,?

How to Examine the Brand,?

Assessing the Management Team

Originally Published at the RedtoBlackPodcast.com