Rule #1 Finance Blog

With Investor Phil Town

Essential Financial Terms That Every Investor Needs to Know

“The beginning of wisdom is the definition of terms.” – Socrates

You may have wondered why so many people get confused about the subject of investing and personal finance. When you search around you might find all sorts of conflicting advice and opinions.

“Investing is too hard for the normal person to do.” “The stock market is insanely risky.” “You should always diversify.” “You can’t beat the market.” These are all examples of investing myths I’ve heard. So, how does this happen? Why do people believe these claims about investing? In order to gain a full and proper understanding of a subject, you have to understand the basic words used to explain it.

That’s why I’ve put together this investment terms glossary to help build your understanding from the simplest of financial terms to the complex. When you learn these, you’ll be able to protect yourself from the scary amount of misinformation about investing that’s out there.

If you’re here searching for a specific word, just use the bar below to navigate to the starting letter of what you need. Let’s get started with this glossary of 80 investment terms.


| # | A | B | C | D | E | F | G | H | I | J | K | L | M | N | O | P | Q | R | S | T | U | V | W | X | Y | Z |


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#

10-10 Rule

A concept used when determining whether a business has Meaning (one of the Four Ms) to you as a Rule #1 investor. The rule states that you should not “Own a business for 10 seconds if you are not willing to own it for 10 years.”

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A

Asset

Resources controlled by a company from which future economic benefits are expected to be generated. In a business, an asset is something the business owns that has a dollar value. (An asset in general is anything of value that can be traded.) An intangible asset is an asset that has a dollar value but may not be worth anything unless the business is successful. Typically this is an asset that was acquired through buying another business. The price paid in excess of that business’s net worth is often called “goodwill” and is treated as an asset for GAAP purposes.

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B

BAG: Big Audacious Goal

Coined by author Jim Collins in the book Good to Great, Rule #1 investors seek businesses led by CEOs driven by BAGs. These goals are bigger and more meaningful than mere mission statements in that BAGs are about passion and relentless drive to change the world in some small or big way.

Balance Sheet

The financial statement that presents a company’s current financial position by disclosing the assets, liabilities and equity claims as of a particular point in time.

Basic EPS

Net earnings that are available to common shareholders. This is calculated as net income minus preferred dividends, divided by the weighted average number of common shares outstanding.

Big Five

The five financial calculations help to confirm the existence of a Moat (see definition) in a business, which translates to the business being protected from competition and thereby having a predictable future. Rule #1 investors only invest in businesses if all five of the Big Five numbers are equal to or greater than 10 percent per year for the last 10 years.

The Big Five numbers are:

  1.       Return on Investment Capital (ROIC)
  2.       Sales growth rate
  3.       Earnings per Share (EPS) growth rate
  4.       Equity, or Book Value per Share (BVPS), growth rate
  5.       Free Cash Flow (FCF or Cash) growth rate

Bond

A debt investment, as in your loaning money to the U.S. government, which borrows from you for a defined period of time at a specified interest rate. The government issues you a certificate, or bond, that states the interest rate (coupon rate) that will be paid and when the loaned funds are to be returned (maturity date). These are often called T-bonds or T-bills, short for treasury bonds or bills.

Book Value

The net asset value of a company, calculated by total assets minus intangible assets (patents, goodwill) and liabilities. It’s what the business is worth if you shut it down.

Book Value Equity Per Share

The amount of book value of common equity per share of common stock. This is calculated as book value of shareholders’ equity divided by the number of common shares outstanding.

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C

Commodity

A bulk good that’s traded on an exchange or in the cash market. Examples include grain, oats, coffee, fruit, gold, oil, beef, silver, and natural gas. A “commodity business,” on the other hand, is what I call any company that produces a product that anyone else can similarly produce, thus eliminating a Moat. If you own a strawberry patch, for example, chances are a neighboring strawberry patch can easily compete with you. A strawberry from your patch is not going to be all that different from a strawberry from your neighbor. It’s very difficult and expensive to create a Moat and protect it with a commodity business.

Compounded Annual Growth Rate (CAGR)

The year-over-year growth rate of an investment over a specified period of time. It’s an imaginary number that describes the rate at which an investment would have grown if it grew at a steady rate.

Current Liabilities

Short-term obligations that are expected to be settled in the near-term.

Current Ratio

Liquidity ratio calculated as current assets divided by current li­abilities.

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D

Debt-to-Equity Ratio

Solvency ratio calculated as total debt divided by total debt plus total shareholders’ equity.

Debt–to-Earnings Ratio

The amount of years it would take a company to pay off its debt using its current annual earnings.

Dividend

A distribution of cash, stock, or property by a company, based on its earnings, to its shareholders. Dividends are usually quoted per share. They are typically the “thank-you” notes for owning stocks in a stable company (which usually doesn’t have stock prices that move rapidly).

Dividends per share

The dollar amount of cash dividends paid during a period per share of common stock.

Dollar Cost Averaging (DCA)

The practice of buying a certain number of shares in a given stock periodically, so you buy a certain dollar amount of shares regardless of the price per share. This allegedly helps reduce their risk of investing a large amount in a single stock at the wrong time. You buy more shares when the prices are low, and fewer shares when the prices are high. In long sideways markets, DCA will not reduce the risk of a zero rate of return. For Rule #1 investors, however, you already know what price you are willing to pay, so DCA isn’t necessary. Dow Jones Industrial Average. A price-weighted average of 30 significant stocks traded on the NYSE and the Nasdaq. Examples of DJIA companies include General Electric, Disney, McDonald’s, and Coca-Cola. Invented by Charles Dow in 1896.

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E

Earnings growth rate (EGR)

The compounded growth rate that is used to fore­cast potential future earnings per share. This is used in connection with other valuation assumptions to forecast the future value of the firm and calculate sticker price.

Earnings per share (EPS)

The amount of income earned during a period per share of common stock.

Earnings Yield

The income return that a full owner would receive from the earnings of the company if the company was purchased at the current market price. It is determined by dividing the current earnings per share by the current market price.

Equity

(1) Stock or any other security representing ownership (“equities” are stocks).

(2) On the balance sheet, equity refers to the amount of the funds contributed by the owners (the stockholders) plus the retained earnings (or losses). Thus, equity is essentially ownership in an asset after all debts associated with that asset are paid off. The importance of equity to a Rule #1 investor is in its growth rate. The growth rate of equity represents the growing surpluses, which in turn increase the value of the business.

Exchange

A market where securities, commodities, options, or futures are traded. Examples of exchanges include the NYSE, Nasdaq, and AMEX.

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F

Four Growth Rates

A subset of the Big Five that includes:

  1.        Sales growth rate
  2.        Earnings per Share (EPS) growth rate
  3.        Equity, or Book Value per Share (BVPS), growth rate
  4.        Free Cash Flow (FCF or Cash) growth rate

Four Ms

Meaning, Moat, Management, and Margin of Safety.

Free Cash Flow

The actual cash that would be available to the company’s investors after operational investments.

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G

Gross Profit Margin

This is calculated as gross profit divided by revenue.

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I

Index

An imaginary portfolio of securities (stocks and bonds) representing a particular market or a portion of it. The S&P 500 is one of the world’s best-known indexes, and is the most commonly used benchmark for the stock market. Technically, you can’t actually invest in an index. Rather, you invest in a security such as an index fund or ETF that attempts to track an index as closely as possible.

Index Fund

A portfolio of investments that are weighted the same as a stock-exchange index, such as the S&P 500, in order to mirror its performance.

Industry

A group of companies that provides similar product and services.

Insider trading

When corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC.

Intrinsic Value

The current value of a business based on its future surplus cash flow. I call it the Sticker Price.

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L

Large-Cap

Stocks with large market capitalization, between $10 billion and $200 billion. Last. The last actual price at which a stock was sold.

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M

Management

One of the Rule #1 Four Ms that qualify a business you are considering investing in. Having good management means the business is led by skilled, experienced individuals that you respect.

Margin of Safety (MOS)

The difference between the sticker price and margin of safety price. This reduction in the sticker price helps to insulate investors from possible valuation mistakes.

Margin of Safety Price (MOS Price)

A potential purchase price for a particular stock that is determined by reducing the sticker price by the margin of safety.

Margin of Safety Yield (MOS Yield)

The return that a full owner of a company would receive from the earnings of the company if the company was pur­chased at the MOS price. It is calculated by dividing the current Earnings per share (EPS) by the MOS Price.

Market Capitalization

The total dollar value of all outstanding (sold and held by investors) shares. A business’s “market cap” is calculated by multiplying its number of outstanding shares times the current market price.

Market Order

An order to buy or sell a security immediately at the best price available.

Meaning

One of the Rule #1 Four Ms that qualify a business you are considering investing in. Meaning is that you understand the business enough to want to own the whole thing if you could, that you’d be proud to own it, and that it reflects your values.

Mid-Cap

Stocks with middle-range market capitalization, between $2 billion and $10 billion. Moat. First coined by Warren Buffett, Moat refers to the competitive advantage a company has over other companies in the same industry.

Minimum Acceptable Rate of Return (MARR)

The rate at which an investor should expect to earn on an investment. In the Payback Time system, this typi­cally equals 15% annually.

Moat

One of the Rule #1 Four Ms that qualify a business you are considering investing in. Moat means that the business must meet certain criteria in terms of financial strength and predictability, creating a symbolic Moat to surround and protect it from competitors. The strength of a business’ Moat, or lack thereof, will surface in one of The Big Five numbers (see definition in this glossary).

The five types of Moats include:

  • Brand – A product you’re willing to pay more for because you trust it. The company is consistent in high quality services.
  • Secret – A business that has a patent or trade secret that makes direct competition illegal or very difficult. Commonly pharmaceutical and technology companies.
  • Toll Bridge – A business with exclusive control of a market—giving it the ability to collect a “toll” from customers needing that service or product.
  • Switching: A business that is so much a part of your life that a switching is not worth the trouble.
  • Price – Companies with prices so low no one else can compete.

Money Flow

The amount of capital that is being invested in or conversely mov­ing out of a particular security, industry, or industry sector.

Moving Average

Frequently used to show the average value of a security’s price over a period of time. A simple moving average is the average price of the stock over a specific period of time. An exponential moving average is weighted to give more emphasis on recent activity.

Mutual Fund

A financial entity that allows a group of investors to pool their money for investing in the market, usually with a predetermined investment objective. A fund manager is responsible for taking that pooled money—usually billions—and buying securities (usually stocks or bonds). When you invest in a mutual fund, you are buying shares (or portions) of the mutual fund and become a shareholder of the fund. The vast majority of mutual funds fail to beat the market, as well as broad indexes like the S&P 500.

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N

Net Income (or net loss)

The difference between revenues and expenses.

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O

Operating Cash Flow Per Share (OCPS)

Denotes the amount of usable cash from operations that is allocated to each share of a company’s stock.

Options

The privilege to buy or sell an asset, such as a stock, at a specified price within a specified time. Options are typically for the advanced investor.

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P

Payback Time (PBT)

The amount in years it would take a full owner of a com­pany to recoup the capital investment using the forecasted earnings stream of the company.

Payback Time Price (PBT Price)

The price that can be paid for a particular stock to receive the forecasted Payback Time. The investor selects the amount of years that determines the price. The default is 8 years.

P/E Ratio

A ratio of price to earnings (market value per share, divided by earnings per share). Sometimes the PE is referred to as the “multiple” because it shows how much investors are willing to pay per dollar of earnings. If Company X has a PE of 10, that means an investor is willing to pay $10 for every $1 of earnings. In general, a high PE means the analysts are projecting higher earnings in the future. When comparing PEs, it’s best to compare PEs within the same industry, or against a company’s own historical PE. The PE of the entire stock market—“market PE”—has historically been about 16.

Portfolio List

A list of businesses that you have bought and may wish to sell. Rule #1 investors use a portfolio list to track the MOS and the Tools.

Price to book value (P/BV) ratio

The price of a share per the company’s book value of equity. This is calculated as price per share divided by book value per share.

Price to cash flow (P/CF) ratio

The price of a share per the company’s cash flow. This is calculated as price per share divided by cash flow per share.

Price to earnings (P/E) ratio

The price of a share per the company’s earnings. This is calculated as price per share divided by earnings.

Price to sales (P/S) ratio

The price of a share per the company’s sales. This is calculated as price per share divided by sales.

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R

REITs (Real Estate Investment Trust)

A security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. This is how you can invest in real estate, without actually buying a piece of property.

Return on Assets (ROA)

Gives an idea as to how efficient management is at using its assets to generate earnings. This is calculated by dividing a company’s annual earnings by its total assets.

Return on Equity (ROE)

The amount of net income returned as a percentage of shareholders equity and a measure of management’s effectiveness in ap­plying equity capital. One way of calculating ROE is to divide net income by shareholder’s equity.

Return on Investment (ROI)

The percentage return you’ve made on your investment. The ROI for a savings account is 2 percent a year. It’s the total you got back from your investment, less the investment itself, divided by the investment. If I got back $120 from selling lemonade and my investment was $100, to find my ROI, I subtract $100 from $120 to get $20. And $20 Π $100 = 20%.

Return on Invested Capital (ROIC)

The return on invested capital measure gives a sense of how well a company is using its money to generate returns. One way to calculate ROIC is to subtract dividends from net income and then divide that number by total capital.

Revenue

The amount a company makes for providing goods and services.

Rule #1: Don’t lose money, Rule #2: Don’t forget Rule #1

Attributed by Warren Buffett to his teacher, Benjamin Graham. The essence of Rule #1 is the idea of certainty and low risk from buying businesses, not stocks, that are wonderful and only at an attractive price—in other words, buy a dollar of value for fifty cents.

Rule of 72

A method for estimating an investment’s doubling time. The number in the title is divided by the interest percentage per period to obtain the approximate number of periods (usually years) required for doubling. A shortcut to calculating the Rule #1 Sticker Price, or value of a business.

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S

Sales Per Share

The amount of a company’s sales allocated to each share of company stock.

Scans

A screening method applying a set of criteria to reduce a set of poten­tial investments to a smaller set having specified desired characteristics.

SEC Filings

A financial statement or other formal document submitted to the U.S. Securities and Exchange Commission (SEC). Public companies, certain in­siders and broker-dealers are required to make regular SEC filings.

Sector

A group of related industries.

Sector Fund

A type of mutual fund that invests in a particular industry or sector of the economy.

Sticker Price

The value of a business, despite the selling price on the market. Rule #1 investors seek to buy businesses at 50 percent of their Sticker Price, when they are undervalued. Sticker Price is determined by performing calculations on the Four Growth Rates (see definition).

Stochastics

An indicator that compares where a security’s price closed rela­tive to its price range over a given time period. In theory, prices tend to close near their high in an upwardly trending market and closer to their low in a downward trending market.

Sustainable Growth Rate

The rate of earnings and dividend growth that can be sustained over time for a given level of return on equity, assuming a con­stant capital structure and no common stock dilution.

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T

Technical Analysis

A method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical ana­lysts do not attempt to measure a security’s intrinsic value. Technical analysts often use charts to identify patterns that can suggest future activity.

Ticker Symbol

Denotes a particular stock on an exchange. Ticker symbols for companies trading on the NYSE or Amex have three letters while companies trading on the NASDAQ have four.

Trailing Twelve Months (TTM)

Denotes that the number or metric being dis­played is for a period that equals the previous twelve months of operation.

Treasury Shares

Shares that were issued and subsequently repurchased by the company.

Trend

A direction that’s discerned by trading data.

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W

Watch List

A list of businesses that you don’t own but may wish to buy. Rule #1 investors use a Watch List to track the MOS and the Tools.

Withholding Percentage

The percentage amount of an investment that a bro­ker will hold to insulate against potential losses.

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Z

Zacks

A Chicago-based firm that provides institutional and individual investors with analytical tools and financial information. You’re likely to find financial data through outlets such as Microsoft Money, Reuters, Quicken, and Bank of America, which originated from Zacks.

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Summary
Financial Terms That Every Investor Needs to Know
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Financial Terms That Every Investor Needs to Know
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Here's a financial dictionary that decodes over 80 investment terms you need to know. From dividends to margin of safety, here's your guide to investing terms.
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Rule One Investing
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