Top 10 Investing Terms Every Serious Investor Should Know

Investing can be hard if you're really trying to understand it.

But if doesn't have to be.

You can put yourself ahead of most investors if you know the important points of analysing companies and the stock market.

By learning these basic but important points of how to invest in the share market, you would be doing your bank account a big favour.

Warren Buffett, the most successful stock market investor in the world, has said investors need to know only two topics to understand investing.

• How to value a company
• How to think about stock prices

Investing seems simple if you put it like that. Of course, it's a little more complicated than that.

Now, Buffett's statement is correct but the key to success in the stock market is in the details of these two topics.

In this editorial, we discuss the top 10 terms you need to know as a serious investor in the stock market.

#1 Intrinsic Value

The intrinsic value of a company is it's theoretical true value. It's different from the company's market capitalization on the stock market.

The intrinsic value of a company can be thought of as the value of all it's growth in profits over the course of its life.

While it's possible to calculate this, the result is not a single objective number. This is because the calculation has assumptions built into it.

Two people can calculate different intrinsic values of the same company, using the same data, just by using different assumptions about the company's future.

Thus, intrinsic value is always an estimate.

The most important thing to understand about intrinsic value is that it acts a guide for making buy and sell decisions.

If the stock price is below its intrinsic value, it could potentially be a buy. The opposite is also true. If the stock price is above its intrinsic value, it could potentially be a sell.

#2 Margin of Safety

Warren Buffett calls margin of safety, the three most important words in investing.

When the stock price its less than its intrinsic value then we say there is a margin of safety in the stock.

For example, if the stock price is Rs 80 and its intrinsic value is Rs 100, then we say that there is a 20% margin of safety in the stock for a potential buyer.

There is no margin of safety if the stock price is higher that the intrinsic value.

Margin of safety is one of the basic concepts of value investing.

#3 Valuations

A stock can be considered expensive or cheap based on how investors are valuing it in the market. This valuation is different from the stock's intrinsic value.

What's the simplest way to gauge how expensive or cheap a stock is?

The answer is the valuation ratios. The lower the ratio, the cheaper is the stock. The two most common valuation ratios are the price to earnings (PE) ratio and the price to book (PB) ratio.

The PE ratio is calculated by dividing the stock price by its earnings per share. The other way to calculate it is by dividing the marketcap by the net profit.

The PB ratio is calculated by dividing the stock price by its book value per share. The other way to calculate it is by dividing the marketcap by the total book value. The book value or net worth of a company is its total assets subtracted by its total liabilities.

The PE ratio is used for valuing asset-light companies or companies with steadily growing earnings.

The PB ratio is used for valuing asset-heavy companies or companies with flat or falling earnings. It's also used for valuing banks and financial companies.

#4 Margins

A company's profitability is usually a good indicator of its quality. The stock market likes high profit margin stocks.

These are usually companies that have strong brands or have some kind of competitive advantage within its industry.

Now a company has low margins, it doesn't necessarily mean it's a bad quality company. It's just that it's susceptible to losses if suddenly, sales were to fall or expenses were to rise.

The two margins you should know about are the operating margin i.e., the operating profit divided by sales and the net margin i.e., the net profit divided by sales.

#5 Return Ratios

The return ratios are the main determinants of business quality.

A good way to start your search for high-quality stocks, is to screen for high return ratios, like high ROE stocks in India.

The two return ratios you should know about are the return on equity (ROE) and the return on capital employed (ROCE).

Return on Equity (ROE) is one of the most important financial ratios. It tells us how well the company has used its shareholder's money to make profits.

The ROE is calculated by dividing the current year's net profit with the average shareholder's equity for that period.

Return on capital employed (ROCE) measures a company's efficiency in using its capital to generate profits. A high ROCE indicates that a company is efficient in generating profits using it's the capital it has invested in the business. These are also called high return stocks.

For financial stocks, a high return on assets (ROA) is also important.

#6 Debt to Equity

Companies often borrow funds to grow the business. There is nothing wrong about that. But things can get unpleasant if the debt levels get too high.

The leverage a company uses is an indicator of the risk in owning the stock. High debt stocks in India have a reputation of being very volatile on the Indian stock market. During market corrections, these stocks tend to fall the most.

On the other hand, debt free stocks are considered safe by most investors are usually in demand.

The debt to equity ratio is a powerful tool in your investing strategy. Make good use of it. This ratio is calculated by dividing a company's total debt (short and long term) by its equity i.e., its net worth.

Considering only those companies with a debt to equity ratio lower than 1 (ideally lower that 0.5), is a good way to filter out risky stocks.

#7 Working Capital

The working capital is the amount of funds a company needs to meet all its financial obligations within a year, i.e., the next 12 months.

It's the difference between the current assets and current liabilities of a company at any given point in time. The current assets and current liabilities can be found on the company's balance sheet.

It's a good measure of a company's liquidity, i.e., its ability to pay the bills as they come due, as well as its short term financial health.

Generally, a company should have a sufficient buffer between its current assets and current liabilities to avoid any liquidity issues.

However, a very high working capital is not always a good thing. It could be a sign that the company has too much cash in the bank without being used productively. It could also be a sign of inventory piling up and going unsold.

#8 Cash flow

If there is one thing that you should absolutely never ignore about any company, it's the cash flow.

The statement of cash flows can be found in the company's annual report. It tells you how much cash is flowing in and out of the business and how it's being used.

The cash flow from operations measures the cash generated by the business.

The cash flow from financing measures the cash raised or repaid via debt and equity.

The cash flow from investing measures the cash be invested/disinvested in the business.

Profits can be manipulated but cash cannot. Always pay attention to how a business is using its cash. It can be a decisive factor in your investing strategy.

#9 Management

At the end of the day, a business is only as good as the people who run it.

A good management can turn help turn around the fortunes of a bad or average business. More importantly, a bad management can destroy a good business.

Pay close attention to the big decisions taken by the management. Ask the following questions...

Are they investing the cash wisely? Are they taking decisions that are in the interests of shareholders? Are they taking steps to grow revenues and improve margins? What is their dividend policy? Are they transparent about the reasons for their actions?

It's never a good idea to be invested in a stock which seems to have good fundamentals if the quality of the management is suspect. The risk is too great.

#10 Dividends

Companies paying out a slice of their earnings to shareholders typically have a record of strong profits.

This gives an incentive to the company to maintain the dividend payments in the future. These stocks are also considered to be a good buffer for one's portfolio during times of market volatility.

High dividend payout stocks also have the potential for value appreciation. They can thus bring a dual benefit in the long run. This provides a good way to beat inflation.

The market likes a payout that is high and stable or a payout that is growing. Companies paying high amount of profit as dividend are called high dividend stocks.

Finally, don't ignore the dividend yield. It's the dividend per share divided by the stock price. A high dividend yield could be an indicator that the stock is undervalued.

High dividend yield stocks are perceived to be safer than low dividend yield stocks. If the market falls, these stocks will offer a higher yield to investors due to higher dividend payouts. These stocks are always scrutinised by investors as potential buying opportunities.

Happy investing.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...