Smarter Investing 101: Understand Key Ratios and why the Company Stage Matters - a Lot
Demystifying Financial Ratios: A Beginner's Guide to Navigating the World of Stock Investing
Hi there
It’s an honor to be on your screen again. I hope you had a great Eastern time. Mine was filled with great food and even more sweets.
If you are new here – welcome!
My name is Michael and I believe anyone can become confident about buying stocks.
I’m on a mission to make stock evaluation as easy as picking your favorite ice cream.
At the end of 2022, I gave myself the challenge to write a program that does the hard and boring work when it comes to stocks.
Read the full story here.
Understanding Stock Ratios
Today we’ll talk about numbers. No.
No complicated calculations or formulas. We will chat about stocks, their ratios and which secrets they tell you. Ok not all, for the beginning we’ll do just one because it becomes pretty dry pretty fast. I’ll do my best to make it as juicy as possible.
Maybe you’ve heard something like P/E Ratio (Price to Earnings Ratio) or EPS (Earnings per Share).
What shares are: Imagine a company as a whole pie, and when you buy a share, you get a slice of that pie. You own a slice of that company pie. It’s yours. Just like the pie, you can do with it whatever you want. Plus, you also take part when they earn money in the future. You get some dollars of it.
You can buy more of it, or sell it.
But Michael, all I want to know is, when is a good time to buy or sell?
We will get there, but we need more context to answer it.
For now, we will keep it short and simple, so the short answer is.
It depends.
The longer answer.
There have been written storehouses full of books about that topic and it never ends.
To make the long story - when to buy vs. when to sell - shorter, here’s my takeaway after many years.
Part of it is science. Part of it is not.
It’s that simple.
Let me explain what I mean and bring the ratios back on stage.
Ratios are part of the harder science gang
If you are like me, their terminology is not always self-explanatory, let alone where, when, and how to use them.
What do these ratios do?
These numbers tell you a story - about the health of a business. Whether it’s printing money like crazy (then it’s considered healthy), or not.
Some of these numbers or ratios are more important than others. And some are completely useless, especially when you consider the phase or stage in which a company is in right now.
Why is the stage so important? When you have dinner, usually you have dessert at the end, right?
Of course, you can have your dessert right at the beginning, but when you are like me, I can’t eat that much after dessert. Yes, perhaps this might be a great way to lose weight, but that’s another story. But it’s certainly a great way to lose money.
My point is.
It’s crucial to know when these ratios tell you the right story, and when not.
Let me give you an example - explaining P/E Ratio
First, let’s break down what this mysterious P/E Ratio is all about. Imagine you’re at a carnival, and you spot a game that costs $8 to play. The game promises you’ll win a $1 prize every time you play.
You might wonder if it’s worth shelling out those 8 bucks for just a single dollar in return. Well, that’s kind of what the P/E Ratio is like!
You take the price of the share ($24 in our example) and divide it by the earnings per share within one year ($3 in our example).
So, with a P/E Ratio of 8, you’re basically investing $8 to get one dollar back in one year.
Is this a good deal?
Hold on to your carnival tickets! This is where I stumbled a lot in the past. What if these earnings are just one-time events, like spotting a unicorn at the carnival?
You’ll have to answer that question as well, and a couple more.
Importance of knowing the stage of a company
The previous example assumed that we have positive earnings. When the earnings are negative, like when you have a baby company, e.g. a start-up, the P/E ratio is completely useless, because there are almost no earnings. This company is actually losing money.
Would you give this company your money?
Probably only if you really believe in the company’s product that it will sell in the future. And voila, we left the hard science zone. We entered a zone where almost no math is applicable anymore. Welcome to the early-stage companies zone.
The only thing that really matters in this stage is your belief in the business model, the company team, and the potential market size (aka total addressable market, aka TAM). Imagine it was 2010 and the company was Tesla - that’s what early-stage looks like. A pure gamble.
Confused?
Yeah, been there.
In the beginning, I tried some ratios plus gut feeling and I failed. My approach shifted to how can I understand as much as possible with as few as-needed metrics.
Your main takeaway right now should be this
These ratios are just insignificant dots of the bigger picture. Imagine a mosaic picture. Every ratio is just one minor part of it.
Look at more than just one, to understand the full picture. Every ratio has its right to exist at the right time. Therefore, never focus on one metric.
For now, my point is this.
Just like driving a car, you have to know what you are doing, or it’s just a matter of time until you make a mistake and lose money because you literally crash. We will dive deeper into the stage topic in the next articles.
Enough for now. This should be fun to read.
Weekly update:
263 days until the end of the year.
Progress:
I’ve made huge progress on the technical side, transferring most of my usable prototype code and filling the new database with 43 years of valuable data.
Learned more about AI.
I had a session with my tutor on Support Vector Machines. Support Vector Machines, or SVMs, sound like a fancy robotic squad.
Picture this: You’re at a party, and there’s a dance-off happening between the bulls (optimistic investors) and the bears (pessimistic investors). The DJ just can’t decide what tune to play next - a bullish bop or a bearish ballad.
That’s where SVMs come in!
SVMs are like party planners who draw the perfect line between the bulls and the bears, separating them and giving the DJ a clear direction on what to play next. In technical terms, SVMs are a type of machine-learning algorithm that helps us classify and separate data into different categories.
My takeaway: I start grasping the possibilities and limitations of AI.Finished an investment course
Made some memes around stocks and posted some on Twitter. If you are on Twitter, my Twitter handle is @Economy_Rocket
Challenges:
The more you know, the more you realize how little you know and how much more there is to learn. It’s tempting to wait and make it better and bloat everything up. The big question is, where is the point where it becomes too much? Too complicated to seize it.
This is the little brother of the shiny object syndrome with some camouflage on its face.
Remind myself to stay on track and roll through it as planned. Add things if it makes sense, not just because it’s new.
Plans:
Continue to transfer the prototype.
Do my AI homework this week – last week I missed it due to too much focus on the prototype transfer and time flew by.
Visit my mom and my boys.
Decide on what I will write about next week – already done 😊
Where is my head?
I felt stressed at the beginning of last week. Mainly because of the expected problems that could arise during the code transfer. But it worked better than expected - hurra.
A great reminder that 95% of the problems we expect actually don’t happen.
That’s it for today.
See you next week.
Michael
Disclaimer:
The information in this article is my personal opinion. It is not consulting, nor does it constitute investment recommendations.
I do my research carefully and follow my personal investment strategy.
The stock market is a complex building with its own rules. They are no rules set in stone, like the rules of physics.
Therefore, use the contents of this newsletter at your own risk. Investing in the stock market can always lead to a total loss of the capital invested.