Welcome back!

After my first article, some readers told me that they didn’t know the financial terms I used. I attempted to remedy this in my second article by explaining each term before I used it, which I was told helped a lot.

But there’ll be more new terms in the future. And there’ll be readers that haven’t seen the explanation in article #2. I wanted a living document that would be the one-stop shop for all financial jargon. I also didn’t want to re-explain the terms in every article.

That brings us to today’s glossary. I’m going to be honest - it’s not the most exciting read. But it’s important to have these explanations written out. It’ll be really valuable to have as a reference for future articles. And there’s no better time than the present.

Next week we’ll be back to the interesting stuff. ASML is a doozy. I’m having a blast with all the research, and I’m excited to share. But I digress.

Let’s dive in!

Table of Contents

• Debt-to-equity ratio

• Discounted cash flow analysis (DCF)

• Earnings per share (EPS)

• Free cash flow (FCF)

• Gross margin

• Market capitalization

• Net debt

• Net income

• Net margin

• Price ratios

  • Price-to-book (P/B) ratio

  • Price-to-cash-flow (P/CF) ratio

  • Price-to-earnings (P/E) ratio

  • PE-to-growth (PEG) ratio

• Revenue

• Share price

• Stock split

Debt-to-equity ratio

The ratio of bad stuff to good stuff. I want 0 debt and infinite equity. Give me a debt-to-equity ratio of 0 any day.

But that’s not realistic. Every company will carry some debt. Obviously, we want this ratio to be as low as possible, but there’s not a consensus “good” value. A SaaS company that has basically no inventory can have a much lower DTE ratio, as compared to a company making very expensive physical products or one that needs to pay for costly factory expansions.

With any ratio, the proper usage is to compare it to other companies’ values within that same industry. That’s the only way to draw a meaningful conclusion. There’s rarely any inherent meaning to the absolute value of a ratio.

Discounted cash flow analysis (DCF)

DCF is probably the most financially technical aspect of my articles, and it can be a useful tool for having confidence in your investment decisions. I don’t use it as the driver of my investment choices, but instead as a quantitative-ish tool that acts as a double-check of my thesis. If the DCF provides projected share prices that are wildly different than my expectations, it’s an indication to look more closely at the company’s financials or my assumptions in the model.

In layman’s terms, what does the DCF do? Simply, it takes the projections for what a company will make in the future, and attempts to find the value of that in today’s dollars. Let’s consider a game:

• I roll a dice.

• Every time it shows 1-4, I get $5.

• Every time it shows 5 or 6, I lose $5.

• If I roll it 100 times, what’s my expected total value? Let’s break down the odds. There’s a two-thirds probability of the +$5 outcome, and one-thirds probability of the -$5 outcome. For a single roll, the expected value is (2/3 * 5) + (1/3 * -5) = $1.66. If I rolled 100 times, my expected total value is 100 * 1.66 = $166.

The DCF is similar to that. It’s taking the possible outcomes that could happen in the future, and adjusting them based on the likelihood that they’ll come true. If I’m extremely confident that a company is going to have 100% growth every year for the next 10 years, then its projected share price is going to be very high. (Imagine in the game if the dice only had 1-4 on it. Then I’d know that I would get paid every single roll. Expected value, very high.) But if I am not confident in the future cash flow growth, then the projected share price will be much lower, since there’s a higher probability that something could go wrong.

That should give you some context when you see the scenarios in the DCF analysis. A conservative scenario means I’m assuming the future holds less cash flow growth and less certainty; an optimistic scenario means I’m assuming the future holds more of both.

Earnings per share (EPS)

One of the most commonly measured and reported metrics in quarterly and annual calls. It’s usually the total revenue of the company, minus the cost of whatever they sold, divided by the number of shares. So why does it exist separate from revenue?

Mainly because shares and share prices exist. A lot of investors want to know what they’re getting in return for buying ownership into a company. If I pay $10 for a single share, how much earnings is the company going to generate for me? That’s EPS.

You want this number to be as high as possible.

Free cash flow (FCF)

Often considered the hardest metric to fake, which is why it’s relied on so much. Money coming in minus money spent on assets.

This can be a barometer for the health of a company.

I want this to not only be positive, but consistently growing. If it’s not growing, why not? Is there something that explains the company’s change in FCF?

This is also what I use to predict a company’s value based on future cash flow in the DCF above.

Gross margin

How much the company keeps from every product it sells. If the product costs $5 to make, and the company sells it for $10, then the gross margin is 50%.

Ideally a higher gross margin is better. But in reality, there are tradeoffs with this. You may have a product that has a 75% gross margin but only 100 units are sold a year. On the other hand, you may have a product with a 20% gross margin but 1 million units are sold a year. It’s important to understand the gross margin so you know how many units a company would need to sell to create significant revenue.

Dream scenario: a 99% gross margin that moves 1 bajillion units a year.

Like other ratios, it’s important to compare to other companies in the same industry. That way you get an idea if one company is able to produce their product more efficiently, or command a higher price.

Below, you’ll see there’s another term called “net margin”, which factors in additional expenses, and therefore is always lower than the gross margin.

Market capitalization

Market capitalization is the total value of the company’s shares. It’s the share price multiplied by the number of shares in the company. If a company is trading at $10 a share, and it has 100 shares, then its market capitalization is $1000. This is often more informative than just looking at share price, because it tells you how much a company is truly worth. It tells you how big the company is.

Consider this example: company A is trading at $30 per share while company B is trading at $900 per share. One might assume that company B is more expensive.

But company A has 10 billion shares, making its market cap $300 billion, and company B has 100 million shares, making its market cap $90 billion. Looking at market cap allows us to understand the relative size and value of companies.

Net debt

Simple - the total amount of money owed. You want this number to be as low as possible.

If a company were a person, it’d be how much they owe on their credit cards, plus how much they owe on their mortgage, plus any Venmos they hadn’t completed yet. If there’s money that you need to pay that you haven’t yet, that contributes to net debt.

Pretty simple as far as financial terms go. If a company owes less money, they’re in better financial shape.

Net income

Another simple one. It’s exactly what it sounds like. How much money a company made after all expenses are factored in.

It answers the basic question, “is this company profitable?”

If the company has a positive net income, then they’re making more money than they’re spending. That’s what we want. Nothing too tricky about it.

Net margin

Similar to gross margin, but it factors in all the costs for a company (net income divided by revenue). Net margin is always lower than gross margin. There are more expenses factored into net margin.

Let’s say a company sells a product for $10, and it costs them $5 to make, like in the gross margin example. But they need to send one of their employees to install it for every customer, and that costs them $3 per product. That means net income is $2, and net margin is 20% (compared to a gross margin of 50%).

Imagine a company that brings in billions of dollars of revenue, but their net margin is 3%. That’s an inefficient business. In spite of how much they’re selling, the business is barely profitable. That would worry me, because the slightest hiccup to sales and suddenly the business isn’t making money anymore.

I want a high net margin business so that there’s buffer in case sales are unexpectedly weak for a quarter or two.

Price ratios

Each price ratio below is a way of quantifying how much of a premium I’m paying to acquire an asset. The higher the ratios, the more of a premium I’m paying.

Consider buying a house. If I had it on good authority that a house was worth $500,000 and the seller was offering me a price of $3 million, I wouldn’t buy. But if they were offering me a price of $550,000, I’d be more inclined to buy.

You can think of P/E, P/CF and P/B as serving a similar purpose - it provides a measurement of how much above intrinsic value I have to pay.

Keep in mind, there’s no “correct” value for any of these ratios. A company with a very low P/E could be a good bargain, or it could be mismanaged and on its way to $0. A company with a very high P/E could be extremely overvalued, or it could be on the cusp of sustained growth.

Each of the ratios calculates the premium using different measurements. I’ll explain each separately.

Price-to-book (P/B) ratio

The premium based on the sum of all the company parts. If the company was being shut down today, and all its assets (e.g. printers, computers, buildings, inventory) were being sold, how much would they fetch? That sum is the book value.

Price-to-cash-flow (P/CF) ratio

Remember the free cash flow from above? That’s what this ratio uses. Which means: how much am I paying for the cash flow generated by this company?

In other words, if I pay $10 to acquire a share in this company, that’ll result in net $8 flowing into the company’s bank account, which then causes the value of the company to rise.

I want the amount I pay to generate the most cash flow possible.

Price-to-earnings (P/E) ratio

Probably the most commonly used metric to determine valuation. I think it’s useful as a comparison metric, but in some ways it’s not as relevant as it used to be.

Warren Buffet and other value investors will swear by this metric. They’ll refuse to buy a company with a high PE because that means you’re overpaying.

But in today’s world of high growth tech companies, I’m not sure that the same rules apply. There are plenty of fantastic investments that have a pretty high PE.

I find it insightful to compare the PE ratio of a company to two baselines: other companies in the same industry, and also the S&P500. The other companies in the same industry is self explanatory. The S&P comparison tells you how much of a premium you’re paying over a well-diversified portfolio of stocks. If you’re paying a huge premium to get a marginal return, then that’s a big risk. But a slight premium with high probably of significant returns, now that’s something I’d take.

PE-to-growth (PEG) ratio

The price-to-earnings-to-growth ratio incorporates the PE ratio and adjusts it for expected growth. If a company has a high PE, but is expected to grow significantly over the next few years, then the PEG will be more moderate. A company that has a share price of $20, EPS of $2, and an expected earnings growth rate of 7.5% a year will have a PEG of

(20 / 2) / 7.5 = 1.33  

The closer a PEG is to 1, the more fairly it is considered to be valued (a PEG < 1 would be considered undervalued).

Revenue

Revenue is the total amount of money that came into the company’s accounts. This is the top line income, before taxes and expenses and everything else. It just answers the question, “how much did this company sell?”

Share price

The price to own a single unit of the business. If the business is worth $100 million dollars, and it has 1 million shares, then each share is $100.

Remember that comparing share prices between two companies is not the way to understand which one has a greater total value. You’d have to look at market cap for that.

So why share price? For a couple reasons:

1. People can buy fractional ownership of a business. It’s like going into a pizzeria and buying a slice or two. Other people can buy other slices, and together the entire pizza is accounted for. It’d be impractical for every person to have to buy a full pizza every time. It’s like that for shares of a business - everyone can buy the slice of the total that they want.

2. It’s easier to conceptualize changes in the value of the business via share price. Working with numbers in the tens or hundreds of dollars is easier for everyone. Oh, Apple’s stock price went from $140 to $148? Cool. It’s more of a mouthful to say “Apple’s market cap went from 3 trillion, 278 billion, 934 million dollars to 3 trillion, 284 billion, 976 million dollars, an increase of 6 billion, 42 million dollars”. Those numbers very quickly lose meaning to the average person.

Stock split

A technique to drive down the price of an individual share of the company.

Let’s say you and your friends have a pizza and it has been cut into 8 slices. You paid for 4, James paid for 3, and Gabby paid for 1.

The pizza company enforces a 2-to-1 stock split on your pizza. Now there are 16 slices total, of which you own 8. You still own the same portion of the total pizza (50%), but you have double the number of slices and each slice has half as much pizza.

A stock split of a company is exactly that. Let’s say I own 5 shares of Amazon at $120 each. Amazon announces they’re doing a 3-to-1 stock split. I end up with 15 shares (5 that I originally had × 3 that each are split into) each valued at $40 ($120 originally / 3 that each are split into).

Total value of my shares before the split?

5 shares x $120 each = $600

Total value of my shares after the split?

15 shares x $40 each = $600

I didn’t lose or gain any money, it’s just a different way of representing what I still own.

That’s all for today. If I use new terms in my articles, I’ll come back and update this document with the latest explanations.

Thanks for reading! Next week, the fun starts again, I promise. Get excited about ASML.

Are there other terms you’d like an explanation for? Drop me a note in the comments!