The Simply Investing Dividend Podcast

EP59: Demystifying Common Investing Terms

November 22, 2023 Kanwal Sarai Season 2 Episode 59
The Simply Investing Dividend Podcast
EP59: Demystifying Common Investing Terms
Show Notes Transcript Chapter Markers

In this episode, you'll learn about the 8 most common investing terms. Successful investing begins with knowledge, understanding these investing terms is the first step to investing successfully. The following topics are covered in this episode:

- What is a Share or Stock?
- What is a dividend?
- What is dividend yield?
- What is EPS?
- What is the Payout Ratio?
- What is Long-term Debt to Equity?
- What is the P/E Ratio?
- What is the P/B Ratio?

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Speaker 1:

In this episode, we're going to cover the eight most common investing terms. Understanding these terms will help you become a better investor. Hi, my name is Kanwal Sarai and welcome to the Simply Investing Dividend Podcast. In this episode, we're going to cover the eight most common investing terms. We're going to start off number one with what is a share or a stock. Number two we're going to look at what is a dividend. Then we're going to look at what is a dividend yield. After that, we're going to look at what is EPS, or earnings per share. Then we'll look at what is the payout ratio. Then what is the long-term debt to equity ratio, what is the PE ratio? Our last topic, number eight, we're going to look at what is the PB ratio, the price to book value. Let's get started with our topic number one what is a share or a stock? The purposes of this episode and all of our episodes. When we refer to as a stock certificate or a share, it means the same thing. Sometimes you'll hear people say, well, I have 100 shares in Coca-Cola or I have stock in Coca-Cola. It means the same thing, at the end of the day, owning a stock or a share, or investing in a share or stock in a company means that it gives you ownership in a company. We're going to talk about what that means in just a minute here. First, let's go right to a quick real-life example of how do you figure out what is the price of a share or a stock today. For this example, we're going to go to Yahoo Finance, google Finance or MSN Money. Other sites like that will give you the same information. In this example we're looking at Yahoo Finance. You would type in the company name. In this example on the screen, we're looking at Coca-Cola. Or you can type in the stock symbol, which is K-O. It's going to give you this information up on the screen. There's a whole bunch of numbers there. What we're looking at right now is the stock price. As of this recording, you can see that Coca-Cola the stock price is $57.83. Let's continue with our example of Coca-Cola. The company itself today has a little over 4.3 billion shares outstanding. If you were to buy all of the shares, technically you would own the entire company. If you were only to buy 5 shares, 10 shares or 100 shares, technically you are still part owner of the company. As part owner of the company, you're entitled to share in the profits of the company. Those profits come to you in the form of a dividend. That is our next topic right now. What is a dividend? Let's take a look at this example. Let's say a company is paying a dividend of $1 per share and you own 1,000 shares. You will receive $1,000 every year for as long as you own those shares and as long as the company continues to pay the dividend. Remember, the dividend is a part of the profits that the company has made and it is now sharing those profits with the shareholders. Even if you have 1 share, or if you have 1,000 shares, you will receive dividends based on the number of shares you own. You can spend that money if you wish or you can reinvest it. The dividends get deposited directly into your stock trading account. For more information about the dividends and specifically, what happens to the dividend when the stock price goes down. Stock prices go up and down all the time and a lot of times I hear from people well, isn't the dividend going to get cut? Isn't it going to get reduced? Well, I answer all of those questions in episode 57. So if you're interested, go back and take a look at episode 57 and we answer those questions for you. For now, in today's episode we're going to move on. Here's three real life examples up on the screen as of this recording Coca-Cola has an annual dividend per share of $1.84. Nike has a dividend of $1.36 and Walmart has a dividend of $2.28. So that just gives you an idea of the type of dividends that companies are paying. Now, some companies don't pay a dividend at all, and some of them pay higher dividends. Some of them pay less dividends. So I just wanted to give you three quick examples up on the screen. Now let's move on to our next topic what is dividend yield? So this is important to know as an investor, and so the dividend yield is quite simply the dividend, the annual dividend, divided by the share price or the stock price. Right, it means the same thing. So if we take a look at this example, let's say the company is paying a dividend of $1 per share and the share price today happens to be $20. So we simply take one divided by 20 and we want to express that as a percentage. You can see that it's 5%. So in this example, the share price is $20, the dividend is $1 per share. The dividend yield is going to be 5%. Now let's take a look a little bit more deeper into what this means. So if you are going to invest $20,000 today in this company now remember the share price is $20 each you're going to be able to buy a thousand shares. So if we take a thousand shares, multiply it by the dividend, which is $1, you can see that in this example, you're going to earn $1,000 every single year. Again, as long as the dividend is $1 and as long as the company continues to pay the dividend and as long as you continue to own those 1,000 shares, so you'll get $1,000. But a quicker way to calculate this is to use the dividend yield. So, remember I said in this example you're going to invest $20,000. So what we can do is we can take 5% of $20,000 and you can see that it's $1,000. So at the end of the day, we end up with the same number, which is how much dividends will you receive each year? So the dividend yield is the return on your investment while you hold on to your shares, regardless of stock price. It is the return on your investment while you hold on to those shares. So that's the dividend yield and that's why it's so important. Now let's take a look at two companies, company A and company B. So in this example, company A has a dividend yield of 5% and company B has a dividend yield of 0.2%. So it's a lot smaller. All things considered equal. Which company is going to be a better investment? So if you said company A, you would be right. Why? Because the dividend yield is much higher. You're going to get much more in dividends the return on your investment with company A. Then you are going to get with company B. Now I mentioned before some companies don't even pay a dividend. So if they don't pay a dividend, the yield is going to be 0%. So there is no return on your investment while you hold on to your shares. When a company doesn't pay a dividend, the only thing then you have to hope for is for the stock price to keep going up, or hope that the stock price will be up when it comes time for you to sell those shares. So with dividends, we get paid regardless of what happens to the stock price. So I'm going to keep coming back to this example throughout the rest of this episode. We're going to compare company A versus company B. So just looking at the dividend yield, all things considered equal, company A is a better investment, company B we would not want to invest in. So if you wouldn't buy company B today or invest in company B today, then why would you invest in it through a mutual fund, an index fund or an ETF? Because those funds invest in hundreds of companies or thousands of companies, and not all of those companies are paying a reasonable dividend yield and not all of those companies pay dividends. So, as dividend investors, it's not in our benefit to invest in mutual funds, index funds or ETFs, because we want to be able to pick and choose which companies we want to invest in. And it's not rocket science, it's not that difficult. I've got over 58 episodes. If you go back and watch them all, you can see that it is not very difficult at all when it comes to selecting dividend stocks, and I'm going to help you with that later on towards the end of this episode to show you how easy it is to pick good quality stocks. So for now, let's move on to our next topic in this episode what is the EPS? So EPS stands for earnings per share. Basically, it's the amount of money that a company makes every year or every quarter. Another way to say this is the amount of profit that a company is making. So those are the earnings. So let's take a quick look at an example of company ABC. Let's say this company earned $250 million last year and let's say the company has a hundred million shares outstanding. Well, we simply take the earnings and divide it by the number of shares. So $250 million divided by a hundred million shares, and you can see that this company has an earnings per share of $2.50. So that gives you an idea of how much money the company made, based on how many shares they have, because it's per share. So the good thing is you don't need to calculate this number yourself. It's already done for you. And for this we're going to go back to our example of Yahoo Finance. We're going to go back to our example of Coca-Cola. So, like I said before, you would go to the website, type in the company name or the stock symbol, which is KO, and if you look right here you can see it says EPS, earnings Per Share. So, as of this recording, coca-cola has an earnings per share of $2.47. Now let's take a look at an example here, a real life example. We're going to look at two different companies and we're going to look at their 30 year history of earnings. So let's start with our first example, the United Health Group. And remember, this is going back 30 years, and so you can see the graph up on the screen and you can see that the line the earnings have grown. The earnings have increased over the last 30 years. Now there is a small dip I see one, two, three dips In the last 30 years which is a very impressive track record. So we see three small little dips, but then after that the earnings keep going up, and so the 30 year trend is for the earnings to keep increasing and going up. Looking at this graph, it gives us a high degree of confidence that this company will hopefully earn more money next year and the year after that and the year after that, cause for the last 30 years they've done a really good job at growing their earnings. Now if we look at another company and here we're going to look at Nokia you can see that the earnings are all over the place. The earnings go up then they go down, and they go up a little bit then they go down. Here you can see examples of where the company actually lost money. This is where the earnings were negative. So we can see that in a couple of places in the graph where the earnings went below zero. So the company actually lost money. Looking at this graph, this 30 year graph, it doesn't give us a high degree of confidence that this company is going to have positive earnings next year or negative earnings next year, we really don't know. Now let's take a look at them side by side. So you've got United Health Group on left, you've got Nokia on the right, and this is just to show you the difference in earnings and earnings growth over time. So, all things considered equal, and assuming we were just looking at company A and B and they were in the same industry, you would not want to invest in company B on the right-hand side let's say Nokia in this example because the earnings are erratic, whereas United Health Group on the left I'll call it company A the earnings have gone up consistently. So if you would not invest in a company with erratic earnings, then why would you invest in that company inside of a mutual fund, index fund or an ETF? Right? Like I said before, these funds have hundreds or thousands of companies within the fund and not all of those companies have consistent earnings growth. Some of those companies are gonna have erratic earnings, and so those are companies we want to avoid. Okay, so let's move on to our next topic, the payout ratio. So what exactly is the payout ratio? And it's really simple. It's the dividend, the annual dividend, divided by the earnings per share. And we just looked at the earnings per share, so you already know what that means. So let's take a look at a quick example here. Let's say the dividend is $1 per share and the company has earnings of $5 per share. So we're gonna take one divided by five, we're gonna express that as a percentage and you can see that it's 20%. So what does this mean? When we look at this, it's telling you that 20% of what the company earned its profits in this example, $5, 20% of that was returned to the shareholders, was distributed to the shareholders. So the company made $5 per share, but they returned $1 per share to the shareholders as a dividend. The rest of the money the company kept and reinvested it back into the business to grow the business. So this is a good payout ratio. When we look at it or look at other companies, we always wanna look at companies that have a payout ratio of 75% or less. So 20% is really good. This means that the company can increase its dividend next year and the year after that and the year after that, and it'll be fine. So the dividend in this example is $1. The company may increase it to $1.15, $1.20, even $2 a share and it would be fine. So that is why the payout ratio is important. Now let's take a look at again company A. So we've just shown you it's 20%. Let's take a look at company B. Company B only earned $1.14 last year, but they paid a dividend of $2 to the shareholders. So this doesn't make any sense. The payout ratio is 175%. Where did they get the money to pay the shareholders? Because the earnings were less than what the dividend was. So in this example, the company probably borrowed money from someplace else to be able to pay the shareholders. So that's not good. When we look at company B and we look at the payout ratio, this company most likely will have to either reduce the dividend or eliminate the dividend, or it has to grow its earnings. It has to more than double its earnings just to be able to afford to pay the shareholders. So company B is a lot more riskier as an investment. So, all things considered equal, we would not invest in company B. Now, for those of you that are interested and want more information on the payout ratio, I have an entire episode dedicated to the payout ratio, and that's episode two, so I recommend you go ahead and watch that. Okay, we're gonna go back to our comparison page that we saw before. We're looking at company A and company B, so we've already looked at the payout ratio. Company A has a healthy payout ratio of 20%. Company B the payout ratio is too high. It's 175%. Most likely they're gonna have to cut the dividend. I would not invest in company B, and because I wouldn't invest in company B as an individual investor, why would I buy or invest in company B through a mutual fund, an index fund or an ETF? Because those funds again, I'm repeating myself but those funds own hundreds or thousands of companies and not all of those companies are gonna have a payout ratio of less than 75%. Okay, let's move on to our next topic what is the long-term debt-to-equity ratio? The long-term debt-to-equity ratio is simply the long-term debt divided by the shareholder equity, so we're not gonna get into details here. I'm gonna leave that for a future episode. So the only thing you need to know here is once you've either calculated this value or have gotten this value. We have that in the Simply Investing Platform for over 6,000 companies you can see here. Let's take a look at company A and company B, and again, this isn't rocket science. If we look at company A, its debt is sitting at 5%, the long-term debt-to-equity ratio 5%. Company B is sitting at 800%. So which company would you invest in? Again, all things considered equal, company B is much more riskier investment because when the market crashes or interest rates go high or we end up in a recession, company B is gonna have a very hard time paying off its debt because its interest payments are going to go up. It's carrying so much debt. It's going to have a hard time paying off its creditors, and that is a risk we don't want to take as investors. So company B is to be avoided. So now I'm going to go back to the comparison slide which I mentioned to you before. We're going to do that after every section here. So now we look at company A has a debt of 5%. Company B has a debt of 800%, and you already know what I'm going to say here. If you would not invest in company B today individually in its stock, then why would you invest in company B through a mutual fund, index fund or an ETF? We wouldn't do that right. Because, again, those funds are buying hundreds and thousands of companies within the fund. Not all of those companies are going to have a debt of less than 70% and we only look at those companies. Any company with a debt of more than 70%, we don't invest in it, we skip it, we move on to something else. Okay, let's move on to our second to last topic. What is the PE ratio? And so the PE ratio I cover in detail. I have an entire episode dedicated to the PE ratio. If anybody's interested, go ahead and watch episode 32. We're going to cover it here briefly. The PE ratio is simply the share price divided by the earnings per share. So let's say the share price is $50 and the company has an earnings per share of $2.50. If we divide 50 divided by 2.5, we can see that it's 20. So the PE is 20. What this means is that to buy one share in this company, you are paying 20 times what the company earned. So in this case, the company earned $2.50,. Multiply that by 20, we end up with the share price, which is $50. So how do we use the PE ratio? It's simple. We're going to look at two examples here. Let's say company A and company B. Company A has a share price of $50. Company B has a much higher share price of $375 each. Both companies have the same earnings, which is $2.50 per share, and you can see, you can calculate it. The PE for company A is 20. The PE for company B is 150. So, right there, just looking at the PE ratio, let's say we didn't have any access to the share price, we didn't have access to the EPS. Just looking at the PE ratio, you can already tell that company B is more expensive. The shares are more expensive. Now, when we invest, we look at a PE ratio of 25 or less. So you can see that company B is going to be very expensive. Now let me show you that as an example here. Let's you know. As an example, let's give a dividend of $2 per share for both company A and B. So the dividend is the same, the earnings are the same, but the PE ratio is a huge difference. So if you were to invest $25,000 today in company A, you'd be able to buy 500 shares In company B, you'd only be able to buy 66 shares because the share price is so high, and company A would give you $1,000 a year in dividends. Company B would only give you $133 a year in dividends. So that is a huge difference in dividend income. So the PE ratio is a good indicator of are you paying too much for a company? And we don't want to pay too much for a company, right that's. The company is overvalued, it's priced too high. So in this example, I would not invest in company B. You wouldn't invest in company B. But then why would you invest in it within a mutual fund and an index fund or an ETF? Because, again, they have thousands of companies in those funds. Not all of those companies are gonna have a PE ratio of 25 or less. Now the good news is you don't need to calculate the PE ratio yourself. It's readily available. We're gonna jump back to our Yahoo Finance example. Again, we're looking at Coca-Cola. If you look right here, you can see the PE ratio as of this recording for Coca-Cola is $23.42. Okay, so that is the PE ratio of 23.42. Okay, so I'm not gonna repeat any more here. We're back to our comparison page company A or company B, and so far things are not looking too good for company B. So let's move on to our last and final topic in this episode, which is what is the PE ratio. So PE ratio stands for price to book ratio. If anyone is interested, we have an entire episode dedicated to the PE ratio and that's episode 52. I highly recommend you go back and watch that episode. So we're gonna cover it here briefly. The PE ratio is simply the share price divided by the book value per share. So let's take a look at the book value per share. It is simply the company's assets minus its liabilities, everything that a company owns minus what it owes to the creditors. So think about, if we think about, a large company, let's say AT&T. They have lots of office space, they have a lot of buildings, real estate, they own vehicles, trucks, vans, they own a lot of equipment, a lot of hardware, computers, furniture, everything. So if the company was to go out of business and they sold everything that they own and they paid off all of their loans and liabilities and creditors, whatever would be left would be the book value, and what we're interested in is the book value per share. So in this example, let's say, a company has assets of $10 million, has liabilities of $3 million. So we take 10 minus three, we can see that the book value is $7 million. Now we're gonna divide that by the number of shares. So let's say the company has 3.5 million shares outstanding. In this example the company would have a book value per share of $2. So now we go back to our original formula for the PB ratio, which is share price divided by book value per share. So let's say the share price is today $15 a share and the book value we just calculated was $2 per share. So 15 divided by two is 7.5. It's a little high. Normally we look for companies with a PB ratio of three or less, but in this example, at 7.5, it means that to buy one share you are paying 7.5 times the book value of this company. So if we're gonna compare company A and company B, I'm gonna give you a different example. Still stick with company A and B, but the dividend, let's say, is $2.50. Let's say the debt we looked at already is 5% versus 800. The book value per share in this example is gonna be the same $18 for company A, $18 for company B. But you can see that the PB ratio. When you calculate it is different. So company A has a PB ratio of two. Company B has a PB ratio of 11. And that is going to. Also. You can reverse engineer the numbers and you can see that the share price for company A is $37. The share price for company B is $198. So what does that mean? If you had $25,000 to invest in each of these companies? In company A, you'd be able to buy 675 shares. In company B, you'd only be able to afford 126 shares. So you're going to be able to buy less shares in company B because the share price is so high, and when you buy less shares you get less dividends. So in company A they would pay you, in this example, $1,687 in dividends every year. Company B would only pay you $315 in dividends every year. Now in this example we were assuming a $25,000 investment in company A or in company B. But look at how little dividends you're going to get in company B. So the price to book ratio is a very quick way just to look at it and approximate that. The company is probably priced too high when the PB ratio is very high, and so that's why we tend to stick with companies that have a PB ratio of three or less. Again, the good news you don't need to calculate the PB ratio, it's readily available. We're going to jump back to Yahoo Finance. This time you got to click on stats and then, when you look down, you can see in this example, coca-cola. As of this, recording the price to book number, the ratio is 9.31. Okay, so now we are at our last sort of slide in this topic area. We're comparing again company A versus company B. Company A has a PB ratio of two. Company B has a PB ratio of 11, a very high number of 11. Just based on that alone, I would not invest in company B, and neither should you. Now, if we put everything together, we can see that company B is a very risky investment. First of all, the dividend yield is very low, so you're not getting a good return on your investment. The payout ratio is way too high. They're going to probably have to cut their dividend. The debt is so high that if we end up in a recession or a market downturn, the company is going to struggle to pay its creditors. The PE ratio is so high that you can't buy that many shares, and the PB ratio is so high that, again, you can't buy that many shares, so you're going to get less than dividends. So company B is not a good investment and we would not invest in company B. And if we wouldn't invest in company B individually, as an individual investor, why would you invest in company B through a mutual fund or an index fund or an ETF? You shouldn't. But those funds have hundreds of companies Some of them have thousands of companies in those funds and they will inadvertently end up investing your money. If you were to invest in index funds, mutual funds or ETFs, they will take your money and invest it into companies that have a very high payout ratio, that have a very high debt or a high PE ratio or a high PB ratio. They might not have all of these numbers being high, but some of them might be higher than the other numbers. So the way we look at it and I'm going to show you just in a couple of minutes here if a company violates even one of the rules and for example I said the PE ratio has to be 25 or less If a company violates that rule, we don't invest in it. We skip it, even if the debt is low and the PB is low and the payout ratio is low. But if it fails the PE value, which is 25 or less, then we don't invest in it and we move on. So now, does this mean that, after watching this far, that you're ready to go out and invest directly into stocks? And the answer is not just yet. This is a great start, but there's a few more things to consider, and I'm going to show you what they are right now. So our approach to investing is to invest safely and reliably, and the way we do that is we invest in quality dividend stocks when they're priced low. Not just any stock has to be a quality stock and not just at any price. It has to be priced low. So how do you know, when you're looking at a company or when you're looking at a stock, if it's a quality stock and if it's priced low? So for that I created what I call the 12 rules of simply investing, and they're up on the screen right now. If you're listening to the audio version. I'm going to go through them right now. So the way this works is this is your checklist A company has to pass all of the 12 rules for you to invest in it. Even if there's one failure, then you skip it, move on to something else. So rule number one do you understand how the company is making money? If you don't skip it, move on to something else. Rule number two 20 years from now, will people still need its products and services? Rule number three does the company have a low cost competitive advantage? Rule number four is the company recession proof? Rule number five is it profitable? Rule number six does the company grow the dividend? Rule number seven can it afford to pay the dividend? And so we covered that in today's episode. That's the payout ratio we are going to look at. Rule number seven is to look at the payout ratio and make sure it's 75% or less. If it's not, skip it, move on to something else. Rule number eight is the debt less than 70%. So we covered that as well today. That's the long-term debt to equity ratio. Rule number nine avoid any company with a recent dividend cut. Rule number 10, does it buy back its own shares? Rule number 11 is the stock priced low. So there's three pieces to rule number 11. Piece number one is to look at the PE ratio, and we covered that in today's episode. So make sure it's 25 or less. The second piece we look at the current dividend yield and we compare it to the company's 20 year average dividend yield, want to make sure the current yield is higher than its average. And piece number three, as part of rule number 11, is we look at the PB ratio, the price to book value, and we covered that in today's episode as well. So we want to make sure it's three or less. And rule number 12, keep your emotions out of investing. So this checklist is going to make it very simple, very easy to identify which stocks to consider for investing and which ones to avoid. And that's the biggest piece in the puzzle. That's missing is a lot of people are fearful and afraid of selecting individual stocks on their own. So then they go ahead and put all their money into mutual funds, index funds or ETFs and, as we've seen in today's episode, that might not be the best approach because a lot of those companies will not pass the 12 rules of simply investing. So for those of you that are interested in learning more about the simply investing rules, I've created the online self-paced simply investing course. It's a video course. It's in 10 modules. Module one we talked about the investing basics. Module two I covered the 12 rules in detail. Module three we apply the 12 rules. I show you how to do that using a Google Sheet. Module number four using the simply investing platform. Module five placing your first stock order, step by step. I'm going to show you how to do that. Next module is building and tracking your portfolio. Next module is learning when to sell, which is just as important as knowing when to buy. The next module is reducing your fees and risk, especially when it comes to mutual funds, index funds and ETFs. Module nine is your action plan to get started right away. And module 10, I answer your most frequently asked questions. For anyone that's interested, we do have the simply investing platform. I took two years to build. It is a web application that applies these rules to over 6,000 companies in the US and in Canada every single day and that's going to tell you which. It's going to show you which stocks to consider and which ones to avoid, because it shows you which rules which companies pass and which rules the companies fail. If you're interested, you may want to write down the coupon code save 10 SAVE10. It's going to save you 10% off of our simply investing course and the platform. If you enjoyed today's episode. Be sure to hit the subscribe button. Hit the like button as well. We have new episode out every week and for more information, take a look at our website simplyinvestingcom. Thanks for watching.

Understanding Investing Terms and Dividends
Comparing Earnings and Payout Ratio
Analyzing Company a and Company B
Company Valuation and Investment Risk