Investing Terms – Busting the Jargon!
Investing can seem like a minefield of confusing terms and ratios to the new investor. In this post i will explain, in plain English, what some of the most commonly used terms actually mean. All of these terms can be found in the key statistics section of a share on Yahoo Finance, a great resource for share information.
Investing Term 1 – Market Capitalization (Market Cap)
The Market Cap is the total market value of a given business at any one time. It is calculated by multiplying the share price by the amount of outstanding shares (total amount of shares issued).
Business A has:
- A share price of £10
- 500,000 outstanding shares
The formula would be: £10 x 500,000 = £5,000,000 (£5 Million)
The Market Cap is useful for understanding how much the whole business would cost to buy. This is the mentality that the best investors in the world adopt, so we do to!
Investing Term 2 – Revenue (Sales)
The Revenue of a company (also known as sales) means how much money the business has generated from selling its products and / or services. This is before any of the costs have been deducted.
The Revenue will be displayed on the Income Statement of any business.
Revenue is useful when assessing the growth of a business in terms of expanding its customer reach and / or market share. A company with growing Revenue is always nice to see however there are many other factors that determine if the growth is beneficial to the business.
Investing Term 3 – Net Income
The Net Income of a business is sometimes referred to as the ‘bottom line’ or Earnings and is a very important investing metric. Net Income is the final profit after all expenses have been deducted from the revenue.
The expenses that are deducted will include:
- Operating Expenses – basically how much the business spent in order to generate its revenue.
- Interest, Tax, Depreciation & Amortization – I will forgive you for thinking this sounds like a load of nonsense! There is a special term for the earnings before these are deducted – EBITDA – which will be covered in another post.
Net Income will also be displayed on the Income Statement of any business.
Investing Term 4 – EPS
EPS stands for ‘Earnings Per Share’ this is quite simply the earnings (Net Income) of the business divided by the amount of outstanding shares.
Business A has:
- Net Income of £5,000,000 (£5 Million)
- 500,000 outstanding shares
The formula would be: £5,000,000 ÷ 500,000 = £10 per share
You can usually find the EPS in the income statement and on most financial websites. Be careful however, sometimes these are the previous years numbers and sometimes they are TTM (Trailing Twelve Months) which means the earnings per share over the previous twelve months from the day you are looking. Both of these numbers have their place, just make sure you know which you are looking at!
Investing Term 5 – P/E Ratio
P/E stands for share price ÷ earnings per share.
Business B has:
- A share price of £8
- Earnings per share of 40p
The formula would be: £8 ÷ 40p = P/E ratio of 20
The P/E ratio is a good measure of how expensive a stock is at any given time because it tells us how much investors are willing to pay for a given amount of earnings.
You can imagine that in the the above example we were actually buying the whole business, if we buy the whole company for 20x the earnings and those earnings do not grow it would take 20 years to earn our initial investment back. This is the way i like to visualize it because it gives me more of a feel for the price i would be paying.
There are 3 types of P/E ratio:
- Previous years P/E (current share price ÷ last years earnings)
- Trailing P/E (current share price ÷ trailing twelve months earnings)
- Forward P/E (current share price ÷ forecast earnings for the current year)
The P/E Ratio deserves more detail in future posts but for now you should just stick to the P/E on Yahoo Finance which is the trailing twelve months.
Investing Term 6 – Dividend
Just the word ‘dividend’ makes me smile!
A dividend is nice chunk of cash you get given by a business when it divides up its profits.
When a business has cash left over after re-investing in growth and paying down any debts etc. it may decide to give a chunk back to the owners (me and you as shareholders).
Not all businesses pay dividends, if the company is growing rapidly they will want to re-invest all of the profits to fund more growth.
The amount a business pays out as a dividend is displayed as a percentage and called a yield. This means a 5% yield pays a dividend to the value of 5% of the current share price out to shareholders.
Investing Term 7 – Shareholder Equity / Book Value
Found on the balance sheet, the shareholder equity represents the value of a business once the liabilities have been subtracted from the assets.
The easiest way to visualize this is with a house, say you own a house with a mortgage you have been paying off for 5 years. The house would be your assets and the amount you still owe on the mortgage would be your liabilities.
- Your house is worth £300,000
- You still owe £220,000 on your mortgage
So £300,000 – £220,000 leaves you with £80,000, this is the ‘shareholder equity’ in your house!
You can probably already tell that a negative number here wouldn’t be ideal! High debt is a major cause for a negative shareholder equity and i would stay well clear if that’s the case!
Investing Term 8 – Operating Cash Flow
This is funny one for new investors to get their head around, net income is not the actual amount of CASH that has come into a business….say whaaat?!
You heard right, the net income amount is made up of money that is owed in which hasn’t been received yet and also money owed out that hasn’t been paid yet as well as things like depreciation.
Operating cash flow gives us a better picture of the cash that has actually flowed in and out of a business in its day to day operations. This allows us to build a better picture of the companies financial health.
The operating cash flow can be found, not surprisingly, in the cash flow statement.
There you have it, hopefully this has helped you understand these investing terms a little bit better. I picked these because they are some of the more important and relevant investing terms. Get the basics right and you have a good foundation right?
Please don’t hesitate to leave a comment below if you have any questions or if there are any other investing terms you are confused on.
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