For the second article of the series, I will explain the terminologies that are important in value investing. You can use this article as a glossary for later articles.
Terms Related to Price
Before finding a value stock, you have to understand what the stock price tells you. Finding a value stock is like finding a good deal on your clothes. Say you find a pair of pants you like; you like the design and the size fits you. How would you know if it's a good deal? You would be looking at the price tag and comparing it to prices of other pants you've seen. If it's on discount, you might consider buying it. Just like clothes, you have to know the price of the stock to judge whether buying the stock is a good deal or not.
The word stocks and shares are used interchangeably in the world of investment. Buying stocks mean you own the part of the company. For example, say a total of 100 shares exist for a company, and you own 5 of the shares. That means you own 5% of the company (5/100). If the company's share price is $1 per share, your share worth is $5 and the total price of the company is $100. Buying stocks means you are buying a part of company.
Market Cap is the price of a company.
Market Cap = number of shares outstanding x the price of the shares
In the example above, the company has 100 shares and each share is priced at $1, hence its market cap is $100.
Enterprise Value is a hypothetical net price of a company if you were to purchase the whole entire company.
Enterprise Value = Market Cap + Total Debt of the Company – Cash
On top of the market cap above, you will be responsible for the company’s debt if you were to purchase the entire company; however, you will also have access to the company’s cash. Hypothetically, you can buy the company at market cap, pay down company’s debt with more money and take out company’s cash to cover the cost.
Terms Related to the Balance Sheet
If you are buying a stock, you become a shareholder. You should know what part of the company you are titled to. Every company has a balance sheet which shows the company's Assets, Liabilities and Equities. The items listed on the balance sheet help value investors see what the company owns and what shareholders are entitled to.
I'll briefly explain each item one by one.
A company owns assets, which includes cash, inventory, land, buildings, machines, etc. The visible things which company owns are called tangible assets.
A company might also invisible assets including brands, patent, customer base, etc. These invisible assets are called intangible assets.
Liabilities are the items that a company owes someone (or items that the company is expected to pay for in the future).
Liabilities include debt, accounts payable, expected legal costs, etc.
Simply speaking, equity is the part where the shareholders are entitled to.
The very core concept you have to know about balance sheet is that
Asset = Liability + Equity
In other words,
Equity = Asset - Liabilities
The main idea is that if a company sold everything it owns and pays its liabilities, equity is the remaining value left which is attributed to the company's shareholders.
Terms Related to Cash Flow
Ultimately, you want the company you own to generate cash. After all, the main point of an investment is for you to see a return in the future. To do so, you have to understand how much cash the company generates.
Operating Cash Flow
Operating Cash Flow is the cash flow that is generated from the company’s business.
EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortization.
It is often used as the approximation of operating cash flow.
Capital Expenditure is basically the amount of cash that the company spends to maintain its business or grow. For example, if a company buys a new machine to expand its business, that's a capital expenditure. Companies could also spend money on research and development to improve the existing product. This is also a capital expenditure.
Free Cash Flow
Free Cash Flow is: Operating Cash Flow – Capital Expenditure
Free Cash Flow shows how much cash will be available to investors.
Using the information above, value investors determine what the price and the value of the company is. In my next article, I will demonstrate how investors use this information to find undervalued stocks.