What is a cash flow?

Cash flow is the specification of cash being received and spent by a company during a defined period of time. Cash flow can be tied to a specific project.

Entire cash flow for the given period is characterized by two parameters:

- direction (cash is received or spent) and

- the type of activities (operating, investing, financing).

Those two parameters are independent. Take a look at the following table:

Activity/Cash direction	Cash received	Cash spent
Operating	Cash received from the operating activity, meaning cash that core business generates. For example: the company sold 100 pizzas for 4$ each yielding 400$ of cash from operating activities	Cash spent on operating activites, meaning cash spent on items necessary to make a product. For example: the company spent 350$ on flower, catchup, etc.
Investing	Cash received by selling assets that produce income.	Cash spent by purchasing assets that produce income.
Financing	Cash received from financing activity such as issuance of own stock, borrowing (bonds, notes, mortgages, etc.)	Cash spent on financing activity such as paying dividends to stockholders, repaying principal amounts borrowed, repurchasing business' own stock.

Cash received from the operating activity minus cash spent on operating activity yields NET CASH FROM OPERATING ACTIVITIES.

Cash received from the investing activity minus cash spent on investing activity yields NET CASH FROM INVESTING ACTIVITIES.

Cash received from the financing activity minus cash spent on financing activity yields NET CASH FROM FINANCING ACTIVITIES.

The sum of those three net cash amounts yields NET (DECREASE)/INCREASE IN CASH AND CASH EQUIVALENTS.

Analyzing cash flow, it is possible to find out how a company earns, and where it spends the money. Does company invest or not, does company borrows a lot, etc.

Every change on account of a company falls in one of the following category:

1) Investing activities income (II) - a large number usually means that a lot of equipment is has been sold.

2) Investing activities outcome (IO) - a large number usually means that a lot of equipment is has been bought.

3) Financing activities income (FI) - a large number usually means that a lot of money has been borrowed.

4) Financing activities outcome (FO) - a large number usually means that a lot of money has been returned to the banks.

5) Operating activities income (OI) - a large number usually means that a lot products has been sold.

6) Operating activities outcome (OO) - a large number usually means that production costs a lot.

It is useless to consider each of these parameters alone. Those parameters make sense only in correlation with other parameters and their historical perspective.

If there is a large amount in the IO category, that means that company invested in that period a lot of money into equipment and machinery, and that is a good indicator.

If OI is less than OO that means that company cannot cover the production cost with income from operation, and that is a bad sign.

IF FI is a large amount, that means that company borrowed the money (loan from bank, issuing more stock, ...). That can be a bad sign, for example when OI is then less then OO.

Another important factor is historical perspective. If the company is getting more and more loans, and less and less income from the operating activities (core business), that is a very bad sign.

Net decrease/increase in cash and cash equivalents is sum of all cash inputs minus the sum of all outputs. If there is an increase in cash and cash equivalents that is good if it is mainly from the operating activities. That means that company uses day to day cash income to cover investing. If there is a decrease in cash and cash equivalents that is a bad sign if income from the operating activities is going down (historically).

Can a pessimist be a good investor?

If you think that money has nothing to do with personality, you are very wrong. How do you feel when your next paycheck is coming the next Friday, you have a few dollars in your pocket and your bills are to be paid tomorrow. Probably not very good. Key here is to identify emotions involved and to learn how to deal with them.

In order to be a successful investor you should have a plan, and to follow it. If it is absolutely necessary, you can change your plan, but not before that, and certainly you should not act without consulting your plan. Why you should be so rigid? The answer is simple, there are two very powerful emotions involved in investing: greed and fear. Depending on situation, those two emotions could have different intensity. Your reaction in a certain situation, is primarily based on your personality and not your IQ nor education. For example, imagine a fearful person that faces dangerous situation (stock prices are going down) could feel a great fear and to decide to escape. Usually, in the moment where prices are starting to going up again. A greedy person on the other hand, could decide to buy some share only because its price is going up, because his colleague said he earned a lot on that share. You can imagine the result. What is common with this two stories? Not having a plan, or not following the plan.

There are a loot of fun and not so fun test for greed and fear, but how is that related to pessimism, optimism and other -isms? You could figure it out on your own. Pessimists basically thinks that the things are in worse case then they really are, and that basically leads to selling things (shares) cheaper than necessary. Optimists, on the other hand, are willing to pay to much for something. If you are, god forbid, a lazybones then you would probably be guided with greed (money for nothing). You can imagine any personal trait and relate it to the greed and fear and to determine what effect it will have on you. That guesswork doesn't necessarily lead to perfect insight but is certainly a good way to understand yourself.

If this is to much introspection for you, you could try this. Subscribe to some virtual portfolio manager were you have option to play the game of investing in stocks with virtual money (use google and find what you prefer), and start playing. Refrain form any real investment for at least 6 months. You will notice how emotions are driving you from greed to fear and panic. You can use margins (meaning to borrow money form your virtual broker) to intensify your emotions. I think this is a great (and free) way to find out something about your self. You will certainly be surprised. Have fun!

What skills do you need to be rich?

It might be obvious, but you should have some math skills. First of all you should know the for basic operations and how to deal with the percentages. Of course, you need to know to read and write. "Hey, I am not a moron!" you probably think, but having this skills is a must. Why? Look at this situation: you want to buy XY-Cola and you find that you can get A) one pack with six cans for 10$ or B) one pack with 8 cans for 12$. Which one should you buy? The point here is to determine how much a single can costs. For A) that is 10$/6 and for B) it is 12$/8. And what now? You should compare the numbers 10/6 and 12/8 with some help of calculator you can find that in the first case the cost of a single can is 1.66$ and in the second case it is 1.5$. That means that the second offer is better.

What does it have in common with being rich? First of all, in order to be rich you must live frugally, therefore you should buy only products with the best price available. To do this you should deal with the process of comparison on the fly. Do you go to shopping with paper, pen and calculator? Probably not. Although it might not looks like that, the same process and skill are used in the process of investing. You should invest only in the best opportunities, or to say it the terms of price you should buy only the best investment opportunities.

The next step is to compare two investment opportunities (or more of them). There are basically several parameters involved. The main parameter is Return rate and it means how much return will I get after certain period of time (usually after one year). It is usually calculated as a percentage of the invested amount. The greater percentage means better results. For example, Return rate of 10% means that if you invest 1000$, after one year you will have 1000$+1000$*10%=1100$. It is also important to know how risky is a certain investment. This parameter can be also calculated an is usually called the risk (quite obvious, isn't it). Risk or volatility is calculated as a Standard deviation of Price history. Standard deviation is a measure of how far are the members of the sample from the average of the sample. More about Standard deviation you can find on http://en.wikipedia.org/wiki/Standard_deviation. It might look horrible, but you can calculate it quickly using some spreadsheet program. We can look at this four samples {0,0,10,10}, {9,9,1,1}, {6,4,4,6} and {5,5,5,5}. The average for all of them is 5. Standard deviations are
5.77, 4.62, 1.15 and 0. We can see that in the first sample value can change a lot and that it carries the highest risk. The fourth sample doesn't carry any risk (value is always 5). Therefore the smaller Standard deviation the better. There is a theory that helps us to create the most efficient portfolio (meaning the best return rate and minimal risk). For now we can say that if we have have to choose between two investment opportunities with the same return rate, we will select the one with smaller risk (i.e. Standard deviation)

It is mentioned above that using a spreadsheet program can help a lot. That means that some kind of Computer skills are necessary. It is not necessary to be a programmer in NASA. Basic level of computer knowledge is enough with some knowledge about spreadsheet programs (MS Excel, Open office Calc, or some something else).

Also you will need and access to the Internet, and have some Internet skills. Expert knowledge is not required, just surfing and searching the net.

An that would be all for the beginning.

How to assess financial state of a company?

The same way you assess your financial state. First you need to know what are your assets? Probably the answer would be, a house, a car, ... Everything you own has some value. If you add up those numbers you will get Total assets, but your mortgage will certainly pop up in your mind. Thats right, you need to know what are your liabilities? Probably mortgage, car payment... Add up all those numbers and you will get total liabilities. If you subtract total liabilities from the total assets you will get total equity.

That's nice but where is my salary and other income? If you add up all payments that you have received in a certain period, you will get total income for that period, also called revenue. You have probably noticed that you cannot spend all that money. First you should set aside money for mortgages, taxes, car payment, ... If you add up those numbers you will get Total Expenses. If you subtract Total Expenses from Revenue you will get Net income. That income you can spend on food, clothing, vacation, ...

If you want to assess financial state of a company, you should use the same method. Total liabilities and Total assets are found in Balance sheet of the company, while information about income and outcome is found in the Income statement. You can find all those data on the http://www.sec.gov.
Balance sheet carries information about worth of the company on a certain date. In Income statement you can find information about income and outcome for a certain period of time. To fully assess the financial state of a company you should compare all those figures in a time line perspective: Is profit increasing or decreasing? Are total assets rising or not. Also you should compare all these parameters to other companies from the same industry.

What are good signals?
- Increasing revenue -- meaning more money
- Decreasing expenses -- optimization of the production process (with less you can achieve the same or even more)
- Increasing Total assets -- more money for each shareholder
- Decreasing Total liabilities -- less money for debts
- Log term liabilities increase over Short term liabilities -- Long term liabilities are usually less expensive than Short term liabilities

What are bad signals?
The opposite of good signals.
- Decreasing revenue -- meaning less money
- Increasing expenses -- you need more to produce the same
- Decreasing Total assets -- Less money for each shareholder
- Increasing Total liabilities -- More money for debts
- Log term liabilities Decrease over Short term liabilities -- Long term liabilities are usually less expensive than Short term liabilities

Will I become rich?

First of all, what does it mean to be rich? Being rich means that you have assets that produces enough income for maintaining a lifestyle you want indefinitely and without you having to work. What does it mean in your case? You should figure it out. Nobody can do this for you, because being rich depends on the lifestyle you would like to have.

Suppose that you would like to have a lifestyle taking 75000$ per year. Assumption is that 75000$ include all your costs: mortgage, food, clothing, vacation, food for pets, books, dinners, CDs, concerts, computers, ipods, ... If you don't eat and you live on the streets this figure is much smaller. The next step is to calculate how much assets you should have in order to get this 75000$ per year. We could be moderately optimistic saying that on average stock market returns 10% per year. You should also consider that your assets are subject to inflation, and that you should guard your assets. Suppose that 2.5% annually is sufficient. This means that in ten years from today $100 000 dollars will worth less. For example, 1$ in 1850 worth about 25$ in 2007.

Let's return to our calculation. If an average stock market returns are 10% and if average inflation ratio is about 2.5% then you would have remaining 7.5% for maintaining your life style. You can now calculate the value of necessary assets like this 75000$/7.5% which is equal to 75000/(7.5/100) which yields one million. If you have return rate of Warren Buffet (around 30%) then you would need 200,000$ in assets.

It is necessary to underline that by assets I mean things that produces some kind of return-profit. For example, your house/apartment probably doesn't produce any income. Your house usually produces outcome (taxes, mortgages). Also, in this calculation there are no debts.

So, will I become rich? If you are very frugal and have a modest lifestyle the answer is probably yes but in your sixties. If you start earlier with investing you could achieve this earlier. If you earn more then an average person does, you could also achieve this earlier.

What is Forex trading?

Forex is short for "Foreign Exchange". Refers to the Foreign Exchange trading. Consider two following currencies USD and EUR. Suppose that at the first moment we have 1000 EUR, and 1000 EUR worths 1000 USD. Suppose that we convert EUR to the USD. After a certain period of time, 1000 USD worth 1200 EUR. If we convert USD to EUR, we have 1200 UER and profit of 200 EUR. However, if after a certain period of time, 1000 USD worth 800 EUR and we convert our money we will have 800 EUR and loss of 200 EUR.

Forex market is very liquid meaning that you will probably be able to buy or sell whatever you want to sell at any time. Also, you can use very high margins. On the other side, there are several currencies that are traded activly (USD, EUR, JPY, CHF, GBP). Using high margins you can acquire a gigantic loss as well as gigantic profits.

It is hard to predict what is going on the Forex market. Of course, that stands for any market, but it is especially true for foreign exchange. The main reason is that investor should observe macroeconomics, politics, warfare on the Middle East, etc. For example a certain statement of the Chairman of the United States Federal Reserves can move USD up or down unexpectedly.

Picking stocks in details

In post http://gtdinvest.blogspot.com/2007/10/picking-stocks.html I stated what should an investor look for. First of all an investor should make an investment plan, specifying how much he is going to invest per year, how long will he will invest and what return rate he expects. With these parameters, an investor should make an outline of his portfolio specifying industries to invest in. An investor could be a little emotional with this by excluding certain industries, but he mustn't be to emotional and exclude all but one (or two) industries. Also, an investor should have at least 30 different assets in his portfolio. The rationale for this is the reduction of risk. If one asset goes to zero (which is very unlikely), than an investor still have the remaining 97% of his investment. This means that in process of picking stocks an investor should first look at his portfolio and investment plan, and then to select a certain industry to invest in.

When a certain industry is selected, then an investor should select different stocks (the more of them the better) and to compare them one by one. In that process, favorites will emerge. How could we compare two different companies? There are a lot of parameters that one could take into account: EPS, P/E, PEG, P/S, P/B, Dividend Payout Ratio, Dividend Yield, Book Value, Return on Equity. The history of these parameters are also very interesting. Let's discus each one of them.


Earnings

Earnings is the after tax net income that company produces during a certain period (usually a quarter which is three months, or a year). This is a widely used indicator. Usually is compared to the prognosis of the management and independent analysts. Surpassing the prognosis significantly usually drives price up and vice versa. To summarize, earnings should be compared to the estimates of the management and the independent analysts. Comparing earnings with earnings of some other company doesn't mean anything. Big companies will have large earnings while small companies will have small earnings.

EPS - Earnings per Share

In order to somehow relate one company with another EPS is devised and is calculated as Net Earnings/Number of shares outstanding. Now we can see how much money each share generates. Greater EPS is better. EPS can be observed for different period of time, previous year, current year and the following year. In the first case, it is the actual data, while in other two cases it is a prognosis. The problem with EPS is in the fact that a company could generate the same amount of money with much less capital being more efficient and a better opportunity for buying. A good indicator for possible buying is the raising of EPS. An investor should be careful with earnings because that parameter could be "tuned up". As number of shares outstanding can differ from time to time, the weighted average number of shares could be used. For example if there were 1000 shares for the first nine months, and 2000 shares for the remaining three, average number of shares can be calculated as 1000x(9/12)+2000x(3/12) and that yields average number of shares 1250.


P/E - Price to Earnings Ratio

As mentioned above two companies cannot be compared neither using Earnings nor Earnings per Share. Let's say that the companies A and B have the same value 10,000$ and the same earnings 1,000$ and that company A has 10 shares and company B has 100 shares. That would give that EPS for the company A is equal 100 and for the company Bis equal to 10. We can see that although companies have the same value, EPS can differ a lot. That is the reason for introducing the Price to Earnings ratio as (Price per share)/(Earnings per share). Price to earnings ratio is usually labeled with P/E, and sometimes is called "earnings multiple" or just "multiple". The meaning of this parameter is how much do you pay for a single dollar of earning.

Let's look at the previous example. Company A has P/E = 1000/100 = 10. Company B has P/E = 100/10 = 10. That would mean that both companies have the same P/E ratio and that it takes 10$ to buy 1$ of earnings. Suppose that there will be the same earnings each year then it would take 10 years to return investment completely. Thus if we want to compare two companies having other important parameters equal we would chose the one with smaller P/E ratio i.e. the one that would return investment sooner.

Average P/E ratios for different industries can differ significantly, making comparison of two companies from different industries difficult. That is not a real problem because if we wish to maintain a portfolio, we are looking for appropriate investment in a certain industry. Average P/E ratio in the last century for the US equity is around 15. If there is unusual activity, it is possible to calculate P/E ratio that would take into account previous years.

What does it mean if a certain company has small P/E ratio (let's say 8)? It could mean several things: company is undervalued at this moment (consequently a good buy), or company is experiencing a great increase in earnings in that period. Also, it is possible that the price of stock is declining.

What does it mean if a certain company has high P/E ratio (let's say 30)? It could mean that the company is overvalued or company is experiencing a great decrease in earnings or that the price of stock is growing expecting increase in future earnings (that could be for example pharmaceutical or mining company).

PEG - Projected Earning Growth

This ratio is calculated as PEG = (Price to Earnings ratio)/(projected growth in earnings). PEG is based on projection, and therefore is a little bit subjective. Being based on P/E, PEGs for companies from different industries are different. Greater the projected growth in earnings, smaller the PEG, meaning "the smaller PEG the better".

P/S - Price to Sales

Price to sales ratio is calculated as P/S=(Share price)/(Revenue per share). Instead of P/S, abbreviation PSR is also used (Price to Sales Ratio). P/S gives us the information how much revenue generates each dollar. For example a Share price could be 100$ and Revenue per share could be 100$ yielding P/S = 1. Usually, the smaller P/S the better (one dollar of investment generates more revenue). P/S can differ for different industries. It is important to note that information about profitability of production of a certain company is not included in this ratio. A company could have small P/S but could be also unprofitable.

Book Value

Book value is the net value of a company (assets minus liabilities). Book value for itself doesn't mean a lot.

P/B - Price to Book

Price to Book ratio is calculated as P/B=(stocks capitalization)/(book value). Usually the lower P/B the better. This ratio is also dependent on industries. For example P/B for consulting firms is different then P/B for manufacture firms.

Dividend Payout Ratio

Dividend Payout Ratio is calculated as DPR = Dividends/(Net income). This ratio is the percentage of earnings paid to shareholders in dividends. Dividend Payout Ratio is usually used for estimation a good cash flow management.

Dividend Yield

Dividend Yield is calculated as DY = (Dividend per share)/(Share price). The greater the Dividend Yield the better. It should be noted that a profitable firm could decide not to payout dividends and to use profits for development. In that case Dividend yield is 0, but firm is still profitable.

ROE - Return on Equity

The Return on Equity is calculated as ROE = (Net income)/(Shareholder's equity). As other ratios ROE is also industry dependent but is useful to compare companies within the same industry. Usually the greater the ROE the better.

This is only a list of the most important ratios. An investor should do his homework and to check all parameters available before any investment made.