Congratulations on making it to the final step of Investing for Beginners 101! I’ve done my best to save the best for last, but each part of this guide is equally important and I encourage those who have skipped sections to go back and read what was missed. Ending with the best way to avoid risk, here are the 7 parts of the Investing for Beginners 101 guide.
1. Why to Invest?
2. How the Stock Market Works
3. The BEST Stock Strategy and Buying Your First Stock
4. P/E Ratio: How to Calculate the Most Widely Used Valuation
5. P/B, P/S: The Single Two Ratios Most Correlated to Success
6. Cashing In With a Dividend Is a Necessity
7. The Best Way to Avoid Risk, and Putting it all Together!!
In this final step, you will learn what I’ve found to be the best way to discover and avoid risk to save yourself from catastrophic losses. Through many back tests for the Value Trap Indicator dating back to 1994, I’ve found a common characteristic in companies about to experience substantial stock price drops or bankruptcy.
These companies would consistently score above 1,000 on the Value Trap Indicator, triggering a strong sell before the stock price greatly deteriorated. The common characteristic I discovered was too much debt when compared to shareholder’s equity.
Avoid Risk by Avoiding Debt
Debt to equity is a common measure of risk in investing. If you think about it, it makes sense too. A person more likely to become bankrupt is one with too much debt, and the same is true for companies.
If the company considered doesn’t have enough assets to cover their liabilities, or shareholder equity, then they have debt to equity ratios that skyrocket to the sky.
Financial companies like banks have extremely high debt to equity ratios compared to other industries because of the nature of their business, but in my opinion you can still use debt to equity ratio to determine their risk as well.
For a normal company, you want to see a debt to equity ratio that is at least below 1. For financial companies, a number below 10 is best to avoid risk.
A company like Lehman Brother’s had a debt to equity ratio of 60 right before their bankruptcy, and the Value Trap Indicator (explained below) would’ve triggered a strong sell signal to prevent investors from losing their shirts at that time.
Many investors overlook the debt to equity ratio and in turn become shocked at seeing staggering portfolio losses, which is why I’ve saved this ratio as the last and most important one. Now that I’ve uncovered its importance, it’s time to show how to calculate debt to equity ratio.
There are two ways to calculate debt to equity ratio, using total liabilities or looking at only long term debt. It’s important to consider total liabilities instead of only long term debt because a company should be able to cover all their total liabilities with their total assets in case of a financial struggle.
Also, a company with less total liabilities is obviously in a favorable financial condition and this must be accounted for. Debt to equity ratio is the total liabilities divided by shareholder’s equity, which is total assets minus total liabilities. The lower the ratio, the more likely to avoid risk.
As can be seen from the picture above, Citigroup ($C) had a debt to equity ratio of $1,673,663/ $189,049 = 8.85. This number is under 10, which is in the preferred range for financial companies to avoid risk.
Debt to equity = total liabilities / shareholder’s equity
Debt to equity = total liabilities / (total assets minus total liabilities)
Moving on to Buying Great Stocks…
With this final lesson, I’ve equipped you with the tools you need to get started investing in the stock market.
You know how to avoid risk, calculate important ratios, and dollar cost average. I hope you’ve enjoyed 7 Steps to Understanding the Stock Market, as I’ve enjoyed sharing what I know and have learned through various sources.
I strongly urge you to take the next step and apply what they have learned to make specific stock selections starting as soon as possible.
To quantify this stock picking format into an easy to follow method, I’ve created a formula called the Value Trap Indicator– to explicitly state whether a stock is a buy or not.
Using the 7 steps you just read about, the Value Trap Indicator assigns any stock a number, with a Strong Buy being 0-250, and a strong sell being larger than 800.
The Value Trap Indicator showed an 800+ score for both Lehman Brothers and Circuit City in the year right before their bankruptcies, and would’ve been very successful in keeping investors from these types of troubled stocks.
Check it out, and congrats on finishing this guide.