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Announcer:                        00:00                     You’re tuned in to the Investing for Beginners podcast. Finally, step by step premium investment guidance for beginners led by Andrew Sather and Dave Ahern, to decode industry jargon. Silence crippling confusion and help you overcome emotions by looking at the numbers. Your path to financial freedom starts now.

Dave:                                    00:36                     All right folks, we’ll welcome to the Investing for Beginners podcast. This is episode ninety-eight. Tonight we’re going to talk about why you shouldn’t be a lone wolf investor. And I’m going to have Andrew kind of take us from there. All Right, Andrew, why don’t you go ahead and chat.

Andrew:                              00:50                     Yeah, I love it. So maybe I’m recording this because this is something I need to tell myself more than anything else. Having people around and having them influence your life can do a lot of things for you. Very, very well. They say the five people closest to you are the most important because they impact how you live your life and the big, big way. So I, I kind of present this topic and this idea based on some personal context. I guess I didn’t mean to get like super personal, but there’s a saying that as you get close to the turn of a decade you start to make big moves, right? So we’re here close to the end of 2020 and that full decade before.

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For investors looking to limit downside risk, the Altman Z Score can be an excellent formula for determining the true strength of a company.

What makes this risk management tool so great is that it focuses almost exclusively on the financials of the business, rather than how Wall Street perceives it through price action. This is in contrast to other risk management tools such as trailing stops or momentum indicators, which could be based more on emotion rather than business financial reality.  

In this post, I’ll go over both the positives and the limitations of the Altman Z Score by breaking it down into each of its 5 formula categories. I’ll also show you how to calculate the Altman Z score exactly by using a real life balance sheet and 10-k as an example.  

Has the Altman Z Score Formula been successful in calculating risk in the past?

This formula was published in 1968, and so we have a long period of time to evaluate its track record through various bull and bear markets.

Perhaps its strongest piece of supporting evidence was the fact that right before the financial crisis of 2008 the median Altman Z score formula across the stock market was 1.81. As we now know, the following years were troubling for many companies.

Various financial websites and blogs have posted that the Altman Z score formula has had an accuracy rate as high as 90% for bankrupted companies.

In an interesting report draft that was published online about the Altman z score’s results in the UK from around 1979 to 2003—using a modified UK version z score that was published around the beginning of that time period (1977) by Agarwal and Taffler.

In this UK version, a z score below 0 was indicative of high risk, while one above 0 was generally considered a signal of strength. Interestingly, one of the tables in the report draft reported a total failure rate for z<0 at 3.2, while the failure rate for z>0 was 0.1.

This seems to prove there’s strong evidence for the validity of the Altman Z Score formula due to its track record across time periods and even countries.

But, we know that no single metric is perfect, and we must examine the possible limitations for the Altman z score formula in any of its 5 formula categories.

How to Calculate the Altman Z Score

The Altman Z Score formula is 5 ways—I’ve denoted each with a “z” before the number. Each formula category can be examined with the following financial statements:

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The returns in the stock market and an investor’s actual total return can be very different. If the investor plays his cards right, his total return could actually be better. In fact it should be. Let’s discuss why.

An investor wanting to calculate total return is simply trying to calculate his return on investment or ROI.

If I have $10 and I turn it into $14, I made $4 on my $10 and that $4 is my ROI. To convert that to math terms, we just take the two numbers and express them as a percentage (4/10 = 40% ROI).

When it comes to the stock market, the ROI calculation becomes a little more difficult. Because the prices in the stock market are changing almost every day, an investor’s total return, or ROI, also changes almost everyday.

It doesn’t really make sense to calculate that everyday, so many investors calculate total return on a yearly basis.

Calculating Total Return with CAGR

Another way this is commonly expressed (in the stock market) is with the acronym CAGR, which stands for Compounded Annual Growth Rate. CAGR tries to calculate total return but over a period of many years, and then express it on a per year basis.

For example, knowing I made 10% per year (CAGR) over 15 years gives me a lot more context than a 280% ROI over 15 years—even though both calculations mean the same thing.

Having an annual comparison allows us to compare things apples to apples and also compare it with everything we hear about the stock market, as the news and media often report on total return as a per year number.

Before we can move along with a practical way for the average investor to calculate his/her total return, we have to understand that there’s another factor that contributes to total return: dividends.

You might hear of dividends expressed as yield, and that’s because yield is just a way to tell you how much income you receive from an investment as a percentage. For example, if I make an investment for $100 and it pays me $2 per year in interest, then I have a 2% yield [(2/100) x 100].

With the stock market and dividends, yield is calculated the exact same way—just substitute the words “make an investment” with the words “buy a stock” and “pays me a dividend” instead of “pays me interest”.

The way that yield relates to total return is that it enhances it, and enhances it a lot if you are reinvesting that yield.

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Part of balance sheet analysis is understanding the intricacies behind each asset and what they represent. Net tangible assets can be a very useful metric for evaluating a company’s future profitability, especially in capital intensive industries.

In this blog post, I’ll explain the basics behind net tangible assets and include a few easy and practical metrics for it.

Then we’ll discuss a bit of the history behind the metric and how this applies to how investors should consider valuing assets like these—amidst today’s economic environment that is increasingly depending on the internet.

To understand net tangible assets, you might understand its two parts: the net assets part and the tangible assets part.

Net assets is simple. It’s just like the term “net worth”. To calculate net assets, you simply take total assets and subtract total liabilities. In a balance sheet, net assets is the same as shareholder’s equity or book value.

The “tangible” definition of an asset is needed because not all assets are created equally. Nor is every asset valued equally.

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There’s many differences between the consolidated balance sheet and income statement in a company’s 10-k, and the vast number of figures in there can make them confusing for the investor just starting to analyze stocks.

In this blog post, I will help you separate the wheat from the chaff.

Let’s talk about the basics behind what the balance sheet and income statement are reporting about the profitability and overall long term health of the business.

Instead of looking at a sample balance sheet and income statement and trying to learn it all at once, I will show you the whole thing then narrow it down to what I feel are the most important metrics to uncovering how the business is performing.

Balance Sheet vs Income Statement Basics

The easiest way I can describe each statement is by relating them to your personal finances.

If any of you like to track your net worth, watching your debts as they relate to your assets like your house, then that is exactly like a company’s balance sheet.

A balance sheet for a major corporation in the stock market might have certain assets that are specific to running a business, such as inventory or accounts receivables (sales that are made but haven’t turned into cash yet), but other than that a balance sheet at its core tells you what a company’s net worth is.

The income statement is very similar to the paycheck you receive from your job. At the very top is your gross, and this is like a company’s revenue. Then taxes are taken out, to arrive at your take home pay which is your net income.

Like an individual person has, a corporation has a net income figure that is calculated after taxes, but it also includes the expenses it takes to run a business—such as the cost to have employees and the costs of buying parts to create inventory.

Like with a person, we can tell the general financial condition of the entity simply by looking at the balance sheet and income statement.

If someone were to have lots of credit card debt and a small paycheck, it’s pretty safe to say that they won’t become Bill Gates anytime soon.

On the flip side, someone with large retirement accounts (which shows as assets) can raise their net income quite substantially by taking that income from investments rather than reinvesting it—and that person also has much less of a chance at going bankrupt if they lose their job.

We can do this with public corporations, and this process of looking at the balance sheet and income statement can help immensely when considering whether we want to invest in these companies through the stock market.

You might think this is common sense, but you’d be shocked at how many people don’t look at the balance sheet or income statement, or even both, when buying stocks. It’s obvious because they’ll buy stocks with terrible financials in either statement, and these type of stocks can sometimes be the most popular, expensive, and highly valued on Wall Street.

Common sense isn’t common.

Now let’s look at a sample balance sheet and income statement, then I’ll show you how to narrow down the key figures to arrive at the overall health of a business. You don’t have to know or learn all of them.

Then I’ll show you a few practical metrics you can use to analyze these two financial statements and pick stocks that are more financially healthy and thus more likely to succeed.

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The public perceptions about people with a finance degree and the realities of finance careers can sometimes be vastly different. Even students studying for a finance major might not realize what going into finance really entails. Then once you have the degree, you might wonder if a professional certification like the CFA or an MBA makes sense.

I don’t have all of the answers, but hopefully I can point you in the right direction so that you can solve them for yourself.

One thing is certain about finance—it’s not what “they” think, and a finance degree can take you in a million different ways. Luckily, these days there’s a ton of great resources to help you build a solid financial career path such as r/financialcareers and Wall Street Oasis.

I don’t know how you got interested in finance in the first place. Maybe you really love numbers. Maybe the business world fascinates you. Maybe you’re an A-type personality who loves the thrill of working hard and seeing major results. Maybe you’re just drawn to the glitz and the glam. Maybe you like FinMemes. Maybe you just love money, and want more of it.

It we can be really honest with ourselves, we’d all like a little more money—and a great finance career can be a way to get there.

Here’s the thing. Studying for a finance degree and learning how to build wealth are actually 2 completely different things. Luckily for those with a finance degree (and especially a finance certification like the CFA), what you learn from studying about finance can also transfer over and help you a lot in building wealth. This is unique to finance that’s not a characteristic in other fields—a doctor doesn’t get to study about assets and ways to value them while in medical school, and so he might not put two-and-two together that he needs to build personal assets with that large income of his.

But here’s the bad thing about finance. As you take that finance degree and start towards a career path, you will get really good at your slice of that world (whether that’s Private Equity, Investment Banking, M&A, etc) but that won’t necessarily translate to building wealth.

Just as there are many heirs who blow their inheritance and squander family wealth, as someone working in finance you could take that gift of a great income and completely waste it in your best working years, and sometimes… it’s not even your fault.

The Truth About Finance Degrees

Truth of the matter is that most finance degrees or certifications won’t teach you about the personal side of finance and building wealth, it’s kind of expected to be common sense.

But while a finance degree might get you into Wall Street, it might not lead to you personally using Wall Street in the best ways to get yourself rich and not just your bosses. Just like the businesses on Wall Street buy more assets to earn higher profits, you need to buy assets to build income streams for yourself.

Here’s what you should know about building wealth.

Contrary to public perception (again), it’s not about hitting the jackpot on a penny stock or day trading yourself to death like a wolf of Wall Street. While people certainly do build fortunes overnight on Wall Street, most successful and financially comfortable people build their wealth slowly, over time.

And this is because of compound interest. As someone with a finance degree, this is something you should absolutely learn—especially if you’re just starting out and studying with a finance major at the moment.

The way compound interest works is that it’s all about money making more money. On Wall Street, this is the closest thing you’ll get to a free lunch.

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Announcer:                        00:00                     You’re tuned in to the Investing for Beginners podcast. Finally, step by step premium investment guidance for beginning led by Andrew Sather and Dave Ahern. To decode industry jargon. Silence crippling confusion and help you overcome emotions by looking at the numbers. Your path to financial freedom starts now.

Dave:                                    00:36                     All right folks, we’ll welcome to Investing for Beginners podcast. This is episode 97. Tonight Andrew and I are going to talk about wisdom, really unwise financial decisions. We’ve put together a list of some things that you should not do if you want to be wise with your money. So Andrew, why don’t you go ahead and talk about our first item, then we’ll kind of go down the list.

Andrew:                              00:59                     Yeah, sounds good. Making this list was fun, wasn’t it? It was fun because I’m guilty of these just as much as anybody else. I don’t like to think that. I don’t like to imply that I’m just like the super wealthy dude that doesn’t make any mistakes. But you know, I think we can kind of learn from other people sometimes. Maybe learn from ourselves sometimes and we can do some things with our money that, uh, you know, when it becomes a money pay, we don’t have to fall into those traps. So I think a huge one, and by the way, I think a lot of these are pretty controversial. I think this one’s controversial too, but credit cards. So my thing with credit cards is obviously my stance is I’m the super no debt guy, only by, you know, I only want stocks that don’t have a lot of debt.

Andrew:                              01:52                     I think that is the devil, the borrower, slave, borrower’s slave to the lender, you know, all these sorts of things when it comes to debt. However, I also like to think that I’m brilliant one. A lot of the times I’m not. So even with my anti-death stance, um, I’ve done like I’ve opened up a, a travel rewards credit card, even after everybody knows that my reputation is, I don’t like that. And I tried to play like the points game where I was telling myself, you know, I have these expenses every month, then might as well take advantage of them, right? If they’re just going to be normal expenses are, they always have. I’ve always been kind of a numbers guy. Math dude, I like to think I knew how to do a good budget at the time. So I said, yeah, well let me get this free interest rate.

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As a financial metric, cash and cash equivalents should be the easiest for investors to understand. After all, we all have had cash at some point ourselves (and hopefully still do). However, with all of the focus on Wall Street on earnings, a metric like cash and cash equivalents can be overlooked and not thought about much.

Not thinking about a company’s cash can a mistake. Thinking about cash and cash equivalents in the wrong way can also be a mistake. Let’s break down this metric to its most basic form, and then use some common sense to think about what that number tells us at any given time.

Now, cash and cash equivalents shows ups in 2 financial statements: the balance sheet and the cash flow statement.

Most investors (amateur and professional) think about cash flow instead of cash, and use those metrics to create valuation models such as a DCF valuation.

Out of the 3 financial statements, the cash flow statement can seem like the hardest to understand—and this may contribute to the lack of interest in the cash and cash equivalents number itself. But just because cash and cash equivalents is ignored in a DCF doesn’t mean we should ignore it too.

The Cash Flow Statement Made Super Simple

To make it simple, let’s examine the flow of money through a business.

REVENUE —> EARNINGS —> CASH AND CASH EQUIVALENTS

Now, from revenue to earnings is where things to run the business get paid. So think like the workers, costs of inventory, etc. The day-to-day operations of the business, if you will.

Also, before the money is allowed to be called earnings (profit)– it has to be taxed, interest on debt needs to be paid, etc.

Where it gets interesting is how the earnings gets converted to cash.

Think of revenue to earnings being the difference between what you’re paid at your company and what you get as take home pay after the government taxes your income.

How earnings gets converted to cash is how your paycheck gets converted to your final checking account balance.

Your CHECKING ACCOUNT BALANCE = A company’s CASH AND CASH EQUIVALENTS

Since business is business and there’s lots of owners involved (shareholders), the money (in theory) should be spent to help the future of the business– whereas with your money you can blow it all for fun and that can be fine for you.

So, when earnings gets converted to cash, some investments for the company’s future are taken out of earnings first.

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When it comes to managing a portfolio, there are two schools of thought: active management and passive investing.

With active management, a fund manager depends on his skill and valuation abilities to improve performance. The major draw for passive management is that there is no effort, and thus the investor can’t sabotage his own progress through his actions.

All things being equal, an active manager who is an above average allocator and determiner of company value should achieve above average results. However, all things are not equal– and there are other uphill battles that active fund managers have to face that can hurt portfolio performance.

In this blog post, I’ll quickly go over some of them so you can see why active management can be much easier said than done, especially when it comes to the biggest hedge funds and mutual funds.

Before I start really digging in to the realities behind active management, first we should look at what people believe about it.

There’s a strong divide in the investing world between fans of active vs passive management. The passive investing crowd believe that paying management fees are a waste of time because an overwhelming majority of them can’t beat the market.

While there’s truth to this statement, you can find countless studies that simply cherry pick data to make this point. Take this article that says that only the 95^th percentile of active managers were able to beat the market over a 15 year time period. In a textbook example of cherry picking, the article cites a study that looked at one time period: the one ending in 2017.

If a study only looks at a single time period, such as 2002-2017 as this exact study did, you can’t make any reasonable conclusions from it. Why? Because the stock market is constantly changing and stocks, sectors, and strategies outperform and underperform all the time.

While most passive investors agree that active management is inferior because of studies like these, it’s not fair to jump into a conclusion like this based on a cherry picked study.

What this really amounts to is a viewpoint from a cynic rather than an observable fact from real life results.

But here’s the other factor that this study (and many others) don’t consider.

And it gets overlooked because it is so simple. [continue reading…]