Are You An Entrepreneur? Here Is Everything You Need To Know About Business Models

For the past couple of months, I have observed myself wondering, how successful businesses make their money, for some, the answer came easy but for others, it required a little more digging. But interestingly enough this path led me to the study of business models.

Without a proper business model, an entrepreneur is bound to fail.

A business model helps founders decide how their business will work, in particular how it will make money.

It is the only documentation that helps you:

• Define your target market
• The market opportunity you intend to capitalize on
• The problems you need to solve,
• The solution your business offers and its value to customers.
• How customers are acquired.
• The costs involved in running the business and staying profitable.

A business model can help you identify what to do differently, which would place you ahead of your competition. For instance, Netflix’s business model proved successful because it provided value in the form of consistent on-demand content instead of the usual TV streaming business model.

Additionally, business models are particularly important for startups, because they help attract investments, recruit talent, and motivate staff.

A business model can simply be defined as a company’s plan for making profit.

The Key ComponentsOf a Business Model

This section is majorly based on the works of Aashish Pahwa of feedough.com. According to Aashish, An ideal business model usually conveys four key aspects of the business which are presented using a specialized tool called business model canvas.

1. Who is the customer?
2. What value does the business deliver to the customers?
3. How does the business operate?
4. How does the business make money?

Who Is The Customer?

The customer forms the heart of a business model. It answers who the company plans to sell its offerings to. A business usually groups customers into different segments with certain homogeneous needs, characteristics, or behavior. It then defines one or more customer segments that it serves or wants to serve, followed by an answer to why it plans to serve this segment.

What Value Does The Business Deliver To The Customers?

This is the most important component of a business model that answers several key customer and business value-related questions. It is often usually presented using a value proposition canvas.

• What are the jobs the customer wants to be done?
• What are their pains in doing the job?
• What do they gain by doing the job?

Once these questions are answered, the business answers another set of questions that relates business to the customers:

• How does the business get the job done?
• How does the business relieve the customer’s pain?
• How can the business help the customer get the gains?

How Does The Business Operate?

It’s the operating model of the business that elaborates:

• Key Activities: What offerings do the business sell to the customers.
• Key Partners: Who help the business in delivering value to the customers.
• Key Resources: What/all resources do the business users to develop and deliver its offerings.
• Key Channels: What channels does the business use to deliver its offerings to the customers.
• Customer Relationships: What type of relationships does the business maintain with its customers.

How Does The Business Make Money?

Making money is important for the business to sustain itself. This component of the business model focuses on elaborating on the financials and how the business makes money.

It’s called the revenue model of the business and has two components:

• The cost structure includes all the expenses that the business incurs in creating and delivering value to the customers.
• The revenue streams include all the primary and non-primary revenue streams that the business utilizes.

The 38 Most Common Types of Business Models

1. Advertising
2. Affiliate
3. Agency-Based
4. Aggregator
5. Auction-Based
6. Blockchain
7. Brick-and-Mortar
8. Bricks-and-Clicks
9. Brokerage
10. Bundling
11. Concierge/Customisation
12. Crowdsourcing
13. Data Licencing/Data Selling
14. Disintermediation
15. Distributor
16. Dropshipping
17. E-commerce
18. Fee for service
19. Fractionalization
20. Franchise
21. Freemium
22. High Touch
23. Leasing
24. Leasing Model
25. Manufacturer
26. Marketplace
27. Network Marketing
28. Nickel-and-Dime
29. On-Demand
30. Pay as you go
31. Peer 2 Peer Catalyst/Platform
32. Razor Blade
33. Retailer
34. Reverse Auction
35. Reverse Razor Blade
36. SAAS, IAAS, PAAS
37. Subscription
38. User Community

Photo by Clem Onojeghuo on Pexels.com

1. Auction-Based

Mostly used for unique items that are not frequently traded and that don’t have a well-established market value, like collectibles, antiques, real estate, and even businesses.

This business model involves the listing of an offering by the seller and the buyers making repeated bids to buy that offering while fully aware of other bids by other buyers. The offering is sold to the highest buyer with the auction broker charging a listing fee and/or commission based on the transaction value.

eBay is one such auction platform.

2. Advertising

The fundamentals of the model revolve around creating content that people want to read or watch and then displaying advertising to your readers or viewers.

In an advertising business model, you have to satisfy two customer groups: your readers or viewers, and your advertisers. Your readers may or may not be paying you, but your advertisers certainly are.

With advertising, a business sells its audience’s attention. Advertisers pay for space — whether it’s in the pages of a magazine or on the side of a vehicle — with rates usually determined by the size of the business’s audience.

Examples: CBS, The New York Times, YouTube

3. Affiliate

Affiliate business models are based on marketing and the broad reach of a specific entity or person’s platform. Companies pay an entity to promote a good, and that entity often receives compensation in exchange for their promotion. That compensation may be a fixed payment, a percentage of sales derived from their promotion, or both.

The affiliate business model is related to the advertising business model but has some specific differences. Most frequently found online, the affiliate model uses links embedded in content instead of visual advertisements that are easily identifiable.

Examples: the wirecutter, top ten reviews livewire.

4. Agency-Based

An agency can be considered a partner company that specializes in handling non-core business activities like advertising, digital marketing, PR, ORM, etc. This company partners with several other companies that outsource their non-core tasks to them and is responsible to maintain privacy and efficiency in their work.

Examples: Ogilvy & Mathers, Dentsu Aegis Network, etc.

5. Aggregator

The aggregator business model is a recently developed model where the company has various service providers of a niche and sells its services under its own brand. The money is earned as commissions.

Examples – Uber, Airbnb, Oyo.

6. Blockchain

The Blockchain is an immutable, decentralized, digital ledger. It is a digital database that no one owns but anyone can contribute to. Many businesses are taking this decentralized route to develop their business models. Models based on blockchain are not owned or monitored by a single entity. Rather, they work on peer-to-peer interactions and record everything on a digital decentralized ledger.

7. Bricks-and-Clicks

A company that has both an online and offline presence allows customers to pick up products from the physical stores while they can place the order online. This model gives flexibility to the business since it is present online alternative for customers who live in areas where they do not have brick-and-mortar stores.

Examples – Almost all apparel companies nowadays.

8. Brick and Mortar

Brick-and-mortar is a traditional business model where retailers, wholesalers, and manufacturers deal with the customers face-to-face in an office, a shop, or a store that the business owns or rents.

9. Brokerage

A brokerage business model connects buyers and sellers without directly selling a good themselves. Brokerage companies often receive a percentage of the amount paid when a deal is finalized. Most common in real estate, brokers are also prominent in construction/development or freight.

Example: ReMax, RoadRunner Transportation Systems

10. Bundling

Bundling capitalizes on existing customers by attempting to sell them different products. This can be incentivized by offering pricing discounts for buying multiple products.

This type of business model allows companies to generate a greater volume of sales and perhaps market products or services that are more difficult to sell. However, profit margins often shrink since businesses sell the products for less.

Examples: AT&T, Also many class-based fitness centers and gyms use a type of bundling model, where clients pay fees for a certain number of classes per month. The more classes a client buys, the cheaper each individual class becomes, even though their total spend increases.

11. Concierge/Customization

Some businesses take existing products or services and add a custom element to the transaction that makes every sale unique for the given customer.

For example, think of custom travel agents who book trips and experiences for wealthy clients. You can also find customization happening at a larger scale with products like Nike’s custom sneakers.

Examples: NIKEiD, Journy

12. Crowdsourcing

If you can bring together a large number of people to contribute content to your site, then you’re crowdsourcing. Crowdsourcing business models are most frequently paired with advertising models to generate revenue, but there are many other iterations of the model.

Companies that are trying to solve difficult problems often publish their problems openly for anyone to try and solve. Successful solutions get rewards and the company can then grow its business. The key to a successful crowdsourcing business is providing the right rewards to entice the “crowd” while also enabling you to build a viable business.

Examples: Kickstarter, Patreon

13. Data Licensing/Data Selling

Many companies like Twitter and Onesignal sell or license the data of their users to third parties who then use the same for analysis, advertising, and other purposes.

14. Disintermediation

If you want to make and sell something in stores, you typically work through a series of middlemen to get your product from the factory to the store shelf.

Disintermediation is when you sidestep everyone in the supply chain and sell directly to consumers, allowing you to potentially lower costs to your customers and have a direct relationship with them as well.

Example: Casper, Dell, Apple.

15. Distributor

A company operating as a distributor is responsible for taking manufactured goods to the market. To make a profit, distributors buy the product in bulk and sell it to retailers at a higher price.

Examples – Auto Dealerships.

16. Dropshipping

Dropshipping is a type of e-commerce business model where the business owns no product or inventory but just a store. The actual product is sold by partner sellers who receive the order as soon as the store receives an order from the ultimate customer. These partner sellers then deliver the products directly to the customer.

17. E-commerce

E-commerce focuses on selling products by creating a web store on the internet.

Photo by Pixabay on Pexels.com

18. Fee for Service

Instead of selling products, fee-for-service business models are centered on labor and providing services. A fee-for-service business model may charge an hourly rate or a fixed cost for a specific agreement.  Fee-for-service companies are often specialized, offering insight that may not be common knowledge or may require specific training. To increase their earnings, businesses with this model usually increase their clients or raise their rates.

Example: DLA Piper LLP, Hairstylists, Accountants, and Real estate agents.

19. Fractionalization

Instead of selling an entire product, you can sell just part of that product with a fractionalization business model.

One of the best examples of this business model is timeshares. Where a group of people owns only a portion of a vacation home, enabling them to use it for a certain number of weeks every year.

Examples: Disney Vacation Club, NetJet

20. Franchise

A franchise can be a manufacturer, distributor, or retailer. Instead of creating a new product, the franchisee uses the parent business’s model and brand while paying royalties to it.

The franchiser, or original owner, works with the franchisee to help them with financing, marketing, and other business operations to ensure the business functions as it should. In return, the franchisee pays the franchiser a percentage of the profits.

Examples: Domino’s, Ace Hardware, McDonald’s, Allstate

21. Freemium

Freemium business models attract customers by introducing them to limited-scope products. Then, with the client using their service, the company attempts to convert them to a more premium, advanced product that requires payment. Although a customer may theoretically stay on freemium forever, a company tries to show the benefit of what becoming an upgraded member can hold.

Freemium isn’t the same as a free trial where customers only get access to a product or service for a limited period of time. Instead, freemium models allow for unlimited use of basic features for free and only charge customers who want access to more advanced functionality.

This model is one of the most adopted models for online companies because it is not only a great marketing tool but also a cost-effective way to scale up and attract new users.

Examples: Youtube, MailChimp, Evernote, LinkedIn.

22. High Touch

The high-touch model is one that requires lots of human interaction. The relationship between the salesperson and the customer has a huge impact on the overall revenues of the company. Companies with this business model operate on trust and credibility.

Examples: hair salons, consulting firms.

23. Leasing

Leasing is like renting. At the end of a lease agreement, a customer needs to return the product that they were renting from you.

Leasing is most commonly used for high-priced products where customers may not be able to afford a full purchase but could instead afford to rent the product for a while.

Examples: Cars, DirectCapital

24. Manufacturer

A manufacturer is responsible for sourcing raw materials and producing finished products by leveraging internal labor, machinery, and equipment. A manufacturer may sell goods to distributors, retailers, or directly to customers.

Example: Ford, 3M, General Electric.

25. Marketplace

Marketplaces allow sellers to list items for sale and provide customers with easy tools for connecting to sellers. In exchange for hosting a platform for business to be conducted, the marketplace receives compensation. Although transactions could occur without a marketplace, this business model attempts to make transacting easier, safer, and faster.

Online marketplaces aggregate different sellers into one platform who then compete with each other to provide the same product/service at competitive prices. The marketplace builds its brand over different factors like trust, free and/or on-time home delivery, quality sellers, etc.

The marketplace business model can generate revenue from a variety of sources including fees to the buyer or the seller for a successful transaction, additional services for helping advertise the seller’s products, and insurance so buyers have peace of mind. The marketplace model has been used for both products and services.

Examples: eBay, Airbnb, Amazon, Alibaba

26. Network Marketing

Network marketing or multi-level marketing involves a pyramid-structured network of people who sell a company’s products. The model runs on a commission basis where the participants are remunerated when –

They make a sale of the company’s product.

Their recruits make a sale of the product.

The network marketing business model works on direct marketing and direct selling philosophy where there are no retail shops but the offerings are marketed to the target market directly by the participants. The market is tapped by making more and more people part of the pyramid structure where they make money by selling more goods and getting more people on board.

27. Nickel-and-Dime

In this model, the basic product provided to the customers is very cost-sensitive and hence priced as low as possible. For every other service that comes with it, a certain amount is charged.

Examples – All low-cost air carriers.

28. On-Demand

An on-demand model is a model where a customer’s demand is fulfilled by delivering goods and services on demand (usually immediately). This business model is driven by the use of the internet and mobile phones. It works like this –The customer order for products on services through a web app.

The request is received by the company’s employee or a demand-fulfilling partner. The employee or a partner fulfills the demand by delivering the ordered product or service either immediately or in the time promised.

Examples: Uber, Instacart, and Postmates

29. Pay as you Go

Instead of charging a fixed fee, some companies may implement a pay-as-you-go business model where the amount charged depends on how much of the product or service was used. The company may charge a fixed fee for offering the service in addition to an amount that changes each month based on what was consumed.

Example: Utility companies, Water Companies

30. Peer 2 Peer Catalyst/Platform

A P2P economy is a decentralized internet-based economy where two parties interact directly with each other to buy or sell goods or to conduct a transaction without the intervention of any third party. A P2P catalyst is a platform where these users meet.

Examples: Craigslist, OLX, Airbnb, etc.

31. Product-as-a-service model

Product-as-a-service businesses charge customers to use physical products. They may charge a subscription fee, a per-use or per-mile fee, or a combination of both.

Example: Bike rental companies offer products as a service. Customers might pay an annual membership fee plus a per-mile fee each time they ride, or they might have the option to rent a bike for the day.

32. Razor Blade

This business model aims to sell a durable product below cost to then generate high-margin sales of a disposable component of that product.

This is why razor blade companies –like Gillette- practically give away the razor handle, assuming that you’ll continue to buy a large volume of blades over the long term. The goal is to tie a customer into a system, ensuring that there are many additional, ongoing purchases over time.

Examples: Gillette, Inkjet printers, Xbox.

Photo by Quintin Gellar on Pexels.com

33. Retailer

This is one of the more common business models. A retailer is the last link in the supply chain. These businesses purchase goods from manufacturers or distributors and then sell them to customers for a price that will cover expenses and turn a profit. Retailers may specialize in a particular niche or carry a range of products.

Examples are Costco Wholesale, Amazon, and Tesco.

34. Reverse auction

A reverse auction business model turns auctions upside down and has sellers present their lowest prices to buyers. Buyers then have the option to choose the lowest price presented to them.

The reverse-auction-based business model is often used when there are several sellers selling a similar offering to a single buyer. These sellers lower their price with every bid and generally the bidder with the lowest bid wins the auction. However, there are cases when the bidder with a price higher than the lowest bid wins the auction as the buyer likes his offer (offering with add-ons)

Examples: Priceline.com, LendingTree

35. Reverse Razor Blade

Instead of relying on high-margin companion products, a reverse razor blade business model tries to sell a high-margin product up front. Then, to use the product, low or free companion products are provided.

Similar to the razor blade model, customers are often choosing to join an ecosystem of products. But, unlike the razor blade model, the initial purchase is the big sale where a company makes most of its money. The add-ons are just there to keep customers using the initially expensive product.

Example: Apple (iPhones + applications), Peloton

36. SAAS, IAAS, PAAS

Many companies have started offering their software, platform, and infrastructure as a service. The ‘as a service business model works on the principle of pay as you go where the customer pays for his usage of such software, platform, and infrastructure; he pays for what and how many features he has used and not for what he hasn’t.

37. Subscription

Subscription-based business models strive to attract clients in the hopes of luring them into long-time, loyal patrons. This is done by offering a product that requires ongoing payment, usually in return for a fixed duration of benefit.

While magazine and newspaper subscriptions have been around for a long time, the model has now spread to software and online services and is even showing up in service industries.

If customer acquisition costs are high, this business model might be the most suitable option. The subscription business model lets you keep customers over a long-term contract and get recurring revenues from them through repeat purchases.

Examples: Netflix, Salesforce, Comcast.

A subscription business model can be applied to both traditional brick-and-mortar stores and e-commerce businesses alike. Essentially, the customer makes a recurring payment for ongoing access to a service or product. A company may directly ship its product in the mail, or you may pay a fee to use its services.

Example: Many local farms offer farm shares or community-supported agriculture subscriptions, where clients get access to fresh produce on an ongoing basis while crops are in season.

38. User Community

Driven by the network effect, this business model involves granting access to a community or a network in return for a membership fee.

Glassdoor is a good example of such a user community.

Final Thoughts

As you have gone through this post you might have realized that there are companies that use more than one business model. For instance, Microsoft. Over the past several decades, the company has expanded its product line across digital services, software, gaming, and more. This is important to know because, for a business model to work in practice, it has to make sense for the business that adopts it. Therefore you should always consider how your business model fits with your business ideas and consistently review this over time, during the course of your business. And should you feel the need to fuse a couple of business models to achieve your business objectives, by all means, go for it!

How Do You Know Your Finances Are in Order?

It is common knowledge that many of the conversations we have around money revolve around how to earn it, but spending it most time is usually left to your discretion. I guess I can understand why; after all, you did all the work that got you the money alone- that tedious hard work! – So why should anybody get to tell you what to do with it.

However the problem of overspending or underspending is always floating around our heads, and usually, the advice you get to this is that “hey, you need to get your finances in order” – even when most people have no clue what that is. So I have always wondered:

What would it take to get my finances in order?

My answer to this question, stated in this post is primarily derived from Paul Mladjenovic’s book Stock investing for dummies (also available on audible), with other additional sources referenced along the way.

1. To Begin: You Need A Budget

Keeping a monthly budget like a diary provides us with an accurate knowledge of our monthly income and expenses. For me, this is particularly important because I get to know if I am progressing toward my financial goals or not. Ok then, how do we create a budget?

Step 1: Estimate Your Monthly Income

The first step is to list all our income sources and how much we expect to receive from them –easy right? Your income sources could include paychecks, pay from gig work, social security income, etc. If your paycheck amounts differ each period, use a conservative estimate to set yourself up for success.

It’s important at this stage that we only focus on consistent sources of income. For instance, a paycheck from your day job is consistent, but money from the sale of your old clothes is not.

Also, net income also known as “take-home pay” is preferred for budgeting.  This is the money you have left over after taxes and payroll deductions.

Step 2: Estimate your Monthly Expenses (Spend a month or two tracking your spending)

There are fixed expenses and variable expenses. Fixed expenses are those that are the same amount each month e.g. your rent or mortgage, cell phone bill etc. You can always get an accurate estimate for these amounts by looking at past credit card or bank statements.

On the other hand, variable expenses are those with varying amounts each month. E.g. your groceries, eating out, gifts, clothes etc. To estimate variable expenses you may need to spend some time tracking these expenses, to get a more accurate estimate.

Also, you may have expenses you pay for annually, to budget for these, divide the expense by 12, then put aside that amount each month.

Calculating all of the above together would give us our total monthly expenses. However, if you want an easier way to track your expenses, consider looking through this list of budgeting apps curated by Daphne Foreman on Forbes advisor.  

Step 3: Compare your Income and expenses, and Consider your Priorities and Goals

All that’s left to do now is to compare your total estimated income to your total estimated expenses. It goes without saying that what we want is a greater monthly income than monthly expenses. If this is what you have then great!

If however you get a deficit, Paul Mladjenovic offers the following considerations, to help bring your budget into balance:

•  How can you increase your income? Do you have hobbies, interests, or skills that can generate extra cash for you?
• Can you get more paid overtime at work? How about a promotion or a job change?
• Where can you cut expenses? Have you categorized your expenses as either “necessary” or “nonessential”?
• Can you lower your debt payments by refinancing or consolidating loans and credit card balances?
• Have you shopped around for lower insurance or telephone rates?
• Have you analyzed your tax withholdings in your paycheck to make sure that you’re not overpaying your taxes (just to get your overpayment back next year as a refund)?

Step 4: Stick with it.

Regardless of whether you have a surplus or deficit on a budget, the benefits of budgeting are best derived when you stick with the habit. Continuously, tracking your spending, plugging spending leaks, adjusting your budget, and saving money.

The team at Bungalow has this to say about budgeting:

“Having a personal budget that you review on a regular basis is an essential part of financial literacy, and it’s the best way to prevent overspending.”

Bungalow

As the name implies the purpose of an emergency fund is to help you with cash during emergencies.

2. After a budget: Consider setting up an Emergency Fund

This next step up the road is based on the assumption that after deducting my monthly expenses from my monthly income in the step above, I have cash left over to pursue my financial priorities and goals.

The purpose of an emergency fund is to store money that you may need in times of distress. The goal is that you have in your fund at least three to six months’ worth of your total monthly expenses in cash.

Three to six months is considered enough to get you through the most common forms of financial disruption such as losing your job. However, you may consider saving up for a year’s worth if you prefer a more conservative cushion.

Paul Mladjenovic advises that you resist the urge to start thinking of your investment in stocks as a savings account, “this is dangerous thinking!” because If your investments tank, or if you lose your job, you’ll have financial difficulty and that will affect your stock portfolio (you may have to sell stocks in a losing position just to get money to pay the bills). An emergency fund helps you through a temporary cash crunch.

3. Understand Your Net worth

Asides from our income and expenses, our financial well-being is also influenced by assets and debts. Having proper knowledge of these amounts and their impacts on your financial well-being is critical to having your finances in order.

Calculating your net worth is relatively straightforward. Pull out a pencil and a piece of paper. For the computer savvy, a spreadsheet software program accomplishes the same task.

Gather all your financial documents, such as bank and brokerage statements and other such paperwork — you need figures from these documents. Then follow the steps below. Review your position at least once a year to monitor your financial progress (is your net worth going up or down?).

Step 1: List your assets in decreasing order of liquidity

Liquidity refers to how quickly you can convert a particular asset (something you own that has value) into cash. If you know the liquidity of your assets, including investments, you have some options when you need cash to buy some stock (or pay some bills). All too often, people are short on cash and have too much wealth tied up in illiquid investments such as real estate. Being Illiquid means that you don’t have the immediate cash to meet a pressing need.

Listing your assets in order of liquidity on your balance sheet gives you an immediate picture of which assets you can quickly convert to cash and which ones you can’t. If you need money now, you can see that cash in hand, your checking account, and your savings account are at the top of the list. The items last in order of liquidity become obvious; they’re things like real estate and other assets that can take a long time to convert to cash.

Selling real estate, even in a seller’s market, can take months. Investors who don’t have adequate liquid assets run the danger of selling assets quickly and possibly at a loss as they scramble to accumulate the cash for their short-term financial obligations. For stock investors, this scramble may include prematurely selling stocks that they originally intended to use as long-term investments.

When listing your assets from most liquid to least liquid, consider the following (provided by the University of Illinois):

• Cash — those things that either are or can be easily converted to cash. Keep in mind that cashing in certificates of deposit (CDs) before they mature may result in an interest penalty.
• Investments — financial assets that can be cashed in or sold for their current market value e.g. own stocks, bonds or mutual funds. Prices will fluctuate with market conditions. Annuities may have surrender penalties. You may also owe income taxes and early distribution penalties on money taken from annuities.
• Retirement Assets — Assets that are held in tax-advantaged retirement accounts, such as 401(k) plans, IRAs, and pensions. You will owe regular income tax on withdrawals from tax-deferred accounts, and withdrawals before age 59-1/2 usually involve an additional 10% penalty.
• Personal Assets — Real estate and personal property that can be sold but usually not as quickly as other assets. Assets such as vehicles, furniture and appliances usually depreciate in value; so they are worth much less now than when you purchased them, even if they are still in good condition.

Liabilities are bills you are obligated to pay in future

Step 2: List your liabilities

Liabilities are simply the bills that you’re obligated to pay. Whether it’s a credit card bill or a mortgage payment, a liability is an amount of money you have to pay back eventually (usually with interest). If you don’t keep track of your liabilities, you may end up thinking that you have more money than you really do. Use the order below as a model when you list your own. You should list the liabilities according to how soon you need to pay them. Credit card balances tend to be short-term obligations, whereas mortgages are long-term.

• Credit card loans
• Personal loans
• Mortgages

Step 3: Calculate your Net worth

Your net worth is an indication of your total wealth. You can calculate your net worth with this basic equation: total assets less total liabilities. Just being in a position where assets exceed liabilities (a positive net worth) is great news. Analyze your own financial situation; your objective should be to increase your net worth from year to year as you progress toward your financial goals.

Step 4: Analyze your Net worth

In his book, Paul Mladjenovic offers the following advice to help in making more positive changes to your net worth by considering some or all of the following:

• Is the money in your emergency (or rainy day) fund sitting in an ultra-safe account and earning the highest interest available?
• Can you replace depreciating assets with appreciating assets?
• Can you replace low-yield investments with high-yield investments?
• Can you pay off any high-interest debt with funds from low-interest assets?
• If you’re carrying debt, are you using that money for an investment return that’s greater than the interest you’re paying?
• Can you sell any personal stuff for cash?
• Can you use your home equity to pay off consumer debt?

Closing Remarks

From the above, the three steps to understanding your financial well-being and getting your finance in order are:

I understand that your real-world affairs may require you to make varying changes to the structure provided here, but I am hoping this would serve as a reasonable background for pursuing your financial goals, especially as we begin 2023 tomorrow. I wish you the very best.

A 4-Step Compilation On: Making Investment Decisions

Our ability to identify patterns provides us with a sense of order and clarity, in situations where we can’t find a pattern things appear chaotic, probably even intimidating.

Over the past few weeks, I have been posting theories about business analysis and how they influence investment decisions. Each post provided a suggested step for investment analysis; for today’s post, I will unite them all on this page. This is a 4-step compilation on how to select a business to invest in.

1. Estimate Growth and Returns
2. Find out what the business is worth
3. Scrutinize the business using financial ratios
4. Scrutinize the business using non-financial factors

1. Estimate Growth and Returns

Growth and returns are two of the most commonly used terms when talking about investment and in many cases, they are used interchangeably. With these estimates, you can proceed to estimate what a business is worth below. Additionally, you can use these estimates to compare two or more companies to see which provides the best benefits for your investment.

Find out more! At: How to estimate the benefits of investing in a company.

2. Find out what the business is worth

Your next course of action is to ensure you are getting the best possible deal for the slice of the business you are about to purchase. Like any other market, the stock market is influenced by demand and supply which means it’s assets can be overpriced or underpriced.

Find out more! At: Everything you need to know about the intrinsic valuation of shares.

3. Scrutinize the business using financial ratios

Following the steps above, it is important to acknowledge that these are just estimates and it would be nice to back them up with some sort of reassurance, so you can be more confident in your decision. Conducting further analysis by using financial ratios helps to provide that reassurance. You will scrutinize the company’s existence and stability, as well as its ability to consistently generate profits.  With these answers, you may then review your chances of getting the benefits you crave.

Find out more! At: Start with what you know: A Beginner’s guide to making stock investment decisions.

4. Scrutinize the business using non-financial factors

A business is not just numbers; it can be influenced by customers, government, competitors, management, shareholders etc. Therefore to fully understand the strengths/weaknesses of a business you should understand how the business interacts with its people and how successful they are in each relationship.

Find out more! At: How to identify high-quality business without doing math.

With these four steps combined, you are now equipped with enough knowledge to decide on buying/selling/holding and investment

Disclaimer:

The information on this page and anywhere else on this website are investment theories, not individual investment advice, therefore their application or otherwise is up to your discretion.

How to Identify High-Quality Businesses Without Doing Math

Your analysis of a company is never complete if you have only considered the numbers of the business.

Actions lead to numbers, therefore considering the activities and events currently happening within a business can give you further reassurance about the safety of your investments.

When analysts examine the qualitative factors of a business they are usually on the lookout for market power and management excellence, with the following six factors featuring regularly:

1. Market power
2. Market share/leadership
3. Customer base
4. Special competencies
5. Supply chain power
6. Management effectiveness

1. Market Power

Market power is strength in the franchise, brand, customer base, supply chain power, or other competence that gives the company an advantage. Market advantage drives and protects the company’s profitability.

Companies with no market power are controlled by the industry they’re in. They’re vulnerable to the whims of their competitors and anyone who chooses to enter their market. As a result, achieving growth/profitability is difficult.

A company’s market power is intricately interwoven with its brand and franchise power, to get an understanding of this strength, consider the answers to the following questions:

• Image: How does the public perceive the brand in the marketplace? Is the company consistent with its effort to develop a high-quality brand image?
• Familiarity: Is the brand easily identifiable? Does it foster repeat purchases?
•  Reputation: similar to the two above, Ask yourself: how well does the company manage their mistakes and legal battles?

2. Market share and Leadership

Market leadership means that a company defines the market, sets the pace in price and product, and (usually) is tied to a strong brand. And market leadership often leads to cost advantages through buying power and economies of scale.

A market leader must devote a lot of energy to staying that way and must avoid the trap of resting on laurels and maintaining a position through arrogance.

Ask yourself: How far ahead of their nearest competitors is the company? Can the company set the pricing pace in its industry?

3. Customer Base

A company with a loyal customer base can depend on repeat sales and spends less money acquiring new customers. Profitability increases through lower marketing costs and repeat sales driven other than by price.

A business that treats a customer base as an asset is more successful than one that doesn’t. The company that “gets it” carefully manages and cultivates its customer base. Such a company learns about its customers, listens to them, talks to them, and nurtures loyalty and referrals. Successful companies build mutually beneficial relationships with their customers.

Ask yourself:  Does the company have a strong loyalty base? Does the value of their customers show through in their services?

Photo by Jopwell on Pexels.com

4. Special Competences

Does the business you’re evaluating have a distinctive competence? Does it have special knowledge, experience, or intellectual capital that others don’t have? Has it learned how to apply management science techniques to the auto sales business? Does it have some other kind of infrastructure, business model, or technology that’s difficult to duplicate?

5. The Supply Chain

When evaluating the business, look at distribution channels and their influence on stability, sustainable and growable sales, and stable costs. A company that can economically sell directly to its customers may have an advantage. Think about the resources needed to sustain and grow the business, and try to picture whether the company is likely to be in a better or worse position five or ten years down the road.

6. Management Effectiveness

Management excellence has four attributes: competence, candour, independence, and customer focus.

• Competence: Good management understands the business, has a realistic view of it, has a solid rationale behind strategies and decisions, and employs resources wisely within it.
  Ask yourself: Does management have the right vision, make the right decisions, and offer good reasons? Does management make sound investments in existing businesses? In new businesses?  Does it understand — and control — expenses?
• Candour: Managers who confess mistakes publicly are “more likely to correct them.” Honesty is the best policy. Along with candour, a little of the right attitude goes a long way.
  Ask yourself: Does the management show accountability?
• Independence: Good management teams think and act independently. They think and work for the business’s long-term health and resist the temptation to pour energy and resources into achieving short-term results.

7. Customer Focus

A management team focused on customers is more likely to succeed than one focused on its internal issues and on competitors. Does the company know its customers? Who they are and what are their needs?

Where do you get qualitative Information?

Intelligent investing requires that you have a solid understanding of the company and of the business to which you plan to commit your money. If you can’t understand the business and its qualitative factors then understanding their effect on the financials will be difficult.

Evaluating a company’s intangibles means that you are willing to read up on them, this is one of the reasons why you should only follow companies that interest you that way reading up does not seem like hard work. You can find a company’s information by:

• Reading the news
• Visiting financial sites like Yahoo Finance, Bloomberg, Morning star e.t.c
• Following them on social media.

Your decision

The information included in this post is by no means conclusive and as you begin to study companies, you will begin to identify patterns that lead you to develop new metrics.

Also, there is no particular scoring system for defining your evaluation of a company, although you can rate each of the factors here with a positive (+) or negative (-), at the end of the day making this decision is ultimately up to your discretion.

Other Methods?

If you want to take your analysis further, you might consider adopting one of the following performance and strategic analysis tools.

• SWOT Analysis
• PESTLE Analysis
• Porters five forces
• Porters diamond model
• Value chain analysis. ETC.

Everything You Need to Know About the Intrinsic Valuation of Shares

The market price of a stock is influenced by the demand and supply for it, which means that at any particular point in time, the price will not always reflect its true worth, therefore as an investor, it’s important to know if you are getting a bargain or a rip-off.

Intrinsic value can be defined as an estimate of a company’s worth. Warren buffet defined it as the discounted value of the cash that can be taken out of a business during its remaining life.

How to Calculate Intrinsic Value

The concept of intrinsic valuation was proposed by Benjamin Graham in his 1934 book security analysis however since then other analysts and investors have developed similar iterations of that formula.

For this post, I will consider 4 different iterations of the intrinsic value formula, namely:

1. The Benjamin Graham formula
2. Growth Modification of The Benjamin Graham Model
3. Discounted model
4. Discounted model using free cash flows

1. The Benjamin Graham Model

In developing the intrinsic value formula ben Graham was trying to establish a stock’s value based on earnings and earnings growth while keeping an eye on bond yields available as an alternative.

You see, bond yields are an important valuation and pricing factor for value investors. The idea is that to justify the added risk, “a stock’s return should be reasonably higher than that of an ordinary bond, if not why not just buy a bond and rest easy.“

Benjamin Graham’s formula requires a combination of the company’s current earnings, a base P/E ratio, a growth factor, and an adjustment according to the current bond yield. See below:

Intrinsic value = EPS * [(2 growth rate) + 8.5] * [4.4/bond yield]

Were:

EPS = the current annual earnings per share.

growth rate = is the annual earnings growth rate of the business, usually for the next 5 years (See how to estimate growth rates here)

8.5 = the Benjamin Graham assumed base P/E ratio for a stock with no growth.

4.5 = Benjamin Graham assumed average yield of AAA corporate bonds.

Y = Current yield of AAA corporate bond. (find this here)

Note: The lower the bond rates the higher the intrinsic value. This is because future earnings streams are worth more in a lower interest rate environment.

2. Growth Modification of The Benjamin Graham Model

Many investors today believe that the growth part of the ben graham formula (2 (growth rate) + 8.5) is far too aggressive and a more realistic price to earnings base for a no-growth company should be: (growth rate + 7).

With those adjustments, the new formula then becomes:

Intrinsic value = EPS * [growth rate+ 7] * [4.4/bond yield]

3. Discounted Model

You already know that inflation is the bad guy that makes a dollar today worth less than a dollar in two years. So if an investment requires you to pay $350 for a return of $370 in 3 years, you would consider what that $370 would be worth in today’s terms before accepting the deal.

With that idea in mind, value investors developed a method of calculating the intrinsic value of shares that also factors in future values.

To do that you’ll need:

growth rate = the company’s growth rate (usually for the next 5 years)

EPS ttm = the current annual earnings per share

P.E = Price earnings ratio

Rate of return = a percentage estimating expected gains on an investment. See how to estimate returns.

Next follow these steps:

1. Use the growth rate and the current year earnings per share to estimate the future earnings on a company’s share.
2. Multiply that figure by the price earnings ratio to get the future value
3. Use your rate of return to discount the future value to today’s terms.
4. Next apply a reasonable margin of safety (more on this later)

See this process in action on YouTube channel ‘Investing with Tom‘:

 4. Discounted Model using Free Cash Flows

This method is similar to the one in 3 above except that instead of using eps you would use the company’s free cash flow instead.

You can find the free cash flow figure in the company’s cash flow chart on Gurufocus.

See proccess in action by YouTube channel: ‘Cooper Academy’

Margin of safety

Value investors are bargain hunters; this means that they only buy a share when it’s worth less than its intrinsic value. The idea is to be in profit the very moment they enter the trade. They achieve this through a margin of safety.

Margin of safety is the difference between what a company is worth and what you are willing to pay for it.

After calculating a company’s intrinsic value, you need to decide what your margin of safety would be, most times this decision is based on how much faith you have in the company’s future growth. This faith is usually influenced by the qualitative factors surrounding the company, e.g. the management style, its competitors, government policies etc.

Price is What we Pay, Value is What we get

A common criticism of buying and holding a company’s share at a bargain price is that the business value may drop below that level and then markets align to that price or lower, effectively leaving you at a loss. To avoid this scenario you must make sure that the business is not just cheap, it should also be highly productive and efficiently managed.

Factors that would influence this decision are called qualitative factors. I consider qualitative factors in my next post.

Start With What You know: A Beginner’s Guide to Making Stock Investment Decisions

As of June 2022, the NYSE had a combined total of 2,584 listed domestic and international companies, so when someone tells you to invest in the stock market, where to begin, which industry, which companies or what shares? These are just a few of the questions that would begin to float through your mind.

Where to begin?

There are different theories on how to choose your first share investment but one thing almost everyone agrees on is that you should choose an industry you like and a business you love. As a shareholder who is also a customer/enthusiast, you’ll find it easier to read up on the company’s information, effectively equipping yourself with the ability to make a decision either to sell/buy/hold your investments.

Summary:  Go for businesses you like and whose products you already. Also, your investment portfolio can include as many industries as you want. In fact investing in multiple industries is a reliable way to manage your portfolio risks.

Incorporating Rational Analysis

After identifying your favourite companies, next you want to find out as fast as possible if the business is doing as well as you would think. In other words, you want to back up your favourite choice with an objective analysis without spending too much time on research.

This is where financial ratios and financial reports come in.

Listed companies are mandated to issue reports on their performance to the public, you can use information from these reports to conduct a quick analysis of the company.

Related: The Foundations of successful investments

Interpreting Financial Statements with Ratios

Over the years financial ratios have been developed to help investors interpret the numbers in a company’s account reports.  Financial ratios are  grouped into:

1. Profitability ratios
2. Liquidity ratios
3. Efficiency/activity ratios
4. Long-term solvency/Leverage ratios
5. Investment ratios

Profitability ratios 

These ratios are used to assess the level of profitability of a business entity in relation to the revenue generated and the capital invested.  Examples include:

• Return on capital employed (ROCE)
• Return on equity (ROE)
• Gross profit margin
• Net profit margin

Liquidity/Financial strength ratios

These are ratios that measure the ability of a business entity to meet its short-term obligation, that is pay its day-to-day debts as they fall due by using assets that can be quickly converted to cash.

These assets are normally referred to as liquid assets and they are shown in the statement of financial position as current assets. They are also referred to as working capital.

The ability of the company to utilize its long-term resources in its day-to-day operations depends on the adequacy of its working capital. The difference between these current assets and the company’s short-term obligations, current liabilities, is known as net working capital.

Examples include:

• Current ratio
• Quick assets ratio
• Absolute liquid ratio
• Net operating cycle
• Number of inventory days
• Number of receivable days
• Number of payable days

Efficiency/ Activity ratios

These ratios measure how efficiently the business entity has been utilizing its assets.

How much inventory, accounts receivable, or fixed asset investment does it take to support a given volume of business? Are these assets being managed effectively with proper controls?

Examples include        

• Total asset turnover
• Net assets turnover
• Trade receivables turnover
• Inventory turnover

Long-term Solvency/Leverage Ratios

These are ratios that show the capital structure of a business entity. They show the mixture of the business capital between equity (proprietary capital) and debts (long-term liabilities). They provide information on the degree of a company’s fixed financing obligations and its ability to satisfy these financial obligations.

Examples include

• Capital gearing
• Debt to Equity ratio
• Interest cover

Investment Ratios/Valuation ratios  

These are ratios that are of interest to investors and potential investors. They show the level of returns that an investor can expect from investing in the business entity. They are also referred to as shareholder ratios.

With valuation ratios, the stock price enters the picture. Valuation ratios, as the name implies, relate a company’s stock price to its performance. The ubiquitous price to earnings (P/E) ratio shows up here, as does its sibling’s price to sales (P/S), price to book (P/B), and a few others.

• Earnings per share
• Price earnings ratio (P/E ratio)
• Dividend Cover
• Dividend yield

Photo by Kaboompics .com on Pexels.com

Ratio Information Sources

The figures you need for your ratio analysis are found in the company’s financial statements (specifically the income statement and statement of financial position) which are part of a company’s annual report.

You can find a company’s annual reports on yahoo finance or do a quick google search with the company’s name, the year you require plus annual reports.

Where can you find computed ratios online?

It’s true that anybody with a company’s annual reports and a calculator can calculate a company’s ratios, however, I must admit that ratio analysis can be cumbersome and time-consuming, particularly when you’re looking at a group of companies or industries. So where can you find services that do the work for you for free?

• Yahoo finance (no registration required)
• Investopedia Stock Simulator (free registration)
• Trading 212 (free registration)

These are just the few that I use there are many others out there. If you know more kindly comment below!!!

What Do you look for When analyzing ratios?

• Consistency
• Trends
• Intrinsic meaning
• Competitive Comparisons

Consistency

The hallmark of good management, as well as of an attractive long-term investment, is the consistency of results delivered. If profit margins are consistent and changing at a consistent rate, the company is predictable — and most likely in control of its markets. Inconsistent ratios reflect inconsistent management, competitive struggles, and cyclical industries, all of which diminish a company’s intrinsic value.

Trends

Better than consistency alone is consistency with a favourable trend. Growing profit margins, return on equity, asset utilization, and financial strength are all very desirable, particularly if valuation ratios (P/E and so on) haven’t kept pace. Value investors who study trends carefully have information that most investors don’t have.

Comparisons

 For many analysts, and especially credit analysts, who are trying to get a picture of a company’s health, a comparative analysis is the most important use of ratios. A ratio acquires more meaning when it’s compared to direct competitors, the company’s industry, or much broader standards, like the S&P 500.

A profitability measure, such as gross profit margin, reported at 25 percent tells more when direct competitors are at 35 percent plus.

Note: Beware of differences within industries when comparing companies. A company mostly in the health insurance business may be difficult to compare to a company that sells mostly life insurance. While the resulting ratio differences may in part be valid, they also may lead you to believe that an apple is bad when it really isn’t. It’s important to compare apples to apples when comparing different companies.

Intrinsic Meaning

 What does the ratio tell you?

• If the debt-to-equity ratio is 3 to 1, then the company has a lot of debt.
• If the inventory-to-sales ratio is greater than 1, then the company turns its inventory less than once per year.
• A P/E ratio of 50 implies a 2 percent return on invested capital ($1 returned per $50 invested).

These numbers tell you something without looking at any comparisons or trends. Want an early test for determining whether a ratio is good, bad, or ugly? Just think of the company’s ratio as it would apply to your personal finances.

A household with 3 times as much debt as equity is in dire straits, as is a household that turns over inventory (say, groceries) only once a year, as is a household that achieves only a 2 percent return on its investments, or a household that’s owed a third of its annual income. You can’t apply this test to all ratios, but where common sense tells you something, use it!

Now you know

Now you know the importance of financial ratios, and where to find them in minutes!! and what to do with them.

Did you enjoy this article? Do you have any questions or corrections feel free to comment below!!! I love to hear from you.

Related: How to estimate the benefits of investing in a company.

Where Do You Go From Here

Analyzing the performance of a company is one of the considerations you make before you decide to invest in them. Next, you have to find out if they are priced correctly, a high-performing company with overpriced shares is not exactly a good investment. Find out more in my next post.

How You Can Estimate the Benefits of Investing in a Company

In my post on the foundations of a successful investment, I explained why estimating the profits you expect from your investment in today’s terms (present value) is essential. For bonds and other fixed investments, estimating these profits are usually straightforward because their returns percentage is given but for shares/stock, you need a little more work.

Recognizing the Options Available to You

If you want to analyse the benefits you get from investing in shares, two words that you’ll come across often are:

1. Growth
2. Returns

Although mostly used interchangeably growth and returns are not entirely the same.

Growth: is used to reference the increase in share price. for instance, if you bought a share for $5 and 3 years later it is now $8, we can say your investment has grown by 60%. If you decide to sell your shares then the benefit you get from that investment would be 60%.

Returns: is used to reference share price growth, dividends, and any other benefit you might have gotten from holding the shares.

TLDR

GROWTH = SHARE PRICE GROWTH

RETURNS = SHARE PRICE GROWTH + DIVIDENDS

Note: Not all companies pay dividends and if that’s the case for you then your returns = growth.

Estimating Growth

If you want to estimate the benefits of investing in a company, especially one that pays no dividend i.e your primary avenue for profit is from growth, it’s best to do so with a 5-year outlook to protect you from loss due to market fluctuations. Therefore for this post, I will be focusing on how you can estimate a company’s 5-year growth.

1. The Easiest Way: Use Yahoo! Finance

On Yahoo’s finance platform, you can easily navigate to the analysis page of your company of choice and scroll down to find analyst growth estimates for the next five years.

See the example for Google’s parent company Alphabet below:

On the analysis page, scroll down to find a series of growth estimates.

That’s it! Now you can apply this estimate in your analysis and calculations.

OR

Find out our to calculate this estimate yourself.

Extrapolation of historical growth

This is based on the idea that the shareholder’s expectations will be based on what has been experienced in the past. An average rate of growth is estimated by taking the geometric mean of growth rates in recent years. The formula for doing this is called Compound Annual Growth Rate, See below:

Geometric mean growth rate can be used to estimate the growth rate of stock prices or dividends

If we apply this formula to Alphabet shares as in above, for a 5-year estimate we will have:

t = 5

Vfinal(price of shares today-04-Feb-2023 ) = 104.78

Vbegin(Price of shares- 04-Feb-2018) = 52.31

CAGR = 14.9%

Adjusting for Risk

Working with the knowledge that the results you get from applying the CAGR formula are just an estimate, it is then important for you to apply a reasonable percentage based on your confidence level about the company’s future, the industry it’s in, and the economy as a whole.

Let’s say for instance I believe that with everything I know about google right now, I am confident that they can achieve 70% of this growth estimate.

Therefore adjusting for my confidence level, the growth rate I will be working with is: 14.9 X 0.7 = 10.43%

Estimating Benefits Through Returns

As an alternative to using growth estimates many shareholders use profit-based estimates to analyze the benefits they could get from an investment, even though not all profit would trickle down to shareholders, especially when a dividend is not paid. This is still useful in reviewing company performance, analyzing share prices, and making growth predictions.

Calculating Return on Equity

The return on equity ratio is used by shareholders to estimate how efficient a company is in converting its shareholders’ investments into profits. This ratio is used to get a sense of what investors’ returns will be.

The return on equity might be calculated based on the most recent financial statements or as an average of the returns on equity over a period of years.

the formula is:

This formula focuses specifically on profits and equity

If you want to apply the return on equity formula for a 5-year estimate, all you have to do is get the ROE value at the beginning and end of the 5 years and apply them to the CAGR formula above.

Summary

The methods of estimating returns on your share investments that I considered in this article are:

1. Yahoo! Finance
2. Geometric mean growth rate
3. Return on investment

With forward-looking estimates such as these, it is important that you acknowledge that accurately predicting the future is not possible (at least not all the time). The purpose of estimating returns is not to give you an exact figure of how much you’ll make from an investment but to provide you with something that can be considered to be within range of the actual figure.

With these estimates in hand, you can now estimate the value of a company’s shares.

How to See Through the Smokescreen of Gurus who Promise you Wealth

Everybody wants a juicy secret, even when it abandons pure facts, we fill in the holes ourselves. If you tried to recall the number of gurus who promised they’ll make you rich and the number of money-making secrets you have heard, I am sure you won’t be able to fit them all in one hand.

But you don’t need secrets to teach you how to be rich, there are three things common to every wealthy person on earth and these things are not secrets. Income, savings and wealth.

If you ever had the opportunity to attend an economics class, you’ll agree with me that  Income, wealth and savings are recurring discussions, but like me, you probably paid attention just enough to pass your exams. It’s time you thought of how these concepts affect your bank account, and before you run away, no you don’t have to pick up your old economics books, Nope! I have done that part for you. Stick with me.

Wealth or Income: Which is it?

Sure you already know what wealth is. Those assets you already own as a result of past incomes.

And of course, income would then be those financial inflows you receive for something sold or services you rendered. You use it to pay for housing, electricity bills, order food and of course, keep that Netflix account running, how else would you save a boring Friday night?

Genius! You are well on your way. Recognizing the difference between the two concepts is key to both building and protecting wealth. Income that is closely managed and carefully invested can create wealth over time.

Costs and debts

After receiving your income you spend it on recurring costs like Food, housing, transportation, clothes etc. These can be properly managed with a budget.

Additionally, you may have debts to pay and if you have the habit of paying them off as quickly as possible, that’s good practice. However some debts are tax deductible, and in those cases, you should consider the benefits of spreading out your repayments, if it’ll save you more money.

Savings and Assets

After deducting costs and debts from your income whatever is left is what you save. To secure their status as wealth-making elements, your savings should be invested as soon as possible, this above all ensures that your financial security is not exposed to inflation.

Related: Reasons Why Your Money Used To Be Worth Much More

Assets are resources that you own, control and obtain benefits from. Investments acquired with your savings are assets, and the most efficient assets generate income which leads to savings, thereby renewing the cycle that created them. The value of an efficient investment is also expected to increase over time. Assets include Property, shares, art, jewelry etc.

Moving From Income to Wealth

There is no formula to determine how much wealth is wealth enough for you, or how much income is needed to build that wealth that will keep you satisfied. It all depends on you.  What’s common to all of us is that In order to start building wealth, a proportion of our after-tax income should be saved regularly. Financial advisers would recommend a target of one-third but your income has a large role to play here. So let’s start with, how you generate income.

1. Generating Income

Unless you encounter the good fortune of inheriting money, property, or other assets to fast-track your journey to wealth, savings and investments from your income are the two principal strategies that can make you wealthy. That income can be earned in two main ways:

• Active or earned income: such as wages, salaries, tips, commissions e.tc which usually involves a degree of exertion to generate.
• Passive income: Money is received in exchange for little ongoing effort. You may have to do some work to set it up but after that, it needs less attention.  Examples include rents from properties, royalty payments for creative work, and portfolio incomes such as dividends from stocks and shares or interest from bonds.

2. Storing And Saving

High income would not make you wealthy if you have poor saving habits. The danger for people who earn top salaries is that it can lead to a false sense of affluence, resulting in big spending on lifestyle but little set aside in savings.

Financial advisers say you should aim for a goal of saving a third of your income; however, this may be an impossible target for you if you have large obligations. A more flexible approach is to ensure that you always save 10% or more of your income.

Consider adopting some or all of the following strategies to aid you in saving:

• Develop a personal budget
• Setting financial goals: such as buying a house or funding a master’s degree.
• Drawing up a spending plan: for expenditures such as housing, food, transportation e.t.c
• Monitoring budgets: weekly or monthly to keep track of spending
• Deciding on a percentage of income to save each month, and setting up a direct debit for that amount to go straight into a savings account.
• Finding cheaper accommodation, or refinancing a mortgage to achieve a cheaper rate.
• Comparing insurance rates and switching to a cheaper insurer; comparing deals from different energy suppliers to cut utility bills.
• Shopping with a list to eliminate impulse buys, and buying in bulk in order to take advantage of cheaper prices or sales.

3. Invest wisely

The closer you are to retirement, the less risk you can afford. Before you make investment decisions assess the risk vs the return of such a decision.

• Shares (Higher risk, potential for higher income)

Your choices include: Ordinary Shares, Preference shares, Options, Futures or Units in managed share funds

• Property (Medium risk, potential for steady income)

Your choices include: Rent from residential, commercial, industrial or Profit from buying and selling

• Interest-paying (Lower risk, potential for some income)

Your choices include Savings accounts, Term deposits, Debentures, and Bonds.

• You can also consider supporting a startup this can result in big gains, but many fail so it can be risky.

One common strategy is to create an investment portfolio spread across a variety of assets with different risk levels, such as shares, property, and bonds.

Related: The foundations of successful investments

4. Maintaining and Managing Wealth

It’s good practice to re-evaluate your investments from time to time; you may find better assets to invest in, or opportunities to have better returns at lower fees.

Also political and economic events affect your investments, so it’s always good to watch out for them and react accordingly.

Now you know.

As you go through life you’ll encounter people promising to make you a millionaire or billionaire, now you know that if their secrets don’t include income, investments or budgets, it’s best you pick up your shoes and run.

Do you like what you see? What stage of the wealth cycle are you in? If there is anything you feel this post is missing, comment below, and let me know. I love to hear from YOU.

Getting Your Investing Sails right Before You Go to Sea: 11 Fundamental Concepts

In the last couple of weeks, I have written many posts on starting a business or making investment decisions, with the idea that sound investments can be a way to raise capital for business and also maintain financial stability.

Over time, I observed there are fundamentals critical to your understanding of trading/Investing that I sort of glossed over to keep those posts relatively short and straight to the point. This article contains explanations of those fundamentals and more. This is your introductory guide to Investing.

Contents

1. Trading Philosophies
2. Types of traders
3. Conducting Analysis
4. The role of central banks
5. Keynes Economic Theory
6. Market sentiments
7. Business life cycle
8. Market Cycles
9. Money supply, interest rates and inflation
10. Money Markets
11. Financial instruments

1. Trading Philosophies

Trading/Investing philosophies are majorly classified into:

1. Mean Reversion: Mean reversion traders typically believe that market prices fluctuate around a certain level of equilibrium, be it the recent mean or something else like intrinsic value. They therefore believe that when a security deviates from this level, it is an opportunity to make a trade in the opposite direction and profit when the price returns to equilibrium.
2. Trend Following: ‘The trend is your friend, until the end when it bends.’
   Trend following describes the simple belief that markets move in trends. It follows the idea that if market prices move in one direction for long enough it is possible to trade in the direction of that movement and make a profit.

Trend following is thus the polar opposite of mean reversion and many trend followers’ trade trends irrespective of fundamental events or news flow.

2. Different Types Of Traders

1. Quants: Starting with the fastest traders of all, quants are the high-frequency traders who trade using quantitative methods and complex computer algorithms.
2. Scalpers: Scalpers also operate in the short term, but they may do so manually or by using a computer program. Scalpers look to profit from inefficiencies in markets and can hold trades for anything from a couple of seconds to a couple of hours.
3. Day traders: Day traders enter and close their trades on a daily basis, rarely holding any positions overnight. Typically, they trade off charts using technical indicators such as pivot points or moving average lines to justify their trades. They may also take into account fundamental factors and news releases – perhaps buying or selling a stock the moment an economic figure is released. Some day traders may also use strategies to hedge their trades as they go.
4. Swing traders: Swing traders typically hold positions for a couple of days, but not normally weeks. They are therefore less active than day traders but they do trade frequently enough to have to stay tuned to the markets at all times. They may use technical indicators such as trend lines or resistance channels to identify profit but are just as likely to look at fundamental news flow. They also look out for the possibility of reactions to upcoming news releases and events.
5. Position traders: Position traders take many longer-term positions and hold positions for weeks, months or years. They are therefore just slightly down from buy and hold investors in terms of time frames. Position traders study big macroeconomic trends in order to find the long-term moves that can often define a market for years. They are also likely to enter big short-position trades and use hedging strategies to build a successful and stable portfolio.
6. All of the above: It is also possible to be one, none, or many of these different trading styles combined. Some traders concentrate on one market and one style only, perfecting their technique as much as they can, while others take a bit of each style depending upon the situation. For example, a trader might take long-term positions but keep a little bit of capital in reserve, in order to profit from short-term opportunities when they arrive.

3. Conducting Analysis

You conduct an investment analysis using either or both of the following methods:

1. Fundamental analysis: is best described as any analysis that looks at data relating to economics or the big picture numbers that operate behind the market. It is therefore not directly interested in the price and can also include top-down or bottom-up analysis.
   As fundamental analysts, position traders study the market rigorously in order to find the big macroeconomic trends that enable them to make huge multi-month or multi-year profits. They study such factors as unemployment, GDP (gross domestic product), retail sales or the outlook for interest rates and they have a firm grasp of how global markets interact with each other.
2. Technical Analysis: Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume. Unlike fundamental analysis, which attempts to evaluate a security’s value based on business results such as sales and earnings, technical analysis focuses on the study of price and volume.

Related: The Foundations Of Successful Investments

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4. Central Banks

One of the key lessons a trader must learn before attempting to trade is that central banks can have a huge impact on stocks, bonds, commodities, forex and the global economy itself. Therefore the activities of the central bank should be followed with keen interest.

These are the three major responsibilities of central banks:

1. First, central banks control and manipulate the national money supply: issuing currency and setting interest rates on loans and bonds. Typically, central banks raise interest rates to slow growth and avoid inflation; they lower them to spur growth, industrial activity, and consumer spending. In this way, they manage monetary policy to guide the country’s economy and achieve economic goals, such as full employment.
2. Second, they regulate member banks through capital requirements, reserve requirements (which dictate how much banks can lend to customers, and how much cash they must keep on hand), and deposit guarantees, among other tools. They also provide loans and services for a nation’s banks and its government and manage foreign exchange reserves.
3. Finally, a central bank also acts as an emergency lender to distressed commercial banks and other institutions, and sometimes even a government. By purchasing government debt obligations, for example, the central bank provides a politically attractive alternative to taxation when a government needs to increase revenue.

5. Keynes Economic Theory

Understanding Keynes’s economic theory can help you understand the efforts of central banks and the government.

Keynesian economics comprises a macroeconomic theory of total spending in the economy and its effects on output, employment, and inflation.

Keynesian economics was developed by British economist John Maynard Keynes during the 1930s in an attempt to understand the Great Depression.

Keynes advocated a countercyclical fiscal policy in which, during periods of economic woe, the government should undertake deficit spending to make up for the decline in investment and boost consumer spending to stabilize aggregate demand.

There are three principal tenets in the Keynesian description of how the economy works:

• Aggregate demand is influenced by many economic decisions—public and private. Private sector decisions can sometimes lead to adverse macroeconomic outcomes, such as a reduction in consumer spending during a recession. These market failures sometimes call for active policies by the government, such as a fiscal stimulus
• Prices, and especially wages, respond slowly to changes in supply and demand, resulting in periodic shortages and surpluses, especially of labour.
• Changes in aggregate demand, whether anticipated or unanticipated, have their greatest short-term effect on output and employment, not on prices. 

6. Market Sentiments

Market sentiment, also known as investor attention, is the general prevailing attitude of investors as to anticipated price changes in a market.

If investors expect upward price movement in the stock market, the sentiment is said to be bullish. On the contrary, if the market sentiment is bearish, most investors expect downward price movement.

Market participants who maintain a static sentiment, regardless of market conditions, are described as permabulls and permabears respectively.

Market sentiment is usually considered a contrarian indicator: what most people expect is a good thing to bet against. Market sentiment is used because it is believed to be a good predictor of market moves, especially when it is more extreme.

Very bearish sentiment is usually followed by the market going up more than normal, and vice versa.

7. Business Life cycle

Your analyses of a company should include an examination of its current life cycle stage

Business Life Cycle is a natural way of business progression. It shows the gradual and slow and steady stages through which business progress begins with developing a prototype idea to gaining traction, moving from the initial phase of slow growth to high growth. Usually, it is divided into four stages:

• Introduction Stage
• Growth Stage
• Maturity Stage
• and Decline Stage.

8. Market Cycles

Markets move in four phases; understanding how each phase works and how to benefit is the difference between floundering and flourishing.

• In the accumulation phase, the market has bottomed, and early adopters and contrarians see an opportunity to jump in and scoop up discounts.
• In the mark-up phase, the market seems to have levelled out, and the early majority are jumping back in, while the smart money is cashing out.
• In the distribution phase, sentiment turns mixed to slightly bearish, prices are choppy, sellers prevail, and the end of the rally is near.
• In the mark-down phase, laggards try to sell and salvage what they can, while early adopters look for signs of a bottom so they can get back in.

9. Money supply, Interest rates and Inflation

The bond market is a great predictor of inflation and the direction of the economy, both of which directly affect the prices of everything from stocks and real estate to household appliances and food. A basic understanding of short-term versus long-term interest rates and the yield curve can help you make a broad range of financial and investing decisions.

• A normal yield curve shows bond yields increasing steadily with the length of time until they mature but flattening a little for the longest terms.
• A steep yield curve doesn’t flatten out at the end. This suggests a growing economy and, possibly, higher inflation to come.
• A flat yield curve shows little difference in yields from the shortest-term bonds to the longest-term. This indicates uncertainty.
• The rare inverted yield curve signals trouble ahead. Short-term bonds pay better than longer-term bonds.

Related: Reasons why your money used to be worth much more

Interest Rates and Bond Yields

The terms interest rates and bond yields are very important for investors, especially those who invest their money in the fixed-income market. The two are often used interchangeably, but it’s important to note that there is a difference.

An interest rate is what someone pays to a lender for borrowing money. This is usually expressed as a percentage of the principal balance.

The bond yield is the return an investor realizes on a bond ( this is mostly interest plus your initial investments)

Using the Yield Curve to Invest

Interpreting a yield curve’s slope is useful when making top-down investment decisions for a variety of investments. If you invest in stocks and the yield curve says to expect an economic slowdown over the next couple of years, you may consider moving your money to companies that perform well in slow economic times, such as consumer staples. If the yield curve says that interest rates should increase over the next couple of years, investment in cyclical companies such as luxury goods makers and entertainment companies makes sense.

Real estate investors can also use the yield curve. Though a slowdown in economic activity might have negative effects on current real estate prices, a dramatic steepening of the yield curve, indicating an expectation of inflation, might be interpreted to mean prices will increase in the near future.

It’s also relevant to fixed-income investors in bonds, preferred stocks, or CDs. When the yield curve is becoming steep—signalling high growth and high inflation—savvy investors tend to short long-term bonds. They don’t want to be locked into a return whose value will erode with rising prices. Instead, they buy short-term securities.

If the yield curve is flattening, it raises fears of high inflation and recession. Smart investors tend to take short positions in short-term securities and exchange-traded funds (ETFs) and go long on long-term securities.

You could even use the slope of the yield curve to help decide if it’s time to purchase a new car. If economic activity slows, new car sales are likely to slow, and manufacturers might increase their rebates and other sales incentives.

10. Money Market

The money market is a component of the economy which provides short-term funds. The money market deals in short-term loans, generally for a period of a year or less.

• An individual may invest in the money market by purchasing a money market mutual fund, buying a Treasury bill, or opening a money market account at a bank.
• Money market investments are characterized by safety and liquidity, with money market fund shares targeted at $1.
• Money market accounts offer higher interest rates than a normal savings account, but there are higher account minimums and limits on withdrawals.

11. Financial Instruments

For the purpose of this article, the instruments we will consider are:

• Treasury Bills
• Bonds
• Forex
• Commodities
• Exchange Traded Funds (ETF)
• Futures
• Stocks
• Index
• Mutual Funds

Treasury Bills

Treasury bills are debt instruments issued when the government needs money for a short period. These bills are issued only by the central government, and the interest on them is determined by market forces.

Treasury bills, or T-bills, have a maximum maturity period of 364 days. So, they are categorized as money market instruments (money market deals with funds with a maturity of less than one year).

Bonds

A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer.

Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually include the terms for variable or fixed interest payments made by the borrower.

Forex

Forex (FX) is a portmanteau of foreign currency and exchange. Foreign exchange is the process of changing one currency into another for a variety of reasons, usually for commerce, trading, or tourism. Trading currencies can be risky and complex. Because there are such large trade flows within the system, it is difficult for rogue traders to influence the price of a currency. This system helps create transparency in the market for investors with access to interbank dealing.

Retail investors should spend time learning about the forex market and then researching which forex broker to sign up with, and find out whether it is regulated in the United States or the United Kingdom (U.S. and U.K. dealers have more oversight) or in a country with more lax rules and oversight. It is also a good idea to find out what kind of account protections are available in case of a market crisis, or if a dealer becomes insolvent.

Commodities

A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. Traditional examples of commodities include grains, gold, beef, oil, and natural gas.

For investors, commodities can be an important way to diversify their portfolios beyond traditional securities. Because the prices of commodities tend to move in opposition to stocks, some investors also rely on commodities during periods of market volatility.

ETFs (Exchange Traded Funds)

An exchange-traded fund (ETF) is a type of pooled investment security that operates much like a mutual fund. Typically, ETFs will track a particular index, sector, commodity, or other asset, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way that a regular stock can. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies.

Futures

Futures are derivative financial contracts that obligate parties to buy or sell an asset at a predetermined future date and price. The buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.

Underlying assets include physical commodities and financial instruments. Futures contracts detail the quantity of the underlying asset and are standardized to facilitate trading on a futures exchange. Futures can be used for hedging or trade speculation.

Stocks

A stock, also known as equity, is a security that represents the ownership of a fraction of the issuing corporation. Units of stock are called “shares” which entitles the owner to a proportion of the corporation’s assets and profits equal to how much stock they own. 

Stocks are bought and sold predominantly on stock exchanges and are the foundation of many individual investors’ portfolios. Stock trades have to conform to government regulations meant to protect investors from fraudulent practices.

Index

An index is a method to track the performance of a group of assets in a standardized way. Indexes typically measure the performance of a basket of securities intended to replicate a certain area of the market.

Indexes and “indices” are acceptable plural forms of the word “index” or refer to more than one index.

Mutual Funds

A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds. Each share represents an investor’s part ownership in the fund and the income it generates.

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Value Investing: The Philosophy That Gets you Investing like Warren Buffett

Prices in themselves are not appropriate determinants of value, this is one of the core principles of value investing and after examining this idea thorougly, you’ll see this principle cannot be denied.

Consider this example

If I went to a store and got two items one for $40 and the other for $90 dollars. You can’t answer the question “which was the better buy?” without at the very least knowing what each item is. If I told you I got a pair of socks for $40 dollars and a $90 dollar tuxedo suit, then you can make a decision. I have probably overpaid for the socks and got a bargain on the suit. 

If we agree with this analogy in other markets why not in the stock market?

The value investing philosophy was pioneered by Benjamin Graham and has been popularly put to great use by Warren Buffett (who needs no introduction). The core ideas behind this philosophy can be summarised as follows:

• Price does not always equal value
• The price you pay for something is only relevant in relation to its value
• The essence of value investing is to purchase shares of a company at a price that is substantially lower than the company’s underlying value.

Margin of Safety

Margin of safety represents the difference between a company’s stock price and the company’s value.

Value investors believe that a large margin of safety provides greater return potential as well as a greater degree of protection over the long term.

When the stock price of the company falls sufficiently below the intrinsic value, it creates a buying opportunity.  Value investors expect that over time, as others recognize the true value of the company, its share price will climb toward its intrinsic value. As this happens, the margin of safety shrinks. When the share price equals or exceeds the company’s intrinsic value, the margin of safety has disappeared and the shares should be sold.

What about Growth Investing?

In truth growth investing and value investing have more in common than apart, the major difference lies in the emphasis on “margin of safety”.

A value investor buys stocks on bargain ensuring that the moment he enters a trade, he is already at a profit. Growth investing however focuses on capital appreciation above all, therefore even if a stock isn’t cheap, if it has the potential to increase in value/price in future a growth investor is satisfied.

Value investing vs Speculating

Benjamin graham defines an investment operation as “one which, upon thorough analysis, promises safety of principal and an adequate return.”

Based on this definition, there are three components to investing:

• Thorough analysis,
• Safety of principal
• Adequate return.

Any operations not meeting these requirements according to Graham should be considered speculative.

Investor Charles.H.Brandes expanded on this definition by adding that speculation is:

• Any purchase any based on anticipated market movements or forecasting.
• Having a holding period shorter than a normal business cycle (typically 3 to 5 years)

The problem with speculating is: Who can predict what a third party will pay for your shares today, tomorrow, or any day? Stock market prices typically swing between extremes, stoked by the irrational emotions of fear and greed.

Criticisms of Value Investing

On paper, the logic of value investing may appear obvious: buy stocks at a bargain price and sell them after the price has gone up. However investment decisions are not that straightforward, an investor is subject to an ever-changing environment where logic can be overshadowed by emotion.

It takes a great deal of conviction to stick to value-investment disciplines, especially when a company’s stock price declines after you purchase its shares.

This is why value investor’s trade long-term (3-5 years).

Value investing principles are therefore majorly unappealing to short term traders.

What do you think about value investing?

Which investment strategy do you prefer? Comment below.