High-Powered Investing All-in-One For Dummies
One key to successfully expanding your investment opportunities is gathering the information you need to make sound investment decisions. Another key is being able to analyze financial information so that you understand what it reveals about a corporation’s financial health, a portfolio’s risk profile, and so on. The articles in this Cheat Sheet explain financial ratios, which help you make sense of financial data; tell you what economic reports to consider when you’re investing; and introduce you to the Greeks, which are calculations that you use to measure risk.
Key Financial Ratios for High-Powered Investing
Financial ratios, or accounting ratios, provide investors with a way of analyzing information in order to evaluate the financial health of a corporation. The values used when calculating ratios come from a corporation’s accounting or financial statements: its balance sheet, income statement, statement of cash flows, and so on.
Following are some common ratios that you see as an investor. These can help you make sense of the information you find in the financial reports you receive.
|Current ratio||Total current assets ÷ Total current liabilities||Gives some indication whether a company has enough financial cushion to meet its near-term obligations.|
|Quick ratio||(Current assets – inventory) ÷ Current liabilities||Same as current ratio, without including inventory in the calculation. Provides another sign of a company’s strength or weakness.|
|Return on equity (ROE)||Net earnings ÷ Owners’ equity||Measures how well the company is managing its resources.|
|Return on assets (ROA)||Net earnings ÷ Total assets||Reflects the relationship between a company’s profit and the assets used to generate it.|
|Debt to equity||Total debt ÷ Owners’ equity||Indicates how dependent a company is on debt.|
|Debt to assets (or debt ratio)||Total debt ÷ Total assets||The higher the ratio, the more financial risk the company has assumed.|
|Price-to-earnings (P/E)||Stock price per share ÷ Net earnings per share||Clues you in to how much you are paying for the company’s earnings.|
|Price-to-book (P/B)||Stock price (total market cap) ÷ Book value||Compares the company’s market value to its accounting (or book) value.|
Essential Economic Reports for High-Powered Investors
To be a serious investor, you have to do some serious research. A key part of your investment research involves economic reports. Following are just some of the economic reports you should peruse regularly.
|Beige Book (from the Federal Reserve)||Compiles regional economic assessments from the Fed’s 12 district banks|
|Consumer price index (CPI)||Measures the cost of goods and services at the retail level|
|Existing-home sales and housing starts||Indicates strength of housing market|
|Gross domestic product (GDP)||Measures total economic activity|
|Index of leading economic indicators (LEI)||Gauges the economy’s direction over the next six to nine months|
|Institute for Supply Management (ISM) and regional purchasing managers’ reports||Indicate current business conditions and future outlooks|
|Monthly non-farm payroll report (NFP)||Assesses the overall labor market|
|Producer price index (PPI)||Measures prices at the wholesale level|
Financial Risk Variables: The Greeks in High-Powered Investing
When you trade options, you need to understand the Greeks. So-called because the most common of these tools are represented by Greek letters, the Greeks provide investors with a way to calculate risks that affect the value of their portfolios. They can then use this information to mitigate, or hedge, their portfolios against adverse market conditions. The Greeks explain several risk variables that influence option prices:
Amount of volatility: An increase in volatility usually is positive for put and call options, if you’re long in the option. If you’re the writer of the option, an increase in volatility is negative.
Changes in the time to expiration: Time value shrinks as an option approaches expiration and is zero upon expiration of the option. The closer you get to the time of expiration, the more negative the time factor becomes for a holder of the option and the less your potential for profit.
Changes in the price of the underlying asset: An increase in the price of the underlying asset usually is a positive influence on the price of a call option. A decrease in the price of the underlying instrument usually is positive for put options.
Interest rates: Higher interest rates make call options more expensive and put options less expensive, in general.
By understanding the Greeks, which follow, you’ll be better able to protect the value of your portfolio.
Alpha (Α, α): Investment return that’s different than you’d expect, given an investment’s beta, which is its exposure to market risk and return. Alpha (which can be positive or negative) describes an intangible value that accounts for the extra return generated (or lost) for the amount of risk taken. Some researchers aren’t sure that alpha exists at all.
Beta (Β, β): The market beta is 1, so an investment with a beta of more than 1 is more volatile than the market as a whole. You can expect the investment to return more than the market in an up year and less than the market in a down year.
Delta (Δ, δ): The percentage change in an investment. Delta often describes how much an option changes in price when its underlying security changes in price.
Gamma (Γ, γ): The rate of change in delta. Gamma is exposure to any change in price, positive or negative.
Sigma (Σ, σ): Standard deviation, or the likelihood that any one number in a series — like a series of investment returns — will be different from the return that you expect. The higher the standard deviation, the greater the investment risk.