Stock investing might sound complicated, particularly for those without a formal background in finance. The world of income statements, balance sheets, cash flow statements, and intricate financial documents can appear overwhelming to the average person interested in exploring the world of investments. But fear not, for in this article I will try to break it down and make it really simple to understand using simple examples.

Let’s start with the most crucial concept: ‘Investing in stocks is like buying a business.’

Imagine you’re thinking of buying a local burger shop. The owner wants PKR 10,000,000 for it. Your first question would likely be, ‘How much money does this burger shop make after paying all the bills?’

In the business world, we call this ‘profit,’ or ‘earnings’ and you’ll find it in the income statement of a company.

Now let’s consider the business makes PKR 1000,000 in profit per year, the next thing you would like to check is whether the profit is consistent or not. Does this burger shop give PKR 1000,000 on a regular basis? Or is it random?

Let’s suppose the profit is consistent and you can earn PKR 1000,000 each year if you buy this business. Now you need to figure out how much you’re willing to pay to own it.

This is where the ‘Price to Earnings Ratio’ (PE ratio)comes in. It’s a fancy term that tells you if you’re getting a good deal.

PE = Price of Business / Yearly Earnings of the Business

If you buy the shop for PKR 10,000,000 and it makes PKR 1,000,000 per year, your PE ratio is 10, and you’ll earn a 10% return each year. If you buy it for PKR 20,000,000, your PE is 20, and your yearly return drops to 5%. But if you manage to buy it for PKR 5,000,000, your PE is 5, and you get a solid 20% yearly return.

Remember, the higher the PE, the lower your return. So understanding profits and what you pay for them is key.

When you’re investing, put aside your love for the business’s products and focus on profit and the cost of ownership. This is what the PE ratio helps you do.

PE = 25 → Return = 4%
PE = 20 → Return = 5%
PE = 15 → Return = 6.5%
PE = 10 → Return = 10%
PE = 5 → Return = 20%

Profits are important but not enough, you need safety. In order to determine your margin of safety you need to look at what happens if the business closes down for some reason. That’s where ‘Equity’ comes in, found in the balance sheet.

Equity = Total Assets - Total Liability

To help clarify the concepts of assets and liabilities, let’s break it down. An asset is something that adds value or puts money in your pocket over time. For instance, owning a rental property, having business equipment or machinery, or maintaining a savings account are all examples of assets.

Conversely, a liability is something that drains money from your pocket or represents a financial obligation. Consider credit card debt, unpaid taxes, medical bills, or personal loans – these are all examples of liabilities.

Consider the burger shop’s numbers:

Assets:

Cash in Account:            PKR 160,000
Burger making Equipment:    PKR 140,000
Furniture:                  PKR 250,000
Supplies:                   PKR 120,000
Shop:                       PKR 1000,000

Total Asset:                PKR 1,670,000

Liability:

Salary owed:                PKR 70,000
Lone on Shop:               PKR 600,000

Total Liability:            PKR 670,000

Equity

Total Equity =. PKR 960,000 - PKR 670,000 = PKR1,000,000

So if the shop closes, it’s worth PKR 1,000,000.

The risk in investing is the difference between the business’s price and equity. For our burger shop, the price is PKR 10,000,000, and the equity is PKR 1,000,000, meaning the risk is PKR 9,000,000. That’s quite risky.

The closer the equity is to the market price, the safer your investment.

So in this article, we learned some of the basics of finance and some of the most important factors one needs to consider while evaluating a business. In my next article, we’ll delve deeper into the concept of shares and connect all the dots we’ve discussed so far to help you understand how stocks represent ownership in a business. So, be sure to stay tuned for an even clearer picture of the stock market and its workings.