In previous posts I’ve written about market capitalization and the P/E ratio, and the basics of the stock market. Today I want to introduce another concept used to analyze a company to determine whether you’d like to invest in it.

Return On Equity (ROE) is a measure of a companies ability to profitably employ the money that shareholders have invested. This measure is calculated as follows:

ROE = Net Income / Shareholder’s Equity

A company’s net income may be obtained from the income statement while the shareholder’s equity is reported on the balance sheet. You don’t actually need to calculate this yourself, though, since many financial sites such as Morningstar will provide it for you.

So, now that you have this number, what does it mean for you? Like I stated earlier, it measures how profitably a company employs its investors money. It should be obvious that the higher this number the better; however, there’s a little more to it than that.

Say a company has an 18% return on equity (General Electric is one example). Let me be clear now; this does not mean that you will earn 18% on the money you invest. If you remember from an earlier post, when you buy a stock, you’re buying it on a secondary market, and it has no effect on the company’s financials. What you are doing is buying an ownership interest in the company that then entitles you to any FUTURE earnings and growth.

This is where the 18% ROE comes into play. Now that you own a few shares of a company, the company will hopefully post a profit from which you determine what’s called Earnings Per Share (EPS). These earnings belong to you as the shareholder. The company now has to make the choice of what to do with these earnings.

There are a few main options. The company may announce a dividend, in which case you will be paid out a portion of these earnings. The company may choose to buy back it’s own stock with these earnings (a topic for another day), or it may choose to reinvest the earnings back into the company which is what we call retained earnings.

It is this last option that we are interested in when we talk about Return On Equity. Based on our example of an 18% ROE, we can expect the company to earn an 18 percent return on this reinvested capital. It is this compounding year after year of profitably retained earnings that can make one wealthy.

There is an upfront cost to get into a stock because of the current market valuation. Looking back at the P/E ratio, if a company trades at 20 times earnings and has earnings of $2 a share, you can expect to pay about $40 per share. If you buy this stock, you can view the earnings as your return on your investment, in this case $2 / $40 = 5%. This doesn’t look like anything spectacular, but it’s the $2 in earning that will compound at the 18% Roe.

In the second year you could reasonably expect earnings increase to $2.36 (2 x 1.18 = 2.36). This then increases your return to 5.9% (2.36 / 40 = 5.9%). After 10 years of the earnings compounding, your $40 initial investment is now returning over 26%.

Obviously there are assumptions being made such as a sustainable ROE and earnings growth and the like, but it’s the concept that I want you to understand. It’s another tool to put in your financial toolbox. Hopefully, this has provided some insight into the investment world and will help you in the future.

Last night, we were at an event with people from our church. After the event was over, another couple asked if we had any other plans for the rest of the evening and suggested that we go to Olive Garden. While I don’t have anything against the Olive Garden, I wasn’t in the mood to throw away about $25.

Actually I find myself in this situation more than I’d really like to be. I understand that most people aren’t working towards the same goals, but I also don’t want to alienate people or make it seem that we don’t want to spend time with them. I also run the risk of people viewing me as “cheap”, but I’ve pretty much gotten over that one.

Instead of actually going out, we invited this other couple over to our place for dinner. We ended up having a great time and were able to get to know each other better. We were able to do pretty much the same thing, but we weren’t out the $25 or so it would have cost us at the Olive Garden.

I’m glad that it worked out so well last night, but it’s not really always that easy. What do you do when you’re faced with a situation like this? Do you have any tips that could help me and other readers out?

I’m reading a book right now entitled Buffettology written by Mary Buffett, Warren Buffett’s former daughter in law. There is a chapter titled The Myth of Diversifications Versus the Concentrated Portfolio. It portrays a very different perspective on investing that what is generally purported.

“Warren believes that diversification is something people do to protect themselves from their own stupidity. They lack the intelligence and expertise to make large investments in just a few businesses, so they must hedge against the folly of ignorance by having their capital spread out among many different investments.”

While I don’t much care for the tone of this quote, I do happen to agree with it. Most people don’t want to spend any more time than necessary on choosing their investments. All you have to do is look at the very lucrative mutual fund industry to see that this is the case. And when I say “very lucrative”, I’m not talking about the individual investor, but instead, the fund managers.

It’s also interesting to note that the bulk of the gains in these funds usually come from a few well performing investments. Proponents of diversification will say that you need to own many investments because you don’t know which one’s will be the outstanding performers. Those like Warren Buffett will say that you should learn the basics and then some of investing and do sufficient research. This way you will only invest in very secure and highly profitable businesses.

You can choose the style that you feel most comfortable with, but it is certainly food for thought. Why is it that we’ll spend hours upon hours researching all the features and specifications for the new LCD TV we want, and we’re content to just deposit our money into a fund where we most likely don’t even know what it’s invested in. No matter what style you choose, it can’t hurt to learn more about how to choose good investments.

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There are so many different financial products out there to choose from these days. There are brick and mortar banks, internet banks, national banks, local banks, standard brokerage firms, online brokerage firms, investment banks, credit card companies, and the list goes on. With all these options to choose from, you could spend a lot of time just trying to decide what products are right for you.

I’m a big believer in knowing what you’re getting yourself into and reading the fine print. I do, however, think that there is a limit to this. You can’t spend all your time researching to the point that you never actually reach a decision and move forward.

Let’s take a basic money market account for example. You can get an account at your local bank, brokerage firm, financial planner, or from an internet bank such as ING (see link to the right). The interest rates will vary from provider to provider and they are also continually changing. Some people have looked at all these accounts many times but are still unsure which one’s the best. In the meantime, their money is sitting in a standard savings account earning next to nothing.

I know I make this point a lot, but doing something is usually better than nothing. Pick an account that meets your needs and don’t worry if there might be something better out there. If you happen to stumble across another option that would be better for you, there’s nothing saying that you can’t switch to it.

The same thing goes for credit cards. There are so many options in this arena and yes, some may be marginally better than the next, but you may as well make a choice that will meet your needs and move on with life.

You also have to realize that a lot of the options that are available today might not even be around in the next 10 years or so. No decision is really final when it comes to your finances. Balances can be moved, rolled over, transferred, or what have you depending on what your then current situation requires.

Don’t misunderstand me, though; it’s important to understand what you’re getting yourself into, but don’t fall into the trap of “analysis paralysis”. Eventually, you need to make a decision and sooner can be better than later.

People often throw this phrase around and it’s usually used in context with earning interest or compound interest, but what does it actually mean? It’s not really as complicated as you might think.

The concept of the “time value of money” is the idea that money in the present is worth more than the same amount of money in the future. It’s based on this basic concept that you’ll hear terms such as “net present value”, “future value”, “discounting”, or “internal rate of return”. Maybe I’ll get into those concepts in the future, but for now let’s stick with the basics.

To explain the time value of money, let’s take an example. Say that the interest rate you can earn on your money is 5% and you have $1,000. At the end of one year you’ll have $1,050. This also works conversely in that $1,000 received a year from now is really only worth $952.38 today.

Companies all over know of this concept and try to use it in their favor all the time. Take the AdSense program, or any other ad network, for example. You won’t get your balance paid out to you until you reach a certain threshold, and even then they take a month or so to actually get the payment to you. They want to hold on to the money as long as possible.

Insurance is probably the best example of the concept of time value of money. Say that you went out and bought a $1 Million dollar 20 year term life policy. The insurance company wants your money in the present (in the form of premiums) and then will pay you out at some point in the future. Assuming an investment interest rate of 10% and a time horizon of 15 years, this $1 Million dollar policy is only presently worth a little under $240,000.

You don’t really need to have a deep understanding of this concept in order to make use of it. Simply put, money in the present is worth more than money in the future.

Just about two years ago I got a summer internship and moved to St. Louis for the summer. After I graduated a year later, I took a full time position with the same company and relocated here. While I was doing this internship, the real world finally hit me. It finally dawned on me that the academic world wasn’t all there was and that I could actually be financially sound.

During those couple of months, I was being paid more than I had ever gotten before (partly because never really worked a full 40 hours consistently during school), and I took an increasingly greater interest in my personal finances. I’ve always been pretty independent, but I was now applying it to my financial situation.

I went to the library quite often and checked out many different books on personal finance and investing. I began reading Yahoo! Finance, MSN Money and CNN Money. By the end of the summer I knew all about 401k plans, Traditional and Roth IRAs, the basics of stocks, bonds, and mutual funds.

What I’m getting at is that I made a concerted effort to learn all I could about how money finances work. I wanted to find out the best ways to put my money to work. I’m still learning more and more everyday, but I encourage you (if you haven’t already) to also make it a priority to learn how to save and invest. Make a trip to your local library. I didn’t read everything in every book; if a chapter wasn’t interesting, I’d move on and read the sections that I wanted. The point is the make the effort. You may surprise yourself at how you can change your financial outlook just by educating yourself with the basics of money and personal finance.