Learn
First Principles Glossary
Every metric, score, and ratio explained in plain English. Understand the “why” behind each number, not just the formula. No jargon, no assumptions — just clear thinking from first principles.
Valuation Metrics
P/E Ratio (Price-to-Earnings)
ValuationIn Plain English
How many dollars you pay for each dollar of profit. If a stock has a P/E of 20, you're paying $20 for every $1 the company earns per year.
Why It Matters
Helps you understand if you're overpaying for earnings. A high P/E means investors expect high future growth; a low P/E might mean the company is undervalued or has problems.
How to Read It
Compare to industry peers and historical averages. A P/E of 15 is typical for the overall market. Tech companies often have P/Es of 30+, while utilities might be 12-15.
- • P/E below industry average
- • P/E below company's 5-year average
- • Growing earnings with stable P/E
- • P/E significantly above peers
- • P/E expanding while earnings shrink
- • Negative P/E (losing money)
FCF Yield (Free Cash Flow Yield)
ValuationIn Plain English
The percentage return you'd get if the company gave you all its free cash. It's like asking: 'If I bought this whole company, what cash return would I get each year?'
Why It Matters
Free cash flow is what's left after the company pays all its bills and invests in growth. It's the money that could theoretically be returned to you. High FCF yield = more bang for your buck.
How to Read It
Higher is better. 5%+ is attractive, 10%+ is exceptional (but investigate why). Compare to bond yields — if the 10-year Treasury yields 4%, a stock's FCF yield should be higher to compensate for risk.
- • FCF yield > 5%
- • Stable or growing FCF yield over time
- • FCF yield higher than dividend yield (room to grow dividend)
- • Negative FCF yield (burning cash)
- • FCF yield declining significantly
- • FCF much lower than reported earnings
EV/EBITDA (Enterprise Value to EBITDA)
ValuationIn Plain English
The total takeover price (including debt) divided by yearly operating profits before accounting adjustments. Think of it as: 'How many years of profits to buy the whole company, including its debt?'
Why It Matters
It's a cleaner comparison than P/E because it ignores differences in debt levels, tax rates, and depreciation methods between companies. Great for comparing companies across countries or with different capital structures.
How to Read It
Lower is cheaper. 6-10x is typical. Below 6x might indicate undervaluation or distress. Above 15x suggests high growth expectations.
- • EV/EBITDA below peers
- • Stable EBITDA with low multiple
- • Declining multiple due to EBITDA growth
- • Very high EV/EBITDA (>20x) without clear growth story
- • Multiple expanding while EBITDA shrinks
Price-to-Book (P/B) Ratio
ValuationIn Plain English
How much you're paying compared to what the company owns (minus what it owes). A P/B of 2 means you're paying $2 for every $1 of net assets on the balance sheet.
Why It Matters
Useful for asset-heavy businesses like banks, insurance, and REITs. If P/B is below 1, you're paying less than the 'liquidation value' — either a bargain or a sign of deep problems.
How to Read It
Banks typically trade at 1-2x book. Tech companies often trade at 10x+ (their value is in ideas, not physical assets). Below 1x warrants investigation.
- • P/B near 1x for profitable company
- • P/B below historical average
- • P/B below 1x with declining ROE
- • Very high P/B for low-growth business
Dividend Yield
ValuationIn Plain English
The annual dividend payment as a percentage of the stock price. It's the 'interest rate' you get from owning the stock.
Why It Matters
Shows how much cash income you receive. But beware: a very high yield might mean the stock price has crashed, and the dividend could be cut.
How to Read It
S&P 500 average is ~1.5%. Utilities and REITs often yield 3-5%. Above 6% warrants scrutiny — is it sustainable?
- • Dividend growing consistently
- • Payout ratio below 60%
- • Yield above average but sustainable
- • Yield >8% in non-REIT
- • Dividend frozen or cut
- • Payout ratio >100%
Profitability & Quality
ROE (Return on Equity)
ProfitabilityIn Plain English
How much profit the company makes for each dollar shareholders have invested. If ROE is 20%, the company generates $0.20 of profit for every $1 of shareholder equity.
Why It Matters
Warren Buffett loves high ROE — it shows the company is efficient at using shareholder money. Consistently high ROE often indicates a competitive advantage (moat).
How to Read It
15%+ is good, 20%+ is excellent. But check if it's artificially boosted by high debt. Compare to industry averages.
- • ROE consistently above 15%
- • ROE stable over 5+ years
- • ROE achieved with low debt
- • ROE boosted by excessive leverage
- • Declining ROE trend
- • ROE below cost of equity
ROIC (Return on Invested Capital)
ProfitabilityIn Plain English
How efficiently the company uses ALL the money invested in it (both shareholder money and borrowed money) to generate profits. It's the 'true' return on all capital.
Why It Matters
ROIC is harder to manipulate than ROE. A company creating value must have ROIC > its cost of capital (WACC). This is the key to long-term wealth creation.
How to Read It
Compare to WACC (typically 8-12%). ROIC of 15%+ sustained over years is rare and valuable. Tech and healthcare often lead; utilities and airlines lag.
- • ROIC consistently above WACC
- • ROIC above 15% for 5+ years
- • ROIC improved with reinvestment
- • ROIC below WACC (destroying value)
- • Declining ROIC trend
- • ROIC volatile year-to-year
Gross Margin
ProfitabilityIn Plain English
The percentage of revenue left after paying for the direct cost of making the product. If gross margin is 60%, for each $1 of sales, $0.60 is left after paying for the goods sold.
Why It Matters
Shows the basic profitability of the product/service. High gross margin = pricing power and competitive advantage. Low gross margin = commodity business.
How to Read It
Software: 70-90%. Consumer goods: 30-50%. Retail: 20-40%. Grocery: 10-25%. Compare to peers in the same industry.
- • Gross margin expanding
- • Higher than peers
- • Stable for 5+ years
- • Declining gross margin
- • Below industry average
- • Volatile margins
Operating Margin
ProfitabilityIn Plain English
The percentage of revenue left after paying ALL operating costs (including salaries, rent, marketing — not just product costs). It shows how well management runs the business.
Why It Matters
Captures operational efficiency, not just product profitability. A company can have high gross margin but low operating margin if it spends too much on SG&A.
How to Read It
20%+ is excellent. 10-20% is solid. Below 10% in most industries suggests thin margins. Tech companies often achieve 25-40%.
- • Operating margin improving
- • Above industry median
- • Stable over business cycles
- • Declining margin despite revenue growth
- • Well below peers
- • Negative operating margin
Net Margin
ProfitabilityIn Plain English
The final percentage of revenue that becomes profit after ALL expenses — operating costs, interest, taxes, everything. This is the bottom line.
Why It Matters
Shows what shareholders actually keep. Two companies with the same revenue can have wildly different net margins based on debt levels, tax strategies, and efficiency.
How to Read It
Varies hugely by industry. Tech: 20-30%. Banks: 20-30%. Retail: 2-5%. Airlines: 2-8%. Always compare to industry peers.
- • Net margin growing
- • Higher than peers
- • Positive in downturns
- • Net margin declining
- • Net margin << operating margin (debt or taxes)
- • Negative during normal times
Forensic Accounting Scores
Altman Z-Score
ForensicIn Plain English
A bankruptcy prediction score invented by NYU professor Edward Altman in 1968. It combines 5 financial ratios to estimate the likelihood a company will go bankrupt within 2 years.
Why It Matters
Helps you avoid 'value traps' — stocks that look cheap but are actually distressed. The Z-Score has correctly predicted ~80-90% of bankruptcies in academic studies.
How to Read It
Z > 2.99 = Safe Zone (low bankruptcy risk). Z between 1.81-2.99 = Grey Zone (uncertain). Z < 1.81 = Distress Zone (high bankruptcy risk).
- • Z > 3.0 (safe zone)
- • Z stable or improving
- • All 5 components positive
- • Z < 1.81 (distress zone)
- • Z declining over time
- • Negative working capital component
Beneish M-Score
ForensicIn Plain English
A score that detects earnings manipulation by comparing 8 financial ratios to prior years. Developed by Professor Messod Beneish, it caught Enron's fraud before the collapse.
Why It Matters
Earnings manipulation eventually unravels, destroying shareholder value. The M-Score helps you avoid companies that might be cooking the books.
How to Read It
M > -1.78 = Likely manipulator (earnings may be overstated). M < -1.78 = Unlikely manipulator. The higher above -1.78, the more suspicious.
- • M < -2.5 (clearly clean)
- • M stable over years
- • Consistent with industry peers
- • M > -1.78 (possible manipulation)
- • M increasing toward -1.78
- • M much worse than industry peers
Sloan Accruals Ratio
ForensicIn Plain English
Measures how much of a company's earnings are 'real' (backed by cash) versus 'paper' (accounting adjustments). High accruals mean earnings might not be sustainable.
Why It Matters
Earnings backed by cash are more reliable. If a company reports $1B in profit but only $200M in operating cash flow, the $800M difference is accruals — and accruals tend to reverse.
How to Read It
|Ratio| > 0.10 (10%) = High accruals, earnings may not be sustainable. |Ratio| < 0.10 = Normal, earnings are backed by cash.
- • |Ratio| < 5%
- • Operating cash flow > Net income
- • Stable ratio over time
- • |Ratio| > 10%
- • Net income >> Operating cash flow persistently
- • Ratio worsening over time
Superinvestor Frameworks
Pabrai Heads/Tails Framework
Investment FrameworkIn Plain English
Mohnish Pabrai's approach asks: 'What's the upside if things go right (heads) vs. the downside if things go wrong (tails)?' Great investments have asymmetric payoffs — limited downside, huge upside.
Why It Matters
Asymmetric bets are the key to compounding wealth. If you can find investments where you might lose 20% but could gain 100%+, you only need to be right 1 in 3 times to make money.
How to Read It
Look for Heads/Tails ratio of 3:1 or better. If heads (upside) is 3x larger than tails (downside), it's an asymmetric opportunity.
- • Upside 3x+ larger than downside
- • Multiple paths to the upside
- • Limited and quantifiable downside
- • Downside similar to or larger than upside
- • Unquantifiable downside
- • Needs everything to go right
Peter Lynch Classification
Investment FrameworkIn Plain English
Peter Lynch (Fidelity Magellan Fund legend) classified stocks into 6 categories, each requiring a different investment approach. Knowing the category tells you what to expect.
Why It Matters
You shouldn't value a Fast Grower the same way as a Slow Grower. Each category has different return expectations, risks, and holding periods.
How to Read It
Slow Growers (2-4% growth): Dividend plays. Stalwarts (10-12%): Core holdings. Fast Growers (20%+): Big winners but risky. Cyclicals: Time the industry. Turnarounds: High risk/reward. Asset Plays: Hidden value.
- • Clear classification match
- • Expectations aligned with category
- • Category-appropriate valuation
- • Paying Fast Grower price for Slow Grower
- • Buying Cyclical at cycle peak
- • Turnaround without clear catalyst
Moat Rating (Economic Moat)
Investment FrameworkIn Plain English
Warren Buffett's concept: A moat is a competitive advantage that protects a company from competitors, like a moat protects a castle. Strong moats let companies maintain high returns for decades.
Why It Matters
Companies with wide moats can reinvest at high returns for years. No moat means competitors will erode profits. Moat is the key to long-term compounding.
How to Read It
No Moat: Commodity business, low barriers. Narrow Moat: Some advantage, but not durable. Wide Moat: Strong, durable advantage (decades). Look for: brands, switching costs, network effects, cost advantages, patents.
- • Wide moat with pricing power
- • Moat widening over time
- • High ROIC for 10+ years
- • Moat eroding (new competitors)
- • Declining market share
- • ROIC falling toward cost of capital
Margin of Safety
Investment FrameworkIn Plain English
Benjamin Graham's core principle: Never pay full price. If you estimate a stock is worth $100, buy it at $70 or less. The $30 discount is your 'margin of safety' — room for error.
Why It Matters
Nobody can predict the future perfectly. Margin of safety protects you when your estimates are wrong. It's the difference between speculation and investing.
How to Read It
Bigger margin = safer investment. 20-30% is typical for quality companies. 50%+ for riskier situations. Near 0% margin = speculating, not investing.
- • Margin > 30%
- • Multiple valuation methods confirm discount
- • Catalyst to close the gap
- • Negligible margin
- • Price > your estimate
- • Requires optimistic assumptions
DCF & Valuation Concepts
Discounted Cash Flow (DCF)
Valuation MethodIn Plain English
The idea that money today is worth more than money tomorrow. DCF takes all future cash flows a company will generate and 'discounts' them back to today's value using an interest rate.
Why It Matters
It's the most fundamental valuation method — what is this business actually worth based on the cash it will generate? Every other metric is ultimately a shortcut to this.
How to Read It
Higher projected cash flows = higher value. Higher discount rate = lower value. Terminal value often dominates — be skeptical of this 'forever' component.
- • Conservative growth assumptions
- • Reasonable discount rate (8-12%)
- • Sensitivity analysis shows upside in all scenarios
- • Heroic growth assumptions
- • Low discount rate to justify price
- • Terminal value > 70% of total
Discount Rate / WACC
Valuation ConceptIn Plain English
The return you require to invest in something risky instead of risk-free bonds. For companies, WACC (Weighted Average Cost of Capital) blends the cost of debt and equity based on how they're financed.
Why It Matters
Higher risk = higher discount rate = lower present value. If you use too low a discount rate, you'll overpay. Too high, and you'll pass on good opportunities.
How to Read It
Typical WACC: 8-12%. Stable blue chips: 7-9%. Growth stocks: 10-12%. Risky situations: 15%+. Always stress-test with higher discount rates.
- • WACC based on realistic component costs
- • Sensitivity tested at +/- 2%
- • WACC < 8% without justification
- • Using historical returns as future expectations
Terminal Value
Valuation ConceptIn Plain English
The value of all cash flows after your forecast period ends (usually 5-10 years). Since we can't forecast forever, we assume the company reaches a 'steady state' and apply a multiple or perpetuity formula.
Why It Matters
Terminal value often represents 60-80% of total DCF value. Small changes in assumptions create huge value swings. This is where DCF gets dangerous.
How to Read It
Terminal growth rate should be ≤ GDP growth (2-3%). Terminal multiple should be reasonable for industry. If terminal value > 70% of total, your 'explicit forecast' period may be too short.
- • Terminal growth ≤ 3%
- • Exit multiple consistent with history
- • Terminal < 60% of total value
- • Terminal growth > GDP
- • Exit multiple > current market multiple
- • Terminal > 80% of value
Free Cash Flow (FCF)
Valuation ConceptIn Plain English
The cash left over after the company pays all operating expenses AND invests in maintaining/growing the business. It's what's available for dividends, buybacks, debt paydown, or acquisitions.
Why It Matters
FCF is the lifeblood of shareholder returns. Unlike earnings, it's hard to manipulate. Sustainable dividends require sustainable FCF. Buy companies with lots of it.
How to Read It
Positive, growing FCF = healthy business. Negative FCF can be fine for growth companies investing heavily, but should turn positive eventually.
- • Positive FCF for 5+ years
- • FCF growing over time
- • FCF conversion > 80% of net income
- • Persistently negative FCF
- • FCF << Net Income (accruals problem)
- • FCF declining while revenue grows
Institutional & Insider Data
Institutional Ownership
Ownership DataIn Plain English
The percentage of a company's stock held by large professional investors like mutual funds, hedge funds, pension funds, and endowments. They file quarterly 13F reports with the SEC.
Why It Matters
Institutional investors do extensive research. High institutional ownership suggests sophisticated money believes in the stock. Changes in holdings can signal sentiment shifts.
How to Read It
30-70% is typical. Very low (<20%) might mean unrecognized value OR red flags. Very high (>80%) limits future buying power. Track changes quarter-to-quarter.
- • Increasing institutional ownership
- • Top-tier funds adding
- • Institutions buying on weakness
- • Institutions selling heavily
- • Very low ownership with declining business
- • Concentrated in a few speculative funds
Insider Buying/Selling
Ownership DataIn Plain English
When executives, directors, or major shareholders (who have non-public information) buy or sell their company's stock. They must file Form 4 with the SEC within 2 days.
Why It Matters
Insiders sell for many reasons (diversification, taxes, buying a house), but they only buy for one reason: they think the stock will go up. Insider buying is a strong bullish signal.
How to Read It
Focus on open-market purchases (not stock options exercised). Look for cluster buying by multiple insiders. Large purchases relative to salary are most meaningful.
- • Multiple insiders buying
- • Large purchases (>$100K)
- • CEO/CFO buying after stock drops
- • Series of insider sales
- • C-suite dumping during earnings
- • Insider buying but business deteriorating
Congressional Trading
Ownership DataIn Plain English
Stock trades made by U.S. Senators and Representatives, who must disclose trades within 45 days under the STOCK Act. Some argue they have informational advantages from their legislative roles.
Why It Matters
Several studies show members of Congress outperform the market. Whether due to skill, luck, or information advantage, their trades can be interesting signals.
How to Read It
Focus on purchases (selling can be for many reasons). Look for trades before relevant legislation or regulatory decisions. Consider committee assignments (e.g., Finance Committee member buying bank stocks).
- • Bipartisan buying (both parties)
- • Multiple members buying same stock
- • Buying after stock decline
- • Selling before bad news
- • Trades in companies they directly regulate
- • Large option trades timing legislation
Ready to Apply These Concepts?
See these metrics in action with real stock analysis.
Start Your First Analysis