LEARN HOW TO INVEST

GUIDE FOR BEGINNERS: Module 7

Michael Santos Presents

HOW TO GROW YOUR MONEY THROUGH INVESTMENTS

Financial statements will help you track performance of investments and grow your money.

Learn How to grow your money through investments

Learning how to grow your money through investments starts with an understanding of business. We know that businesses operate in cycles. They create the most value when they have good leadership, excellent execution, and time to grow. 

As investors, we rely upon financial statements to track the performance of investments we make. From insight financial statements provide, we can act decisively, making adjustments to suit our investment strategy. 

In this chapter we will continue to study the performance of Liberty Hot Dogs as a case study. We’ll learn: 

  • How to assess performance of the investment
  • How to measure growth of the business
  • How to determine if we made a good investment

Tracking Performance of the Investment

Financial statements for Liberty Hot Dogs show how our investment performed after its first year of operations. Unfortunately, Liberty Hot Dogs suffered a net loss of $15, or 1 penny per share. 

  • What should we do?
  • How should we respond as investors? 

Disciplined investors understand that businesses come with risks and rewards. When leaders lay out a plan, they sometimes anticipate losses. In some cases, the business model forecasts many years of losses. 

For example, take a look at Amazon.com. It’s currently one of the most valuable companies on the planet, with a total market capitalization (shares of stock multiplied by share price equals the total value) that exceeds $750 billion. 

Yet Jeff Bezos, the founder and CEO of Amazon, started the company with a plan to lose money every year for longer than a decade. 

 

When it Makes Sense to Lose Money

Losing money may be part of an elaborate strategy for business. Business leaders sometimes call it a “hockey-stick chart” approach. The analogy suggests that leaders expect the business to lose money for a period of time. Those business losses are part of the investment to build market share or create scale. Later, once the business grows, the plan to lose money pays off because the business becomes more valuable. By tracking the business performance on a chart, the chart takes the form of a hockey stick. 

While learning how to invest, consider the entire business model and long-term plans. Determine where the company will be in years to come and assess whether the company’s performance warrants further investment of time or resources. 

After a year of operations, Liberty Hot Dogs lost $15, or roughly 1 penny per share. Yet with a year of operations behind us, we learned a great deal. Experience brings value that we can leverage going forward. 

Although our income statement showed a loss of $15, Liberty Hot Dogs generated $800 in sales. We interacted with customers. We built brand awareness. These are the types of “intangible” assets that a shrewd business owner can use to grow. 

As founder and leader of Liberty Hot Dogs, I had a duty to build shareholder value by executing the business model I described to investors. By reinvesting revenues, we could expand operations and improve the financial performance of Liberty Hot Dogs. With discipline and commitment, I grew the company in ways that were consistent with the company’s five-year plan.

Five-Year Growth Plans

In year 1, Liberty Hot Dogs operated one hot dog stand. It sold 800 hot dogs at $1 each, generating $800 in sales. 

From that experience, I concluded that customers would respond well to the brand I was building. Liberty Hot Dogs operated a clean business, and it was convenient for customers. I anticipated that each hot dog stand would sell 5% more hot dogs each year, which was a good reason to expand. Also, experience convinced me that customers would not object if Liberty Hot Dogs raised prices by 5% every year. 

For the purposes of this case study, we’ll assume that our costs remained the same (in proportion to sales) throughout the five-year cycle. 

Year 2

In year 2, we invested in a second hot dog stand. Our sales grew by 5% and we increased prices by 5%. In total, each stand sold 840 hot dogs. With our expansion, we sold a total of 1,640 hot dogs. Our customers paid $1.05 for each hot dog. Our total sales during our second year amounted to $1,764. 

Year 3

In year 3, we continued to grow by adding a third hot dog stand. Sales grew at 5% per stand, and we increased prices by 5%. Each stand sold 882 hot dogs during the third year, for a total of 2,646 hot dog sales. Customers paid $1.10 for each hot dog, bringing total revenues to $2,911. 

Year 4

In year 4, we added a fourth hot dog stand. Each stand sold 926 hot dogs, and each hot dog cost $1.15. The total sales from 3,704 hot dogs, at $1.15 each, brought us total revenues in year 4 of $4,260. 

Year 5

With our growth spurt, we added three additional hot dog stands in year 5. Each of our seven stands sold 972 hot dogs for $1.20 each. We sold 6,807 hot dogs in year five. We sold more than 8 times the 800 hot dogs we sold in our first year. Those sales brought us total revenues of $8,168.

BENEFITS OF GROWING THE BUSINESS

Our first-year financial statement showed only $800 in revenues and a $15 loss. But by reinvesting corporate assets, we were able to grow the business quickly and profitably. If we assume our costs of goods sold stayed the same through the business’s cycle (which wouldn’t be accurate, but which makes this example easier to follow), our income statement showed the following: 

Costs of Goods Sold:

Year 1: $200

Year 2: $420

Year 3: $662

Year 4: $926

Year 5: $1,702

 

Non-cash depreciation expenses ($60 per year, per hot dog stand):

Year 1: $60

Year 2: $120

Year 3: $180

Year 4: $240

Year 5: $420

LABOR EXPENSE

Our labor costs stayed at $530 per year, per hot dog stand. By year 5, while we operated seven hot dog stands, with total labor costs of $3,710.

By considering all of the numbers of above, we see that Liberty Hot Dogs performed really well by its fifth year of operations. Before considering expenses for taxes and interest, our profit and loss showed the following:

Year 1: $10 / 1.3% gross profits

Year 2: $164 / 9.3% gross profits

Year 3: $479 / 16.5% gross profits

Year 4: $974 / 22.9% gross profits

Year 5: $2,335 / 28.6% gross profits 

So at scale, our little business is starting to look much more attractive in year five. We’ve grown from 1.3 percent gross profit margins to 28.6 percent in gross profit margins. We’re still paying $25 interest on our debt each year. And that leaves us with earnings before taxes as follows: 

Year 1: $15 loss

Year 2: $139

Year 3: $454

Year 4: $949

Year 5: $2,311

ASSESSING THE INVESTMENT

When we take all of this into consideration, we can look at Liberty Hot Dogs from the lens of an investor. 

Our original outside investor, Frank, invested $500 in cash to buy 500 shares. We also raised $250 in debt from a lender, Tom. And by executing our plan over five years, our financial statements show that we’re now earning a profit of $2,311. 

We have to pay taxes to the government of about 35% on profits. Let’s take those expenses into account to see how we did in total:

Year 1: $10 loss / loss of a penny a share.

Year 2: $49 in tax, leaving net income of $90, or six cents per share

Year 3: $159 in tax, leaving net income of $295, or 20 cents per share

Year 4: $332 in tax, leaving net income of 617, or 41 cents per share

Year 5: $809 in tax, leaving net income 1,502, or about $1 per share

Those totals give us a better picture of how we did for the stakeholders in our business. Frank invested $500 to buy 500 shares. After five years, Frank is actually earning $1 per share in profit. And Tom is well secured on his note, because the corporation is worth considerably more than the money we owe. 

That’s a pretty good deal!

CASH FLOW

We also have to consider the cash flow statement. As the company grew, it generated more cash. 

Year 1: $10 loss / depreciation expense: $60 / Cash from operations: $50

Year 2: $90 income / depreciation expense: $120 / Cash from operations: $210

Year 3: $295 income / depreciation expense: $180 / Cash from operations: $475

Year 4: 617 income / depreciation: $240 / cash from operations: $857

Year 5: $1,502 income / depreciation $420 / Cash from operations: $1,922

Cash flow from investing in fixed assets:

Year 1: $300, first hot dog stand

Year 2: $300, second hot dog stand

Year 3: $300, third hot dog stand

Year 4: $300, fourth hot dog stand

Year 5: $900, three more hot dog stands

Each of those hot dog stands has value. Those assets show up on the Liberty Hot Dog Stand balance sheet, increasing shareholder equity in the business. 

At the end of the first year, with the small loss, shareholders had equity of $1,490. But as the business became more profitable. Those profits added to the cash balance and also grew the assets of the company. The liability from the $250 loan did not change, because we only made interest payments of $25 each year. But the balance sheet showed clearly how Liberty Hot Dogs grew in value over time. 

At the end of year five, Liberty Hot Dogs had about $4,000 in shareholder equity—almost three times what it was when the business started.

MEASURING OUR INVESTMENT

We also have to consider the cash flow statement. As the company grew, it generated more cash. 

Year 1: $10 loss / depreciation expense: $60 / Cash from operations: $50

Year 2: $90 income / depreciation expense: $120 / Cash from operations: $210

Year 3: $295 income / depreciation expense: $180 / Cash from operations: $475

Year 4: 617 income / depreciation: $240 / cash from operations: $857

Year 5: $1,502 income / depreciation $420 / Cash from operations: $1,922

Cash flow from investing in fixed assets:

Year 1: $300, first hot dog stand

Year 2: $300, second hot dog stand

Year 3: $300, third hot dog stand

Year 4: $300, fourth hot dog stand

Year 5: $900, three more hot dog stands

Each of those hot dog stands has value. Those assets show up on the Liberty Hot Dog Stand balance sheet, increasing shareholder equity in the business. 

At the end of the first year, with the small loss, shareholders had equity of $1,490. But as the business became more profitable. Those profits added to the cash balance and also grew the assets of the company. The liability from the $250 loan did not change, because we only made interest payments of $25 each year. But the balance sheet showed clearly how Liberty Hot Dogs grew in value over time. 

At the end of year five, Liberty Hot Dogs had about $4,000 in shareholder equity—almost three times what it was when the business started.

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