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The word of the week for this week is hedge. This word is very important for investors who may have a large position in a stock, and believe that the price of it may start moving in an unfavorable direction.

Suppose that a company owned 10,000 shares of Netflix. They bought the stock 6 months ago at $15/share for a total investment of $150,000. Since then, the stock has doubled up to $30, which gives them the value of their Netflix holdings to be $300,000. Now they would like to continue to hold the stock, but the company predicts that the economy may not be as strong as usual, and this could have a negative effect on the price of their stock. In order to protect against these losses, the company purchases protective puts with a strike price of $30 for June 2008. These puts cost $3/share. Each contract is for 100 shares, and the company purchases 100 of these contracts for a total of (100 contracts x 100 shares/contract x $3/share = $30,000). These options give the company the option, but not the obligation to sell all of their shares at $30 per share before June 2008 regardless of the current market price. If the price of the stock rises, then the options will expire worthless.

Let’s imagine though that by May 2008 the price of Netflix has dropped from $30/share to $20/share. Without the hedging that the company did, the value of their Netflix holdings would be only $200,000. This is a loss of $100,000. With the options, they could exercise them at the $30 strike price for the total value of $300,000. The only cost to them would be the $30,000 insurance policy that they took out. By using the options, the company will sell at a realized value of ($300,000 - $30,000 = $270,000). this is $70,000 more than what they would have had if options were not used.

So as a definition, hedging is essentially an insurance policy that companies take out in order to lock in profits.

Word of the week hedge, hedging, insurance, investment, netflix, profit, puts

The word of the week for this week is Volume. When we refer to volume, this is referring to the number of shares that are traded for a stock in a given day. Volume can be a very important indicator of the health of a stock. The higher the volume, the more buying or selling interest there is for it. When a stock has low volume, it means that most people aren’t following it, and there is little interest in the stock. When there is low volume, it also means that the stock is not very liquid. If you wanted to sell/buy it, there may not always be another party to take part in the trade. Another useful tool for dealing with volume is checking how the current volume compares with the average volume over the last 30-90 days. This can give you an idea of whether or not the stock is becoming more or less popular.

Word of the week volume

The word of the week for this week is short sale. A short sale takes place when an investor feels that a stock will drop in value. When an investor shorts a stock, they are selling shares of stock that they do not own. They hope to later buy back the shares at a lower price and return them to the broker. In order to short sell, one must create a margin account with their broker. This can be a very risky investment since the potential loss is unlimited.

Here is an example of a short sale. On January 2nd, 2008 an investor feels that shares of AAPL (Apple) are overpriced at their closing price of $194.84. He initiates a short sale of 100 shares through his margin account with his broker. His account will be credited with ($194.84 x 100 shares = $19,484). On February 19th, the investor repurchases the 100 shares at the closing price of $122.18/share. This costs the investor ($122.18/share x 100 shares = $12,218). His profit over this 1 1/2 month period of time is ($19,484 - $12,218 = $7,266) even though the price of AAPL dropped by over $72!

To see a growing list of past words of the week, click .

Word of the week aapl, margin account, short, short sale

Yes the word of the week is a day late this week. Sorry. This week’s word is a common investing term that may not be that well known to new investors. That word is market capitalization. We hear this word all the time, but what does it truly mean? Market capitalization is essentially the dollar amount that the market values a company at. This sounds all well and good, but how does one figure out what the market values a company at? The answer to this is quite simple really. Market capitalization is determined by multiplying the number of outstanding shares by its current price.

Say company WXYZ is trading at $20/share and has 1 million shares outstanding. The market capitalization for WXYZ corporation is $20/share x 1 million shares = $20 million. So we can say that the market values WXYZ at $20 million.

Word of the week market capitalization

It’s Sunday again, and you know what that means…time for another word of the week! This week’s word/term is “intangible assets.” Intangible assets are things owned by a company that you cannot see or feel, but are very important to the operations of a company. One example of an intangible asset could be a trademark. A trademark allows a company to give itself an identity that cannot be copied by other corporations. Pepsi for example has a trademark on their red, white and blue ball symbol. The company has spent years making that symbol a recognizable representation of the company. There is obviously some value attached to the trademark that prevents other companies from using the Pepsi symbol, and therefore the company must account for this. Intangible assets are listed in the “Other Assets” category of the Balance Sheet. Other intangible assets include: patents, franchises or brands.

Word of the week definition, intangible assets, Word of the week

Here is another very important word for investors: Dividends.

Dividends are a large reason why people invest in companies. We invest in hopes of receiving future dividends from the company. When a company makes a profit there are a few things they can do with it. They can save it up as a cash buffer so that they have access to liquid funds. They could also reinvest the money back into the company by expanding operations or increasing research and development. Finally, they could declare a dividend to the shareholders. Since shareholders are the owners of the company they are entitled to a portion of the earnings. Dividends are usually paid out on a per share basis. An increase in the quarterly dividend is generally seen as positive news for the company, while a decrease in the quarterly dividend tends to be viewed negatively by investors.

There are two different types of dividends that can be paid out. The first one is a cash dividend. For example, a company may declare a $.10 per share cash dividend. In this case a shareholder would get $.10 for every share that they owned. If you owned 1,000 shares, you would receive (1,000 shares x $.10/share = $100). Typically the per share price of a stock will drop by the amount of the dividend. This will keep the overall market capitalization of the company consistent.

The other type of dividend that a company might declare is a stock dividend. They might announce that they are giving out one share of the company for every 10 shares that someone owns. This type of dividend is not as common as the cash dividend. One possible advantage of the stock dividend is that you are not taxed on these shares until you sell them. Depending on your tax situation this might be an important thing to consider.

Word of the week

I’m a day late on the word of the week for this week, so without further ado the word of the week is revenue.

Revenue is a very simple, yet important word that everyone should know. Revenues are what keeps a company in business. Without sufficient revenues a business would fail. Put a simply as possible, revenue = price x quantity.

Here is a simple example:

Jim’s Tractor Depot sells two different types of tractors. They sell the BT-550 for $15,000 and the ST-320 for $5000. This month Jim sold 10 BT-550s and 50 ST-320s. The revenues for the BT-550 are ((10 tractors sold) x ($15,000 per tractor)) = $150,000. The revenues for the ST-320 are ((50 tractors sold) x ($5000 per tractor)) = $250,000. The total revenues for Jim’s Tractor Depot are the sum of BT-550 revenues and ST-320 revenues. So, his total revenues for the month are ($150,000 + $250,000) = $400,000.

Word of the week definition, revenue

I have decided that each Sunday I am going to choose and define a financial word of the week. I know it sounds kinda lame, but it is important to know what certain terms mean when reading about different companies and such. Each week after I define a new word, I am going to add it to my term list.

To start things off we should begin with the most basic financial term. This term is the reason that companies are in business. The term for this Sunday is “profit.”

There are two main types of profit: accounting profit and economic profit.

Accounting profit is simply described as the difference between the sales price of a good and the cost to produce that good. If it costs McDonald’s an average of $1.50 to produce a Big Mac and they can sell it for $2.50, then they have made a profit of $1.00 ($2.50 - $1.50 = $1.00) per Big Mac sold.

Economic profit is measured slightly differently from accounting profit. Economic profit is the accounting profit of a good, plus the opportunity cost of creating that good. For example: the opportunity cost of producing one Big Mac could be that Mc Donalds would have had the opportunity to use that hamburger patty on a more profitable burger. Say for example a double quarter pounder with cheese has an accounting profit of $1.50. If Mc Donalds uses two quarter pound patties to create one Big Mac, they are leaving an extra $.50 on the table, because now they can make one fewer double quarter pounder with cheese. Based on this example, we can say that the economic profit of the Big Mac is (sales price - production cost - opportunity cost = economic profit). Plugging in the numbers, we can find that the economic profit for the Big Mac is ($2.50 - $1.50 - $.50 = $.50).

As you can see, it can be easy to get confused between these two different definitions of profit. The version that we as investors should be most concerned with is accounting profit, because this is what is reported on a companies’ annual and quarterly report.

As a final note, the author does not have a financial stake in McDonalds.

Word of the week