Motley Fool Answers Mailbag: By the Numbers and Buy the Numbers

This month our questioners are focused on figuring out figures, from ratios to GAAP to EBITDA and more.

Alison Southwick
Alison Southwick and Robert Brokamp, CFP
Jul 1, 2019 at 9:53AM
Other

It would be hard to find a podcast-hosting duo more fully invested in answering your financial questions than Alison Southwick and Robert Brokamp -- they even put Answers in their show's name! This week they're at it again, combing through the Motley Fool Answers mailbag in search of conundrums to address for their listeners.

But because three heads are better than two, for this episode they have recruited senior analyst -- and frequent podcast guest -- Ron Gross to help out. Among the topics they cover are why non-GAAP numbers and EBITDA are worth watching, the right ratio of stocks for a retirement portfolio, how to make sense of the numbers in earnings reports, and what moves stock prices.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on June 25, 2019.

Alison Southwick: This is Motley Fool Answers! I'm Alison Southwick, and I'm joined, as always, by Robert Brokamp, personal finance expert here at The Motley Fool.

Robert Brokamp: Greetings, everybody!

Southwick: On this week's episode it's the June Mailbag with the help of Ron Gross. Hey, Ron!

Ron Gross: Hello! Good to be here!

Southwick: Good to have you back! He's a senior analyst with us, with The Motley Fool...

Brokamp: You may have heard of it.

Southwick: You may have heard of it.

Gross: That's why I happen to be here! It worked out perfectly!

Southwick: He's going to help us answer your questions about how to read an earnings report, buying your first investment, and what the heck is EBITDA? All that, and more, on this week's episode of Motley Fool Answers

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Southwick: Let's just get into it, shall we?

Brokamp: We shall.

Southwick: Our first question comes from Tim. "I have heard some analysts on Motley Fool podcasts discuss companies' non-GAAP numbers and often followed with a chuckle." 

Gross: Like this? 

Southwick: Non-GAAP numbers!

Brokamp: Non-GAAP earnings! 

Southwick: Come on!

Gross: Silliness. 

Southwick: Oh! "My question is why is non-GAAP useful in evaluating a business? If their numbers are not in line with GAAP, what can be learned from those statistics?" And if I remember right, GAAP is general, something, accounting, principles?

Gross: Yes, generally accepted accounting principles. 

Southwick: Accepted accounting principles. 

Gross: Here we go. Ready? This is going to get a little weedy, but I'll try to make it fun.

Brokamp: Not the cannabis weeds. 

Southwick: Apparently we all chuckle. 

Gross: No, in the weeds. In the weeds. 

Southwick: Ah ha ha ha!

Gross: So companies must follow GAAP accounting by law. I don't know if law's the right word. By regulation.

Southwick: By accounting law!

Gross: But sometimes both companies and analysts want to make adjustments and look at things a little bit differently. Often that's because a company will have a one-time charge that doesn't recur -- a non-recurring event, a non-recurring charge -- so the company will want to point that out to investors. And analysts will want to do a little digging of their own and start to make adjustments.

Southwick: Could that example be like a lawsuit payout?

Gross: Absolutely!

Southwick: Or what are some other examples of a one-time charge?

Gross: Something weather related. 

Southwick: Oh yeah, blaming the weather is good!

Gross: But I meant like if there's a manufacturing facility that has to close down for a few days because there was a hurricane. Or even layoffs that have never happened before. You wouldn't want to necessarily project those into the future. So we want to make adjustments. But when a company does that, they're in violation of GAAP, so they have to point out they're introducing non-GAAP numbers to the world, and they really have to make that very clear. 

And it's supposed to be helpful to investors. The one caveat, I would say, is if these adjustments are being made because of what we just said -- one-time events, non-recurring events -- let's all be very sure that we buy into the fact that they're non-recurring. Restructuring charges are kind of a notorious thing here. 

There are many companies that somehow seem to have a restructuring in some form every single year; yet, they count them as non-recurring. A good analyst, a good investor will recognize that they're playing some shenanigans, here, and let's actually count that as a recurring expense and not give the company credit for this one-time event. 

So you've got to be careful, but they can be very helpful. We, as analysts, adjust income statements all the time for things that aren't really kosher from a GAAP-accounting perspective because accounting rules can be kind of wonky and sometimes they don't reflect reality, especially with things like depreciation and amortization, which are non-cash expenses. People play around with those. Make adjustments for those. So non-GAAP is actually quite helpful. 

Southwick: How much of your time, as an analyst and an investor, do you spend looking at these numbers, GAAP or non-GAAP or otherwise, vs. anecdotally looking into the company and thinking about their future?

Gross: I would say most of the time should be looking at the qualitative. The words. What does the company do? How does it make money? Who's the management team? Does the company have a competitive advantage? Who are the competitors? What's their market share like? All those things that really help you understand the business. 

And then maybe 25% -- just making that up -- is digging into the numbers. What do the growth trends look like? Is revenue trending upwards? Are they profitable? What do their margins look like? And then we can use all that information to maybe get a gauge of whether we think the stock price is fair. Cheap or expensive at any given time. But especially for just non-analysts or everyday investors, I think you want to spend most of the time just trying to understand the business. 

Southwick: I kind of ended up accidentally, inadvertently, jumping ahead to a future question, so we're going to talk about what you just said even more in just a minute. But first off, we're going to get our question from Ross. "My parents are retiring in a few years and they plan on retiring with a 90/10 split of stocks and cash, with the cash covering about two years of expenses. Should I try harder to get my parents to change their allocation? Is the two years of cash enough to meaningfully offset stock market drops relative to a traditional split?"

Brokamp: Ross, I'll start with the guidance we provide in Rule Your Retirement and that is for the retiree portfolio, it's that classic 60% stocks, 40% bonds split. We also talk about an income cushion of three to five years of portfolio-provided income outside of the stock market in cash or term bonds because, historically, bear markets last about three years from peak to trough to peak again, though there are many that last longer. So three to five years out of the stock market, I think, is a start. So yes, your gut reaction that maybe your parents are being too aggressive makes sense to some degree.

That said, there are situations when it's OK to be more aggressive with your portfolio. Maybe they have a pension. Maybe they have business income. Maybe they have rental property. So they have other sources of income that they can rely on that will allow them to be a little bit more aggressive in their portfolios. 

If you look at the safe withdrawal rate research, it definitely indicates that the optimal stock allocation is between 50-70%. Maybe 75% is high, but it's actually not quite as dire if you go higher than that, and we'll talk about why and I'll give you an example. 

In 2013 Warren Buffett ,in his annual letter, said that he's directed in his will that when he passes on, his wife's portfolio will be 90% S&P 500, 10% short-term bonds. Now, on the one hand, of course, whatever she's going to inherit -- he didn't say how much -- but it's probably in the tens of millions...

Gross: I would think that's fair.

Southwick: It's enough. 

Brokamp: ... so when you have that much money, when the market drops 50% you're probably OK; but, in 2015 an economist, Javier Estrada, took a look at this and said, "OK, this is Buffett's advice. How would that have worked out over the 30-year period starting in 1900 -- so every 30-year period -- all the way up through the period ending 2014?" 90% stocks, 10% bonds. A 4% withdrawal rate. Withdrawals are coming proportionately from the stocks and the bonds, 90%, 10% and then rebalanced annually. In how many 30-year periods did that person run out of money? Only 2.3% of the time.

Gross: That's nice!

Brokamp: So it's actually not quite as risky as you might think. That said, in 10% of the time, this retiree was getting close to having only 20% left of their portfolio. So it's still pretty risky, but he came up with two other tweaks to it. One was when you take out a withdrawal, any time the stock market is up, you take it from stocks. If it's down you take it from the bonds. The other tweak was whatever is outperforming you take the money from. So if stocks do better than bonds, you take it from stocks. If bonds are better, you take it from bonds. What did that do? It actually increased the upside potential and downside protection, so it was even safer.

The bottom line is while I think that for most retirees having 90% in the stock market is too aggressive, I would just talk to your parents and ask what's going to happen if we have another decade like we had the first decade of this century, where we had two significant bear markets and over the whole 10-year period stocks lost money. Do they have a backup plan? Talk to them about that. But as long as the future looks vaguely like the past, it's actually not as risky as we might think.

Gross: May I ask a question? I know I'm the new guy. Is that allowed?

Brokamp: Sure!

Southwick: Yes, I'll allow it!

Gross: Is it fair to say that once you reach a certain age -- let's say you're in your 90s -- that you can start to think of it no longer as your portfolio but the portfolio of your heirs and if your heirs are 40 or 50 years old, then 90% stocks for those folks may be perfectly appropriate?

Brokamp: Yes, absolutely! There's some research that came out maybe four or five years ago by Wade Pfau, who's been on our show, and Michael Kitces and they found that it actually makes sense to reduce your stock allocation right around retirement, but as you get older to increase your stock allocation largely because of that. In the end, most of the money that you have is going to be left to your heirs. 

Southwick: The next question comes from [Montash]. "I'm a student who's just beginning to get into the world of investing. I always hear that you should read earnings reports for the companies you invest in. What can I do to make sense of the numbers? I have no idea if the numbers are good or bad. Should I just be reading more other financially literate people's analyses?"

Gross: This we did discuss a little bit...

Southwick: I did, yes. 

Gross: ... but we can revisit it. This is good. I think it's always good to read what a company says focusing on the words first. Let's leave the numbers aside. That has to do with what a company does, and how it makes money; but, each quarter how's it doing. The CEO will make comments. There'll often be a conference call where analysts can ask questions. So it's really nice to just hear what the company has to say.

Then you can look at the numbers and focus on the trends. You don't have to be an expert about what a good gross margin is, or a good operating margin is, or how to calculate free cash flow. Look at the trends. Is the company increasing their revenue each year? Are they increasing their profits each year? Does it [continuously go up and down]? Are those things maybe deteriorating and going down? Looking at trends can tell you a lot and used in conjunction with what the CEO is telling you about their business should be really enough, I think, for the average investor. 

Southwick: Do you listen much to the earnings calls?

Gross: I read them more than I listen to them. 

Southwick: I'm wondering how often you can just tell from a CEO's tenor how excited he or she is about the future of the company? If they're like, "Ohhh!"

Gross: You have to be careful, because some CEOs are sales-y, and you don't really like that. I don't like when CEO's talk about their stock price a lot. I want them to talk about the business and let the stock worry about itself. But you can gauge if someone's really upbeat about the business, but if it doesn't jive with the way the numbers look then it seems a little fishy, so you want the two things to go hand in hand.

Southwick: What about reading other people's analyses?

Gross: Always good if you can get your hands on other people's analyses. It's sometimes quite difficult to maybe get your hands on a Goldman Sachs report or a Morgan Stanley report; but we are here, as Fools, for our members and that's what we do all day long, is read these reports and offer our opinions. Definitely this is one place you can trust. And Google is there for you, too. You can always google a company and you'll get an article here or there from a financial expert or perhaps an analyst. All that information is useful, too. 

Southwick: The next question comes from Ray. "My wife and I have been married for five years and are expecting our first child later this year." Aw! Yay! "She's 38 with no job and no savings. I'm her retirement plan. I'm 37. I contribute to the thrift savings plan and have three years to go until I'm eligible for my pension. I have two additional brokerage accounts as I pick socks as a hobby."

Brokamp: I think he meant stocks, but you never know.

Southwick: I love that idea! I just like to spend my time pointing at socks. I choose you!

Brokamp: I do have a 401(k) where someone holds Babe Ruth's bat in the account.

Southwick: Oh, really?

Brokamp: I don't know. Maybe he has a collection of really valuable, famous socks.

Southwick: We used to joke about starting "Sock Advisor," right? Wasn't that a joke around the office? We're going to start Sock Advisor.

Gross: I'm sure it was!

Brokamp: A perfect April Fool's joke!

Southwick: Sorry! Probably Ray likes to pick stocks as a hobby and not socks, but we like both ideas. "I would really like for both of us to be working toward a retirement plan together, but whenever I mention money she gets upset. Here is a direct quote from her: 'Why are you always trying to get me to get a job?' Another common line from her is, 'Do you ask your mother to work?' My mother is 70-plus and retired. Can you help me understand her and/or help me convince her to see the need for income both now and later in life?"

Brokamp: Boy, this is a tricky one!

Gross: Wow! You need a marriage counselor, not a personal finance...

Brokamp: We're getting there. We're getting there! First of all, congrats on the new baby!

Gross: Yes, for sure!

Brokamp: That's great news. There is a somewhat objective right answer to this and that is how much you should be saving for retirement to meet your goals. One possibility is to get a fee-only financial advisor to sit down and say when you want to retire or this is how much you want to save for your kids' college educations. Also, is your wife going to stay home with the kids? What are the consequences of that or what's the cost of day care? To look at all those and [decide that] you are saving enough or you are not. Start there!

That said, it may not be enough because there's clearly a little bit of tension here. So yes, a marriage counselor is probably a good idea. I've mentioned before the Financial Therapy Association. I went to their annual meeting last month. You can go to the website of the Financial Therapy Association, put in your zip code, and it will tell you whether there's a financial therapist in that area. A lot of them have experience in couples counseling to begin with if they started their career that way. 

But I think you are going to have to work this out. It might be that she just doesn't want to work and she wants to stay home and take care of the kids, which is a very difficult thing to do and a very noble thing to do. If you're going to get a pension and you're contributing to the TSP you may be financially OK. 

Southwick: My armchair therapist advice is that usually when people respond with anger and exclamation points, they're coming from a place of fear. And when she's asking if you want her to get a job and she's angry, she may think you think she's lazy -- and it sounds like maybe you do. But maybe she's just scared of getting back out there and getting a job. Finding something that she loves to do. Maybe it's a matter of, "Is there something you want to do? What would make you excited to go to work every day?" 

That's fulfilling! We just talked about that with the expert from AARP. And again, raising kids is so hard and that is a job. That is absolutely a job. But having work outside the house can be fulfilling and exciting, too, if you find the right thing.

Gross: For sure!

Southwick: That's my advice, which is to maybe see if she's scared, and if she's responding from that.

Brokamp: That's great advice!

Gross: That is good advice! I like it!

Southwick: Hey, thanks!

Brokamp: It is. No, it's very valuable advice! One other thing that I forgot to mention was that she actually can start saving for her retirement, because if you are married and you are earning an income, the spouse can open an IRA. It's called a spousal IRA. That way you can start building up a retirement account for her. 

I would also say to her she should know that if the unfortunate happens, and you get divorced, there are plenty of studies that have shown that it's harder on someone who is a stay-at-home spouse. Who has not built up their own savings, and not built up their own credit score, and not built up their own job skills. So it might be something she wants to think about in terms of...

Southwick: Maybe he frames it, "If I die..." rather than getting a divorce.

Brokamp: There you go! That's a much better one!

Southwick: It may be a better way to frame it. 

Gross: You don't need your own earned income to contribute to a spousal IRA? Is that the benefit of it?

Brokamp: Yes. 

Gross: Oh, interesting!

Brokamp: It's about the only example where you can have money put into an IRA for you where you're not actually earning the money.

Gross: 5,500, too? The same amount?

Brokamp: 6,000. It went up this year. 

Gross: Wow! Nice!

Southwick: The next question comes from Dave. "Have been listening to Answers and Rule Breaker Investing for a couple of years and that experience drew me into joining both Stock Advisor and Rule Your Retirement."

Gross: Nice!

Brokamp: Heeey!

Southwick: "One of the things that concerns me is that I still feel like I'm somewhat blind in my investing approach. I would like to learn more about how to determine the value of a company. Ideally you guys or Rule Breakers could do a regular episode on how to do that. If I cannot entice you, some recommendations for a non-finance person on how to get started would be appreciated." Ron?

Gross: Oh, Dave!

Southwick: Question! 

Gross: Oh, Dave! I could teach a semester-long class on valuation. Maybe two semesters of long classes. I'll give you 10 seconds of free advice. I'll do my best!

I think the simplest thing for an individual investor to do is focus on what we call "relative valuation measures" and those are basically in the form of ratios. Price-to-earnings ratio is probably the one that people are most familiar with -- P/E ratios. Other valuable ones would be the enterprise-value-to-EBITDA ratio or the price-to-operating-cash-flow ratio...

Southwick: More on EBITDA later.

Gross: Later, yes. I teased the question. 

Southwick: A teaser for you.

Brokamp: I was going to turn it off, but now I'm staying!

Southwick: She's come for the ratios. You stay for the EBITDA. Here's what you can do. You can calculate these ratios; but, as I mentioned, they are relative valuation metrics, which means you need to compare them to something. They're not useful in a vacuum just by themselves. 

What do you compare them to? Let's take a P/E ratio. Let's say you calculate a P/E ratio of a company and it turns out to be 18. That means the price is 18X the earnings. Price divided by earnings. What does "18X" mean in a vacuum? Nothing. But if you compare it to its peers or its competitors and you see that those are trading at 25X earnings while your company is only 18, that's something interesting to note. It may be an indication that your company is cheaper; cheaper being an interesting word, but perhaps "undervalued relative to the peers."

You can also compare that 18 number to how that company traditionally has traded in the past. Again, if that company traditionally trades at 14X earnings and now it's 18; well, based on historic data, that company could potentially be expensive right now. 

And the third thing you could compare it to is the market as a whole. The S&P 500 has its own P/E ratio. So you can look at how your company is trading, relative to the market as a whole, and compare that to historical data, as well. Three different ways that you can get a gauge on a relative valuation metric. 

An absolute valuation metric would be something like running a discounted cash flow and that's a whole semester in and of itself. We won't go down that road. I don't think it's really necessary for an individual investor. But using some key metrics, some key ratios would be a really nice thing to add into the research you do with most of the research being focused on is this a good company? Do they make money? Are they profitable? Do you like the management team? All those good things. 

Southwick: Does P/E ratio work particularly well for some industries vs. others? Like I feel like you wouldn't use a P/E ratio to understand a bank's profitability. 

Gross: Yup. Exactly the right example I would have given. For financial, I tend to shy away from P/E ratios. In general, if truth be told, I prefer a cash flow metric. A cash flow ratio. The other two examples I gave are more cash-flow oriented. Earnings -- because of GAAP accounting like we discussed earlier -- can sometimes be a little misleading, so if we look at cash flow, instead, it takes away some of the wonkiness of GAAP accounting. It's a little harder to calculate. P divided by E is easier than figuring out enterprise value and EBITDA. But if you can -- you can sometimes get these metrics online calculated for you -- they're good to focus on. 

Southwick: The next question comes from Bill. "I purchased shares of a foreign company over the counter through an ADR." What does ADR stand for?

Brokamp: American Depositary Receipt.

Southwick: Thank you! "All indicators said it pays a good dividend and it does; but, a big chunk is taken in German taxes. Ach du Lieber! They take a lot. I know you can't give tax advice, but what comments do you have?" 

Brokamp: This is actually pretty frequent where when you buy shares of a foreign company the government will take some of those dividends and you'll see exactly how much at the end of the year when you get your 1099-DIV. Box 7 tells you how many taxes were withheld. The good news is you can get most or all of that back in the form of a tax credit as long as you know to do that on your tax return. In your case, Bill, it sounds like you probably can get most of that back. 

That said, if you are holding this company in an IRA or a 401(k), you cannot take the credit, so you just lose it. Then people will say, "Well, should I hold all my foreign stocks outside of my IRA?" I would say if you're still saving for retirement and you're many years away from needing the money, I think it's still better to keep it in an IRA or a 401(k) because you don't want to pay taxes on those dividends each and every year. 

Even though many foreign stocks do keep some of those taxes on hold, the average international stock yields more than the average U.S. stock, so even accounting for those taxes you're still probably getting a higher yield than you're getting from a U.S. stock.

Southwick: The next question comes from P.T. in Utah. "Why do we care about EBITDA?"

Gross: Good question!

Southwick: "I know what it stands for, I know what it means, but I must not know what it means because I always think, 'Why not tell me E-A-B-I-T-D-A? Earnings after...'" Oh, my goodness! Now we've got a lot. 

Gross: We'll get into it.

Southwick: "EBITDA is like G-B-B-P-C-I-S (grades before parties, tier parties and calling in sick)." Oh, so funny!

Gross: Oh, boy! For the rest of the audience, let's define EBITDA: earnings before interest, taxes, depreciation, and amortization. It's a quick and dirty method of estimating operating cash flow. All over Wall Street investment bankers -- all over the world right now -- are talking about EBITDA because it's just a really quick way to think about cash flow. 

Now I say operating cash flow rather than total cash flow or free cash flow because this just focuses on the operating business. It removes interest because it's before interest. Interest is not an operating decision of management -- it's a financing capital decision of management. It's different than do you make a good product and do you sell it for a fair price and make a profit? So if you want to just look at the operating business, let's remove the effect of interest. 

We also take out taxes because there's a lot of decisions that affect taxes. Everybody has to pay them by law but if we really just want to focus on do you sell your product and do you make a profit, let's just remove taxes for analysis purposes. 

And finally the bigger deal, here, is we want to remove the impact of depreciation and amortization, which are non-cash expenses. When you buy a big manufacturing facility for $500 million, GAAP accounting lets you divide that amount by 15 or 20 years and deduct from your income that one-fifteenth as an expense, which lowers your profits, which lowers the taxes you have to pay. So it's a tax benefit. But it's non-cash. You didn't really have that expense.

So we adjust for it to get an idea of the actual cash flow a company has. If you owned 100% of that company yourself, how much actual cash could you put in your pocket at the end of each year? That's different than GAAP net income. It's not the same thing. So we make adjustments, here, to look at operating cash flow to get a better understanding of how this business is performing and how much cash they're actually producing. 

Southwick: And you're fine with EBITDA?

Gross: I'm a big fan!

Brokamp: A big fan!

Southwick: All right, Bro. The next question comes from Mike. "I'm 37 and I know I have too much money in a savings account -- about $200,000. I want to eventually be a homeowner again, but the timing isn't right to buy because of my job. I don't want to buy more individual stocks because I look at them as only a long-term play and I don't want to get crushed on capital gains taxes if/ when I sell. What suggestions do you have on making my liquid money work for me? It's already in a savings account earning 2% interest. There has to be better options that won't lock my money away for two-plus years. Also, when do you suggest individuals start working with a financial advisor?"

Brokamp: Mike, I totally agree that if your job is in any sort of flux, you don't want to be buying a house. We've talked about that on a couple of episodes now. It's definitely a long-term proposition, so I agree with you waiting on that.

You said you want to avoid stocks because you don't want to get crushed by capital gains taxes. Just so you know, for most people the capital gains rate on long-term capital gains is only 15% and, of course, you're only paying that because you made a profit, so I wouldn't let taxes, necessarily, prevent you from investing. I would say if you do think you're going to need the money in the next two years, I wouldn't invest it. But anytime I hear someone say I don't want to do something because of the taxes, it raises a yellow flag for me.

Now as for what to do with your cash, you're already earning 2% which is great, because the vast majority of people are letting their cash sit in their bank where they're earning nothing, so that's good. Unfortunately I don't have too many other great options. There are some credit unions that will pay very attractive rates on a certain amount of money that you have. I looked this morning. A credit union called Consumers Credit Union pays 5.09%. But...

Gross: There's a but. There's got to be a but!

Southwick: Oh, no! Never mind!

Brokamp: It's only on balances up to $10,000. After that it pays like 0.2%. 

Gross: There you go!

Brokamp: But plenty of other things. Like you have to make 12 debit card point-of-sale purchases without using the PIN. You have to log in once a month. So there's some criteria. That said, I think it's still worth looking at what credit unions are offering in your area which you can do by just visiting MyCreditUnion.gov. You might find something there for at least a little bit of your money.

Beyond that we have The Ascent, which is a site owned by The Motley Fool which will help you find higher-yielding accounts. You can get a savings account yielding upwards of 2.4%. One-year CDs upwards of 2.8%. I think those are worth looking at. But generally speaking you're not going to get anything like 4-6%.

Southwick: What are CDs doing these days?

Brokamp: 2.8%.

Gross: If you could never get 4-5% for cash, that means the stock market's in trouble, so be careful what you wish for!

Brokamp: I think it was Will Rogers who said this. "You're more interested about the return of your money than the return on your money if you're looking for something that is safe and liquid." And your final question. When do you get a financial advisor? As soon as you ask the question. If you think you might need a financial advisor, it's certainly worth doing. Just based on what you've told me already, it sounds to me like you certainly have complicated-enough finances where a financial advisor could probably give you some good advice.

Southwick: The next question comes from Tristan. "I just turned 23 this April." Yay! "I have been listening to Motley Fool podcasts and reading articles on first investments for the past few weeks, thanks to my uncle." Oh, what a great uncle! "I have earned a bonus at work and I would like to begin my portfolio. I'm curious about where you think is a great place to begin. To me, investing in the S&P 500 seems like a fairly safe first investment. If I understand things correctly, in the past few years the S&P 500 has actually gone down in price, or just haven't performed as well as the overall market. What do you think?"

Gross: Well, I love the fact that you're thinking about getting into investing...

Southwick: So great!

Brokamp: Yes.

Gross: ... at 23 years old. 

Southwick: At 23. 

Brokamp: Outstanding.

Gross: Go for it! I do like the diversification of an index fund for a first investment, something like an S&P 500 -- either ETF like the SPDR's SPY or from Vanguard like the Vanguard 500. It gives you instant diversification. You own little pieces of each of the 500 companies, and then you can start building your portfolio with individual companies after that. 

With respect to the performance of the S&P 500, which you just mentioned, yes in 2018 it was a bit shaky. In fact the S&P 500 was down; but over the last decade, the S&P 500 has performed wonderfully and including this year it is very strong, as well. 

When you reference the S&P 500 vs. the market, the S&P 500 is the market, or at least it's a proxy that we use to approximate the market. So it's almost synonymous. If we say the market or we say the S&P 500, we're kind of saying the same thing typically, and I think it'd be a perfectly fine place for your first investment. You might have an opinion, Bro.

Brokamp: I would just say that you're right. The S&P 500 is a proxy for the market. What it's missing is midcaps and small-cap stocks; so if you wanted something that is really the total U.S. stock market, the Vanguard ETF [VTI] owns thousands of stocks. 

Over the long term, because it does have some of those smaller companies, I'm going to guess that it might outperform the S&P 500 by a percentage point or so, maybe; but, if you feel like you even want more diversification, then I think the S&P 500 is a good option.

Southwick: I would suggest it might be more fun for Tristan if Tristan did some in the S&P 500 but then maybe also bought a stock or two that he was interested in. That might help get him more excited about investing.

Gross: That's totally fair! For me the very first button I'd press would probably be for the index fund but right thereafter, especially if I had money left over or would have money coming in shortly thereafter, finding a company that I really love or a product that I use; something I care about that I would actually get a kick out of being a part-owner of, I would do a little research into that company and make sure it's a well-run company first. Just don't assume because you like Snickers that the company that makes Snickers is a good company. Do a little research and then I think that's a great thing to do. 

Southwick: The next question comes from Zack. "My wife and I are in our late 20s and we're each opening an IRA. The Vanguard fund minimum is $3,000 and the Roth IRA contribution limit is $4,500. Should we each add $4,500 to one fund each year but diversify in two or three years, or use Vanguard ETF with lower minimums?" Fun!

Brokamp: Kudos to Zack and his wife for starting to save for retirement in their 20s. You mentioned that the contribution limit is $4,500. Actually, as we mentioned earlier in the show, it's actually $6,000 this year, and I think the key, there, is sometimes you can go on the internet, look for some information and basically you've stumbled upon an outdated article. I think it's always important to make sure when it comes to taxes and retirement savings that you are looking at something that was published in that year so you have the most recent numbers.

You highlight something that has come up before in discussions with people who love Vanguard, but they do have these higher fund minimums. Some other companies have lower fund minimums. Schwab's index funds have lower minimums. But really you can get around all that by just opening a Vanguard brokerage account (if you love Vanguard)...

Gross: As we do.

Brokamp: ... as we do, and you can buy all their ETFs one share at a time commission free. It's very easy with a very small amount of money to get a very diversified portfolio. Just make sure that generally speaking, when you're buying ETFs, that you are reinvesting the dividends. That's the default for all traditional mutual funds. It's not necessarily a default for all ETFs and that you're not paying commissions on reinvested dividends. With the vast majority of brokerages you don't do that, but there still are a couple that will charge you for reinvesting the dividends.

Southwick: And our last question comes from Al. "I have a very basic question. I'm trying to work out how the price of the shares in my portfolio are calculated. Often when I think the price will remain steady or go up a little, it will go down. Is there an algorithm that is used or some sort of formula that I can use to determine share prices?"

Gross: No, there is not, Al, and this is important. Share prices of stocks are all based on the supply and demand for that stock. So all day long the stock market is a huge auction in which people want to buy stock and sell stock, and the prices move up and down based on the supply and demand. 

The supply and demand is based on fundamentals. Is the company a good company? Are earnings growing? Is it a good management team? What are the expected growth rates? And all day long, auction, auction. Buy, sell, buy, sell. No algorithm. 

Brokamp: Basically when you look that stock up, and I'll quote Yahoo Finance or Motley Fool, "That's the price." No calculations involved.

Gross: No calculations. It's often the last trade of the day. If you're looking after the market has closed, the market really matches up a buyer and a seller. That's what it really is. It's like eBay. You want to sell a Cabbage Patch doll and somebody wants to buy it, and you settle on a price. That's really what the stock market is. So whenever you look at a quote, at any point of the day, that's typically the last trade that happens in the actual stock market. 

Now one other thing. If it's a mutual fund price you're looking at, or an ETF -- an exchange-traded fund price you're looking at -- that's different. That's the actual value of all the stocks in the portfolio divided by the shares outstanding in that portfolio. That's actually a calculation that mutual funds and ETFs have to calculate on a daily basis to figure out what the price is of that fund; but, I think Al was talking mostly about stocks. You've just got to think it's an auction. Supply and demand. People asking to buy. People asking to sell. Market makers match those two things up. Actually computers do it nowadays most of the time, and that's the price.

Brokamp: I'll build on what you just said and it builds on our previous question. Really one of the big differences between ETFs and traditional open-end mutual funds; ETFs trade throughout the day, so you will see their prices go up and down. Open-end mutual funds like the ones you probably have in your 401(k) are not valued until the end of the day, so when you put in an order to buy or to sell, you actually don't know the price you're going to get until the market closes and it gets settled up at the end of the day. 

Gross: That's actually a good point. I think I actually misspoke, because ETFs are based on supply and demand. The price of those move just like stocks.

Brokamp: But what you said was true in that price is reflective of all the underlying securities and there does have to be some calculating going on. 

Gross: But what's interesting is sometimes the actual price that an ETF is trading at can diverge from the actual underlying value and there are actually investors that make a living trying to find that divergence.

Brokamp: That small little arbitrage, and that's what keeps the prices, generally. And for the big ETFs, it's almost negligible. For smaller ETFs and more obscure ETFs... I just learned about an ETF that invests in companies that provide pet care. The ticker is PAWS. 

Gross: Cute!

Brokamp: I don't know how frequently traded that ETF is.

Southwick: I feel for Al, though. When I think the price will remain steady or go up a little, it will go down.

Gross: But that is an interesting point that we didn't address. It's all based on what the market, as a whole, thinks. What institutional traders think. What analysts are putting out there. You might read a headline and say, "Ooh, I think this company is going to have a really good day." Then when you look under the hood a little more, or maybe read the press release, or listen to the transcript, or hear what an analyst has to say, it turns out it wasn't as rosy as maybe the headline indicated and the stock will actually trade down that day whereas you would have guessed it would have traded up.

Southwick: There is some amount, as with anything in life. When you get experienced enough reading financial news and reading how analysts react that you miss as a new investor... Like it took me a while to realize a company can have an amazing quarter, but because they didn't beat analysts' expectations, the stock will take a hit. Or maybe they didn't meet analysts' expectations as much as the analysts wanted.

Gross: In the short term, stocks trade on reality vs. expectations. In the longer term, stocks trade based on whether the companies are good or not. So take heart that if you're a long-term buy-and-hold investor it all shakes out in the end; but, on a daily basis, anything can happen.

Southwick: Ron, that's it! Thank you so much for joining us today!

Gross: Thank you! Lots of fun! Always happy to be here!

Southwick: Oh, we love having you! Let's close on a super-exciting note with a disclaimer. 

Brokamp: Let's do it!

Brokamp: Oh, yeah!

Southwick: As always, The Motley Fool might have formal recommendations for or against the stocks we talked about today. Don't buy and sell stocks based on what you heard on this show, or something like that. I think I got most of the words right on that disclaimer. Nobody call the SEC. I think I got that mostly right. Thanks again, Ron!

Gross: Thank you for having me!

__

Southwick: Hey, let's head to the postcards!

Brokamp: Oh, let's do so!

Southwick: Also let me say how much of a joy it was to meet so many of our listeners at The FoolFest.

Brokamp: That's the highlight of FoolFest.

Southwick: I met people like Melanie, and Rita, and Louis, and a bunch of you just ran up and said, "I love the podcast!" and then you ran away, so I didn't get a chance to catch your name, but you're all wonderful and you're all welcome to come up and chat longer next time. Some people even yelled, "Stocks!" which made me laugh. 

All right, so let's head to the postcards! Apparently, Mark dropped by Fool HQ and dropped off his own handmade postcard and yelled, "Stocks!"

Brokamp: He wrote it on a piece of paper. Oh, my gosh! That's so funny!

Southwick: Rich sent a postcard from Texas and he's still travel-hacking his way around. There's a big cow. 

Brokamp: Another cow.

Southwick: Mark sent a card from Tampa. Well, he's from Tampa.

Brokamp: Go Bucks! I've got my Bucks shirt on.

Southwick: Sorry! He's from Tampa. 

Brokamp: That's still good. He's a Bucks fan, I'm sure!

Southwick: He's from Tampa, but he sent us a card from Mont Saint-Michel, which is so beautiful. Look at that!

Brokamp: That place is like a fairy tale!

Southwick: I've never been! Don sent a card from the Museum of the Bible, just down the street in D.C. Oddly enough, it's our first card from D.C. 

Brokamp: Really?

Southwick: He knew it was going to be our first card from D.C. 

Brokamp: The Museum of the Bible.

Southwick: Yes, it's new. Thad wrote in from Biloxi to say how he's been enjoying the Major Money Event series. How nice is that?

Brokamp: Good!

Southwick: I'm glad you're enjoying it. Sarah sent a card from Alhambra in Spain. I went there! This island there was amazing. And then [Swimmingly Jim] sent a card from a board game and convention in Seattle. 

Brokamp: Oh, wow! Oop, I'm going to be there very soon! Tomorrow. 

Southwick: You are going to be there very soon, but for when people are listening it's actually in the past.

Brokamp: Right, so when they're listening, I am home. Don't try to break into my house. 

Southwick: Or do and just say hi, because he missed seeing you at FoolFest.

Brokamp: And I think you're all wonderful!

Southwick: Anyway, we appreciate you guys sending in those postcards. If you, other fellow listeners, would like to send in a postcard, we would love to receive it. Our address is 2000 Duke Street, Alexandria, VA 22314. They still continue to bring much joy to my life, getting these cards from you guys, so thank you so much!

That's the show! Our email is Answers@Fool.com. The shows is edited non-GAAP-ingly by Rick Engdahl. For Robert Brokamp, I'm Alison Southwick. Stay Foolish everybody!