Traditional IRA vs Roth IRA

Traditional IRA vs Roth IRA – Understanding The Difference

It’s good to invest for retirement.

It’s even better to invest for retirement if you can also pay less in taxes during the process. That’s what the traditional and Roth IRA provide. They allow you to pay fewer taxes. But they have a few differences, which I will explain below.

The federal government has decided to encourage you to do your own saving for retirement. You see, back in the good ole days, everyone either had a pension from their employer, or they just worked until they died. Only the rich were investing in the stock market.

In the modern era of investing, the pension started to go away. Thus, the government started feeling pressure to take care of older citizens. Because social security isn’t supposed to be a complete answer to your retirement needs, and because Americans started living longer, they needed a solution. They needed something to encourage do-it-yourself investing.

Traditional IRA

Along came ERISA and the traditional IRA in 1974. The traditional IRA is a retirement account in which the contributions you make to that account are tax-deductible. In other words, if you contribute $1,000 to a traditional IRA, you will be able to reduce your taxable income for the year by $1,000. Depending on your tax bracket, this could mean up to $250 in tax savings. All that just for saving for your retirement.

Over the years, the traditional IRA has seen come changes. We now have limits to the amount that you can contribute each year towards your IRA. Also, if you participate in an employer sponsored plan, like a 401K, you will not typically be able to invest tax-deductible dollars into a traditional IRA. Additionally, if you make over a certain amount each year, you will not be able to contribute tax-deductible dollars to your account.

When you pull money out of your traditional IRA (called a distribution), you will have to pay taxes on the money. So even though you skipped the taxes on the way end, you will make it up in retirement. Your contributions and earnings from those contributions will be taxed when you pull them out.

Lastly, you should know that there are penalties if you pull money out of your traditional IRA before you retire, and there are also required minimum distributions you must make starting in retirement. The traditional IRA has a lot of restrictions, but it’s the best place to save for retirement for those without a 401K who are looking for an instant tax deduction.

Roth IRA

That brings us to the Roth IRA. The Roth IRA was created by the in Tax Act of 1997, which was authored by William V. Roth, Jr., a Senator from Delaware. The Roth IRA was aimed at helping people save outside of their employer 401Ks.

You contribute after-tax dollars to a Roth IRA, but when it’s time to withdraw those funds in retirement, you can do so tax-free. Nice, right? Just like the traditional IRA, the Roth has income limits and contribution limits you must deal with. See more at the Roth IRA explained.

Other than that, there’s not much downside. Since the funds are after-tax (meaning you’ve already paid taxes on them), you have a lot more flexibility. You can withdraw your contributions without many limits and you can withdraw them in retirement any time you want. No required minimum distributions.

Traditional IRA vs Roth IRA

A good thing to keep in mind is that if you qualify for both accounts you can certainly contribute to both. There’s no rule saying you can’t. Keep in mind that if you do, you need to watch your contribution limits as those will be spread across both accounts.

The traditional IRA and Roth IRA are both excellent tools to help you get started with your retirement savings effort. It’s more important to get started with something than stopping down because you are stuck deciding which one of these is the best.

As a quick rule of thumb, I like to tell people that if you don’t have a company 401K, then consider the traditional IRA if you want to see some savings to your high tax bill. If you do have a company 401K, then just go with a Roth IRA to do all of your extra investing. That’s what I do.

Once you decide which account to use, you can start thinking about what to put inside your IRA. Good luck.


Related Articles:

 

Can You Contribute to 401k and IRA

Can You Contribute to a Roth IRA and 401K?

Can you contribute to a Roth IRA and 401k?  Yes, you can contribute to a Roth IRA and 401K at the same time.

In this post I’ll share my experience of simultaneously contributing to a Roth IRA and 401K, as well as the requirements you’ll need to meet in order to do the same.

When it’s time to get serious about your retirement, it’s not a stretch to imagine you might start thinking beyond your 401K. If you have a 401K at work, that’s great. Your employer cares about you and your ability to support yourself in retirement. If your employer is offering a matching contribution, well, you’ve struck gold. That’s free money. The next logical step is to consider a Roth IRA.

Before you consider a Roth IRA, you should be fully taking advantage of your company 401K. By that I mean contributing enough annual dollars to get the full match that the company offers. It’s likely that you are already doing that so let’s dive into the next step of also investing in a Roth IRA.

As a side note, if you don’t have a 401K, then consider reviewing the Difference Between Roth IRA and Traditional IRA.

Difference Between 401K and Roth IRA

Remember that the Roth IRA and 401K are just accounts where you keep your investments. They aren’t actual investments. They are just the account (or vehicle, as some put it) where the money is held. These accounts are great because they get special tax treatment.

You are able to contribute pre-tax dollars to a 401K. This means that no tax is taken from your money that is placed into the 401K. If you earn a dollar and put it in your 401K, you pay $0 in taxes on that dollar. If you earn another dollar and put it in your checking account instead, you have to pay taxes on that money.

There is a limit to your contribution though. It changes every year usually, but right now you can contribute $18,500 (2018) to your 401K.

You can’t contribute pre-tax dollars to a Roth IRA. You can only contribute dollars that have been taxed already. However, unlike a 401K, when you distribute that money to yourself in retirement, you don’t have to pay a tax. Nice, huh? For more on this account see the Roth IRA Explained.

401K and Roth IRA

Because the Roth IRA and 401K have opposite tax treatments, the IRS allows you to contribute to both at the same time. The only thing you have to worry about is the income limitation set on the Roth IRA. Your ability to contribute to a Roth IRA starts to “phase out” at $189,000 (2018) for those who file “married filing jointly”.

Here’s a strategy I follow. To contribute to both of these accounts, just make sure you start with contributions to the 401K to get the match. Then, switch to contributing to the Roth IRA. Once that is maxed out for the year ($5,500 for 2018), then you can go back to the 401K until you reach your annual limit there.

I did that for the tax years 2016 through 2017 and saw significant increased in my tax-advantaged retirement investing accounts. Not to mention, I have two different account with different distribution rules. So now I can consider things like using my Roth IRA for a down payment.

How about you, do you contribute to a Roth IRA and 401K at the same time?


Related Articles:

The Path To Financial Freedom

Unlimited Financial Freedom, Financial Bondage, & Everything in Between

Whether you’ve done a formal budget or not, what if it’s clear to you that you’re on a financial path that’s unsustainable?  What should you do?  Well, you’d better do something, because your financial freedom is at stake.

What is Financial Freedom?

Money is a form of freedom because it provides you with the ability to make choices with respect to things that have a financial cost.  Financial freedom is measured in dollars, so the more money you have the more financial freedom you have.  Spending money is an expression of your financial freedom and, paradoxically, each time you do you actually reduce the amount of freedom that you have, because spending money on one thing deprives you of the ability to spend it on something else.

For example, let’s say that you have $100 that you’re completely free to use; you don’t need it for housing, food, transportation, or any other living expenses.  In short, you have $100 of pure financial freedom to do with as you wish.  If you save it you continue to maintain that freedom, and it will even grow over time as your $100 earns interest.  If, however, you choose to spend it on something then you’re free to do so, but once you make that choice then you’re no longer free to buy anything else.

The Myth of Unlimited Financial Freedom

There are varying degrees of financial freedom.  On one extreme end of the scale is unlimited financial freedom.  Unlimited financial freedom is the ability to do or to buy anything that costs money.  Nobody in the history of the world has ever had unlimited financial freedom.  The Pharaohs, the Khans and the Caesars didn’t have it anciently and, despite the many billions certain people have amassed in our time, nobody has it now.  In fact, nobody is even remotely close.  The bottom line is that even the richest of the rich have financial limitations.  Thus unlimited financial freedom is a mythical goal that can never be achieved, so you can go ahead and scratch it from your life’s “to do” list.

Financial Security

Since unlimited financial freedom is unattainable then I recommend that you strive for financial security.  You achieve a state of financial security when you can comfortably meet both your needs and all of your reasonable wants without having to work and without going into any kind of debt.  Financial security is what most people visualize when they think about the ideal form of retirement.  Again, it’s the ability to do what(within reason), when you want, without having to worry about money.

Having a true understanding of the concept of financial security is vitally important, because you’ll never be able to obtain it (much less be able to appreciate it) if you don’t even know what it is!  And how might you not recognize financial security even if you obtained it?  The reason is because “financial freedom” is such a heavily cited yet rarely defined goal in personal finance guides and literature that it’s easy to misunderstand what the term really means.  Again, if taken literally, one can easily be led to believe that financial freedom is the ability to do anything that costs money.  But remember, that’s the definition of unlimited financial freedom, which you just learned is an unobtainable goal!

Does that mean that all personal finance literature that uses the term “financial freedom” is wrong?  Of course not!  It’s just important to remember that whenever you encounter the term “financial freedom” you should interpret it in your mind as “financial security.”  If you do that then things you read on personal finance and money management will make a lot more sense.  Having said that, know that I myself will sometimes use the term “financial freedom” as a substitute for “financial security” in my own writing because in the context of certain discussions the idea of freedom actually conveys more meaning.  But again, to have the right understanding and expectations, in the context of money it’s always important to interpret financial freedom to mean the ability to do what you want within reason (as opposed to doing anything you want), when you want, without having to worry about money.

Financial Stability

Achieving a state of financial security is an ambitious goal that could take you many years of wisely applied learning and sustained effort to achieve.  Fortunately along the way there is another worthwhile and satisfying goal to strive for: financial stability.  You achieve a state of financial stability when you can comfortably meet all of your needs and some of your reasonable wants without going into any kind of debt.

Those who achieve financially stability are generally thought of as “getting ahead.”  What exactly does that mean?  It means you reach a point where you consistently spend less than you earn, and by doing so you generate what’s commonly referred to as “discretionary income.”  Discretionary income is what’s left to save or spend after you have met all of your financial obligations.  For example, in a typical month if you have income of $4,000 and your standard monthly expenses are $3,500 (housing, transportation, food, etc.) then you would have $500 of discretionary income ($4,000 – $3,500 = $500).  Granted you can’t walk away from your job just because you’ve achieved a state of financial stability.  After all, using the previous example, you can’t exactly retire to an island paradise on $500.  But that aside, financial stability is a nice place to be because it means:

  • You can comfortably meet all of your needs.
  • You can meet some of your reasonable wants.
  • You can put some money in an emergency fund and/or investments with an eye towards eventually achieving financial security.
  • You can weather financial disruptions without undue stress (precisely because you have set aside some money to deal with such situations).

Financial Instability

Financial instability is a state where you have just enough income to meet your needs, along with perhaps a few meager wants.  In other words, you’re barely scraping by living at the subsistence level, right on the edge of your income.  Here are some signs that you’re financially unstable.

  • You feel a substantially heightened degree of stress if anything out of the ordinary happens that might cost money.
  • You can’t take advantage of good deals and opportunities even though you would like to because you don’t feel like you have enough extra money to do so.
  • Long periods of time can go by as you wait to be in a position to do or buy even modest wants (with higher level wants being out of the question).

Do you see the pattern?  Remember, financial freedom is the ability to make choices with respect to things that cost money, but when you’re financially unstable you have very little of such freedom.  It’s hard to be happy on a day-to-day basis in such a condition, because so much of your money is tied up just keeping your head above water that there’s little to nothing left to do anything satisfying or enjoyable.

If you ever reach a state of financial instability, and especially if you’re there for a long period of time, it can be tempting to compensate for your lack of discretionary income by turning to credit cards or other forms or borrowing to finance purchases for things that you want.  While that may feel satisfying in the short term, it’s just an illusion.  As time goes on the finance charges associated with your debts will mount, pushing you closer and closer to the brink of the worst state of all: financial bondage.

Financial Bondage

If financial instability represents a state where you have lost the ability to make choices with respect to things that cost money, financial bondage is a state where others actually have control over you.  In other words, you not only lose the ability to act financially, but you’re subject to being acted upon in ways that are beyond your control.  Following are some examples of things that can happen to you when you’re in financial bondage, whether you want them to or not.

  • You can be forced out of your home due to foreclosure (or you can be evicted from your apartment).
  • You vehicle can be repossessed.
  • Your wages can be garnished (which means they’re taken out of your paycheck before they ever even hit your bank account).
  • Your electricity, phone, Internet connection, gas and water can all be shut off.

It can be severely debilitating mentally, physically and emotionally to be in a state of financial bondage, but don’t give up hope!  If you combine the knowledge you gain from this website with other good resources and work hard to intelligently apply the things you have learned, I am confident that you can progressively gain more freedom until you find your feet financially…and then you can build from there.

 

How Overdraft Protection Works With a Debit Card

Why Does Overdraft Protection Work a Little Bit Differently for Checks and Debit Cards?

It’s important to understand that there are important differences in paying for something with a check vs. a debit card as far as overdraft protection is concerned.  Think about it.  As a purchaser, when you pay with a check you get what you want right away, but the seller has to wait for a period of time in order for your check to clear.  On the other hand, when you pay for something with a debit card the transaction goes differently.  First your debit card is run through a payment processor and then, after a little bit of a wait, your purchase is either approved or denied.  And it’s that difference –the speed at which checks (slower) and a debit cards (faster) can be validated – which is the reason overdraft protection is just a little bit different for check and debit card transactions.

Savings Account and Credit Card Overdraft Protection Works the Same for Check and Debit Cards

Before explaining the differences in how overdraft protection works for checks and debit cards let me first explain how they are the same.  If you overdraw your account on a debit card purchase and you DO have savings or checking account overdraft protection then you should generally be able to make your purchase without too much hassle; the necessary money will be transferred to your checking account to cover the shortfall in the same manner as if you had overdrawn the account by writing a check.  Read about How to Use a Credit Card Effectively.

Something Different: Automatic Debit Card Overdraft Protection

Budget Calculator

Try Our Free Budget Calculator

Prior to August 15, 2010 if you overdrew your account as a result of a debit card transaction then your bank could automatically charge you a substantial overdraft fee of approximately $27 per transaction.[1]  For example, if for whatever reason you didn’t realize that you had no money left in your checking account and you made 3 separate purchases of $5 apiece using a debit card then your errands could end up costing you a whopping $96 (3 purchases at $5 apiece plus 3 bank fees at $27 apiece)!  But now, based on the new regulations, your bank can no longer automatically hit you for overdraft charges related to debit card purchases unless you affirmatively sign up for the program.

To illustrate how this works, let’s say that you did NOT have savings account, credit card, OR the automatic debit card overdraft protection.  What would happen if you attempted to buy something with a debit card for more money that you had in your account?  The seller would run your card through a payment processor and, after a brief wait, your card would be denied.  Perhaps you might find that a little embarrassing if you were making the purchase in person rather than online, but at least you would be spared a far more expensive alternative.

And what is that expensive alternative?  If you had signed up for automatic debit card overdraft protection (or whatever your bank might call it) and you had made the purchase described above then the good news is that it would be approved even though you didn’t have enough money in your account to cover it, but the bad news is that you would be subject to the $27 overdraft fee.  That’s enough money to hurt any regular person!  As a result, I recommend that you cancel, resist, turn down, or otherwise opt out of automatic overdraft protection and instead utilize the much less expensive alternatives of saving account or credit card overdraft protection.

How Do You Cancel Automatic Debit Card Overdraft Protection if You Already Have it?

If you have any question in your mind about whether or not you have automatic debit card overdraft protection (as opposed to savings account or credit card overdraft protection) then contact a customer service representative from your bank to find out for sure.  Now if you do indeed have automatic debit card overdraft protection then, again, I recommend that you opt out of it.  If the bank’s customer service representative cannot help you do that, or they are not giving you information that’s sufficiently clear enough to enable you to make informed financial decisions, then consider taking your business to a competing bank that will.

A Reminder on How all of This Relates to Overdrawing an Account by Bouncing a Check?

I want to again emphasize that the August 15thregulations relate to automatic debit card overdraft protection.  In other words, while banks can no longer automatically charge you fees for overdrawing your account as a result of debit card transactions, they can still automatically charge you for bouncing checks.  As a result, regardless of whether you generally use a debit card or checks to make purchases and pay bills, I highly encourage you to get savings or credit card overdraft protection.

 

How to Use a Credit Card Effectively

Understanding How to Use a Credit Card Responsibly Can Increase Your Credit Score!

The Ideal: Pay Your Credit Card Balance Each Month in Full and On Time

RV Loan Calculator

Quickly Find Out Your Payments With Our RV Loan Calculator

At its core a credit card is simply a means of borrowing money.[1]  It’s also important to understand that a credit card is an exceptionally lousy means of borrowing money if you carry a balance.

Thus any credit card strategy in that doesn’t also involve paying off your balance in full and on time each month is, at best, of limited value and, at worst, downright stupid.  In short, how to use a credit card effectively entails you pay off your credit card balance each month then you can reap significant benefits from making purchases with a credit card.  However, if you consistently carry a balance from month to month then your credit card issuer is the one reaping the benefits (at your expense!).

For example, let’s say that you need to buy a plane ticket that costs $1,000.  You have both a credit card and $1,000 in the bank that you could use to make the purchase.  Should you pay in cash or use your credit card?[2]  If you use the cash then you can purchase the ticket outright without incurring any credit card debt.  Of course that’s good, but if you purchase the same $1,000 ticket with a credit card then you could automatically receive accidental death and dismemberment (“AD&D”) insurance for the flight as well as 1,000 bonus points or flight miles.[3]  Further, when your credit card statement comes the next month you can use the $1,000 you have in the bank to pay it off in full.  So either way you’ll end up with no credit card debt, but if you pay in cash you’ll get no special benefits whereas if you pay with a credit card you’ll get valuable insurance for the flight with credit card bonus points to boot.

Budget Calculator

Try Our Free Budget Calculator

Second Prize: Make Purchases With a Credit Card as Long as You are Able to Steadily Reduce Your Debt

While it would of course be great to have your credit card fully paid off, what if you’re not in a position to do that right now?  Does that mean that you should lock your credit card away and only pay for things in cash until it’s fully paid off?  Not necessarily, because you can still benefit from making purchases with a credit card as long as you’re disciplined enough to continue to make meaningful progress towards paying down your credit card debt.  Understanding how to use a credit card effectively may vary from situation to situation.

Danger: How To Use A Credit Card Negatively By Using Rewards & Points as an Excuse to Pile on Unsustainable Debt

While it’s true that paying by credit card offers some unique advantages that paying with a check, a debit card or cash does not, I want to again emphasize that you should never use the benefits you receive from paying with a credit card as a means to rationalize making purchases you can’t afford.  For example, don’t talk yourself into buying a $1,000 plane ticket you can’t afford just because you’re going to get a few credit card bonus points or flight miles. If you choose to go down that road then it won’t take long before the deadly math behind credit card interest threatens to make financial bondage your destination.[4]  The Fidelity credit card has one of my favorite reward programs.

Summary: Credit Cards are Great Financial Tools if Used Correctly

There’s a myth among some that only those who are irresponsible, addicted to spending, or deeply in debt use credit cards on a regular basis.  While there are some who do indeed fall into one or more of those categories, it’s also true that those who understand the benefits of making purchases with credit cards and pay off their balances each month use credit cards to make practically every purchase they can.


[1]  See the article, “How Do Credit Cards Work”.

[2]  Note that “paying in cash” means paying with cash, a check or a debit card.

[3]  These are just examples of the types of benefits you could receive; individual credit card terms vary.

[4]  At 22% the interest on $1,000 of credit card debt for 1 month is about $18.33 (22% divided by 12 months x $1,000) whereas 1,000 bonus points can typically be redeemed for something valued at about $10 (equal to about 1 cent per bonus point).

Personal Money Management

Why Personal Money Management Is Important

In order to understand why personal money management is so important consider the following questions.

  1. Do you ever worry about money?

    Budget Calculator

    Try Our Free Budget Calculator

  2. Does it ever seem like your money just disappears and you have no idea where it all went?
  3. Are you now on your own (or soon will be) and you have no idea how money really works?
  4. If you’re married, do you and your spouse ever have tense conversations (or flat-out argue) about money?
  5. Would you like to know how much money you can safely spend before your next paycheck and still be okay financially?
  6. Do you have hopes and dreams that are bigger than your bank account and you wonder if you will ever be able to achieve them?
  7. Do you have a tendency to spend money on things that you can’t afford?
  8. Despite big plans, do you always have trouble coming up extra money to save or invest?  Would you like to know what it will take to make that happen?
  9. Does it seem like you never make any headway paying off your debts (or worse, they continue to grow)?
  10. Have you ever felt overwhelmed by the thought of what it would take to get your finances organized?
  11. Does it seem like you’re never getting ahead despite the passage of time and all of your hard work?
  12. Do you sometimes feel tossed about as external events crash upon you, feeling that they are in control of your financial destiny rather than you?

If the answer to any of these questions is “yes” then I would suggest that personal money management is very important to you.  Then you’ve come to the right website.  Keep reading!

Related Articles and Information on Personal Money Management

If you have not already done so, reading the following articles will enhance your understanding of the concepts presented in this one.

Budget Planner Template

Using A Budget Planner Template

I recently received an email from John about using a budget planner template.  He wrote:

“Hello, I’m feeling a little lost and have some questions in regards to budgeting and saving.  1. Which budget planner template should I use?  2. From the total salary what percentage is ideal to spend for various needs, and how much to be saved for future?  Any insight would be greatly appreciated.”

It’s a question that we all must answer. Even if some of us would prefer to ignore it! Because, with rare exceptions, we all have to deal with having just so much money to cover all our expenses. And, if we spend more than we take in for very long we get into trouble.

Let’s look at a “typical” budget planner template. Then we’ll discuss it.

Category% of Income
Housing35%
Food15%
Auto15%
Insurance5%
Entertainment5%
Clothing5%
Medical5%
Everything Else5%
Savings10%

Understanding The Budget Planner Template

Budget Calculator

Try Our Free Budget Calculator

The first thing you’ll notice is that I didn’t include any taxes (either income or Social Security). You can choose to do that if you like (in fact, it’s a real eye opener). But for our purposes it’s easier just to deal with your ‘take home’ pay.  The second thing to notice is that this is a guideline, not a straight jacket. The truth is that very few of us will fit into this exact framework.  So if your spending doesn’t match, don’t despair! Analyze the situation before you panic!  Try our free excel budget template!

Customize the Budget Planner Template To Fit Your Wants & Needs

For instance maybe your entertainment spending is closer to 10%. Is that a problem? Maybe not, if you’re young, single and sharing an apartment with three friends. In that case what you save on housing is going for entertainment. So overall you’re not spending more than you’re making.  Or you may be a city-dweller where housing is very expensive (think NYC). But because of public transportation you don’t own a car. So the extra you spend on housing is offset by the reduced spending on transportation.  You get the idea. Tailor your spending plan to your needs. And, adjust it as you go through life and your needs change.  One other thing to notice is that housing, food and auto make up the lion’s share of the expenses. That’s true for almost everyone.  It’s in those three areas that most families get into trouble. Most often by buying a home or vehicle that they cannot afford. But once the commitment is made it’s very hard to undo.

Categorizing Your Expenses

You might wonder where a certain expense goes. For instance, household cleaning supplies. Many people buy them at the grocery store. So are they a housing or food expense? The answer is: it doesn’t much matter. Put them wherever it seems best to you. The key is always putting them in the same place, so you can compare results from month to month.

Another common question is what should I do with charitable contributions. You can either take it off the top (like taxes) or create a separate category for it. If you believe that contributions should come before your expenses you’ll want to take it off the top. If you think that it’s part of your regular spending then include it as another expense category.  For a budget planner template to be effective you must continuously follow your progress.

How Much Should You Save?

401k Calculator

401k Calculator That Allows You See The Impact of Changes

Finally, let’s look at John’s question about saving. There probably isn’t any single right answer, because saving isn’t really an expense. It’s an investment for a better future.  So I prefer to think of savings in terms of priorities. Before I can put money aside for savings I need food and a reasonable shelter. Probably also need dependable transportation to get to my job.  But after those basic needs are met, it’s time to begin saving some money. Not necessarily the 10% in our guidelines, but 2, 3 or 4%. Enough so that there’s some money set aside for the so-called unexpected expenses that happen to us all (dead appliances, home and auto repairs, unexpected sickness, temporary lack of work).

One other comment about savings. Paying off debt (especially credit card debt) is a little like savings. Consider payments used to reduce the amount owed as if they were savings or a Bank CD.  Finally, for those of you who don’t want to bother with any of this. I know what you’re thinking: I’m fine and don’t need any help monitoring my money. Just remember that most people who are in trouble today said the same thing when everything looked good to them.

 

Stock Valuation – How To Value A Company

Stock Valuation – The Relationship Between A Company’s Stock Price and Cash

In another article titled Companies To Invest In, I made the point that, at its core, a well-run company is simply a money making machine.  That concept – that the value of a company is ultimately tied to cash – is one of the keys to understanding how to value a company and it’s relationship stock price.  Stock valuation are great to get quick snapshot of a company’s value.  I’ll illustrate this point with a simple example, and then build on it in ensuing articles.

How To Value A Company – Cash Per Share Example 1

If there were a company that had $1,000 in cash with 100 shares of stock outstanding then you could calculate the value of each share of stock as follows.

Stock Valuation Cash Per Share Example

How To Value A Company – Acquiring 20% Ownership Example 2

If that were the case and you wanted to own 20% of the company then how much stock would you have to buy, and how much would it cost?  The answer is that you would have to pay a total of $200 for 20 shares of stock, which can be calculated as follows.

Stock Valuation Ownership Example

How To Value A Company – 10:1 Stock Split Example 3

What if the company did a 10 for 1 stock split, meaning instead of having 100 shares outstanding, it had 1,000 shares outstanding?  Would that change the value of the company?  The answer is no.  The company’s only asset is $1,000 of cash, and no amount of stock splitting (or combining) can change that.  However, by doing a 10 for 1 stock split the value of each individual share is diluted, going from $10 to $1 per share.  So in summary, a stock split affects the value of each share of stock, not the value of the company itself, which can be illustrated as follows.

 

Stock Valuation Stock Split Example

 

Now, what if our little company went public and was traded on the New York Stock Exchange?  Wow, that’s big time!  Wouldn’t that would boost its stock price above the $1 it’s now trading at after the stock split?  Not at all!  The stock could be traded on the moon, and that still wouldn’t alter the fact that the total assets of the company are worth $1,000, making the value of each of those 1,000 shares equal to $1.

401k Calculator

401k Calculator That Allows You See The Impact of Changes

How To Value A Company Using The Terminal Valuation Method

But wait, isn’t just focusing on a company’s cash overly simplistic?  After all, there’s no company of any size or consequence whose only asset is cash.  While that may be true, at the end of the day, determining how to value a company is ultimately measured in money (or cash) – nothing else.  This is known as the terminal value of a company.

The application of this concept is known as the Terminal Valuation Method.  To illustrate how it works, say a company’s stock price is trading at a value that suggests the total worth of the company is $10,000,000.[1]  How can you tell if this stock valuation is reasonable?  One way to go about it is by to pretending that the company sold everything off: its inventory, furniture and fixtures, real property, and so on, until it converted all of its assets to cash.  After going through exercise you estimate that upon liquidating all of its assets and settling all of its outstanding debts (or “liabilities”) that the company would end up with $4,000,000.

“It’s Important To Note Stock Valuation Can Vary Greatly Depending On A Number Of Factors Such As: Industry, Maturity Level of Company, Ect.”

What…$4,000,000?  Didn’t we say that the value of the company’s stock suggested that it was worth $10,000,000?  Does this mean that the company’s stock price is vastly over inflated relative to its true worth? Perhaps, but not necessarily.  For example, aside from tangible assets (assets that you can touch) that could be converted into cash, an established company might have valuable intangible assets that would substantially contribute to its ability to make money: established business relationships, a highly skilled workforce, an efficient supply chain, secret formulas and patents, widely recognized brands and trademarks, etc.  In short, there can be a lot more to the value of a company than just its “hard assets” such as cash, inventory, property, etc.

However (and this is a BIG however), if a company is being valued at $10,000,000 and yet it would only be worth $4,000,000 upon liquidation, there still has to be a financial explanation for where that remaining $6,000,000 of value is coming from.  In other words, what is it about the company that makes it worth more than sum of its tangible assets?  If there is a compelling story there – a story that explains how the company’s business prospects, activities and operations are worth an extra $6,000,000 – then the stock valuation of the company can be justified.  If not then the company’s stock price is being pumped up by hype and hot air.

Summary

While it’s true that you cannot you cannot fully measure the value of a company based on its hard assets (cash, inventory, buildings, etc.), it’s also true that a company’s value is ultimately measured in dollars.  That means when it comes to a company’s stock valuation, cash is king!

 


[1] This would be the case if, for example, a company’s stock was trading at $50 a share and there were 200,000 total shares outstanding ($50 x 200,000 shares = $10,000,000).