#1: Change the Way You Think About Money

The general population has a love / hate relationship with wealth. They resent those who have it, but spend their entire lives attempting to get it for themselves. The reason a vast majority of people never accumulate a substantial nest egg is because they don’t understand the nature of money or how it works.

Cash, like a person, is a living thing. When you wake up in the morning and go to work, you are selling a product – yourself (or more specifically, your labor). When you realize that every morning your assets wake up and have the same potential to work as you do, you unlock a powerful key in your life. Each dollar you save is like an employee. Over the course of time, the goal is to make your employees work hard, and eventually, they will make enough money to hire more workers (cash). When you have become truly successful, you no longer have to sell your own labor, but can live off of the labor of your assets.

#2: Develop an Understanding of the Power of Small Amounts

The biggest mistake most people make is that they think they have to start with an entire Napoleon-like army. They suffer from the “not enough” mentality; namely that if they aren’t making $1,000 or $5,000 investments at a time, they will never become rich. What these people don’t realize is that entire armies are built one soldier at a time; so too is their financial arsenal.

A friend of mine once knew a woman who worked as a dishwasher and made her purses out of used liquid detergent bottles. This woman invested and saved everything she had despite it never being more than a few dollars at a time. Now, her portfolio is worth millions upon millions of dollars, all of which was built upon small investments. I am not suggesting you become this frugal, but the lesson is still a valuable one. Do not despise the day of small beginnings!

#3: With Each Dollar You Save, You Are Buying Yourself Freedom

When you put it in these terms, you see how spending $20 here and $40 there can make a huge difference in the long run. Since money has the ability to work in your place, the more of it you employ, the faster and larger it will grow. Along with more money comes more freedom – the freedom to stay home with your kids, the freedom to retire and travel around the world, or the freedom to quit your job. If you have any source of income, it is possible for you to start building wealth today. It may only be $5 or $10 at a time, but each of those investments is a stone in the foundation of your financial freedom.

#4: You Are Responsible for Where You Are in Your Life

Years ago, a friend told me she didn’t want to invest in stocks because she “didn’t want to wait ten years to be rich…” she would rather enjoy her money now. The folly with this school of thinking is that the odds are, you are going to be alive in ten years. The question is whether or not you will be better off when you arrive there. Where you are right now is the sum total of the decisions you have made in the past. Why not set the stage for your life in the future right now?

#5: Instead of Buying the Product… Buy the Stock!

Someone once asked me why they weren’t wealthy. They always felt like they were putting money aside, yet never seemed to get any further ahead. The answer is simple. I told them to stop buying the products companies sell and start buying the company itself! A survey of America’s affluent (those who make over $225,000 a year or own $3,000,000 in assets) revealed that 27-30% of all the income the wealthy earned went into investments and savings. That isn’t a result of being rich, that is why they are rich. When the pain of getting out of the bondage of financial slavery is greater than the pain of changing your spending habits, you will become rich. Either change, or be content to live as you are.

#6: Study and Admire Success and Those Who Have Achieved It… Then Emulate It

A very wise investor once said to pick the traits you admire and dislike the most about your heroes, then do everything in your power to develop the traits you like and reject the ones you don’t. Mold yourself into who you want to become. You’ll find that by investing in yourself first, money will begin to flow into your life. Success and wealth beget success and wealth. You have to purchase your way into that cycle, and you do so by building your army one soldier at a time and putting your money to work for you.

#7: Realize that More Money is Not the Answer

More money is not going to solve your problem. Money is a magnifying glass; it will accelerate and bring to light your true habits. If you are not capable of handling a job paying $18,000 a year, the worst possible thing that could happen to you is for you to earn six figures. It would destroy you. I have met too many people earning $100,000 a year who are living from paycheck to paycheck and don’t understand why it is happening. The problem isn’t the size of their checkbook, it is the way in which they were taught to use money.

#8: Unless Your Parents Were Wealthy, Don’t Do What They Did

The definition of insanity is doing the same thing over and over again and expecting a different result. If your parents were not living the life you want to live then don’t do what they did! You must break away from the mentality of past generations if you want to have a different lifestyle than they had.

To achieve the financial freedom and success that your family may or may not have had, you have to do two things. First, make a firm commitment to get out of debt. To find out which debts should be paid off before you invest and those that are acceptable, read Pay Off Your Debt or Invest?. Second, make saving and investing the highest financial priority in your life; one technique is to pay yourself first.

Purchasing equity is vital to your financial success as an individual whether you are in need of cash income or desire long-term appreciation in stock value. Nowhere else can your money do as much for you as when you use it to invest in a business that has wonderful long-term prospects.

#9: Don’t Worry

The miracle of life is that it doesn’t matter so much where you are, it matters where you are going. Once you have made the choice to take control back of your life by building up your net worth, don’t give a second thought to the “what ifs”. Every moment that goes by, you are growing closer and closer to your ultimate goal – control and freedom.

Every dollar that passes through your hands is a seed to your financial future. Rest assured, if you are diligent and responsible, financial prosperity is an inevitability. The day will come when you make your last payment on your car, your house, or whatever else it is you owe. Until then, enjoy the process.

To help you understand the traits of an excellent business, I’ve put together some resources that will give you an idea of what you should look for in a stock, and, just as vital, why it is important. Armed with this information, over time you’ll be more likely to build a portfolio of wealth creating assets that can provide financial security for you and your family.

An excellent business earns high returns on capital with little or no debt

There seems to be little doubt, based upon the evidence, that it’s easier to build a large net worth through value investing – that is, the disciplined purchase of stocks, bonds, mutual funds, and other assets that appear to be selling at a substantial discount to a reasonable person’s estimate of intrinsic value (or “the real” value.) Think of it as if you knew a local car wash had gold buried underneath it. The proprietor might be asking $800,000 for the land and enterprise, but you know full well that you could pay substantially more, not only owning the business, but also selling the gold you dug up on the open market. Thus, you had reason to believe that it was being sold for far less than its intrinsic value.
The one major shortcoming of this approach is that an asset bought cheap must be sold when it reaches intrinsic value unless it is an excellent business. As Charlie Munger has pointed out, over long periods of time, the rate of return which an investor earns is likely to be very close to the total return on capital generated by a firm, adjusted for dilution in shares outstanding. Thus, you are likely to do better paying fair value for a business that can reinvest its capital at high rates of return – say, over 15% to 20% per annum – than buying a mediocre business trading at a small discount to its liquidation value.
For more information, read Business Like Investing: Thinking Like an Owner; on the second page of the article you’ll find information on why return on capital matters.

An excellent business has durable competitive advantages

If you had unlimited funds, do you really believe that with the best pick of any manager in the world, you could unseat Coca-Cola as the undisputed leader in the soft drink industry? How about Johnson & Johnson with its myriad of patents, trademarks, and brand name products? The reason these businesses are able to succeed so well is that they have durable competitive advantages – things that their competitors can’t reproduce.

Sometimes these advantages are easy to spot – as is the case of Coca-Cola, which is the second most recognized word on Earth. However, it is possible for them to remain buried. One of the secrets to the phenomenal success of Wal-Mart is that Sam Walton built a distribution system with logistical capabilities that allowed him to lower the transportation costs of moving merchandise to his stores, allowing him to make far more profit than competitors selling at higher prices. He and his fellow shareholders won from the increased income while consumers won from the lower prices. These forces worked in combination with one another, reinforcing and accelerating the results so much that the tiny five-and-dime grew into the largest retailer the world has ever seen.

When you buy into a company through the purchase of its common stock, try to identify the durable competitive advantages it has that could stand up from attack by competitors and market forces such as outsourcing and increased globalization.

An excellent business is scalable

When businesses are highly successful, one of the key ingredients more often than not is scalability. Take American Eagle Outfitters, which has one of the best long-term investment records over the past decade. Why was it successful? Target? Wal-Mart? McDonald’s? Coca-Cola? Pepsi? Microsoft? All are excellent businesses in part because they had products or services that could be replicated in cookie-cutter fashion very, very rapidly.

Think about it. The McDonald’s in Hong Kong is very much like the McDonald’s in Chicago. And New York. And Southern California. By having the menu, layout, fixtures, and technology packaged in a way that restaurants could be rapidly opened, it made it easier for the chain to roll out across the United States and world. Coupled with its relatively high returns on equity and the cash provided by the franchisees, which footed the bill to build a huge portion of the overall business, it’s not hard to see why the shareholders might consider Ray Kroc as a hero.

The price still matters …

For those of you too young to remember the Nifty Fifty, this idea of buying excellent businesses was taken to such ridiculous extremes in the 1960’s that investors paid upwards of sixty and seventy times earnings! To contrast, a normal price-to-earnings ratio on Wall Street is considered fifteen; that is, for every $1 in per share profit a company generates, it would trade for $15. It didn’t take a genius to see that even if the business was all it was cracked up to be, at those prices, it would be virtually impossible to earn a satisfactory long-term rate of return.

That’s why you need to take a moment to read Price is Paramount to see an illustration of how lower growth rates can actually lead to higher rates of return in certain circumstances.

What’s a new investor to do? Let’s take a look at a few of the options now available if you want a simple, easy to understand way to track your investments.

The Online Options

Most top-tier financial institutions now offer tracking services online. Just to name one: Bank of America now has a feature that allows clients enter the username and password for their other accounts at institutions throughout the world, including retirement and brokerage accounts, and the Bank of America website will pull all of the data together on one screen so you can see your entire financial picture. You can even create manual entries to track loans from family members or other items that don’t show up on a regular statement.

The same is true at a start-up called Mint.com, which has reportedly won backing from Microsoft. Other brokers, such as Charles Schwab and E-Trade allow clients to review years of past records online in free, downloadable PDF format.

If you have only a handful of accounts and just want to know where you stand each month, these can be great choices that are, in most cases, completely free as part of your regular banking or investing relationship.

Using Microsoft Excel to Track Your Investments

A popular option among many investors is to use Microsoft Excel to track their accounts. By creating different tabs in a workbook, you can keep records for each individual account, and then aggregate them together, run different scenarios, and basically manipulate the figures any way you need to get an idea of how your financial life is going.

Using Excel to track your investments does require working knowledge of the program, but it is used in virtually every office in the world, there are millions of pages of books dedicated to teaching beginners how to use the program, and you likely have family members that can spend an afternoon showing you how to setup your file. For most people, it’s the best, and easiest, choice now that Microsoft Money has been removed from the picture.

Using QuickBooks to Track Your Investments

My personal favorite is the use of QuickBooks to track investments. We use it at several of the new companies we established in 2009, and it allows us to record anything that we need to in a matter of a few clicks, including really complicated stuff such as advanced stock option trades. The downside is that it requires a thorough understanding of accounting debits and credits, otherwise it could be overwhelming.

QuickBooks does offer a free online edition for beginners that you can download and begin using right away if your needs are simple. For most people or small businesses, it just may fit the bill – and at a price tag of $0, it certainly helps your budget.

Quicken and Other Options

There are several other options, including Quicken (some people love the program – I was never that into it but that is entirely personal preference) to track your investments. In an Internet-based world, it’s not difficult to find reviews of software packages so you can find one that works for you.

Working Capital is the easiest of all the balance sheet calculations. Here’s the formula:

Current Assets – Current Liabilities = Working Capital

One of the main advantages of looking at the working capital position is being able to foresee any financial difficulties that may arise. Even a business that has billions of dollars in fixed assets will quickly find itself in bankruptcy court if it can’t pay its monthly bills. Under the best circumstances, poor working capital leads to financial pressure on a company, increased borrowing, and late payments to creditor – all of which result in a lower credit rating. A lower credit rating means banks charge a higher interest rate, which can cost a corporation a lot of money over time.

Companies that have high inventory turns and do business on a cash basis (such as a grocery store) need very little working capital. These types of businesses raise money every time they open their doors, then turn around and plow that money back into inventory to increase sales. Since cash is generated so quickly, managements can simply stock pile the proceeds from their daily sales for a short period of time if a financial crisis arises. Since cash can be raised so quickly, there is no need to have a large amount of working capital available.

A company that makes heavy machinery is a completely different story. Because these types of businesses are selling expensive items on a long-term payment basis, they can’t raise cash as quickly. Since the inventory on their balance sheet is normally ordered months in advance, it can rarely be sold fast enough to raise money for short-term financial crises (by the time it is sold, it may be too late). It’s easy to see why companies such as this must keep enough working capital on hand to get through any unforeseen difficulties.

One of the greatest economists in history once remarked, “Markets can remain irrational longer than you can remain solvent.” Take the recent case of the most royal of blue chips, General Electric and Berkshire Hathaway. Within the past year, GE has fallen from roughly $40 per share to as low as $5.87 per share and the dividends slashed from $1.24 per share to $0.40 per share. Even if you had waited until the stock fell the first 50% to $20 per share, and borrowed against your stocks, you would have long been hit by a margin call requiring you to come up with more money to avoid your broker liquidating your position. Berkshire Hathaway, likewise, has seen its Class A shares fall from $150,000 to roughly $72,000 and it Class B shares falling from $5,000 to $2,150 per share.
In both cases, you are dealing with a company that would appear to have a better than average probability of trading at substantially higher prices five years from now. Yet, if you had borrowed money, you would have been forced to sell out long before the stocks began to rise. To add insult to injury, not only would have been correct, you would have suffered the pain of losing large amounts of money because your timing was not perfect.
For more information on the subject, read Margin 101 – The Dangers of Speculating with Borrowed Money.

2. Don’t Invest Funds You Need for the Next 5 Years

As Warren Buffett pointed out in his most recent shareholder letter, the market was up 75% of the time during the past century. Trying to figure out the specific years those gains would happen is a fool’s game. If you want to buy a house, prepare for retirement, send yourself or your children to school, or expect to have large medical bills over the next five years, stocks are not an appropriate place for you to invest your money. In the long-run, they have proven to be the surest path to wealth for those who are disciplined and rational. In the short-run, they can experience nauseating volatility, fluctuating like a roller coaster.

3. Once You Have Developed a Plan, Don’t Check Stocks Daily

Have you put together a plan that works? Do you dollar cost average, reinvest your dividends, max out your 401(k), and contribute to a Traditional IRA or Roth IRA? Are your investments low cost and diversified like an index fund? If that’s the case, you simply need to follow the same instructions that appear on most shampoo bottles: Wash. Rinse. Repeat.
Over several decades, a program such as this has proven to be hugely successful, resulting in millions of dollars in wealth for those who follow it. If you have the patience, will power, and discipline to engage in such an investing plan, why make yourself sick by looking at stock prices daily? Just as a sale at the grocery store allows you to buy everything from cereal and milk cheaper, a drop in stock prices allows you to get more equity (ownership) in companies. When things recover, that means you have a right to even more earnings and dividends.

4. Don’t Rely on One Salary or Source of Income

A big danger to your investments is the risk that you will find yourself unable to pay your day-to-day bills and forced to sell assets to fund your living expenses. The most sensible way to avoid this is to follow the Berkshire Hathaway Model, which calls for multiple sources of income that are non-correlated. In other words, your income isn’t diversified if both you and your spouse work at the same factory or in the same industry. If you are a realtor and own rental properties, you are less diversified in your income sources than a dentist who owns rental properties.

5. Don’t Cut Your Health Insurance
Nothing ticks me off more than to read about a family earning $30,000 to $40,000 a year cutting off their health insurance because it isn’t affordable yet if you go into their homes, many of these people still have cable television or cigarettes or iPods. What happens if you or your children get seriously injured or sick? Health insurance is the last – read it again – the absolute last area you should cut because of the serious bankruptcy risk that can occur in the event of a disease. Even a policy with a high deductible is better than no coverage at all.

For example, you would want to see some of the following relationships:

• A higher growth rate in earnings than the “stock” of the index.
• Lower price-to-earnings ratio than the “stock” of the index.
• A higher dividend yield than the “stock” of the index.
• A much higher return on equity and invested capital than the “stock” of the index.
• If, on average, you can construct a portfolio with these characteristics, over long periods of time your results and compound annual growth rate should, judging by past history, beat the market.

Need a Little Help?
All of that statistical work can be extraordinarily difficult, time consuming, and costly. Thankfully, Morningstar, the market leader in mutual fund research and a major player in the equity markets, as well, has created a tool called X-Ray. For only $14.95 per month (the cost of a premium subscription to the company’s website), you can enter your portfolio one investment at a time. When you’re done, it will prepare a detailed report comparing your assets with the broader market. It will save you all of the time and effort and arm you with the data you need.

Commissions and Fees

The most frequent frictional expense is brokerage commissions and fees. Thankfully, with the advent of the discount broker, the cost of buying and selling securities has been dramatically reduced over the past few decades. At Commerce Bancorp, for example, an investor that places a $2,500 or less trade of no more than 1,000 shares of stock will pay a commission of $29.95 if he places the order online. If, on the other hand, he opts to call the bank and have a broker execute the trade, he will pay $31 plus 1.50% of the principal value of the investment for a total of $68.50. If you had an established dollar cost averaging plan on a monthly basis, that additional commission expense of $38.55 would add up to more than $462.60 per year. Assuming the historical rate of long-term appreciation on equities remains twelve percent, over the course of forty years that would amount to $354,856 in foregone wealth!

Asset management fees can be an even greater impediment to long-term wealth building. Many firms focusing on high net-worth clients will charge fees of 1.5% of assets. A family with a $10 million net worth, under this type of arrangement, would pay $150,000 per year in fees even if they lost money on their investments. This sort of arrangement hardly seems fair. In certain situations, such as estate planning, trusts, and foundation management, however, the fee is justified by the services provided.
Spreads

When buying or selling an investment, a percentage of the investor’s principal is reallocated to the market maker. This reallocation is the spread (i.e., difference) between the bid price (what the buying is willing to pay) and the ask price (what the seller is willing to accept). Like the compounded future value of brokerage commissions, this can amount to significant foregone wealth.

Capital Gains Tax

The unique thing about the capital gains tax is that the investor is free to decide when the tax bill will come due by selling his appreciated securities. Each year that goes by without selling, the value of these deferred taxes becomes greater. To illustrate: assume Adam Smith owns 1,000 shares of Green Gables Industries which he purchased at $35 per share four years ago. Today, the stock is trading at $50 per share. The total value of his holdings is $35,000, of which $15,000 is a capital gain ($50 selling price – $35 cost = $15 per share capital gain x 1,000 shares = $15,000 capital gain). If he were to sell the stock, in addition to the money paid out as brokerage commissions and the spread taken by the market maker, he would have to pay $3,000 in capital gains tax.

This means that he now has $3,000 less in assets working for him, accruing to his benefit. Hence, it would only be intelligent to change investments if Adam believed that 1.) Green Gables Industries was overpriced, or 2.) he found a more attractive investment offering a higher rate of return. For this reason, Benjamin Graham recommended investors only change positions when they are fairly certain the alternative investment has a twenty or thirty percent advantage over their current holding. This rule, although necessarily arbitrary, should help ensure that frictional expenses are covered and the investor’s net worth increases enough to justify the time and effort required to discover the investment and to make the change.

Frictional Expense in the Mutual Funds

Frictional expenses, including management fees and sales loads, are the primary reason actively managed funds as a whole have not outperformed their non-managed counterparts such as index funds over long periods of time. In order for an actively managed fund to merely break even with the market, it would have to earn higher returns by several percentage points to pay the frictional expenses. This is especially true thanks to capital gains taxes which are not applicable to index funds which, because they are a group of non-managed stock assumed to rarely change, do not require the frequent sale of securities.

The owners of the property came back with their counteroffer, but refused to budge much. They had in mind a price that they thought appropriate for the property based upon their own analysis of the comparable sales in the neighborhood. They determined that based upon their own financial needs that they couldn’t afford to sell their asset for the price the market was currently indicating it was worth; indeed, they demanded the same appreciation that had been the rule for the past twenty years, not recognizing the new reality. That’s fine. That’s what I’ve been trying to teach you with the thousands of articles that have been published. Although I trust my own analysis (this is what I do for a living – valuing assets, buying them at attractive levels, and generating profit on those capital commitments), they had arrived at their own estimate of replacement value for the property. They will now either have to continue holding the real estate, wait for an offer that they think is more inline with their estimate of value, or be forced into a sale if they can’t hold out until the market recovers.

Now, here’s where most people make huge errors that cost them years, even decades, of wealth building effort. If they had owned a basket of stocks – say, shares of Wal-Mart, General Electric, Johnson & Johnson, and U.S. Bancorp – and they had experienced a drop of 10% or 20%, let alone the 50% drubbing many equities have taken over the past year, it’s unlikely that these same people would apply a rational disposition to their portfolio like they did their house. They wouldn’t research the valuation of comparable businesses to each of those they owned, estimate what they think their share of those businesses was, and then refuse to sell (or better yet, buy more while it was cheap) until it reflected a conservative estimate of intrinsic value.

Instead, it’s likely that they would be more likely to sell the further prices fell because they trusted their neighbor’s estimate of what their property is worth instead of their own, cold, dispassionate calculation. I wrote you a few weeks ago and told you that if you were selling your 401(k) assets, people like me were out there buying them in the midst of all the fear. In a few years, you would wonder why we had gotten substantially richer.

The bottom line: You must assess all of the assets in your life based on their estimated intrinsic value. There’s nothing more irrational than saying, “My accounts are down $10,000 or $100,000 or $500,000! What do I do?” If you are invested in a broad-based, low-cost index fund, falling prices are good for you in the long run. That’s because the dividend yield on your portfolio will increase, allowing you to purchase more shares with your reinvested earnings. Your regular contributions will also purchase more shares. This is the secret to building equity, which is the surefire way to building wealth.

Otherwise known as “net worth” or “book value”, this figure represents assets minus liabilities. There are some businesses that are funded entirely with equity capital (cash written by the shareholders or owners into the company that have no offsetting liabilities.) Although it is the favored form for most people because you cannot go bankrupt, it can be extraordinarily expensive and require massive amounts of work to grow your enterprise. Microsoft is an example of such an operation because it generates high enough returns to justify a pure equity capital structure.

Debt Capital

This type of capital is infused into a business with the understanding that it must be paid back at a predetermined future date. In the meantime, the owner of the capital (typically a bank, bondholders, or a wealthy individual), agree to accept interest in exchange for you using their money. Think of interest expense as the cost of “renting” the capital to expand your business; it is often known as the cost of capital. For many young businesses, debt can be the easiest way to expand because it is relatively easy to access and is understood by the average American worker thanks to widespread home ownership and the community-based nature of banks. The profits for the owners is the difference between the return on capital and the cost of capital; for example, if you borrow $100,000 and pay 10% interest yet earn 15% after taxes, the profit of 5%, or $5,000, would not have existed without the debt capital infused into the business.
Specialty Capital

This is the gold standard. There are a few sources of capital that have almost no economic cost and can take the limits off of growth. They include things such as a negative cash conversion cycle (vendor financing), insurance float, etc.

· Negative Cash Conversion (Vendor Financing) Imagine you own a retail store. To expand your business, you need $1 million in capital to open a new location. Most of this is the result of needing to go out, buy your inventory, and stock your shelves with merchandise. You wait and hope that one day customers come in and pay you. In the meantime, you have capital (either debt or equity capital) tied up in the business in the form of inventory.

Now, imagine if you could get your customers to pay you before you had to pay for your merchandise. This would allow you to carry far more merchandise than your capitalization structure would otherwise allow. AutoZone is a great example; it has convinced its vendors to put their products on its shelves and retain ownership until the moment that a customer walks up to the front of one of AutoZone’s stores and pays for the goods. At that precise second, the vendor sells it to AutoZone which in turn sells it to the customer.

This allows them to expand far more rapidly and return more money to the owners of the business in the form of share repurchases (cash dividends would also be an option) because they don’t have to tie up hundreds of millions of dollars in inventory. In the meantime, the increased cash in the business as a result of more favorable vendor terms and / or getting your customers to pay you sooner allows you to generate more income than your equity or debt alone would permit. Typically, vendor financing can be measured in part by looking at the percentage of inventories to accounts payable (the higher the percentage, the better), and analyzing the cash conversion cycle; the more days “negative”, the better. Dell Computer was famous for its nearly two or three week negative cash conversion cycle which allowed it to grow from a college dorm room to the largest computer company in the world with little or no debt in less than a single generation.

· FloatInsurance companies that collect money and can generate income by investing the funds before paying it them out in the future in the form of policyholder payouts when a car is damaged, or replacing a home when destroyed in a tornado, are in a very good place. As Buffett describes it, float is money that a company holds but does not own. It has all of the benefits of debt but none of the drawbacks; the most important consideration is the cost of capital – that is, how much money it costs the owners of a business to generate float. In exceptional cases, the cost can actually be negative; that is, you are paid to invest other people’s money plus you get to keep the income from the investments. Other businesses can develop forms of float but it can be very difficult.

Sweat Equity

There is also a form of capital known as sweat equity which is when an owner bootstraps operations by putting in long hours at a low rate of pay per hour making up for the lack of capital necessary to hire sufficient employees to do the job well and let them work an ordinarily forty hour workweek. Although it is largely intangible and does not count as financial capital, it can be estimated as the cost of payroll saved as a result of excess hours worked by the owners. The hope is that the business will grow fast enough to compensate the owner for the low-pay, long-hour sweat equity infused into the enterprise.

1. The Real Risk-Free Interest Rate

This is the rate to which all other investments are compared. It is the rate of return an investor can earn without any risk in a world with no inflation.

2. An Inflation Premium

This is the rate that is added to an investment to adjust it for the market’s expectation of future inflation. For example, the inflation premium required for a one year corporate bond might be a lot lower than a thirty year corporate bond by the same company because investors think that inflation will be low over the short-run, but pick up in the future as a result of the trade and budget deficits of years past.

3. A Liquidity Premium

Thinly traded investments such as stocks and bonds in a family controlled company require a liquidity premium. That is, investors are not going to pay the full value of the asset if there is a very real possibility that they will not be able to dump the stock or bond in a short period of time because buyers are scarce. This is expected to compensate them for that potential loss. The size of the liquidity premium is the dependent upon an investor’s perception of how active a particular market is.

4. Default Risk Premium

How likely do investors believe it is that a company will default on its obligation or go bankrupt? Often, when signs of trouble appear, a company’s shares or bonds will collapse as a result of investors demanding a default risk premium. If someone were able to acquire assets that were trading at a huge discount as a result of a default risk premium that was too large, they could make a great deal of money. Many professional money managers actually bought shares of Enron’s corporate debt during the now-famous meltdown of the energy-trading giant. In essence, they bought $1 of debt for only a few pennies. If they can get more than they paid in the event of a liquidation or reorganization, it can make them very, very rich.

K-Mart is a wonderful example. Prior to its bankruptcy, hedge fund manager Eddie Lampert and distressed debt expert Marty Whitman of Third Avenue Funds, bought an enormous portion of the retailer’s debt. When the company was reorganized in bankruptcy court, the debt holders were given equity in the new company. Lampert then used his new controlling block of K-Mart stock with its improved balance sheet to start investing in other assets.

3. Maturity PremiumThe further in the future the maturity of a company’s bonds, the greater the price will fluctuate when interest rates change. That’s because of the maturity premium. Here’s a very simplified version to illustrate the concept: Imagine you own a $10,000 bond with a 7% yield when it is issued that will mature in 30 years. Each year, you will receive $700 in interest in the mail. Thirty years in the future, you will get your original $10,000 back. Now, if you were going to sell your bond the next day, you