Man consider the stock market to be a source of passive income.

I do not.

It can be manipulated into passive income by investing in mutual funds or allowing your stock broker to take care of your investments.
Because you would be putting forth no or little effort, it would be considered passive income.

But if you choose to invest on your own- you had better be making that active income.

In the entries to come we will go over different tools and necessary methods to use with investing, but today we will be covering the time consuming aspect.  Your “homework“, as Jim Cramer puts it, should take up at least one hour per stock that you own per week.

So if you own shares of Google, TBSI, Boeing, MNKD, and WaMu(haha) then you should be doing five hours of homework per week.

We will go deeper into what is expected of your homework in the weeks to come, but it should include things like researching management, listening and watching press conferences, keeping track of the multiple, etc.

By managing these sorts of issues you make the giant leap from being a hobbyist to creating what I consider a second job.

But by doing so you are becoming an educated investor, prepared for both the bull and the bear.  People are making money in the good and the bad markets- and the only thing that distinguished them from you is that they educate themselves.
Why not you?

In our last post we learned what the Price to Earnings Ratio was and how it related to the Multiple of a share.

For Reviews sake, you’ll recall that the Multiple can be calculated by taking the market price of a share and dividing it by the earnings per share of the company. This is because a share’s multiple is a calculation of how many times it’s earnings you will pay for the share.

So if a share is $10 and has $2/share earnings then the multiple would be 5 and it would have a 5:1 P/E ratio.

Using the P/E Ratio in Practice

When choosing stocks, you should not be taking stabs in the dark. Do your research.

So you’ll probably remember that I also said that a P/E ratio was an important part of your homework. It is even more important for choosing a stock though. We’ll go through how to use it for both of these purposes now.

When choosing a stock, you need to be comparing different companies within the same sector. For example: to understand if I should be buying Microsoft I compare it’s multiple to Google’s, Cisco’s and several other tech companies. Now I consider whether or not Microsoft is cheaper than these other companies.

Now — this is very important — in order to justify a purchase you MUST have a reason to assume that the price will be going up. If you cannot convince a friend exactly why this stock will be growing, do not buy.

Let’s say you’ve compared your stock to your sector, found a reason to believe it will grow (be it new management, product launch, simple under-valuing), you may just have found a winner!

Monitoring the P/E Ratio

For the purpose of homework, a P/E ratio must constantly be examined and watched; just as stock prices can be under-valued or a sector’s growth can under-perform an individual stock, stock prices can be be over-valued as well. If the multiple ends up very expensive then it can be just as important to dump the stock as it is to pick up a cheap multiple.

Hopefully this gives you a better understanding of how to go about using the multiple. I can promise you- this is not the last you’ll hear of it!

The P/E Ratio is an Important Tool that Every Investor Should Look Into Before Making Decisions.

If you’ve ever wandered onto Yahoo! Finance, read the Wall Street Journal or watched CNBC then you have definitely heard things like “Walmart’s price to earnings ratio is…”, “Home Depot’s multiple…”, or “Caterpillar is trading at 10 times earnings.”

It may surprise you to know that each of these phrases is actually describing the same thing. Each statement is keeping up with a company’s Multiple, or the amount of times that an annual earnings per share can be divided into the market share price.

You are calculating how much more, in times, you are paying for a share than the company’s earnings for that share.

Example of a P/E Ratio

Why is this important? I will use an imaginary example to illustrate.

Let’s say that Caldwell Inc.’s shares are trading at $10.00 per share, and Leggett Co.’s shares are trading at $45.00.

Which one is more expensive?

At first glance you would say that Leggett Co. Is the more expensive share, but this is inaccurate and the multiple can show us why.

You see, the earnings per share at Caldwell Inc. was $2.00 per share last year. So that means Caldwell Inc. has a 5:1 P/E ratio ($10 divided by $2). It is trading at 5 times earnings.

Leggett Co. had earnings per share of $10.00 last year ($45 divided by $10). So Leggett Co. is trading at 4.5 times earnings.

What Does it Mean?

So let’s put this into perspective: would you prefer to pay 5 times what a car is worth or 4.5 times what a car is worth? Of course, 4.5 times is cheaper!

So even though numerically Leggett Co. appears to be more expensive than Caldwell Inc. when you utilize the Price to Earnings Ratio you see that it is actually quite the opposite!

And this is Important because…

When you are looking to purchase shares of any company, you should ALWAYS be comparing them to the industry and sector you find them in, as well as all of its major competitors. The P/E Ratio is a great starter’s tool for comparing companies’ prices.

Photo Credit: justonlysteve

As I hope that all of you realize, you will never get rich off of your day job. Now, I’m not saying that through disciplined saving and investing you may not retire wealthy, but a salary will never make you wealthy on its own.

Your active income alone will not build wealth. If you want a healthy income, you should focus on both active and passive income.

In this post we’ll be covering Active Income and Passive Income — a way to assist you in a journey for a wealthy retirement. Along the way, I’ll cover a few ideas for generating increased earnings from each of them.

Your Active Income is any income that you exchange work or time on a regular basis for money. An example of this would be working 40 hours a week at Walmart as a cashier for a preset salary of $7.00 an hour.

Your Passive Income is any income that does not require work and time on a regular basis, yet still continually feeds your income. An example of Passive income can be anything from interest yielded from a bank account or mutual fund to a small business that “practically runs itself”. We’ll get into more examples soon.

Which is Which? And How Do I Improve My Income?

We run into a few problems with these definitions, and in all honesty you will need to define for yourself what each of your income streams should be classified as.

After analyzing your income streams, if you’re as novice as I often find myself to be, I’m sure that you’ll find two things.

1. I only have three(or fewer) seperate income streams.
2. Almost all of my income is active.

So how can we go about increasing Active Income? This is a much simpler sector of your income to grow than your passive income. You can go about doing this by getting a new job, starting a new business, or investing in the stock market. Why do I include investing in the stock market in Active Income? What work does that involve? It’s outside the scope of this post, but to answer in short Jim Cramer (a stock Guru) does a good job summarizing by saying you should be spending a minimum of one hour per week per stock you own. Definitely active in my book.
So a few very simple Active Income Ideas:

1. Get a second or third job
2. Start a small fundraising business
3. Start selling cold water bottles at large outdoor events (braves game, etc.)

How About Increasing my Passive Income?

How can we increase Passive Income? This becomes a bit more difficult, only because it takes more creativity. Passive income, in my book, is sort of the epitome of the American Dream. Earning money with little or no work.

This includes things like mututal fund yields, bank account interest, a guy who is afraid of you and pays you $40 a week not to beat him up (this is a financial idea, not a moral one…)

So then what are some realistic ideas to increase my Passive Income?

1. Start a blog and sell advertising on it with Google Adsense or others (Which could also be defined as Active in a sense).
2. Invest in Mutual Funds or Index Funds.
3. Purchase real estate and rent it.

You will never truly begin to accumulate wealth until you’ve increased your Passive Income. This is how the rich get richer. The ideas on here are decent, but excellent ones are to be made by the entrepreneur (you). That’s how you get rich — Passive income is an idea game.

Real World Analysis

We covered what Active Income and Passive Income are and we went through a few methods of increasing them. So now it’s time to apply it to ourselves. I’ll show you my personal analysis of my Active and Passive income and you can go about doing the same for yourself

So first lets list my current income streams:

I have a total of six very limited income streams. I do want to make a note that I am ONLY including Regular income. I own several small businesses that bring in intermittent income, but I cannot include those for valid planning purposes.

The next step then would be to outline ideas for increases in both sides of the chart:

Now I will say — You’re not going to see all of my ideas. You’ll hear about them once they’re already in place. But this is the majority of them.

You’ll notice that there is much more listed on the Passive side than the Active side. I am ALWAYS looking for ways to increase the side of the chart that takes no regular work or time from me. I’m busy enough as it is, and chances are, you’re in the same boat if you’re attending college full time like me. I want and need to make money in ways that take the least out of my agenda.

Income Allocation is the splitting up of your income. It’s the discipline of dividing your cash into multiple areas for unique spending, saving, and investment.

That doesn’t sound very fun now does it. It is an INCREDIBLY important principle though… One that each and every person who strives to manage their own finances should utilize.

What Should I Be Doing?

Before you throw all of your income into a single spending account, consider the consequences of immediate spending… It

Discipline is necessary to any kind of expertise, and allocating your income is no exception. I’ll use my own as my example for this particular lesson, laying out how I allocate my income using percentages for every dollar of that comes into my possession.

Whenever I receive any kind of income — and like I said, DISCIPLINE, so this means ANY kind of income, from my monthly paycheck to a birthday check — I immediately deposit it into a free checking account I have with Wachovia labeled “Spending Account”. From there it is immediately disbursed among several other accounts, each labeled as follows:

• 30% remains in my Spending Account
• 30% is transferred into my Bills Account
• 30% is transferred into my Investment Account
• 10% is withdrawn in Cash and placed into envelopes for my Tithe

Spending Account Example

It’s very simple — My spending Account goes many more places though.

For example, For every purchase that I make with my spending Debit Card, I have one dollar removed from the Spending account and automatically transferred into a Wachovia Way2Save high yield Savings account.

I also use this for longer term accumulation for large spending that doesn’t qualify as an “investment”. What is an example of this? Well, I hope that in the next five years I’ll be blessed enough to ask someone to marry me. So, to prepare for this sort of a purchase, I dedicate 10% of my spending account to an envelope on my desk with a circle drawn on it and no label, so that no one walking in will think I’m jumping the gun… but now you all know. Shoot.

Bills Account

My Bills account gets used for things like gasoline, groceries, etc.

This account is ONLY used for paying off bills. No tapping into this account to cover personal expenses. It’s all a part of that disciplinary lifestyle I keep referring back to.

Investment Account

My investment account is widespread, but ONLY used for purposes that will yield some sort of return. This could range anywhere from purchasing a domain for a website (not a fun website but one I think could yield a return) to a business flight.

Overview of MY Income Allocation

If there’s anything I would encourage you to do before doing ANYTHING else — Set up an income allocation procedure for yourself. This discipline is important because without it, none of these important fields of your personal finance will see a dime of your income. Each of the things that I account for within my list are important and necessary to devote a portion of my income to. If I didn’t make a point to move money into those accounts each and every time I received an income check, I would probably spend it before I could ever place it where it needed to be.

I believe that most Americans are more similar to myself in their irresponsible spending habits than those who can keep all their money together and still manage to plan for retirement and investments.

So to counter my irresponsible tendencies, I force myself to divide the checks immediately. It’s a surefire way to get things done automatically, saving me time, and saving me money.