Clay Fink (2:42)

So I think the next place to go here is to talk about the Master Accounting Equation. I love the name of that. I'M not sure if you came up with it or not. What is the master accounting equation, and why is that important?

Brian Feroldi (2:55)

The master accounting equation is assets equals liabilities plus shareholders equity. Now, that is the accounting way of saying, what is a company's net worth? Clay, if I asked you, what's your net worth? You'd do a very simple math equation in your head. You'd say, what do I own minus what do I owe equals my net worth. That is the master accounting equation, except for it's in accounting speak. So what you own is a company's assets. What you owe to others is a company's liabilities. And a company's net worth is just called shareholder's equity or owner's equity. But that is the master accounting equation, and it rules the company's financial statements.

Clay Fink (3:38)

And that naturally brings us to the three financial statements. Talk to us about each of these statements and how all of these tie together as well.

Brian Feroldi (3:49)

The three most important financial statements to know are the balance sheet, the income statement, and the cash flow statement. Let's take them one at a time. The balance sheet is a snapshot picture of a company's net worth on paper at a point in time. And the balance sheet follows the master accounting equation. So on one side of the balance sheet is the company's assets. On the other side are the company's liabilities and shareholders equity. Now, the balance sheet is called the balance sheet because those two numbers, assets and liabilities plus owner's equity, must always exactly equal each other, or balance. Hence the term balance sheet. Now that is the company's balance sheet. Then there's the company's income statement. And the income statement tracks a company's revenue and expenses over a set period of time. Now, the period of time is typically a quarter or a year. And think of an income statement kind of like a movie. So there's a start to it and there's an end to it. And the income statement records all revenue and expenses incurred during that period of time. And the income statement is used to tell whether a company is profitable or unprofitable, at least on paper. The third financial statement is called the cash flow statement. And this financial statement's purpose is to just track cash, cash movement in and out of a business. So think of this kind of like your personal checking account. It just measures, did cash come in or did cash come out? Having all three of these statements is incredibly important because they each give you a different window into a company's financial situation. And it's by analyzing all three of them together that you can get a true picture of a company's financials.

Clay Fink (5:37)

So going back to my accounting 101 days, one of the things that always sort of tripped me up and sort of confused me was this concept of double entry bookkeeping. Right. So for every debit there's a credit. So a company raises money, they get cash on the balance sheet, it's offset by some sort of liability, whether they raise that money through debt, whether they raise it through equity and whatnot. So how about you talk more about this concept of double entry bookkeeping of how for every transaction there's a credit and a debit.

Brian Feroldi (6:07)

Yeah. This is recorded on the balance sheet and it is the method that keeps the balance sheet in balance to your point. Every time there is a transaction that affects something on the balance sheet, by definition, it also has to affect another ledger to ensure that the balance sheet remains in perfect balance with each other. For example, if a company goes out to the market or goes out to the private markets and raises capital from investors, that's when an investor injects cash into a business in order to fund operations that would have two transactions that appear on the balance sheet. First, the company is receiving cash from investors. So therefore the company's cash balance would go up. Now cash is an asset, so that affects the left side of the of the balance sheet. And because the left side of the balance sheet is going up, there must be something on the right side of the balance sheet that also increases in order to make sure that the balance sheet is perfectly imbalanced. Now in the case of a company selling stock to other investors, that would affect the shareholders equity portion of the income statement and particularly two numbers. One is common stock and the second is called additional paid in capital. So if a company raises a million dollars from selling to investors, cash balance would go up by $1 million. And then common stock and additional paid in capital would combined go up by $1 million as well. That would ensure that the balance sheet remains in balance. And this is true for every single transaction that can possibly occur in a company. So when revenue comes in, when sales come in, those would increase the company's retained earnings and it would increase the company's cash balance when an expense is paid. So like employees salaries are paid or rent is paid, if that was paid in cash, that would decrease the company's cash balance, simultaneously decreasing a company's retained earnings. So it's an incredibly important concept, the concept of double entry accounting, to ensure that the master account equation is always perfectly in Balance.

Clay Fink (8:10)

As you know, I recently interviewed David Gardner and our episode will be going out next week. And one of the things we discussed during that conversation was just how so many of a company's assets you won't even find on the balance sheet. For example, Amazon. Their most important asset over the years was having Jeff Bezos as a CEO for such a long time. So, you know, many successful companies today are making these investments into intangible assets, which is becoming more and more prominent with all these technology names rising up. Intangible assets. You can think of things like brand patents, proprietary technology, or human capital. Whereas decades ago, oftentimes companies were investing in these tangible assets such as a plant, property, equipment and inventory. So how about you talk about the differences and how these intangible versus tangible investments flow through the financial statements?

Brian Feroldi (9:03)

Sure, great question. That simple concept is worth exploring. More tangible versus intangible. To me, the word tangible, the easiest way to think about it is tangible means something you can physically touch. Intangible means something that you can't physically touch. So a tangible asset would be a store, a retail store that a business operates out of. You can go down and touch a Home Depot. Home Depot. Stores are a tangible asset. But if I was to say touch the brand name or the copyright for Home Depot, that's something that exists in a ledger somewhere. So you can't physically touch the brand name of Home Depot. So that would be an example of an intangible asset. Companies derive value from both sources, and both are really important to know. But the tricky thing about intangible assets is they're often incredibly, incredibly difficult to value. If I said to you, what's the value, the dollar value of the word Coca Cola, what would you say? And how could you possibly come up with a figure? You could go anywhere on the planet and talk to almost any human, and if you said the word Coca Cola, they would understand what you're talking about and know exactly what you mean, even if they didn't speak Eng. So what is the dollar value that we should assign to that name? It's really hard to do. And accountants do attempt to put a dollar value behind it, and they do often to make sure the financial statements work. But it's very challenging to do, so much easier to say, what's the dollar value of the manufacturing building where we create the Coca Cola? You can go in and say, well, how much did it cost to make it? How much does the equipment cost and what are the operating expenses of it? And how can we depreciate that over time, that is a much easier thing to come up with. But David Gardner, I've learned so much from him, and he has taught me the value of intangible assets. One that you didn't touch on is just something called Mindshare. Do your customers know and think of your product? And if I said to you, Clay, name a store that you would go to to get groceries, what would you.

Clay Fink (10:59)

Say closest to down the street would be Target and Costco.

Brian Feroldi (11:03)

There you go. So two brand names. So I said, you need something, and you immediately thought of Target and Costco. Is there value in that? Are there millions of people just like you who named, say, a toothpaste or name a computer or name a phone company, they would instantly have something in mind. I would argue that there's tremendous value to that, to having your name implanted in the customer's mind. But how can you express that on a financial statement? It's really hard to do. This is why marrying both the details of accounting with the soft art of analyzing companies at a high level is so important.

Clay Fink (11:37)

Yeah, I mean, to pull the thread on that a little bit. A company like Coca Cola is investing in marketing each year. So on the one side, I could see where these marketing expenses are flowing through the income statement, and they're just like expenses or the cost of doing business. But then there's also the case of maybe part of this spend should be flowing through to the brand value in these intangible assets. So how does this end up manifesting in the accounting statements for something like a marketing budget?

Brian Feroldi (12:04)

Yep. So that is one way of doing it. You can say, how much dollars have we put behind advertising campaigns? Or in the case of creating intellectual property or materials. Think about Disney. Disney made the movie Snow White like, what, 80, 90 years ago or something like that. But we still know the name Snow White. And think of all the ways that Disney has monetized the movie Snow White over the last 100 years. The monetization that they've got out of that movie is. Is enormous when compared to the resources that they put into creating that. So to your point, one way that you can account for the value of a company's brand is to look at the spend that the company has put into sales and marketing over that brand's lifetime. And that is one way of valuing an intangible asset. It's an imprecise way, but it's kind of the best that accountants have at any given time. This is why one trick that I know that David Gardner uses when he's looking at financial statements is he looks at a company's intangible value and then he asks himself, is the actual value that the company derives from the intangible that it has far higher than what's recorded on the financial statements? That's one way that you can look for a mismatch between what a company is worth in reality and what it's worth on paper.

Clay Fink (13:14)

I guess we'll jump here to GAAP accounting. So financial statements for companies that are listed here in the US are constructed based on GAAP accounting. How about you just talk a little bit about what GAAP accounting is and you know why it's used here in.

Brian Feroldi (13:29)

The US when it comes to creating financial statements, it's important that there are a set of rules and procedures that all companies follow to make sure that the reports that they're issuing to investors are accurate. In the United States, the accounting procedures that we use are called GAAP or Generally Accepted Accounting Principles. GAAP and all companies that are publicly traded in the United States are required by law to report their financial statements using GAAP accounting. Now, for some businesses, because of the black and white nature of GAAP accounting and the role that GAAP accounting uses when valuing things like intangible assets, sometimes the rules that companies have to follow are too rigid and too black and white. So some companies, especially modern day tech companies, choose to report in addition to GAAP accounting, non GAAP accounting, which is the financials that do not comply with GAAP accounting because they give the company more wiggle room to report information that they think is more valid. Here's a simple way to think about GAAP versus non GAAP accounting. I play golf with my son. My son and I played golf the other night and I took a drive and duffed it and I said I'm going to take a mulligan and I hit a second shot and then I duffed my third shot out of the sand. It took me two tries and I got up onto the green and then I putted and I was within six feet and I said it's a gimme. Well, according to GAAP accounting, that's like a nine in the golf scorecard. But if you use non GAAP accounting, I would say that's a five. I'm going to forget all those things that don't account. So GAAP accounting, rigid following of rules and they're standardized and all companies must report them. Non GAAP accounting is massaging the rules and often leaving out certain items to make your financial statements look Better?

Clay Fink (15:16)

Yeah. I mean, that's such an important point because you see so many companies report these non GAAP measures. I can imagine. In some cases it makes a lot of sense. But then I can't help but think there's going to be some bad actors out there that try and make the company look better than it actually is, which can lead people to investing in the company and they can finance their operations through issuing equity and whatnot and get some investors into trouble. So how reliable do you think the non GAAP measures are? How do we know if we can really trust them and trust what management's trying to tell us with these numbers?

Brian Feroldi (15:54)

Well, it's important that whenever a company reports non GAAP numbers, it tells you precisely the adjustments that it's making to the GAAP figures in order to come up with them. The most common adjustment that we see that most investors have a problem in or that there's a big debate about is the treatment of stock based compensation. Stock based compensation is a non cash expense that according to GAAP accounting must be accounted for on the company's financial statements. So if a company pays hundreds of millions of dollars in stock based compensation, that reduces their GAAP earnings by hundreds of millions of dollars even though it did not have a cash cost to the business. This is why many companies that pay huge amounts of stock based compensation also report non GAAP numbers and say, well, if we exclude stock based compensation from our reporting, here's how much of a profit we would have recorded. That is probably the most common thing that is adjusted for with non GAAP accounting. But there's lots of other things that are adjusted for. Some companies choose to exclude one time events or one time anomalies from their financial statements. For example, if they closed down a factory and they had big severance payments, in theory, that is a one time expense, one time thing that they have to do. Now with GAAP accounting, they have to record that one time expense in their financial statements. But from an operating perspective, it does make sense for a company to say here's what it is with that expense excluded and here's what the numbers would be without that expense included. This is why some companies find it helpful to report both GAAP and non GAAP numbers. Now it's up to the individual investor that's analyzing the financial statements to look at the adjustments and see if they agree with the adjustments that are being made. When I'm looking at a financial statements, if I find a company that touts its adjusted ebitda, a very non GAAP number. I automatically deduct points in my head for that company's management team because I think they're focused on the wrong metric. But if a company is touting its GAAP earnings per share or that's the number that they report to the markets, I immediately give that management team points and credit because that's a much harder number to manipulate. So the onus, like always, is always on the individual investor or the investor that's analyzing financial statements and do the work to see is this management team trustworthy. Let's take a quick break and hear from today's sponsors.

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Clay Fink (22:16)

I'm happy you mentioned stock based compensation there because I feel like Warren Buffett has almost trained a lot of us to dislike this metric and it's something that's been used more and more here in the US especially within technology companies. On the one hand, stock based compensation many people view as a real expense. There's no free lunch as they say. But one thing I do appreciate about stock based compensation is based on my understanding employees that work at the company part of their benefit is receiving stock as a part of their total compensation. I can appreciate this because it can really create this culture of ownership where the employees actually own shares in the company and now they're vested in that company's success, especially as employees work there over a long period of time, then a substantial portion of their net worth might be in those shares, especially if the shares appreciate. I don't know if you have any follow ups to that on of course stock based compensation is a real expense, but there could be some benefit for some companies that have that ownership culture.

Brian Feroldi (23:20)

Yeah, I see both sides of it. And stock based compensation makes a ton of sense for startup and early stage businesses. Oftentimes they do not have the cash resources to go out and pay executives their market rate. So if an executive they want to pay them $500,000 per year and the company might not have that operating income to support that kind of executive payment. So it makes a lot of sense for them to say we're going to pay you $100,000 in cash and $400,000 in stock, which might be attractive to the executive if they think that the company could be worth far more into the future. But while I do see both sides of the stock based compensation perspective, I've become firmly in the camp of Warren Buffet that I would vastly prefer bonuses to be paid for with cash. Because I think that cash is actually a better motivation tool for the employee than I do stock based compensation. Reason I now think that is if you are anything other than the CEO, you do not have full control over what the company does. Imagine that you're a mid level executive in the sales department. You have control over the sales and the actions in your specific region. But you have no control over the research and development department or the manufacturing department, or the legal department or acquisitions that are made made yet those other actions will directly impact the stock price. So therefore, by owning just stock in the company, you have no control over what the company does. Only the CEO does. So I think that every executive, except for the CEO should not have stock based compensation in their package. I would prefer them to be paid for with cash. Now, the CEO who does have control over all operations should absolutely be paid in stock based compensation because they actually have the control over what happens at the company level. But I've become much less of a fan of it at any other level of the organization.

Clay Fink (25:10)

So some of the investors I've talked to here on the show have mentioned that the US is an attractive place to invest for several reasons. One of which is related to the regulatory environment and how much information public companies are required to publish for investors. I've never purchased a stock in China or India, but I've heard that investing in stocks in those countries can be tricky because, you know, you tend to find a number of fraudulent names there. And that isn't to say that all companies in the US Are perfect by any means at all. But I think that it just gets to the point that oftentimes you can trust the numbers at least a little bit more. So how about you talk a little bit about some of the protections that are in place here in the US that seem to hold public companies that are listed here to a higher standard.

Brian Feroldi (25:54)

The United States is blessed with a few hundred year operating history of public markets. And because of that, the US Is a highly regulated market. And thanks to the actions of the sec, there are far more investor protections in place today than there have been historically. And oftentimes it's often a tragedy or a big high flying disaster that causes regulations to be put into place. As an example, I think most listeners are familiar with the name Enron and the Enron scandal that happened in the late 1990s early 2000s, where companies like Enron and Arthur Andersen and WorldCom were essentially cooking their books. They were making their financial statements look much better than the underlying performance of the company was. Well, thanks to the outfall of the Enron debacle, companies are now required to include a cash flow statement. They are required to report a cash flow statement when they file with the sec. Prior to Enron, they were not required to issue a cash flow statement, which made it really hard for investors to track the true earnings performance that a company has. In addition, executives are also now required to sign their name on all of their financial statements, putting themselves personally liable for the reliability and the accuracy of those financial statements. I'm not an expert in international markets by any means, but I don't think that those same regulations are in place that would give investors protection. So one reason why it makes a lot of sense to me to invest mostly in the United States is that companies are required to follow GAAP accounting, which is the accounting that I know best. And there are some basic shareholder protections in place. Not to say that there aren't fabulous companies and great exchanges elsewhere, but for my money, I am perfectly comfortable and happy to invest in the US and.

Clay Fink (27:35)

One of the funny things about accounting and financial statements is that people tend to think of accountants as very rational, very logical thinkers that follow a very strict set of rules. So once people pull up a financial statement, they tend to just take the numbers for what they're worth. I think it's important to mention that there's actually some subjectivity when it comes to creating financial statements. So to use just a simple example, I think everyone can understand, let's say a manufacturing company buys machines for its plants and the life of those machines is expected to be 10 years. Well, if the company depreciates those machines over 20 years, then they're likely to be overstating earnings. So if an investor takes those earnings at face value, then they might not necessarily make the right investment decision based on what's happening in reality. And here at tip, I'm reminded that we have an advertising segment of our business and I could come up with a handful of ways that we could recognize revenue. For example, we could recognize revenue when a deal signed, when the ad starts running, when the advertiser actually pays us, if they do pay us, and whatnot. So there's all this nuance that can go into it. And you know, all of these methods can paint a much different financial picture when you're looking at the statements. So, you know, I just illustrate this to just show how subjective accounting can be at times. It's not always that the economic earnings actually reflect economic reality. And we might find ourselves in a case where the analysis was spot on, but our investment decision was incorrect based on our analysis of the numbers that the company showed us. This is also one reason I like to prioritize management. In my analysis of a company. If I know I'm working with a highly ethical manager that I can trust, then it could be the case that they tend to understate earnings because they care about investors and protecting investors. So I think in these cases it could be a situation where they tend to surprise to the upside over the long term rather than disappointing investors.

Brian Feroldi (29:38)

Yeah, to your point, you just laid out a great example of how creative accountants can be when it comes to creating their financial statements. Revenue recognition is a huge area that CFOs or management teams have control over. And to your point, when is revenue recorded? Is it when the item is actually shipped and leaves the factory? Is it when you receive the cash from the customer? Those can be months apart. And when a company is publicly traded, there is huge financial pressure on the management team to report numbers that exceed or beat Wall Street's estimates. That controls their bonuses, that controls the stock price, that controls whether or not they get to keep their job. So there are huge incentives in place to, for management teams to fudge the numbers or do everything that they can to present the best story that they can at any given time to Wall Street. So to your point, if you find a company that is very conservative with the accounting, that speaks volumes about the integrity of the management team. And if you find the inverse, you should probably just stay away from that business.

Clay Fink (30:37)

Yeah, that is an excellent point that so many companies just want to hit their quarterly eps. And in the short term, that might be a great thing, but over the long term, it could end up hurting investors that aren't investing in companies that use more conservative accounting. Another point I'd like to mention is this concept of fungibility. So intuitively, as humans, we tend to think of money as fungible. So, Brian, if you and I walk into a Starbucks, we each go and buy an overpriced, expensive latte. We're each going to pay $6 for that latte and essentially get the exact same product. So your $6 have the exact same utility as my $6. And I think carrying this line of thinking can sometimes actually hurt us in investing who treat each dollar the same. So, for example, a dollar's worth of earnings at a company like Costco might actually be worth considerably more than a dollar's worth of earnings at another retailer that might be in decline or might have volatile earnings from year to year. So how about you talk about this concept of understanding that there's more to just looking at the numbers?

Brian Feroldi (31:40)

You hit on a really important point when it comes to analyzing business. And this really confused me when I first started investing, because the thing that you read in investing books and value investing books is low PE ratios mean a company is cheap. High PE ratios mean that a company is expensive. So if you were looking at, say, an automaker like Ford, you might see that it's trading at 8 times earnings, 6 or 8 times earnings. And your natural thing to say would be, well, that number is cheap. Ford in stock is cheap. Conversely, you might find a company like Costco or Visa or MasterCard trading at 30 times earnings. And your natural inclination might be, those stocks are expensive. Look how high their PE ratios are in comparison to the market or in comparison to Ford. But you hit on an incredibly important point that not all profits and not all revenue is created equally. A dollar in sales at one business should be worth completely different than a dollar in sales at another business, because not all revenue and not all profits are created equally. High quality revenue, really high quality revenue has some key characteristics. Revenue that is recession proof, that happens in good Times and bad is far more valuable than revenue that is cyclical in nature and that a lot of it happens in good times and it disappears in bad times. Revenue that becomes cash is far more valuable than revenue that becomes accounts receivable. Revenue that is recurring in nature or where a customer makes continual payments, say for a software license or utility is far more valuable than revenue that is related to a one off purchase or a one off transaction that happens every five to 10 years. Revenue that is very high margin has a gross margin of 80% is far more valuable than revenue that has a very low gross margin of say 10% or something. So to your point, if you were analyzing a dollar worth of sales at Ford, the market only might assign a 6 or 8 multiple to that because the market believes that Ford's profits are not highly valuable profits. Those profits might disappear completely when the economy goes through a downturn. Ford also issues credit, so it becomes an accounts receivable for the business. You compare that to Costco. People shop at Costco in good times and in bad, and you could even argue that people shop at Costco more when the economy goes. Therefore, you can have a lot of confidence in the continual earnings power of a company like Costco when compared to a company like Ford. This is why when you're looking at companies that trade at wildly different P E ratios, that's the market's way of saying this profit is highly valuable and this profit is not nearly as valuable.

Clay Fink (34:20)

I also wanted to touch on the options a company has when they generate cash, what they can do with that cash. So generally they can do six different things. When a company generates cash, it can keep that cash on the balance sheet, pay down debt, distribute dividends, repurchase its own shares, make an acquisition, or reinvest back into the business. I would say that those first five tend to be relatively easier to follow in the financial statements. But I think that the reinvestment piece can be a bit more elusive. What are some of the line items that we should look out for to better understand to what extent a business is reinvesting back into its own operations?

Brian Feroldi (34:59)

Yeah, you can determine that when looking at the company's income statement and what its operating expenses are doing, as well as looking at its cash flow statement. If a company, for example, is reinvesting into the business through capital expenditures, it's building new factories, it's building new stores, it's making new equipment that would be reflected in the capital expenditures or purchase of property, plant, equipment, line of the cash flow statement. And you would Also see a corresponding increase in a company's operating expenses on the income statement. But you just hit on a really important point. What you just described is something called capital allocation. And Warren Buffett has called a CEOs most important job capital allocation. There are six levers that a management team can pull at any time with the cash that it has available to them. And the order and the magnitude of which those levers are pulled can have tremendous outputs on the returns that shareholders receive. When a company is in the early stages of its development, when it's a startup, or when it's in the hypergrowth mode, or it's really starting to get growing, a company often does not have excess capital. All capital that's generated in the business goes right back into the company and is reinvested. This is when a company is hiring engineers in research and development, hiring salespeople, opening up new geographies, creating new products, and launching those to market. When a company is in that stage of the business growth cycle, all capital should be reinvested back into the core business to drive future growth. That's unquestionable. Once a company runs out of internally generated projects in order to continue growing itself, that's when those other five options become available to the business. And so many management teams screw this part up. They have some excess capital to them, and they don't have the training or discipline that they need to make the right choices. Application choices to maximize shareholder value. For example, some companies buy back their stock because they think that's a good way to return capital to shareholders with no regard to the valuation or the market price that they're paying for that stock. And buying back a stock when it's overvalued is a horrible use of capital. Buying back that stock when it's dramatically undervalued can be a great use of capital. The same can go for issuing and paying off debt. Paying off debt that's at a high rate can be a great use of capital. Paying off debt that's at a very low rate can be a poor use of capital. The same can be true of making acquisitions or even paying dividends, or just building the company's cash position. So capital allocation is something that investors should really pay attention to, and they can tell you a lot about the decision making of the management team.

Clay Fink (37:30)

Financial statements also play a big role in how many investors are viewing the company's valuation. So David Gardner, he was talking about how he's actually attracted to companies that financial commentators and analysts are saying are overvalued. Yet I think the irony with many great businesses is that they oftentimes appear more expensive than they really are when you're looking at these financial statements. So one example I thought of was looking at Netflix, for example. They've been investing in new content to try and boost their subscriber numbers over time. In theory, they could stop investing in new content and generate a ton of cash, a substantial amount of profit, and the stock might actually look cheap, but this would actually be detrimental to their business in the long term. So there's this aspect of looking at the numbers and understanding them, but not getting too bogged down in the numbers today. Maybe focusing more on, if it's a growth company like Netflix, focusing more on their management's ability to execute, on their strategy, and how successful they are in painting that vision for where they want to be.

Brian Feroldi (38:39)

Yeah, you just highlighted probably one of the most confusing aspects of investing in valuation, especially if you're a new investor. And when I first started, I thought that the way that you valued a business was by looking at its PE ratio, its price to earnings ratio. When I first understood what the P E ratio was, I would look at great companies like Apple, Netflix, Amazon, Intuitive, Surgical, all of which had P E ratios that were 50, 80, 100 or even 1,000. And my immediate next thought was too expensive, can't buy that stock. It is just not for me. The problem is the P E ratio is a highly useful tool, but you have to use it at the right time. The price to earnings ratio is only a meaningful number when a company is fully optimized for generating profits. When a company is in growth mode, it is often not not optimized for generating profits. It's optimized for growth companies like Netflix or Amazon, when they were in build out mode, were investing heavily in content in the case of Netflix, or investing heavily in distribution in the case of Amazon, in order to increase their capacity in the anticipation of future growth that would come from future customers. Those proved to be very smart, savvy investments. But as a byproduct of that, it meant that their expenses were inflated when compared to the current size of the business. And since the expenses were inflated or overstated, that meant the company's profits, true profits, were understated. And when profits are understated, that means the price to earnings ratio is inflated. And that's why we saw companies like Amazon have a pe ratio of 4 or 500. And they were actually tremendous buys back then, even though they optically look extremely expensive. So a key thing I want listeners to do. When you're analyzing a company's price to earnings ratio, ask yourself, is this company optimized for profits today? If the answer is no, don't use the P E ratio.

Clay Fink (40:42)

I'd also like to mention another item that you won't find on a balance sheet, which is optionality. So when you look at Netflix, in 2015 they had zero advertising business. And today Netflix has an advertising aspect to their business which as we know is extremely profitable for many of these big tech platforms. And this is same with Amazon. They might have had very little to no advertising 10, 20 years ago. And now advertising is a major segment of their business. So that's why it also mentioned just how well is management executing on what they say they're trying to do and what their strategy is and gaining market share and whatnot. Because that optionality piece is something that you need to consider if you're going to hold a stock for 5, 10 plus years.

Brian Feroldi (41:26)

Totally. And this is one of the most difficult things when it comes to analyzing a business. So let me give you my definition of optionality. I define optionality as the company's ability to launch new products and new services to its customers that generate needle moving revenue and profits in the future. The best classic example that everyone can think of is Amazon. When Amazon first was a company, it sold books. That was the business. It was selling books. What does Amazon sell today? Everything, like everything that you can possibly think of. So Amazon, by starting in books, was developing a customer list and getting the operations in place to deliver books. But then it added on CDs and movies and electronics. And now I think you can go as far as buying kayaks delivered straight to your home directly on Amazon. So Amazon is a tremendous example of a company that was able to launch new products and new services that opened up needle moving revenue. When I look back at some of the best investments that I've ever made, many of them. The reason for the upside that I have achieved is because of optionality. As an example, Axon, which is formerly called taser, they made 100% of their revenue from Tasers that police use. The police stun guns. If you look at the company today, that is still a major revenue driver for the company. But it also has Axon body cameras as well as a software solution that it developed internally that ties all of its hardware components to together. So if you were buying Exxon stock 10 or 20 years ago, you were buying future optionality and these future products that you could not see at the time and that is one reason why companies like Amazon, why companies like Apple, why companies like MercadoLibre have been such extreme outperformers over the last 10 and 20 years is because 10 and 20 years ago there was hidden value in the company from future optionality. I know that's something that David Gardner, when he's investing, looks for very closely. He asks, can this company launch new products and new services that open up new revenue opportunities? And if the answer is yes, the company might just be undervalued. Let's take a quick break and hear from today's sponsors.

Clay Fink (43:38)

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Brian Feroldi (47:03)

All right, back to the show.

Clay Fink (47:05)

Let's talk about red flags. So although accounting is the language of business, sometimes we can make the wrong interpretation of a company based on the numbers. Either because management is intentionally trying to show us what we want to see as investors, or we aren't looking in the right places within the financial statements. How about we'll start with the income statement? What are some of the red flags that you look out for on the income statement?

Brian Feroldi (47:27)

Yeah, there's a couple of them. I define these more as yellow flags. To be perfectly honest, when I think the word red flag, I think that means stop, do not go any further, do not invest. So I call the flags that we're about to go over yellow flags because when I see them tripped, it just to me means investigate further. You need more information about this on the income statement in particular, I like to look at the revenue growth rate and I judge the revenue growth rate from year to year. And if you see a sudden change in a company's revenue growth rate, that is a signal to Wall street that the thesis might be running out. And oftentimes that can trigger a severe decline in the company's stock. So revenue growth rate from year to year is something that I do track. And if a company has a history of growing its revenue 30% per year and then suddenly it comes out with a report where revenue is growing 10% per year. That is a significant change in the company's revenue growth rate. And when that happens, it's often associated with a meaningful decline in the company's stock price. Another number that I track closely on the income statement is something called gross margin. Gross margin is a company's gross profit divided by its revenue and it tells you how profitable a product or service is on a unit basis. When the company's gross margin is declining over time, that to me is a big yellow flag that needs to be investigated because it either means the company is being forced to discount its product to consumers in order to drive sales, or its suppliers are increasing prices on its supplies and the company can't successfully pass those along to consumers. Both of which are big yellow flags to me. The final one that I look at is a company's shares outstanding or how many shares of stock exist. If this number is rapidly increasing over time, more than 3% per year, that to me is a yellow flag because it means the company doesn't respect their equity and is likely diluting shareholders through the issuing of too much stock based compensation. So those are three big yellow flags that I look for. A growth rate, gross margin, and dilution rate.

Clay Fink (49:31)

Yeah, I think dilution is definitely an important one to highlight because using that term I used earlier, it can be a bit more elusive where if you see the stock price falling and management still needs to issue shares just to finance their business, it's a bit in desperation mode, if we can call it that. How about we jump to the balance sheet? What are the red or yellow flags on the balance sheet?

Brian Feroldi (49:54)

First thing I look at when I'm analyzing a balance sheet is the company's cash versus the company's debt. Cash is king. In a business, there's only one true sin and that is running out of cash. So I like to compare how much cash or marketable securities, which is essentially the same thing as cash a company has, and I compare that to its debt load, both short term debt and long term debt. Best case scenario is a company has millions or billions of dollars in cash and zero debt, although that's pretty darn rare. So I at least like to check out the relationship between the company's cash balance and debt balance. And as a general statement, it's okay that a company has debt, but I also want to see plenty of cash to be able to finance and support that debt into the future. So that's the first thing that I check. Another number that I look for on the balance sheet is something called goodwill. Goodwill is the premium that companies have paid in the past to make acquisitions. And it shows how much management teams overspent on the acquired company's assets in order to make the transaction happen. Now, goodwill by itself is not necessarily a bad thing. There's no liquidity to the asset. You can't turn goodwill back into cash unless you sell the company that you acquired. So I like to make sure that a company's goodwill is less than 10% of of the company's total assets. Company can get into trouble if goodwill becomes the company's largest asset. So if I see goodwill over 50% or even 60%, that's when I raise that to me is a red flag. And the final thing that I look at are some current assets that are called accounts receivable and inventory. These are assets that the company has that will be converted into cash in the future. But you don't want too much of a company's liquidity to be tied up in accounts receivable or inventory because the company might have trouble collecting on the accounts receivable that it has, or the company might have trouble selling inventory that it has and converting it into cash. So if a company has too much working capital or too much accounts receivable or inventory and that number dwarfs its cash balance, to me, that's another red flag.

Clay Fink (51:59)

Yeah, I love in one of your videos, you highlighted Goodwill right down by teladoc. So in 2021, they had a $14 billion in goodwill, and in 2022, that was written down to 1 billion. So just a classic example of a company massively overpaying in an acquisition and paying for it in the end.

Brian Feroldi (52:20)

That made me feel good as an investor because I've certainly bought lots of bad stocks that have cost me money, but I've never bought a company that cost $13 billion. So management teams make plenty of mistakes too.

Clay Fink (52:32)

Yeah. How about red flags for the cash flow statement finally?

Brian Feroldi (52:36)

Yeah. The cash flow statement is my favorite statement to analyze because it shows you whether or not a company is producing or consuming cash. So one of the first things that I look at on the cash flow statement is a company's net income. And I compare that directly to a company's free cash flow. Now, free cash flow is not a number that's reported on most cash flow statements, but it's easy to calculate. You take operating cash flow and you subtract out capital expenditures. These numbers are right next to each other on the cash flow statement. What you want to do as an investor is you compare net income to a company's free cash flow. In the best case scenario, a company is producing more free cash flow than it is net income. That would be a positive thing. And the downside or the worst case scenario is a company is reporting lots of net income, but its free cash flow is a negative number. Which means that the company is profitable on paper, but the company is not actually generating cash from operations. And there's a couple of big reasons why that could happen. They could be related to stock based compensation expenses. They could be to big changes in working capital. They could be to just huge capital expenditures to get the business off the ground. So that's not necessarily a red flag, but it definitely is worth a deeper dive as an investor. Another thing that I look at is stock based compensation. I compare how much stock based compensation is being issued and compare that to a company's net income. As a general broad statement, I like it when less than 10% of a company's net income is issued as stock based compensation. That's not always possible with high growth companies that are in the tech sector. But if a company is issuing stock based compensation, I want to make sure it's a relatively small figure.

Clay Fink (54:20)

I wanted to jump to one of the items you include in your investing checklist. So one item you look for that would make a stock uninvestable is what you refer to as accounting irregularities. I don't know if I've had anyone discuss this in depth, so I'd love for you to explain this for our listeners.

Brian Feroldi (54:38)

When a company says has to issue a press release saying we have some accounting irregularities, what they're telling you in plain English is our financial statements that we have issued in the past are not accurate. They are wrong. And they could be wrong for a bunch of reasons and they could be wrong in one direction and the other as a general statement. When a company does that, that means that they overstated their previous revenue or their profits and the orders of their companies found significant problems with the way the company reports financial statements. To me, that is the only true red flag that exists when I'm making an investment. An inherent promise of that investment is that the numbers that I'm using to make a decision about the company and the valuation are accurate. If all of a sudden I have to question the validity of the numbers that I use to make that decision, I just immediately sell that stock and write that company off as dead to me forever. There are thousands of companies out there that do not have to restate their financial Statements. I don't think investors should bother at all with companies that accounting is a problem.

Clay Fink (55:47)

Are there any examples in the past of this happening? Maybe you've owned a company that has published this announcement?

Brian Feroldi (55:53)

Yeah, there's lots of them that happen. They don't always happen to big name companies. But the one that comes to mind immediately was Luckin Coffee, the Chinese high growth coffee company that in a matter of three years or something like that had as many locations as Starbucks did. And it's 50 year history as a company. So when I saw that I was scratching my head like that's interesting to see a company that in just a couple of years has matched Starbucks distribution scale. And after being public for a couple of months, they did have to come out and say that we are restating our financial positions and we found some accounting irregularities. When that happened, the Stock dropped like 60% or something like that. And I think peak the trough the stock went down like 90 ish percent. I believe in the case of Luckin Coffee, the company has since cleaned up its financial act and is back to being in the good graces of Wall Street. And I think the stock has appreciated meaningfully from when it declined. But for me, the investor, I still would have zero faith in the accuracy of Luck and Coffee's financial statements at this point in time. And to me I would never include that company in my portfolio.

Clay Fink (56:53)

And is it the SEC that's sort of tapping him on the shoulder to confirm that these numbers are correct and they find that they're not? Is it the SEC that does it? Is it shareholder pushback or what leads to these irregularities?

Brian Feroldi (57:05)

It's a combination of the SEC and the auditors of the business. So companies that are publicly traded do have to get an outside auditing firm to go in and confirm that the numbers are correct. This is where the big four auditors come find and is one reason why if an investor does not see one of the big four auditors on the company's financial statements, they oftentimes will have big questions in the place and saying why are you bothering with this outside auditor? We don't trust them. We do trust the big four auditors in the US but typically it's a combination of the management team, the auditors, the board of directors and the regulators that identify whether a company has financial problems or not.

Clay Fink (57:42)

Excellent. We've already mentioned David Gardner a couple of times during this conversation and I mentioned I had just interviewed him and that episode will go live a week after this one. And I must say that it's one of my favorite conversations to date. And you worked at the Motley fool for a number of years, and I know that Gardner was highly influential for you and your investment strategy and whatnot. As I was reading through the book, I know that I see plenty of parallels between how both of you think about the world of investing. And I'll also mention that Gardner, amazingly I read in his book that his portfolio has seven 100 baggers and Amazon's more than a 1000 bagger in his portfolio. So really excited for that episode to go out next week. But before I give you the final handoff, I was curious if you could just talk a little bit about the impact that David Gardner has had either on you as an investor or as a person.

Brian Feroldi (58:32)

David is a tremendous human being on so many fronts. And one thing that I really like about studying David's investing style is it's so back backwards and so differs so greatly from what you hear from the investing rates like Warren Buffett and Charlie Munger and Seth Klarman who emphasize valuation first in everything that they do. David is I view as almost a venture capitalist investor who just so happens to fish in public markets, and his six signs of a rule breaker have been instrumental in helping me as an investor. In particular, the thing that he has changed my mind about the most is valuation and how to think about companies that are valued. I am a natural value investor. When I first started investing, I looked for big dividend yield and low PE ratios and those were the stocks that I wanted to own. So when I heard him say things like it's okay to pay 100 plus P E ratios for businesses, and when I saw him recommending Amazon and Netflix early on in their growth phase, I thought he was nuts. I just thought he was absolutely backwards and he was violating so many of the sound investing principles. But when I look back at my biggest winners of all time, the things that have the biggest network impact on my personal net worth, they are almost exclusively companies that David Gardner picked out. Companies like Netflix, Amazon, Intuitive, Surgical, Axon. These are companies that I never would have put into my portfolio if he hadn't recommended them and convinced me to. And in many cases I was holding my nose about the valuation and buying. And looking back, they were some of the best purchases I ever made. So he's had a tremendous impact on my financial life.

Clay Fink (60:12)

Are there any ways in which you feel that your approach differs from his? Certain things you look for that he might not, or certain things you emphasize?

Brian Feroldi (60:20)

Yeah, if you look at my checklist and compare it to his. I have more components on my checklist, but I am more of a quality investor at this time. I am okay with giving up the upside potential of a business. I tend to invest at later stages than he does because I want to see more that the thesis has been proven. Now one thing that I like about his style is despite picking stock publicly for like 20 plus years, he is perfectly okay with striking out on an investment, going up and being the champion for a company like Peloton early on and saying yes, I like this company, that stock went on to fall like 70 plus percent and he's willing to shake it off, step up to the plate and still pick another stock that he thinks has upside potential. And what he showed me is that it is perfectly okay to lose and it's perfectly okay to have a portfolio filled with losers. You just need to get one Amazon or one Nvidia or one Apple into your portfolio and the gains that you get from that mega winner will pay for all of your losers combined.

Clay Fink (61:21)

Since valuation is such an important piece of Looking at the financial statements you mentioned initially you got attracted to juicy dividend yields to low PE ratios. And I remember very vividly back in college I saw AT&T at a dividend yield of 5, 6% and I was like, man, why am I not just putting a bunch of money into this, getting these what I viewed as sort of guaranteed dividends? Of course they probably cut the dividend since then and highly indebted company and whatnot. I don't know if you have anything else that you feel is really important for your journey as an investor. And looking at the numbers and understanding the numbers, but also understanding how they fit into the bigger picture of understanding a company's value, where that might be in the future, and just viewing that from an investor standpoint, good investing is.

Brian Feroldi (62:11)

All about marrying the left side of your brain with the right side of your brain. And I've learned that good investing is part art and part science and you need both working in tandem with each other in order to do well. You need to have the financial knowledge to be able to analyze a company's financial statements and ask what's happening with revenue, what's happening with margins? Can the company's balance sheet allow it to survive or will it have to raise capital and dilute investors into oblivion? That's a very important skill that you need to know and to look at. Equally important is to be able to see the company where it is today and have the vision in your mind to say what can happen if this company does what it says it can do? Or is the future of this company even brighter than the most bullish analyst that's covering this stock today believes it's oftentimes those companies, the one that's outperform even the most wide, wildly optimistic expectations that are out there that truly go on to deliver life changing returns for their investors. This is one of the most important things that everybody listening this needs to know what kind of investor are you? Where on the risk reward spectrum do you lie? Are you going after 100 bagger stocks? If so, you need to really emphasize the story of the business and really de emphasize the current financials of the business. If you're a value investor or dividend investor or a quality investor, you need to really emphasize the financials of a business and de emphasize the story of the business. But it's really important to know yourself and to know what you're looking for so you can make the right investing decisions for you.

Clay Fink (63:41)

And lastly, how much emphasis do you put on building a dcf? Building a model to determine whether you're going to invest in a stock or not?

Brian Feroldi (63:50)

Personally, I put zero emphasis on DCF models. I don't use DCF models. I know many valuation gurus say that they're the only way to value business. I don't agree with that at all. I think the most useful DCF model is called the reverse DCF model where you solve for the company's implied growth rate by using the current stock price. That makes a lot of sense to me because you're not making estimates about what the company is going to do. You're seeing what does the market estimate that this company is going to do and do. I think the company can outperform or underperform that valuation is one of the most tricky things to do. But I think the simpler you can keep it with valuation, the better you would do as an investor. So when I'm valuing companies, I'm looking at typically reverse discounted cash flow analysis or simple multiples to determine valuation. I think while that is a very broad stroke, I think that's all you need to do well as an investor.

Clay Fink (64:40)

Well, Brian, this was fantastic. A great conversation for many in our audience to become more familiar with financial statements and understanding how this all fits together and how understanding financial statements can help us as investors. I'd like to give you the final handoff here. Please let the audience know where they can get in touch with you and maybe even learn more about these concepts.

Brian Feroldi (65:01)

Yeah, so financial statements are a really hard thing to express over a podcast. So if anybody follows me on social media, I create a lot of visuals that kind of explain the nuance of accounting. So if your listeners go to Financial Statements School Financial Statements school there I have an ebook that has 10 of my most popular accounting infographics and you can download them and then they'll make a lot of the concepts we talked about on today's episode make a whole lot more sense.

Clay Fink (65:28)

Excellent. Well, Brian, I really can't thank you enough and look forward to our next conversation in the future.

Brian Feroldi (65:33)

Thank you for the invite, Clay. It's a pleasure to be here. Thank you for listening to tip. Make sure to follow we study billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to theinvestorspodcast.com this show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.