How to Read Financial Statements w/ Brian Feroldi (TIP752)

Summary

• Financial Statements Analysis: Brian Feroldi emphasizes the importance of understanding financial statements as a critical component of the investment process, likening it to a musician needing to read music.
• Master Accounting Equation: The fundamental equation assets = liabilities + shareholders' equity is crucial for understanding a company's net worth and is the basis for the balance sheet.
• Key Financial Statements: The balance sheet, income statement, and cash flow statement provide different insights into a company's financial health and should be analyzed together for a comprehensive view.
• Intangible vs. Tangible Assets: Modern companies often invest in intangible assets like brand and human capital, which can be challenging to value but are crucial for long-term success.
• GAAP vs. Non-GAAP Accounting: While GAAP provides a standardized framework, non-GAAP measures can offer additional insights but require careful scrutiny to ensure they aren't misleading.
• Stock-Based Compensation: This is a contentious issue, with some viewing it as a real expense that can dilute shareholder value, while others see it as a tool to align employee interests with company success.
• Investment Strategies: Different investment styles range from venture capitalists focusing on potential upside to value investors prioritizing valuation, with GARP investors seeking growth at a reasonable price.
• Red Flags in Financials: Key indicators like sudden revenue changes, declining gross margins, and high goodwill or stock dilution rates can signal potential issues that warrant further investigation.

Transcript

(00:00) 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 companies  on acquired companies assets in order to make   the transaction happen. Now goodwill by itself  is not necessarily a bad thing but goodwill is   a very there's no liquidity to the asset. (00:29) 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 the  company's total assets. [Music] Before we   dive into the video, if you've been enjoying  the show, be sure to click the subscribe   button below so you never miss an episode. (00:51) It's a free and easy way to support us,   and we'd really appreciate it. Thank you so much.  Welcome to the Investors Podcast. I'm your host,   Clayfink, and today we welcome back  longtime guest Brian Faldi. Brian,   so great to have you back. Clay, awesome to be  back. Thank you for the invite. So, I've long   wanted to do an episode touching on accounting  and financial statements, but as you know, it can   be so difficult to do just in a podcast format. (01:18) So, I thought there's no better person to   bring onto the show to explain these concepts  as simply as possible. So to kick us off,   how about we just start with um talking about the  role that analyzing financial statements plays   in your investing process. To me, it's a critical  component. I like to think of financial statements   as a company's report card to judge how well the  business is executing against the story or the   promise that the business inherently has. (01:49) So if you don't know how to read   financial statements, I liken that calling  yourself a musician but not knowing how to   read music. It is that important  and that fundamental. So for me,   I would never make any investment into  any stock without analyzing its financial   statements deeply. So I think the next place  to go here is to talk about the uh master   accounting equation. I love the name of that. (02:13) I'm not sure if you came up with it or   not. Um what is the master accounting equation  and why is that important? 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. (02:36) 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 shareholders equity or owner's equity.   But that is the master accounting equation and  it rules the company's financial statements.  (03:03) Mhm. And that naturally brings us uh  to the three financial statements. Talk to   us about you know each of these statements  and how all of these tie together as well.   The three most important financial  statements to know are the balance sheet,   the income statement, and the cash flow statement. (03:22) 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.  (03:41) 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. (04:06) Now the period of time can be is typically   a quarter or a year. And think of a 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. (04:29) The third financial statement is called   the cash flow statement. And this financial  statement's purpose is to just track 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. (04:58) And it's by analyzing all three   of them together that you can get a true  picture of a company's financials. Mhm. So,   going back to uh my accounting 101 days, one  of the things that, you know, always sort   of tripped me up and sort of confused me was  this concept of um double entry bookkeeping,   right? So, for every um debit, there's a credit. (05:20) So, you know, a company raises money,   they get cash on the balance sheet, you know,  it's offset by um 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   um transaction there's a credit and a debit. (05:37) 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. (05:57) 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. (06:23) Now cash is an asset so that affects   the left side 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 (06:51) million dollars from selling to   investors, cash balance would go up by a  million dollars and then common stock and   additional paying 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 um in in in a company. (07:13) So when revenue comes in, when sales   come in, those would increase the company's  retained earnings and it would uh increase   the company's cash balance. When an expense is  paid uh 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. (07:33) 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. Um, as you know,  I recently interviewed uh David Gardner and   our episode will be going out next week. And  one of the things we discussed uh during that   conversation was just how so many of a company's  assets you won't even find on the balance sheet.  (07:58) For example, uh Amazon, their  most important asset over the years was   uh having Jeff Bezos as a CEO for 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 uh rising up. (08:16) Intangible assets you can think of things   like brand uh patents proprietary technology or  human capital whereas decades ago often times   companies were investing in these tangible  assets such as uh plant property equipment   and inventory. So, how about you talk about  uh the differences and how these intangible   versus tangible investments flow through the  financial statements? Sure, great question.  (08:38) And that 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 uh operates out of.  (08:58) You can go down and touch a Home Depot.  A 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 uh exists uh   in 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. (09:18) 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 CocaCola, they would understand what you're  talking about and know exactly what you mean,   even if they didn't speak English. So (09:49) 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. It's so much easier to  say what's the dollar value of the manufacturing   building where we create the Coca-Cola. (10:08) You can go in and say well how much   did it cost to make it? How much is the equipment  uh uh 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 have learned so much from him and  he has taught me the value of intangible assets.  (10:26) One that um you didn't touch on is just  something called mind share. Do your customers   know and think of your product? And if I said to  you uh uh Clay, uh name a store that you would go   to to get uh groceries, what would you say? Uh I'd  go the closest to down the street would be Target   and Costco. There you go. So two brand names. (10:45) So I 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 uh named say a toothpaste or name a  computer uh company 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. (11:06) But how can you how can you express that   on a financial statement? It's really  hard to do. This is why marrying both   the the details of accounting with the soft  art of analyzing companies at a high level   is so important. Yeah. I mean to pull the  thread on that a little bit, a company like   Coca-Cola is investing in marketing each year. (11:25) So um you know on the one side I could   see where these marketing expenses are flowing  through the the income statement and they're   just like expenses or the cost of doing business.  But then there's also the case of you know maybe   part of this spend should be flowing through uh  to the brand value in these intangible assets.  (11:43) So how does this end up manifesting in  the accounting statements for uh something like   a marketing budget? Yeah. So that 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 um intellectual property   or or materials like think about uh Disney. (12:00) Uh 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 hundred years.   That is the the monetization that they've got out  of that movie is enormous when compared to the   resources that they put into uh uh creating that. (12:22) 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 an intangible asset. It's an  imprecise way, but it's kind of the best that   accountants have um at at any given time. (12:43) 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 the financial   statements. That's one way that you can look  for a mismatch between what a company is worth   um in in reality and what it's worth on paper. (13:04) And uh I guess we'll jump here to   um GAP accounting. So, financial statements for  companies uh that are listed here in the US are   constructed based on GAAP accounting.  And our longtime listeners are going   to likely know what this means, but for  those who might be newer to the show,   uh they might have no idea what this means. (13:24) So, how about you just talk a little   bit about what GAP accounting is and uh you  know why it's used here in 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 are accurate. (13:43) In the United States, the accounting   uh 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,   uh, because of the black and white nature of of of  GAAP accounting and the role that a GAP 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 (14:15) 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 uh to report  information that they think is more valid.  (14:34) Here's a simple way to think about GAAP  versus non-GAAP accounting. I played golf with my   with my son and my my son and I played golf  uh the other night and uh I I took a drive   um and and duffed it and I said I'm gonna  take a mulligan and I hit a second shot and   then I duffed my third shot out of the sand. (14:51) It took me two tries and I got up onto   the green and then I I puted and I was within like  you know six feet and I said it's a gimme. Well,   according to gap accounting that's like a  nine in in in the in the golf scorecard.   But if you use non-GAAP accounting I  would say that's a five. I I'm going to   forget all those things that that don't account. (15:08) 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.   Yeah. I mean, that's such an important uh  point because you see so many companies,   you know, report these these non-GAAP measures. (15:32) You know, I can imagine in some cases   it it makes a lot of sense, but then uh you  know, 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,   you know, which can lead people to investing  in the company and you know, they can finance   their operations through issuing equity and  whatnot um and get some investors into trouble.  (15:53) So, how reliable do you think the non-GAAP  measures are? like how do we know if we can   really, you know, trust them and trust, you know,  what management's trying to tell us with these   numbers? Well, it's important to that uh whenever  a company reports non-GAAP numbers, it tells you   precisely the adjustments that it's making to  the gap figures in order to come up with them.  (16:12) 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  stockbased compensation. Stockbased compensation   is a non-cash expense that according to  GAP accounting must be accounted for on the   company's financial statements. So if a company  pays hundreds of millions of dollars in stockbased   compensation that reduces their GAP earnings by  hundreds of millions of dollars even though it   did not have a cash cost to the business. (16:40) This is why many companies that   pay huge amounts of stock-based compensation  also report non-GAAP numbers and say, "Well,   if we exclude stockbased compensation uh  from our reporting, here's how much of a   profit we would have uh recorded." That  is probably the most common thing that   is adjusted for with with non-GAAP accounting. (17:00) 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   uh financial statements. For example, if  they close 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.  (17:24) 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   uh 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.  (17:48) When I'm looking at a financial  statements, if I find a company that touts   its adjusted IBITa, 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 GAP earnings per  share or that's the number that they report   uh to the markets, I immediately give that  management team points and credit because that   that's a much harder number to manipulate. (18:14) So, like always, it's always on   the individual investor or the investor that's  analyzing the financial statements to do the work   to see, do is this management team trustworthy.  Yeah, I'm happy you mentioned uh stockbased   compensation there because I feel like uh Warren  Buffett has almost trained a lot of us to,   you know, dislike this metric and it's something  that's been used uh more and more here in the US,   especially within technology companies. (18:40) Um, on the one hand, you know,   stockbased compensation many people view as a real  expense. Um, you know, there's no free lunch as   they say. But, uh, one thing I do appreciate  about stockbased compensation is, you know,   um, based on my understanding, employees that work  at the company, part of their benefit is receiving   stock uh, as a part of their total compensation. (19:02) And um I can appreciate this because   it can really give um create this culture of  ownership, right? Where the employees actually,   you know, own shares in the company and now  they're vested in that that company's success   um you know, especially as you know, employees  work there over a long period of time,   but then a substantial portion of their  net worth might uh be in those shares,   especially if the shares appreciate. (19:25) So yeah, maybe uh I don't know if   you have any follow-ups to that on, you know, of  course stockbased compensation is a real expense,   but um there could be some benefit for some  companies that have that ownership culture. Yeah,   I see both sides of it and stockbased  compensation makes a ton of sense for   startup and early stage businesses. (19:46) Oftent times 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 they 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 um into the future.  (20:12) But I I've come I I while I do see both  sides of the stockbased compensation perspective,   I am firmly I've become firmly in the camp uh of  of Warren Buffett that I 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 stockbased compensation. (20:33) The 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. (20:56) 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 uh does.  Only the CEO does. So I think that executive every   executive except for the CEO uh should not  have stockbased compensation in their package.   I would prefer them to be paid for with cash. (21:16) 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.  Jim Ran once said that you're the average of   the five people you spend the most time with. (21:37) and I really could not agree with him   more. And one of my favorite things about being  a host of this show is having the opportunity   to connect with high quality like-minded people  in the value investing community. Each year we   host live in-person events in Omaha and New  York City for our tip mastermind community,   giving our members that exact opportunity. (21:59) Back in May during the Bergkshire weekend,   we gathered for a couple of dinners and social  hours and also hosted a bus tour to give our   members the full Omaha experience. And  in the second weekend of October 2025,   we'll be getting together in New York City for two  dinners and socials as well as exploring the city   and gathering at the Vanderbilt 1 Observatory. (22:23) Our mastermind community has around 120   members and we're capping the group at 150  and many of these members are entrepreneurs,   private investors, or investment professionals.  And like myself, they're eager to connect with   kindered spirits. It's an excellent opportunity  to connect with like-minded people on a deeper   level. So, if you'd like to check out what the  community has to offer and meet with around 30   or 40 of us in New York City in October,  be sure to head to the investorspodcast.  (22:52) com/mastermind to apply  to join the community. That's the   investorspodcast.com/mastermind or simply  click the link in the description below.   If you enjoy excellent breakdowns on  individual stocks, then you need to   check out the intrinsic value podcast hosted by  Shaun Ali and Daniel Mona. Each week, Shawn and   Daniel do in-depth analysis on a company's  business model and competitive advantages.  (23:19) And in real time, they build out the  intrinsic value portfolio for you to follow   along as they search for value in the market. So  far, they've done analysis on great businesses   like John Deere, Ulta Beauty, AutoZone, and  Airbnb. And I recommend starting with the episode   on Nintendo, the global powerhouse in gaming. (23:38) It's rare to find a show that consistently   publishes highquality, comprehensive deep dives  that cover all the aspects of a business from   an investment perspective. Go follow the  Intrinsic Value Podcast on your favorite   podcasting app and discover the next stock  to add to your portfolio or watch list. So,   some of the investors I've talked to uh here  on the show have mentioned that the US is an   attractive place to invest uh for several reasons. (24:07) One of which is related to the regulatory   environment and how much information public  companies are required to publish for investors.   You know, 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   uh a number of fraudulent uh names there. (24:25) 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 often times 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? Well, the United   States is blessed with a few hundredyear operating  history of public markets and be because of that,   the US is is a highly regulated market and and uh (24:53) thanks to the actions of like the SEC,   there are far more investor protections  in place today than there have been   uh historically and oftentimes it's often a  tragedy or big high-flying um 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 in the late uh 1990s, early 2000s   where companies like Enron and Authur Anderson  and WorldCom were essentially cooking their books.  (25:21) 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're required to   report a cash flow statement with their um  with the when they file uh with the SEC.  (25:41) 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 um that   a company has. Uh in addition, executives  are also now required to sign their name   uh on all of their financial statements, putting  themselves personally liable for the reliability   and the accuracy of those financial statements. (26:03) I'm not an expert in international markets   um by any means, but I don't think that those  same regulations are in place that would give   investors protection. So, one 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 GAP accounting,   which is the accounting that I I I know best. (26:20) Um 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.   Mhm. And one of the funny things about, you  know, accounting and financial statements is   that people tend to think of accountants as  very rational, very logical thinkers that,   you know, follow a very strict set of rules. (26:45) So, you know, once people pull up a   financial statement, they tend to, you know,  just take the numbers for what they're worth,   right? Kind of just accept  them as the truth. But I think,   um, 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 uh 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. (27:11) Well you know if the company depreciates   those machines over 20 years then they're likely  to be overstating earnings. So if an investor   takes you know those earnings at face value  then they might not necessarily make the right   investment decision based on what's happening in  reality. And um here at TIP, I'm reminded that,   you know, we have an advertising segment  of our business and I could come up with a   handful of ways that we could recognize revenue. (27:35) For example, we could recognize revenue   when a deal's signed, uh 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 um you know I just illustrate this  to just show how subjective accounting can be at   times and um it's not always that the economic  earnings actually reflect economic reality and we   might find ourselves in a case where you know the (28:07) analysis was spoton but our investment   decision was incorrect based on you know  our analysis of of the numbers that uh the   company showed us. So, you know, 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, you know, it could be the case that they  tend to understate earnings because they they   care about investors and protecting investors. (28:36) So, um I think in these cases, it could be   a a situation where they tend to surprise to the  upside over the long term rather than, you know,   uh disappointing investors. Yeah, to to  your point, uh, you 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.  (29:00) And to your point, when is revenue  recorded? Is it when the item is actually   shipped and leaves the factory? Uh, is it when you  receive the cash uh from from from the customer?   Those can be months apart. And when a company is  publicly traded, there is huge financial pressure   on the the management team to report numbers  that exceed or beat Wall Street's estimates.  (29:20) 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 for management teams to to   fudge the numbers or do everything that they  can to present the best story that they that   they they can income time uh to to Wall Street. (29:36) So to your point, if you find a company   that is very conservative with the accounting,  that speaks volumes about the integrity of of   the management team. And if you find the inverse,  uh you should probably just stay away from that   business. Yeah, that is an excellent point  that you know so many companies just want   to hit their their quarterly EPS and now in  the short term that might be a great thing,   but over the long term it it could end up hurting  investors that um aren't investing in companies   that use more conservative accounting. Another (30:04) point I'd like to mention is that   uh this concept of fungeibility. So uh intuitively  as humans we tend to think of money as fungeible.   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.  (30:26) So your $6 have the exact same utility as  my $6. And I think carrying this line of thinking   can sometimes actually hurt us uh 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 dollars worth of earnings at another  retailer that might be in decline or might   have volatile earnings from year to year. (30:48) So how about you talk about uh   this concept of you know understanding this  there's more to just looking at the numbers.   you you hit on a really important point when  it comes to analyzing businesses and this   really confused me when I first started investing  because the thing that you read in investing books   and value investing books is pay 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 auto uh maker like Ford you might see that   it's trading at eight times earnings six or (31:18) eight times earnings and your natural   thing to say would be well that number is cheap  for 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 uh to Ford. (31:40) But you hit on an incredibly important   point that not all profits and not all revenue  is created equally. Um, a dollar in sales at one   business is 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. (32:03) Um, revenue that is recessionp   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 in bad times.   Revenue that becomes cash is is very 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 oneoff purchase   or a one-off transaction that happens every 5 (32:36) 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 six or eight multiple to that because  the market believes that Ford's profits   are not high highly uh valuable profits. (33:02) um those profits might disappear   completely when when the when the the economy  goes through a downturn. Uh 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 down. (33:22) So 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 PE ratios, that's the market's way  of saying this profit is highly valuable and   this profit is not nearly as valuable. (33:44) And uh I also wanted to touch on   um the options a company has when they when they  generate cash, what they can do with that cash.   So generally they can do six different things uh  when a company generates cash. it can, you know,   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.  (34:07) And 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, you know, can be a bit more elusive.   What are some of the line items that we should  look out for to better understand uh to what   extent a business is reinvesting back into its own  operations? Yeah, you can you can determine that   when looking at the company's um income statement  and what its operating expenses are doing as well   as looking at its cash flow statement. (34:32) If a company, for example,   is making is reinvesting into the business through  capital expenditures, it's building new factories,   it's building new stores, it's 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.  (34:48) And you would also see a corresponding  increase in a company's operating expenses uh on   the income statement. But you just hit on a really  important point that what you just described is   something called capital allocation. And Warren  Buffett has called a CEO's most important job   capital allocation. There are six levers that a  company can that a management team can pull at any   time with the cash that it has available to them. (35:10) And the order and the magnitude of which   those levers are pulled can have tremendous  tremendous outputs um on the on the returns   that shareholders receive when a company is in  the early stages of its development. So when   it's a startup or when it's in the hyperrowth  mode or it's really starting to get growing,   um a company often does not have excess capital. (35:31) All capital that's generated in the   business goes right back into in into the  company and is reinvested. This is when a   company is hiring engineers to in research and  development, hiring salespeople, opening up new   um 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. (35:55) That's that's um unquestionable. Once the   company runs out of internally generated projects  in order to to um 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 they have some excess capital to them   and they don't have the training or discipline  that they need to make the right application   choices to maximize shareholder uh value. (36:21) 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 uh 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. (36:42) 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 uh use of capital.  The same can be true of making acquisitions or   or even uh paying dividends or just building the  company's uh cash position. So capital allocation   is something that investors should really pay  attention to and and they can tell you a lot   about the decision-making of the management team. (37:06) Financial statements also play a big   role in how many investors are are viewing  the company's valuation. So David Gardner,   you know, he was talking about how um he's  actually attracted to companies that uh   financial commentators and analysts are saying  are overvalued. Yet I think the irony with with   many great businesses is that they often times  appear more expensive than they really are when   you're looking at these financial statements. (37:34) So, uh, one example I thought of was,   um, 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, um, 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.  (37:59) So there's this aspect of not, you know,  looking at the numbers and understanding them,   but not getting too bogged down in the numbers  today. Um, and maybe focusing more on, you know,   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 in  painting that vision for where they want to be.  (38:21) Yeah, you just highlighted probably one of  the most confusing the the most confusing aspects   of investing in valuation, especially if you're  a new investor. Again, when I first started,   I thought that the way that you valued a  business was by looking at its PE ratio,   its price toearnings ratio. And when I first  understood what the PE ratio was, I would look   at great companies like Apple, Netflix, Amazon,  Intuitive Surgical, all of which had PE ratios   that were 50, 80, 100, or even a thousand. (38:50) And my immediate next thought was   too expensive. Can't buy that stock. It is  just not for me. The problem is the PE 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.  (39:18) it optimized for growth. Companies like  Netflix or Amazon when they were in buildout mode   were investing heavily in content in the case of  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. (39:36) 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 messy's profits, true profits were  understated. And when profits are understated,   that means the price toearnings ratio is inflated. (40:01) And that's why we saw companies like   Amazon have a PE ratio of four or 500. and  they were actually tremendous buys back then,   even though they optically  looked 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 PE ratio. (40:26) I'd also like to   mention another item that you won't find on the  balance sheet, which is uh optionality. So you   know 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 uh is extremely profitable for for   many of these big tech platforms and this is same  with Amazon you know it they might have had very   little to no advertising 10 20 years ago and now  advertising is a major you know segment of their   business so that's why I'd also mention just how (40:59) well is management executing on what they   they uh they're trying to do and what their  strategy is and gaining market share and   whatnot. Um because that optionality piece  is is something that you need to consider if   you're going to hold a stock for 5 10 plus years.  Totally. And this is one of the most difficult   things when it comes to analyzing a business. (41:18) So let me do 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 needlemoving revenue  and profits in the future. The best classic   example that everyone can think of uh is Amazon.  When Amazon first was a company, it sold books.  (41:41) 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 operators in place  to to 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. (42:08) So, Amazon is a tremendous example   of a company that was able to launch new  products and new services that opened up   needlemoving 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 uh as   an example, Axon, which is formerly called Taser. (42:28) Uh they they made 100% of their revenue   from from tasers that police use the police uh  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 that   ties all of its hardware components together. (42:48) So, if you were buying Axon stock 10   or 20 years ago, you were buying future  optionality and these future products   that you could not see at at at the time. And  that is one reason why companies like Amazon,   why companies like Apple, why companies  like Marcato Libre have been such extreme   outperformers over the last 10 and 20 years is  because 10 and 20 years ago there there was hidden   value in the company from future optionality. (43:15) 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 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  (43:43) looking in the right places within  the financial statements. Uh 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? Yeah, there's  there's a couple of them. I I define these   more as yellow flags to to be perfectly honest. (43:57) I think 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, I it just to me means investigate   further. You need more information about this.  So in the income statement in in particular,   um I like to look at the revenue growth rate and  I judge the revenue growth rate from year to year.  (44:19) And if you see a sudden change in a  company's revenue growth rate, that can be   that that is a signal to Wall Street that the the  thesis might be might be running out. And oftent   times that can trigger a severe decline in the  company's uh stock. So revenue growth rate from   year to year is something that I do track. (44:39) And if a company is 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.  (45:02) 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 it sales or its suppliers are increasing  prices on its supplies and the company can't   successfully pass those along to to consumers. (45:33) by both of which are are big yellow flags   uh to me. The final one that I will look at is a  company's shares outstanding or how many shares   of stock uh 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 stockbased compensation.  (45:57) So those are three big yellow flags  that I look for. A growth rate, gross margin,   and a dilution rate. Yeah, I think delilution  uh is definitely an important one to highlight   because using that term I used earlier, it can be  a bit more elusive where you know if if you see   the stock price falling and management still needs  to uh issue shares just to finance their business.  (46:18) It's it's a bit in uh desperation mode  if we can call it that. Uh how about we jump to   the balance sheet? What are the red or yellow  flags on the balance sheet? Sure. First thing   I look at when I'm analyzing a balance sheet is  the company's cash versus the company's debt. Uh,   cash is king in a business. There's only one  true sin and that it's running out of cash.  (46:36) So, I like to compare how much cash or  marketable securities, which is the same thing,   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   or billions of dollars in cash and zero  debt, although that's pretty darn rare.  (46:55) So, I at least like to check out the  relationship between a company's cash balance   and debt balance. 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 um in into the future. So,   that's the first thing that that I check. (47:09) 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   companies on the acquired companies assets  in order to make the transaction uh happen.  (47:30) Now, goodwill by itself is not necessarily  a bad thing, but goodwill is a very there's no   um 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 the company's total assets.  A company can get into trouble if goodwill   becomes the company's largest asset. (47:53) So if I see goodwill over 50%   or or or even 60% that's when I raise  that to me is a is a red flag. And the   final thing that I look at are some current  assets that are called accounts receivable   um and and inventory. These are these are assets  that the company has that will be converted into   cash in 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 (48:24) trouble selling inventory that it has and   converting it into cash. So if a company has too  much um uh working capital or too much accounts   receivable or inventory and that number dwarfs  its cash balance to me that's another red flag.   Yeah. I love uh in one of your videos you  highlighted goodwill right down by Teldoc.  (48:46) So in 2021 they had a $14 billion in  Goodwill and in 2022 you know that was written   down to to1 billion. So um just a classic  example of a company massively overpaying   in an acquisition and uh you know paying for  it in the end. 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. (49:10) So, uh, so management teams make plenty   of mistakes, too. Yeah. How about red flags for  the cash flow statement? Finally. Yeah. The cash   flow statement is my favorite statement to 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. (49:29) 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 on the cash flow statement.  (49:45) And 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  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 quote unquote  profitable on paper but the company is   not actually generating cash from operations. (50:16) And and there's a couple of big reasons   why that could happen. They could be related to um  to stockbased compensation expenses. They could be   to big changes in in working uh capital. um or  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 as an investor. (50:37) Another thing that I look at is   stockbased compensation. I compare how  much stockbased compensation is being   issued and compare that to a company's net  net income. As a general broad statement,   I like it when less than 10% of a company's net  income is issued as stockbased compensation.   That's not always possible with high growth  companies that are in the tech sector,   but if a company is stock issuing  stockbased compensation, I want to   make sure it's a relatively small figure. (51:05) Excellent. Well, uh, I wanted to   jump to one of the items you include in your  investing checklist. Um, so one item you look   for that would make a stock uninvestable is  what you refer to as accounting irregularities.   Uh, I don't know if I've had had anyone  uh discuss this in depth, so I'd love   for you to explain this for our listeners. (51:26) 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. (51:46) As a general statement, when a company   does that, that means that they overstated their  previous revenue or their or their profits and the   auditors 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   that 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. (52:14) 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. (52:36) Yeah. Are there any examples in the   past of this happening? Um maybe you've owned a  company that is that has this published this this   announcement. Yeah, there's lots of them that  that happen. They they they they don't always   happen to bign name companies, but the one that  comes to mind immediately was Luck and Coffee,   the uh the Chinese high- growth coffee  company that in a matter of like three   years or something like that had had as much  uh as many locations as Starbucks did in its   like 50-year history as a company. So when I (53:03) saw that, I was kind of scratching my   head like, hm, that's interesting to see a  company that in just a couple of years has   matched Starbucks distribution scale and uh  after being public for a couple of months,   they did have to come out and say that  we are restating our financial positions   or we found some accounting irregularities. (53:19) When that happened, the stock dropped   like 60% or something like that. I think peaked  the trough, the stock went down like 90ish%.   I believe in the case of Luck and Coffee, the  company has since cleaned up its financial act   and is back to being um in the good graces of  Wall Street. I think the stock has appreciated   meaningfully from when it declined. (53:37) But for me, the investor,   I still would have zero faith in the accuracy of  Luck and Coffey's financial statements at this   point in time. And to me, I would never include  that company in my portfolio. And is it the SEC   that's sort of tapping him on the shoulder to to  confirm that these numbers are correct and you   know, they find that they're not? Is is it the SEC  that does it? Is it shareholder push back or what   leads to these regulations? It's a combination of  of the SEC and the auditors of of the business.  (54:02) So, companies that are publicly uh traded  do have to get an outside auditing firm to go in   and confirm that the numbers uh are correct.  This is where the big four uh auditors uh come   from and is one reason why if an investor  does not see one of the big four auditors   um on the company's financial statements. (54:19) They often time will have big questions   in the place and saying u why are you bothering  with this the outside auditor? We don't trust   them. We do trust um the big four auditors uh in  in the US. But typically it's a combination of the   management team um the auditors uh the board  of directors and the and the regulators that   come up with these um that identify whether  a company is has financial problems or not.  (54:41) Excellent. We'll uh we've already  mentioned David Gardner a couple of times   during this conversation and uh I mentioned uh  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   uh you worked at the Mly Fool for a number  of years and I know that Gardner was highly   influential for you and your investment strategy  and whatnot and uh 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  (55:10) investing and Um, I'll also mention that  Gardner amazingly I read in his book that uh his   portfolio has seven 100 baggers and Amazon's  more than a 1,000 bagger in his portfolio. Um,   so really excited for that episode to go out next  week. But um, 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. (55:36) uh he David is a tremendous human being   on so on so many fronts and uh one thing  that I really like about studying David's   investing style is it's so backwards and  so differs so greatly from what you hear   from the investing greats like Warren Buffett and  Charlie Mer and and and Seth Clarin who emphasize   valuation first in everything that they do. (56:01) David is I view as almost a venture   capitalist investor who just so happens to  fish in in public markets and he has his   six signs of a of a rule breaker uh have been  instrumental in helping me um as an investor in   particular the thing that he has changed my  mind about the most is is valuation and how   to think about companies and that that that  are valued. I am a natural value investor.  (56:24) When I first started investing, I looked  for big dividend yields 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 PE ratios for businesses." And I when  I saw him recommending Amazon and Netflix early   on in their growth phase, I thought he was nuts. (56:44) I just thought he was absolutely backwards   and he was violating so many of the sound um  investing principles. But when I look back at   my biggest winners of all time, the things that  have the biggest network uh impact on my personal   net worth, they are almost exclusively companies  that David Gardner uh picked out. Companies like   um Netflix, Amazon, Intuitive, Surgical, uh Axon. (57:07) These are companies that I never would   have put into my portfolio if he hadn't um  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 on on my financial life.   Are there any ways in which you feel that your  approach uh differs from his certain things you   look for that he might not or or certain things  you emphasize? Yeah, if you look at my checklist   and compare it to his. Uh I have more (57:36) 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 try to I tend to invest later  at later stages than he does because I want   to see more that the thesis has been proven out.  One thing that I like about his style is despite   picking stock publicly for like 20 plus years,  he is perfectly okay with with striking out   uh on an investment going up and and being the  champion for a company um uh like like Pelaton   early on and saying yes, I I like this company. (58:08) that stock went on to fall like 70 plus   uh percent and he is 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 um a portfolio filled with losers.  (58:28) 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. And um since valuation is  is such an important piece of of looking at   the financial statements, you mentioned,  you know, initially uh you got attracted   to to juicy dividend yields to low PE ratios. (58:55) And I remember very vividly back in   college like I saw AT&T had a dividend  deal to 5 6% and I was like man why am   I not just putting a bunch of money into this  but getting these these what I viewed as sort   of guaranteed dividends you know of course  they probably cut the dividend uh since then   and um highly indebted company and whatnot. (59:14) Um so yeah I think it I don't know   if you have anything else that you feel  is um really important for your journey   uh as an investor and you know looking at the  numbers and understanding the numbers but also   understanding how they fit into the bigger picture  of understanding you know a company's value where   that value might be in the future and just uh  yeah viewing that from an investor standpoint.  (59:37) Good investing is all about marrying  the left side of your brain with the right   side of your brain. And 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 um dilute investors   into oblivion? That's an very important skill (1:00:04) that you need to know. uh 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 uh   believes it's oftent time those companies the one  that's outperform even the most wildly optimistic   um expectations that that are out there that truly  go on to deliver life-changing returns for for for  (1:00:35) 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 riskreward spectrum do you lie?   Are you going after a 100 bagger stocks? If  so, you need to really emphasize the story   of the business and really deemphasize  the current financials of the business.  (1:00:53) If you're a value investor or dividend  investor or a quality investor, you need to really   emphasize the the financials of a business and  deemphasize the um 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. (1:01:11) And lastly, uh how much emphasis do   you put on, you know, building a DCF, building  a model to determine whether you're going to,   you know, invest in a stock or not? 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.  (1:01:31) I I I don't agree with that um at  all. Uh, 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's going to do. (1:01:47) You're going to see 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 um uh analysis or um or   simple multiples to determine uh a valuation. (1:02:10) I think while that is a very broad   stroke, um I think that's all you need to do  well as an investor. Excellent. Well, Brian,   uh this was fantastic. A great uh conversation for  many in our audience to become more familiar with   financial statements and understanding, you know,  how this all fits together and how understanding   financial statements can help us as investors. (1:02:31) Um, 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  uh these these concepts. Yeah. So,   financial statements are a really hard  thing to express over a a a podcast. So,   um I if anybody follows me on social  media, I create a lot of visuals that   kind of explain the nuance of accounting. (1:02:50) So, if you go to if your listeners   go to financialstatements.school,  financialstatements.school,   school. Uh there I have an ebook that has 10 of  my most popular accounting infographics all time   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. Excellent. (1:03:09) Well, Brian, I really can't thank you   enough and uh look forward to our next  conversation in the future. Thank you for   the invite, Clay. It's a pleasure to be here. On  one extreme end of the valuation mindset spectrum,   you have venture capitalists and growth investors.  Those type of investors deemphasize valuation.   The only thing that they are focused on  is the upside potential of the business.  (1:03:29) On the other extreme end is the  Ben Graham, Michael Bur type of thinking   where valuation is first and foremost the most  important filter to put investments through and   anything has a value if you buy it a cheap  enough. In between those two extreme styles   is what's called GARP investors, which  is more growth at a reasonable price.  (1:03:50) Those type investors are willing  to pay a premium to own companies that   have superior growth prospects, but companies  that have lower growth prospects, they're not   willing to pay as much of a premium uh for. So  valuation is an important part of that process.