[00:03:09] Kyle Grieve: What was the catalyst that stoked a fire under you to write this book all these years later? 

[00:03:14] Brian Feroldi: Light a fire is a very important term there, because I never fancied myself to be a writer, in fact, my grades in high school and college in English were sub par, so the idea that I would write a book, if you would have told me that 20 years ago, I would have laughed in your face.

[00:03:30] Brian Feroldi: The reason that I was motivated to actually go through the painful process of writing a book was I didn’t see any book out there on the market that covered the specific question that is in the title of my book, why does the stock market go up at all? I myself am a voracious reader and I have been obsessed with all things related to money, personal finance, and investing for almost 20 years.

[00:03:53] Brian Feroldi: When I was self educating myself back in 2004, I was voraciously reading books at the time, that was the best way to educate yourself, and I read books by all the greats, on and about by Warren Buffett, Charlie Munger, Peter Lynch, The Motley Fool, etc. Many of those books all said the same thing about the stock market.

[00:04:15] Brian Feroldi: Consistently dollar cost average into the market. Doing so, you’ll earn a 10 percent return over the long term. Just keep buying if the stock market goes down. This is what this market has done over long periods of time. And while that logically made sense to me, and the data clearly supported that was the right thing to do, what was never explained in any of those wonderful books was why the stock market has continued to go up in the United States over the last 200 years.

[00:04:43] Brian Feroldi: What was the forcing function that led to the market to continue to rise? It was almost like somebody saying, get on an airplane and you’ll just go up into the air, but nobody ever explained Bernoulli’s principles and Newton’s laws of motion. So I wanted to create a book that explained in as simple a terms of possibles the reasons underlying why the stock market has gone up for 200 years to show that you should have faith that it will continue going up moving forward.

[00:05:13] Kyle Grieve: So when I write, I like to use a fictional lemonade stand to help me explain more complicated business concepts in simple ways. And you use the example of the best coffee company in your book to help readers understand your concepts in as simple a way as possible. How do you think investors can benefit from using simplification for improving their investing skills?

[00:05:31] Brian Feroldi: I think making things as simple as you possibly can, and if you add in visuals too, that really helps to hammer home the core ideas that you need to know about investing. The reason I made up a fictional coffee company is because I’ve heard so many people make up fictional lemonade stands because it’s just such a simple business to understand and by showing that you could take the profits of a business and reinvest those to open up the new locations of the business, I think that’s the easiest way for investors to get the mental model in their head of how compounding can work.

[00:06:04] Brian Feroldi: So I’m a huge fan of simplifying things and I think visuals and using simple examples do a great job of doing just that. 

[00:06:11] Kyle Grieve: Excellent. And do you have any heuristics, obviously trying to oversimplify things can be dangerous as well, but do you have other heuristics that you like to use in general in the markets?

[00:06:21] Brian Feroldi: So when it comes to investing, there’s a lot that people need to know to invest the right way. The best heuristics that I can think of are essentially the mental models that have been put out there by others. And specifically the ones that I find to be the most helpful were covered by the late great Charlie Munger.

[00:06:38] Brian Feroldi: In his book, the psychology, in his talk on the psychology of human misjudgment, I think the mental models that he explains about how investors or people in general can do themselves in by making poor decisions, understanding those heuristics, if you will, or those razors or those mental models, however you want to call them, can really help investors to make sound investing decisions in the future.

[00:06:59] Kyle Grieve: So many investors will describe businesses using earnings before interest taxes, depreciation and amortization or EBITDA. I don’t think it’s a mistake to look at this number when looking at comparisons to other businesses in the same industry. But how do you view this number when compared to something like net income or free cash flow when evaluating a business?

[00:07:17] Brian Feroldi: EBITDA has become a very popular term on Wall Street to use for valuation purposes, to use for leverage purposes. And at its core, the logic behind using EBITDA does make sense. EBITDA was popularized by the cable cowboy John Malone in the 1980s and 90s, and he used it to convince lenders to allow him to lever up his businesses more and more.

[00:07:43] Brian Feroldi: And keep in mind, Malone was operating in the cable industry, and the cable industry is highly attractive for a few key reasons. It has extremely predictable revenue because it’s a subscription basis. You can also shield a lot of your profits from from taxes by taking accelerated depreciation charges and doing so by doing so allows you to use a lot of leverage in this business because the revenue is so dependable and it really allows a good capital allocator like John Malone certainly is to turbocharge a shareholder returns.

[00:08:17] Brian Feroldi: When he was essentially operating the model that he was in the cable industry, he could not show his lenders a net income or earnings growth because of the high depreciation charge and the high interest charge. So he went on an offensive to talk to them about using the merits of EBITDA, a much higher number up on the income statement, to say, no, this business can handle leverage.

[00:08:40] Brian Feroldi: And Wall Street really took a shining to EBITDA because it allows them to compare companies that were in the same industry, but had different capital structures to each other. You can’t simply look at two businesses, one that has massive interest expense, one that doesn’t have interest expense, and compare them equally.

[00:08:56] Brian Feroldi: So given all that, I understand why EBITDA has become useful in Wall Street and why it’s become the focus of many management teams. It’s a much easier number for management teams to manipulate and a much easier profit, and I put that in air quotes, profit target for management teams to hit. Given all of that, I understand the history of EBITDA, I understand why it’s useful.

[00:09:19] Brian Feroldi: I personally all but ignore it and I think that Munger and Buffett have the best explanation of why you should ignore it of anyone’s I’ve ever heard to look away from depreciation in particular to, to pretend that depreciation is not an expense in a business is as silly as pretending that stock based compensation is not an expense in a business.

[00:09:43] Brian Feroldi: If I buy a factory and that factory has a useful life of 30 years 30 years from now, I’m going to have to replace that factory to pretend that factory has no cost to me as an investor, which is essentially what the depreciation charge is accounting for, simply overstates the profitability of a business.

[00:10:01] Brian Feroldi: So I understand EBITDA. I understand why management teams are using it, but I personally do not use fake profit metrics like EBITDA. I much prefer real profit metrics like free cash flow. 

[00:10:14] Kyle Grieve: So how do you think other investors should use EBITDA when analyzing a stock? 

[00:10:19] Brian Feroldi: I mean, the most useful metric that I can think of when it comes to EBITDA would be a valuation metric, and that would be specifically enterprise value, EV, which of course is the market capitalization minus the cash the company has plus the company’s debt divided by EBITDA.

[00:10:35] Brian Feroldi: That is at least a multiple that makes sense to me as an investor for doing a comparison between two companies to see what the relative value of them should be. But beyond using it as a multiple metric, I don’t think that EBITDA is all that important of a number and it shouldn’t really be relied upon.

[00:10:52] Brian Feroldi: If you insist on using a non profit metric like earnings or free cash flow, I would much prefer you to look at EBT, Earnings Before Taxes, which is a number that Buffett himself references all the time. That does include interest expense, which is of course a real expense, depreciation expense, which is of course a real expense, and amortization.

[00:11:12] Brian Feroldi: Now amortization is a particularly tricky one because that is a non cash expense that can have some wiggle room. Certain things do amortize over time, but other things do not amortize on the schedule that accountants lay out there. So if I was going to use not net income or not free cash flow, earnings before taxes, EBT would be my preferred choice.

[00:11:33] Kyle Grieve: And just for listeners who might not be super familiar with depreciation amortization, can you just briefly discuss what the differences are between the two of them? 

[00:11:42] Brian Feroldi: Sure. They are the gradual writing down of the value of an asset over its useful period of time. The one that investor everyone is most useful most familiar with is depreciation of a car.

[00:11:53] Brian Feroldi: You buy a car for 20, 000. That car has a useful life of 10 years. You face a depreciation expense of roughly 2, 000 per year. You buy a car for 20, 000. You try and sell it 10 years later. You’re not getting 20, 000 for it. So depreciation accounts for the accumulated loss of using up that asset over a period of time.

[00:12:16] Brian Feroldi: Depreciation. This is the simplest way I have found to, to think about it. Depreciation happens to tangible things. All tangible means is you can physically touch it. You can touch a building. You can touch real estate. You can touch a car. You can touch manufacturing equipment. Things that you can touch depreciates.

[00:12:36] Brian Feroldi: Amortization is the same concept, the writing down of the value of an asset over time, but amortization happens to intangible assets, things you cannot touch. You can’t touch a patent. You can’t touch a copyright. You can’t touch interest. Those things are amortized over time. So both are very similar concepts.

[00:12:57] Brian Feroldi: Depreciation happens to tangible, Amortization happens to be intangible. 

[00:13:02] Kyle Grieve: One of my favorite parts of your video analysis is your thesis breakdown for individual businesses. For instance, when looking at DocuSign, you made a visual showing how you track net dollar retention, sales and marketing spending, dilution, and cash flow.

[00:13:15] Kyle Grieve: Can you outline how you decide which KPIs are most important to the businesses that you are tracking? 

[00:13:21] Brian Feroldi: Sure. When you are analyzing businesses, Depending on the sector that business is in, there are usually some industry specific key performance indicators that are worth tracking. You brought up DocuSign.

[00:13:31] Brian Feroldi: DocuSign, by and large, is a software as a service business. For software as a service company, a key metric to track is called net dollar net dollar retention rate. What that effectively measures is same customer spending from one year to the next. If the number is over 100%, the average customer in your business is spending more than they were the year before, that would be a good thing.

[00:13:56] Brian Feroldi: Or if that number is below 100%, the average customer in your business is spending less one year to the next. So it accounts for upselling and it accounts for churn. It’s a wonderful metric that every software as a service investor needs to know. But that same metric, net dollar retention rate, is useless when you’re thinking about other industries to track.

[00:14:17] Brian Feroldi: If you’re investing in the railroad industry, or you’re investing in a consumer goods company, or you’re investing in a retailer, net dollar retention is useless. If you’re going to be investing in retail companies, a key metric to watch there is same store sales. How much did the average store in my business sell this year compared to the next?

[00:14:36] Brian Feroldi: Every industry tends to have its own unique language, its own unique KPIs, and if you’re going to invest in those industries, you must understand which metrics matter, how you should track them, and how you should think about them before you get into that investment. 

[00:14:52] Kyle Grieve: So in terms of KPIs, do you have global ones that you do feel are relevant for any business as well that you use?

[00:14:59] Brian Feroldi: Absolutely. Some metrics are universal. Revenue is certainly a universal metric that you should look at and track and the revenue growth rate. Gross margin is a very useful metric that the I track from business to business. Operating margin is certainly one. A free cash flow is a metric that you can look at.

[00:15:17] Brian Feroldi: Returns on equity, returns on invested capital. Those tend to be metrics that are universally applicable. The amount of cash that a business has, the amount of debt that a company has capital expenditures, or also called property, plant, and equipment. So the financial statements the general generic terms on the financial statements do apply from industry to industry.

[00:15:36] Brian Feroldi: So there are many metrics that you can track that do span companies. There are some exceptions to those that I would say, but I would say that those are the big ones. 

[00:15:44] Kyle Grieve: And how do you determine your company’s specific numbers? Are you, what specific resources or what are you using to understand them better?

[00:15:51] Brian Feroldi: So this is a key point that I learned over time. The metrics that you should watch and the metrics that you should focus on really depend on what phase a company is in the business growth cycle. If a company is in a startup phase, it’s just launched as product or service to market. The only metric that you can really focus on as an investor is revenue.

[00:16:13] Brian Feroldi: That will show you a revenue and the revenue you growth rate. That will show you does this company has this company established product market fit with its particular product and service. And you should really want to focus on hyper revenue growth. Above all, gross margin is usually not optimized.

[00:16:30] Brian Feroldi: Operating margin is not optimized. The company is not producing net income and the company is not producing free cash flow. So the metrics that really measure when a company is young is revenue growth rate and how much cash does it have in the bank. As the company product or service matures, then you can start to look down on the income statement as those numbers become more real.

[00:16:51] Brian Feroldi: So as a company matures, its established product market fit, revenue growth still becomes very important, but I would start to add into that the gross margin of the business. As a company scales, it should be able to increase its gross margin and ultimately get to its peak gross margin relatively early in its operating history.

[00:17:09] Brian Feroldi: Once the gross margin becomes optimized, the company is typically reinvesting very heavily into itself, hiring sales and marketing people, hiring research and development teams, and building out management infrastructure. Doing so usually means that its operating margin is depressed for a long period of time until the company finally reaches a break even.

[00:17:29] Brian Feroldi: After it gets over the break even point, that’s when you can start to look at the company’s operating margin, net income margin, and free cash flow margin. Finally, when a company is in the mature phase, when it’s big, it’s established, its margins are fully optimized, then you should shift your focus to other metrics, such as what’s the return on capitals for this business, return on equity, return on assets, return on invested capital, how, what are they doing with the cash and the free cash flow that they generate?

[00:17:55] Brian Feroldi: Are they buying back stock? Are they paying a dividend? Are they paying down debt? So what metrics you focus on totally depends on what phase of the business growth cycle a company is currently in. 

[00:18:06] Kyle Grieve: And in order to understand what phase the business cycle is in, you basically just reverse engineer the income statement and look at their numbers to try and figure out what they’re in?

[00:18:15] Brian Feroldi: Yeah, the income statement is by far the best indicator of what stage the company is in. Revenue growth will be the first thing to look at. If a company is early on in the business growth cycle, you definitely want to see 50 percent plus. revenue growth rate. After revenue growth, you next pay attention to the gross margin of the business.

[00:18:33] Brian Feroldi: And depending on what industry the company is in, there are some rough targets that you should have in your head for the kind of gross margin that a company could produce. The share count will also typically indicate what stage a company is in. The company is in the early stages of the business growth cycle.

[00:18:49] Brian Feroldi: It typically is spending far more capital than it needs. And to fund that difference, it is typically issuing a lot of stock to the markets to raise cash to fund that gap. As a company matures, the dilution rate, the share count growth rate should decline dramatically. And when it’s in the fully optimized stage, when it’s returning capital to the shareholder, you actually want to see the share count declining over time.

[00:19:12] Brian Feroldi: That would indicate the company is buying back stock. So there are a couple of key metrics that you can look at. Revenue, gross margin, and the share count will give you a strong indication of what phase the company is in. 

[00:19:23] Kyle Grieve: You recently published an excellent thread on Buffett’s nine financial rules of thumb to determine if a business has a moat.

[00:19:29] Kyle Grieve: Can you first tell the audience what a moat is, and then let us know why you like gross margins as a number to help you identify a moat? 

[00:19:36] Brian Feroldi: Buffett famously popularized the idea of a moat. And essentially a moat is just a competitive advantage that one company has over another. There are several sources of moats that company can have.

[00:19:48] Brian Feroldi: One could be the network effect, another could be high switching costs for its customers, another could be low cost production, and a final category could be something that’s broadly called intangibles, and that could be a brand name or a patent or a government license. Emote is an incredibly important attribute for an investment to have because the forces of capitalism all but ensure if a company finds a product or service, introduces it to market and succeeds, other companies will take note, try to copy that product or service and offer it at a lower price in an effort to steal customers.

[00:20:23] Brian Feroldi: If a company doesn’t have a moat, what will happen to that company’s profits over time is they will eventually mean revert, and the company’s profits will eventually become the normal ones they have for the industry, and they might actually dip below normal as they fend off the initial intense competition that they face.

[00:20:41] Brian Feroldi: Buffett, rightly has emphasized the need for a company to have some attribute at least one. Working in it favor resists the for the focus of capitalism. Now, in that thread that you mentioned, I did call out nine different rules of thumb, if you will, that he has to check to see if a company has a moat.

[00:21:00] Brian Feroldi: I think of all of them, but probably the most telling one is the gross margin rule of thumb. Warren Buffett’s rule of thumb on gross margin, and again, it’s just a rule of thumb. Not every company will hit this, is that a company’s gross margin should consistently be above 40%. A gross margin for those that don’t know is simply a gross profit, which is revenue minus cost of producing the revenue divided by revenue.

[00:21:25] Brian Feroldi: And a number over 40 percent consistently over 40 percent tends to mean that the company has pricing power with consumers. So it can set a price and increase that price as inflation increases, which is a sign that a company has a moat. It also could mean that the company has bargaining power over suppliers, because the supplier cost is embedded into that gross margin number.

[00:21:49] Brian Feroldi: And the big thing that he likes to look for is this number to be consistent. in good economic times and bad. So if you look at many of Buffett’s biggest and top holdings, like Apple, like Coca-Cola, and you look at their gross margin throughout the the business cycle in recessions and in, and bull markets, they tend to have gross margins that are above 40 percent and they are consistently above 40%.

[00:22:15] Brian Feroldi: Now, if you see a gross margin that is declining over time, that typically means one of three things is happening. A thing one is the company is facing intense competition and in order to fend off that competition, it’s lowering its prices. That’s never a good sign for investors if a company is getting to a price war.

[00:22:35] Brian Feroldi: Another thing that it could indicate is that the company’s costs from suppliers is increasing so rapidly that it doesn’t have the ability to pass on those increases to consumers, which of course could mean the third thing, the company lacks pricing power whatsoever. which Buffett has consistently called out as one of the most important attributes that a company can have.

[00:22:54] Brian Feroldi: So if you’re going to focus on any one of these nine rules of thumb, the one that I pay the most attention to is gross margin and gross margin durability. 

[00:23:03] Kyle Grieve: You’ve written that the financial statements answer three simple questions. The income statement answers, are you profitable? The balance sheet answers, what is your net worth?

[00:23:12] Kyle Grieve: And the cash flow statement answers, are you generating cash? I’d like to start off with the income statement. What are the biggest mistakes that investors make when analyzing a business income statement, and how do you think they can best overcome these mistakes? 

[00:23:24] Brian Feroldi: The biggest mistake that I see investors make with the income statement is they basically look at revenue and then stop.

[00:23:29] Brian Feroldi: The only thing that they pay attention to is did revenue grow? How much did it grow? And was that number above what Wall Street was expecting or below what Wall Street was expecting? And they make their decisions about this is a great company or terrible company solely based on the most recent quarter’s revenue growth rate when compared to the prior year.

[00:23:48] Brian Feroldi: Growth is an important thing for any business to hit, but revenue growth is not the be all, end all number that you should pay attention to on the income statement. I myself pay much more attention to margins, specifically gross margin, which we just talked about, operating margin, and net margin, than I do the absolute change in the revenue growth rate of a company.

[00:24:09] Brian Feroldi: Another thing that investors overemphasize when they’re looking at the income statement is simply earnings per share. They look at revenue, then they scroll their eyes down all the way to earnings per share, and they draw conclusions from there. Did earnings per share beat Wall Street’s estimate, or did they miss when compared to Wall Street’s estimate?

[00:24:28] Brian Feroldi: An unfortunate truth about accounting in the last couple of years is some subtle changes to the rules of accounting, specifically gap accounting in the United States, make that earnings per share number less reliable than it has been historically. One big change that the was recently made a change to to Gap was that when a company owns a position, owns stock in another publicly traded company, they now have to actually mark up or down their net income based on the share price movement of the other stock that they own.

[00:25:00] Brian Feroldi: Quick example of this would be Amazon. Amazon owns a significant chunk of stock in Rivian, the startup electric car company. So when Rivian’s stock now goes up, Amazon has to mark up its net income saying, we made this money on our Rivian investment. And the inverse is also true. When Rivian’s stock goes down, which by the way, it largely has since it came public, Amazon now has to take charges against its net income based on Rivian’s stock.

[00:25:30] Brian Feroldi: So because of that, Amazon’s net income, which was already dubious as a metric because of the way Jeff Bezos runs the business. is now completely irrelevant of a metric to use to judge Amazon. So to me, I think net income, I could care less what Amazon’s net income is in any given quarter. It’s a completely useless number to me as an investor.

[00:25:51] Brian Feroldi: One mistake, other mistake I see people make when they’re looking at the income statement, even if I understand that, they pay too little. Attention to the number of shares that are outstanding. I actually focusing quite heavily on the share count that a company has and specifically how that share count has trended over the last 1, 2, and 3 years and specifically the percentage change in the share count.

[00:26:15] Brian Feroldi: I personally like to see it when a share count is stable or declining, and if it’s declining, I want to see it declining by 1, 2, or 3 percent or even more over periods of time. That indicates that the company is aware of the importance of its share count and is taking actions to reduce its share count over time through stock Buybacks.

[00:26:36] Brian Feroldi: The inverse is also true. When a company is rapidly growing, a lot of companies abuse their share count. They issue tons of stock based compensation, which balloons their share count, or they use their stock to make acquisitions. And that can cause their share count to increase dramatically.

[00:26:52] Brian Feroldi: I would say people spend too much time on revenue and earnings per share and not enough time on margins and share count. 

[00:26:59] Kyle Grieve: Let’s look at the balance sheet now. Which areas of the balance sheet do you think investors need to emphasize more that will help them make better decisions? 

[00:27:07] Brian Feroldi: The balance sheet is a particularly useful statement for investors to look at when I look at a balance sheet I try and key in on a couple of key metrics.

[00:27:15] Brian Feroldi: The first thing I look at is to me the most important number on there, which is the cash balance that a company has. Cash is like oxygen to a business. It can be, if you don’t have enough of it, when bad times hit, you’re going to be in a really tough spot. Meanwhile, if you have excess cash, when bad times hit, you can actually go on offense.

[00:27:33] Brian Feroldi: Your cash balance can allow you to acquire competitors on the cheap, to invest in sales and marketing and really take in to buy back their stock. So cash I view as giving a company options. I also take a look at accounts receivable and inventory. I want to know how much working capital a company has and how much inventory and accounts receivable consume a company’s current assets because that can give you an indication of the working capital needs of the business over time.

[00:28:01] Brian Feroldi: Another thing that I like to focus in on is goodwill. Goodwill is an accounting term that essentially shows the premium that a company has paid in the past for previous acquisitions. Goodwill is my least favorite asset. In fact, I think it should be called badwill because the only thing that can happen to goodwill on a balance sheet is it can be written off over time if a management team is forced to admit that it paid too much in the past for previous acquisitions.

[00:28:29] Brian Feroldi: So if I see that Goodwill in particular makes up a substantial portion of a company’s balance sheet, that means it’s extremely acquisitive and I typically want to avoid those businesses. On the liability and equity side of the balance sheet, I pay attention to debt volumes, how much debt a company has, how much, how that compares to the company’s cash, and what type of debt is it?

[00:28:51] Brian Feroldi: Is it just straight up long term debt that needs to be replayed or is it convertible debt that could potentially lead to dilution over time? One other metric I love to see on a on the liability side of a company’s balance sheet is something called unearned revenue or deferred revenue.

[00:29:07] Brian Feroldi: What that means is that a customer has made a pre payment to a business for a product or service that is yet to be delivered. So for example, if I was subscribing to a magazine and I paid for that magazine all up front on day one, the company gets the cash, but since I haven’t received all the magazines over the course of a year, the company has to record that as a liability.

[00:29:32] Brian Feroldi: So when you see unearned revenue on the balance sheet, that is a wonderful sign to see because that means the business gets paid before it actually has to deliver the product or service. And then finally in the retained earnings, excuse me, in the shareholders equity section to look at the retained earnings that a business had, which is the cumulative profits that have been generated by the business over time.

[00:29:54] Brian Feroldi: And I look for something called treasury stock. Treasury stock indicates the stock that has been repurchased from the market and retained by the company. It effectively tells you in one number, is the company buying back stock. Now, another unfortunate accounting rule is that some companies do not have to report out, separate out treasury stock.

[00:30:12] Brian Feroldi: They can actually roll it in to retained earnings. So it isn’t as prevalent as it was in years past. But I would say those are the big numbers that I like to focus on. 

[00:30:20] Kyle Grieve: And how do you determine how much cash you’d like to see on the balance sheet? You can make the argument that obviously more and more cash is a good thing because it just means they have more money to deploy.

[00:30:28] Kyle Grieve: But You could also make the other argument that they have cash and obviously in these times of high inflation rates that cash is not the best use of money if it’s just staying there earning zero interest. So how do you view that on a balance sheet? 

[00:30:41] Brian Feroldi: Yeah, there’s different schools of thought with how I think about with how investors Think about cash on the one hand, cash is a relatively unproductive asset, although now with interest rates about 5%, it’s a more productive asset than it has been in every, any time over the last 20 years.

[00:30:56] Brian Feroldi: But I would say the more dependable the revenue of a business is, the less cash there needs to be. And the more cyclical a company’s revenue is, the more I would, the more emphasis I would place on a cash. As we said before, take a subscription business like a cable business. Even though those businesses are largely in decline nowadays, their revenue is extremely predictable over long periods of time.

[00:31:21] Brian Feroldi: Because their revenue is so predictable, I would say that a business like that doesn’t have to keep as much cash on its balance sheet as would a company that has extremely unpredictable revenue that is up and down, that is cyclical and cyclical profits. I would say it’s more important to keep a lot of cash on your balance sheet.

[00:31:38] Brian Feroldi: As a general rule, I like to see more cash than debt and the more cash the company has. All things held equal the better, but I would say it’s particularly important for companies that have a cyclical revenue versus ones that have a sustainable revenue.

[00:31:52] Kyle Grieve: Let’s look at the cash flow statement. Do you feel that generally accepted accounting principles gap, which you referred to earlier, does a good enough job as is for the cash flow statement, or do you think that there are specific adjustments that should be made to more accurately portray a business’s cash flow?

[00:32:07] Brian Feroldi: Yeah, I think that Gap Accounting does a fine job with displaying the cash flow statement. And what’s so interesting is that companies have only had to report cash flow statements for roughly the last 20 years or so. In fact, we can thank Enron for investors having to get a look at the cash flow statement.

[00:32:23] Brian Feroldi: Prior to Enron, companies did not have to produce a cash flow statement in the wake of the accounting scandal of the 2000s. One change that was made was companies were forced to produce a cash flow statement. For those that aren’t familiar, a cash flow statement simply reports the cash flow in and out of a business.

[00:32:39] Brian Feroldi: So while the income statement includes cash and non cash charges, the cash flow statement only cares about did money come in or did money and money leave. And it’s really important that investors look at both statements to get a true idea of how much cash, how much profits a company has made. When I’m looking at a cash flow statement, there’s a few dynamics that I particularly pay attention to.

[00:33:01] Brian Feroldi: Net income is, of course, the first number to look at, and that is at the top, so I always pay attention to that. As I scroll down, and I’m looking at the cash adjustments, right below that, and cash from operations, I’m paying particular attention to stock based compensation. It’s probably the number one thing I look at.

[00:33:16] Brian Feroldi: How much stock did a company pay out to its employees, and how big of a number was that in absolute terms? I also look for any other unusually large charges or adjustments that explain the difference between net income and cash from operations. That could be things like inventory, or accounts receivable, or unearned revenue.

[00:33:37] Brian Feroldi: So I look for those numbers on the cash flow statement. After that section, there’s a section called cash flow from operations, and this is essentially the cash that a business generated during a specific period. I think that this is a very important number for investors to look at, and I always compare it to, is this number higher or lower than net income?

[00:33:57] Brian Feroldi: It should, in most cases, be a higher number than net income, and if it’s not, I want to know why. Right below that figure on the cash flow statement is capital expenditures, also called spending on property, plant and equipment. This is essentially the assets that a company was purchased during the period that do depreciate over time that the company needs to operate and fund for the business.

[00:34:18] Brian Feroldi: And if you subtract those two numbers, that gives you the simplest definition of free cash flow that is out there. Free cash flow to me is a much more reliable profit number than net income is. So that is a key number that I look at on the cash flow statement. And then finally, if you keep scrolling down to cashflow from financing activities, I want to know, is the company issuing debt or repaying debt?

[00:34:41] Brian Feroldi: Is the company issuing stock or repaying stock? And then finally, how did cash change throughout the period? There are a couple of numbers that I really key in on, and I would say that cashflow from operations, capital expenditures are the two biggest ones. 

[00:34:54] Kyle Grieve: So you invest in a lot of tech, and as we know, they use share based compensation to retain and attract talent.

[00:35:00] Kyle Grieve: How do you view share based compensation as a part of free cash flow? Do you add it back in, as Gap would say, or do you make adjustments for it? 

[00:35:08] Brian Feroldi: I understand both sides of the argument, and it’s just an unfortunate truth of the time that we are living in, that a lot of companies, especially ones that are young and growing fast, do not have a lot of cash on hand to pay their employees what their market rates would be.

[00:35:21] Brian Feroldi: So they use stock based compensation. To fill the gap. And a lot of employees also like that because then that gives them upside potential if the business does succeed. So I understand the merits of stock based compensation. Now, I personally am okay with using stock based compensation as a part of free cash flow.

[00:35:40] Brian Feroldi: Because again, the thing that I care about is how much cash is the business generating in any given period. And free cash flow does include the stock based compensation as a part of that. When a company pays stock based compensation, that naturally increases the share count of the company, so I think that the dilution that you’re paying is accounted for in the increasing number of shares outstanding that a company has, so that to me is really one of the ways the costs are being accounted for of that stock based compensation.

[00:36:10] Brian Feroldi: But on the flip side, if a company would not be generating positive free cash flow without that stock based compensation, I will certainly note that against them. But it just totally depends on what stage of the business growth cycle you’re going to be investing in. If you’re investing in stage 1, companies, so startups or companies that are not yet profitable, You’re going to have to just be okay with that stock based compensation.

[00:36:31] Brian Feroldi: You’re not going to find fast growing companies that really don’t have it nowadays. You just have to be aware of the negatives to doing so. And it’s up to every investor to decide for themselves whether or not they should include or exclude free cashflow stock based compensation from free cashflow.

[00:36:47] Kyle Grieve: There was an excellent graph you showed on X of the returns over the last two decades by asset class. In it, it shows the returns of the average investor versus other asset classes such as cash, bonds, index funds, REITs, etc. The sad fact is that the average investor gets crushed by the majority of asset classes and had a 3.

[00:37:05] Kyle Grieve: 6 percent return between 2002 and 2021. You’ve gotten to educate many investors. What behaviors do you think are causing this massive performance lag? 

[00:37:14] Brian Feroldi: That’s quite simple. Investors are humans. And humans are born, naturally born to be terrible at investors. There are so many innate human characteristics that we share that were extremely positive for us in hunter gatherer societies that kept us alive.

[00:37:32] Brian Feroldi: And many of those same natural attributes make us terrible investors. Real simple ones are things like a herd behavior. If you see other people making money in the market and their stocks are going up, that naturally makes it feel like it’s a safe time to invest, and you want to get in on the performance that you see many other people making, and that causes many people to buy or add money to whatever is.

[00:38:02] Brian Feroldi: At the moment, they look back at what stocks, what industries or what mutual funds have gone up the most in the last three months, six months, one year or two years, and they want to naturally rush into that market because they think that those returns are sustainable. That is a perfectly natural human emotion.

[00:38:20] Brian Feroldi: We copy other what we see other people doing and that causes investors to buy at the exact wrong time. The inverse of that is also true. When markets are in free fall, when you see a sea of red, when you see negative headlines, when you see other people freaking out, It’s a natural human tendency to also want to freak out and it takes real gusto, real conviction to see blood on the streets in air quotes as it’s been called to see other people losing money, to see yourself losing money and to be excited enough by that to actually buy when everybody else is selling.

[00:38:56] Brian Feroldi: That’s an extremely hard thing to do. And even if you understand At the outset, the nature of those emotions and the nature of the emotions that you go through in bull markets and bear markets. It’s a completely different thing to actually live through those market cycles in real time. The best thing that people can do, especially investors that don’t pay a lot of attention to the markets, is take their emotions completely out of the picture by simply dollar cost averaging a fixed amount on a fixed schedule into the markets.

[00:39:25] Brian Feroldi: And that way there’s no thinking, there’s no emotions at play, and they’re just continually buying at both the highs and the lows. And if you do that for a long enough time, the buys that you make at the lows will be so profitable for you that they’ll more than offset any losses that you have from investing at the highs.

[00:39:42] Kyle Grieve: So market cycles move up and down, and similarly, investor sentiment moves up and down in lockstep with these cycles like you kind of just discussed. At market highs, market sentiment is at its most euphoric, with money coming in from all over the place to ride the momentum of the current upswing. When the market inevitably swings back down, sentiment becomes much less euphoric, quickly transitioning to panic and fear, which pushes investors to sell.

[00:40:03] Kyle Grieve: And on it goes. What are the keys that investors should understand about market cycles and investor sentiment to help them make the right decisions when emotions are running hot? 

[00:40:12] Brian Feroldi: It’s really hard to do it’s really easy to fool yourself ahead of time to tell yourself, I’ll be able to sell when markets are at their high and I’ll be able to buy when markets are at their low.

[00:40:22] Brian Feroldi: Because if you look back at any chart, of the S&P 500 over the last hundred years. It’s very easy to be a investor in the rearview mirror. You say, Oh, I would go all in, in 1982. I would sell everything in the year 2000. I would buy everything in 2002, sell everything in 2007, buy everything in 2009, sell everything in 2020.

[00:40:42] Brian Feroldi: It’s like the easiest thing in the world to look backwards and say, this is what I would have done if I was in that timeframe. What that logic eliminates, though, is that living through something day by day, a moment by moment, is a completely different experience than simply imagining what it was like to live through those periods of history.

[00:41:01] Brian Feroldi: I wasn’t alive during the Cuban Missile Crisis in the United States, so to me, that was an interesting footnote of history that had a very interesting movie. I can’t imagine what it was like to actually live through that, to be in constant fear that literally a nuclear war was starting at any given time and to not know the ending of that, how that would play out.

[00:41:18] Brian Feroldi: So I can’t imagine what my emotions would be doing to me at that time. They would probably be screaming at me to sell everything that I own, to go to cash and to hide away in a bunker somewhere. When obviously looking back, I’d have been like, wow, great time to buy. The market was cheap. during that timeframe.

[00:41:33] Brian Feroldi: So again, I think best thing that investors can do is take as many emotional decision making out of their process as they should by simply dollar cost averaging. Or if you want to try and time the market and you think that you can do it, do so with only a small part of your capital. So I, myself, all of my retirement funds are simply dollar cost average index funds.

[00:41:54] Brian Feroldi: I don’t even have to think about them as a part of my investing process. My cast that I invest beyond in, in taxable brokerage account that I try and be more opportunistic with, I try and buy when I think, see things that are attractive and I try and just hold when I see prices that are a little bit more insane.

[00:42:11] Brian Feroldi: I do try and quote unquote time the market or time the purchase of my buys, but I offset that with the simple dollar cost averaging that, that happens with the majority of my capital. 

[00:42:21] Kyle Grieve: So for investors who maybe just feel the need to own specific companies rather than index funds, what are some of their best kind of guardrails that they can do to help prevent them from making common mistakes?

[00:42:33] Brian Feroldi: I don’t think there are guardrails that you can set up. I think that a lot of investing is studying and learning from others, but some lessons just have to be learned the hard way. The most impactful, the most important money lessons that I’ve ever learned was when I took my capital, I put it at risk, I did something stupid, and I said to myself, lesson learned, tuition paid, I’m never going to make that mistake again.

[00:42:56] Brian Feroldi: This gets back to the whole, the theory of investing versus the actual experience. of investing. When I first started investing, I had no idea what I was doing. I was buying absolute garbage. I was buying penny stocks. I was buying dividend stocks that yielded 15 or 20%. I wasn’t doing any research at all. I was trying to trade them based on a couple of price movements over a couple of weeks.

[00:43:18] Brian Feroldi: I deserved to lose money because I was doing the exact wrong thing. And those mistakes that I made paved the way for me to become a better investor. In time. So just know if you are a new investor and you have felt like you have no idea what you’re doing, especially over the volatility that we’ve seen over the last three years, that’s pretty normal.

[00:43:36] Brian Feroldi: You shouldn’t expect to succeed at investing right out of the gate. In fact, that could actually be a bad thing if you do, because you can get a false sense of security and you can bet beyond what you actually can reasonably afford. So some lessons, unfortunately, but this is just life have to be learned the hard way.

[00:43:54] Kyle Grieve: So you just mentioned, for instance, when you started looking for high dividend paying stocks or stocks with charts that had, just very short periods of success, what are other common mistakes that investors are likely to make at the onset of their investing career that they’ll probably end up regretting?

[00:44:11] Brian Feroldi: There’s so many of them. If you’re familiar with the Dunning Kruger chart, it’s essentially a graph that shows how much confidence somebody has in a new venture versus the experience that you have. And when you first start learning about investing, I know this was true for me. God, when I first learned about earnings per share and things like book value and things like the P.

[00:44:28] Brian Feroldi: E. ratio, I thought I knew everything I needed to know. about investing. God, this company is trading at five times earnings. It’s a great buy. God, this company is trading at a hundred times earnings. It’s a sell. How hard is that? It’s like a single number you can use to make intelligent, in air quotes investing decisions.

[00:44:44] Brian Feroldi: Or people look at dividend yield. This company has a 10 percent dividend yield. This one has a 1 percent dividend yield. Obviously, the 10 percent dividend yield is the much more attractive investment. That is the logic that makes so much sense to a beginner that doesn’t know enough about the nuances of investing.

[00:45:02] Brian Feroldi: I would say overly focusing on a single metric is a big mistake that investors make. They pay too much attention to Revenue growth rate, too much attention to earnings per share, too much attention to dividend yield, those are three common metrics that people look at. Another would be, what did the stock price just do?

[00:45:20] Brian Feroldi: Did it just go up yesterday? Did it just go down yesterday? That is a good or bad stock, fill in the blank, depending on your interpretation of the situation. Investing is one of those endeavors where it is extremely easy to make the wrong decision. And just listen to that talk by Charlie Munger on the psychology of human misuse judgment.

[00:45:38] Brian Feroldi: He lists out in there in, in wonderful detail, all of the biases that are working against us as an investor. And I myself, the first time I heard of that talk was like, yep, I’ve done that. Yep. I’ve done that. Yep. I’ve do that. In fact, I’m still doing many of those things. So the best you can hope to do is study them and learn from them by getting, gaining actual experience.

[00:45:57] Kyle Grieve: So the media, news, and markets are always giving us reasons to sell our stocks, but as great long term investors know, most of the content out there is just noise, which just acts to confuse our decision making. What do you think are the best strategies for investors to help them differentiate between noise and usable information which they can make better decisions based off of?

[00:46:17] Brian Feroldi: For me, that’s simple. Watch less news, pay less attention to daily stock price movements, pay less attention to the movements of the Fed, pay less attention to what is, what the hot thing they’re talking about on CNBC is. To me, 90%, 95 percent plus of that content out there is just financial entertainment.

[00:46:37] Brian Feroldi: I’ve spent much more time listening to podcasts, listening to interviews of people, reading books about investing, and critically, Reading actual SEC filings from companies. That is signal. That is actual in information. When an earnings report comes out about a company, I take a fresh look at the income statement, a fresh look at the balance sheet, a fresh look at the cash flow statement.

[00:47:00] Brian Feroldi: The company will also talk up the key metrics of that particular industry. That is signal. That is actual information. The commentary from the management team is actually signal. What happens between quarters is largely to be just noise. So pay attention to the things that determine the things that matter.

[00:47:20] Brian Feroldi: Pay attention to those things and do your best to tune out everything else. It’s again, a very simple concept that’s easy in theory, hard to do in reality. 

[00:47:28] Kyle Grieve: One of the worst mistakes investors make is confusing the direction of a stock’s price with the direction of its value. A large percent of investors will see a stock price go up and conclude that the stock’s value is going up at the same time.

[00:47:40] Kyle Grieve: Alternatively, they’ll see a stock’s price crash and assume that the stock’s value is also going down. Can you explain why this isn’t the correct way to look at your stocks and the market and how price and value regularly diverge? 

[00:47:52] Brian Feroldi: Yeah, I’m gonna take a wonderful butcher, a wonderful Morgan Housel quote to explain this and he just said it elegantly, he said the stock price today is the numbers from today times a story about tomorrow.

[00:48:04] Brian Feroldi: And that essentially is, explains what every stock price is happening right, right there. And the thing that’s so interesting about that is that the numbers from today, part of that equation, doesn’t really change all that much and doesn’t doesn’t really move all that much from period to period. I mean, take a company that’s growing like 30 percent per year, which is an extremely fast growth rate.

[00:48:24] Brian Feroldi: What that effectively means is that every given month, they’re adding 3 percent or so to their business. Not really all that big of a change, but of course, when you pick it out over a full year, it adds up to a pretty large number. So for so many companies, this story of the business, the numbers from a business aren’t really changing all that drastically one way or the other over periods of time.

[00:48:47] Brian Feroldi: However, the thing that does change drastically is the story about tomorrow. What a stock price will pay for today could be to change drastically based on the emotions, the collective motions, and the collective feelings of all market participants. And there are good reasons for the emotions of investors to change drastically over a short period of time.

[00:49:09] Brian Feroldi: If investors, more recently in the last couple of years, we’ve seen investors go from thinking that inflation was a thing of the past to inflation being a major thing that is impacting every business and every consumer out there. That caused a massive shift in sentiment out there and rightly impacted stock prices.

[00:49:27] Brian Feroldi: Interest rates have been something that investors have all but ignored for the past 15 years, essentially everything in the wake of the great financial crisis of 2008. And more recently for the first time in almost 15 years, interest rates are now something that investors have to seriously think about and consider.

[00:49:44] Brian Feroldi: Those are monumental changes in the short term psychology of the market that can significantly impact and rightfully so the stock price, the prices that those businesses are trade at. As a long term investor, it’s your job to do your best to understand those changes, but focus heavily on the actual numbers, actual performance of the business.

[00:50:05] Brian Feroldi: That will tell you what direction the intrinsic value of the business is growing. I’ve personally seen instances when businesses are flatlining or they’re kind of stale and their stock prices are soaring. And if you only look at the stock price, you would get the wrong information about what’s actually happening at the business.

[00:50:22] Brian Feroldi: I’ve also seen the exact opposite where the business is producing record results and everything is going great and yet the stock is down 80 percent from its recent high because the sentiment has shifted that, that much. So it’s not easy, it’s not easy to focus on the business and to de emphasize the stock, but if you want to make opportunistic investment decisions, that’s precisely what you have to do.

[00:50:44] Kyle Grieve: Let’s turn our attention towards an often misunderstood topic, which is Buybacks. You shared an excellent article which discussed 6 examples of Buybacks which may act in opposition to the interests of shareholders. They were 1. Bolster the stock price 2. Increase book value 3. Increase earnings per share 4.

[00:51:01] Kyle Grieve: Reduce taxes 5. Use treasury shares to pay employees 6. Hostile takeover protection When you are analyzing a business’s Buyback program, what keys are you looking for to best ensure that the share repurchases are optimized to benefit you as a shareholder? 

[00:51:17] Brian Feroldi: I give management teams a lot of leeway when how I think about Buybacks, because what a Buyback is essentially a management team making a decision the same way that an individual investor would and making decisions as an investor into a business, especially when you’re dealing with scale of millions or potentially billions of dollars, not easy to deploy capital like that intelligently.

[00:51:36] Brian Feroldi: So when I think of a big company like say Apple, Apple has consistently over the last call it nine years or so taken a huge amount of its free cash flow and use that to buy back stock from the markets, which has significantly reduced the number of shares outstanding and has added huge gain to long term investors in Apple.

[00:51:56] Brian Feroldi: However, Apple is not really being opportunistic with its share purchase program. It’s essentially making cash flow and immediately using that cash flow to buy stock. And sometimes that looks like a genius move when the stock is trading low. And other times it looks like a less genius move when its stock is trading high.

[00:52:13] Brian Feroldi: So I would say that the, that’s the quote unquote, normal way of investors doing it. What they’re essentially doing is dollar cost averaging into their stock via their stock purchase programs, which is perfectly adequate, but it’s not the optimal way to do it. The management teams that do stock Buybacks best are those that build up cash over long periods of time and when they see their stock price take a short term hit or get impacted for a reason, which is bound to happen, that’s when they get aggressive with a tender offer or they go in and meaningfully use the stock price to buy back their stock.

[00:52:48] Brian Feroldi: That requires patience, that requires timing, and that requires being yelled at by investors for just letting your cash balance grow and grow and essentially do nothing while you wait for that to happen. So that is the better way to do it, but it’s way harder for management teams to do that than it is to just dollar cost average a Buyback.

[00:53:07] Brian Feroldi: If I see intelligent use of Buybacks and a history of buying back at opportune times, that management team gets a huge vote of confidence from me. But if I see one that is just consistently lowering the share count, to me, that’s acceptable. 

[00:53:20] Kyle Grieve: So Charlie Munger sadly just passed away on November 28th and he was an inspiration for many of the investing community.

[00:53:26] Kyle Grieve: What were the primary lessons that you took away from him? 

[00:53:30] Brian Feroldi: Charlie Munger is a fountain of investing and life wisdom, really. And it’s hard to even summarize all the wonderful things that I’ve learned from him over time, but I will just point out a few. First off is that talk that I’ve mentioned now three times in this podcast is the psychology of human misjudgment.

[00:53:46] Brian Feroldi: If you have not viewed that and listened to that and you invest, you are doing yourself a massive disservice. So go on YouTube, go on a podcast, type in Charlie Munger, psychology of human misjudgment and listen to every word that he said. That to me was the thing that when I first heard it, I was like, wow, this Charlie Munger guy is really a genius.

[00:54:05] Brian Feroldi: Another thing that I love that he really emphasizes is the inversion principle. It’s a quote from Jacoby who says, invert, always invert. And I just really love the idea of thinking forwards and backwards through through, through, through problems. And then the final thing that I really take away from him is a quote that he almost just said in passing, but I think it’s just so profoundly important.

[00:54:26] Brian Feroldi: And it’s that be reliable. As a human, be a reliable person. If you’re an unreliable person, it will actually cancel out a lot of other positive attributes that you have. And being reliable is something that is completely within our own control. So those are just a few that come to mind, but he is someone that should be studied deeply for years to come.

[00:54:48] Kyle Grieve: Ryan, thank you so much for joining me today. Before we say goodbye, where can the audience connect with you and learn more about your course and your book? 

[00:54:55] Brian Feroldi: So the easiest place to connect with me is on Twitter or on LinkedIn. I’m just Brian Feroldi on both platforms, but I will say I recently created a free stock investing course.

[00:55:06] Brian Feroldi: It’s just a five day email based course for people that want to get the most important lessons. From the book that I wrote just for free. And that is just stockinvesting.school, stockinvesting.school. Just put your email address in there and I’ll send you the lessons for free. 

[00:55:21] Kyle Grieve: Okay folks, that’s it for today’s episode.

[00:55:23] Kyle Grieve: I hope you enjoyed the show and I’ll see you back here very soon. 

[00:55:27] Outro: Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday, we teach you about Bitcoin, and every Saturday we study billionaires and the financial markets. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com.

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