Rebecca Hotsko (02:52):

I’m so happy to have you back. I want to go back to some basics with you today and discuss what drives company value versus what can change a stock price that doesn’t actually change a company’s value. Then I want to get into some accounting 101 with you later because that’s also a big factor that can change the reported earnings per share. So we have lots of great things to cover today’s episode, but to start off on the high level, can you talk about what a stock price is and why stocks have value in the first place?

Brian Feroldi (03:28):

Yeah, and let’s even start even more basic than that. What the heck is a stock? That is a term that is thrown around very commonly and I don’t think people stop to actually think about what it actually is. A stock simply represents fractional ownership of a corporation. So when a corporation is started, it is split up into a record keeping tool for figuring out who owns how much, and that record keeping tool is called a stock or a share. The reason that a stock has value is because that stock has a legal claim on that company’s assets and profits indefinitely.

(04:07):

In a very real way, when you buy a stock in a company, you become a part owner of that business, and if that business goes on to generate profits, those profits belong to the shareholders of the company. If those profits go up, broadly speaking, the value of that stock should also go up. The inverse is also true, but that’s what a stock is, and the sole reason it has value is because it has a legal claim on the profits of that business.

Rebecca Hotsko (04:40):

Can you talk about, I guess, the main factors that cause a company’s value to increase over time?

Brian Feroldi (04:48):

There are several different answers to that question, but they all come back to one basic truth, and it’s very similar to what I just said. The reason that stock has value is because it has a legal claim on the profits of a business. If you have a business that makes one million dollars in profits in year one and those profits grow over a long period of time and then in year 10 that business is doing 10 million in profits, all things held equally, you should expect that the value of that stock would’ve also gone up by a factor of 10. So stock prices and the value of companies act in direct proportion to what happens to the underlying profitability of those same companies.

(05:29):

Now, that’s not an exact one-to-one relationship. There can be various reasons while profits and the price tag of a business can diverge from each other, sometimes wildly so. However, in the long run, what ultimately drives a value creation in a business is growth and profits.

Rebecca Hotsko (05:47):

Yeah. I wanted to really dissect that because there are times where we might think that a stock price would react positively to say like a new growth opportunity of a business, but sometimes it doesn’t. Can you speak about some of the reasons why that might happen?

Brian Feroldi (06:05):

In the short term, you have to think of the stock market as an ongoing live auction. If you’ve ever been to an auction before, you know what happens. The auctioneer gets up, they have an item, they offer that item for sale, and they put it out for bid, and the ultimate selling price of that item is determined by how many bidders there are on that price and the eagerness of those bidders. The more eager bidders are to buy that item, the higher the price goes. Conversely, the less people are interested in that and the less eager those buyers are, the lower the price goes.

(06:40):

The stock market works on that basic principle day-to-day, second-to-second, but the principle is exactly the same. The reason that stock prices move around every day is that there are thousands, perhaps even millions, of daily market participants putting in various buy and sell orders for a company’s stock. The more eager the buyers are to acquire that stock, the more of a high price they’re willing to pay, the higher the price goes in the short term. The inverse is also true.

(07:09):

What can severely impact the eagerness of the buyers and the eagerness of the sellers is often related to news. So occasionally, news can come out and it can have a severe impact on the day-to-day price movements of a stock because that impacts the eagerness of both the buyers and sellers of that stock.

(07:27):

Now, what’s also confusing is that good news does not automatically mean the stock’s going to go up, the same way bad news doesn’t automatically mean the stock is going to go down. There’s other forces at work that are acting behind the scenes, but generally speaking, as a general speaking, good news tends to lead to a rise in stock prices, bad news tends to lead to a fall in stock prices.

Rebecca Hotsko (07:50):

I love that you mentioned both of those things because I think that’s a common misconception where investors might think that good news just automatically means that it will go up, and that’s not always the case in the short run. I’m curious if you can talk about share repurchases and dividends and how those impact the company’s stock price and how that impacts a company’s value.

Brian Feroldi (08:14):

Sure. Let’s start with the easy one, dividends. What is a dividend? A dividend is when a company takes a portion of its profits and it gives those directly to the shareholders of that company. Do some simple math. Let’s say that a company makes one million dollars in profit and there’s simultaneously one million shares outstanding. That would be $1 per share. So the company would pay out $1 per share to each of its shareholders. So if you had 10 shares, you would get a check for $10.

(08:43):

The reason that companies do that is pretty apparent. It allows the investors in that company to realize a cash gain on holding that company’s stock, and dividends are very attractive to certain subsets of investors, particularly those older investors that are relying on their portfolio for income. So that is what a dividend is and how it creates value.

(09:02):

Now, conversely, when a company takes cash out of its bank account and it gives it to its investors, that weakens the company financially speaking, right? The same way if you took cash out of your bank account and paid it out to your kids, you yourself would become weaker financially for doing so. That’s why only strong companies that are very strong and stable financially tend to be ones that pay out dividends to their investors.

(09:29):

Now, investors tend to really like getting those dividends, but it can be a mistake if a financially weak company is paying out cash to its shareholders because that can increase the chances of the business having a very bad outcome. So that’s dividends. Very easy to understand. The cash goes from the company’s bank account into the shareholders bank account.

(09:46):

Stock buybacks are a little bit more complex to understand, but let’s go back to our very simple example. Let’s pretend that a company makes one million dollars, has one million dollars in profits, and it has one million shares outstanding. Let’s say that instead of taking that million dollars and paying it out to shareholders as a dividend, it uses that million dollars to buy back the stock from some of its investors, and let’s just say that one million dollars buys back 100,000 shares from its investors base. So its stock is trading at $10 per share.

(10:18):

When the company does that, some investors will sell their stock back to the company. They’ll get the $10 that the company was worth. Now, after that buyback is done, instead of having one million shares outstanding, we only have 900,000 shares outstanding. Let’s say the year after that, that company decides to pay out that million dollars as a dividend. Instead of having one million shares outstanding to split that dividend payment amount, it now only has 900,000 shares outstanding.

(10:49):

So that would lead each individual shareholder instead of receiving a dollar in dividends, they would get a dollar and 11 cents in dividends. So without selling their stock, by buying back the stock from the shareholders, there are less shareholders, fewer shareholders that have a legal claim on the company’s profits, and that leaves more for each remaining shareholder to gain ownership of.

(11:12):

Now, there’s more nuance than stock buybacks to that. Sometimes stock buybacks create lots of value for shareholders. Other times, they destroy value for shareholders, but that is the theoretical way that stock buybacks increase shareholder value.

Rebecca Hotsko (11:26):

Yeah. We probably won’t go into detail of that because that’s a whole another topic in itself. I’m also wondering if you can talk about the PE. So I know you recently chatted with Trey and you were talking about how you’ve made a mistake in the past of ruling out companies just based on they were too high of a PE, and I actually had a similar conversation with Robert Hagstrom who said, “Don’t confuse PE with value. A high PE doesn’t mean a company is automatically overvalued. It just means that the market has a high expectation for that stock.”

(11:59):

So I want to get into this a bit more with you because now that we’ve talked about the difference between stock price and a company value, I just think this is super relevant today because there’s a lot of times, especially in our market cycle, when a company’s EPS is lower and that’ll impact the PE. So can you just talk about this aspect and why a PE can be inflated, why that doesn’t necessarily mean it’s overvalued?

Brian Feroldi (12:25):

This is one of the most confusing things to me when I first started buying individual stocks. If you read books about value investing, the data is pretty clear. Your goal as an investor is to buy companies when they are cheap and sell them when they are expensive. That just totally, totally makes rational logical sense to me. Now, one of the ways, and in fact the simplest way of telling whether a business is cheap or expensive or not is called the PE ratio. It stands for price to earnings ratio, and that is simply a relationship between the market capitalization of the business, which is reflected in the current stock price, divided by the net income or profits or earnings, all those words are synonymous with each other, of the business. If you’re looking at it on a stock basis, you typically take the current share price, which is the thing that’s trading up and down every day, you divide by the last one year’s earnings on a per share basis, and that simple division will give you the price to earnings ratio.

(13:18):

PE ratio is a very quick, easy number that you can look at to tell whether or not a company is expensive or not. Generally speaking, the higher the PE ratio, the more expensive a company is, and the lower the PE ratio, the cheaper a company is. The average company in the S&P 500, for example, is trading somewhere around 22 times earnings. So if you came across a company that was trading at 80 times earning, that’s significantly higher than the PE ratio of the average business in the S&P 500, and a logical conclusion from there is that stock is very expensive. Conversely, if you come across a company with a PE ratio of five, that is substantially lower than the average business in the S&P 500, and a natural conclusion is that business is cheap.

(14:02):

That works wonderful in theory. However, there are a number of reasons why the E, the earnings that a company have can be dramatically overstated or it can be dramatically understated. If you are just looking at the PE ratio of a business and you have no context to whether the earnings power of the business is fair, overstated or understated, then the PE ratio associated with that business is going to lie to you and tell you information that is false about that business.

(14:34):

A couple of reasons why the PE ratio can be understated or overstated. One is accrual accounting. The nature of the income statement is it uses a method of accounting called accrual accounting. That is different than cash accounting. So accrual accounting is like an accountant’s opinion of how profitable a business is over a period of time, and cash accounting simply measures the actual cash movements in and out of a business. For a variety of reasons, there can be wide divergences between the cash flow of a business and the profitability of a business.

(15:09):

Another one that has come up more recently is equity investments. When one company buys a stock in another company and that company is publicly traded, the company that owns the stock in the other business has to mark up or down its net income, its profits over a period depending on what happened to that other company’s stock. So more recently, Shopify, for example, took a pretty big equity position in a financial company called Affirm. When Affirm’s stock goes up, Shopify has to say, “Our net income went up,” and the inverse is also true. So that means that Shopify’s earnings are heavily influenced now by what happened to Affirm’s stock price. For that reason, Shopify’s PE ratio is essentially useless to investors because it tells you nothing about the underlying business. It has to reflect what happened to Shopify’s investment.

(16:03):

Another is just one time events, whether they’re earnings growth or cash infusions or cash outflows from, say, legal settings. Those things can significantly impact a company’s earnings for a period of time. Moreover, there are things like operating leverage, where the company is in its growth cycle, and just some basic industry dynamics that can also distort what a company’s earnings are at any given period of time.

(16:28):

When you learn about each of the ways that the earnings of a business can be dramatically overstated or understated, it becomes pretty clear that the PE ratio is at a fantastic number, but it has a tremendous amount of limitations to it. I didn’t understand that when I was a brand new investor, that there’s so much nuance related to the earnings of a company. So I personally love the PE ratio, and it’s my favorite valuation metric to look at when it works. The only problem is there are many, many, many cases when the PE ratio does not work at all and it will tell you the wrong thing.

Rebecca Hotsko (17:06):

I’m so glad that you touched on all of those accounting aspects because that’s what I want to dive in with you deeper now, as I mentioned in the beginning. I think it’s so important for investors to understand even basic level of accounting because it really impacts your analysis and the way that you can figure out if the numbers that the company’s reporting are actually reflective of their operations, their value opportunities because they’re highly subjective to management assumptions related to accounting. So backing up a little bit on the accounting aspect, can you talk about, just on a high level, GAAP accounting and what companies are subject to that, I guess?

Brian Feroldi (17:47):

So if you’re a publicly traded company in the United States, you are required by law to report your earnings, your profits to investors using what’s called GAAP accounting. GAAP is G-A-A-P and that stands for Generally Accepted Accounting Principles. GAAP accounting is essentially a set of commonly adopted accounting principles, standards, and procedures that accountants have to follow in the United States when they are accounting for or showing their profits, their earnings, and their balance sheet.

(18:21):

Now, having a common set of standards amongst all companies makes tons of sense. You don’t want companies reporting different accounting methods to each other. If they did so, it would make it impossible to compare one company to another. GAAP accounting makes things that everything is uniform, right? It makes it neutral, and it really makes it easy for one accountant to verify the results of another and it makes it easy to compare companies to each other.

(18:45):

There’s a problem with GAAP accounting, though. A GAAP accounting works very well for a certain subset of companies and traditional businesses, especially those that manufacture physical goods. GAAP accounting works very well and makes tons of sense. GAAP accounting doesn’t work very well when you’re talking about a lot of modern day companies. Companies that make physical goods that sell them, GAAP accounting works great. A lot of companies that sell digital goods or digital services, GAAP accounting doesn’t always necessarily accurately reflect what is happening in the business.

(19:19):

For that reason, a lot of companies nowadays, especially newer companies, in addition to reporting GAAP accounting numbers, which they’re required to by law, they also provide investors with an alternative view of their accounting by reporting what’s called non-GAAP accounting, which is exactly what it sounds like. Here is a different accounting standard that does not comply with GAAP.

(19:40):

The biggest difference between GAAP and non-GAAP accounting is non-GAAP accounting tends to exclude one-time transactions that can cause big fluctuations in GAAP accounting. So by excluding a lot of those one-time transactions, investors can get a better idea of the core operations of the business. That sounds great in theory, but since non-GAAP accounting gives management teams a lot of leeway with how they do things, that can make results between one company and another non-comparable. You also have to dig into the details of what assumptions is this management team making when they’re reporting a non-GAAP accounting to me.

(20:21):

So I understand why GAAP accounting exists. It makes total sense to me. I understand why some companies choose to also report non-GAAP, and as an investor, it’s really your job to dig into the details of both and ask yourself if you trust management and if you believe the assumptions that management are putting up forth to you, but I’ll always like it when companies report both and then I can make judgment calls for myself.

Rebecca Hotsko (20:44):

I want to jump into the GAAP versus non-GAAP adjustments in more detail. I first want to just back up one step because you mentioned accrual accounting, and there’s so many assumptions that go into the accounting choices of how companies report. So I thought it would be helpful to just cover maybe the main ways that companies can make their earnings look better or even make their earnings look worse for some periods by just changing how they report in their accounting. So maybe we could talk about the main lines on the income statement that are highly based on management assumptions and that would change the resulting net income or earnings per share.

Brian Feroldi (21:26):

Sure. Broadly speaking, there’s several different categories that have to be reported occurring to GAAP accounting. Management teams do have discretion over what information they report to investors. For example, some companies choose to break out how much they’re spending on sales, how much they’re spending on marketing, how much they’re spending on overhead, how much they’re spending on R&D, how much they’re spending on depreciation, how much they’re spending on amortization.

(21:53):

When companies do that, they’re choosing to give investors more detailed look, a more granular look at the numbers behind the business so that they can get a sense of where management is putting its capital. They’re not required to do that. Some companies take all that information and they lump it all together into one or even two numbers and they just basically call that overhead. The same thing can happen on the balance sheet. The same thing can happen on the cash flow statement. So managements teams do have discretion with what numbers they choose to break out and what numbers they choose to lump together.

(22:24):

There are a few terms on the income statement in particular that can lead investors to get a different view of the true accounting profitability of a business. Two that I will call in particular are called depreciation and amortization. That is when you write down the value of either intangible assets, which are things that you can’t physically touch or tangible assets, which is things that you can physically touch. Everybody listening is familiar with depreciation. You buy a car, you drive that car for 10 years, that car loses value over that 10 year. It’s the same car, but why is it worthless after 10 years than when you bought it brand new? The answer is because that car has been used up in some way and the car has depreciated in value.

(23:13):

That same term, depreciation, applies to things that businesses buy. Buildings depreciate. Equipment depreciates. Computers depreciate. Manufacturing equipment depreciates. Management teams have to account for that depreciation on their income statement when they’re figuring out how much the earnings power of the business was over any given period of time, but management teams have discretion over the way that they depreciate those values over time. You can imagine if one management team is very aggressive with its depreciation assumptions, that can make the business look less profitable today than it might be otherwise.

(23:51):

Conversely, if a management team is very cautious or it depreciates its power of its earnings very, very little, that can boost the company’s earnings today. That’s depreciation. Depreciation is fairly straightforward, at least, right? We can estimate how long equipment is going to last, how long a car is going to last. It’s a whole different story when you get into the amortization of intangible assets, right? One company buys another company’s brand name, right? They buy a company out, and they have to assign an economic value to that brand name, and then they can choose if they want to amortize or reduce the value of that brand name over time. How do you do that? What is the name Mickey Mouse worth, right? That name was created, what? A hundred years ago? At this time, what is the economic value of the name Mickey Mouse today? How would you go about assigning a value to that? That is just one relatively easy example, but you can think about how creative accountants have to be when they’re coming up with how to assign value to intangible assets like patents and brand name and consumer list, et cetera.Moreover, those assets are sometimes written off as the value is decreasing over time with an accounting procedure called amortization. Again, you can choose how you amortize your non-tangible assets and that can also impact a company’s earnings over any given period of time. Broadly speaking, CFOs and management teams do have discretion with how they massage the numbers that they report to investors and they can make those numbers look worse if they want them to, which sometimes makes sense for tax purposes or they can make those numbers look better than they want to, which sometimes can make sense if you want to show that your business is doing better than it is.

(25:32):

This is why it’s so critical for investors to look beyond just the income statement of a business and marry that with another statement that is required to be reported, which is called the cash flow statement, which eliminates or at least neutralizes a lot of those massaging that management can do with its income statement and actually shows the cash movement in and out of a business, but this is why if you’re going to invest in individual stocks, you have to understand how accounting works and the nuances of accounting because it’s a tricky thing. If a management team wants to, they can deceive investors for a long period of time.

Rebecca Hotsko (26:08):

I’m so glad you touched on all those points, the depreciation and amortization. That is so important to the end result of net income, which is a number that we rely on as investors to value businesses, but it’s just so subject to those assumptions. So it’s really important to, yeah, look beyond the numbers and figure out if that makes sense and what their incentives are.

(26:31):

So one other thing I want to talk to you about because you mentioned how GAAP accounting is better suited for manufacturing companies or the old companies versus new tech companies. One thing comes to mind that I’ve heard lots is that R&D expenses is one that technology companies, that’s one of their biggest expenditures, but it’s created, it’s listed as an expense and not, say, an asset, which is what they typically think of it as. Can you explain that and why maybe a lot of tech companies they have been operating, I guess at losses for years when in reality maybe that’s not their, I guess, true reality of their operations?

Brian Feroldi (27:11):

Yeah. Again, investors sometimes are given that level of clarity where a business will break out, “Here’s how much we’re spending on R&D,” but that is purely treated as an expense for the company, a net outflow. How do you account for, from an accounting perspective, the value that is created from that R&D spending, right? If R&D goes on to create the iPhone, well, that was money extremely well spent, right? Sure, the output of that could be patents. For example, it could be the copyrights, it could be a customer list, it could be economic value in some way captured, but broadly speaking, R&D is written off as an expense to the company.

(27:46):

A bigger way or a bigger debate in the investment community isn’t necessarily about just the spending on R&D. The one that trips up a lot of people is the way that we account for stock-based compensation. When companies are small and rapidly hiring, one way that they entice the best and the brightest to come work for them is they give them stock in the company it itself. If that company goes bankrupt, that stock will be worth zero. If that company is the next Amazon, that stock that they’re given could become life-changing amounts of money, and there’s a big debate in the investment community, “How should we account for the value of that stock that is given out to employees of a company?”

(28:27):

On the one hand, people like Buffett make a very logical argument that stock-based compensation is compensation. Compensation is an expense. An expense should be reported on the income statement. Sounds extremely logical. Other people argue that it’s not an expense in the same way, and because that stock-based compensation leads to dilution, leads to the absolute number of shares that are outstanding increasing, that’s the way that investors pay for it. They’re paying for it with dilution. We don’t also have to account for it on the income statement in addition to that, but this is one of the biggest reasons why there tends to be a difference between GAAP accounting, which you are forced to call out stock-based compensation as an expense on there, and non-GAAP accounting, which you are not forced to, and a lot of management teams remove that from the number to give a different view of a company’s earnings.

(29:16):

Yeah, again, details like this can lead to big time changes in the company’s reported incomes and the earnings power of the business, and it’s on you, the investor, to think through which of those arguments makes the most sense to you.

Rebecca Hotsko (29:30):

I recently had on a guest named David Hay, and he wrote a book called We’re in Bubble 3.0: History’s Biggest Financial Bubble Ever, and a piece in his book talked about how GAAP accounting, it allows for a stock option to be granted and then expensed over time using the value of the option at the time of the grant. So basically saying that this is how these large companies have been able to, I guess, increase their profits over time by using this. Is that something that you are talking about or is this even a different piece?

Brian Feroldi (30:05):

That gets even more into the weeds than what I’m talking about. I was talking about more of the generalized debate with how should we account for stock-based compensation, but there’s no doubt today that stock-based compensation has become an extremely popular way for companies to pay their employees. This is true not only in tech companies, this is also true in other businesses as well. Employees tend to really like stock-based compensation because it allows them to retain ownership of the company. If they just happen to get hired at the next Amazon, the next Apple, the next Netflix, that stock-based compensation can become life-changing amounts of money for them.

(30:41):

So in many ways, employees, especially the best and the brightest, now demand stock-based compensation. Otherwise, they’re not going to be working there, but there are certainly ramifications to what that can mean for investors.

Rebecca Hotsko (30:53):

So would you say, because we know that when owners own stock, that is a positive? We want a high degree of, the CEO and the managements, they want a lot of ownership in the company. Is that the same then for stock-based compensation? Would you say that that is a positive when a company has that or not necessarily?

Brian Feroldi (31:12):

It’s both a positive and a negative. Broadly speaking, the downside to stock-based compensation for investors is companies are diluting themselves. So just like before we were talking about how stock buybacks can increase your ownership in a business over time, a stock-based compensation does the exact opposite. It dilutes your ownership in a business over time. A real simple way to think about that. Let’s say your parents have three kids and they have a million dollars that you guys are going to inherit. That’s $333,000 each that you’ll inherit because there’s three of you. Well, lo and behold, before they die, they have another kid, and now there’s four kids to split that money with. How much are you now getting from an inheritance from them? The answer is $250,000. So there used to be three kids splitting the inheritance, now there’s four kids splitting the inheritance.

(32:00):

The million dollars didn’t change, but your share of the inheritance went from 333,000 down to 250,000 because of dilution, right? There are more people to split the total profits with, therefore, each person gets less. That’s why stock-based compensation can be bad for shareholders because if the a company is diluting its share count by say a very big number, 10, 20 percent year, which is not impossible out in the public markets, that is diluting your future economic interest in that business. You can tell why that is such a hotly debated topic.

(32:35):

Conversely, to your point before, as an investor, I love it when the management teams of the companies I invest in own a significant amount of the stock. Why? Because if I’m hurt as a shareholder from that company’s stock going down, I want the management team to be hurt a thousand times more than I could ever be hurt, right? People act differently when they are owners of a company and they spend money differently when they’re owners than when they’re just hired guns in a business. A lot of people that make it to the executive ranks that aren’t founders, they don’t necessarily think of themselves as owners of the business. Their expertise might be extracting the highest possible salary and a compensation from the business and they might not necessarily be skilled at growing the value of the business over time.

(33:20):

So this is why a lot of investors, myself included, like to buy and invest in companies where the CEO is also the founder because that could mean that a substantial amount of that person’s net worth is tied to the value of that business. If I buy a stock and that stock goes down 70%, I want to know that the CEO has lost millions upon millions of dollars just like I’ve lost money from that stock performance.

Rebecca Hotsko (33:44):

Where can investors go to see where that ownership in the stock lies, how much the CEO or their founder owns?

Brian Feroldi (33:52):

There’s a couple of places you can go to find that out. There are some websites out there that track that kind of thing, but my go-to for anything is just SEC filings. Once a year, a company has to, by law in the United States, report what’s called a proxy statement. The technical statement definition is DEF 14A, which is a horrific name and title for an important document, but you’re basically looking for what’s called the proxy statement. Every year when this proxy statement comes out, companies are required to report the ownership amount, not only the compensation of the CEO and their top officers, but as well as guidelines for how much stock they have to own if they have those in place and how much shares each individual executive in that company owns, and that includes stock, it includes stock-based compensation, et cetera.

(34:37):

Now, that is given out once per year, and I always look at that document when I’m doing research on a company. If a company makes transaction, if an insider makes transactions on its stock throughout the year, those also have to be reported to the SEC, and those come out on form for each and every time a transaction is made and they have to tell you their updated ownership amounts. My go-to for inside ownership is the most recent proxy statement. Then I also check to see are there any major sales that they’ve made since that came out.

Rebecca Hotsko (35:05):

Awesome. So now that you talked about GAAP versus non-GAAP and how companies can report both, and stock-based compensation was one of the items that can be reported on a non-GAAP basis, can you talk about some of the other main items that can be reported on a non-GAAP basis and how those compare to what’s reported on a GAAP basis?

Brian Feroldi (35:31):

Sure. So by and large, the reason that companies report non-GAAP earnings is because GAAP earnings have to put in one-time events, stock-based compensation, et cetera. Sometime those one-time events can distort a company’s profitability. So by looking at non-GAAP, companies often strip out from their one-time expenses to give a truer idea of what the business would’ve earned if it wasn’t for those one-time events. So what kind of onetime events can be put in there? Well, how about acquisitions, right? When there are acquisitions happen, there are often one-time expense that a company has to go through to integrate that one or how about currency, currency movements? Those often can be taken out.

(36:07):

How about if you pay off debt early? This oftentimes penalties for doing so. Should you penalize the company’s earnings because it shows to pay off debt? How about it has to pay a fine or has to deal with a litigation expense? How about if it has a relocation expense or an unusual tax rate? If it goes through a restructuring or if it lays off a bunch of employees, it often has to pay severance to those employees. Again, the big one attempts to be a stock-based compensation that is pulled out.

(36:33):

Again, most management teams that report non-GAAP earnings will show you what factors cause them to report different non-GAAP results than GAAP results on a line by line basis. Again, it’s up to you, the investor, to read through those and say, “Does that make sense or does it not make sense?”

Rebecca Hotsko (36:49):

So which one do you usually rely on when you’re doing your valuation analysis or does it just highly depend on the company, you work through those two different figures and what they’re adjusting or what’s your approach to that?

Brian Feroldi (37:03):

My personal approach is I don’t mind using non-GAAP accounting. If I’m going to invest in a company, I am taking a leap of faith in that management team one way or the other. Sometimes taking a leap of faith with a management team results in me getting burned, right? The management team is unscrupulous, they’re lying to investors or they’re doing whatever. They’re telling one story and then they’re acting a different way, but if I am taking that leap of faith with a management team, I also have to take a leap of faith that the accounting they’re showing me on a non-GAAP basis also makes sense. If I get the sense that I don’t believe I can trust that management team before, I’m just going to sell. I’m just going to sell and say, “Forget this company forever. I’m going to move on to the next investment,” or if I got the sense upfront in my due diligence that something was fishy with the management team or didn’t sit right, again, I just wouldn’t buy that stock.

(37:49):

There are thousands upon thousands of public traded investments for us to make. So I tend to invest with the people that I think are most trustworthy. Another, again, shorthand is I like to invest in companies that also have a huge amount of ownership in the company itself. Doing so, if they’re reporting false numbers in any way or if they’re reporting accounting that doesn’t match up, their stock is eventually going to get whacked and their net worth is going to get declined far more than mine is as an outside shareholder, but I personally am okay with using non-GAAP accounting for figuring out valuation metrics on company, but that’s to each their own on that one.

Rebecca Hotsko (38:27):

I know we could probably do an entire episode on warning signs for accounting, but do you have any on a high level of what are some warning signs that investors could look for in a company’s financials related to accounting?

Brian Feroldi (38:43):

So first off, let’s start with the obvious one. If a company comes out and says, “We have accounting irregularities and we’ve issued fraudulent statements in the past,” such as Luckin Coffee did a few years ago or Wirecard, I think Wirecard did last year, you’re dead forever to me, right? If I can’t trust your numbers, why on earth would I ever put capital behind this business? So that one for me is an automatic, “Forget it. I’m not going to invest in you again.”

(39:08):

Looking beyond that, there are some yellow flags that I look for in a company’s financial statements. They’re not necessarily going to make me not invest or bail out of in business, but it will cause my ears to perk up and I’ll do a little bit more research. A few that come to mind for me, a number one would be declining gross margin. A gross margin is simply the gross profit that a business generates, which is revenue minus cost of goods sold divided by the revenue of that company. A gross margin is like the market’s way or a customer’s way of telling a business that, “We value your product.” All things held equal, I’ve dramatically prefer to invest in businesses that have a stable gross margin that rises over long periods of time.

(39:53):

If I come across a business where I see their gross margin is steadily declining, that is a big warning sign for me because that tells me that the company is having to discount its goods in order to entice buyers to buy them. One example of that in recent memory is Beyond Meat. Beyond Meat, when it came public, had a gross margin of about 35% or so. So for every dollar in sales, the company would keep 35 cents as gross profit that it could then use to pay for research and development, sales and marketing, et cetera.

(40:25):

That number has steadily been declining over the last couple of years, and in the most recent quarter, it came in at zero. So the company’s revenue matched what it costs the company to produce the product, not pay for any of the expenses of the business, just to produce the product that it sold. So the company’s margin declining over periods of time tells me that the company’s brand name isn’t as strong as a management team like it to be, and that in order to entice sales, they’re having to significantly lower their price and offer sales to investors. To me, that’s a recipe for subpar investment returns indefinitely. So a decline in gross margin is something that make my ears perk up.

(41:04):

Another one is rapidly expanding sales and marketing expenses. Companies often have to spend heavily on sales and marketing to make a name for themselves, to enter new markets, to make consumers of what they’re having. On a percentage basis, the best case scenario is as a company grows, it becomes better. Its marketing spending becomes even better, even more efficient at capturing new customers. If the inverse is true, if it has to spend even more money to capture the same number of customers, that’s a really bad sign to me that will lead to poor earnings per share, poor net income growing over time.

(41:40):

There’s other ones beyond that such as depreciation, margin, net margin, earnings per share growth, the balance sheets that I look at, but I would say gross margin and sales and marketing margin are two that I pay particularly attention to.

Rebecca Hotsko (41:53):

That was super helpful. I think the last thing I kind of want to touch on today, and you mentioned it before how investors can look to the cash flow statement because that one is less subject to adjustments. So can you talk a bit about that and maybe what discrepancies you could look for between what the cash flow statement says versus the income statement in which to rely on more?

Brian Feroldi (42:16):

So the income statement uses accrual accounting, which is very much an accountant’s opinion of how much profits did we make over this period of time. By law, they’re also required to report a cash flow statement to investors, which literally shows how cash moves in and out of a business over a period of time. So the cash flow, you can only report cash flow from a business when cash comes in or it actually doesn’t leave, but you said we had an expense, but cash doesn’t leave, and the inverse is always true. You can’t report cash coming in until the cash actually hits your bank account.

(42:50):

There can sometimes be a wide divergence between how much profits a company is making on the income statement and the actual cash flowing in and out of a business. Broadly speaking, I vastly, vastly, vastly prefer companies that are unprofitable, not making money on an income basis, but are cash flow positive. So their bank account is increasing each and every month or quarter because the core operations is generating cash, even if it can’t, from an accounting perspective, say that, “We are profitable.” That is vastly preferable to the opposite, which is some companies say, “We are profitable on a net income basis,” yet those same companies are reporting negative free cash flow. So cash is actually leaving their bank account each and every quarter and year despite the fact that they are profitable.

(43:38):

There’s often nothing nefarious going on with companies that report positive net income but negative for free cash flow, but this shows why it’s so important for investors to always look at both statements at the same time and to match them up. In a perfect world, free cash flow and net income would always marry each other exactly, and if a company was profitable, it would be free cash flow positive and the inverse would also be true. That doesn’t match up with the realities of accounting because there can be dynamics that cause cash flow to look poor some periods and net income to look poor in other periods. As an investor, it’s your job to … I always make it a note to look at both, and when forced to choose, I’ll look at the cashless statement. I’ll emphasize the cashless statement every time.

Rebecca Hotsko (44:23):

What would you say are the main reasons that can cause those major disconnects? I love how you made it so explicit there about the accrual accounting versus the cash flow because accrual accounting, it’s income when earned and expenses when incurred. So that’s vastly different from when they actually receive the cash. I guess, hone in on why those might be different.

Brian Feroldi (44:45):

There’s often a couple of big culprits. We already talked about some previously. A depreciation is one, amortization is another. Stock-based compensation tends to be the third, and the final one tends to be capital expenditures or also called capex, also called in some cases spending on property plants and equipment. If a company goes out and buys a new manufacturing facility because it sees lots of demand for itself and it wants to increase its capacity, it has to invest to do so. It often requires millions, tens of millions, hundreds of millions, even billions of dollars upfront to get a factory up, up and running. That is a drain on cash flow in the short term. That pulls capital out of a company as it pays off those investments.

(45:30):

That can be one big reason why a company can be earnings positives, so have positive net income, but also massively negative cash flow because of the cash dynamics of the business. Conversely, there are some businesses out there that get cash from their customers before they can report it as income. So if you subscribe to a magazine, for example, let’s say you pay for a magazine subscription and you buy a year supply on day one. You pay upfront for the next year’s worth of magazine’s subscription. So the company has a cash inflow from you doing that. However, it can’t report that cash inflow as revenue and as profits until it actually delivers you the magazines over a period of time.

(46:15):

The dynamics of the business, because the customers are giving you cash before you actually deliver them the product or service, causes your free cash flow to look much better than your reported income. So the nature of the business model of the business itself can cause some wonky things to happen with net income and free cash flow. Yet again why investors need to look into the details of the company and understand the dynamics of accrual accounting and cash accounting so they can understand those principles.

Rebecca Hotsko (46:42):

That was so helpful. I think that we will stop there. We covered so much today. Thank you so much, Brian, for coming on again.

Brian Feroldi (46:50):

Thank you so much for having me, Rebecca. It’s always great to be here.

Rebecca Hotsko (46:53):

So where can the audience go to learn more about you and connect with you and watch all your videos?

Brian Feroldi (47:00):

Yup. So I am very active on Twitter. My name there is @BrianFeroldi. We also talk about accounting and more on YouTube. In the next couple of months, we’re going to be doing webinars with people if they want to get more details and see examples of some of the changes that happen with accounting. So if you’re interested in that, the best way is to just follow me on Twitter and I’ll make my audience aware of when that happens.

Rebecca Hotsko (47:23):

All right. I hope you enjoyed today’s episode. Make sure to subscribe to the show on your favorite podcast app so that you never miss a new episode. If you’ve been enjoying the podcast, I’d really appreciate it if you left us a rating or a review. This really helps support us and is the best way to help new people discover the show. If you haven’t already, be sure to check out our website, theinvestorspodcast.com. There’s a ton of useful educational resources on there, as well as our TIP Finance tool, which is a great tool to help you manage your own stock portfolio. With that, I will see you again next time.

Outro (48:00):

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. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.