How to Evaluate a Stock Like Warren Buffett with Brian Feroldi

Transcript:

This is why again, I was so confused for a long time because I was like how can Amazon trade it 100 times earnings? Like every book I've ever read says that 100 times earnings is way too expensive and yet the company was actually cheap at 100 times earnings.

And if you bought it in a 10 years ago, 20 years ago when it was trading at those insane prices, it was a great buy. So the PE ratio can be useful as long as it's in the correct phase. Now, valuing companies in this phase is very difficult because it's basically the price to hope ratio.

It's like what could this business be worth in the future if they can hit a Grand Slam, which is very hard to do. So these businesses, phase one businesses are basically lottery tickets and you can do that hard work to figure out if you can go under the bridge. Well, in Buffett's mind, he's like, if it's too close to call, pass like I'm not going to go ahead and do that.

So when he's valuing a business, if it doesn't simply scream out this is cheap on a first glance, it's too close to call and he and he doesn't bother with the advanced calculations. On this episode of the Personal Finance Podcast, we're going to show you how to evaluate a business.

Like Warren Buffett. What's up everybody? And welcome to the Personal Finance Podcast. I'm your host, Andrew, founder of mastermoney.co.

And today on the Personal Finance Podcast, we're going to be diving into how to evaluate a business like Warren Buffett. If you guys have any questions, make sure you join the Mastermind newsletter by going to mastermoney.co/newsletter. And don't forget to follow us on Apple Podcast, Spotify, YouTube, and whatever podcast player you love listening to this podcast on.

And if you want to help out the show, consider leaving a five star rating and review on Apple Podcast, Spotify, or your favorite podcast player. Now, Warren Buffett has spent the last 60 years looking at businesses and deciding what they're worth. And he is one of the best of all time at ever doing this.

And he's done it in a way where he hasn't even had to use a spreadsheet, and he's done it in a very simplified way. And Charlie Munger. Who is his? Business partner has even stated that he has never once seen Warren Buffett run any fancy math that Wall Street uses.

So how does he do it? Today? You're going to learn how to evaluate a business that way and the way that Warren Buffett does it, not the version that you read about in textbooks, but the actual processes that he uses and how to think like Warren Buffett. My guest today is Brian Ferraldi, and Brian is the author of Why Does the Stock Market Go Up?

And he has taught. Hundreds of thousands of everyday investors how to read. A company without a finance degree. So he went through every single company that Berkshire Hathaway owns and he even built his own tool to help him evaluate stocks just like Buffett. So you're going to learn how Buffett actually decides which businesses are worth his time.

You're going to learn about discounted cash flow and if you should consider something like that or not. You're going to learn about the five stages that a business could fall into and some of the metrics that you need to look at and why you need to evaluate a business differently depending on what stage that it is in. Then we're going to go through how to look at a company's history and make decisions based on that.

And finally, some of the other qualifiers that Brian has on his list. And by the end of this episode, you'll be able to look at a company and ask a lot of the same questions that Warren Buffett does. And then you'll understand why he owns Coca-Cola and American Express but doesn't own a single share of Tesla.

So I'm super excited for this episode. So without further ado, let's welcome Brian to the Personal Finance podcast. Brian, welcome back to the Personal Finance Podcast. Andrew, awesome to be here. Thanks again for for having me again.

It's always fun to come and chat with you. I am really excited to dive into this because we're going to talk through how to evaluate a business like Warren Buffett. And I think a lot of our listeners are super interested in this. I'm a huge Warren Buffett fan. I talk about Warren Buffett all the time. And this is going to be one that I think is really cool.

And one of my favorite things about this is that you built a tool that is going to help a lot of people be able to kind of evaluate some of these businesses as we dive deeper into this. So if anybody is listening to this episode and you kind of want to see what we're talking about as we start to go through this as well, make sure you're watching on YouTube, Spotify by Apple podcast, wherever you watch video, you'll be able to see some visuals on this episode as well, which is going to be really, really exciting.

So the first thing I want to talk through is, you know, back in the 90s, Warren Buffett was kind of talking through discounted cash flow and how he kind of evaluates a business. And Charlie Munger interrupted him and, or interrupted during that time frame or later on down the time frame and said, hey, I've never seen Warren actually run a discounted cash flow model.

So can you kind of talk through, you know, what Warren Buffett does and and what's really going on there? Yeah. So Buffett has been asked for, you know, he's like the king of valuation, right? Price is what you pay, value is what you get. So he has always had a sharp eye for figuring out how to figure out if a business is a buy or a sell, if it's undervalued or overvalued.

He's always been really good at about that. And he's been asked for years. You know, how Warren, what do you do? What is your process? And he always gives the standard academic answer to that question, which is basically, basically you build a discounted cash flow calculator, you figure out the cash flows of the business, you discount them back to present value and you have and you compare that to the current stock price.

So he gave that answer during one of his annual meetings. And Charlie Munger, as you point out immediately said, you know, he talks about these discounted cash flows. I've never seen him do one right. And this is on stage. And of course, it got a big laugh from everybody.

But what Buffett later kind of admitted, he says, you know, it's, it's true what Charlie is saying, he what, what he what he basically admitted is valuation to him is so easy and it's so simple that if, if, if looking at the business doesn't just scream at you, this stock is undervalued.

It's basically too close for him to call. So, so one kind of like mental waddle of a way of thinking about this. Imagine you're driving like a semi truck and you're going under. You see a, a bridge ahead and the bridge says like, you know, clearance like 9 feet, 6 inches.

Yeah, you could get out and you could like measure the top of your, your truck and see like, am I going to, am I going to make it? And you can do that hard work to figure out if you can go under the bridge. Well, in Buffett's mine, he's like, if it's too close to call, pass, like I'm not going to go ahead and do that.

So when he's valuing a business, if it doesn't simply scream out this is cheap on a first glance, it's too close to call and he and he doesn't bother with the advanced calculations. And I love that. I think that should be, there should be some natural inclinations of like how you look at a business and there should be some natural things where you can kind of react pretty quickly and make some quick decisions.

So then you can decide, hey, am I going to dive deeper into this or is this something that is probably just too close to call like you said, and I need to kind of move on. And so one thing that I love is that you kind of analyze and broke this this process down into steps. And so before we go through these steps, because I think they're really important for people to understand, what surprised you most about how simple this is?

Well, I think the surprising thing is just what you just said exactly how simple this is. You know, there are advanced college courses that on on how to value businesses. If you study the the academics out there like Oswat Demoterin, who is some of that I greatly admire. I think he does does great work.

You know, valuation is like multi tab spreadsheets with all kind of assumptions built in and discounted back to the present value and you get precise numbers from this. I just love that Buffett just throws all of that out the window and keeps things extremely simple.

I think there's great beauty in in simplicity and it's very clear that he developed a system that allows him to quickly and simply analyze a businesses. And I think the more simple you can keep the process for yourself, the better off you are in the long run. Absolutely.

And that's where I love like there's this this image that you show. You have this great YouTube video, which we'll link down below in the show notes. But there's this image that you show in that YouTube video of Warren Buffett sitting at his desk. And I've never seen the actual picture of this. I've always heard about him having this pile that's called too hard on his desk. But you actually had the image in that YouTube video, which was which is awesome, where he just kind of looks through a bunch of different companies.

And like if a if a company seems as though it is too difficult or too hard, he puts in the too hard pile. And famously, this was happening, you know, in the early 2000s during the tech boom, where he feels as though he probably missed out on a couple of them because they were just too hard. They were too hard for him to kind of understand during that time frame. And so I think that's really, really cool and interesting.

Good way that he kind of does that. Can investors kind of do the same thing? And do you do this? Is it? Is it too hard pile something that you consider every single time you look through a company? Yeah, absolutely. I think it's totally, you know, one thing that he has popularized over the years is just circle of confidence, knowing what you know and knowing what you, you, you don't know.

You know, I spent a couple years my life writing for The Motley Fool about biotechnology companies. And I was spending all day every day looking at finding, analyzing biotechnology companies. And what I learned after doing that for a couple years is this this whole category is just too hard.

Like you really have to, you already have to know a lot about the science and you have to follow the clinical trials. And even then, even when you're like convinced all this drug or this product is going to get approved, sometimes the decisions would come out of nowhere and they would blind side you.

Same thing to me with the banks, you know, people that invest in like JP Morgan or Goldman Sachs. I can guarantee you those people haven't read the 10K of of those businesses because they are insanely complicated. And as Buffett has says, you don't get paid more money for for for making things difficult on yourself.

In fact, some of the best businesses that he has owned and he made the most money on are really simple businesses that anyone can understand, right? Coca-Cola apples mood These like very simple, straightforward businesses, so there's no extra points in investing for for making things difficult.

And I think that's. Where most people get caught up, there's a lot of folks out there who feel as though the more complicated their models are, the more complicated the way that they analyze a stock is, the better off they are going to be long term. But simplicity is tried and true over and over and over again.

You can kind of see that simplify, simplify, simplify as much as you possibly can, even when you're evaluating stocks all the way down to the bare bones of what you need to understand. And then you can kind of go from there and build it out a little bit more. Is there anything that you would tell an investor who maybe is overcomplicating something and, or if they are not looking at investments and and throwing enough in the too hard pile, is there anything you would tell them in terms of, you know, some of the things that maybe they should consider in terms of simplifying this down a little bit more?

Yeah, always, always ask yourself, the most important investor to study thoroughly is, is yourself. Like what are you actually doing with your money? What is actually going into your portfolio? What have your actual returns been overtime and how do you behave during during downturns, which is really the, the, the true thing that matters for an investor.

Investing is easy and fun during bull markets. It's, it's really during the bear markets that you discover things about, about, about yourself, but truly yourself go through your portfolio and say, could I explain to a layperson or to my, to my spouse or to my friend what this company does?

And could I answer some very basic questions about what this company does, how it makes money and why customers choose it over, over the competitors? If the answer there is yes, and you could, and you can do that. And I think all of us can do that with simple businesses like Nike or Chipotle or, or, you know, Marriott hotels.

We we could, we could let people, we could answer the question, what does this company do and why do people choose it? Could you say the same things about more complex companies like like Charles Schwab or again, Bank of Bank of America? I think if you actually push people to do that kind of thing, the answer would be no.

Exactly. And I think that's the, the, the perfect test of the way to kind of think about this. It's funny because I'm teaching my kids. So I have an 8 year old A5 year old and then my daughter's too young. But my 8 year old, I'm kind of teaching them about stocks and how to kind of think about stocks and develop some sort of thesis around them.

And one of the big things that we talk about is developing an explanation of what this company does, how they operate, some of those types of things. And his answers a lot of times because he's got a a kid's mind, a child's mind are so much better than what I've seen a lot of adults do only because he just simplifies everything all the way down and kind of looks at some of the things that kind of makes sense.

And so we're looking at companies that are a little bit easier for him to understand. But I think a lot of people need to figure out how to kind of simplify that down where they can have an explanation of what the company does, why it is does have this competitive Moat. Some of those different areas I think are really, really important. And so this is this system.

What we're about to talk about is going to help a lot with that is kind of thinking through, you know, some of the life cycles of a company and kind of where they stand. When I started the personal finance podcast, I had no idea how big it could become. I just knew I had something I wanted to share.

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Wayfair. Every style, every home. And, you know, you've talked about their, you know, each company is in one of these five different life cycles. And this is one of the things that Buffett kind of looks at and one of the ways that we can kind of see, you know, where these company life cycles are.

So can you walk us through these five different life cycles and you know how we can recognize if a company is at each and every stage? Yeah, this is something that I haven't heard many other investors talk about. I think some of the more advanced investors kind of know this intuitively.

But the only person that I heard put this concept into like words and visuals was Aswath Demotoran, who again, is is someone that I looked up to as an investor, even though I think he makes evaluation a bit too complex. But the general idea here is just like animals and humans and and and plants, businesses go through different phases in their life and you need to know what phase the company is in at any given time so you can learn how to analyze it correctly.

Anybody that knows the history of say Amazon, like inside of the company knows that for like 15 years or maybe more, the company was famously not profitable. Like they literally lost money or made next to no profits for again like 15 years.

And during that time the stock price while it was wild went up and up and up and up. And that confused me so much as an investor because I was like this business isn't making money. Its profits aren't growing yet the value of this company just keeps going higher and it's price to earnings ratio was ridiculous.

And in in in the stock price is still appreciated. From there, once I understood the mental model that there's different phases that the company and everything became clear because I was analyzing Amazon stock, assuming that it was in phase 4, the capital return phase, when in reality it was in Phase 2, the hyper growth phase.

And this mental model I think can be really helpful for investors because you need to analyze companies differently depending on where they are. As a simple analogy, you wouldn't look at a three-year old and judge it by its SAT score, right? It's simply too young in the child's life for the SAT score to be relevant.

Well, that's again looking at Amazon in the year 2003 and saying, well, what's the company's PE ratio? It's too early in the company's lifestyle to make that make that determination. So this, this mental model, this, this business growth cycle phase and we can go through it step by step is really useful for figuring out what metrics matter, when they matter and, and, and what doesn't matter at all.

Let's go through it. So like I think there there's five different phases here that we can go through and kind of give people an understanding of how to look at a business and how to decide, you know, where it is. And then you have a great tool that's going to help people just kind of do this really quickly and and fast, which I absolutely love. And so one of the things that we're going to look at here for investors is trying to understand, hey, what phase is this company in?

What phase is this business in? And then how do we make a decision based on that? I think that's kind of part of this process that most people need to understand. So let's go through each one. We go from there. So phase one is the startup phase. So what happens in the startup phase? Yeah. So this is when a company is in in just getting off the ground.

Maybe they have a little bit of revenue, maybe they're just in the R&D phase, but they have that they're not really actively going out there and getting customers. So think of like open AI six years ago when Elon Musk first funded them, right? It required a huge amount of capital, all kinds of researchers, all kinds of people pulling in, and they didn't launch their first product until what, 2022 or something like that.

So there was a multi year period where the company was hiring people, spending money like crazy, its losses were growing, and the company's revenue was 00 during this time period. So this is the startup phase. Every famous business that you've ever heard of was at one point in its life in the startup phase.

Now, because they're losing money, the way to judge them is not on revenue growth, it's on milestones. Did they launch a product, right? Are they getting new users to to their product? Are they doing something that indicates the business is making progress to getting them towards commercialization?

So companies that are in this phase today are companies like Rocket Lab or Lucid Motors or Ion Q, which is a quantum computing company. You can't look at any of these companies and say, boy, the price to earnings ratio looks really cheap on them because the things that's driving their price is really the milestones that they're hitting and the story that they're telling investors along the way.

Now valuing companies in this phase is very difficult because it's basically the price to hope ratio. It's like, what could this business be worth in the future if, if they can hit a, if they can hit a grant Grand Slam, which is very hard to do. So these businesses, phase one businesses are basically lottery tickets.

That's so this is basically the high risk phase. And if you're, if you're buying one of these companies, you it probably needs for most people to be a very small percentage of your portfolio if you're going to go this route. Is that kind of what your your thought process is on that? Absolutely, this is where the life changing returns live, right.

But this is where the odds are stacked as as high against you as you can. So a lot of biotechnology companies, small biotech companies are in this phase, no revenue that. And the thing that moves their stock is press releases related to phase one clinical trials and the stock goes up like crazy if they get FDA approval.

But these companies are losing money intentionally, and the losses are getting worse. OK, So the losses are getting worse. So that's where a lot of people are just kind of starting up. This is where a lot of companies you probably see, you know, can go into like the penny stock range. They can end up, you know, going backwards and or some of the the big wins are also in this pot as well.

So again, high risk in the first phase, in the start up phase. But this is also an area, if you have a very small percentage of your portfolio, maybe you want to go that route #2 is ramp. So ramp is going to be the second phase of a business. What happens in the ramp phase? Yep. So this is when a company gets a product or service to market, establishes clear signs of product market fit and revenue really starts to take off.

Now in this phase, the company is still growing, it's still hiring people like crazy, but the revenue growth and is so high in this phase that while the company is still losing money, instead of the losses getting worse every year, the losses have peaked and the losses are getting lower every year.

So companies that are in this phase have been on have products or service that have been established and they're growing customer counts. So companies like DraftKings, companies like Rivian automotive, companies like Soundhound AI, I'll be familiar with any of these companies. They've all established clear signs of product market fit.

They've attracted enough customers early on and generate enough revenue that it's starting to cover the the businesses costs. These businesses are significantly less risky than those that are in phase one, the startup phase and you can still hit grand slams in this phase, but these these companies are also high risk when compared to the other phases.

And so, yeah, this is still a small portion of your portfolio most likely, but you can take some, you know, calculated bets potentially. And it's it's one of those areas that I think it's pretty interesting. A lot of these are probably more recognizable names as well for a lot of folks. And so you can kind of see some some really interesting things there.

The third one is operating leverage. Now this is where it gets a little bit fun, I think. And this is where it gets interesting because there is a shift from maybe some of these being in the start up and ramp phase where they're just the hot. The risk is really high and you can find some some nice companies here. Yeah, absolutely. So in the phase three, the operating leverage phase, the business has crossed over the point where it has reached break even.

So the company is profitable, but just barely in many cases. And the real goal of the company here is to achieve enough size and scale where it can start to optimize the business for profits. Up until this point, the management teams of these companies are really hyper focused on revenue, get customers, get market share, take advantage of the market opportunity.

Profits are not the focus, revenue and revenue growth is. That's how these management teams are judged. Once they get into the operating leverage phase. They've proven that the business has economics that work that they can, that they can fund themselves, which makes themselves dramatically less risky than in phase one or phase two.

But now the now the focus becomes grow revenue and start to optimize costs. So these businesses are not fully optimized for profits yet and that is the thing that the management teams try to do during these phases, really go from optimizing for revenue to optimizing for profit.

I love that and I think, you know, you have this and on the chart, we'll put it on the screen here so people can see it, But Brian has this chart here that I think is really cool where it kind of gives you the human equivalent to help you understand, Hey, what are all of these phases? Like if you were someone, you know, in life and in the life that you've gone through. And for the start up phase, Brian has, you know, a college student kind of burning called loans.

You probably have a negative net worth. Most likely you're kind of doing this thing where you're, you're going deeper into deeper into debt, but you have potential, like you have potential to be able to, to do a lot of cool things. And the ramp phase, you're in your, your, your first job, you're still eating ramen, you're still, you know, trying to just get things figured out. I remember during this time frame, I wasn't making much money, but I was living paycheck to paycheck.

And that's still kind of like the company version of that is the ramp phase and then operating leverage. This is where I think it makes a lot of sense. It can all come together for a lot of people is like someone who is in, you know, their mid career, they're starting to get raises, they're starting to save hard and you're starting to build a little bit of wealth here. And I think for a lot of folks out there that can help them kind of think through this in a, a human equivalent, which I think is really, really cool that you have this year, right.

Phase four, this is the this is where it gets fun is the capital return phase. So this is one that we we are going to be talking about probably a little more here. So what is in the capital return phase? So this is when a company has gone through phases 1/2 and three, and now the business is fully optimize for profit.

Along the way, the company has been reinvesting all the profits to hire more people, launch new products, maybe make acquisitions. But the company is now fully optimized for profits and the business is far more predictable and stable than at any time during its life.

And this is finally the phase when the company has excess capital. It's actually producing more profit than it knows what to do with. And one decision that management teams can make during this phase is all right, we're making all this extra profit. Let's finally start to give some of this capital back to the owners of the business, the shareholders.

And there's there's three primary ways that a company can do this. The first way is the most boring, but it's pay down debt. If the company has debt that it has acquired some of these businesses true to pay down their debt to again make the business more more robust.

The second way is to repurchase the company's own stock. So this is the buybacks that get all kinds of negative press about them. But this is just when the company is repurchasing the stock on the open market, which shrinks the share count and that boost the company's earnings per share.

And then the final way that they can return capital shareholders and just to give it to them as a cash payment and we call that a dividend, A dividend payment. So phase four, capital return is finally when the company is reliably producing cash and starting to return it to shareholders.

And your examples of this is something like an Apple or a Costco. And the interesting part about this is I remember when Apple finally started to issue a dividend, it was this huge big deal. And that was kind of their crossover point to do the capital return phase where you could see a lot of this was happening where they're just growing more and more and more and they just have so much cash on hand now.

They didn't know what to do with it anymore. And so they had to do something with it with no debt or anything else. So this is the area where I think is, is super interesting. Like some of these examples, for example, like in operating leverage, we have like kind of Amazon and Tesla are kind of in that range. And then you look at capital return, have you ever seen companies go from being maybe being a capital return company backwards back into an operating leverage company again?

Absolutely yes. These are these are loose guidelines and you can go from one phase to the other and you can go forward. You can also go backwards. Let me give you an example. So in around the year 2012, Netflix was a capital return company.

The company was actively profitable, it's DVD business and it was buying back stock. One of them that follows Netflix knows that they chose to disrupt themselves. They essentially transition the business to being a streaming company and doing so required a lot of capital.

So they were in the capital return phase phase. They suspended all buybacks and took all of that capital and put it back into the business. And during a period of time, I don't know if they were losing money, but they were certainly nowhere near as profitable as they were. And that takes real guts as a as a CEO to do.

Very hard to go backwards on this. But the the founder, Reed Hastings was still the CEO at the time. He knew this was right move for the business. He chose to disrupt themselves. So they slid down back into hyper growth phase, completely trans form the business and as the streaming has obviously taken off, that was a brilliant move to do and now the company is fully back in phase 4, the capital return fee.

So it is possible to slide backwards on purpose, but very few companies do that. Let me give you a human equivalent example of this. So this is perfect. Is my brother-in-law, for example, is now an executive at a very large, a company that a lot of people would know. But before that he was a middle level manager.

And when he was a middle level manager, he realized I couldn't grow anymore at the place that I'm currently at. And so he actually took a demotion in another department in order to kind of climb the ladder again. And so this is kind of the one of those examples of, you know, how you can look at that for companies as well. Sometimes it's not really that the company's going backwards, but they're just shifting strategy for a time frame so they could grow a little more.

And it like you said, it's hard to do that. It's hard to go from one phase backwards to the other and then try to try to shift there. But I think that's a really important thing to note. And then the last one is decline and decline is something that is the the last phase here. So what is decline and can you tell us more about that?

Yeah, this is the phase that no company wants to be in, right. But we live in a capitalist society and is it is always just a matter of time before businesses become disrupted and they become irrelevant. So the decline phase, kind of tricky to figure where out that is.

But these are your old stodgy businesses that are just not adapting to the modern times and they're slowly bleeding customers every year. So every year revenue goes down that causes the other expenses to remain high, so the profits go down even faster. These companies can be losing money and you hear things like they're in turn around mode.

So this is where like Bed Bath and Beyond used to be, RadioShack used to be. I would say that right now, Target and Altria Group are kind of in this category. So you are not dead by any means, but revenue is trending in the wrong direction and usually drastic action is needed to get these companies back to the capital return phase.

So Sears for one time was like in the in the capital return phase for for decades, one of the most dominant businesses in America. Now it's bankrupt, right? So lots of famous examples of companies that were once at the king of their industry and are now shells of their former selves or just, or just completely bankrupt altogether.

So this this is a phase that no company wants to find its itself in, but every company eventually will. Would you find something like a hot stock? Right now we're just talking about is like a Nike or a Lululemon. They've kind of declined in terms of like their stock price. But would that would that be something that would fall in in play into into this category or not quite yet?

Yeah. So, so that's a really good point because a stock price declining may or may not indicate that the business is in decline. So stocks react far more wildly to, to change far more drastically than the, the company's operating business does.

So for drawing the line between what, what separates capital return and decline is actually really, really hard thing to do. What I came up with is basically two years in a row of revenue decline because some companies occasionally go through rough patches for a couple of quarters.

You're, you're still in the capital return phase, but I think two years in a row of declining revenue and declining profits, that's what triggers a company to be in the decline phase. And again, just because you're in the decline phase doesn't, I mean, you're stuck there, you can do things to get back to the capital return phase.

I mean, Apple was in the decline phase in like 2000 before they, they rehired Steve Jobs. Seven years ago. Everyone thought that Best Buy was in the decline phase because it was just a showroom for Amazon. Best Buy stock has flourished since there.

So it is entirely possible to return yourself to the capital return phase. It's just very hard to do. So why is knowing what phase the business is, the business in it, the thing that that you need to get right before you try to value anything?

Why is this so important for investors to understand? Because if you don't know what phase the company is in, you don't know what metrics you should pay attention to and you don't know how to tell if the management team is doing a good job or or not. So for example, if you're in the startup phase, you can't look at that company and say, well, the price of free cash flow ratio here is negative.

So this business is just insanely overvalued. No, the way that you value startups is based on how big of a market opportunity is this and what milestones is the management team hitting along the way? That's what really matters in a startup startup phase. Startup companies are extremely hard, extremely hard to value in the hyper growth phase.

Remember, these companies are losing money, the losses are decreasing and sales are increasing rapidly. If you're going to be analyzing these companies, you should judge management teams based on the revenue growth rate and the gross margin change. Those are the key metrics that indicate the businesses having success.

And if you're going to value it, you should value it on the price to sales ratio. So every phase that you're in changes the key metrics that you need to look at and that you should judge management success on and the way that you value it. So you have this tool that you created that is super cool that that allows you to kind of see which phase businesses are in and helps you kind of look at this.

Can we show this on the screen? And maybe we'll go through a couple of different companies and, and kind of show exactly what this looks like. So people can see, you know how you can kind of evaluate this and see these phases, 'cause I think these visuals are super helpful for people. Yep, Yep, sure. So I built a tool, it's stock simplifier.com back slash phase.

It's a completely free tool to use and you can just enter any company and it'll go through, analyze the financial statements and give you the numbers and then AI analysis on what phase it thinks it in. So any of these stick out in your mind is worth investigating. Let's do, let's do some.

OK, we'll think of a couple of Warren Buffett companies here. So let's start with Coca-Cola. Let's start there and see what comes up. OK, Coca-Cola is KO. So Coca-Cola, this one's probably going to be pretty easy and I think I know the answer to it, but Coca-Cola. So let's take a look. There's really three questions that you asked.

Number one is revenue growing. So yes, Coca Cola's revenue here is still growing very slowly, but it is growing. Question number 2, is the company profitable? Here's a key thing you have to understand. The way that you judge profits changes from industry to industry.

You can't judge a bank's profitability the same way you judge a beverage company's profitability. They can't judge the same way you can't judge a tech companies. So we actually pick a metric, a profit metric based on the industry that the company's in. In this case for Coca-Cola, we we use operating profit.

That figure is also positive and growing. And then finally, is the company buying back stock, paying a dividend or both? O yes, Coca-Cola is buying back stock and yes, it's paying a dividend. O when combined, Coca-Cola is in the capital return phase according to that those three questions.

And that means you should judge the management team based on their capital allocation skills. You shouldn't judge them based on milestones, right? The most important metric to watch is free cash flow and the best metric to value it is price to earnings. So Coca-Cola is a fairly easy business to analyze and value because it's in the capital return phase.

OK, let's do another one. Let's look at let's look at Nike, the one we just mentioned because I want to see it's interesting, Nike has been declining for a long time, but let's kind of see where it where it lands with, with the phase that it's in. And Nike is, I have a feeling is going to be one of those, but that's like literally on the razor edge here.

So Nike, so it's a consumer discretionary company in the textile business. So the correct profit metric is operating profits. So is it growing? Well, it's growth is 0%, right? So revenue was 51 billion in 2024, that dipped to 46 billion and it's basically flat year over year.

So boy is that hard. It's like, is that two years in a row of decline? I mean, technically, technically no, but it's it's right on that razor's edge. Is the company profitable? Yes, it is profitable, $4 billion in operating profit over the last two 12 months, but that's down from 6 billion.

Is it buying back stock? Yes, but the buybacks are declining. And is it paying a dividend? Yes, it is paying a dividend. So stocks up of the the app here does say Nike is in Phase 4, but boy is it on that razor's edge in being in phase five.

And This is why it's really important to look at revenue growth as as the key metric. So again, you're almost might be splitting hairs here. You could argue it's in Phase 5 even though it's technically in Phase 4, but either way, not a good recent trajectory for for Nike's business.

That be 1 potentially, you know, you could use the tool and all of a sudden you could look and say, OK, well right now I'm looking at this and maybe I'm going to hold off for another two or three quarters before I actually do anything on this to see which phase it actually falls into. So that's a perfect example of one that may be a waiting position or something to wait on.

Let's we can do one more. Let's think through maybe either let's do an Amazon or a SpaceX. Which one you think would be better? Well, I'm, I'm curious in space, in space SpaceX, we have it SPCX. Let's see, SpaceX operating cash flow is positive.

I'm not sure that that is actually correct. SpaceX is multiple businesses in one. See that this gets into the point of the, the, the analysis here. Analyzing these businesses is very difficult. Some businesses are easier than others. SpaceX is an AI company, a rocket company and a satellite company kind of all, all in one.

So let's just call that one probably too hard to analyze this. What was the other one you said? Amazon. Amazon, yeah, much, much cleaner business to look at Amazon. OK. So Amazon is revenue growing, yes, 12% in the last year to 717 billion.

I think Amazon is the most revenue of any company in the world. I believe so, Yep. So it is a broad line retailer, at least that's how it's classified. That's even, that's even a question mark there because it's like, yeah, is it a retailer? Is it a tech company? Is it a, is it a tech service provider?

Like there's so many businesses under Amazon, but it says, OK, the the best profit metric to use here is the operating profit number. And then finally, is it returning capital, shareholders? No. So revenue is growing. So operating profit is positive. And they do occasionally buy back stock, but nothing over the last three years, no dividend.

So Phase 3 operating leverage. So how do you analyze Amazon's business? Take a look at growth and margins. Those are the key things to judge management on. The key metric to watch is operating margin and the direction of that and then you value it using the not the trailing price to earnings ratio, the forward price to earnings ratio that's looking a one year ahead and saying what's the estimated profitability of the company.

That's what's so helpful about this. It kind of tells you, hey, what are the metrics that you need to be looking at based on what phase this company is in. And that's what's the most important thing for investors is to understand kind of how to to look at those metrics. And so that's why this is so helpful. I love that for sure. Yep, and and the reason we give you the data behind all this is because it can be sometimes easier for a human to see the kind of nuances there and and almost disagree with what the tool says.

So we provide you with the information and you can make the call because sometimes companies fall very cleanly in this line or another. Sometimes it's not clear at all. In either case, I just think the general mental model in your head of what phases it in, what are the key metrics to look at and then use your your human judgement to judge based on what you know about the business is a vital is a vital step.

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And so once people understand what phase the business is in and they're looking at this and saying, OK, I went through some of the things on my watch list currently and I put some of the two hard pile and then I decided some of these are worth pursuing. And I now I understand, you know what phase the business is in, what metrics to look at, what is the next thing they should do?

Yep. Well, so the next thing that Buffett does and again we're basing this based on Buffett. So Buffett, the first thing he does is say, OK, is it in, is it in a phase, phase that I know which he invests pretty much exclusively in phase four and phase five, phase five, that is his thing that the next thing that he he looks at is instead of doing discounted cash flow analysis, remember that Buffett keeps it simple, simple, simple.

So he uses multiple analysis to make valuation decisions. So the phase analysis is important because it lets you know, well, what multiple should I look at to make that decision? And then you and then and then Buffett basically he almost exclusively uses price to earnings ratio given the faces that he looks at, but he looks at the multiple and then compares that to both the absolute level that it trades at and the company's recent history, recent trading history to figure out is that a cheap number or an expensive number.

Awesome. And I think that's kind of where a lot of people, you know, can look at this and say, OK, this is this is one of those areas where we're looking at this multiple and we can kind of decide and make some choices based on that. Is there a mistake people make? Like when they look at the PE ratio, for example, this is something I think a lot of investors when they first get started, this is the first number that they're taught or one of the first numbers that they're taught to look at.

Is that the wrong metric to look at? Or how do they kind of have to think about that when they make decisions based on APE ratio? Yeah, the PE ratio is simultaneously one of the most helpful ratios and one of the most confusing ratios at the at the exact same, same, same time. So the price dragging ratio for those that are unaware, just compares the market cap or the the value of of the stock to the companies earnings typically over the last 12 months.

Now when those numbers are clean, when a company is fully optimized for earnings, AKA it's in phase 4, the PE ratio is very, very helpful because it's a quick way of you looking at a number and saying well this company is cheap or this company is expensive.

It's a very short shorthand way of doing it. The problem with using the price to earnings ratio is not the P, it's the E it's the bottom number in that equation. And there's a whole bunch of reasons, accounting reason why a company's earnings might be overstated or understated that there could be accounting reasons like if you make a big acquisition, if you take a big, if you take a big write off, if you pay a lot of stock based compensation, all of those can impact your earnings positively or negatively.

And if the E in in that equation is being influenced up or down, well, that by definition means that the price to earnings ratio that you're seeing on the screen is also going to be impacted, sometimes up or down. This is why, again, I was so confused for a long time because I was like, how can Amazon trade it 100 times earnings?

Like every book I've ever read says that 100 times earnings is way too expensive. And yet the company was actually cheap at 100 times earnings. And if you bought it in 10 years ago, 20 years ago when I was trading at those insane prices, it was a great it was a great buy.

So the PE ratio can be useful as long as it's in the correct phase, phase four, and the earnings are fully optimized and there's no accounting gimmicks. But you have to have those two caveats in place in order to use it. So once we have the right multiple and we're looking at that, you know, you've decided, OK, I understand what phase this is in.

I'm looking at the correct multiple currently. What do they, what do you do next? Because I saw, you know, when you were talking through comparing a company to its own history, for example, is, is the next thing that you kind of talked about in your, in your video, which we again, we'll link that up down below. And I loved that. I love the way that you can kind of look at this because in, in stock simplifier, you have a basically a tool that allows you to look at a company's history.

And so how do we kind of do that? And why is this so important? Yeah. So, So what I like to do is I like to, when a company is fully optimized for earnings and here on screen, if you're following us, we, you have Coca-Cola. Coca-Cola is a great company to use the price to earnings ratio on.

This is a very stable, highly profitable, predictable business. Coca-Cola is a company that the price to earnings ratio absolutely works on. So what this tool does is it just shows you, well, what is the range of the company's PE ratio over a different time period.

And in this case, I just chose five years. We can go longer if we want to, we can go shorter if we want to, but I just chose five years. So with Coca-Cola, over the last five years, the company's PE ratio has averaged 26.1. Sometimes it's been as high as 29, sometimes it's been as low as, let's see, 21, but it's basically in that range of 2126 times times earnings.

So what we do is we then show you how does that compare to the current PE ratio of the company. And as of the time this recording Coca-Cola PE ratio is about 26.4, so ever so slightly above the range that is traded at over the last five years.

And when presented visually like you're seeing on the screen here, I think it's fair to say that Coca-Cola stock is fairly valued right now, right? So it's not extremely overvalued. It's not extremely undervalued. I would think that it's fairly valued.

And then we just apply some bands kind of above or below that to say, well, this stock historically over the last five years has been cheap anytime it trades below 27.4 times earnings and it's been expensive when it trades above 27.5 times earnings.

So as a time is recording, Coca-Cola stock is about $8788 per share and I would consider it cheap at about $82 per share and expensive at about $92 per share. And you know you can adjust those up or down kind of as you see fit.

But when you look at a company using this kind of view, it becomes very obvious. Well, Coca-Cola stock was obviously cheap in October of 2023 and the company's stock was expensive in September of 2024.

So this is the kind of analysis that I'm very confident Warren Buffett does when he's analysing businesses. Again, this requires no advanced math. This is like back of the envelope scream you incredibly simple way of determining is a company cheap or is it expensive?

But remember the caveats that we gave upfront. This only works if the company is in the right phase and there's nothing nefarious going on with the company's earnings. So as long as it checks both of those boxes, I think this kind of analysis is very simple and easy to do.

Awesome. I love. This and I think, you know, this visual just helps, you know, anybody when you look at this, you'll see, you know, this is a very simple thing to to understand and look at and it's very helpful. I mean, it's one of those areas where you can kind of see, you know, just the trends of the, the historic return or the the stock price and kind of where it was.

And I think that's really, really important and I love that you can kind of take it out even further too. I think that's super helpful. If you want to go 10 years or even longer, I think that's really, really powerful. So that's awesome. So looking on screen here, Andrew, we can see that during the period, what's this 20/20/17 to 2019 during this time, like Coca Cola's price to earnings ratio was sky high, like well above 40, like way outside of this range.

So your first inclination might be to be like, oh, the company's stock was very expensive at this time. My hunch would be if we went and dug into the numbers that actually the company's earnings were temporarily understated. There's during this period, maybe it was an acquisition, maybe there was a goodwill write off that they had, maybe they had some kind of one time legal settlement or something like that that caused the number to go kind of crazy.

But if you didn't know that nuance and you just looked at the company's price to earnings ratio during this time, like it got a high as 150, you'd be like, oh God, Coca-Cola stock way too expensive right now. But that's why you need to understand the nuance of how earnings are calculated before you can use it as a reliable valuation metric.

And that makes complete sense, which is why it's important to to do your homework and do the extra research to make sure you understand why this is happening. If you see something that looks way off from everything else, you got to dig deeper and figure out why that is. Otherwise you're flying blind. The last step that we talked about is adjusting for quality.

And I think this is where, you know, you've talked about this is where the art comes in a little bit and there's a little bit of, you know, experience can come into play on this as well. So how, how does this work? How do you kind of adjust for quality? And then how does a beginner kind of build a judgement here when it comes to adjusting for quality?

Yeah. So this is something that again, I had to learn the hard and expensive way. Some companies out there are cheap, are literally cheap when they trade at APE ratio of 30 and other businesses out there are expensive, legitimately expensive when they trade at 10 times earnings.

So if that's not confusing I don't know what is. Like why is the why are some companies cheap when they trade at 30X earnings and others are expensive when they trade at 10 times earnings? Well, that takes down to the quality of the business. This is something again I've learned the hard way as a general statement, the more predictable, the more recession proof and the higher growth a company's earnings are, the more the market, the higher the multiple the market assigns to that earnings.

If you look at Costco's price to earnings ratio right now, it's very high. I think it's like 40 or 50. But it's hard to find another business in the world with more predictable recession proof earnings out there or profits out there that then Costco.

Inversely, if you were to look at a bank or an automaker like GM or Ford, it's very common for those businesses to trade at single digit price to earnings ratios. Same goes for like oil companies. Now, now why?

Well, that's because those companies earnings are often highly dependent on outside forces. So in the case of oil companies, the price of oil highly dictates how much profits those companies will make. When oil prices are high on the earnings of ExxonMobil and Chevron spike up.

When when a crash comes along, those companies profits all but disappear. So the market knows that those companies profits are not recession proof and they're not predictable. And therefore the market assigns those businesses a lower multiple than they would a highly predictable company like Costco.

So growth takes into account how recession proof the companies earn earnings are takes into account and how predictable that takes into account. You need to adjust the average number for those factors. When you're going to tell is a company stock cheap or expensive, it's absolutely vital.

That makes sense. And I think that's, that's super important for people to understand as they get to some of these these final phases is making sure that you have those in place so that you don't get fooled. I think that's really, really important. So that's, that's a great tip there as well. Well, Brian, this has been absolutely amazing. I think, you know, people are going to absolutely love this.

Where can they find out more about you, Stock simplifier and everything else? I'm on any social platform, so just search for my name, Brian Feraldi. And if you want to check out that phase tool that I showed before, you can just enter any stock. It'll tell you what phase it's in. It's stock simplifier.com back slash phase and it's completely free to use.

Awesome. Well, we'll link all that up down below in the show notes below. So, Brian, thank you so much for coming on again. Thank you for having me Andrew, always fun to be here.