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2:26

All right folks, welcome to Investing for

2:28

Beginners podcast. Today we're going to talk

2:31

about four ways to value a stock.

2:33

I created this handy dandy little infographic

2:35

that I will share in the show

2:37

notes that talks about four ways that

2:39

you can value a company. And Andrew

2:41

and I thought we would talk about

2:43

the four different ways and maybe throw

2:45

you some examples of companies you can

2:47

use for each particular type. So maybe

2:49

we can start with price to earnings

2:52

or the PE ratio. So what are

2:54

your thoughts on the PE ratio? What

2:56

does it mean? How do we figure

2:58

it out? And what would be

3:00

some good examples to use with that?

3:02

PE ratio stands for price to

3:05

earnings ratio. You put the price

3:07

divided by the earnings and that's

3:09

your PE. So what that tells

3:11

you and what it gives you

3:14

is a tool where you

3:16

can compare companies apples to

3:18

apples. So I can look at

3:20

Apple who is a three trillion in

3:23

the market cap, 90

3:25

billion dollars in profits,

3:27

and I can compare

3:30

how expensive that company

3:32

is to something like

3:34

Simpson manufacturing that

3:36

has. 800 million in profits

3:39

or something like that. And

3:41

so you're giving yourself a

3:43

way to compare options in

3:45

the stock market because at

3:47

the end of the day when you

3:50

are picking a stock in the market

3:52

you are saying I am buying you and

3:54

I'm saying no to every other stock

3:56

in the world. Very special

3:59

decision. And that's kind of

4:01

what it comes down to because as

4:03

investors we have so many options of

4:05

what we want to do with our cash.

4:08

You could put it in a savings account,

4:10

you could put it under your pillow and

4:12

maybe that helps you sleep better at night.

4:14

Any of those things you can do,

4:17

you have to ask yourself is buying

4:19

Apple stock or is buying Simpson manufacturing

4:21

stock? Is that the best option

4:23

for me right now? One of the tools

4:26

you can use to help you decide

4:28

that is the PE ratio, because then

4:30

you can know essentially how much

4:32

are you paying for companies

4:35

earnings. Yeah, exactly. And the way

4:37

I kind of try to think of

4:39

it is it relates relationally to what

4:41

you would pay for the earnings

4:43

of the business. If you see

4:46

a company that has a PE

4:48

ratio of 10, that means you're

4:50

paying $10 for $1 of earnings

4:52

of that business. It's an easy

4:54

way to value companies in a

4:56

way that it's a it's a

4:58

it's a nice jargon. So Andrew

5:00

and I can talk about relative

5:03

companies related companies and talk about

5:05

the PE ratio and it's a

5:07

language that we could both understand

5:09

and it's a shortcut if you

5:11

will or shorthand for value and

5:13

company. We still. are big fans of

5:15

discounted cash flow models or DCFs,

5:18

but this is an easy way

5:20

to, especially if you're like screening

5:22

for companies or looking for business

5:24

to invest in, and you can

5:26

use a PE ratio or any

5:29

ratio like this that we're going

5:31

to talk about today as a way

5:33

to value a company and see what

5:35

other people in the market think

5:37

it's worth. And generally, the lower

5:39

the better, but Not always. And

5:42

sometimes it depends, right? And

5:44

I think you also, one

5:46

thing to keep in mind

5:48

is different industries are going

5:50

to have different ratios. So

5:52

for example, if you look at

5:54

the PE ratios of the home

5:56

builders or banks or some of

5:58

the big high flying. text stuff,

6:00

you're going to see maybe not

6:03

a wide range, but you're going

6:05

to see different ranges. And what

6:07

may be really high for the

6:09

banking industry, let's say a Wells

6:11

Fargo, for example, if it trades

6:14

at a 16 PE, that might

6:16

be kind of expensive for a

6:18

bank. But if you look at

6:20

a PE of 16 for meta,

6:22

that's really low. And so it

6:25

just kind of depends on where

6:27

companies trade and whatnot. Is there

6:29

a PE ratio that is too

6:31

high for you? Like if you

6:34

see this, you're like, no, not

6:36

yet. Yeah, it depends on interest

6:38

rates. It depends on what growth

6:40

rate I'm targeting. I would say

6:42

when you get above 35 in

6:45

today's market, anything above 35, I

6:47

would start to get cautious. And

6:49

anything above 45, that's not Costco,

6:51

I would not buy. I love

6:53

that qualifier. It's not Costco. Yeah,

6:56

I would pay, I would pay

6:58

more for like a Visa MasterCard

7:00

Costco than I probably would for

7:02

JP, not a GP Morgan, that's

7:05

a special case, but maybe Wells

7:07

Fargo or something along those lines.

7:09

Right, right, right. Yeah. And like,

7:11

I think a good example of

7:13

how these can be so different.

7:16

depending on different variables. We were

7:18

talking last episode about TSMC Taiwan

7:20

semiconductor and you mentioned that they

7:22

can trade for a lower PE

7:24

ratio compared to what the value

7:27

that they create because of some

7:29

of the geopolitical risks that's priced

7:31

in to the company. So if

7:33

you look at a dominant company

7:35

like TSMC, they can still trade

7:38

at a fairly low PE ratio,

7:40

even though it's a beast of

7:42

a business. So that's what's interesting

7:44

about using the PE ratio. You

7:47

have to understand the limitations, but

7:49

you also have to understand the

7:51

variables that can go into where

7:53

the company might trade. Totally. Yeah,

7:55

you don't. want to just use

7:58

it blindly. I would say the

8:00

other thing, the types of businesses

8:02

that you try to apply it

8:04

to or the types of stocks,

8:06

it's been to work for some

8:09

types of companies and it's not

8:11

going to work for others. So

8:13

in general, I mean it could

8:15

work for a lot of companies

8:18

but in general you want to

8:20

look for companies that are later

8:22

along their life cycle. And for

8:24

obvious reasons, you can't use a

8:26

price to earnings ratio on a

8:29

IPO stock that does not make

8:31

money because you need earnings to

8:33

do a price to earnings ratio.

8:35

But even there are stocks, Uber

8:37

not a good example, because they

8:40

actually also have a low PE

8:42

ratio right now, but there are

8:44

stocks in the Uberesque stage where

8:46

they are blossoming into these. potentially

8:48

multiplying their earnings because their margins

8:51

are expanding by a lot. You

8:53

can get exponential growth in those

8:55

situations. And so a PE ratio

8:57

might not be good for that

9:00

either because they are not in

9:02

this cash flowing mature side of

9:04

the company life cycle. They are

9:06

still in the. I'm a seed

9:08

exploding out of the ground and

9:11

let's see where I where I

9:13

go life cycle. So you do

9:15

want to make sure also you

9:17

are looking at PE ratios for

9:19

companies that earnings are stable. You

9:22

talk about home builders, one of

9:24

the reasons why home builders price

9:26

earnings ratios are so much lower

9:28

is because that E part of

9:31

the equation is crazy. It is

9:33

there's wilder than the waves in

9:35

Southern California. So PE can get

9:37

all all out of whack in

9:39

companies where the earnings are volatile.

9:42

So you also have to be

9:44

careful when you're looking at a

9:46

PE if it looks too good

9:48

to be true or if it

9:50

looks too bad to be true.

9:53

Like I just. a stock six

9:55

days ago that had a PE

9:57

of 144. But if you look

9:59

at a longer average of their

10:01

earnings, you realize, oh, okay, it

10:04

is an Andrew stock. It's not

10:06

some AI bubble stock. So those

10:08

are all things I think to

10:10

keep in mind. Make sure you

10:13

are applying matching the PE ratio

10:15

to the types of stocks that

10:17

it best applies to. Yeah, that's

10:19

a fantastic point. I think our

10:21

friend Brian Farraldi, if I remember

10:24

right, he said a PE ratio

10:26

is great to use when companies

10:28

are fully optimized for profits, I

10:30

think is how he said it.

10:32

And I think that, to me,

10:35

that really kind of resonated. To

10:37

your point, a company that I

10:39

followed and have not taken participation

10:41

in CrowdStrike is not fully optimized

10:44

for profits. And so you're trying

10:46

to use a PE ratio for

10:48

that company would be futile. trying

10:50

to use it for Berkshire Hathaway,

10:52

which you could argue is definitely

10:55

fully optimized for profits, would also

10:57

be futile because of the nature

10:59

of accounting and how their income

11:01

statement works. And because they have

11:03

a very large investment portfolio, 300

11:06

billion or so, the way accounting

11:08

works is they have to realize

11:10

unrealized losses or gains on their

11:12

income statement. And so even though

11:14

Buffett doesn't sell any... Coca-Cola for

11:17

example, if the stock is up,

11:19

he still has to realize those

11:21

potential gains or losses on that

11:23

investment. And so that can make

11:26

his PE ratio. You can swing

11:28

from 3 to negative 40 to

11:30

122 and quarter by quarter. So

11:32

it could be kind of crazy.

11:34

So you have to also be

11:37

aware of. What kind of company

11:39

it is and what's going on

11:41

with the accounting rules because that

11:43

can make a big impact on

11:45

it as well. So I think

11:48

all the points you made were

11:50

the best ones. What would be

11:52

some companies maybe you throw out

11:54

there to you could use PE

11:57

ratio as an example? Maybe. like

11:59

three or four. I would say

12:01

most of the top stocks in

12:03

the S&P 500, Apple, Microsoft, Alphabet,

12:05

arguably, Amidia, but you know, it's

12:08

it's kind of in its own

12:10

universe right now. A company that

12:12

it did not work well for

12:14

for a while is Amazon, and

12:16

for the same reasons you were

12:19

talking about with Berkshire, how marketable

12:21

securities, aka one company owning another

12:23

company stock. In the case of

12:25

Amazon, they had a big stake

12:28

in Rivian. And I guess Uber

12:30

has a pretty big size of

12:32

marketable securities as well. So companies

12:34

like that, you do not want

12:36

to use the PE ratio for.

12:39

Right. Totally agree. Totally agree. All

12:41

right. So maybe let's move on

12:43

to the next one, which would

12:45

be the price to sales. or

12:47

the PS ratio. So let's talk

12:50

a little bit about that. Like

12:52

what does that mean and how

12:54

should people use that one? Similar

12:56

to price to earnings. We're going

12:58

to take the P on top

13:01

and instead of E we're going

13:03

to take an S and so

13:05

that's the sales. Price to sales

13:07

can be nice because the thing

13:10

we talked about earlier about earnings

13:12

being jumpy. You don't see that

13:14

as much usually for most companies.

13:16

Sales tend to be a lot

13:18

more kind of up into the

13:21

right. Of course you have your

13:23

exceptions and cyclicals and commodities can

13:25

have sales that are just as

13:27

wild as some companies profits. So

13:29

you do always have to be

13:32

careful with that as well. But

13:34

what's nice about price of sales

13:36

is and I'm not a growthy

13:38

investor, but from my understanding, if

13:41

you're a growthy investor with. At

13:43

least you respect valuation. You can

13:45

use price to sales to compare

13:47

valuation and get a decent sense

13:49

of how exciting. is the stock

13:52

market for this company? Does it

13:54

need to grow 10x for me

13:56

to get a good return or

13:58

does it only need to grow

14:00

2x for me to get a

14:03

good return? And sometimes price of

14:05

sales can help you with that

14:07

too. Yeah, exactly. I think it's

14:09

probably the perfect one of the

14:11

best ratios used for you were

14:14

talking about the life cycle. If

14:16

a company is an IPO or

14:18

post. IPO or it's in the

14:20

early sprouting stages of growing its

14:23

revenues and potential profits. I think

14:25

that's when you want to use

14:27

this kind of ratio. So if

14:29

you're looking at companies like a

14:31

crowd strike, a cloud flare, Palantir,

14:34

even Uber early on, those kinds

14:36

of companies, as you put it,

14:38

the growthy companies, the price to

14:40

sales is a really good ratio

14:42

to use because They don't have

14:45

profits to measure against, and it's

14:47

also easier to measure against like-to-like

14:49

companies. I think that's something important

14:51

to remember when you're using any

14:54

sort of ratio to value companies

14:56

as you want to compare them

14:58

to like-to-like. You don't want to

15:00

compare Palantir to Bank of America.

15:02

That's not going to be a

15:05

fair comparison. If you look at

15:07

the price to sales of Palantir

15:09

versus Bank of America, you're going

15:11

to... What? That's kind of the

15:13

way I look at it. Are

15:16

there any, is there a ratio

15:18

too high with this one? Like

15:20

the PE that you'd be like.

15:22

Well, I don't really use it,

15:24

so I don't know. Do you,

15:27

are you familiar with any? No.

15:29

I don't know. I don't know.

15:31

I remember back in a day.

15:33

I think I remember reading that

15:36

price to sales of 10 or

15:38

less was what you would want

15:40

to see. I read recently priced

15:42

to sales of less than one

15:44

is ideal. extreme, but I know

15:47

some of the growthy people that

15:49

I follow on Fintuit have talked

15:51

about anything above like a 15

15:53

price to sales is too expensive.

15:55

And so companies, some of these

15:58

really big growthy companies that are

16:00

selling, you know, having a price

16:02

to sales of 50, they're, they're

16:04

like, that's kind of out of

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18:29

right, so let's talk

18:31

about item number three, behind door

18:34

number three, which is price to

18:36

free cash flow. So this is a

18:38

newer -ish one to me in my

18:40

toolbox, if you will. So maybe

18:42

you could talk a little bit about

18:44

price to free cash flow and

18:46

why this is a good one. Well,

18:49

if you've been paying attention to your

18:51

listener, we went P

18:54

on top, what's gonna be on

18:56

the bottom, this time free cash flow, good job. Same

18:59

kind of concept. So

19:01

what we want is

19:03

companies who are at least making

19:06

their net income and free cash flow. Since

19:09

I've used this one longer than Dave,

19:11

I'll tell you that over the long

19:13

run, free cash flow and

19:15

net income is about the same. So

19:17

this is very similar to using

19:20

the PE ratio, but where it can

19:22

help you find opportunities would be

19:24

a company like Costco. Costco

19:27

actually always has, I

19:30

don't know about always, but the vast

19:32

majority of the time, free cash flow

19:34

is higher than their net income because

19:36

they're working capital. They

19:38

get basically free financing from

19:41

their working capital. So you can

19:43

find businesses like that using

19:45

the price to free cash flow

19:47

metric. But that's pretty rare. Basically

19:50

these companies that are earning

19:52

themselves afloat. You can

19:54

use a price to free

19:57

cash flow metric on and find

19:59

potentially undervalued companies. Because at the end

20:01

of the day, free cash flow is what

20:03

matters. Net income or earnings is a

20:05

accounting measure. Free cash flow is the

20:07

actual cash that the company can use

20:09

in the myriad of ways that they

20:12

use cash. And they use cash to

20:14

grow, by the way. They also use

20:16

cash to pay you money through a

20:18

dividend or through buybacks. They don't do

20:20

that from that income. They do it

20:23

from free cash flow. So free

20:25

cash flow is important, but net

20:27

income usually leads to free cash

20:29

flow. So price of free cash flow

20:31

can help you in case that's not

20:33

the case, if a company is not

20:35

generating a lot of free cash flow,

20:37

or it can help you find a

20:40

company like a Costco where the

20:42

company's growth is giving them even

20:44

more free cash flow than that

20:46

income is suggesting. So that's why I

20:49

say cost scale you can pay more

20:51

for the PE because it's more of

20:53

a free cash flow story. But I

20:55

digress. So for those of the, maybe

20:58

we have new listers. How, what is

21:00

this free cash flow thing? Is this

21:02

something I can find on a cash

21:04

flow statement or do I actually have

21:07

to do some math? You gotta do

21:09

some math. I hate to break

21:11

your heart. It's really hard math.

21:13

You gotta use this thing call

21:16

a subtraction. You gotta subtract one

21:18

number from another. It's terrible.

21:20

So terrible. Horrible. End of

21:22

the world. It very much is.

21:25

So cash was the same as

21:27

you can, it's broken up into

21:29

three big chunks. And so that

21:31

first chunk at the top is

21:34

going to be operating activities. At

21:36

the bottom of that is cash

21:38

from operating activities. That's all the

21:40

cash that the business generated from

21:42

its operations. It did not find money

21:45

from outside sources. This is all

21:47

through the business, through the core

21:49

business, let's say. And then they

21:52

have to subtract capital

21:54

expenditures. That's basically investments

21:56

in long-term assets.

21:59

And then that. number after so

22:01

we have cash from operations you

22:03

subtract capital expenditures or cap X

22:05

that's your free cash flow perfect

22:07

a lot of sites do it

22:10

for you so if they yeah

22:12

they have price to free cash

22:14

flow for you then they've done

22:16

it yeah exactly if a company

22:19

so like earnings if they don't

22:21

have free cash flow this is

22:23

not applicable correct yeah exactly and

22:25

like with price to earnings Do

22:27

we want a lower number as

22:30

better kind of thing? Yeah, same,

22:32

same kinds of concepts. I would

22:34

say even price to free cash

22:36

flow can be even more bumpy

22:38

than price to earnings, depending on

22:41

the company, depending on the industry,

22:43

depending on who the CEO is

22:45

and how aggressive he wants to

22:47

be. We talked about those tsunamis

22:50

in the last episode. invest like

22:52

a tsunami, like they really load

22:54

up in like inventory and things

22:56

like that. And sometimes that pays

22:58

off and sometimes it doesn't. So

23:01

in that way, it can be

23:03

an indicator, a warning signal. Okay,

23:05

price of free cash was really

23:07

high, even though the PE looks

23:09

good. Maybe I dig into that.

23:12

Oh, is it because they're investing

23:14

in all this inventory? Okay, do

23:16

I agree with that? On the

23:18

flip side. Are they also investing

23:21

heavily in capital expenditures? You know,

23:23

maybe they're opening 100 stores. Do

23:25

I agree with that? Do I

23:27

think that the demand will support

23:29

that growth? So in that way,

23:32

it can be also very valuable.

23:34

And the DCF, which is like,

23:36

that's next level valuation, they will

23:38

all, if you're using the equity

23:40

model, they would use that same

23:43

free capsule metric that you use

23:45

in the P. That you use

23:47

in the P. fc f they

23:49

would use that same number to

23:51

get a DCF. So yeah, you're

23:54

getting yourself a pretty good coverage

23:56

by using the price to free

23:58

cash flow. Yeah, for sure. Is

24:00

it, is there a situation where

24:03

life with the price to earnings,

24:05

it could be too high? Is

24:07

it kind of the same range?

24:09

Yeah, I would put it around

24:11

the same range as a price

24:14

to earnings. Yep. That's a good

24:16

way to look at it. Yeah.

24:18

Yeah. Are there, you kind of

24:20

mentioned, like sometimes there may be

24:22

disparities between the price of earnings

24:25

and the price to free cash

24:27

well, a company that kind of

24:29

comes to mind when I think

24:31

a little bit about that is

24:34

Amazon. Amazon has experienced, if you

24:36

look at a chart of their

24:38

free cash well on Finchat, you

24:40

can see wild swings because they

24:42

will go in and out of,

24:45

you mentioned capital intensity, they'll invest

24:47

a lot in CapX. which can

24:49

sometimes lead to negative free cash

24:51

flows because they're actually spending more

24:53

in cap X than they're earning

24:56

and operating cash flow. And those

24:58

are part of the investments that

25:00

they choose to make. Jeff Basos,

25:02

when he was running the company,

25:05

was very adamant and also talked

25:07

a lot about free cash flow

25:09

in his shareholder letters that he

25:11

would issue every year. And so

25:13

he was a very big proponent

25:16

of. valuing company, Amazon in particular,

25:18

on their free cash well, but

25:20

that was something you also had

25:22

to take into account was, hey,

25:24

we're going to spend a butload

25:27

of money on our infrastructure or

25:29

buying more capacity or more space

25:31

for our warehouses or things that

25:33

enjoy spending a lot more money

25:36

on servers for AWS. And so

25:38

that can really skew the price

25:40

to free cash well for a

25:42

company like Amazon. So it's something

25:44

I think you need to make

25:47

sure you're paying attention to when

25:49

you're looking at it because like

25:51

you said if it's if there's

25:53

a big disparity between the price

25:55

to earnings and the price to

25:58

free cash flow of one positive

26:00

and the other one's negative why

26:02

why is this why is this

26:04

different and that's something that's important

26:07

to pay attention to I think

26:09

well force you to look at

26:11

the capsule statement more closely yeah

26:13

anything that does that is good

26:15

in my book yeah me too

26:18

me too and I guess the

26:20

other thing to keep in mind

26:22

is it could be a bit

26:24

of a third rail sometimes is

26:26

the whole stock-based compensation thing yeah

26:29

if you see a a lower

26:31

price to earnings and a higher

26:33

price to free cash flow, or

26:35

vice versa, it could be because

26:38

the companies, you know, spent, maybe

26:40

they've gone crazy and are spending

26:42

a lot of money on stock-based

26:44

compensation, either for management or for

26:46

employees, and that can skew the

26:49

number vastly too. Yeah, that's. You

26:51

have to be careful. The, a

26:53

lot of these growthy SAS companies

26:55

have. a high PE and a

26:57

low price to free cash flow.

27:00

And stock-based compensation is a huge

27:02

culprit in that. There's also some

27:04

companies that are hitting that emerging,

27:06

I forgot what we call it,

27:09

the sprouting stage, sprouting stage, breaking

27:11

into profitability. A lot of those

27:13

companies. Maybe have now we're getting

27:15

into like super into the weeds

27:17

like tax write-offs basically these carry-forwards

27:20

so they have deferred tax assets

27:22

so Actually Buffett found a company

27:24

like this Decades ago where he

27:26

was he was taking advantage of

27:28

deferred tax assets. It's kind of

27:31

fascinating, but basically if you're a

27:33

company and you've lost money for

27:35

10 years some of those years

27:37

where you lost money you can

27:40

use as a future tax write-off

27:42

and so that's money that will

27:44

be It is free cash flow

27:46

that goes to the company and

27:48

it shows up in free cash

27:51

flow, but you have to be

27:53

careful because if you are valuing

27:55

the company and let's say you

27:57

want to own it for 10

27:59

years, is it likely that they're

28:02

going to get that much tax

28:04

write-offs? every single year for the

28:06

next 10 years. Is that, are

28:08

you factoring that into their growth

28:11

rate? So you do have to

28:13

be careful in another way, stock

28:15

base compensation and another way, deferred

28:17

tax assets. Watch those things and

28:19

be careful. So basically what you're

28:22

telling me is I have to

28:24

read the financial statements at least

28:26

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