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2:18

Starts now. Alright

2:26

folks, welcome to investing for beginners

2:28

podcast today. We have a

2:31

special show. We have our friend

2:33

Brian Feraldi back Brian is

2:35

a financial educator and co -founder

2:37

of long -term mindset and Also,

2:39

probably one of the best minds

2:41

on Twitter or LinkedIn YouTube and

2:43

so on so he's here to talk

2:46

to us about Why is Amazon so

2:48

freakin expensive or why do we think

2:50

it's so freakin expensive and why looking

2:52

at the PE ratio is the wrong

2:54

way to value Amazon. So

2:56

Brian, welcome back to the show. Thank you,

2:58

Dave. It is a pleasure to be

3:01

back as always. And I think this

3:03

episode is going to be great because

3:05

I myself have been extraordinarily confused by

3:07

Amazon's PE ratio. And I think many

3:09

investors have been too. But

3:11

once you understand the framework that we're

3:13

about to discuss in this episode,

3:15

I think it'll help to demystify that

3:17

complication. Yes, for sure. And I

3:19

will freely admit I was on that bandwagon. I

3:21

missed it. I didn't understand the business. I

3:23

thought it was too expensive because I was looking

3:25

at the PE ratio, which, as we're going

3:27

to talk about today, was the wrong way to

3:29

do it. And I remember Brian

3:31

Stoffel had a tweet about this, and it was kind

3:34

of a light bulb moment for me. And

3:36

hopefully we can have the same thing

3:38

for people today. So I guess let's start

3:40

off with talking about It's not

3:42

exciting, but it's certainly something revolutionary that I

3:44

wish I had known earlier on, which

3:46

is the business growth cycle. So let's talk

3:48

a little bit about that. Yeah,

3:50

this is probably one of the most

3:52

important frameworks for or mental models for individual

3:54

stock pickers to get into

3:57

their head. The idea here is

3:59

that companies, just like humans,

4:01

have a life cycle to

4:03

them. And at different periods in

4:05

their life, they are trying

4:07

to optimize their business

4:09

for different things. So

4:12

Because once you understand that you

4:14

need to know that the company

4:16

is trying to do something very

4:18

specific in each phase of its

4:20

development So the way that you

4:22

judge a company's progress and a

4:24

company's evaluation has to change Over

4:26

time to align with what the

4:28

company is trying to do if

4:30

you try and use a ratio

4:32

like the price to earnings ratio

4:34

on a company that is not

4:36

optimized for earnings That's not what

4:38

it's trying to do. You're gonna

4:40

get a full vaults signal from

4:42

the market, which is why so

4:44

many investors, myself included, have been

4:46

incredibly confused by Amazon's PE ratio.

4:48

But this framework applies to almost

4:50

every publicly traded company, not just

4:52

Amazon. Yeah, exactly. And I wish,

4:54

I wish, I wish so many

4:56

things. But I wish that I

4:58

had worn this earlier on in

5:00

my investing life because it would

5:03

have saved me a lot of

5:05

pain and heartbreak for sure. Yeah,

5:07

it explains so many things. It

5:09

explains why losing money can actually

5:11

be a good thing. I put

5:13

good in air quotes, but an

5:16

understandable thing. It explains why expensive

5:18

looking stocks can actually be cheap.

5:20

And it explains why cheap stocks

5:22

can actually be expensive. So if

5:24

you've ever been confused by any

5:26

of those things, the business growth

5:28

cycle framework helps to explain all

5:31

of them. Yeah, so let maybe

5:33

let's let's dive in. Let's start

5:35

talking about the business life cycle.

5:37

So I guess what is it

5:39

and how do you kind of

5:41

try to define it? Yeah, the

5:43

framework are is that there are

5:46

six distinct phases that publicly traded

5:48

companies go through. I should say

5:50

successful publicly traded companies go through

5:52

in their lifetime. Those six stages

5:54

are the startup phase, the

5:56

hyper growth phase. the self -funding

5:59

phase, the operating leverage phase,

6:01

the capital return phase, and the

6:03

decline phase. Now in each

6:05

of those six stages, which we're going to

6:07

discuss in more detail, the management

6:09

team is trying to do something

6:11

unique with the business to get

6:13

to the next stage. So the

6:15

way that you judge the company's

6:17

success, or the way that you

6:19

value the company, has to be

6:21

aligned with what the company is

6:23

trying to do to get to

6:25

the next stage. This is why

6:27

with Amazon, Amazon has

6:29

not been, since it was

6:31

founded, trying to optimize itself

6:34

for earnings. That's not been the

6:36

goal of the company. So

6:38

therefore, if you're looking at Amazon,

6:40

if you're judging Amazon by

6:42

its price to earnings ratio, you're

6:44

going to get a false

6:46

signal. Amazon is not optimized for

6:48

earnings even today. 20, whatever,

6:50

eight years later, it's not optimized

6:52

for earnings. So you have

6:54

to judge the company's progress by

6:56

what is being optimized for. Exactly.

6:59

And Jeff Bezos even told us

7:01

in his 2004 letter, I was actually

7:03

reading it yesterday, and he said,

7:05

we're optimizing for free cashflow. That is

7:07

our main goal 100%. And so

7:09

I was like, duh, you know, and

7:11

in hindsight, it's like, duh, but,

7:13

you know, then it just just went

7:15

right over my head. So let's

7:17

talk about each stage a little bit.

7:19

Sure. So let's start with phase

7:21

one. This is the startup phase. This

7:24

is when a company, and again, we're to be

7:26

judging it primarily through the lens of publicly traded

7:28

companies, but this also applies to private companies. So

7:31

in this startup phase, a

7:33

company is trying to establish product

7:35

market fit. They're searching out

7:37

there, they're creating an innovative new

7:39

product or an innovative new

7:41

business model and they're trying to

7:43

establish that there is a

7:45

market for this new product or

7:47

service. Now companies in this

7:49

stage have very little revenue or

7:51

no revenue at all. They're

7:53

often hiring like crazy engineers in

7:55

particular and sales people to

7:57

build out the infrastructure that the

7:59

company needs and companies in

8:01

this stage are actively losing money.

8:03

And even more confusing, the

8:05

losses that a company has in

8:07

this stage expand over time.

8:09

So the company loses more money

8:11

each year. Now, an example

8:13

of a company that's currently in

8:15

this phase one is a

8:17

publicly traded company called QuantumScape. ticker

8:19

symbol QS. So QuantumScape is

8:21

trying to develop the next generation

8:23

lithium ion battery and they

8:25

have next to no revenue. They

8:27

might even have zero revenue

8:29

and their losses are growing. So

8:31

what they're trying to do

8:33

is create this new battery in

8:35

the hopes that they can

8:37

establish strong product market fit. That

8:40

makes a lot of sense. So

8:42

something that may confuse other people would

8:44

would you consider a startup something

8:46

that would IPO or is that is

8:48

that maybe farther down the chain

8:50

or could that be a startup? There

8:53

aren't many of these companies that

8:55

come public, or at least ones that

8:57

we've heard of, but this is

8:59

fairly common for biotechs to do. Clinical

9:01

stage biotechs, right? Those are companies

9:03

that are developing a drug. It is

9:05

extraordinarily expensive to develop a drug.

9:08

They are trying to establish product market

9:10

fit. Now, the only way that

9:12

they can do so is by getting

9:14

regulatory approval for that drug, which

9:16

requires Huge amounts of capital hundreds of

9:18

millions of dollars. So it's fairly

9:20

common to see cutting -edge companies that

9:22

are trying to develop some brand new

9:24

technology that come public so like

9:26

quantum scape There's a couple of companies

9:29

that are trying to do the

9:31

the electric electric helicopters and get them

9:33

get them around there That's another

9:35

industry. That's like potentially brand new requires

9:37

millions of dollars in funding and

9:39

has not established product market fit so

9:41

there aren't a lot of these

9:43

companies, but they do exist. Okay.

9:45

All right. That makes a lot of sense. All

9:47

right. So what's, what's number two? So

9:50

phase two is called the

9:52

hyper growth phase. So the company

9:54

has established Product market fit

9:56

revenue is there revenue is growing

9:58

very fast The company is

10:01

still expanding like crazy But the

10:03

key difference between phase one

10:05

and phase two is there's lots

10:07

of revenue revenue is growing

10:09

fast But importantly the company is

10:12

losing money, but the amount

10:14

of money it's losing each year

10:16

is shrinking It's declining over

10:18

time so phase one The losses

10:20

are increasing. Phase two, the

10:23

losses are decreasing over time. So

10:25

the company has established product

10:27

market fit because of the fast

10:29

revenue growth. Now it's trying

10:31

to prove that it can make

10:34

the business sustainable financially. That

10:36

makes a lot of sense. So

10:38

in companies in this stage, they're

10:41

obviously not optimizing for profits. It's

10:43

all about growth. Yeah, that

10:45

is the way that you judge

10:47

them. Revenue growth and perhaps even

10:49

gross profit growth and the amount

10:51

of cash that they have in

10:53

comparison to the losses that they

10:55

have. So an example of a

10:57

company that's in hyper growth phase

10:59

today is Cloudflare, which is ticker

11:01

symbol NET. This is a company

11:03

that has not made an accounting

11:05

profit since it came public, but

11:07

the losses that it's generating are

11:09

currently in shrink mode. So crowdfair

11:11

is trying to prove to the

11:13

market what it's trying to do

11:15

is that it can become a

11:17

financially sustainable business. What kind of

11:20

revenue growth like percentages would be,

11:22

would something fall in this category that

11:24

you'd want to see? Like if you're

11:26

seeing 20 % or 15 % revenue growth,

11:28

is that considered hyper growth or would

11:31

it be something greater than that? Yeah,

11:33

typically I would want to see greater

11:35

than 25 % revenue growth. It depends on

11:37

the nature of the business, right? Companies

11:40

that have to physically produce something for

11:42

sale, you would expect that their growth

11:44

rate would be slower than companies that

11:46

are just selling digital products or digital

11:48

internet things. So a company like Cloudflare,

11:50

which has nearly infinite scalability, you would

11:52

expect to see faster growth on. But

11:54

I would say as a general statement,

11:56

you would want to see at least

11:58

25 % annualized growth. Okay, that makes

12:01

sense. All right, so let's move on

12:03

to stage three. So in

12:05

stage three, this is when a

12:07

company successfully proves that it's

12:09

a sustainable business and it does

12:11

there by generating break even.

12:13

on the bottom line. So the

12:15

company's goal in this stage

12:18

is to prove that it can

12:20

scale operations. So companies

12:22

that are in phase three, the

12:24

self -funding phase are typically still growing

12:26

the top line very fast, but

12:28

margins have improved across the business.

12:30

And importantly, the losses are basically

12:32

zero. It might not be making

12:34

any money at all, or it

12:36

might even be losing a tiny

12:39

little bit of money. But at

12:41

this stage, the company has proven

12:43

to the market that it's self

12:45

-funding. So the revenue that it

12:47

generates are covering all of its

12:49

costs. And an example of a

12:51

company that's in this stage today

12:53

is CrowdStrike. Now, CrowdStrike is a

12:55

huge software company focused on cyber

12:57

security, which many people know because

13:00

of their outage, what was that,

13:02

six months ago or last year.

13:04

But CrowdStrike recently became on a

13:06

gap basis, operating margin essentially break

13:08

even. So they've gotten through the

13:10

startup phase, they've gotten through the

13:12

hyper growth phase, and now they're

13:14

self -funding. And importantly, Dave, for investors,

13:17

this is when a company's

13:19

risk profile decreases substantially because

13:21

they've proven to the market

13:23

that the company can self -fund.

13:26

All right, I'm going to ask

13:28

a dumb question. So, excuse me.

13:31

So when you refer to self -funding,

13:33

does that mean that the business

13:35

can operate on its own without

13:37

having to, I guess, take in

13:39

outside money to continue operations. So

13:41

comparing CrowdStrike to maybe Cloudflare. Exactly.

13:44

Exactly. The company has proven that

13:46

it no longer needs to raise

13:48

outside capital from either investors or

13:50

lenders in order to just fund

13:52

its operations. Companies in phase one

13:54

absolutely are dependent on outside capital

13:56

to fund themselves. Remember, their losses

13:58

are growing. Companies in phase two,

14:00

they may rely on outside capital

14:02

because it depends on how big

14:04

the losses are in comparison to

14:07

how much cash they have. But

14:09

when a company gets to phase

14:11

three, it does not need to

14:13

ever raise outside capital again. It

14:15

might choose to do so. It's

14:17

to make an acquisition or make out a

14:19

big project, but it never has to raise

14:21

outside capital again. Awesome. All

14:23

right. So let's move on

14:26

to, I guess, stage four. So

14:28

in phase four, a company has

14:30

successfully proven that it can get

14:32

to self -sustaining, right? It's generating

14:34

more revenue than it needs to

14:36

cover all of its costs. And

14:39

now the business becomes focused on

14:41

maximizing its profit. So this is

14:43

called the operating leverage phase. Now

14:45

it's common for companies that are

14:47

in phase four operating leverage, their

14:50

revenue growth is still there, but

14:52

it slows down. But because the

14:54

company is focused on efficiency and

14:56

driving profit growth, not revenue growth,

14:58

its profits are growing much faster

15:00

than revenue. So if a company's

15:03

revenue is growing 10%, a company

15:05

in operating leverage phase is going

15:07

to have its profits growing 20 %

15:09

per year or more through efficiency.

15:12

And an example of a

15:14

company that's in operating leverage

15:16

phase today is Amazon. Which

15:18

explains why its price to

15:20

earnings ratio in particular looks

15:22

so crazy because believe it

15:24

or not, Amazon is still

15:26

not yet fully optimized for

15:28

profit. Yeah, exactly. What

15:31

meta went through with Zuck's year of

15:33

efficiency? Would that be like an operating

15:35

leverage, a good example of

15:37

something like that? Yeah, exactly. So

15:39

in Zuck's case and Metta's case,

15:41

the company was in the next phase,

15:43

the capital return phase, and it

15:46

chose to go backwards one phase to

15:48

make itself more efficient. And it's

15:50

important to note that the terms that

15:52

we're using here, they have blurry

15:54

lines to them. There aren't like hard

15:56

lines in between them, but still

15:59

getting the mental model in your head

16:01

is very important for figuring out

16:03

what is the company actually focused

16:05

on doing right now. Right. Yeah,

16:07

exactly. All right. Let's move on

16:09

to phase five. So phase

16:11

five is where all companies

16:13

want to get to eventually. This

16:15

is the capital return phase.

16:18

The primary objective that the company

16:20

is trying to perform in

16:22

this phase is reward its shareholders,

16:24

return capital to shareholders. So

16:26

typically companies in this phase, their

16:28

revenue is still growing, but at

16:30

a modest pace, usually 10 %

16:32

per year or less. Their profits

16:34

are still growing, but also at

16:36

that same modest pace. All the

16:39

efficiencies are essentially behind the company.

16:41

So now profit growth and revenue

16:43

growth are very similar. However, you

16:45

can tell a company is in

16:47

stage five, the capital return phase,

16:49

because it's Returning capital to shareholders

16:51

now there are multiple ways that

16:53

a company can return capital to

16:55

shareholders the two most well -known are

16:57

a dividend payment or a buyback

16:59

but this could also include paying

17:01

off debt or even making acquisitions

17:03

to strengthen the company's a mode.

17:05

But there are lots of examples

17:07

of companies that are in stage

17:09

five today one simple one would

17:11

be home depot if you look

17:13

at home depot it essentially is

17:16

using. all of its profits to

17:18

buy back stock and pay a

17:20

dividend. So that is the company's

17:22

objective right now. Yeah, that's a

17:24

great example. Would Google and Meta

17:26

be a good example of companies

17:28

that maybe straddle four and five?

17:30

Totally. Yes. I mean, Google, I

17:32

believe, is paying a dividend now.

17:34

I know it's been buying back

17:36

a stock, but Google, in

17:38

particular, has multiple businesses in it, which

17:40

are at different stages of growth. So

17:42

its core search business is in the

17:44

capital return phase, but its Google Cloud

17:46

business and YouTube are in stage three

17:48

or stage four. I actually don't know

17:51

where they are in particular, but the

17:53

overall Google business, if you were to

17:55

say, what stage is Google in, I

17:57

would definitely say it's in the capital

17:59

return phase. Yeah, yeah, exactly. All right,

18:01

let's move on to phase six. The

18:03

one, unfortunately, I tend to invest in

18:05

sometimes. Yeah, this is

18:07

the stage six. This is the

18:09

phase that no company wants to find

18:11

itself in. This is the turnaround

18:13

phase. This is when a company is

18:15

in decline. Revenue is

18:17

moving in the wrong direction. Profits

18:20

are moving in the wrong direction

18:22

margins are moving in the wrong

18:24

direction and this is when a

18:26

company's core operation its core business

18:28

has been either disrupted or So

18:30

poorly managed that the company is

18:33

now permanently permanently is the key

18:35

point heading in reverse so the

18:37

company's objective in this phase is

18:39

to Turn operations around.

18:41

Perhaps they're going to sell off

18:43

some bad assets. Perhaps they're going

18:45

to make moves that improve their

18:47

balance sheet. But this is a

18:50

very peculiar phase to try and

18:52

invest in. Because if you look

18:54

optically at many companies other than

18:56

this phase, they look cheap. They're

18:58

trading at maybe a single -digit

19:00

-digit earnings multiple. Maybe their assets

19:02

or their book value is

19:04

below one. So a lot of

19:06

value investors look at companies

19:08

in this phase thinking, oh, look

19:10

how cheap this company is.

19:12

But if a company is truly

19:14

in stage six permanently and

19:16

there's no chance of returning to

19:18

the other stages, it's all

19:20

a mirage. You can buy a

19:22

company in this stage at

19:24

two times earnings and still lose

19:26

100 % of your investment. Yeah.

19:28

Yeah. As a former Intel

19:31

bag holder, I can attest to

19:33

this, this phase quite well. So

19:35

an example of a company that's in

19:37

this, that was recently in stage six

19:39

was Bed Bath and Beyond. So Bed

19:42

Bath and Beyond's core operations were completely

19:44

disrupted. It was poorly managed. And while

19:46

this was a great company for a

19:48

long period of time, it's since gone

19:50

bankrupt. And a great example of you

19:52

could have looked at Bed Bath and

19:55

Beyond's PE ratio over the last five

19:57

or 10 years before went public and

19:59

said, single digit. Right? This is a

20:01

well -known retailer trading at five times

20:03

earnings or seven times earnings. And if

20:05

you bought it and held, you had

20:07

a total loss, 100 % loss on your

20:10

investment. Because if the business is headed

20:12

towards bankruptcy, there's no valuation.

20:14

You can pay that's low enough to

20:16

make a profit. Yeah, you can't

20:18

get under zero Kenya Another example of

20:20

a company that's that you might

20:22

argue is in this stage is Dollar

20:24

General and Dollar General they've been

20:26

they've they've struggled over the last couple

20:28

years And I think it was

20:30

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20:32

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20:34

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20:36

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20:38

the idea behind that was that

20:40

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20:42

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20:44

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20:46

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23:40

So now that we kind of have a

23:42

good idea of the different phases and

23:44

maybe what identifies them, how the heck do

23:46

you tell Where each company or

23:48

where a company is in each phase?

23:50

Yeah that so the answer there is

23:52

slightly more complicated and requires some visuals

23:54

that are very helpful So hard to

23:56

do in a podcast, but I will

23:58

do my best so when it comes

24:00

to figuring out what phase of the

24:02

business growth cycle is a company currently

24:04

in you have to really look at

24:07

three numbers all of which are found

24:09

on the company's income statement, so Number

24:11

number one is revenue Look

24:13

at a company's revenue over as long of

24:15

a period of time as you can. Three

24:17

years, five years, 10 years. If a company's

24:19

revenue is growing very quickly, it's

24:21

likely to be in stage one, two, or three.

24:23

If it's growing at a modest race, it's

24:25

likely to be in stage four or five. And

24:27

if it's going down for a couple of

24:30

years in a row, it could be in stage

24:32

six. So start your analysis with this revenue. The

24:35

second number to look

24:37

at is operating profit. also

24:39

called operating income, depending

24:41

on the income statement. So

24:43

operating operating profit, not earnings by

24:45

the way, operating profit. If this

24:47

figure is a negative number, you

24:49

know that it's in phase one,

24:52

phase two or phase six. If

24:54

a positive number, you know, it's in

24:56

phase three, phase four or phase five. So

24:58

now you have to look and say,

25:00

okay, is operating loss a negative number and

25:02

it's getting worse than it might be

25:04

in stage one or stage six. Is

25:06

it a negative number? But it's

25:09

getting better than it's probably in

25:11

stage two. So figuring out

25:13

the direction of operating profit will also

25:15

tell you and give you a hint about

25:17

what stage it's in. And then the

25:19

final number to look at is the company's

25:21

capital return program. If it's paying a

25:23

dividend, it's in stage five

25:25

or potentially stage six. If it's

25:27

buying back stock, it's in stage

25:29

five or potentially in stage, in

25:31

stage six. If it's paying off

25:33

debt. It could be in stage

25:35

five or in stage six. So

25:37

you have to know the nuances

25:39

of the six stages, but those

25:41

are the three numbers to look

25:43

at revenue, operating profit and

25:45

capital return. Okay. All right. That,

25:48

I mean, that's a, that I think a great

25:50

framework. So, okay, now we're

25:52

going to talk about the big, the

25:54

big boy in a room. What

25:56

about valuation? And I think particularly with

25:58

Amazon, because we tease that the

26:00

beginning. So let's talk through that. Yep.

26:02

So again, let's get back to

26:04

the six stages. What is the company

26:06

trying to do in each stage?

26:08

What is the primary objective? Well,

26:10

let's go to stage one. The

26:12

only objective is establish product market

26:14

fit. The way that you

26:16

tell if a company has established market market

26:19

fit is revenue. Full stop,

26:21

period, revenue. You don't care about

26:23

really any other number than revenue. So

26:25

the way that you value a

26:27

company, in stage one, which is a

26:29

very hard stage to value, is

26:31

primarily by looking at the price to

26:33

sales ratio, the PS ratio. Now,

26:35

this gets pretty tricky because some companies

26:37

don't even have revenue in stage

26:39

one, like a lot of clinical stage

26:41

biotechs or the startups that are

26:43

trying to launch new products or services

26:45

to market, they often don't have

26:47

revenue. So for them, you might have

26:49

to do total addressable market analysis

26:52

when you look at Well, how what

26:54

could what could sales be if

26:56

this company is successful? What could the

26:58

market cap be if those sales

27:00

materialized? And then how does that compare

27:02

to today's valuation? So it's very

27:04

hard to value a stage one company,

27:06

but the only thing you can

27:08

really look at is sales. That makes

27:10

sense. What about like hyper growth

27:12

or self funding? Yep. So stage two,

27:14

we're going to be looking at

27:16

the price to sales ratio. And ideally

27:18

you'd be looking at the forward.

27:20

price to sales ratio. FinChat includes this

27:22

number. So it's the company's price

27:24

divided by. next year's sales estimates. And

27:27

it's useful to look forward at what sales

27:29

are expected to be because companies are growing

27:31

so fast in this stage. That would be

27:33

the primary one that I would use. A

27:35

secondary one that you can use in this

27:37

stage is the company's price to gross profit

27:40

ratio. So gross profit excludes

27:42

all operating expenses. And if the odds

27:44

are good that the company might be optimized

27:46

for gross profit in this stage, but

27:48

the number one metric that I will

27:50

look at would be forward price to

27:52

sales ratio. What would be a good ratio

27:54

for that? What would tell you, okay,

27:56

maybe this is cheap or maybe this

27:58

is expensive? It always depends on the

28:00

growth rate of the business, the opportunity the

28:02

business, and a bazillion other factors. But

28:04

as a general statement, anything under

28:07

five would be cheap. in air

28:09

quotes between 5 and 10 would be

28:11

fairly valued and over 10 would

28:13

be expensive with 100 billion caveats necessary

28:15

in there. But as a general

28:17

framework for me, I think under 5

28:19

cheap in air quotes and over

28:22

10 expensive. That would get you in

28:24

a ballpark. Yes. All right. Perfect.

28:26

All right. So let's talk about phase

28:28

three, self -funding. How do we how

28:30

do we value those companies? Yeah.

28:32

Again, so companies self -funding, that means

28:35

that its revenue is now covering all

28:37

of its costs and it's breaking

28:39

even on the bottom line. So we

28:41

still can't look at earnings because

28:43

they're essentially zero, but that's a really

28:45

good thing. The company got to

28:47

the self -funding phase. So we still

28:50

have to focus our attention at the

28:52

top portion of the income statement.

28:54

So now I will look at the

28:56

price to sales ratio. not the

28:58

forward price -to -sales ratio, just the trailing

29:00

price -to -sales ratio, and the trailing

29:02

price -to -gross profit ratio. Those two numbers

29:05

would be the best indicators of

29:07

value in Stage 3. Real

29:14

estate. Yeah. Okay. So here we

29:16

are stage four operating leverage This is

29:19

a company that is growing still

29:21

and it's officially focused on optimizing margins

29:23

So it's focused on making the

29:25

business more profitable. So because if the

29:27

company does have profits and those

29:29

profits are improving we have to look

29:32

at Estimated profit margins over the

29:34

over the next year because the company

29:36

is is focused on increasing its

29:38

profits. So in this stage, I would

29:40

look at the forward price to

29:42

earnings ratio as my primary measure and

29:45

my secondary looking at the forward

29:47

price to free cash flow ratio. Again,

29:49

the denominator here is an estimate

29:51

in the future. So it's less precise

29:53

than looking at the actual numbers.

29:55

But because a company is still optimizing

29:57

for profit, it makes a heck

30:00

of a lot of sense to look

30:02

forward than it does to look

30:04

backwards. Okay. So why, why,

30:06

I guess what would be a good

30:08

range for, for those, for these

30:10

companies? It always depends on the

30:12

company's growth rate and a bazillion

30:15

other factors. But again, as a general

30:17

statement, I would look towards Peter

30:19

Lynch's famous peg ratio as a rough

30:21

number. So if a company's sustainable

30:23

growth rate is 30%, I would want

30:25

a forward PE ratio of 30

30:27

or under. And if a company's sustainable

30:29

growth rate is 50%, I'd be

30:31

okay with a PE ratio of 50

30:33

or more. But there are multiple

30:35

things that you need to think about,

30:37

like how How early on in

30:39

the operating leverage phase is a company,

30:41

right? If it's current, net margin

30:43

is 2%, and you think it could

30:46

get to 20 % with a lot

30:48

of improvement, well, I would be

30:50

very lenient with the forward price to

30:52

earnings ratio that I would pay.

30:54

But if a company has a 10

30:56

% margin and you think it could

30:58

get to 12%, there's less room

31:00

in there for lots of operating gains.

31:02

So I would be more focused

31:04

on valuation. But as a general statement,

31:06

Under 20 would be cheap and

31:08

over 40 would be expensive with, again,

31:11

a bazillion caveats. Right, bazillion. All

31:14

right. So why does

31:16

Amazon, why is using the

31:18

PE ratio not appropriate

31:20

for Amazon? Again, Amazon

31:22

is clearly in the stage four.

31:25

It's in the operating leverage

31:27

stage. So Amazon is not optimized

31:29

currently to show earnings, the

31:31

E in that equation. It

31:33

is optimized to show or not

31:35

fully optimized to show free

31:37

cash flow. With Amazon in

31:39

particular, I'm going to make an

31:41

asterisk here and say probably the

31:43

best number to use for Amazon

31:45

would be the price to operating

31:47

cash flow ratio. Not one that

31:49

many people talk about, but that

31:51

excludes essentially, that is the cash

31:53

that the business generates with excluding

31:55

Capital expenditures so you might be

31:58

able to do that kind of

32:00

analysis on companies that are investing

32:02

so heavily in their own capital

32:04

expenditures Which Amazon has been now

32:06

that is not that is not

32:08

a ratio that I throw around

32:10

lately or would use very often

32:12

but since Amazon is has been

32:14

investing so heavily in its own

32:16

infrastructure for years, it might be

32:18

a more accurate way to look

32:20

at the company's profit than to

32:22

use free cash flow, which is

32:24

being depressed because of those huge

32:26

capital investments. But when it

32:28

comes to valuing any company, I

32:30

always like to look at several

32:32

ratios and use kind of like my

32:34

intuition for which would be best.

32:36

But if you if you force me

32:38

to say which is the best ratio

32:40

for Amazon, I would say price to

32:42

operating cash flow. Yeah. Yeah, I would

32:45

totally agree. What do you think Amazon,

32:47

I'm sorry, Google, Metta, and maybe Microsoft

32:49

would fall under that same category

32:51

because of the capital investments they're throwing

32:53

around? Those businesses are more optimized for

32:55

profits than Amazon is so for for

32:57

meta I would use the the price

32:59

to earnings or even the forward price

33:02

to earnings ratio Similar for Google

33:04

similar for similar for Microsoft So I

33:06

would actually lean more heavily on the

33:08

price to free cash flow, but you

33:10

are correct that those businesses in particular

33:12

right now are investing tens of billion

33:14

dollars goes in the data centers

33:16

and video chip take advantage of AI

33:18

so Perhaps you're right that looking at

33:21

price to operating cash flow for those

33:23

businesses would be more accurate right now

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right, awesome. All right, let's move on

34:34

to phase five, capital return. Yep. So

34:36

this is a business, again, that is

34:38

fully optimized for profits. It's fully optimized

34:40

for returning capital to shareholders. So

34:42

finally, in phase five,

34:44

we can look at the plain

34:46

old boring price to earnings

34:48

ratio. It's finally a useful number.

34:50

And I would also look

34:52

at the company's price to free

34:54

cash flow ratio and compare

34:56

how those two numbers are. But

34:58

this is when the PE

35:00

ratio is Finally, useful. A company

35:02

is fully optimized for profits,

35:04

its growth is relatively slow, and

35:07

it is optimized for returning capital

35:09

to shareholders. So price to earnings

35:11

ratio works. Price to free cash

35:13

flow ratio works. Dividend yield works.

35:15

Earnings yield works. Free cash flow

35:17

yield works. So when it comes

35:19

to, if you like using multiple

35:21

analysis, which many investors do, phase

35:24

five is the phase to do

35:26

it in. Yeah, exactly. All right. So

35:28

phase six, what can we use

35:30

to value any of those? So this

35:32

is a phase that comes with

35:34

a lot of asterisks and for me

35:36

personally i just avoid phase six

35:38

all to all together so i actually

35:40

think it's very dangerous to use

35:42

traditional valuation metrics to look at phase

35:44

six companies because they optically often

35:47

look so cheap. The price to free

35:49

cash flow ratio looks cheap. The

35:51

price to earnings ratio looks cheap. The

35:53

price to sales ratio looks cheap.

35:55

The price to book value ratio looks

35:57

cheap. But again, if you are

35:59

convinced that a company is in a

36:01

permanent state of decline, there's no

36:03

multiple low enough that you can pay

36:05

and earn a good return over

36:08

time without trading and getting very, very

36:10

lucky. So in phase six, I

36:12

personally avoid all phase six companies and

36:14

only will look at them again

36:16

if they've proven that they can get

36:18

back back into stage five. But

36:20

if you're the type of investor that

36:22

loves dumpster diving and looking for,

36:24

like, ultra deep value, this is the

36:26

place to look. But I don't

36:28

know how to do that successfully. Yeah,

36:31

I don't either. I'm a DCF guy. I

36:33

like to use the DCFs. I know that

36:35

makes me strange. But would

36:37

it fit for any of these

36:39

phases and where? Yeah. So DCF

36:41

analysis works best when a company

36:43

is in phase five. It works.

36:45

It works OK when a company

36:47

is in phase four, and it

36:49

doesn't work at all in phases

36:51

one through three. A DCF model

36:54

might be useful in stage six,

36:56

but I would use an extremely

36:58

high discount rate. But again, to

37:00

me, if a company is truly

37:02

in stage six, there are very

37:04

few valuation techniques that you can

37:06

use. But if you like DCFs,

37:08

I would totally use them on

37:10

phase five companies. Okay, awesome. Awesome.

37:12

All right. So how long will

37:14

companies stay in these phases? Will

37:16

they vacillate back and forth or

37:18

will they stay in one stage

37:20

forever? Yeah, this is another

37:22

tricky thing. So companies can be in

37:24

any of these stages for as

37:26

little as a day and as long

37:28

as a couple of decades. Like

37:31

Coca -Cola, for example, has been

37:33

in stage five, the capital return

37:35

phase since like 1915. or something

37:37

or something along those lines. So

37:39

there's no limit on how long

37:42

a company can be in any

37:44

of these stages for. Conversely, there

37:46

are critical stage biotechs that came

37:48

public over a decade ago that

37:50

still have no product on the

37:52

market and are still in the

37:54

startup and the startup phase. Now,

37:56

the only way that those companies

37:59

are surviving is by continually raising

38:01

outside capital from investors. So they've

38:03

been horrible investments, but companies can

38:05

stay in any of these stages

38:07

for any period of time. There's

38:09

no time limit. The best companies

38:11

get to phase five very quickly

38:13

and then stay in phase five

38:15

for decades. But those are, of

38:18

course, are very rare. Yeah, very

38:20

rare. Do companies all follow this

38:22

pattern from going from startup all

38:24

the way to decline or were

38:26

they Move back and forth

38:28

so that that's what it's tricky. I

38:30

was at the mental model here

38:32

and the visuals are extraordinarily useful for

38:35

thinking about companies for looking at

38:37

key metrics for judging the progress for

38:39

figuring out how to value them

38:41

but not all companies perfectly fit into

38:43

this mold some companies are Instantaneously

38:45

profitable they start up and they are

38:47

profitable right away so they kind

38:49

of blitz right into phase four and

38:52

phase five just because the economics

38:54

of the business are so good other

38:56

companies have cyclical revenue and cyclical

38:58

profits so. their their they might not

39:00

their their revenue might not go

39:02

up in a straight line since they

39:04

since they were founding it might

39:07

squiggle up and down depending on the

39:09

the business the overall cycle the

39:11

economic cycle in the world and they

39:13

might generate they might go for

39:15

being profitable to unprofitable profitable to unprofitable

39:17

while staying in a distinctive phase

39:19

other companies might be in

39:21

stage five and intentionally move backwards

39:24

to previous stages a good example

39:26

of this would be on netflix

39:28

so netflix was a phase five

39:30

company was actually buying back its

39:32

stock returning capital shareholders and then

39:34

they decided to go all in

39:36

on streaming and their profits went

39:39

from being very high to negative

39:41

so netflix made the intentional decision

39:43

to go for me a capital

39:45

return company to being a. Basically

39:48

a startup where it was losing money

39:50

at a fast pace That's a very

39:52

difficult thing for companies to do and

39:54

I would say it can only be

39:56

done by visionary leadership like Netflix has

39:58

so so companies can go forward through

40:00

this process and backwards Okay, that makes

40:02

a lot of sense. Alright, so maybe

40:04

I could quiz you on a few

40:06

companies and you can kind of tell

40:09

me where you think they might be

40:11

Not holding anybody's feet to the fire.

40:13

So I guess the first one would

40:15

be Tesla. Where do you think they

40:17

fall into this? Category now. Yep. So

40:19

Tesla would be I would argue one

40:21

of the hardest companies in the world

40:23

I thought it was something easy for

40:25

you. I would say Tesla overall the

40:27

overall business is in the operating leverage

40:30

phase a few years ago It was

40:32

fully optimized for profits and they were

40:34

talking about returning capitalist shareholders, but but

40:36

Tesla has sick has reached the scale

40:38

where the business cycle is going to

40:40

affect its revenue. So because so much

40:42

of its profits are generated from selling

40:44

cars, it's now going to be, and

40:46

it's reached enough scale, it can't grow

40:48

without a strong economy. So the company's

40:51

revenue and profits are going to fluctuate.

40:53

But I would argue the overall business,

40:55

Tesla, the overall company is in stage

40:57

four operating. Awesome. All right.

40:59

How about visa and mastercard visa and

41:01

mastercard are easy They are both clearly

41:03

in stage five and there are so

41:05

many numbers that you can look at

41:07

so many multiples that you can look

41:09

at to judge their value How about

41:11

Uber? Uber recently came through and is

41:13

now generating profits. So Uber is in

41:15

stage four, perhaps even, I haven't

41:17

looked at them closely, perhaps even late

41:19

stage four, eking into stage five. But I

41:21

know that that company, that is a

41:24

great case study to look at for the

41:26

stick stages because Uber is like matching

41:28

up with this perfectly. Oh, yeah. Yeah, exactly.

41:30

When you look at their charts on

41:32

FinChat, you could see, I mean,

41:34

you can almost literally see this chart just

41:36

as the company has evolved. It's amazing. How

41:39

about, let's throw out a

41:41

company like Costco. Costco,

41:44

stage five. Okay. Easy.

41:46

All right. Easy. How about

41:48

TSMC? Not a company I

41:50

know well at all, but I'm going to

41:52

guess stage five. I think, I mean,

41:54

they're a massive business, right? So I'm going

41:56

to guess capital return. I'm

41:58

going to assume, since they're in the semiconductor space,

42:00

that they have some cyclicality to their revenue, but I'm

42:02

not sure of that. Okay. How

42:04

about something like S &P, Global, or

42:06

Moody's? Both of those would be

42:09

in stage five, capital return. Okay.

42:11

Fantastic businesses, by the way. Yeah.

42:13

Yeah. Fantastic businesses. I'm trying to

42:15

think of some other ones that are maybe super popular.

42:17

How about Celsius? Celsius?

42:19

Again, I have not looked at them closely.

42:21

If I was to guess, I would

42:23

say in stage four operating leverage, but isn't

42:25

Celsius's revenue heading in reverse? Yeah,

42:27

I think so. Yeah, I again, I

42:29

don't I don't follow the company that closely.

42:31

So I don't know for sure. So I

42:34

would argue that Celsius was probably in stage

42:36

late stage four. But when they were in

42:38

hyper growth mode, and now they're moving backwards,

42:40

maybe into stage stage three. But because of

42:42

their deal with Pepsi, I know that I

42:44

know that they have like inventory issues that

42:46

they have to deal with. But Celsius is

42:48

somewhere between stage three and stage four. But

42:50

recently heading in the wrong direction. Yeah, for

42:53

sure. What are some

42:55

companies that other companies besides Qualifier that you can

42:57

think of that might be in the hyper growth

42:59

stage at this moment? I haven't

43:01

looked at Rivian closely recently. I don't

43:03

know if their operating profits are increasing

43:05

or decreasing. I think they're still

43:08

Increasing but they might be at that

43:10

peak operating loss right now. So ribbon

43:12

would be somewhere between phase one and

43:14

and phase two. I also haven't looked

43:17

at Coinbase recently but Coinbase is probably

43:19

actually I know that Coinbase is Extraordinarily

43:21

cyclical like their revenue is tied to

43:23

crypto prices more so than anything That's

43:25

a really hard company to figure out

43:27

what phase are they in because I

43:29

think when they came public they were

43:31

way into phase five And then the

43:33

crypto market fell out the floor and

43:36

they went back to losing money. So

43:38

they might be a tricky one. I

43:40

don't particularly invest in phase two. So

43:42

I don't know many examples off the

43:44

top of my head. Yeah.

43:46

Do you mostly stick in the three, four

43:48

and five range? Yeah. And

43:50

this is actually a great point. You

43:52

have to know as an investor,

43:54

which of these six stages interests you?

43:57

If you were to ask me

43:59

what stage most of my portfolio in,

44:01

I would have told you it's

44:03

in stage four. A stage four is

44:05

my favorite stage. This is when

44:07

a company has gotten to scale. It's

44:09

reached profitability, so the business has

44:11

been significantly de -risked. But because the

44:14

business growth cycle, many investors forget. Ignore

44:16

these companies because optically they look expensive

44:18

But if the company can grow and

44:20

and get efficient it can become cheap

44:22

really really quickly So if you were

44:24

to if you were to ask me

44:26

what stage is your portfolio in personally?

44:28

I would have said stage four, but

44:30

then I did some analysis in finchat

44:32

I loaded my portfolio in there and

44:34

look at the statistics and it was

44:36

clear that actually I'm a stage five

44:39

investor almost all of my The vast

44:41

majority of my capital is in companies

44:43

that have already are already in stage

44:45

five, but to be fair when I

44:47

bought them, they were in stage three

44:49

or stage four. Yeah. And that's

44:51

so funny because if I think of the

44:53

companies that you and I talked about, I definitely

44:55

would have put you in four or maybe

44:57

three. But to your point, when

44:59

you bought them, they were much

45:01

earlier and now they're matured. Yeah.

45:03

I mean, take Tesla, for example,

45:05

when I first invested Tesla, like six

45:08

months after the IPO. So it

45:10

was like 2011. Tesla was a stage

45:12

one company. No doubt about it.

45:14

They were losing money and their losses

45:16

were growing over time. Extraordinarily risky

45:18

investment. That one just happened

45:20

to work out and it proved to

45:22

be one of my biggest winners ever.

45:24

And more recently, Tesla has reached stage

45:26

five. So it took them 13 years

45:28

or whatever from my initial investment to

45:31

get there, but they have successfully climbed

45:33

through the business growth cycle. And the

45:35

earlier you invest in these companies, the

45:37

higher the returns you can make, But

45:39

the higher risk that you are taking

45:41

on so this is why as an

45:43

investor it's important to ask which of

45:46

these stages Appeals to my investing style

45:48

and I think it's a trade -off between

45:50

risk and reward potential Yeah, for sure.

45:52

So how do you analyze companies like

45:54

this? Like we've gone through all these

45:56

stages We've gone through are the phases

45:58

and we talked about valuation like how

46:01

can I? How can I analyze these?

46:03

Like, how can I find these kinds

46:05

of companies? Yeah. So the first thing

46:07

to do is just be aware that

46:09

the business growth cycle exists. Once

46:12

you understand the mental model and the

46:14

six stages that you can go through,

46:16

analyzing a company becomes so much easier.

46:18

Because this to me is the very

46:20

first question that I ask when I

46:23

come across any stock is what phase

46:25

of the business growth cycle that it's

46:27

in. Because once I know the phase

46:29

that the company's in, I know what

46:31

metrics I should pay to in order

46:33

to judge the company's progress. So I

46:35

would say that this is a very

46:38

common mistake that so many individual investors

46:40

make. They're not even aware that the

46:42

business growth cycle is in and they

46:44

don't know which metrics to look at

46:46

to judge the company's progress, which is

46:48

why as we queued up at the

46:50

top of the episode, if you've been

46:53

judging Amazon's valuation by its PE ratio,

46:55

you've been wrong. for two decades

46:57

because Amazon is not in

46:59

the capital return phase. You can't

47:02

look at that. So just

47:04

being aware of the six phases

47:06

is step one. Yes.

47:08

And step two is a tool that you

47:10

guys built. Yes. So

47:12

we recently built a tool.

47:14

It's called Stock Simplifier. And what

47:16

it does is it walks

47:18

you through the step by step

47:20

process of figuring out first

47:22

which phase. of the business growth

47:24

cycle is a company currently

47:26

in. And then secondly, the

47:28

tool actually automatically shows you the key metrics

47:30

that you should track depending on which

47:33

phase of the business growth cycle a company

47:35

is in. So we built a tool

47:37

that's very simple with drag and drop icons

47:39

that you can fill in to track

47:41

the company's revenue, operating profit and capital returns.

47:43

It actually comes with a full course

47:45

that shows you if you're like, how do

47:47

I look up revenue? How do I

47:50

look up operating profit? What metrics do I

47:52

look at? that comes

47:54

alongside with it that teaches you each

47:56

of those each of those steps

47:58

and In addition, everyone that buys Stock

48:00

Simplifier gets a live training workshop

48:02

with me where I walk through the

48:04

entire process of analyzing a company's

48:07

business growth cycle, looking up the key

48:09

metrics, and then showing you where

48:11

in FinCHA and SEC filings to actually

48:13

find the numbers. So if you

48:15

are interested in learning more about the

48:17

business growth cycle or learning the

48:19

key metrics and want hands -on help,

48:22

check out Stock Simplifier. Yeah, exactly. And

48:24

I was lucky enough to be

48:26

a beta tester for this. And I

48:28

got to see it and see

48:30

everything that these guys built. And it

48:32

was so easy to use. And

48:34

I remember thinking many times when I

48:36

was looking through everything, why

48:39

did I wish I had had this at the

48:41

beginning? I wish I would have known about all

48:43

this and had this something like this when I

48:45

first started because it made it made it so

48:47

much easier is so much quicker to move through

48:49

companies. When we were building this thing,

48:51

the thing that we kept on having in

48:53

our head was What do we

48:55

wish we had when we bought our

48:57

first stock? And essentially, that is what

48:59

stock Simpafire is. We also made it

49:01

extremely affordable. It's 99 bucks to get

49:03

started. So we want it to be

49:05

accessible to basically everyone in the world.

49:07

Yeah, yeah, exactly. I mean, it's a

49:09

great tool to help you get started,

49:11

especially if, you know, it doesn't matter

49:13

where you are in your investing journey.

49:15

This is something that would help you

49:17

out a lot. And it's actually something

49:19

that Andrew and I believe in enough

49:21

that we're affiliates for Brian with this.

49:23

And we will have a link in

49:25

the show notes for you to check

49:27

it out to see if it can

49:29

help you. It definitely will help you.

49:31

We're big fans of everything these guys

49:33

do, and they're very good educators as

49:36

you've seen through the time that we

49:38

spent together today. I'm glad you

49:40

mentioned that we have had some investors

49:42

that have that have used it and I

49:44

try and talk to basically as many

49:46

people as I can that have used it

49:48

and I there are some investors that

49:50

we've talked to this that I've been investing

49:52

for 10 years 20 years 30 years

49:55

and I could never explain Amazon's PE ratio

49:57

or I could never understand why this

49:59

stock looks so cheap but it went down

50:01

but once they once they took stock

50:03

Simplifier and kind of run it through this

50:05

this framework. They're like God this makes

50:07

so much sense. Yeah, it really does. and

50:09

it helps explain, you know, to your

50:12

point why using certain ratios for different companies,

50:14

it's just wrong and it leads to

50:16

lots of investing mistakes either on the optimistic

50:18

side or the pessimistic side. Yep, I've

50:20

made all those mistakes myself So I wish

50:22

had access to this tool when I

50:24

first started Yeah, me too. Me too. Well,

50:26

Brian, this was awesome. I really appreciate

50:29

you coming on and helping educate our listeners

50:31

and me again. where can people find

50:33

more about you and what you got going

50:35

on? I'm on all the social platforms

50:37

you can search for my name and if

50:39

you're interested in Stock Simplifier, I just

50:41

click the link in the show notes or

50:44

visit just stocksimplifier.com. Yep. Yep. Awesome All

50:46

right Well, that folks, We will go ahead

50:48

and wrap up our show you guys

50:50

go out there and invest with margin of

50:52

safety If this is on safety, have

50:54

a great week and we'll talk to you

50:56

next week We hope

50:58

you enjoyed this content seven

51:00

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51:03

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51:05

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