An investor's guide to valuation. July 7, 2023

28:25So, yeah. We've talked about this, I think, relatively recently too. Just beware the so-called yield trap that's in there. If it's too good to be true, it's probably too good to be true. 15 % dividend yield? That's great. I'll buy those shares. Why would I not buy shares on a 15 % dividend yield, mate? Well, it's probably not going to be 15%. They're not going to pay the dividend out because the company's in trouble or just having a rough patch. It might not be anything that's sort of permanent. But that is exactly why. And just be careful as a shareholder not to – I think we speak to CEOs frequently at Strawman.

29:04And one question that is always consistent regardless of the business type or industry is how they think about capital management. I think, and I've said this before too, but the job of senior leadership is one of culture and capital allocation. I mean, the nitty gritty is sort of delegated downwards there. That's when you want really good, you know, lieutenants and the rest to sort of handle the sort of the operational side of things. But you're making the big calls on the money that is available to you that has been generated through the business. And if you ever have a wonderful opportunity to invest that, nothing's sure, right?

29:40So they can have the best of intentions and be the smartest people and just things don't always go well. But that's got to be the lens through everything is looked at. What is the ROI, as they say? What is the return on investment potential? Add a margin of safety in that. Is that significantly better than what I think my owners, my shareholders can get by just popping it into term deposit or another company? Then if so, keep it. And you should be really happy you didn't get any cash that year. because more is going to come back to the asset that you won't. And then maybe they run out of investment opportunities and then they switch to dividends.

30:17I've got to tell you, it's a real frustration of mine. I own shares in a few companies that have sort of hinted at, oh, we're going to pay a dividend in FY24 and FY25. It's like, you guys are growth companies. You've been raising capital. Some of you have got debt on there. Like, don't pay me. I mean, if you pay me something that amounts to a 1 % or 2 % yield, it's not going to change anything for me. but as a company at large it's going to result in a whole bunch of money flowing out which i would rather you would just you know continue to pursue these growth ambitions if they if they're so good pay down the bloody debt you know but they do it i think because investor relations people sometimes get in there and say oh people will love it if you pay a dividend and that'll help support the share price and it's just it's really dumb dumb dumb thinking yeah it is um a couple things on that quickly for me uh yeah i've had some people before on amazon shares we all know that um who've said how can you buy out shares they don't pay any dividend how can they worth anything at all and the answer is because they're building an earnings generating machine and that is the really key what's it's like what we're saying so my portfolio right i don't take i have a separate bank account for my portfolio and the money when i give dividends goes into that bank account and I save every paycheck, goes into that bank account, and I use that to buy well shares.

31:31Now, my portfolio is currently paying me zero, right? In terms of me personally. If I consider my investment account a separate entity or a separate bucket, I get nothing from my investment account. So what is my investment account worth to me? Now, I can measure the account itself by the cash it generates, but if I don't take anything out, then it's worth nothing to me, right? Now, of course it's not. Of course, it's worth a lot more to me because it's going to generate future earnings, either forms of capital gains or dividends. And when I take those out at some point in 10, 20, 30, 40 years time, I'll be very, very happy.

32:05That is the same as those companies. This is where it really helps to think about the, I'll use the word entities, which means various buckets or groupings, legal structures sometimes. The company that earns money and instead of paying it out, leaves it there to reinvest it, is exactly what I do every single day with my share portfolio. there i reinvest that money and reinvest because i want to actually generate more returns at some future time for me and my family and that's what companies do if they're not paying the dividend they're saying actually i could pay it out now but i'm going to keep it use that money and generate even more value for you down the track it's exactly what you should want them as andrew said to do as long as they can do it successfully at a high rate of return if they can't give me the money i'll go invest somewhere else thanks very much but that's it's just a i find that a useful way to think about you know the cash from out of a company um yes if it's out of the company it's your hands plenty of companies do waste capital so again your point about capital allocation ram is really valuable um there's nothing worse than a you know a company's balance sheet burning a hole in the pocket of a ceo who wants to go and build an empire right they can always find a reason to justify the the growth i've owned some stinkers of businesses i own shares in blackmores currently a couple of years ago they decided to be really great for them to get into the manufacturing business it was just a stupid idea it was always a stupid idea at the time stupid idea since it's cost them a fortune it was just dumb like really dumb why because they thought they could they had the money they wanted to have a go at something they literally just burnt value by trying to get clever and become a manufacturer now it could have worked potentially in other cases there are many many many more egregious examples this one was well meaning it was just it was just dumb idea in my opinion why did they do it probably because someone got excited about thought it'd be a cool thing to try and do now you know this is the way they should go maybe maybe they get it right sometimes maybe vertical integration or something like that god kills me anyway so that's dividend yield mate let's go let's go back to the price uh style um metrics now because there's a whole lot i'm going to read them out just give our list as a sense of them and then we'll talk about some of them so the price earnings we said was the most recent we'll stick with p rather than earnings yield because it's it's harder when we go through these other metrics other ones are price to sales price to book price to free cash flow and a whole lot of other things you can might otherwise choose.

34:15These are variations of the same kind of idea, but rather using earnings as their basis, they try to calculate and compare value based on other parts of a business's balance sheet or P &L, both in this category, actually one of each. One uses the P &L, one uses the balance sheet, one uses the cash flow statement, just to mess us up. And these are designed by, well, sometimes companies try and fool us, often investors who are trying to find a way to think differently about these businesses. Now, we're going to talk about price to sales, mate. And I want to throw something out. We got a message this morning.

34:49We got tagged on Twitter. Did you get tagged on Twitter? I think you did. By someone I'm just scrolling through really quickly because I should have had this already. Dwight Donald, who just says, at Sage underscore him in, at Team F Scott P. Yikes. Now, he's talking about NVIDIA. We're not going to go on NVIDIA itself, but the tweet he was referencing for us. Just tell the audience before you do what NVIDIA is trading at at the moment on the price to sales. Exactly. So he sent us a tweet. And the tweet says, NVIDIA is now trading at 37 times its revenue, price to sales, and 202 times its earnings, PE.

35:24And the tweet is a little bit acerbic. Let me read it because it's interesting in terms of the way we calculate it. And this is – we'll give away some – our listeners know what we thought about price sales in the past. But let me just read this. this tweet that was forwarded from Donald says, now's the right time to remember what Scott McNeely, CEO of Sun Microsystems, told Bloomberg just after the dot-com collapse. I'm going to give this guy a million gold stars, mate, for absolute candor. He said, quote, two years ago, we were selling at 10 times revenue when we were at$64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100 % of revenues for 10 straight years in dividends.

36:05That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39 ,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R &D for the next 10 years, I can maintain the current revenue run rate. now having done that said scott mcneely from sun microsystems would any of you like to buy my sock at 64 do you realize how ridiculous those basic assumptions are you don't need any transparency you don't need any footnotes what were you thinking love it isn't that brilliant love it so i say that which which which casts a meaningful poll on what we're about to talk about which is price to sales what i want you to do mate is i want you to talk about what price to sales is But then I want you to share with our listeners your view on why, for good reasons and for ill reasons, it became something that analysts started to talk about when it came to valuing companies.

37:10Yeah. I mean, you said it at the start. It's just a different thing to benchmark the share price against. Originally, we're just contrasting with earnings, but I can contrast it with sales or assets or whatever I want. And it's the same general observations kind of apply. How reliable are those numbers? What does a reasonable average tend to be? What's it really sort of telling me? And so they're all just different flavors of it. Price to sales is perhaps the crudest of the crude because the saying is revenue is vanity, profit is sanity, and then cash flow is king. Because if you and I are both making$100 million as businesses, it doesn't really say anything about our underlying economics.

37:50You could be at a 20 % margin. I might not even be past the break-even point yet. So it's very rough and very ready. So why do you use it? Well, you use it because oftentimes there's no other choice because there are no earnings. There is no free cash flow. There are no dividends. So I need to compare it with something. And in that regard, it can be pretty helpful. Well, at least a better option than sucking your thumb entirely. You have nothing else to do, so why don't you use price to sales? Got to use price to sales, right? And I would actually say for these kinds of companies, it's probably better to – one of two things is just really go back and nut into some kind of DCF where I just sort of – I look out into the future where there actually are earnings.

38:36So I sort of say, look, I do this a lot. I mean, I shouldn't make fun of it. I have plenty of pre-profit companies. but very strong strong sales trajectories figure is like oh gosh you guys should be earning at least 100 million dollars in a few years time i know you're not past the break even point yet but you're probably going to get a 10 margin at least that seems to be a reasonably conservative estimate compared to what others in the in the industry do and i can sort of all work it out that way but but just as a as a metric price to sales will still give you that i know that 50 is high because of the way that that was just outlined.

39:08And I know that two is much better. But it does need to be looked, I think, through the context of what you think eventual margins will be. Zero might be a recent good example of this because they've had a wonderful spike in their share price recently. And the sales have always been pretty good. The growth has been there. But what's really changed is the new CEO is basically saying, we're just going to cut a bunch of costs. right so in other words our margins are going to be much better so a very high sort of pe ratio but it starts to look a lot better i mean so for example try and look this up on the fly zero won't last year about let's call it nine dollars in in sales per share yeah uh and they're you know they're trading at 110 so that's a pretty you know it's it's it's sort of up there but i mean they made a they made a loss last year but you've got to think a company in that kind of economic model and that kind of economic position and the rest of it, probably at scale, should be able to run at a 15, maybe even a 20 % net margin, right?

40:12So it's really not so much what are the earnings, but what, I mean, imagine if I got in charge tomorrow and I did an Elon Musk and just fired half the staff. I mean, as long as the software continues to work, I mean, probably not going to lose any subscriptions whatsoever. Going to get rid of all the, most of the development team. I'm only going to do basic bug fixing and maintenance. I'm not doing new features, not going to bother marketing. There goes the marketing budget. We're all going to work from home and I'm going to do it on 10 % of the work. This thing becomes like probably a 50 % net margin business the year after I've done it.

40:42Now, I completely hobble it for the long term and it's a terrible kind of thing. But at least I've got something to anchor on with sales and what could be. And I know that's not a very satisfying answer, but it's the least bad option when there's not much else. to go on i'm gonna put a massive big button there that well no you did i the bottom i add is the last bit which is uh it's better to go on there's nothing else to go on i i i would just say to people that i think that's you're right as long as you still continue to use it wisely when you kind of go i know what profits gonna do so let me use price to sales it goes back to your point and you've already made the point though which is what are the eventual margins look like right i get i get no profit i'll just use price to sales i'll just pick 10 because 10 seems okay and guess what?

41:30Woolies is on 1.3 times sales. If Woolies goes to 10 times sales, you can pay$250 for Woolies shares and justify it by, well, it's less than 10 times sales. What's wrong with you people? And the answer is, of course, we know A, it's a mature business, B, it's a very low margin business, great business, but the reality is you don't want to pay too much in terms of a sales multiple for it. On the flip side, I will also say, I'll use the Amazon example because I did it earlier. Amazon's price sales have been extraordinary for the last 25 straight years. While it's gone from$2 to$100 and something, less than that, whatever the split adjusted cost was originally.

42:01Because it's generated that value we talked about, we talked about the PE. And this is where the growth thing matters. I despise the price to sales ratio, Ram. I got to say, and maybe just come out old fuddy-duddy and I don't love the sort of growth companies you love. But I'm absolutely with you when it comes to looking at the... So go on, Kogan, drink, everybody go and have a drink. It's Friday afternoon. By now it should be after five o 'clock Eastern Standard Time. Knock yourselves out. the i kogan wasn't profitable for quite a few years and kind of barely profitable at that and i will i'll just give it i'll just give a counterpoint to price to sales mate very quickly not to not say i'm right i could be entirely wrong right i have been so far so let's let's put that up there um i've never gone oh well it's growing business and it's therefore it's worth x times sales what i've always said is okay well at some point if the sales directory continues it could do sales of about x at some future point and at that point if we can make a margin of six or eight percent which is more than a standard retailer but not bad for an internet retailer then okay that might be worth x dollars of profit and at that price if i'm paying this price today for that level of profitability that seems justifiable to me so that's my and everyone's different mate and full credit to those who've bought in video and made a squillion dollars but um i'm not saying it's bad company either by the way i really have no don't have a view on it but i will say looking at the um a business and sort of looking at what because the other day you even if you use price to sales you at some point either i hope you want of two things either that some other idiot pays even more as a multiple of sales than you did he makes some money or this company eventually becomes profitable and can be reasonably traditionally valued by somebody and so either those two things is fine but you have to believe you can get to that point with some degree of confidence and justifiable confidence not just made up you know dutch courage after a few beers and you say, okay, well, I think that, you know, Kogan is worth paying$4 for, whatever price was, because in five years' time, sales could be in this rough range and margins could be in this rough range.

43:58And at that point, I'm likely to get a decent outcome. So I think, you know, as I said, I hate price loss, never, ever, ever, ever used it. If I ever do, feel free to tell me I've jumped the shark and I can go and do something else. Not because I'm necessarily right. It's not my way of thinking about it because the rest matters. And I don't, I think the further you get away from profit, the more you let yourself live in, not you personally, although feel free to dox yourself if you want to. I think people who use price sales live in fairness. There's a whole total addressable market problem as well.

44:26This could be$84 trillion market and it's only trading on 84 times sales. Therefore, it's a great buy. It's like, well, maybe. You know, the biggest little word in the world, biggest little word in the world, if this and if that and if that and if that, the fewer ifs you have, the less risk you take with your investing. And that doesn't mean you're not going to get a return because you're paying cheap enough price. Again, Amazon's a great example. If in 1997, I'd be clever enough to actually buy the shares rather than watching it for 15 years first, I could have made an absolute truckload of money.

44:55But the ifs were in the way. I don't disagree with anything you've said. You absolutely nailed it. So I should clarify things here. I don't think I ever have based an investment on, oh, the price to sales is this and that seems low to me. Never, never, ever have I done that. It's one of a thousand data points that you can draw on. And so if we got on the call this morning before hitting record, you said, oh, Ram, look, here's this company. It's really interesting. They don't make any profit yet, but I really like it, blah, blah, blah, blah, blah. One of my first questions to you probably would be, what's the price to sales?

45:29Not because I'm going to make an investment on it, but instantly that information tells me a great deal about expectations in the market. If you could say to me, oh, look, they are growing like the clappers. I think they're going to pass break even soon. and compound growth is at 20%, 25%, should stay that way for five years, and the price to sales is three. Now, I've got to do a lot of extra homework beyond that point. But as a heuristic, as a shortcut, that's interesting. That doesn't actually seem too high based on what you told me, assuming they can get to decent margins, et cetera, et cetera, and all the qualifications you put around it.

46:04If it was the exact same conversation, but then you said, oh, the price to sales is 50, it's kind of a hard pass right from the get-go. Now, I still haven't done any of that work, but what I know intuitively, rationally, is that, well, even if you're right, Scott, that's going to be a very, very hard position to get a good return on because the market, obviously, at 50 times sales is forecasting all of that. In fact, it needs to be that and more for much longer than everyone expects, generating much higher margins than everyone thinks. So that's how you use these kinds of things. It's not like I've got to choose something and that's what I'm going to make my investment on.

46:42It's a nice little hack, for want of a better word, just for me to go, I need to put something in context from the get-go. And I find that's what I'm doing a lot with the investing process. You start with a very general blunt kind of questions. And then you're trying to get to that statue of David in the big block of marble, right? You're just chipping this away. You're chipping that away. And sometimes you just hit something and go, I'm done. I'm done with this block of marble. there's no point shipping further so i agree 100 with everything you said but it can be useful it can be useful as a as a single data point to frame up some context for you yeah absolutely and and that's that's where it's of value to my mind um let's really quickly as much as i've just poo-pooed price sales and i i still stand by it the other thing i would just want to mention to people both in support and and just something else to watch out is this should be obvious to most people once you to learn to think in exponential compound terms it's really really hard to do but important if i bought a business with a dollar of savings a dollar of sales at 50 times sales there's a decent you have to do okay because at some point it's going to be a hundred dollars in sales and a thousand dollars in sales you know it's probably okay it's because there's a base effect correct at play there because at a dollar it's just like it's not i only have to earn one more dollar and i've doubled my revenue yes whereas if i bought if you're a billion dollars of revenue, doubling that is much harder.

48:03Correct. And that is the key one, right? So the other thing to think about, actually any price-based metric, but particularly price to sales, but price to some degree, the higher you go, there should be an inverse relationship, generally speaking, depending on the market size, between the size of the business and the size of the multiple. Just because, to Andrew's point about the base effect, the trillion dollar business has got to double sales to grow versus the million dollar business who's got double sales to grow, doesn't mean that the million dollar business is necessarily worth investing in or a slam dunk because there's plenty of small businesses that go broke because they'd never quite make it for a million different reasons.

48:40So I'm not saying it's lower risk at all. You should pay more for those businesses. All I'm saying is as the business grows, you should be ratcheting back your expectations of future compound growth by definition. Buffett himself has said, I own Berkshire shares, everyone knows. Berkshire can't keep growing at previous strike rates. And you made this point at a different podcast, Andrew. I'm not sure if it's in the past or upcoming because we're recording out of sequence. You know, if Berkshire grew around 20 % a year, eventually it would be bigger than the world economy. That's not going to, obviously.

49:06So there is simply a law of large numbers problem here. Trees don't grow to the sky. Choose your preferred metaphor again. Which is why the NVIDIA situation is so ridiculous. It's a trillion dollar company. It's almost a trillion. Oh, okay. It's a trillion dollar company. There you go. Yeah. All right. So it's$963 billion US. Yeah. Like whatever. Yeah. It's massive. and you think about if it's... It can't 10x easily from here. Motley Fool Money. For more, subscribe to the free newsletter at fool.com.au forward slash listener.

49:41Price to free cash flow. Now, we've talked a little bit about the cash flow statement last week. We don't do a lot more on that, but I would like you to give our listeners a sense of what free cash flow is and why that's a different metric again than either sales or earnings? Really, free cash flow is the gold standard in the metric I think that you should use because profit is statutory profit won't always equal cash. Actually, case in point, just before we got on the call this morning, we're talking with the CEO of Pioneer Credit. It's a purchase debt ledger provider later on today. Anyways, I'm doing a little bit of prep before we chat to the MD.

50:26and they've got a bunch of revenue in there and the operating cash flow looks pretty good, but the profit was this huge loss. What's going on here? There must be some one-off sort of cost or something. Well, this company, the way they have to do their accounting rules, says that when you – maybe I need to back up a little bit here. What they do, Credit Corp is another example, they buy purchase debt portfolios, purchase debt ledgers. So basically a utility has all these clients who haven't paid their bill. Rather than collecting all of them themselves, they bundle them all up and they sell them to these other people who buy them for cents on the dollar with the general aim of collecting more than they spent for it.

51:05That's the business model. Very easy in concept, very hard in execution because maybe you won't get what you expect. And sometimes there can be competitive tenders. You have to kind of sort of pay a lot for that. But what it says to me in that instance, and I'm probably speaking too soon because I haven't spoken to the CEO yet. But I actually think that statutory profit number is very sort of deceptive there because it includes this huge investment you've made. Presumably, you hope to collect far more than what you spent on those purchase debt ledgers last year. But it has been expensed in that year.

51:35The full expense comes now. And I will collect that on that over the next three, five and seven kind of years. So at first glance, like, oh, there's no way I'm making a huge loss. It's like, well, actually, strip out that investment. maybe it should go under investment cash flows and I'm sure there's a reason why it doesn't you think that's actually a profitable business so they this is way off sort of topic here but it just it's an example of how things can can differ and when it comes to the good thing about cash is cash is sort of cash and correct and and free cash flow that well the formal definition of it is it's just the operating cash flow so everything I've done in in running my business all the money I've taken in, all the money I've sort of paid out, minus any investing cash flows, right?

52:26So it's the money that's free, as the name implies. It's left over. I can pay a dividend. I can do whatever. It's free to be used. That's really what I've got available short of raising more money via debt or equity. So that's really nice. Companies with high growing, reliable free cash flows are wonderful because there's this actual stream of cash coming through, regardless of what the statutory sort of accounts kind of say. So it's really, really nice. Again, though, where it gets tricky is just sort of like, well, sometimes it can move around. It can be very volatile as companies make investments.

53:01And again, you've got to come back to, well, how good was that as an investment? That's the case with Pioneer, right? They're trading on half their book value. I'm getting ahead of myself here with book value. But on half their book value at this point in time. and and here's that here's that biggest little word again if they get the expected return on the on the ledgers that they've purchased recently things are screaming buy right um and let me very carefully i'm not saying it's a screaming buy i don't own shares i haven't done any reason it's the if we have also seen examples of collection house which are you and i made the misfortune of talking about everyone.

53:40And I had some shares in that. Yes. Yeah. Yeah. Yep. And they didn't collect at a rate that managed to supersede the costs and the whole business model sort of came crashing down. I've gotten segues and segues here, mate, but save me up. Tie that in a bow. Put a bow on that for me. I will do that for you. I will only say, by the way, that as much as your members should absolutely tune into that conversation, by the time this goes where it will be done, but what will be available, to myself a plug The Good Oil with Scott Phillips the podcast other podcast that I host I actually interviewed the CEO of Pioneer Credit and that episode is available it was done on the 19th I missed that I'm definitely have a squeeze or a listen what were your impressions to go off a bit off topic doesn't go too far off topic what I loved have a listen for we don't go into book value or the value of the P &L what I loved is their remuneration strategy I was going to ask How will this well do?

54:38Because you'll be fascinated by the answer. I will happily share it now because I won't steal your thunder. Your meeting's already done by the time this goes to air. The long-term nature of the management incentives is exactly what you would plan if you were doing it from scratch. So huge props to them. By the way, Keith-John founded the company. So funnily enough, when you have a founder involved who wants to maximize long-term value, they tend to set the incentives appropriately. Go on. You still own 16%, I believe. It's a huge, huge deal. Hey, let's go to price to book then because this is the last one of our valuation metrics.

55:16This is, Joe Omega, a former colleague of ours, used to say that in the good times, everyone compares price to earnings. In the bad times, everyone compares price to book. And that's because in the good times when there's lots of profits, you go, oh, look how much money we'll make. This is all wonderful. And the bad times when profits maybe falter or maybe there's some concern around the market, people go back to, what does it actually own? What are the fundamental, you know, what am I getting when I buy this thing? Now, book value has gone a little bit skewy in the last 10, 20 years. I don't think we'll be talking about it in 15 years for most businesses, Andrew.

55:47Because the old days, we were talking about the steel factory last time, and again, this time the steel mill. The book value is all of the value of all the things the company owns, less all the things it owes. Liabilities. Thank you. so uh my book value is that value of my house and my car and my computer and whatever else i own minus the mortgage minus the car loan minus any credit card or personal debts or anything gambling debts and other things i might urge from people i don't for the record um but taking all that stuff off what's left over you know if you if you liquidated scott phillips incorporated the book value is is the total amount of what's left after all the assets as andrew said that's all my liabilities.

56:28What's left at the end is the book value. Now, in the old days, Ben Graham, Warren Buffett's mentor, going back to the 1920s-ish, used to love doing this stuff. He'd literally look around and he'd do it slightly differently. But he'd basically, at that time, see lots of businesses who were, you know, had a book value of 100 and they were trading for, selling for 80 or 70. So, so you meant I can just pay 70 bucks and a hundred dollars worth of assets? Well, of course I would do that and do as much as I'm allowed to. And Graham did it over and over and over again. Did extraordinarily well. These days - Just very quickly, that was the whole corporate raiders deal in the 80s right correct buy up a business and then you'd break it up into lots of little bits and you'd be able to sell it for more than what you paid in total that was the plan spot on so look you don't get much of it anymore for a couple of reasons one is the market's smart of that now you don't get those mispricings as often second book value doesn't do a very good job at all of capturing things like what we call intangible assets so think about mastheads for newspapers think about the value of brands think about things like network effects or the customer list, that kind of stuff.

57:28Those are real serious value creating assets, but they're very rarely recorded on the balance sheet because accountants don't really have a good way of doing that. You can kind of do it a little bit with acquisitions through effectively a balancing item. We won't get into that today. But basically, it's not as useful as it used to be. It is still very useful in my mind for both insurance companies and banks, because the assets are the assets of the assets. Yes, CBA is worth a little bit more than Westpac maybe if it's a slightly better business, but broadly the value of its assets are the value of its assets.

57:57The same with a real estate investment trust, another really good example, right? If you've got$100 million of property on the books, you're not going to pay much more than that because the property is worth the property. You're not going to pay too much less than that. So what's left is the book value at the end of the day. Yeah, yeah. Go on. But this is why we, well, it's not uncommon to see write downs, right? Correct. So here's another qualifier to just frustrate people even further. It's like, well, they might say that they have$100 million worth of property. When the value has come around or when they actually test that in the actual market, they might find that, oh, no, we can only get$80 million for it.

58:35So there is that. I would suspect that there's probably some write downs in the commercial real estate sector. So we should say very quickly too, and this again, weeds very shortly and very, very, very, very small weeds. Managers and boards are required to have those assets revalued. And generally speaking, those revaluations are relatively conservative and relatively accurate. But what book value is, is if the asset was to be sold in a free and fair market at arm's length. And that's important. Now that's every side. If I want to sell my house, I will sell it in open market when the markets when people know what's going on they can look at the property do all that kind of stuff that's different from what we call a fire sale price which would be to Andrew's point and we saw this during the GFC with a business called Centro Property Group it's changed names three times I had to go back a couple of times in my head to get back there when they got into trouble they couldn't refinance their debt and they wanted to sell the properties and they were selling the equivalent of$100 million properties for$20,$30,$40 million because they were desperate it and there weren't many buyers and so the fire star price is very different so book value is not fire star price book value is you know if i wanted to sell it today and i had the time to sell it at my leisure to a range of buyers who all knew everything about the business i knew everything about the business i could just sell it put on the market sell it for a you know a reasonably conservative ish but not not fire star price that's what i'd get to andrew's point if you got messy then uh no assets worth what it says on the books yep and look at the end of the day it's the opinion of someone or a small group of people.

1:00:10And I'm not trying to suggest anything untoward, but I mean, you see, look at it every weekend, you know, houses are listed for one price and there's sort of these price guides and they're never, you know, they're always off because you don't really know until you sort of test it. So, I mean, I think it's an excellent thing to look at. Don't get me wrong. Like it is, there is something very comforting knowing that regardless of what might be happening with earnings in the short term there are real and valuable assets here whether tangible or intangible you know they they are they are real and i can get something for them you can debate exactly what it would be but it's not a zero right now again that's not the basis of an investment but it does it can provide some some comfort that there is there is something there because the let's say that let's say that the the carrying values are reasonably correct and the market just gets insanely stupid, there will come a point where you will just go, all right, stuff it.

1:01:06We're closing the doors. We're selling all the assets. Yes, exactly. Because I can, and why wouldn't I? Because I'm going to get more than what the market says that I'm worth. So it would have to be pretty extreme and egos will maybe prevent this. But it becomes the only rational kind of thing to do at that point. And you should do it at that point. You should do it because I'll buy shares for a dollar each and then I'll just do this and get$2 back. Thank you very much. Like, you know, yeah. Yeah. So all of the things, to tie all of this up, really, again, it comes back to there's just different things that you can benchmark price to.

1:01:43Assets, cash flows, dividends, earnings, you name it. Look at all of them, right? But just look at them all in the right context. Understand what they're telling you. Look at what similar companies are kind of doing. And it's a really, really useful sort of place to start. But then before any trigger is pulled for buying, it's just a question of then looking into your crystal ball and sort of saying, how does the future look? And what do these things now look like in that future sort of context? Assume that you're going to be wrong because you probably are. So you just sort of edge it back with a margin of safety, you know, and you're just on a – there's no guarantees in this game, right?

1:02:22We always say it's probabilistic, but you are on a much firmer footing than someone has gone, well, the PE is three and the dividend yield is 15%, so it's cheap, I'm all in, right? Like you're just so significantly ahead of that kind of person. And that's why these things can be really, really, really valuable. But, you know, devil's in the detail, context matters. Yep, exactly. Mate, that takes us to the end of the price numbers. It probably just works. We're only up on about an hour. I want to spend the last little bit of time talking about a different, a whole different category. It's not going to take another hour, don't worry.

1:02:54A whole different category of analysis. We've talked a lot of, there's been valuation metrics the whole way through. How much am I getting and what am I paying for what I'm getting? And the what I'm getting thing can be sales, earnings, book value, free cashflow. And we talk about the dividend yield, what return am I getting in cash? Again, measured as a proportion of the purchase price or the current share price. The group I want to quickly talk about, mate, is the return on. In other words, return on assets, return on capital, return on equity. These aren't metrics that talk about at all, actually, about the price we're paying.

1:03:34It talks about the business's ability to generate returns based on the money. And those are all different metrics. So I'll say money for now. The money that's used to generate those returns. And broadly, the idea is, hey, if you want a dollar of profit from Woolworths or a dollar profit from straw man or a dollar profit from the motley fool or a dollar profit from tesla you how much money do i have to give you to get that dollar of profit back out and again these are very different metrics because they rely on different funding models or methodologies but they also depend on the structure of the business the amount of money you need to put into the new steel mill is obviously much higher than the amount of money you need to put into a new piece of software for example and around and around it goes so let's talk about a bit about that mate which of these which of we'll start with your favorite mate which of these return on equity return on assets return on capital which is your favorite of those metrics and why oh that's that's it's that's another it depends but i look to play along return on equity i think is probably it's it's probably the most widely used and i think it speaks more directly to the shareholders like on the equity that has been put in me and all the shareholders have put into this business what return are we getting might actually be a pretty ordinary return on an asset basis or a capital basis when I factor in all the debt.

1:04:55But if the return to me after that interest expense has sort of been paid is still better off, it can be super attractive. So all the usual caveats apply here. It's only as good as the expectations for certain future events are maintained in the sense that it could be that the profit falls in half and all of a sudden the return on equity is going to fall in half as well. But the higher the better is always the way to go. And consistency and stability are important. I agree. Let's break that up because I don't want to talk about these in turn. They are all functions of the same thing. You've already kind of talked about that in general.

1:05:41And I want to use the example. Listen, I love this. Let's use the example of an investment property. And the reason I say that is because it's something people get and it's really simple to illustrate. It's the way to go. The return on equity, if I was to buy a house tomorrow and I was going to say, I'm going to put up 10 % and borrow the other 90%, I'm effectively leveraging 10 to 1. Now, that's risky. Andrew will tell you that's risky. But, or 9 to 1. Not in this country. You're too timid if you're only 10 to 1. What are you doing, man? let's assume 20 to 1 let's you for now although we'll come back to let's you for now it doesn't hurt you we'll come back to why we that why there's a different way you need to be careful if i was to earn a 10 return on that house the asset of the house worth a million dollars because i just like to be like to keep things simple if i get a 10 return on my house over some period of time the return on equity would be a hundred thousand dollars 10 of a million so my return equity is 10 my sorry my turn asset is 10 on assets 10 the return on equity if i've only put up 100 grand and i get a 100 grand return i've got a 100 percent return on equity in other words i put up a dollar of cash i'm getting a dollar back for every dollar i put up that's astonishing even though the asset itself only returns me 10 percent now those are very generous numbers andrew will happily tell you if i don't mention already he'll make the point that you won't get those sort of returns from property that's absolutely true but whatever number you use well you have well you have for a long period but not a single year though a return equity is normally a single year's profit divided by that money that's used.

1:07:14So one year's rent divided by the equity, one year's rent divided by the asset value, right? So it might be 10%. But yeah, the idea broadly is by using that leverage, I get a much better return on my equity than I put up. And that's why people do it. It's why they borrow a truckload, hope the share price, oh, the house price goes up. Because if you buy, let's, okay, just very quickly. If I buy a million dollar house, 10 years later, it's worth about a half million dollars. it's got 50 % which is fine when I sell it and take out my half a million dollars I've got five times my money in a in a in whatever I said it was five or ten years that's a remarkable return that's why people would do it if you believed that return was possible now let's try and stay away from property around me know it's hard when it comes to companies the same thing is also true if you look at a business like transurban for example I regularly laugh that transurban is a loan with a toll road attached rather than actually toll road business right because it's just got extraordinary amounts of debt.

1:08:07And that makes it extraordinarily, you know, it's an extraordinary return for shareholders because for every dollar of equity you put up, they borrowed an absolute truckload of debt to support it. The banks lend them the money and the corporate bond market lends them the money because what's safer cashflow-wise than a toll road, almost nothing. So you can borrow a truckload and you get a fantastic return, not on the asset, which is the big toll road, but the equity you put in, which is almost minuscule compared to that. On the flip side, a company with no debt, super, super, super conservative, not risky at all, right?

1:08:42Because you can't go broke if you've got no debt. Warren Buffett said leverage is the only way a smart guy can go broke. But your return on equity is going to look terrible because you haven't borrowed any cash. And this is the crux of why these metrics need to be considered in consultation, in my view, together, because you need to say, the ROE can look spectacular, but if it's juiced by debt, You need to know you're taking much, much more risk in a relative sense than a business without debt. Not saying it's bad, not so you can't do it, not so you can't get away with it. It's just you need to keep those all in mind.

1:09:12ROE is kind of the cool kid's favorite, right? It's the every value investor loves it. An ROE with over 30 % is wonderful and blah, blah, blah. And of course it is by definition. If you can get a 30 % return in a given year on$1 equity capital you've put into the business, that's great. Why wouldn't you do it? And the answer is in a good business, you absolutely would. In a bad business, have you seen the debt pile? that stuff's crazy and somewhere in between it's why you should always in my view look at those together because it helps you understand not only the absolute return on the the equity but also the return on the asset itself how good is that are we just pretending that it's good because we're getting using lots of debt and then what's the risk that comes with that debt right yep uh so a few things i want to say a few things about transurban now um return on equity is uh when you see a business that has a consistently high return on equity that's a really wonderful sign And it's particularly if they've done it with a prudent level of sort of leverage.

1:10:04The first company that came to mind for me was ResMed. They do the sleep apnea devices, help people with breathing at night, et cetera. They're always north of 20 % on their return on equity. They get an incredible return and they're not highly leveraged. Here's what's interesting. You said everything that you said about Transurban was absolutely correct. I punched it into ComSec though. Actually, the return on equity was negative in the last few years. and even before that on a more consistent base it kind of hovered around 5 % so wait a sec that's exactly at odds with what you just said so just to fill in some blanks there for anyone who's scratching their head I wasn't going to go there but thank you for yeah just because someone might look at it as an example because I was like oh don't use Transurban Phillips you're an idiot but go on let's backfill my mistake well that return on equity is calculated on a statutory profit figure and that statutory profit figure will have very significant depreciation costs in all of that because roads you know tend to wear out sort of over time.

1:10:58They're non-cash chart. I imagine that their return on equity looked through a cash flow lens is much more attractive. And that absolutely underscores your point. What's also interesting, someone once said to me, you only dig a tunnel once, right? Yeah, that thing's going to depreciate over 20 years or something like that. Yes, they're ongoing maintenance costs and that is reflected in depreciation to some extent. But there's really interesting investment opportunities out there when people straight, The accountants say, the auditors say, you've got to depreciate or amortize these assets, and you do and your thumb suck.

1:11:31But there's a lot of cases where it's like, that's actually not in line with reality. We have to do it to be conservative. We can't assume that this value persists forever. Yeah, yeah, yeah. But you do get these, that help. If ever you see these kind of disconnects, that's the kind of thing to look for here is sort of like, so the trans-urban shareholders are getting much better return on equity on a cash flow basis than that. So just to help square that. yes that was my fault for taking down that wrong the wrong rabbit hole um and i will say too by the way uh federal laws were changed to allow things like transurban and sydney airport to actually even exist in the first place as investable entities um because governments wanted to basically use private capital to build these assets and so or buy the assets so for example in the old days you used to only be able to pay a dividend out of what they said what they called retained earnings in other words you had to have a statutory profit pool from which to pay those dividends they actually changed those rules specifically for those companies and their real because they wanted to create structures that people could invest in that would make statutory losses that effectively would fund this infrastructure project so the whole thing is all a mess in general because they can actually pay dividends even though they haven't made a profit again because statutory profit is not necessarily reflected in the the absolute results because of those depreciation administration charges it's a nightmare looking through those financial statements it really is but it tells you something about it though doesn't it i mean think of it like Like on paper, it's just the world's worst business, right?

1:12:55Because I got to spend literally billions of dollars on this thing. I don't know really what the traffic flows are going to be like after the fact. I mean, if this was a high return business operation, the government wouldn't be outsourcing it. It's like, well, we'll just use taxpayer funds and get a 20 % return on our investment if it was that lucrative. It's not. It's really ordinary. In fact, the only way for it to make sense from an investment lens is to lever up to make sure that the returns are sort of half decent. And it's not as reckless as it sounds because, you know, on the main, these are very, well, they're very durable, long lasting assets that have a great utility and are very much sort of used.

1:13:35They just need to be juiced with all of that kind of stuff. Sydney Airports is the other classic example, right? So, yeah, all of those things are still true. So see, actually what I did, mate, this is the thing. I actually did that on purpose. I mentioned Transurban just to give you the opportunity to tell me I was wrong because I'm a nice bloke like that. No, I didn't really. But what I like about it actually in the end is it kind of wrapped up beautifully the last hour or so of this very podcast because it gave us the opportunity to talk about earnings and cash flows. And we got to talk about return on equity and depreciation.

1:14:07And frankly, the dividend yield, it tells you more about Transurban's business than the earnings yield in this case. So it's a really lovely combination of all of the above, which obviously I did deliberately because I'm that sort of plug. I'm good like that. So you're welcome, listeners. You're welcome, Ram. It's what I do. Mate, did I get away with that, do you reckon? Yeah, mate. Look, what you said, there was nothing wrong with what you said. I was just, there is - No, you're right. You're dead right. You know, there is just these wrinkles that are very common. They're all different kinds, but it is really frustrating.

1:14:38I still find it frustrating to this day. I found it really frustrating in the early days. It's like, well, how does this sort of all add up? And it's just so very difficult. But, I mean, TransAmin, as you say, what a wonderful sort of example here too because this is probably one where I would lean a bit more on the price to book, speaking of some of the choices that we had. I wouldn't put as much weight on the price to earnings ratio. I'd put a lot of weight on the dividend yield in this because no matter how complicated your structure, That is a very real return and reasonably reliable, given the nature of what their revenues sort of come from.

1:15:18You know, COVID being a very interesting exception there. But, you know, and so, you know, I actually really like the business in a lot of ways. I think they have done spectacularly well out of the naivety and short-termism of government, frankly. Exactly. You know. But it's also, I'm not a shareholder because the yield is 3.4 % in a rising yield environment. I know before anyone adds in, there's expected to be some really decent growth in dividends in the coming. And that's actually the right thing to look at. In fact, looking at some of the forecasts here, it's like, wow, they're really going to sort of ramp up as volumes continue to recover and new assets come online, et cetera, et cetera, et cetera, et cetera.

1:16:00But yeah, what a wonderful example of the kinds of things you would look at in that context. It's pretty cool. Mate, I reckon that's given us a pretty good run through. Listen, I hope you've enjoyed this kind of two-part-ish episode. I will look at the financial statements and I'll look at some valuation metrics and methodology. We've been asked a lot about those in the past. We might have some other point, mate, probably not next week. We're probably going to move on to something else. But at some point, we might actually even maybe grab ourselves a grab bag of companies and sort of talk about relative valuation, not to make a formal recommendation or a view, but just think about how we might consider the valuation, what to use and when.

1:16:36I love that. A useful conversation. I love that idea because you can talk theory until you're blue in the face. Yes. It's sort of going through it. And when we, I can already, I don't even know what companies I'm going to use, but I can already tell you that there will be some things that I, there will be a bunch of things that I think, oh, this is really interesting and look what this says. But on the other hand, there's also these things. Like nothing's going to fit in a nice little easy template. But I think it'll be very, very useful. the other thing i would say too is that um i'm very very humbled to be part of the education process for our listeners but gosh there's this thing called the internet and there's so much free stuff out there just just whenever what was scott saying about this and then google it right like no no we didn't invent any of these things and there's just there's there's there's it's like any googling any topic you do have to sort of wade through a bit but you'll find some really really really great resources out there but just always bring it back to what does this actually mean for the business and what it's going to cost me to get involved in it.

1:17:38And I think it's just the process of starting down that pathway just be a very fulfilling journey in the fullness of time. I love it. Mate, that's a wonderful way to finish off. Thank you for spending some time going through this list. Thank you for listening. Ram, will you come back on Sunday? Yeah, looking forward to it. I cannot wait. Mate, just so others know, if you want to ask us a question, I want holidays, but refill the mailbag for us when we get back hit us up on email at info info at fool dot com dot au follow us on Twitter Andrew is on Twitter exclusively as a special deal with Elon Musk there's a whole lot of people signing up for Tucker Carlson's on Twitter only these days so is Andrew Page draw your own conclusions at sage underscore Simeon or at straw man invest get me on Twitter or Insta at TMF Scott P be warned as I said before you'll get travel photos right now but I will get back to business and policy at some point.

1:18:31And of course, follow me on Facebook. It's facebook.com forward slash Scott Phillips Money. All that's left for me to say then is, Fool on. Cheers. The Motley Fool and people appearing in this program may have positions in the companies mentioned. General advice only. Please speak to your financial professional to understand how it may pertain to your situation. Subscribe to the free newsletter at fool.com.au forward slash listener. The Motley Fool operates under Financial Services Licence 400691.