Financials Demystified: Operating Expenses and Company Growth

0:00There's a huge misconception that to start a business, you need to invent some revolutionary product. But the truth is, you really don't. Some of the best businesses start as a simple side hustle, like selling a craft you make on the weekends or turning a hobby into extra cash. For a lot of people, the real hurdle isn't the idea. It's the technology. Figuring out how to actually sell online is where a lot of folks just give up. That's exactly why you need Shopify. Shopify is the e-commerce platform responsible for millions of sales worldwide. It handles all facets of your business, your online storefront, your inventory management, and your point of sale.

0:36So you don't have to juggle 10 different systems. One platform is all you need. You also don't need to be a tech expert. Shopify templates and AI tools get you a stunning site up and running fast. No coding needed. And because Shopify handles the setup and checkout, you have more time to focus on actually growing your business. If you're ready to hear the of your first sale today, head over to Shopify.com slash beginners to start your free trial. That's right. Start your free trial at Shopify.com slash beginners. That's Shopify.com slash beginners. Support comes from Wise, the smart way to manage the currencies you need around the globe.

1:18Fed up with losing out to hidden fees when you send money abroad with your everyday bank? Choose the smart way. Wise. You can count on the exchange rate you'd usually find on Google. No unwelcome surprises. Plus, ditch that where's my money feeling. Most transfers arrive in under 20 seconds. Join millions saving billions on hidden fees. Be smart. Get wise. Download the Wise app today. T's and C's apply.

1:55tuned in to the Investing for Beginners podcast. Led by Andrew Sather and Dave Ahern. Step-by-step premium investing guidance for beginners. Your path to financial freedom starts now. Starts now.

2:16All right, folks. Welcome to Investing for Beginners podcast. We are going to revisit financials demystified. We did gross margins earlier, about a month ago or so. You can check that in the archives. Today, we're going to go a little bit deeper on the income statement and talk about operating margins and maybe a little bit of OPEX or operating expenses and such. Andrew, let's talk about operating. Guess what is operating margin? If I say that to people and they're like, what? What does that mean? It's very helpful when you can start to visualize what an income statement looks like. Basically, what operating profit is trying to tell you is what does the operations of a business, what kind of profits are coming from that?

3:03There's a lot of different profit metrics that a business reports, which try to tell you, they try to give you a picture of different parts of the business because obviously at the very bottom is your bottom line. That's the profit. But there are a lot of pieces that go into that when you run a business. So for example, if we had a lemonade stand, you want to know how much does it cost you to make a lemonade and then how much do you make when you sell it? That's gross profit. We talked about that last time. You also want to think about, well, how are you getting this to market? You not only have to make it, but you also have to spend money to advertise to get people in the door.

3:42So that's part of what we're going to be talking about today is operating margin. And then the last piece is just general things you have to pay for as a business, like the one we all hate, taxes. That stuff still happens and that stuff changes. If you've followed politics and business history, tax rates change all the time. And so we don't want to be looking at just bottom line profit because it's not apples to apples if tax rates are changing. That's why we want to look at operating margin. That's why we want to look at operating profit. So that's really the three big pieces. Obviously, we're focusing on that second one today, but it tells us a lot as an investor.

4:22How do you use operating margin when you're looking at stocks? Oh, I use it a lot. I kind of said this before we were recording. Between the gross margins and the operating margins, that's really where the rubber meets the road. for the business, like this is where all the really good stuff happens. And if you can understand these two parts of the income statement, then you can really get a really good handle on how this company operates, how they make money, how management manages the business, because these are the two main things that they have to manage is how much do these things cost them and how can they make it profitably and how can they come up with new products?

5:04So all those things are all kind of wrapped up in the gross margin and the operating margin. And I love to spend a lot of time looking at the operating margin as we're going to kind of deconstruct. It's a good way of really understanding what's going on with a business, like who does what, how they do what they do, and how efficiently and effectively do they do this. And it's a great way to separate the kings from the not kings in a particular industry or sector. So if you're trying to compare companies looking at the operations if they're making the same widget and one does it at a better operating margin than the other one then you could probably conclude that they're just a better operation they can charge more they do it more effectively they make more money and the stock price will be rewarded over time and so that's really what i try to use operating margins for is to help me determine okay if i'm looking at this company versus this company which one is better.

6:04And you can learn a lot from the operating income or the operating profit of the business. And I guess, so that's how I use it. I'm curious how you use it. Well, I mean, it's the same way. It's very helpful to do it like that. So how do you calculate operating margin? Operating margin is the gross profit or the money that the company makes after their costs. And you You take out the operating expenses and that leaves you the operating income. And then you divide that by the revenue of the business. So just like gross margin, any gross profit you compare to revenue and that gives you a margin number.

6:44You do the exact same thing with the operating income. You divide that by what's left over after all those costs and expenses are taken out and you compare that to the revenue and that gives you a margin, which you can then therefore compare to other companies. So you can look at the operating income margin of a company like Google and Microsoft and compare them if you wanted to. Or you could look at Uber and Lyft and compare them if you wanted to. So that's how I do it. Yep. Yep. That is how to do it. It's pretty easy. And the nice thing with Fiscal AI is it's now Fiscal AI. I will probably say FinChat, just a heads up, but they have changed their name.

7:28with fiscal ai they make it super easy for you to track all this with the company so maybe let's talk a little bit about the margins what they can tell you about a business and maybe some of the components that go into determining what the operating income or the operating profit of a company is yeah so there's different operating expenses like you mentioned the two big ones that you will see in fiscal.ai, R &D and SG &A. R &D, I think, self-explanatory research and development. Tech companies rely on that a lot. That's where you get the big innovations. That's where the semiconductor companies make those great chip designs that lead to bountiful profits.

8:17SG &A is selling, general, and administration. you'll see sales and marketing costs in here usually. Things like hiring sales people, paying commission to sales people, paying for advertising, all sorts of advertising can all be bucketed in there. And so you have the gross margin telling you what have you made after you've created the product. Now after you have researched to try to make better products like I almost look at OPEX operating expenses like investments almost where at the end of the day if push came to shove you could kind of shelve SG &A and R &D wouldn't be great for your business long term but you could still technically shelve that and then make a profit from how much it costs because I mean you can't get away from what does it cost you to make a product that's always going going to be there.

9:16So it's hard to dial that back, though companies can, but it's harder to dial that back. Something like SG &A or R &D is a little more discretionary. So I kind of think of that in the investments category. And it's how companies, especially nowadays, how a lot of companies reinvest for growth. Back in the old days, everything used to be tangible. Everybody would invest in warehouses and buildings and assembly lines. Tangible went through CapEx. We talked about CapEx previously. These days, the newer companies, the tech companies, are investing through the income statement and looking at R &D and SG &A is a great way to try to decipher what's going on there and figure out how a business is performing and how they may perform in the future.

10:03Yep, exactly. One thing to note, some companies, they may list general and administration as one item and they may list marketing as a, as a separate line item because they want to, they want to differentiate for investors, how they, how they kind of do that. It's the same idea as just sometimes you may see it broken out a little bit more in detail than other companies will just like, like Andrew said, they'll just lump it all in together and you have to kind of determine, okay, are they really spending that much on administration or is it really all sales of marketing. And to Andrew's point, a lot of these companies that you look at nowadays, if you take a stroll through a cloud security type businesses, I'm thinking like CrowdStrike, Datadog, MongoDB, any of those kinds of businesses, you're going to see a lot of R &D and a lot of SG &A and not much CapEx.

10:56And so just because of the nature of how they operate and how they really invest in the business to kind of double down on what Andrew was saying, that is very much, you'll see those numbers higher than you may see on the cash flow statement or even the balance sheet. And so don't think that they're not investing or they're not spending a lot of money to try to grow or build new products for customers. They most certainly are. It's just showing up in a different place. So that kind of leads me to how would you, like when you're trying to analyze a business, how would you try to analyze how the R &D and how the SG &A really match up and how you can kind of compare them across companies so i guess i'm gonna have to let people get a little more under the hood like they did last time so going back to my fiscal dot ai custom metrics dashboard a few custom metrics that i've added on here some of them are part of fiscal ai already some of them i add myself but what you can do is especially for like a day of the dog or a CrowdStrike, you can compare it to revenue and then you compare what are the percentages and what are the percent differences.

12:11So for example, we mentioned the different ways you can invest CapEx, R &D, and SG &A. You can put metrics for each of the three of those. So let's look at CrowdStrike for a second. These are last 12-month numbers.

12:30CapEx huge amount of OpEx in the SG &A category for CrowdStrike. So they are growing a lot, but they are spending a lot to grow. R &D, they're also reinvesting a lot in R &D, trying to make their product that much better. And then to your point, Dave, about the CapEx being so small, 7 % versus 50 % for SG &A. 7 % CapEx, that's hardly anything. So there are growth metrics. And again, I talked about it previously, but you can use CapEx to try to project future growth, but for a company like CrowdStrike, you would never want to do that because it's not the CapEx that's going to lead to their future growth.

13:13It's going to be more on the R &D and the SG &A side. Yeah, exactly. Could you pull up NVIDIA? I'm curious. One of the things I want to kind of throw out there when people are looking at these numbers and comparing them, One thing you want to see for businesses that are doing really well is to see if that gap is widening. So as the company scales up their revenues, R &D, for example, is the R &D to revenue percentage, is that growing along with the revenue growing? And I suspect with NVIDIA that they're actually creating a gap. And that's one of the ways you can see if a company has operating leverage, which is basically can they grow faster than their expenses grow?

14:00And that can lead to a lot of profitability or free cash flow, which the company can use to reinvest and thus the flywheel. So I'm just curious when you pull up NVIDIA if that is what we see or not. In the case of NVIDIA, you do see the operating leverage from 2016 to last 12 months. R &D the revenue from 27 % to 10%. SG &A, 12 to 2. so as to your point Dave as these numbers have gotten smaller that means NVIDIA has just gotten more and more profitable and it's interesting to see for me okay is NVIDIA a sales company or are they an R &D company and that kind of sounds silly right saying out loud but the numbers do check out that yes in fact they're spending right now almost five times more on R &D than they are sales SG &A, Sales General and Administration.

15:01So that's a good way to check. And this is very helpful to me, not just to confirm narratives, but to help you when you're looking for the first time in the business. What are the things that are most important to track for a business? And that can help you learn so much about the business. You could Google endlessly. You can chat GPT endlessly about different random facts about the business. But until you put, you know, pen to the paper, numbers to the narrative, you won't really know what's really driving the business until you check on some of those things. And so going back to the whole CapEx idea, which if you know NVIDIA, if they're fabulous, it's all obvious, but the numbers check out.

15:45CapEx is only 2.76, SG &A 2.5, and then R &D is 9.5 compared to revenue. So again, R &D is driving that growth. And even though they're not having to spend as much R &D as they were before, which is making them more profitable, they are still continuing to push that investment lever, which makes you hope as a shareholder that they will continue to have the best, most dominant product to help them continue to grow like they have. September is World Alzheimer's Month, but most people never check their brain health until something's feeling off or wrong way down the road. I wanted to stop waiting and look of my own data ahead of time.

16:24I highly prioritize long-term cognitive health. I mean, you can feel everything going right in your body, but if you've already set yourself down a road mentally that you don't even realize you're on, it can be difficult or impossible to recover later on. And I wanted to know whether it's just a bad mental foggy day or if it's a sign of something for the future. Your focus and mental health leave a data trail in your body and function tracks it. Did you know that these core biomarkers are tied to brain health? Omega-3 index fuels brain cell membranes and is tied to focus and cognitive performance.

16:53Function actually helped me find out I was deficient in this. Homocysteine, when high, it can be linked to brain fog and cognitive decline risk. Plus, Function members can add on brain-related add-on tests like Alzheimer's detection test, blood markers that can flag Alzheimer's risks years before symptoms. We're talking about life-altering signs that, if discovered early, can put your life on a completely different course than you would have otherwise been on. Check your brain and health the way I do. Function provides 160-plus lab tests for$1 a day and member pricing on advanced imaging. Join at functionhealth.com slash beginners and use code beginners25 for a$25 credit.

17:29The more I've gotten to learn about Bitcoin and start to dip my toes with it, the more I realized some of my preconceived notions were incorrect. For example, I don't have to be all Bitcoin or all stocks. I can learn very instructive lessons about assets, currencies, and investments from the very long-term history of the world. And I don't have to be a speculative trader or radical enthusiast or even somebody who frets about the volatility when I have the right tools to set up a prudent allocation for my finances. That's why I use Cash App and love the recurring feature, which automatically takes a percentage of my paycheck and places it into Bitcoin, which I can spend at any time on the app or continue to let it sit and potentially grow over time.

18:08If Bitcoin is part of your long-term strategy, consistency matters. Cash App lets you set up automatic Bitcoin purchases with AutoInvest so you can build exposure over time instead of trying to time every move. You can also use roundups or pay them Bitcoin to make Bitcoin part of your normal money flow. Automatic Bitcoin purchases on Cash App have zero fees and zero spread, which matters if you're buying regularly. Download Cash App today. Visit our link in bio. Bitcoin services by Block, Inc. See the Bitcoin disclosures at cash.app.legal.podcast. Let's face it, modern work life is complicated.

18:47But good news, we're here for you. I'm Kayla Lopez. And I'm Kyle Hege. And together, we've helped thousands of Morning Brew subscribers grow in their careers. And now, as the co-host of Per My Last Email, we're bringing that advice straight to you each week with hot takes and tactics on how to succeed in every area of work. Whether that's figuring out if you're being underpaid. Or how to stand out in a remote work environment. So join us each week on Per My Last Email on Spotify, Apple, YouTube, or wherever you get your podcasts. Yeah, that's awesome. So would you say that these kinds of businesses, I'm not just saying NVIDIA in general, but these kinds of businesses are maybe the ones that we really should try to seek out?

19:28Are these companies that can start to exhibit some of those operating leverages, perhaps? You don't want to ask me that. Okay.

19:41I'm a little more of a pessimistic kind of guy I'm more Mr. No than Mr. Yes so the counter argument is you can spend a lot on R &D but that doesn't guarantee anything so the way I kind of look at it is not that R &D is good or SG &A is bad more so like what is the company's strategy So in the case of NVIDIA, I wouldn't care about analyzing their sales team or something if I was trying to figure out, do I think they still have the moat? I would really focus, and everybody does obviously, but really focus on the tech and what are they spending the R &D on? How is their tech evolving? And so for companies you're not familiar with, that can be a very helpful step.

20:27Yeah, yeah, for sure. That's a very good point. One of the things that also can make looking at the R &D of a business challenging is that typically when they are spending money on R &D, they may or may not necessarily reap the results of that spending for many years. It could take a while. So when you think about a company like NVIDIA or Microsoft, any of these businesses that are investing in these products, they don't build something like a Blackwell overnight. And it doesn't happen in seven months. It takes many years and a lot of work to get to the point where they can sell something like that that is a hit on the market.

21:11and so when you're talking about investing when a company's trying to invest and you look at NVIDIA or any of these other companies that we talked about the thing I always like to think about is how does that really translate to the investments and it goes to something Michael Mobison has talked a little bit about I'm not going to go super in depth on this because this could really derail everything but he talks a lot about in some of his papers talks about kind of deconstructing how companies actually invest. And because companies like NVIDIA, Microsoft, and others spend so much on R &D, those investments aren't realized immediately.

21:50And so it's kind of unfair to those companies to look at their earnings, for example, and they're actually probably a little bit, I guess, more pessimistic than they really should be because they're expensing that money of R &D. It's coming out of the income statement immediately, whereas balance sheet investments may take a little bit longer to be realized on the income statement and so what michael mobison talked about was basically kind of in essence taking money from the income statement and adding it to the balance sheet and then kind of rearranging how the accounting actually works and it it sounds like a lot of gobbledygook and i will put a link in the show notes to his paper that that he discusses this because he really kind of deconstructs the cash flow statement and the income statement and shows how we should try to look at these investments and how it can help you kind of adjust how you think about the companies.

22:47So maybe not necessarily the numbers per se is important. It's more about thinking about how NVIDIA really invests is a little different than other businesses. And so you have to think about it differently. And his paper can help you kind of deconstruct that a little bit. yeah um one of the things and i'm glad you brought that up and we're gonna go a little bit down the rabbit hole so just buckle up if you aren't already and there's nothing you could do at this point so here we go yeah um one of the things that these great tech companies have which i love it by the way i mean i have some great tech in my portfolio so i'm not bashing on tech whatsoever but one of these things that is so special about some of these businesses is they have crazy high return on invested capital or ROIC, which means that based on that metric, you're trying to see how capital efficient are they.

23:40So Apple is an extreme example. I've used it before. If you're netting for cash, they have ROIC above 100%. Booking holdings actually have negative invested capital based on the way the accounting is. So their ROIC is infinite, right? Warren Buffett used to talk about return on equity, which is very similar to return on invested capital. And you can take return on equity to try to project what future growth will be. In theory, you have to adjust for retention, dividends, buybacks, these things. The problem with the fact that ROIC is not adjusted like Mobusun is saying it should be is that the high ROIC is an illusion.

24:26Because it's expense, it's making the invested capital look so low. So when you see Airbnb or a booking or one of these huge ROIC companies, that's not actually the type of growth that will happen. A lot of it can be just because of the fact that they have invested through other means in order to get that growth. it's just one of those weird things I think you said it best a while ago on the show and you used to say it a lot no matter how gray a company is they always have to invest capital to grow and so just because the accounting makes an RIC look too good to be true doesn't mean that this is just a company that's going to continue to grow at 20 % for the rest of the universe's life or anything like that so So I think taking Mobison's ideas and thinking about the way that companies invest and how we can try to account for those things is helpful.

25:30And I think doing that can really help tamper down expectations on what to expect for a stock. So I'm going to use booking holdings again because, like I said, it's one of those examples where you pull up the ROIC, you make some adjustments, and even after doing that, you're like, wow. ROIC 300%, this must be the best business that's ever been around. Ever. Ever. Or ROIC infinite because invested capital is negative. With metrics, you always want to have checks and balances. You always want to have other metrics that provide context. In the case of booking, what you would want to add is not just looking at ROIC, but you would also want to look at how much are they doing in buybacks, how much are they doing in dividends.

26:16and so when you take that into account which is something I think Dama Doran mentioned when you project growth using ROIC and retention you want to look at how much money is given back in dividends and buybacks and so when you do that again I can look at the custom metric if that number is negative meaning there's more money being bought back than actually earned in the business then you can't really use ROIC to project what future growth will be. And I promise you this ties into our whole conversation today. So again, if the company is just buying back with all the profits, it doesn't make it a bad business or a bad investment.

27:04I think Seize Candy was the perfect example of a company like that for Buffett, where he said, look, Seize Candies is only in California, I think, at the time, and is not trying to expand all the way across the United States. Seize Candies is raising its prices year after year after year. And rather than taking that money and reinvesting it, trying to get into Texas and New York and Canada and Mexico, they're just taking that cash and giving it back to the owners. and so when you look at a booking i have them pulled up here capex to revenue tiny like less than two percent r d the revenue zero sgna the revenue yeah it's a lot 50 but that number is kind of flat over if you click on the chart it's mostly flat a little bit up and down but mostly flat and then mna which is mergers and acquisitions another way companies choose to grow is very very small percent as well.

28:04And they haven't done anything in the last two, three years. So you look at all those things and you're like, okay, there's no obvious reinvestment lever. So what are they going to do with, how are they going to reinvest in themselves? And sometimes the answer is they're not. And so if you're looking at, again, to prove the point, if you're looking at ROIC and you think this is the best, most capital efficient business I've ever seen, but there's nowhere to put that capital and they're just buying back shares, then you just have to kind of temper your expectations on where you think the stock's going to go, how you think the business is going to go.

28:46And like I said, that could be a great investment. But we want to try to analyze a business in that where are the reinvestment opportunities rather than just saying, well, they've grown, okay, I can pull it up. They've grown five-year revenue at 10 % a year over the last five years. So they're going to continue to do that because that's what they've done and their ROIC is really high. I'm trying to avoid that kind of thinking because then you can avoid disappointment when things actually don't work out that way. Am I making sense here because I've gone on? Yeah, yeah. No, no, no. That totally makes sense.