The First Metric Every Investor Must Check Before Buying

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2:04Limitations and exclusions may apply. See our seven-day return policy at Carvana.com. You're tuned in to the Investing for Beginners podcast. Investing for Beginners podcast. The show for the long-term investor. We cut through the noise to focus on what works, compounding, discipline, and the conviction to buy wonderful businesses and stick with them. Your path to financial freedom. Start now. And welcome back to Investing for Beginners podcast, everybody. My name is Stephen Morris and he is Andrew Saylor. And Andrew, I guess we're going to just straight up ask the question. i'm brand new to investing what is the first thing i should understand or start doing uh when when i start to analyze a stock for the first time yeah i mean brand new to investing may be questioned even if you want to buy a stock because we try to caution people against it um but uh if you are going down the path of buying stocks rather than buying an ETF, the first thing I always look at is the company's revenue growth.

3:17That is the company's top line. That is how much sales are they bringing in. And the reason behind that is twofold. So Peter Lynch from Fidelity Investments, he's one of the more popular investors who's ever lived. He had a crazy track record over 13 years or something. He wrote a book called Beating the Street. And in that book, there was a study showing the correlation between a company's earnings per share and their stock price. And it was a pretty decently strong correlation once you zoomed out for like five years. So if a company's earnings per share is going to grow by 200%, stock price might grow close to that, especially the longer and longer you go.

4:04And so there's another study by McKinsey. McKinsey writes a lot of textbooks for finance professionals. And their study called The 10 Rules of Growth talked about biggest driver for company growth being revenue. So revenue growth leads to earnings per share growth, which leads to stock price growth. And since we're buying stocks, that's what we want. so let's break this down then so a common acronym that you'll hear especially if you're new to investing a very common acronym you're going to hear earnings earnings per share or eps um is how it's usually depicted if you if you're reading it or if someone's just spouting off numbers at you.

4:51EPS, earnings per share. Andrew, can you break down the difference between EPS and stock price? Because they kind of sound like the same thing. Yeah. I mean, earnings per share looks at the business and the stock price can jump around, but tends to follow the business over the long term. So earnings per share is what a company made in their profits. You take that revenue number that we're talking about, You subtract expenses, you subtract taxes, interest they pay on debt. You end up with this earnings number, and then you divide it by how many shares a company has outstanding. Think of it like a pizza.

5:33The company is the pizza. These little slices of pizza are the shares that we own. So we all look at these stocks. We compare what their EPS is and their stock price. And that kind of tells us how expensive or how cheap a stock is. Got it. And so just because a stock is$20 compared to a stock that is$500, one stock, the$20 stock could be drastically skewed from its stock price to its EPS, making that$20 stock insanely expensive. compared in that$500 stock being insanely cheap. Is that a good way to break that down? Yeah, absolutely. Exactly. So when you talk about growing revenue, obviously we want a company to make money.

6:34What's the difference between a company making money and revenue growth? So the reason why there's such a big focus on revenue growth is because obviously when you cut costs, you make more profits. If you let your costs go and you hire a bunch of people or you spend a bunch on marketing or you have a lot of litigation expenses, whatever it is, obviously as your expenses go up, your profit shrinks. But when you look at profit margins, profit margins go from zero to 100%. You can't go higher than 100 % profit margin. So there is a limit to how much you can grow your profit by cutting expenses. At a certain point, you cut so far to the bone that there's no more expenses to cut.

7:19So if you want to grow, you have to get that revenue growth. And so that's why there's a big focus on revenue growth on Wall Street because that's kind of the longer term, more sustainable way to grow a business. And a lot of the things that you would expect a healthy business to have, you can see in revenue growth. So if we take a restaurant like Chipotle as a stock I own, if more people go in to chipotle every single year that's going to grow revenue uh as long as more people went in this year than last year that's not the only way to grow revenue it's one way to grow revenue another way to grow revenue is uh everything on the menu is a little bit more expensive than it was last year so you could have the same number of people go in but we have pricing power that increases revenue and then another way is you could open more restaurants that increases revenue.

8:12And you can also get them to buy more guac or something that increases revenue. So you notice all of these things that we're talking about when we talk about growing revenue all have to do with making the business bigger, making more sales happen, more money flowing down the financial statements. And all of that leads to profit and all of that leads to cash flow, which the company then can reinvest and make it grow even more the next year. Right. How much does market cap play into those numbers? I would kind of look at market cap separately. When I'm looking at revenue growth, I'm really trying to look at the business and isolate the business.

9:02So whether your market cap is$500 million, your small little website, or you are Apple and you're$4 trillion market cap, I'm going to look at your revenue just the same. Because every company has revenue. Yeah, every company has revenue or should have revenue. But every company has to report revenue. And that's the starting point. That's how we start to first look at analyzing the company. So you're not going to... That$100 million company, I don't remember the number, 500 million, you're not going to judge it with maybe more scrutiny than you might a larger cap company? No. And that's a good question.

9:49Everything needs to work off percentages. So a 10 % growth at a small company and a 10 % growth in a big company, we should be looking at that apples to apples. And that's one of the things that sounds very obvious, but the The media really does a great job of hyping up these headlines, especially with this CapEx and the AI stuff that's going on. They make it sound like insane numbers, but when you use percentages and look at the revenues that Amazon's bringing in, the profits they make, the cash flow they make, it's not as big as the headline numbers make it sound. So we absolutely always want to look at percentages, and that's true whenever you're looking at any business.

10:38So, and this is going to be a hard question to ask too, because I know what I want to ask, I just don't know how to ask. So bear with me here. If I come, when we're talking about these things, sometimes it can be misleading because, and I wish I could think of a good example company. I can't, maybe you can, where their year over year is gets skewed by a cyclical, maybe not even cyclical, just by a few good quarters or one good quarter. So not everything is skewed. So we can't just look at the percentage. We also have to look quarter by quarter, correct? Or to avoid that, that I don't even know what the word is for that.

11:31Is there a word for that number being skewed like that? I don't know if there's a word for it, but I totally understand. And it's something you absolutely have to do. There are so many great stock tools that are out there. Screeners, websites that help us look at different growth rates, and they make it so easy. Here's the growth for this, this, and this. The problem with that, like you're alluding to, is one big year up or down for any reason. can really skew your numbers. A lot of the websites I like to use will compare revenue growth, let's say three-year period or five-year period. So if that starting point or that end point of three-year, five-year, or 10-year period is another common one, that starting or end point of the three, five, or 10-year is skewed, your entire number doesn't give you an accurate picture.

12:24Because what are we trying to do when we look at the number? A, we're trying to see, was it good? Did the company do good in the past? But B, the next step, which I always try to do, is like, okay, what's the growth I expect moving forward? And if our rear view number is skewed, then how are we going to make a good future-looking number? So absolutely. A good example of this, I own a stock called Dick's Sporting Goods. Not the greatest stock to talk about on the podcast because sometimes it gets misconstrued. maybe the AI bots like to censor us or whatever but they just recently did an acquisition of Footlocker and had those numbers flow into the financials which flew into the revenue and made the revenue jump massively that skewed all of their revenue growth numbers and so if you look at surface level you're like wow Dick Sporting is such a high growth company but it's actually because they had this one big year thing and actually that big year could live anywhere in that range of 3, 5, 10 and it could skew the entire thing.

13:34So you do have to be careful. One of the things I like to do is I like to look at let's say I'm looking at 10 years of year over year numbers and try to take like a median. So what's that middle line of all the growth rates because that's probably more sustainable, but it all depends. Yeah, it can get tricky. I think it was Michael did I say that right? That wrote about the average median being between 4-6 % for the 10-year period. So is that what we're aiming for? Obviously, better is good. But is that also the number you prescribe to as well? I'm pretty aggressive, greedy, however you want to describe it.

14:24I like companies that can grow really fast. A dirty capitalist.

14:31But no, I mean, that is the reality. That is why we flip over a lot of the rocks and have to look really hard for businesses because like you're saying, a lot of them grow at 4%, 5%, 6 % a year. When I'm trying to think about what's a good kind of growth rate and how do I determine what's good and what's not good, that 3%, 4%, 5%, baseline is a good way to think about it. So it's like, if I'm seeing 8 % revenue growth over a long time or 10 % revenue growth over a long time, we know that those are really good numbers because of what you're saying, this four to six. I also like to just look in the context of US GDP has been around 6%, the nominal, so not the inflation adjusted.

15:19It's been around 6 % a year for over 100 years. Inflation has been around 2 % or 3 % over 100 plus years. So we know that if you're getting below 6 % revenue growth, you're not growing as fast as the economy. And what does that do for your stock? Well, I mean, it depends on what price you pay for it. So any stock that you buy cheap enough can be a really good gain for you. But if you're holding a stock for a long time and it's not growing alongside the economy, you're not getting good tailwinds from the market, you'll probably lag the index, which isn't the worst thing in the world. But if we're going to spend all this time being dirty capitalists, we might as well try to pick stocks that will beat the index and not fall behind it because then we might as well just buy the index at that point.

16:19Right. So listening to you talk about this, it makes it seem super simple. But if you're a new listener, or I'm sorry, if you're not a new listener, you've been listening for a while, we talk about much more complex things like valuations. so how does the valuation work alongside of revenue does it take over the you know the revenue calculation to use them together um is one better than the other like talk to us about valuation versus revenue growth yeah so one of the things that the og warren buffett said is growth. It's not growth versus value, but rather growth is a part of value. So when me or anyone on Wall Street or you are trying to analyze how expensive should a stock be, it's all going to depend on how much growth everybody is expecting.

17:19So a lot of people are expecting Tesla to grow a lot and that's why it trades at a PE of like 300 and nobody is expecting I hate to pick on Adobe because I just sold them but nobody's expecting Adobe to grow because their PE is like a 10 and so when you're doing valuation work and trying to figure out what that growth rate is to figure out how expensive should the stock be. Revenue growth should play a big part of that. And just as a general rule, I like to use that kind of like my baseline. There's so many things that can go into a company's EPS growth, right? Like we said, they could cut expenses.

18:12They could get really good at doing that. And you can do endless spreadsheets to make it super, super complex. But when you keep it in the revenue growth kind of arena, then it leads you against getting too complicated. So sometimes the simpler, at least in my mind, when I make things simple enough, that helps me ground myself and not get too caught up in the rabbit hole and try to do things that are reasonable. We talked about 4 % to 6 % Mobuson's base rate for revenue growth. So then I know if I'm thinking the stock's going to grow 25%, I've probably missed something.

19:00When doing valuation, revenue growth can help ground yourself and put you back in reality because we know that there's limits to revenue growth. 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 at my own data ahead of time. I 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.

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22:05what what what advice would you have for for a beginner investor you know is it okay to buy a stock if you understand their revenue growth without fully understanding the valuation of a company or would you uh steer clear until you you get that valuation piece down yeah it's a it's a really good question um obviously obviously more more knowledge more experiences is better, but I think you can go a long way with just like a PE ratio. If, what do they say? Like you need duct tape and what's the other thing and you can fix? Oh, duct tape and WD-40. WD-40, yeah. So your PE ratio is your duct tape and your WD-40 is your revenue growth.

22:55And just being reasonable with it, right? So if something's growing at 10 % a year, I know it's above average, then maybe I'm willing to pay more on the higher range of an average PE ratio. So if the market's at a 25 PE now, maybe I'm willing to pay like 30.

23:20That's the thing that's hard about it, because at least when you learn valuation, you kind of know where those limits are. But when you just have WD-40 and duct tape, you don't always know, am I getting too high? right there's like there's no definition at that point so um it's tough but definitely like not going to the extreme of like i'm gonna buy 300 p because uh this revenue growth is 25 avoiding that is probably the best thing you can do uh definitely i would agree with that um and if you've listened long enough you you've heard me complain about that very fact because initially when I started this journey, I thought, you know, it was like a standard between this PE and this PE is good.

24:05And I quickly learned that that is false because you can have a 35, 40, 45 PE of a company and that's still good value for the growth of the company. It just all depends on the valuation. And so I agree with that 100%. I think that's really good advice. Is there anything else, because I still feel like, I understand it now, and maybe everyone out there is just smarter than me, but I feel like it's still super confusing about how the PE actually works. Can you boil it down a little bit more? yeah so it's it's again giving us that relationship between the stock price and the company's profitability so um the math would be you know if you have a stock that's a hundred dollars a share and then our earnings are 25 a share um then the pe is four it's 100 divided by 25 um and so we can use that as a yardstick.

25:17So whether your stock price is at like$1500 or$1500, we can always bring things apples to apples to get our PE ratio. And the weird thing about the PE ratio, it's like always changing the markets. PE is always changing. And so what could be a good PE ratio two years ago is a bad one or a great one. but looking at, I think, averages can help. And as much as people rip on like, oh, you're just using relative valuation to... Like, for example, a lot of people use relative valuation in an industry. So if I'm going to compare banks, it would be like, all right, this bank's at 12 PE, this bank's at 10 PE, so the 12 PE is more expensive.

26:05The stock's more expensive than that stock. That's actually a pretty decent way to kind of understand PEs. Because I guess you don't have to know the rest of the details, which can be a blessing in disguise. And less chance for blow up, right? The fewer rabbit holes, the better sometimes. But definitely. And I mean, I'm not trying to get confusing or deep into the weeds, But I feel like the PE probably should have been one of the first things I learned about. And I feel like it took me way too long to fully understand it. So, I mean, and if someone were to, I'm glad you weren't like, well, why don't you try to thank you for not doing that to me?

26:55Because I would have had to fumble the ball and pass it right back to you. But no, I think that was a really good explanation. So when we're looking at a company, like you said, you know, and if you go back and listen to our last episode, that kind of might counteract some of the things we're about to talk about. But when we see a company that's a 15 to a 20 percent growth, typically we could catalog that company as a hyper growth company. Correct. these are usually going to be at least right now probably more of your tech startup type companies would you say Andrew that while some of these investments have very high upside on the reward side they also come with a very very high on the risk side as well yeah it's a great point and worth talking about because it's a perfect example of what's happening in the rearview mirror doesn't tell you what's happening moving forward.

28:12Companies will have explosive growth in their early years and then it saturates. The problem with it is nobody knows when that saturation is going to happen. And so people just keep bidding the stock and they bid the stock because They look at 30 % growth, 50 % growth, whatever it is. But once it gets to that growth rate that's more normal, then that's when you see the stock just completely plummet. Because now the stock's in the real world rather than in this happy land. And so that's a place we try to keep people from investing in. because how can you know when the party is going to stop in that case?

28:58But if you stay in the real world with real stocks, with companies that are already growing at real-world rates, you don't have to worry about that too much because nothing's ever predictable, but it's a lot more predictable than the stock that's going through its happy land phase. And the other caution, which I'm actually telling myself, It's like I'm teaching myself at this moment, reminding myself, is that you'll see stocks have a couple years of breakout growth or explosive growth. And you have to be careful about saying, well, this stock had two years of 15 % growth, so I'm going to just assume that that's going to happen for the next 10 years.

29:43And you've got to be careful about that because it's just not sustainable. Going back to the Michael Momison that you referenced, very, very few number of stocks can sustain super, super above average growth rates over a very long time period. Those are the ones we all study and remember because everybody who looks at the winners, but countless more don't do that. And they just drop and nobody talks about them. So we want to avoid the sad stories and keep things in the real world as much as possible. And so that's why being generally skeptical towards hyper growth stories is a decently good way to go.

30:34I mean, it's more safe for sure. Definitely. So, you know, with Michael Mobison, you know, being the, the four to 6%, um, average, what could, could we say safely, would you be comfortable saying, okay, I'm seeing this company at seven to what did I say? So 7 % to 14 % might be, okay, so this is maybe a steady compounder range where we can make a good, safe investment while still getting a little bit of the upside of the growth. Does that make sense? Yes. Yeah, I mean, I like that idea a lot, having kind of like an upper range of estimates. It's like the way I kind of see it is like if the company grows more than 15%, then you're kind of like, oh, that's icing on top.

31:37But I'm not going to assume it because the odds of that happening are lower. So we don't want to have to rely on that. I think that's a very good, prudent, just reasonable way to think about things. there's a lot of different studies you can look up about what are the odds of a company growing this much for this long and Mobison did his base rates book which is worth checking out as well I ran just a random basket of stocks this is just again an andrewism so it's far from an academic study. I was looking at the S &P 500 from 2014 to 2023 and I saw that the odds of getting a company growing more than 20 % a year over 10 years was just 7 % of companies.