TIP752: Financial Statements Explained Simply w/ Brian Feroldi

26:59I think it's important to mention that there's actually some subjectivity when it comes to creating financial statements. So to use just a simple example, I think everyone can understand, let's say a manufacturing company buys machines for its plants and the life of those machines is expected to be 10 years. Well, if the company depreciates those machines over 20 years, then they're likely to be overstating earnings. So if an investor takes those earnings at face value, then they might not necessarily make the right investment decision based on what's happening in reality. And here at TIP, I'm reminded that we have an advertising segment of our business, and I could come up with a handful of ways that we could recognize revenue, for example.

27:40We could recognize revenue when a deal is signed, when the ad starts running, when the advertiser actually pays us, if they do pay us, and whatnot. So there's all this nuance that can go into it. And all of these methods can pay to a much different financial picture when you're looking at the statements. So I just illustrate this to just show how subjective accounting can be at times. It's not always that the economic earnings actually reflect economic reality. And we might find ourselves in a case where the analysis was spot on, but our investment decision was incorrect based on our analysis of the numbers that the company showed us.

28:17So this is also one reason I like to prioritize management in my analysis of a company. If I know I'm working with a highly ethical manager that I can trust, then it could be the case that they tend to understate earnings because they care about investors and protecting investors. So I think in these cases, it could be a situation where they tend to surprise the upside over the long term rather than disappointing investors. Yeah. To your point, you just laid out a great example of how creative accountants can be when it comes to creating their financial statements. Revenue recognition is a huge area that CFOs or management teams have control over.

28:57And to your point, when is revenue recorded? Is it when the item is actually shipped and leaves the factory? Is it when you receive the cash from the customer? Those can be months apart. And when a company is publicly traded, there is huge financial pressure on the management team to report numbers that exceed or beat Wall Street's estimates. That controls their bonuses. That controls the stock price. that controls, whether or not they get to keep their job. So there are huge incentives in place for management teams to fudge the numbers or do everything that they can to present the best story that they can in any given time to Wall Street.

29:32So to your point, if you find a company that is very conservative with the accounting, that speaks volumes about the integrity of the management team. And if you find the inverse, you should probably just stay away from that business. Yeah, that is an excellent point that so many companies just want to hit their quarterly EPS. In the short term, that might be a great thing, but over the long term, it could end up hurting investors that aren't investing in companies that use more conservative accounting. Another point I'd like to mention is this concept of fungibility. Intuitively, as humans, we tend to think of money as fungible.

30:06Brian, if you and I walk into a Starbucks, we each go and buy an overpriced expensive latte, we're each going to pay$6 for that latte and essentially get the exact same product. So your$6 had the exact same utility as my$6. And I think carrying this line of thinking can sometimes actually hurt us in investing who treat each dollar the same. So for example, a dollar's worth of earnings at a company like Costco might actually be worth considerably more than a dollar's worth of earnings at another retailer that might be in decline or might have volatile earnings from year to year. So how about you talk about this concept of understanding this, that there's more to just looking at the numbers?

30:46Robert Leonard You hit on a really important point when it comes to analyzing business. And this really confused me when I first started investing, because the thing that you read in investing books and value investing books is low PE ratios mean a company is cheap, high PE ratios mean that a company is expensive. So if you were looking at, say, an automaker like Ford, you might see that it's trading at eight times earnings, six or eight times earnings. And your natural thing to say would be, well, that number is cheap, Ford's stock is cheap. Conversely, you might find a company like Costco, or Visa or MasterCard trading at 30 times earnings.

31:19And your natural inclination might be, those stocks are expensive. Look how high their PE ratios are in comparison to the market or in comparison to Ford. But you hit on an incredibly important point that not all profits and not all revenue is created equally. A dollar in sales at one business should be worth completely different than a dollar in sales at another business because not all revenue and not all profits are created equally. High quality revenue, really high quality revenue has some key characteristics. Revenue that is recession proof that happens in good times and bad is far more valuable than revenue that is cyclical in nature and that a lot of it happens in good times and it disappears in bad times.

32:02Revenue that becomes cash is far more valuable than revenue that becomes accounts receivable. Revenue that is recurring in nature or where a customer makes continual payments, say for a software license or utility, is far more valuable than revenue that is related to a one-off purchase or a one-off transaction that happens every five to 10 years. Revenue that is very high margin, has a gross margin of 80%, is far more valuable than revenue that has a very low gross margin of, say, 10 % or something. So to your point, if you were analyzing a dollar worth of sales at Ford, the market only might assign a six or eight multiple to that because the market believes that Ford's profits are not highly valuable profits.

32:48Those profits might disappear completely when the economy goes through a downturn. Ford also issues credit, so it becomes an account receivable for the business. You compare that to Costco, people shop at Costco in good times and in bad. And you could even argue that people shop at Costco more when the economy goes down. So therefore, you can have a lot of confidence in the continual earnings power of a company like Costco when compared to a company like Ford. This is why when you're looking at companies that trade at wildly different PE ratios, that's the market's way of saying this profit is highly valuable and this profit is not nearly as valuable.

33:26I also wanted to touch on the options a company has when they generate cash, what they can do with that cash. So generally, they can do six different things when a company generates cash. It can keep that cash on the balance sheet, pay down debt, distribute dividends, repurchase its own shares, make an acquisition, or reinvest back into the business. I would say that those first five tend to be relatively easier to follow in the financial statements. But I think that the reinvestment piece can be a bit more elusive. What are some of the line items that we should look out for to better understand to what extent a business is reinvesting back into its own operations?

34:04Yeah, you can determine that when looking at the company's income statement and what its operating expenses are doing, as well as looking at its cash flow statement. If a company, for example, is reinvesting into the business through capital expenditures, it's building new factories, it's building new stores, it's making new equipment, that would be reflected in the capital expenditures or perpetrators of property, plant equipment line of the cash flow statement. And you would also see a corresponding increase in a company's operating expenses on the income statement. But you just hit on a really important point.

34:33What you just described is something called capital allocation. And Warren Buffett has called a CEO's most important job capital allocation. There are six levers that a management team can pull at any time with the cash that it has available to them. And the order and the magnitude of which those levels are pulled can have tremendous, tremendous outputs on the returns that shareholders receive. When a company is in the early stages of its development, when it's a startup or when it's in the hyper growth mode, or it's really starting to get growing, a company often does not have excess capital.

35:05All capital that's generated in the business goes right back into the company and is reinvested. This is when a company is hiring engineers in research and development, hiring salespeople, opening up new geographies, creating new products and launching those to market. When a company is in that stage of the business growth cycle, all capital should be reinvested back into the core business to drive future growth. That's unquestionable. Once a company runs out of internally generated projects in order to continue growing itself, that's when those other five options become available to the business.

35:40And so many management teams screw this part up. They have some excess capital to them, and they don't have the training or discipline that they need to make the right choices, application choices, to maximize shareholder value. For example, some companies buy back their stock because they think that's a good way to return capital to shareholders with no regard to the valuation or the market price that they're paying for that stock. And buying back a stock when it's overvalued is a horrible use of capital. Buying back that stock when it's dramatically undervalued can be a great use of capital.

36:12The same can go for issuing and paying off debt. paying off debt that's at a high rate can be a great use of capital. Paying off debt that's at a very low rate can be a poor use of capital. The same can be true of making acquisitions, or even paying dividends, or just building the company's cash position. So capital allocation is something that investors should really pay attention to, and they can tell you a lot about the decision-making of the management team. Financial statements also play a big role in how many investors are viewing the company's valuation. So David Gardner, he was talking about how he's actually attracted to companies that financial commentators and analysts are saying are overvalued.

36:51Yet I think the irony with many great businesses is that they oftentimes appear more expensive than they really are when you're looking at these financial statements. So one example I thought of was looking at Netflix, for example. They've been investing in new content to try and boost their subscriber numbers over time, in theory, they could stop investing in new content and generate a ton of cash, a substantial amount of profit. And the stock might actually look cheap, but this would actually be detrimental to their business in the long term. So there's this aspect of looking at the numbers and understanding them, but not getting too bogged down in the numbers today.

37:31Maybe focusing more on, if it's a growth company like Netflix, focusing more on their management's ability to execute on their strategy and how successful they are in painting that vision for where they want to be. Yeah, you just highlighted probably one of the most confusing aspects of investing in valuation, especially if you're a new investor. And when I first started, I thought that the way that you value a business was by looking at its PE ratio, its price to earnings ratio. When I first understood what the PE ratio was, I would look at great companies like Apple, Netflix, Amazon, Intuitive Surgical, all of which had PE ratios that were 50, 80, 100, or even 1 ,000.

38:12And my immediate next thought was too expensive. Can't buy that stock. It is just not for me. The problem is the PE ratio is a highly useful tool, but you have to use it at the right time. The price to earnings ratio is only a meaningful number when a company is fully optimized for generating profits. When a company is in growth mode, it is often not, not optimized for generating profits. It's optimized for growth. Companies like Netflix or Amazon, when they were in build-out mode, were investing heavily in content in the case of Netflix or investing heavily in distribution in the case of Amazon in order to increase their capacity in the anticipation of future growth that would come from future customers.

38:59Those proved to be very smart, savvy investments. But as a byproduct of that, it meant that their expenses were inflated when compared to the current size of the business. And since the expenses were inflated or overstated, that meant that the company's profits, true profits, were understated. And when profits are understated, that means the price to earnings ratio is inflated. And that's why we saw companies like Amazon have a PE ratio of 400 or 500, and they were actually tremendous buys back then, even though they optically look extremely expensive. So a key thing I want listeners to do, when you're analyzing a company's price to earnings ratio, ask yourself, is this company optimized for profits today?

39:44If the answer is no, don't use the PE ratio. I'd also like to mention another item that you won't find on the balance sheet, which is optionality. So when you look at Netflix in 2015, they had zero advertising business. And today, Netflix has an advertising aspect to their business, which as we know, is extremely profitable for many of these big tech platforms. And this is the same with Amazon. They might have had very little to no advertising 10, 20 years ago. And now advertising is a major segment of their business. So that's why I also mentioned just how well is management executing on what they say they're trying to do and what their strategy is in gaining market share and whatnot, because that optionality piece is something that you need to consider if you're going to hold a stock for five, 10 plus years.

40:32Totally. And this is one of the most difficult things when it comes to analyzing a business. So let me give you my definition of optionality. I define optionality as the company's ability to launch new products and new services to its customers that generate needle moving revenue and profits in the future. The best classic example that everyone can think of is Amazon. When Amazon first was a company, it sold books. That was the business. It was selling books. What does Amazon sell today? Everything, like everything that you can possibly think of. So Amazon, by starting in books, was developing a customer list and getting the operations in place to deliver books, but then it added on CDs and movies and electronics.

41:17And now I think you can go as far as buying kayaks delivered straight to your home directly on Amazon. So Amazon is a tremendous example of a company that was able to launch new products and new services that opened up needle moving revenue. When I look back at some of the best investments that I've ever made, many of them, the reason for the upside that I have achieved is because of optionality. As an example, Axon, which is formerly called Taser, they made 100 % of their revenue from tasers that police use, the police stun guns. If you look at the company today, that is still a major revenue driver for the company, but it also has Axon body cameras, as well as a software solution that it developed internally that ties all of its hardware components together.

42:01So if you were buying Axon stock 10 or 20 years ago, you were buying future optionality and these future products that you could not see at the time. And that is one reason why companies like Amazon, like companies like Apple, like companies like MercadoLibre have been such extreme outperformers over the last 10 and 20 years is because 10 and 20 years ago, there was hidden value in the company from future optionality. I know that's something that David Gardner, when he's investing, looks for very closely. He asks, can this company launch new products and new services that open up new revenue opportunities?

42:37And if the answer is yes, the company might just be undervalued. Let's take a quick break and hear from today's sponsors. One part of being an investor that I don't think gets enough attention is how hard it can be to continue to improve as an investment researcher. And for myself, I often find that when I finish a great conversation with some industry expert or fund manager, my head is full of ideas. But by the time I sit down to write it all up, half of them are already gone. That's why I've been using Plod Note Pro. It's a small device that sticks to the back of my phone and captures the conversation and hands me back a clean, searchable recap.

43:15And so the key points, the follow-ups, the things I usually want to act on, it has all of that. And that allows me to stay present in the room instead of scribbling notes that I won't be able to read back later. And I notoriously have very bad handwriting. And so changed how I prep and how I follow up with investors. It's also built for people who take conversations seriously. Enterprise-grade security. So if you're recording calls with clients or industry contacts, that's covered too. So if you live in meetings, calls, and interviews, well, give it a look. Go to plod.ai slash WSB and use code WSB for 10 % off.

43:50That's plod.ai slash WSB code WSB. And always get consent before you record a conversation. They say every day your business is late to AI, you fall two days behind in the competition. They're only moving faster. Fortunately, there's NetSuite next. You probably already know NetSuite, the AI-powered business suite that securely connects all your data, financials, inventory, e-commerce, HR, and CRM all in one source of truth, trusted by over 43 ,000 customers. NetSuite Next is the next huge leap because now AI is built into everything you do. It surfaces custom insights throughout your day. AI agents work alongside you on the routine stuff.

44:35And anytime you've got a question about anything, you just ask, like you're talking to a colleague. And I use it. And really, I think you should too. For the first time ever, you can try NetSuite next for free. If your revenue is at least in the seven figures, go to netsuite.ai slash tip. Built for every industry, ready for every boardroom, netsuite.ai slash tip. Curious about online trading, but haven't taken the first step yet? You're not alone. And Plus 500 Futures is a great place to start. The futures markets are moving fast. And with plus 500, you can explore popular assets like oil, gold, S &P 500, Bitcoin, and more.

45:15From crypto to commodities, there's always something happening. The platform is super easy to use, so you can trade on the go right from your phone. You can get started with just $100 and jump into the action. See something interesting? Once your account is open, you can trade it in just a couple of clicks. And if you're not quite ready yet, you can practice with a free demo account. No risk, no pressure. With 20 years of experience, Plus 500 makes trading more accessible than ever. Check it out at plus500.com. Trading and futures involves risks of loss and is not suitable for everyone. Not all applicants will qualify.

45:51Plus 500. It's trading with a plus. All right, back to the show. Let's talk about red flags. So although accounting is the language of business, Sometimes we can make the wrong interpretation of a company based on the numbers, either because management is intentionally trying to show us what we want to see as investors, or we aren't looking in the right places within the financial statements. How about we'll start with the income statement. What are some of the red flags that you look out for on the income statement? Yeah, there's a couple of them. I define these more as yellow flags, to be perfectly honest.

46:23When I think the word red flag, I think that means stop, do not go any further, do not invest. So I call the flags that we're about to go over yellow flags because when I see them tripped, it just to me means investigate further. You need more information about this. So in the income statement in particular, I like to look at the revenue growth rate, and I judge the revenue growth rate from year to year. And if you see a sudden change in a company's revenue growth rate, that is a signal to Wall Street that the thesis might be running out. and oftentimes that can trigger a severe decline in the company's stock.

46:56So revenue growth rate from year to year is something that I do track. And if a company has a history of growing its revenue 30 % per year, and then suddenly it comes out with a report where revenue is growing 10 % per year, that is a significant change in the company's revenue growth rate. And when that happens, it's often associated with a meaningful decline in the company's stock price. Another number that I track closely on the income statement is something called gross margin. Gross margin is a company's gross profit divided by its revenue, and it tells you how profitable a product or service is on a unit basis.

47:32When the company's gross margin is declining over time, that to me is a big yellow flag that needs to be investigated because it either means the company is being forced to discount its product to consumers in order to drive a night's sales, or its suppliers are increasing prices on its supplies and the company can't successfully pass those along to consumers, both of which are big yellow flags to me. The final one that I will look at is a company's shares outstanding or how many shares of stock exist. If this number is rapidly increasing over time, more than 3 % per year, that to me is a yellow flag because it means the company doesn't respect their equity and is likely diluting shareholders through the issuing of too much stock-based compensation.

48:17So those are three big yellow flags that I look for, a growth rate, gross margin, and dilution rate. Yeah, I think dilution is definitely an important one to highlight because using that term I used earlier, it can be a bit more elusive where if you see the stock price falling and management still needs to issue shares just to finance their business, it's a bit in desperation mode, if we can call it that. How about we jump to the balance sheet? What are the red or yellow flags on the balance sheet? First thing I look at when I'm analyzing a balance sheet is the company's cash versus the company's debt.

48:51Cash is king in a business. There's only one true sin, that is running out of cash. So I like to compare how much cash or marketable securities, which is essentially the same thing as cash, a company has, and I compare that to its debt load, both short-term debt and long-term debt. Best case scenario is a company has millions or billions of dollars in cash and zero debt, although that's pretty darn rare. So I at least like to check out the relationship between the company's cash balance and debt balance. And as a general statement, it's okay that a company has debt, but I also want to see plenty of cash to be able to finance and support that debt into the future.

49:26So that's the first thing that I check. Another number that I look for on the balance sheet is something called goodwill. Goodwill is the premium that companies have paid in the past to make acquisitions. And it shows how much management teams overspent on the acquired company's assets in order to make the transaction happen. Now, goodwill by itself is not necessarily a bad thing. There's no liquidity to the asset. You can't turn goodwill back into cash unless you sell the company that you acquired. I like to make sure that a company's goodwill is less than 10 % of the company's total assets. Company can get into trouble if goodwill becomes the company's largest asset.

50:07If I see goodwill over 50 % or even 60%, that's when I raise, that to me is a red flag. The final thing that I look at are some current assets that are called accounts receivable and inventory. These are assets that the company has that will be converted into cash in the future, but you don't want too much of a company's liquidity to be tied up in accounts receivable or inventory because the company might have trouble collecting on the accounts receivable that it has, or the company might have trouble selling inventory that it has and converting it into cash. So if a company has too much working capital or too much accounts receivable or inventory, and that number dwarfs its cash balance.

50:48To me, that's another red flag. Robert Leonard Yeah. I love in one of your videos, you highlighted Goodwill right down by Teladoc. So in 2021, they had$14 billion in Goodwill. And in 2022, that was written down to 1 billion. So just a classic example of a company massively overpaying in an acquisition and paying for it in the end. Robert Leonard That made me feel good as an investor, because I've certainly bought lots of bad stocks that have cost me money, but I've never bought a company that cost$13 billion. So management teams make plenty of mistakes too. Yeah. How about red flags for the cashflow statement finally?

51:27Yeah. The cashflow statement is my favorite statement to analyze because it shows you whether or not a company is producing or consuming cash. So one of the first things that I look at on the cashflow statement is a company's net income, and I compare that directly to a company's free cash flow. Now, free cash flow is not a number that's reported on most cash flow statements, but it's easy to calculate. You take operating cash flow and you subtract out capital expenditures. These numbers are right next to each other on the cash flow statement. What you want to do as an investor is you compare net income to a company's free cash flow.

52:00In the best case scenario, a company is producing more free cash flow than it is net income. That would be a positive thing. And the downside or the worst case scenario is a company is reporting lots of net income, but its free cash flow is a negative number, which means that the company is quote unquote profitable on paper, but the company is not actually generating cash from operations. And there's a couple of big reasons why that could happen. They could be related to stock-based compensation expenses. They could be to big changes in working capital. They could be to just huge capital expenditures to get the business off the ground.

52:38So that's not necessarily a red flag, but it definitely is worth a deeper dive as an investor. Another thing that I look at is stock-based compensation. I compare how much stock-based compensation is being issued and compare that to a company's net income. As a general broad statement, I like it when less than 10 % of a company's net income is issued as stock-based compensation. That's not always possible with high growth companies that are in the tech sector. But if a company is issuing stock-based compensation, I want to make sure it's a relatively small figure. I wanted to jump to one of the items you include in your investing checklist.

53:15So one item you look for that would make a stock uninvestable is what you refer to as accounting irregularities. I don't know if I've had anyone discuss this in depth, so I'd love for you to explain this for our listeners. When a company says, has to issue a press release saying, we have some accounting irregularities, what they're telling you in plain English is our financial statements that we have issued in the past are not accurate. They are wrong. And they could be wrong for a bunch of reasons, and they could be wrong in one direction or the other. As a general statement, when a company does that, that means that they overstated their previous revenue or their profits, and the auditors of their companies found significant problems with the way the company reports financial statements.

54:01To me, that is the only true red flag that exists. When I'm making an investment, an inherent promise of that investment is that the numbers that I'm using to make a decision about the company and the valuation are accurate. If all of a sudden I have to question the validity of the numbers that I use to make that decision, I just immediately sell that stock and write that company off as dead to me forever. There are thousands of companies out there that do not have to restate their financial statements. I don't think investors should bother at all with companies that accounting is a problem. Are there any examples in the past of this happening?

54:41Maybe you've owned a company that has published this announcement? Yeah, there's lots of them that happen. They don't always happen to big name companies, but the one that comes to mind immediately was Luckin Coffee, the Chinese high growth coffee company that in a matter of like three years or something like that had as many locations as Starbucks did in its like 50 year history as a company. So when I saw that, I was kind of scratching my head like, hmm, that's interesting to see a company that in just a couple of years has matched Starbucks distribution scale. And after being public for a couple of months, they did have to come out and say that we are restating our financial positions or we found some accounting irregularities.

55:16When that happened, the stock dropped like 60 % or something like that. And I think peaked the trough, the stock went down like 90-ish percent. I believe in the case of Luck & Coffee, the company has since cleaned up its financial act and is back to being in the good graces of Wall Street. And I think the stock has appreciated meaningfully from when it declined. But for me, the investor, I still would have zero faith in the accuracy of Luck & Coffee's financial statements at this point in time. And to me, I would never include that company in my portfolio. Robert Leonard And is it the SEC that's sort of tapping him on the shoulder to confirm that these numbers are correct and they find that they're not?

55:51Is it the SEC that does it? Is it shareholder pushback or what leads to these irregularities? Robert Leonard It's a combination of the SEC and the auditors of the business. So companies that are publicly traded do have to get an outside auditing firm to go in and confirm that the numbers are correct. This is where the big four auditors come find. and is one reason why if an investor does not see one of the big four auditors on the company's financial statements, they oftentimes will have big questions in the place and saying, why are you bothering with this outside auditor? We don't trust them.

56:22We do trust the big four auditors in the US. But typically, it's a combination of the management team, the auditors, the board of directors, and the regulators that identify whether a company has financial problems or not. Robert Leonard Excellent. We've already mentioned David Gardner a couple of times during this conversation. And I mentioned I had just interviewed him and that episode will go live a week after this one. And I must say that it's one of my favorite conversations to date. And you worked at The Motley Fool for a number of years. And I know that Gardner was highly influential for you and your investment strategy and whatnot.

56:54As I was reading through the book, I know that I see plenty of parallels between how both of you think about the world of investing. And I'll also mention that Gardner, amazingly, I read in his book that his portfolio has seven 100 baggers and Amazon's more than a 1000 bagger in his portfolio. So really excited for that episode to go out next week. But before I give you the final handoff, I was curious if you could just talk a little bit about the impact that David Gardner has had either on you as an investor or as a person. David is a tremendous human being on so many fronts. And one thing that I really like about studying David's investing style is it's so backwards and differs so greatly from what you hear from the investing greats like Warren Buffett and Charlie Munger and Seth Klarman, who emphasize valuation first in everything that they do.

57:43David is, I view, as almost a venture capitalist investor who just so happens to fish in public markets. And he has his six signs of a rule breaker have been instrumental in helping me as an investor. In particular, the thing that he has changed my mind about the most is valuation and how to think about companies that are valued. Kevin Patton, I am a natural value investor. When I first started investing, I looked for big dividend yields and low PE ratios, and those were the stocks that I wanted to own. So when I heard him say things like, it's okay to pay 100 plus PE ratios for businesses, and when I saw him recommending Amazon and Netflix early on in their growth phase, I thought he was nuts.

58:25I just thought he was absolutely backwards and he was violating so many of the sound investing principles. But when I look back at my biggest winners of all time, the things that have the biggest network impact on my personal net worth, they are almost exclusively companies that David Gardner picked out. Companies like Netflix, Amazon, Intuitive, Surgical, Axon. These are companies that I never would have put into my portfolio if he hadn't recommended them and convinced me to. And in many cases, I was holding my nose about the valuation and buying. And looking back, they were some of the best purchases I ever made.

58:59So he's had a tremendous impact on my financial life. Are there any ways in which you feel that your approach differs from his? Certain things you look for that he might not or certain things you emphasize? Yeah. If you look at my checklist and compare it to his, I have more components on my checklist, but I am more of a quality investor at this time. I am okay with giving up the upside potential of a business. I tend to invest at later stages than he does because I want to see more that the thesis has been proven out. One thing that I like about his style is despite picking stock publicly for 20 plus years, he is perfectly okay with striking out on an investment, going up and being the champion for a company like Peloton early on and saying, yes, I like this company.

59:44That stock went on fall like 70 plus percent, and he is willing to shake it off, step up to the plate, and still pick another stock that he thinks has upside potential. And what he showed me is that it is perfectly okay to lose, and it's perfectly okay to have a portfolio filled with losers. You just need to get one Amazon or one NVIDIA or one Apple into your portfolio, and the gains that you get from that mega winner will pay for all of your losers combined. Since valuation is such an important piece of looking at the financial statements, you mentioned initially you got attracted to juicy dividend yields to low PE ratios.

1:00:23And I remember very vividly back in college, I saw AT &T had a dividend yield of 5%, 6%. And I was like, man, why am I not just putting a bunch of money into this, getting these, what I viewed as sort of guaranteed dividends. Of course, they probably cut the dividend since then, and highly indebted company and whatnot. I don't know if you have anything else that you feel is really important for your journey as an investor and looking at the numbers and understanding the numbers, but also understanding how they fit into the bigger picture of understanding a company's value, where that might value might be in the future, and just viewing that from an investor standpoint.

1:01:00Preston Pyshko, Good investing is all about marrying the left side of your brain with the right side of your brain. And I've learned that good investing is part art and part science, and you need both working in tandem with each other in order to do well. You need to have the financial knowledge to be able to analyze a company's financial statements and ask, what's happening with revenue? What's happening with margins? Can the company's balance sheet allow it to survive, or will it have to raise capital and dilute investors into oblivion? That's a very important skill that you need to know and to look at.

1:01:30Equally important is to be able to see the company where it is today and have the vision in your mind to say, what can happen if this company does what it says it can do? Or is the future of this company even brighter than the most bullish analyst that's covering this stock today believes? It's oftentimes those companies, the one that's outperformed even the most wildly optimistic expectations that are out there that truly go on to deliver life-changing returns for their investors. This is one of the most important things that everybody listening to this needs to know. What kind of investor are you?

1:02:03Where on the risk reward spectrum do you lie? Are you going after 100 bagger stocks? If so, you need to really emphasize the story of the business and really de-emphasize the current financials of the business. If you're a value investor or a dividend an investor or a quality investor, you need to really emphasize the financials of a business and de-emphasize the story of the business. But it's really important to know yourself and to know what you're looking for so you can make the right investing decisions for you. And lastly, how much emphasis do you put on building a DCF, building a model to determine whether you're going to invest in a stock or not?

1:02:41Personally, I put zero emphasis on DCF models. I don't use DCF models. I know many valuation gurus say that they're the only way to value business. I don't agree with that at all. I think the most useful DCF model is called the reverse DCF model, where you solve for the company's implied growth rate by using the current stock price. That makes a lot of sense to me, because you're not making estimates about what the company is going to do. You're seeing what does the market estimate that this company is going to do, and do I think the company can outperform or underperform that? Valuation is one of the most tricky things to do, But I think the simpler you can keep it with valuation, the better you would do as an investor.

1:03:19So when I'm valuing companies, I'm looking at typically reverse discounted cashflow analysis or simple multiples to determine valuation. I think while that is a very broad stroke, I think that's all you need to do well as an investor. Well, Brian, this was fantastic. A great conversation for many in our audience to become more familiar with financial statements and understanding how this all fits together and how So understanding financial statements can help us as investors. I'd like to give you the final handoff here. Please let the audience know where they can get in touch with you and maybe even learn more about these concepts.

1:03:52Yeah. So financial statements are a really hard thing to express over a podcast. So if anybody follows me on social media, I create a lot of visuals that kind of explain the nuance of accounting. So if your listeners go to financialstatements.school, financialstatements.school, there I have an ebook that has 10 of my most popular accounting infographics and you can download them and then they'll make a lot of the concepts we talked about on today's episode make a whole lot more sense. Excellent. Well, Brian, I really can't thank you enough and look forward to our next conversation in the future.

1:04:25Thank you for the invite, Clay. It's a pleasure to be here. Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts, or courses, Go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor's Podcast Network. Written permission must be granted before syndication or rebroadcasting.