Motley Fool Hidden Gems Investing - Financial Metrics that Actually Drive Profits

Episode Date: March 12, 2022

A company's financials are more than just a set of numbers. They can tell a story that helps us understand the core of a business and where its growth opportunity lies. John Rotonti talks with fellow Motley Fool senior analyst Auri Hughes about the financials to watch before putting your money into a publicly traded company. They discuss: - Profit drivers in a company’s balance sheet - The portions of a 10-K that investors should pay close attention to - Metric that provide insights about a company’s growth prospects Stocks discussed: AAPL, SBUX, CPRT, CNSWF Host: John Rotonti Guest: Auri Hughes Producer: Ricky Mulvey Engineer: Tim Sparks, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

Chris Hill You just described it beautifully, this idea that companies reinvest and they grow bigger over time. That's the compounding effect, that's the snowball effect. That's how the math of compounding works. Chris Hill I'm Chris Hill, and that was Motley Fool Senior Analyst John Rotonti. The financials of a business are more than just numbers. They tell a story that helps investors understand the core of a business and where its growth opportunity lies. On this Saturday Classroom, John is talking with fellow Motley Fool Senior Analyst Ari Hughes about the profit drivers in a company's balance sheet, the part of a 401 they love to read,

and a financial metric that can tell you a lot about a company's growth potential. Hi, Fools. I'm John Rotante. I'm here again with Ari Hughes, and today we're going to be talking about understanding the core business and the key drivers of value in that business. How are you doing, Ari? I'm good. How's it going, John? Things are going well. One of my favorite topics to talk about, so things are going, yeah, even better. So, Fools, we thought we would maybe start by going through a quick example of how sales flow through a company to become earnings. And so, let's just take a quick example of looking at Starbucks, because Starbucks is a company that most of us are very familiar with. So, the sale that Starbucks makes,

sales are what happened at the point of sale. So, point of sale, meaning the cash register in the store or on app if someone is doing mobile order and pay. That is the sale. When you go into Starbucks and you pay $4 for a cup of coffee or whatever it is, that is the sale. From sales, we subtract something called cost of goods sold or COGS, C-O-G-S. That is everything that goes into specifically making that cup of coffee. So, those are expenses that are involved in making that cup of coffee. So, the coffee beans, the coffee cups, the plastic lids, the straws, any syrups or whipped creams that go into that coffee, the salaries of the baristas that make that coffee for you in the store, any pastries you may buy in the store, napkins, sugar packets,

all of that is direct cost of making that product. So that's cost of goods sold. So we take the $4 sale, we subtract the cost of goods sold, and we get something called gross profit. And that's really the unit economic you're looking at. How much profit is left over after you subtract the cost, the input costs that go into making that product. And that's your gross profit or your unit economic. From gross profits, we subtract operating expenses. And for operating expenses are things like SG&A or sales, general, and advertising. And then R&D expense, things like keeping the lights on, paying your water bill, paying your utility bills, paying the rent on the location. Those are all operating expenses or costs of doing business. So from gross profit,

we subtract out operating expenses and we get something called operating income, which is also called, and this is really important, earnings before interest and taxes, or EBIT. From EBIT, we subtract interest expense if the company has debt. So this is a really important point. From EBIT, we subtract interest expense, meaning debt holders are the first to get paid. Debt holders or creditors have a primary claim on a company's cash flows. So, remember, we had EBIT, E-B-I-T, and we subtract the interest. We subtract the I. And so, now we are left with earnings before taxes, or E-B-T. And from that, the business pays taxes to the government. So, the government is actually the second in line to get paid. And then what is left over is net income or net

profit or net earnings. They all mean the same thing. Net income, net profit, or net earnings. And that is the bottom line of the income statement. Remember, the top line of the income statement, was the sale that was made at the point of sale, the sale of that cup of coffee. Then we subtracted out the cost of goods sold to get gross profit. Then we subtracted out operating expenses to get EBIT. Then we subtracted out the I, the interest expense on the debt, to get EBT. Then we subtracted out the T, the taxes paid to government, and what is left over, if there's anything left over, is what goes to shareholders, is what goes to us as the owners of the business. Keep in mind, fools, we are last to get paid. We get the residual. We get

what is left over at the bottom of the income statement. That is why it is called bottom line. But for a lot of great companies, like Starbucks, for example, like Apple, which we may talk about later, there's a whole lot left over. There's a whole lot of net income left over. Ari, maybe over to you, now that we have an idea of how sales flow through an income statement or flow through a profit and loss statement, how do you find out the most important metrics or the most important drivers to focus on when you are analyzing a new business? Yeah, wonderful. That was a great description, by the way. That was amazing. I feel that much more confident in understanding the income statement. So basically, I start with a 10K

document. Again, that's probably one of the most important documents in researching a company. And after I read the beginning that just describes the business model, I'm going to look for a section called MDNA, which stands for Management Discussion and Analysis. And there's usually commentary from management describing what are the most important things, what are the drivers of the business. And they may have some metrics that directly feed into revenue or show what is revenue is comprised of. So just to give you an example, a few years ago, they don't do this anymore. But a few years ago, Apple used to break out how many iPhones they sold. They broke out the iPhones, the tablets, and the Macs. And you could actually calculate on average the average price

they were selling them at and the number. So if you think about their business, a big portion of it is going to be at its core, the number of devices they sell and the average price of those devices. So you could see that in their MD&A section. And then you could, if you wanted to forecast and estimate how much they would sell in the future based on guidance or just the environment, you could do that. So that was very critical. So that's a section I usually go back to for most companies to understand what are the core drivers of this business? What does management want me to know? What are they showing me? They'll usually talk about the trend. Has it trended downward year over year or upward? And they'll probably give some reasoning as to why

that trend has changed. So maybe if it's Etsy, they may say, we had a great holiday season or we had more visitors due to this. Or maybe a lot of times over the past couple years, I would see things with information related to COVID. So if it's a business that's affected by travel or people being out, you may see some pullback due to COVID or things like that. It just provides a lot of insights into the key drivers of revenue of those businesses. So again, I like the MD&A section. I agree completely, Ari. In that 10K is where management is going to talk about the metrics that drive value for their business. And these metrics are different across industries, right? And so if you're looking at a bank, for example, banks take in deposits and they pay a

tiny, tiny bit of interest on those deposits, right? And then they lend out those deposits and charge a higher interest rate. So banks, traditional banking, they make their money on that spread. The difference between the small amount of rate they pay on a deposit and the higher rate they earn when they lend out those deposits, whether it's for a car loan or whether it's for a mortgage or whatever it is. When you're analyzing a bank, you want to focus on that spread, which is called the net interest margin. There's very few other companies outside of banks where the net interest margin is going to be the key driver of value, but it is for banks. If you are analyzing banks, you have to know that is a key driver of value. If you are analyzing

insurance companies. Insurance companies look at their own set of metrics, the most popular of which is probably something called the combined ratio, which is a measure of their underwriting profitability, the profitability they earn on their insurance business, on the risk that they take underwriting insurance. And so, if it's a software company, we look at a different set of metrics. We look at sales growth rates, we look at gross margins, we look at gross profit dollar growth, we look at revenue retention rates, we look at how much of revenue is recurring, we look at net revenue retention rates. And so, we look at the rule of 40 for software companies, which is basically revenue growth rate plus the free cash flow margin. And so, there is

lots of different metrics, lots of different drivers of value across industries. But Ari, to send it back to you, what metrics would you say at the end of the day you place the most emphasis on when you're analyzing businesses? Yeah, that's a great question. And I think after working here and just looking at historically the best performing stocks of all time. I would say the first one is revenue growth. So it doesn't have to be a huge, insane amount of revenue growth, but I like to see sustained revenue growth, ideally organic, preferably. If it's not organic, I want to see a team that has executed on acquisitions over time or that's their specialty or they know what they're doing. So sustained

revenue growth over maybe like a 15% hurdle. And then second and third, I'll put them on the same bar, is probably free cash flow. I do like money coming in. It makes me a little bit more comfortable in that I know the company won't need to go back to the market. And then net cash on the balance sheet. I like a safe business that has less likely to go bankrupt or just doesn't need cash. And I think a lot of those, a few of those things have been correlated with high stock returns over time. So those are kind of my go-to metrics. Yeah. All right. Those are so similar to mine. And so it's, I love that. And so for the portfolio that I lead for the Motley Fool for Showdown, we had to share our investor philosophy statements or IPSs with our members. And I wrote

out mine and I bullet pointed the things I look for. And so, I said, resilient growth businesses. So, you said organic revenue growth. I said, with superb leadership that are solving important problems. But then I gave the metrics. I said, they've already achieved scale. So, these are companies that, you know, they're larger, they're mid-cap or large cap. They've already achieved scale. I said, they have strong, I said, immensely strong balance sheets, usually with net cash. I then said, are highly profitable with high and or rising returns on invested capital, or ROIC. I said, have strong and growing free cash flow generation. And then I said in parentheses, in other words, they are self-funding, which is what you said.

They don't have to tap the markets. They don't rely on other people's money for their growth. And then I said they likely operate in an oligopoly or duopoly with limited competition, wide modes, and very high barriers to entry. One of those that I do want to drill down on, just because this is a segment on key performance indicators, KPIs, and key metrics that drive value, I do want to talk a little bit and briefly about the power of the return on invested capital calculation. So, ROIC, or return on invested capital, if you assume we have two companies already, Company A and

Company B, that both aim to grow their earnings at a rate of 5% per year. So, that's the target growth rate that both companies have set for themselves. They want to grow their earnings, which remember, earnings are what belong to shareholders. That is what's left over at the end of the day. So both company A and company B want to grow their earnings at 5% per year. But company A has a return on invested capital of 20%. And company B has a return on invested capital of only 10%. Under these parameters that I've just laid out, company A only has to reinvest 25% of its earnings back into the business to achieve its goal of 5% earnings growth. But company B has to reinvest 50% of its profits to grow its earnings at the same 5% rate.

So company A, which has the higher ROIC, only has to reinvest 25% of its earnings to grow at 5%. But company B, which has a lower ROIC, has to reinvest 50% of its earnings to grow at the same 5% rate. In other words, Company B that has half of the return on invested capital has to reinvest double to grow at the same rate. So, because Company A can reinvest less of its earnings back into the business to grow at the same rate, it's reinvesting less back into the business, that means it has more

free cash flow left over. It's reinvesting less back into the business, so more free cash flow is left over. And free cash flow, Fools, is ultimately what drives business value. There's one of the definitions of Corporate Finance 101 or Valuation 101, is that the intrinsic value of a business, the fundamental fair value of a business, is the present value of all of its future free cash flows that it will generate. And so, free cash flow is what drives business value. And I just went through the math showing you that companies with high ROIC, companies with high return on invested capital are capable of generating far more free cash flow. So, any last words, Ari? Yeah. Return on invested capital,

return on equity are amazing concepts. And I think when you truly understand them, the way I think about it is the business produces cash. If you're just an entrepreneur, were, are you going to buy more lemonade? Are you going to hire more employees? And then reinvest that into the business. And then next year, the business should produce more cash. And then you reinvest that and the business grows over and over. And that's why the relationship, that formula between ROE and growth is so important and they go hand in hand. It's just about your opportunities. So is there an opportunity to keep growing the business? And that's one of the core concepts of understanding how businesses get bigger and grow over time. And I think your example is great

because it touches on the efficiency and how effective of a return that business is generating internally. So these are just very important concepts to understand. And if you look at a lot of the best performing stocks over time, the ones that have been profitable have had high ROEs are high return on invested capitals, co-parts, constellation software, just amazing ROEs over multiple years, and they've gotten substantially bigger. So, very important concept. Yeah. And you just described it beautifully, this idea that companies reinvest and they grow bigger over time. That's the compounding effect. That's the snowball effect. That's how the math of compounding works. You mentioned the ROE formula. Fools, let me briefly give you that

formula. The formula is net income growth. We talked about net income. That's what goes to shareholders. Net income growth is equal to return on equity multiplied by one minus the dividend payout rate. So to reframe that, net income growth is equal to ROE multiplied by the reinvestment rate. Whatever a company does not pay out as a dividend, it retains or reinvests back into the business, right? And so if we do ROE multiplied by one minus the dividend payout rate, then we get ROE times retained earnings or ROE times reinvestment, and that gives you growth of net income. I will leave our fools with one last formula, and that is there's also a formula for growth of operating income, and that is ROIC times the reinvestment rate. Ari, you bring up

such a great point. These return metrics that we're talking about, ROIC and ROE, they're not only measures of profitability and performance, they're also drivers of growth. And so there you have it, Fools. Ari, thank you so much. Thank you, John. This was a lot of fun. Full on. That's all for today, but coming up tomorrow, we're going to talk about Russian oligarchs. Yeah, we really are. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening.

We'll see you tomorrow. Thank you.