How to Evaluate a Stock Like Warren Buffett! With Brian Feroldi
00:00This is why, again, I was so confused for a long time because I was like, how can Amazon trade at 100 times earnings?Like every book I've ever read said that 100 times earnings is way too expensive.And yet the company was actually cheap at 100 times earnings.And if you bought it 10 years ago, 20 years ago, when it was trading at those insane prices, it was a great buy.So the PE ratio can be useful as long as it's in the correct phase.Now, valuing companies in this phase is very difficult because it's basically the price to hope ratio.It's like, what could this business be worth in the future if they can hit a grand slam?Which is very hard to do.
00:41So these businesses, phase one businesses are basically lottery tickets.And you can do that hard work to figure out if you can go under the bridge.Well, in Buffett's mind, he's like, if it's too close to call, pass.Like, I'm not going to go ahead and do that.So when he's valuing a business, if it doesn't simply scream out, this is cheap on a,first glance, it's too close to call and he doesn't bother with the advanced calculations.On this episode of the Personal Finance Podcast, we're going to show you how to evaluate a business like Warren Buffett.What's up, everybody, and welcome to the Personal Finance Podcast. I'm your host, Andrew, founder of
01:27MasterMoney.com. And today on the Personal Finance Podcast, we're going to be diving into how to evaluate abusiness like Warren Buffett. If you guys have any questions, make sure you join the Master Moneynewsletter by going to mastermoney.co slash newsletter. And don't forget to follow us on Apple Podcast,Spotify, YouTube, and whatever podcast player, you love listening to this podcast on. And if you want tohelp out the show, consider leaving a five-star rating and review on Apple Podcast, Spotify, oryour favorite podcast player. Now, Warren Buffett has spent the last 60 years looking at businesses anddeciding what they're worth. And he is one of the best of all time at ever doing this. And he's done itin a way where he hasn't even had to use a spreadsheet and he's done it in a very simplified way.
02:14And Charlie Munger, who is his business partner, has even stated that he has never onceseen Warren Buffett run any fancy math that Wall Street uses. So how does he do it? Today,you're going to learn how to evaluate a business that way and the way that Warren Buffett does it.Not the version that you read about in textbooks, but the actual process.that he uses and how to think like Warren Buffett.My guest today is Brian Ferraldi, and Brian is the author of Why Does the Stock Market Go Up?And he has taught hundreds of thousands of everyday investors how to read a company withouta finance degree.
02:47So he went through every single company that Berkshire Hathaway owns, and he even built his owntool to help him evaluate stocks just like Buffett.So you're going to learn how Buffett actually decides which businesses are worth his time.You're going to learn about discounted cash flow and if you should consider something like thator not, you're going to learn about the five stages that a business could fall into and some of themetrics that you need to look at and why you need to evaluate a business differently, dependingon what stage that it is in. Then we're going to go through how to look at a company's historyand make decisions based on that. And finally, some of the other qualifiers that Brian has on his list.
03:23And by the end of this episode, you'll be able to look at a company and ask a lot of the samequestions that Warren Buffett does. And then you'll understand why he owns Coca-Cola and Americancan express but doesn't own a single share of Tesla.So I'm super excited for this episode.So without further ado, let's welcome Brian to the Personal Finance Podcast.Brian, welcome back to the Personal Finance Podcast.Andrew, awesome to be here.Thanks again for having me again.
03:50It's always fun to come and chat with you.I am really excited to dive into this because we're going to talk through how toevaluate a business like Warren Buffett.And I think a lot of our listeners are super interested in this.I'm a huge Warren Buffett fan.I talk about Warren Buffett all the time.and this is going to be one that I think is really cool.And one of my favorite things about this is that you built a tool that is going to help a lot of people be able to kind of evaluate some of these businesses as we dive deeper into this.
04:14So if anybody is listening to this episode and you kind of want to see what we're talking about as we start to go through this as well,make sure you're watching on YouTube, Spotify, Apple Podcasts, wherever you watch video, you'll be able to see some visuals on this episode as well, which is going to be really, really exciting.So the first thing I want to talk through is, you know, back in the 90s, Warren Buffett,was kind of talking through discounted cash flow and how he kind of evaluates a business.And Charlie Munger interrupted him or interrupted during that time frame or later on down thetime frame and said, hey, I've never seen Warren actually run a discounted cash flow model.So can you kind of talk through, you know, what Warren Buffett does and what's really going onthere?
04:52Yeah.So Buffett has been asked for, you know, he's like the king of valuation, right?Price is what you pay.Value is what you get.So he has always had a sharp eye for figuring out.how to figure out if a business is a buy or a sell, if it's undervalued or overvalued.He's always been really good about that. And he's been asked for years, you know,what do you do? What is your process? And he always gives the standard academic answer to that
05:18question, which is basically you build a discounted cash flow calculator, you figure out thecash flows of the business, you discount them back to present value, and you compare that tothe current stock price. So he gave that answer during one of his annual meetings andCharlie Munger, as you point out, immediately said, you know, he talks about these discutted cash flows.I've never seen him do one, right? And this is on stage, and of course it got a big laugh fromeverybody. But what Buffett later kind of admitted, he says, you know, it's true what Charlie is saying.He, what he, what he basically admitted is valuation to him is so easy and it's so simple thatif, if looking at the business doesn't just scream at you, this stock is under vassive.
06:04valued, it's basically too close for him to call. So one kind of like mental waddle of a way ofthing about this. Imagine you're driving like a semi truck and you're going under, you see a bridgeahead. And the bridge says like, you know, clearance like nine feet six inches. Yeah, you could get outand you could like measure the top of your, your truck and see like, am I going to, am I going to make it?And you can do that hard work to figure out if you can go under the bridge. Well, in Buffett'smind, he's like, if it's too close to call, pass. Like, I'm.not going to go ahead and do that. So when he's valuing a business, if it doesn't simply scream out,this is cheap on a first glance, it's too close to call and he doesn't bother with the advanced
06:44calculations. And I love that. I think that should be, there should be some natural inclinationsof like how you look at a business and there should be some natural things where you can kind ofreact pretty quickly and make some quick decisions. So then you can decide, hey, am I going to divedeeper into this or is this something that is probably just too close to call like you said? And I needto kind of move on. And so one thing that I love is that you kind of analyze and broke this,this process down into steps. And so before we go through these steps, because I think they'rereally important for people to understand, what surprise you most about how simple this is?Well, I think the surprising thing is just what you just said, exactly how simple this is.
07:20You know, there are advanced college courses on how to value businesses. If you study theacademics out there, like Oswath-Dimotron, who is someone that I greatly admire, I think he doesgreat work. You know, valuation is like multi-tab spreadsheets with all kind of assumptions builtin and discounted back to the present value and you get precise numbers from this. I just lovethat Buffett just throws all of that out the window and keeps things extremely simple. I thinkthere's great beauty in simplicity and it's very clear that he developed a system that allowshim to quickly and simply analyze a business. And I think the more simple you cankeep the process for yourself, the better off you are in the long run.
08:04Absolutely.And that's where I love, like, there's this image that you show.You have this great YouTube video, which we'll link down below the show notes,but there's this image that you show in that YouTube video of Warren Buffett sitting at his desk.And I've never seen the actual picture of this.I've always heard about him having this pile that's called Too Hard on his desk.But you actually had the image in that YouTube video, which was, which is awesome,where he just kind of looks through a bunch of different companies.
08:25And like if a company seems as though it is too difficult or too hard, he puts in the too hard pile.And famously, this was happening, you know, in the early 2000s during the tech boom where he feels as though he probably missed out on a couple of them because they were just too hard.They were too hard for him to kind of understand during that time frame.And so I think that's really, really cool and interesting the way that he kind of does that.Can investors kind of do the same thing?And do you do this?Is the too hard pile something that you consider every single time you look through a company?Absolutely.
08:52I think it's totally, you know, one thing that he has popularized over the years is just circle of confidence.knowing what you know and knowing what you don't know.You know, I spent a couple years of my life writing for The Motley Fool aboutbiotechnology companies, and I was spending all day, every day,looking at finding, analyzing biotechnology companies.And what I learned after doing that for a couple years is this,this whole category is just too hard.Like, you really have to, you already have to know a lot about the science,
09:23and you have to follow the clinical trials.And even then, even when you're like,convinced, oh, this drug or this product is going to get approved. Sometimes the decisionswould come out of nowhere and they would blindside you. Same thing to me with banks. You know,people that invest in like J.P. Morgan or Goldman Sachs, I can guarantee you those people haven't readthe 10K of those businesses because they are insanely complicated. And as Buffett says, you don't get paidmore money for making things difficult on yourself. In fact, some of the best businesses that he hasowned and he made the most money on are really simple businesses that anyone can understand,
09:59right? Coca-Cola, apples, Moody's, like very simple, straightforward businesses. So there's noextra points in investing for making things difficult. And I think that's where most people getcaught up. There's a lot of folks out there who feel as though the more complicated their modelsare, the more complicated the way that they analyze a stock is, the better off they are going to belong term. But simplicity is tried and true over and over and over again. You can kind of see thatsimplify, simplify, simplify as much as you possibly can, even when you're evaluating stocks, all the waydown to the bare bones of what you need to understand and that you can kind of go from there and buildit out a little bit more. Is there anything that you would tell an investor who maybe is overcomplicating
10:39something and or if they are not looking at investments and throwing enough in the too hard pile?Is there anything you would tell them in terms of some of the things that maybe they shouldconsider in terms of simplifying this down a little bit more?Yeah.Always, always ask yourself, the most important investor to study thoroughly is yourself.Like, what are you actually doing with your money?What is actually going into your portfolio?What have your actual returns been over time?
11:05And how do you behave during downturns?Which is really the true thing that matters for an investor.Investing is easy and fun during bull markets.It's really during the bare markets that you discover things about,about yourself, but truly ask yourself, go through your portfolio and say, could I explainto a layperson or to my spouse or to my friend what this company does? And could I answersome very basic questions about what this company does, how it makes money, and why customerschoose it over the competitors? If the answer there is yes, and you can do that, and I think all of us
11:40can do that with simple businesses like Nike or Chipotle or Marriott Hotels, we could, we couldwe could answer the question,what does this company do and why do people choose it?Could you say the same things about more complex companies,like Charles Swab or, again, Bank of America?I think if you actually push people to do that kind of thing,the answer would be no.Exactly. And I think that's the perfect test
12:07of the way to kind of think about this.It's funny because I'm teaching my kids,so I have an eight-year-old, a five-year-old,and then my daughter's too young.But my eight-year-old, I'm kind of teaching them about stocksand how to kind of think about stocksand develop some sort of thesis around them.And one of the big things that we talk about is developing an explanation of what this
12:23company does, how they operate, some of those types of things.And his answers, a lot of times because he's got a kid's mind, the child's mind,are so much better than what I've seen a lot of adults do, only because he just simplifieseverything all the way down and kind of looks at some of the things that kind of makes sense.And so we're looking at companies that are a little bit easier for him to understand.But I think a lot of people need to figure out how to kind of simplify that down where they canhave an explanation of what the company does, why it does have this competitive moat.Some of those different areas, I think, are really, really important.
12:54And so this system, what we're about to talk about is going to help a lot with that,is kind of thinking through some of the life cycles of a company and kind of where they stand.When I started the personal finance podcast, I had no idea how big it could become.I just knew I had something I wanted to share, so I started putting it online.And looking back, I definitely wish I would have started it.decade earlier. One of the horror parts about building something online, though, is making it lookprofessional. A website used to mean hiring a developer, figuring out design, and potentiallyspending thousands of dollars. In fact, on my website, I spent tens of thousands of dollars.
13:35That's what impressed me when playing around with Hostinger's AI website builder. I told it whatkind of website I wanted, and I built the first version in minutes. No coding, no designer, or developerneeded. And Hostinger doesn't stop at launch. Their AI can help with SEO,website copy, email marketing, and more. Plus your domain, website, email, and marketing can all livein one account, with plans starting at just $3 every single month. Hostinger builds your visionstep by step. Create your website today. Go to hostinger.com slash pfp and use code pfp for 10%off now. If you've been listening to this show for a while, you know it's not just me anymore.It takes a great team behind the scenes to make everything happen.
14:20And if I had to hire someone tomorrow, I'd want someone who could jump right in and make an impact.That's why I'd use IndeedSponsor jobs.When Workplace Chaos hits, IndeedSponsor Jobs helps you reach qualified candidates faster.Your job gets boosted in search results, so you're spending less time searching and more time interviewing the right people.Plus, you only pay for results, which I absolutely love.Sponsored jobs posted directly on Indeed are 95%, more likely to report a higher than non-sponsored posts.That's a huge advantage when you're trying to grow your business.Spend less time searching and more time actually interviewing candidates who check all of your boxes.
15:00Less stress, less time, more results.When you need the right person to cut through the chaos, this is the job for Indeed sponsor jobs.And listeners of this show will get a $75 sponsored job credit to helpget your job, the premium status it deserves at Indeed.com slash podcast.Just go to Indeed.com slash podcast right now and support our show by saying you heard about Indeed onthis podcast. Indeed.com slash podcast. Terms and conditions apply. Need to hire? This is a jobfor Indeed sponsored jobs. Now, if you watch this podcast on Spotify, Apple Podcasts, or YouTube,you probably notice the wood slat walls behind us. We wanted this podcast set to look professional,
15:41but also not be a project that was overly complicated.And I found these slat walls on Wayfair, and it completely changed this space.And it's now basically the background that you see in every single podcast or piece of content that we record.And that's one of the things that I love about Wayfair.You can shop thousands of products across different styles and budgets,use customer photos and reviews to see how things actually look in real homes and find something that fits your space.They also have Wayfair verified products that are hand vetted by product specialists,using a 10-point quality inspection.
16:16And with more than 20 million verified five-star reviews,you can feel a lot more confident about what you're ordering.I've used Wayfair for this studio and our home,and I absolutely recommend them for your space.So transform your space with pieces that hold up to real life.Join Wayfair rewards today and get 5% back on every single purchase.Head to Wayfair.com or shop the Wayfair app for all things home.That's W-A-Y-F-A-I-R-com.
16:46Wayfair, every style, every home.Wayfair, every style, every home.And you know, you've talked about their, you know, each company is in one of these five different life cycles.And this is one of the things that Buffett kind of looks at in one of the ways that we can kind of see, you know, where these company life cycles are.So can you walk us through these five different life cycles and, you know, how we can recognize if a company is at each and every stage?Yeah, this is something that I haven't heard many other investors talk about. I think some of the moreadvanced investors kind of know this intuitively, but the only person that I heard put this conceptinto like words and visuals was Oswath Demoderan, who again is someone that I looked up to
17:30as an investor, even though I think he makes valuation a bit too complex. But the general idea hereis just like animals and humans and plants, businesses go through different,phases in their life. And you need to know what phase the company is in at any given time so you canlearn how to analyze it correctly. Anybody that knows the history of, say, Amazon, like, andstudied the company, knows that for like 15 years or maybe more, the company was famously notprofitable. Like they literally lost money or made next to no profits for, again, like 15 years.and during that time the stock price while it was wild went up and up and up and up and upand that confused me so much as an investor because I was like this business isn't making money
18:20its profits aren't growing yet the value of this company just keeps going higher and its price to earnings ratio was ridiculous andand the stock price is still appreciated from there once I understood the mental model that there'sdifferent phases that the company in everything became clear because I was analyzing Amazonstock, assuming that it was in phase four, the capital return phase, when in reality it wasin phase two, the hypergrowth phase. And this mental model, I think, can be really helpful forinvestors because you need to analyze companies differently depending on where they are. As a simpleanalogy, you wouldn't look at a three-year-old and judge it by its SAT score. Right? It's simply tooyoung in the child's life for the SAT score to be relevant. Well, that's again looking at Amazon
19:07in the year 2003 and saying, well, what's the company's PE ratio?It's too early in the company's lifestyle to make that determination.So this mental model, this business growth cycle phase,and we can go through it step by step,is really useful for figuring out what metrics matter,when they matter, and what doesn't matter at all.Let's go through it.So, like, I think there's five different phases here that we can go through
19:33and kind of give people an understanding of how to look at a businessand how to decide, you know, where it is.And then you have a great tool that's going to help people just kind of do this really quicklyand fast, which I absolutely love.And so one of the things that we're going to look at here for investors is trying to understand,hey, what phase is this company in?What phase is this business in?And then how do we make a decision based on that?
19:53I think that's kind of part of this process that most people need to understand.So let's go through each one.We can go from there.So phase one is the startup phase.So what happens in the startup phase?Yeah.So this is when a company is,in just getting off the ground.
20:09Maybe they have a little bit of revenue.Maybe they're just in the R&D phase,but they're not really actively going out thereand getting customers.So think of like Open AI six years agowhen Elon Musk first funded them, right?It required a huge amount of capital,all kinds of researchers,
20:25all kinds of people pulling in,and they didn't launch their first productuntil what, 2022 or something like that?So there was a multi-year periodwhere the company was,hiring people, spending money like crazy, its losses were growing, and the company's revenue waszero, zero during this time period. So this is the startup phase. Every famous business that you'veever heard of was at one point in its life in the startup phase. Now, because they're losing money,
20:53the way to judge them is not on revenue growth, it's on milestones. Did they launch a product,right? Are they getting new users to their product? Are they doing something thatindicates the business is making progress to getting them towards commercialization.So companies that are in this phase today are companies like Rocket Lab or Lucid Motors or IonQ,which is a quantum computing company.You can't look at any of these companies and say, boy, the price to earnings ratio looksreally cheap on them because the things that's driving their price is really the milestonesthat they're hitting and the story that they're telling investors along the way.
21:32Now, valuing companies in this phase is very difficult because it's basically the price to hope ratio.It's like, what could this business be worth in the future if they can hit a grand slam, which is very hard to do?So these businesses, phase one businesses are basically lottery tickets.So this is basically the high risk phase.And if you're buying one of these companies, it probably needs for most people to be a very small percentage of your portfolio if you're going to go this route.Is that kind of what your thought process is on that?Absolutely.This is where the life-changing returns live, right?
22:05But this is where the odds are stacked as high against you as you can.So a lot of biotechnology companies, small biotech companies are in this phase.No revenue.And the thing that moves their stock is press releases related to phase one clinical trials.And the stock goes up like crazy if they get FDA approval.But these companies are losing money intentionally and the losses are getting worse.Okay.So the losses are getting worse.
22:30So that's where a lot of people are just kind of starting off.This is where a lot of companies you probably see, you know, can go into like the penny stock range.They can end up, you know, going backwards and or some of the big wins are also in this pot as well.So again, high risk in the first phase in the startup phase, but this is also an area.If you have a very small percentage of your portfolio, maybe you want to go that route.Number two is ramp.So ramp is going to be the second phase of a business.What happens in the ramp phase?
22:55Yep.So this is when a company gets a product or service to market.establishes clear signs of product market fit and revenue really starts to take off.Now, in this phase, the company is still growing.It's still hiring people like crazy, but the revenue growth is so high in this phasethat while the company is still losing money, instead of the losses getting worse every year,the losses have peaked and the losses are getting lower every year.So companies that are in this phase have products or service that have been established,
23:29and they're growing customer accounts.So companies like Draft Kings,companies like Rivian Automotive,companies like Soundhound AI,I'd be familiar with any of these companies.They've all established clear signs of product market fit.They've attracted enough customers early onand generate enough revenue that it's starting to cover the businesses' costs.
23:50Now, these businesses are significantly less riskythan those that are in phase one, the startup phase.And you can still hit grand slams in this phase.But these companies are also high risk when compared to the other phases.And so, yes, this is still a small portion of your portfolio most likely,but you can take some, you know, calculated bets potentially.And it's one of those areas that I think is pretty interesting.A lot of these are probably more recognizable names as well for a lot of folks.
24:16And so you can kind of see some really interesting things there.The third one is operating leverage.Now, this is where it gets a little bit fun, I think.And this is where it gets interesting because there is a shift from maybe some of thesebeing in the startup and ramp phase where the risk is really high.And you could find some nice companies here.Yeah, absolutely.So in the phase three, the operating leverage phase, the business has crossed over the point
24:39where it has reached break even.So the company is profitable, but just barely in many cases.And the real goal of the company here is to achieve enough size and scale where it can startto optimize the business for profits.Up until this point, the management teams of these companies are really hyper-focused on revenue.Get customers, get market share, take advantage of the market opportunity.Profits are not the focus.Revenue and revenue growth is.
25:11That's how these management teams are judged.Once they get into the operating leverage phase, they've proven that the business has economics that work, that they can fund themselves,which makes themselves dramatically less risky than in phase one or phase two.but now the focus becomes grow revenue and start to optimize costs.So these businesses are not fully optimized for profits yet,and that is the thing that the management teams try to do during these phases,really go from optimizing for revenue to optimizing for profit.I love that.
25:43And I think, you know, you have this, and on the chart,we'll put it on the screen here so people can see it.But Brian has this chart here that I think is really cool.It kind of gives you the human equivalent to help you understand,hey, what are all of these phases like if you were someone,one in life and in the life that you've gone through. And for the startup phase, Brian has,you know, a college student kind of burning loans. You probably have a negative net worth,most likely. You're kind of doing this thing where you're going deeper into deeper into debt,
26:07but you have potential, like you have potential to be able to do a lot of cool things. And the rampphase, you're in your first job. You're still eating ramen. You're still, you know,trying to just get things figured out. I remember during this time frame, I wasn't making much money,but I was living paycheck to paycheck. And that's still kind of like the company version of that isthe ramp phase. And then operating leverage, this is where I think it makes.a lot of sense. It can all come together for a lot of people is like someone who is in,you know, their mid-career, they're starting to get raises, they're starting to save hard,and you start to build a little bit of wealth here. And I think for a lot of folks out there,
26:36that can help them kind of think through this in a human equivalent, which I think is really,really cool that you have this here. All right, phase four. This is the, this is where it gets fun,is the capital return phase. So this is one that we, we are going to be talking about probably alittle more here. So what is in the capital return phase? So this is when a company has,has gone through phases one, two, and three, and now the business is fully optimized for profit.Along the way, the company has been reinvesting all the profits to hire more people,launch new products, maybe make acquisitions, but the company is now fully optimized for profits,and the business is far more predictable and stable than at any time during its life.
27:18And this is finally the phase when the company has excess capital.It's actually producing more profit than it knows what to do with.And one decision that management teams can make during this phase is, all right, we're making all this extra profit.Let's finally start to give some of this capital back to the owners of the business, the shareholders.And there's three primary ways that a company can do this.The first way is the most boring, but it's pay down debt.If the company has debt that it has acquired, some of these businesses true to pay down their debt to again make the businessmore robust. The second way is to repurchase the company's own stock. So this is the buybacks that get all
28:01kinds of negative press about them. But this is just when the company is repurchasing the stock on theopen market, which shrinks the share count and that boost the company's earnings per share.And then the final way that they can return capital shareholder is just to give it to them as acash payment. And we call that a dividend, a dividend payment. So phase four, capital return is finallywhen the company is reliably producing cash and starting to return it to shareholders.And your examples of this is something like an Apple or a Costco.And the interesting part about this is I remember when Apple finally started to issue a dividend.It was this huge big deal.
28:35And that was kind of their crossover point into the capital return phase where you could see a lot of this was happening,where they were just growing more and more and more.And they just have so much cash on hand now.They didn't know what to do with it anymore.And so they had to do something with it with no debt or anything else.So this is the area where I think is super interesting.Like some of these examples, for example, like in operating leverage, we have like Amazon and Tesla are kind of in that range and then you look at capital return. Have you ever seen companies go from maybe being a capital return company backwards back into an operating leverage company again?Absolutely. Yes. These are loose guidelines and you can go from one phase to the other and you can go forward. You can also go backwards. Let me give an example. So in around the year 2012, Netflix was a capital return.
29:21company. The company was actively profitable. It's DVD business and it was buying back stock.One of them that follows Netflix knows that they chose to disrupt themselves. They essentiallytransitioned the business to being a streaming company. And doing so required a lot of capital.So they were in the capital return phase. They suspended all buybacks and took all of thatcapital and put it back into the business. And during a period of time, I don't know if they werelosing money, but they were certainly nowhere near.as profitable as they were.And that takes real guts as a CEO to do.
29:57Very hard to go backwards on this.But the founder, Reed Hastings, was still the CEO at the time.He knew this was the right move for the business.He chose to disrupt themselves.So they slid down back into hypergrowth phase,completely transformed the business.And as the streaming has obviously taken off,that was a brilliant move to do.
30:15And now the company is fully back in phase four,the capital return phase.So it is possible to slide back.backwards on purpose, but very few companies do that.Let me give you a human equivalent example of this.So this is perfect.Is my brother-in-law, for example, is now an executive at a very large company that a lot ofpeople would know.
30:33But before that, he was a middle-level manager.And when he was a middle-level manager, he realized I couldn't grow anymore at theplace that I'm currently at.And so he actually took a demotion in another department in order to kind of climb the ladderagain.And so this is kind of one of those examples of, you know, how you can look at that forcompanies as well. Sometimes it's not really that the company's going backwards, but they're justshifting strategy for a time frame so they could grow a little more. And like you said, it's hard to do
30:57that. It's hard to go from one phase backwards to the other and then try to try to shift there.But I think that's a really important thing to note. And then the last one is decline. Anddecline is something that is the last phase here. So what is decline? And can you tell us more aboutthat? Yeah, this is the phase that no company wants to be in, right? But we live in a capitalist society.and it is always just a matter of time before businesses become disrupted and they becomeirrelevant. So the decline phase, kind of tricky to figure where that is, but these are your old,stodgy businesses that are just not adapting to the modern times and they're slowly bleedingcustomers every year. So every year, revenue goes down. That causes their expenses to remain high
31:40so their profits go down even faster. These companies can be losing money and you hear things likethey're in turnaround mode. So this is where, like,like Bed Bath and Beyond used to be.Radio Shack used to be, I would say that right now Target and Altria group are kind of in this category.So you are not dead by any means, but revenue is trending in the wrong direction.And usually drastic action is needed to get these companies back to the capital return phase.So Sears, for one time, was like in the capital return phase for decades.It was one of the most dominant businesses in America.
32:15Now it's bankrupt, right?So lots of famous examples of companies that were once at the king of their industry and are now shells over their former selves or just completely bankrupt altogether.So this is a phase that no company wants to find itself in, but every company eventually will.Would you find something like a hot stock right now everybody's talking about as like a Nike or a Lulu Lemon?They've kind of declined in terms of like their stock price.But would that would be something that would fall in play into this category or not quite yet?Yeah.So that's a really good point because a stock.
32:47price declining may or may not indicate that the business is in decline. So stocks react far more wildlyto change far more drastically than the company's operating business does. So drawing the linebetween what separates capital return and decline is actually a really, really hard thing to do.What I came up with is basically two years in a row of revenue decline because some companiesoccasionally go through rough patches for a couple of quarters, you're still in the capitalreturn phase.But I think two years in a row of declining revenue and declining profits, that's what triggersa company to be in the decline phase.
33:27And again, just because you're in the decline phase doesn't mean you're stuck there.You can do things to get back to the capital return phase.I mean, Apple was in the decline phase in like 2000 before they rehired Steve Jobs.Seven years ago, everyone thought that Best Buy was in the decline phase because it waswas just a showroom for Amazon. Best Buy stock has flourished since there. So it is entirely possibleto return yourself to the capital return phase. It's just very hard to do. So why is knowing whatphase the business is the business in the thing that you need to get right before you try tovalue anything? Why is this so important for investors to understand? Because if you don't know
34:07what phase the company is in, you don't know what metrics you should pay attention to and you don't knowhow to tell if the management team is doing a good job or or not.So, for example, if you're in the startup phase, you can't look at that company and say,well, the price to free cash flow ratio here is negative.So this business is just insanely overvalued.No, the way that you value startups is based on how big of a market opportunity is thisand what milestones is the management team hitting along the way.That's what really matters in a startup phase.
34:41Startup companies are extremely hard, extremely hard.to value. In the hypergrowth phase, remember, these companies are losing money. The losses aredecreasing and sales are increasing rapidly. If you're going to be analyzing these companies,you should judge management teams based on the revenue growth rate and the gross margin change.Those are the key metrics that indicate the businesses having success. And if you're going to valueit, you should value it on the price to sales ratio. So every phase that you're in changes the keymetrics that you need to look at and that you should judge management success on and the way thatyou value it. So you have this tool that you created that is super cool that allows you to kind of see
35:22which phase businesses are in and helps you kind of look at this. Can we show this on the screenand maybe we'll go through a couple of different companies and kind of show exactly what this looks likeso people can see, you know, how you can kind of evaluate this and see these phases because I thinkthese visuals are super helpful for people. Yep. Yep, sure. So I build the two. It's stock,simplifier.com backslash phase.It's a completely free tool to use,and you can just enter any companyand it'll go through,
35:47analyze the financial statements,and give you the numbersand then AI analysison what phase it thinks it in.So any of these stick out in your mindis worth investigating?Let's do...Okay, we'll think of a couple
36:00of Warren Buffett companies here.So let's start with Coca-Cola.Let's start there and see what comes up.Okay, Coca-Cola is K-O.So Coca-Cola, this one's probably going to be pretty easy,and I think I know the answer to it.But Coca-Cola.So let's take a look.
36:14There's really three questions that you ask.Number one, is revenue growing?So yes, Coca-Cola's revenue here is still growing.Very slowly, but it is growing.Question number two, is the company profitable?Here's a key thing you have to understand.The way that you judge profits changes from industry to industry.You can't judge a bank's profitability the same way you judge a beverage company's profitability.
36:38the same way you can't judge a tech companies.So we actually pick a metric, a profit metric based on the industry that the company's in.In this case, for Coca-Cola, we use operating profit.That figure is also positive and growing.And then finally, is the company buying back stock, paying a dividend, or both?So yes, Coca-Cola is buying back stock, and yes, it's paying a dividend.So when combined, Coca-Cola is in the capital return phase, according to those three questions.and that means you should judge the management team based on their capital allocation skills.
37:12You shouldn't judge them based on milestones, right?The most important metric to watch is free cash flow, and the best metric to value it is price to earnings.So Coca-Cola is a fairly easy business to analyze and value because it's in the capital return phase.Okay, let's do another one. Let's look at Nike, the one we just mentioned, because I want to see, it's interesting.Nike has been declining for a long time, but let's kind of see where,where it lands with the phase that it's in.And Nike, I have a feeling is going to be one of those,but that's like literally on the razor edge of here.
37:45So Nike, so it's a consumer discretionary companyin the textile business.So the correct profit metric is operating profits.So is it growing?Well, growth is zero percent, right?So revenue was $51 billion in 2024.That dipped to $46 billion,and it's basically flat year over year.
38:07So, boy, is that hard.It's like, is that two years in a row of decline?I mean, technically, technically no, but it's right on that razor's edge.Is the company profitable?Yes, it is profitable.$4 billion in operating profit over the last to 12 months, but that's down from $6 billion.Is it buying back stock?Yes, but the buybacks are declining.
38:28And is it paying a dividend?Yes, it is paying a dividend.So the app here does say Nike is in phase.four, but boy is it on that razor's edge in being in phase five. And this is why it's reallyimportant to look at revenue growth as the key metric. So again, you almost might be splittinghairs here. You could argue it's in phase five, even though it's technically in phase four,but either way, not a good recent trajectory for Nike's business. And that'd be one potentially.You know, you could use the tool and all of a sudden you could look and say, okay, well,
39:02right now I'm looking at this. And maybe I'm going to hold off for another two or threequarters before I actually do anything on this to see which phase it actually falls into.So that's a perfect example of one that may be a waiting position or something to wait on.We can do one more.Let's think through maybe either let's do it Amazon or a SpaceX.Which one do you think of you better?Well, I'm curious in space SpaceX.Do we have it?
39:26SPCX.Let's see.SpaceX.Operating cash flow is possible.I'm not sure that that is actually correct. SpaceX is multiple businesses in one. See,this gets into the point of the analysis here. Analyzing these businesses is very difficult.Some businesses are easier than other. SpaceX is an AI company, a rocket company, and a satellitecompany, kind of all in one. So let's just call that one probably too hard to analyze. What was the
40:01other one you said? Amazon. Yeah, much, much cleaner business to look at.Amazon. Okay. So Amazon is revenue growing. Yes, 12% in the last year to $717 billion. I think Amazon is the most revenue of any company in the world.I believe so, yep.So it is a broad-lined retailer, at least that's how it's classified.That's even a question mark there because it's like, yeah, is it a retailer?Is it a tech company?Is it a tech service provider?Like there's so many businesses under Amazon.
40:36But it says, okay, the best profit metric to use here is the operating profit number.And then finally, is it returning capital to shareholders?No.So revenue is growing.So operating profit is positive.they do occasionally buy back stock, but nothing over the last three years, no dividend.So phase three operating leverage. So how do you analyze Amazon's business? Take a look at growthand margins. Those are the key things to judge management on. The key metric to watch is operating
41:06margin and the direction of that. And then you value it using the not the trailing price to earningsratio, the forward price to earnings ratio that's looking one year ahead and saying what's the estimatedprofitability of the company.That's what's so helpful about this.It kind of tells you,hey, what are the metrics that you need to be looking atbased on what phase this company is in?And that's what's the most important thing for investors
41:28is to understand kind of how to look at those metrics.And so that's why this is so helpful.I love that for sure.Yep.And the reason we give you the data behind all thisis because it can be sometimes easier for a humanto see the kind of nuances thereand almost disagree with what the tool says.
41:45So we provide you with the informationand you can make the callbecause sometimes companies fall very cleanly in this line or another.Sometimes it's not clear at all.In either case, I just think the general mental model in your head of what phases it in,what are the key metrics to look at, and then use your human judgment to judge based on what you know about the business,is a vital step.Even if you never do this analysis, just having this mental model in your head, I think will make you an investor.
42:12Absolutely.If you've heard any recent episode of Health Corner, you know that I have spent thelast few years trying to optimize my sleep. I've tried sleep trackers, cooling my room, changing mynighttime routine, all the different things. But nothing really matters as much as having the rightmattress. And that's one of the reasons I love Lisa. A great mattress is one of those things that youuse every single night and you spend a third of your life sleeping. And it can make a huge differenceon how you feel the next day. Lisa has mattresses designed for different sleep positions and comfortreferences. And their sleep quiz can help you get matched in less than two minutes. Plus, they're
42:54designed and they're assembled in the USA and they come with free shipping. Easy returns and a 120night free sleep trial. So go to Lisa.com for up to 30% off mattress plus and get an extra $50off with promo code PFP, exclusive from my listeners. That's L-E-E-S-A.com promo code P-F-P for30% off mattresses plus an extra $50 off. Let them know we sent you in the survey after checkout.Lisa.com promo code PFP. It's kind of amazing how much can change in just a single year. Every summer,the kids are a little bigger, a little more independent, and life looks a little different than it did theyear before. And it reminds me that while we can't predict the future, we can prepare for it.That's one of the reasons I like PolicyGenius. See, PolicyGenius is a lot of
43:49isn't an insurance company. They're an online marketplace that lets you compare life insurance quotesfrom some of America's top insurers side by side for free. And their licensed team helps you comparecoverage, prices and terms, answers your questions and even handles the paperwork so you can getthe right policy without the hassle. For me, having life insurance isn't about expecting somethingto happen. It's about knowing my family is protected so I can actually enjoy these moments togetherinstead of worrying about what comes next.And with PolicyGenius, you can find 20-year life insurance policies,starting at just $276 a year for $1 million of coverage.
44:27Head to PolicyGenius.com to compare life insurance quotes from top companiesand see how much you can save.That's PolicyGenius.com.And so once people understand what phase the business is in,and they're looking at this and saying, okay, I went through some of the things on my watch listcurrently, and I put some in the too hard pile,and then I decided some of these are worth pursuing,and now I understand what phase the business is in,
44:51what metrics to look at?What is the next thing they should do?Yeah.Well, so the next thing that Buffett does,and again, we're basing this based on Buffett.So Buffett, the first thing he does is say,okay, is it in a phase that I know,which he invests pretty much exclusively in phase four
45:06and phase five, phase five.That is his thing.The next thing that he looks at is instead of doing discounted cash flow analysis,Remember that Buffett keeps it simple, simple, simple.So he uses multiple analysis to make valuation decisions.So the phase analysis is important because it lets you know, well, what multiple should I look at to make that decision?And then Buffett basically, he almost exclusively uses price to earnings ratio given the phases that he looks at.But he looks at the multiple and then compares that to both the absolute level that it trades at and the company's recent history, recent trading history.
45:44to figure out, is that a cheap number or an expensive number?Awesome. And I think that's kind of where a lot of people, you know, can look at this and say,okay, this is one of those areas where we're looking at this multiple and we can kind of decideand make some choices based on that. Is there a mistake people make? Like when they look at thePE ratio, for example, this is something I think a lot of investors when they first get started.This is the first number that they're taught or one of the first numbers that they're taught to look at.Is that the wrong metric to look at or how do they kind of have to think about that when they makedecisions based on a PE ratio? Yeah, the PE ratio is simultaneously.
46:14one of the most helpful ratios and one of the most confusing ratios at the exact same same time.So the price earnings ratio for those that are unaware, just compares the market cap or the value of the stockto the company's earnings typically over the last 12 months.Now, when those numbers are clean, when a company is fully optimized for earnings,a.k.a. it's in phase four. The PE ratio is very, very helpful because it's a quick way of you looking at anumber and saying, well, this company is cheap or this company is expensive. It's a very shorthand way of doing it. The problem with using the price to earnings ratio is not the P, it's the E.It's the bottom number in that equation. And there's a whole bunch of reasons, accounting reasons,
47:01why a company's earnings might be overstated or understated. That there could be accountingreasons, like if you make a big acquisition, if you take a big write-off, if you pay a lota stock-based compensation, all of those can impact your earnings positively or negatively.And if the E in that equation is being influenced up or down, well, that by definition meansthat the price to earnings ratio that you're seeing on the screen is also going to be impacted,sometimes up or down. This is why, again, I was so confused for a long time because I was like,how can Amazon trade it 100 times earnings? Like every book I've ever read said that 100,times earnings is way too expensive. And yet the company was actually cheap at a hundred times
47:50earnings. And if you bought it 10 years ago, 20 years ago when it was trading at those insaneprices, it was a great, it was a great buy. So the PE ratio can be useful as long as it's inthe correct phase, phase four, and the earnings are fully optimized and there's no accounting gimmicks.But you have to have those two caveats in place in order to use it. So once we have the rightmultiple and we're looking at that you know you've decided okay i understand what phase this is in i'm lookingat the correct multiple currently what do they what do you do next because i saw you know when you weretalking through comparing a company to its own history for example is is the next thing that you kind oftalked about in your in your video which again we'll link that up down below and i loved that i love that
48:32i love the way that you can kind of look at this because in in stock simplifier you have a basically a toolthat allows you to look at a company's history and so how do we kind of do that and why is this soimportant. Yeah. So what I like to do is I like to, when a company is fully optimized for earnings,and here on screen, if you're following us, we do have Coca-Cola. Coca-Cola is a great companyto use the price-to-earnings ratio on. This is a very stable, highly profitable, predictable business.Coca-Cola is a company that the price-to-earnings ratio absolutely works on. So what this tool doesis it just shows you, well, what is the range of the company's PE ratio over? And so, you, you,over a different time period.
49:12And in this case, I just chose five years.We can go longer if we want to.We can go shorter if we want to, but I just chose five years.So with Coca-Cola, over the last five years,the company's PE ratio has averaged 26.1.Sometimes it's been as high as 29.Sometimes it's been as low as, let's see, 21.But it's basically in that range of 26 times earnings.
49:38So what we do is we then show you how does that compare to the current P.E. ratio of the company.And as at the time this recording, Coca-Cola's P.E. ratio is about 26.4.So ever so slightly above the range that is traded at over the last five years.And when presented visually like you're seeing on the screen here, I think it's fair to say that Coca-Cola stock is fairly valued right now.Right? So it's not extremely old.overvalued. It's not extremely undervalued. I would think that it's fairly valued. And then we justapply some bands kind of above or below that to say, well, this stock historically, over the last fiveyears, has been cheap anytime it trades below 27.4 times earnings. And it's been expensive when it
50:28trades above 27.5 times earnings. So as a time is recording, Coca-Cola stock is about $87, $88 per share. And I wouldconsider it cheap at about $82 per share and expensive at about $92 per share. And you know, you canadjust those up or down kind of as you see fit. But when you look at a company using this kind of view,it becomes very obvious. Well, Coca-Cola stock was obviously cheap in October of 2023,and the company stock was expensive in September of 2024. So this is the kind of analysis thatI'm very confident Warren Buffett does when he's analyzing businesses. Again, this requires noadvanced math. This is like back of the envelope, an incredibly simple way of determining,is a company cheap or is it expensive? But remember the caveats that we gave up front. This only
51:25works if the company is in the right phase and there's nothing nefarious going on with thecompany's earnings. So as long as it checks both of those boxes, I think this kind of analysisis very simple and easy to do.Awesome. I love this. And I think, you know, this visual just helps, you know, anybody,when you look at this, you'll see, you know, this is a very simple thing to understand and look at,and it's very helpful. I mean, it's one of those areas where you can kind of see, you know,just the trends of the historic return or the stock price and kind of where it was.And I think that's really, really important. And I love that you can kind of take it out even
51:59further, too. I think that's super helpful if you want to go 10 years or even longer.I think that's really, really powerful. So that's awesome.So looking on screen here, Andrew, we can see that during the period, what's this, 20, 2017 to 2019.During this time, like Coca-Cola's price to earnings ratio was sky high, like well above 40, like way outside of this range.So your first inclination might be to be like, oh, the company's stock was very expensive at this time.My hunch would be if we went and dug into the numbers that actually the company's earnings were temporarily understated during this period.Maybe it was an acquisition, maybe there was a goodwill write-off that they had.Maybe they had some kind of one-time legal settlement or something like that that caused the number to go kind of crazy.
52:43But if you didn't know that nuance and you just looked at the company's price to earnings ratio during this time, like it got as high as 150.You'd be like, oh, God, Coca-Cola stock way too expensive right now.But that's why you need to understand the nuance of how earnings are calculated before you can use it as a reliable valuation metric.And that makes complete sense, which is why it's important to do your homework and do the extra research to make sure you understand why this is happening.If you see something that looks way off from everything else, you've got to dig deeper and figure out why that is.Otherwise, you're flying blind.The last step that we talk about is adjusting for quality.And I think this is where, you know, you've talked about this is where the art comes in a little bit and there's a little bit of, you know, experience could come into play on this as well.
53:25So how does this work?How do you kind of adjust for quality?and then how does a beginner kind of build a judgment here when it comes to adjusting for quality?Yeah.So this is something that, again, I had to learn the hard and expensive way.Some companies out there are cheap, are literally cheap when they trade at a PE ratio of 30.And other businesses out there are expensive, legitimately expensive, when they trade at 10 times earnings.So if that's not confusing, I don't know what it is.
53:56right? Why are some companies cheap when they trade at 30x earnings and others are expensive when they trade at 10 times earnings?Well, that takes down to the quality of the business. This is something, again, I've learned the hard way.As a general statement, the more predictable, the more recession proof and the higher growth a company's earnings are, the more the market, the higher the multiple, the market assigns to that earnings.If you look at Costco's price to earnings ratio right now, it's very high.I think it's like 40 or 50, but it's hard to find another business in the world with morepredictable recession-proof earnings out there or profits out there than Costco.Conversely, if you were to look at a bank or an automaker like GM or Ford, it's very commonfor those businesses to trade at single-digit price to earnings.
54:53ratios. Same goes for like oil companies. Now, why? Well, that's because those companies' earnings areoften highly dependent on outside forces. So in the case of oil companies, the price of oilhighly dictates how much profits those companies will make. When oil prices are high,the earnings of ExxonMobil and Chevron spike up. When a crash comes along, those companies' profitsall but disappear. So the market knows that.those companies' profits are not recession-proof and they're not predictable.And therefore, the market assigns those businesses a lower multiple than they would a highlypredictable company like Costco.
55:36So growth takes into account, how recession-proof the company's earnings are takes intoaccount and how predictable that takes into account.You need to adjust the average number for those factors when you're going to tell is a companystock cheap or expensive.absolutely vital. That makes sense. And I think that's that's super important for people to understand as they get to some of these these final phases is making sure that you have those in place so that you don't get fooled. I think that's really, really important. So that's a great tip there as well. Well, Brian, this has been absolutely amazing. I think, you know, people are going to absolutely love this. Where can they find out more about you, stock simplifier, and everything else?I'm on any social platform. So just search for my name, Brian Feraldi. And if you want to check out that phase tool that I showed before, you can just enter any stock. It'll tell you what phase it's in.It's Stocksimplifier.com backslash phase, and it's completely free to use.Awesome.
56:29Well, we'll link all that up down below in the show notes below.So, Brian, thank you so much for coming on again.Thank you for having me, Andrew.Always fun to be here.
There aren't comments yet for this episode. Click any sentence in the transcript to leave one.