[00:02:26] Brian Feroldi: Only over time did I realize that valuation isn’t either-or. It is more of a spectrum, and where any individual investor thinks about a valuation really depends on where on this spectrum between “valuation doesn’t matter” to “valuation is everything” it exists. So I think a big first step in figuring out how to value any business is knowing what type of investor you are, and it’s critical to know where you lie on that spectrum.

[00:02:56] Clay Finck: Let’s step more into that spectrum. You mentioned Warren Buffett and Marc Andreessen. Can you just sort of highlight how the buffets of the world think, how the Andreessen’s of the world think, as well as the investors in the middle? 

[00:03:08] Brian Feroldi: Sure. So let’s imagine that you are a venture capitalist, and the Google guys come to you saying, “Hey, would you invest in our business today?”

[00:03:19] Brian Feroldi: It doesn’t really matter the valuation that they offer you. If you got into Google early, whether it was at a $1 million valuation, a $10 million valuation, or even a hundred million dollars valuation, you would have done incredibly well as an investor. The right decision would have been putting money into Google, and the valuation that you paid would have been almost a non-factor.

[00:03:45] Brian Feroldi: That is one extreme mindset, and it really shows that if you buy the next Google or the next Amazon or Netflix early, the valuation that you pay almost doesn’t matter. However, those are, of course, rare companies. Finding companies that can go up in value a thousand or 10,000 times over time is extremely hard to do.

[00:04:08] Brian Feroldi: On the other side of the spectrum is value investing, where you’re trying to figure out what is the value of this asset and how can I put money to work in this asset at a lower price than it’s currently trading at? That builds in a margin of safety to your purchase that really protects you from losing a lot of money on the downside, which we all know is Warren Buffet’s rule number one and rule number two of investing.

[00:04:41] Brian Feroldi: Well, what’s so fascinating is that both valuation mindsets can work. You just have to know which type of investor you are.

[00:04:50] Clay Finck: And how does this tie into the history of value investing? I know you’ve talked about history and how this sort of ties in, so I’d love for you to elaborate on this as well.

[00:05:03] Brian Feroldi: If you look back at the 140-ish years of the Dow Jones Industrial Average, I think there are five distinct phases that valuation has gone through during that time, and knowing the history is actually really important. So, prior to 1929, before the Great Crash of 1929, the stock market was essentially the Wild West.

[00:05:25] Brian Feroldi: The data provided to investors was extremely limited, and it was largely unregulated. The SEC did not exist at all, and back then, stocks were very much viewed as gambling devices. In fact, one reason that companies paid out such a large portion of their earnings as dividends was to prove to investors that they were actually making money.

[00:05:48] Brian Feroldi: So, companies were not encouraged to reinvest in themselves. Instead, they were encouraged to pay out that money to investors to demonstrate profitability. Now, immediately preceding that time came the crash of 1929 and then the ensuing Great Depression, which was a horrible economic period in America’s history.

[00:06:07] Brian Feroldi: Unemployment rates skyrocketed, and the US stock market fell by about 89%. Plenty of people went completely belly up. In the wake of that, FDR came in and enacted some changes that put regulations around Wall Street, including the creation of the SEC in 1933 and the passage of the Glass-Steagall Act in 1934, which helped to regulate companies and securities that would come public.

[00:06:33] Brian Feroldi: After that period happened, I think it is really when value investing was first invented. It was invented in part by a guy named John Burr Williams, who wrote a book in 1938 called “The Theory of Value Investment,” and that was the first time that concepts like intrinsic value and discounted cash flow were really created. In 1949, that’s when Ben Graham published his very popular book, “The Intelligent Investor,” and he introduced concepts such as Margin of Safety, buying companies below their book value, and really focusing on the price-to-book ratio.

[00:07:10] Brian Feroldi: Now, after that period, and really after World War II, I think came the next phase of valuation. In 1958, Phil Fisher published a very popular book called “Common Stocks and Uncommon Profits,” and he focused on buying businesses that could substantially grow their profits over time to lead to superior returns. In the 1950s, that’s when a young Warren Buffet studied those books – Phil Fisher’s book, Ben Graham’s book, John Williams Bur book – and developed his own investing style at the time. He famously said, “I’m basically 85% Ben Graham, 15% Fisher.”

[00:07:47] Brian Feroldi: During the age from, let’s say, the 1940s to the 2000s, this was the age of mass media, the age of consumerism. It was still hard for investors to find information on companies, but it did exist. That information was largely limited to big mutual fund managers and big institutions, and during that phase, we saw the rise of people like Peter Lynch and Charlie Munger, who focused on quality businesses that had wide enduring moats. They would try to buy those businesses with a margin of safety and let those companies compound over time. That was the style of investing that worked out so well.

[00:08:30] Brian Feroldi: I would argue that the fifth valuation phase, the one that we’re in right now, really started in the mid-nineties to early two thousands, thanks to the adoption of the internet. It was really during that time that we saw a massive rise in venture capitalists.

[00:08:48] Brian Feroldi: We saw the internet come and disrupt so many things. We saw data become incredibly easy for investors to access, even for individual investors like myself, and all of it for free. We saw lots of companies go public because the world was awash in cash. Companies could now focus on growing their revenue, taking advantage of markets, and actually losing money for long periods of time.

[00:09:15] Brian Feroldi: That wasn’t even an option for companies that came public prior to them. We’ve seen many investors become famous during this period, like Marc Andreessen, or growth investors like David Gardner or Kathy Wood, and we’ve seen new valuation techniques emerge, such as focusing on total addressable market opportunity and reverse DCF models.

[00:09:36] Brian Feroldi: So once you understand the history, you can kind of understand how valuation has grown in importance over time.

[00:09:44] Clay Finck: You’ve been on our show a number of times, talking about how a lot of investors view certain investments through their lens, and it might not be the appropriate way to view a company and how valuation fits into it.

[00:10:00] Clay Finck: One example is a PE ratio. People use a PE ratio on these earlier stage companies. I’d like to transition to discuss how investors can best decide where on this valuation spectrum they should fit or how do they decide what sort of game they should play? Because you talked about how all these investors, different people have been successful at different strategies.

[00:10:25] Clay Finck: So how should people think about where they fit on the spectrum?

[00:10:30] Brian Feroldi: Yeah, great quote by Osworth. “The most important investor to study thoroughly is yourself,” which I totally love. That phrase, figuring out what type of investor you are, can be incredibly helpful not only in figuring out what kind of investments you’re looking for but also what kind of investing advice you should follow.

[00:10:51] Brian Feroldi: So, again, on one extreme end of the valuation mindset spectrum, you have venture capitalists and growth investors. Those types of investors de-emphasize valuation. The only thing that they are focused on is the upside potential of the business.

[00:11:07] Brian Feroldi: On the other extreme end of the mindset spectrum is the Ben Graham, Michael Burry type of thinking, where valuation is first and foremost, the most important filter to put investments through, and anything has value if you buy it cheap enough. In between those two extreme styles are what’s called GARP investors, which stands for growth at a reasonable price.

[00:11:31] Brian Feroldi: Those types of investors are willing to pay a premium to own companies that have superior growth prospects, but for companies that have lower growth prospects, they’re not willing to pay as much of a premium for, so valuation is an important part of that process. Figuring out where you are on that spectrum depends on numerous things, such as your personality, which is a huge one, as well as your risk tolerance.

[00:12:01] Brian Feroldi: But four other things I’ll throw out there: First is your time horizon. If you’re going to be investing like a growth investor or a venture capitalist, you better have a multi-year, multi-decade time horizon because it can take a long time for those early-stage companies to execute against the game plan ahead of them and for the compounding to really kick in.

[00:12:26] Brian Feroldi: Another question to ask yourself is how comfortable are you with volatility? Not in theory, but in reality. If you’re going to be investing in growth companies that are in the early stage of development, you better be ready, willing, and able to stomach occasional 20, 30, 50, even 70% drawdowns in those stocks, which is not easy to do.

[00:12:50] Brian Feroldi: If you’re not comfortable with volatility, you should lean more towards the value investor side of the spectrum. Another question to ask is, are you a bargain hunter at your very nature? This is how I started out investing in my real life. Whenever I’m purchasing goods for my house, I look for bargains. I like to know that I’m getting a good value for something, and I apply that same mindset to the markets. When I first started investing, I was looking for stocks that were cheap and had high dividend yields. That kind of appealed to me. If that appeals to you, perhaps you’re naturally drawn to value investing.

[00:13:34] Brian Feroldi: And the final thing is, what matters more to you? Does protecting the downside of your investment matter more to you, or does going after the upside matter more to you? If upside is the thing that you’re after and you’re willing to take on more risk, then you should think about adopting a venture capitalist approach to valuation. If you really want downside protection, well, then you better really get to know how valuation works.

[00:14:05] Clay Finck: It’s interesting when you look at the venture capital approach to valuation; all you can really look at is what is the overall market potential or the TAM (Total Addressable Market), and how much can they capture from that total market? It’s an approach where you’re purely looking far out into the future. Then you turn to the pure value approach, where you’re looking at just the earnings, and you’re not as concerned about where the business is going to be 10 or 20 years down the line. So all you really care about is what is tangible and what’s happening today with the business.

[00:14:47] Clay Finck: So it’s interesting to me to compare the difference in time horizons between those two approaches. You actually have six valuation methods we can use in our own valuation toolkit, depending on where the business is in its growth cycle. Could you walk us through these six valuation methods?

[00:15:06] Brian Feroldi: There are lots of ways that you can value a company, and a big mistake that investors make, myself included, is they get to know one valuation style and they apply that valuation technique to all companies at all times. I think that’s a mistake to do so. In fact, I think it’s really important to know what phase of the business growth cycle a company is currently in before you can know what type of valuation style you should use.

[00:15:39] Brian Feroldi: For example, if a company is in the startup phase or in the hyper growth phase, it’s small, it’s young, and it’s rapidly growing. The future potential of that business is incredibly wide. If it executes against its opportunity, it could go up 10, 50, a hundred, a thousand times in value. Doing so would be incredibly hard, but that’s certainly in the realm of possibilities. Also in the realm of possibilities is that the company is going to run out of money and go to zero. So the range of outcomes is very huge.

[00:16:16] Brian Feroldi: For those types of early-stage companies, I don’t think DCF models or reverse DCF models have any real value at all. I also don’t think that multiples have much value at all because oftentimes the only metric that a company has to show is sales, and sometimes those sales are very meager. So for companies that are in the early stage, I think it makes sense to focus on total addressable market analysis, which is simply how much revenue is available to this company in any given year. Now, once you know that number, you can do some analysis from there to figure out, okay, what is a realistic market share for this company to capture?

[00:17:03] Brian Feroldi: What are its margins gonna look like once this company scales? What are its – what could its future multiple trades be if this company executes successfully? And from there, you can back in. What kind of valuation makes sense today, given this company’s potential? Now that kind of analysis is very squishy.

[00:17:23] Brian Feroldi: There’s not a lot of hard numbers that you can go on, but when a company’s in an early stage, you don’t have much data to look at, so you have to make more educated guesses. As a company grows and as it matures and as its revenue starts to tick up, that’s when you can start to see some meaningful improvement in the company’s income statement.

[00:17:50] Brian Feroldi: Companies eventually start to produce positive gross profit, and that number grows. Companies then start to produce positive operating income, and then that number grows. And finally, companies start to produce free cash flow and earnings, and those numbers grow as the company is moving up, maturing, and the business growth developer cycle is moving up.

[00:18:13] Brian Feroldi: That’s when you can start to look at multiple analyses. When a company is early and sales are the only numbers you can look at, the only option you have from a multiple perspective is to look at the price-to-sales ratio as gross profit continues to grow. I’m actually a big fan of calculating companies’ price-to-gross profit ratio, which is not a number or a metric that I hear many other investors talking about, but I think it’s an incredibly useful number to look at. As the company continues to mature, then you can gradually introduce things like price-to-EBITDA or price-to-EBT or even price-to-earnings or price-to-free cash flow. There are a bunch of companies there.

[00:18:59] Brian Feroldi: So, that would be something that you can do analyses on—companies that are in the semi-mature semi-growth stage. After a company is reliably producing free cash flow (which typically indicates it’s fairly mature), only then do I think it makes sense to look at discounted cash flow (DCF) models and reverse discounted cash flow (DCF) models.

[00:19:21] Brian Feroldi: Prior to that, you’re making so many assumptions about the company’s growth rate and margin profile that I don’t think DCF models and reverse DCF models are really that helpful in the early stage. However, these types of valuation methods can be very useful once a company is in the mature phase.

[00:19:42] Brian Feroldi: Additionally, you could argue that in the mature phase, methods like TAM analysis or the price-to-sales multiple aren’t useful at all. The bigger point is that businesses go through a relatively predictable growth cycle, and you need to know which valuation method to use depending on the phase the company is in.

[00:20:03] Brian Feroldi: Using the wrong valuation method on a company at the wrong time can get you into a lot of trouble.

[00:20:11] Clay Finck: I’m curious if there’s an area of this growth cycle and spectrum, an area you believe is more, I don’t know a better phrase than more winnable by your average investor, or you think it’s just a matter of investor preference?

[00:20:26] Brian Feroldi: I firmly believe it’s a matter of investor preference for myself. I like to invest in companies that are in the self-funding or operating leverage phase. These are companies that have reached the point where they’re no longer losing money; however, they’re not making a lot of profit. They’re perhaps right at the break-even phase, or it could be there in the near future. Companies in this phase are easy to misvalue because a lot of people, a lot of investors, look at the price-to-earnings ratio and the price-to-free cash flow ratio, which are often very inflated because their profits have not matured, making it easy to draw the conclusion that these companies are overvalued.

[00:21:12] Brian Feroldi: However, companies that are in that phase and can grow at an above-average rate for five, 10, or even 20 years are compounding machines if you can get them right. I like to look for companies like that, buy them, and let the company execute against its opportunity.

[00:21:31] Brian Feroldi: And if you can find a handful of those companies that execute the way Lululemon has or the way Netflix has, you can earn absolutely gargantuan returns while taking much less risk than you would if those companies were still in the startup or the hyper growth phase. But I think that investors can do well in any phase, so long as they know and understand the nuances of what goes along with investing in that phase.

[00:22:01] Clay Finck: I’m somewhat hesitant to throw the terms value investors and growth investors here, but I almost have no better terms to use here in this context, but I’m gonna go ahead with it anyways. We have a lot of value investors in the audience, which it’s a term nowadays doesn’t really mean a lot because people can see value in many different ways and.

[00:22:22] Clay Finck: Skeptics of quote unquote growth investing of that strategy. They might say that paying up for a highly disruptive company might not be a reliable way to invest because the market can tend to become pretty optimistic about these types of companies, and I. They can be prone to facing a lot of competition.

[00:22:40] Clay Finck: And then you throw on top of that things like a charismatic c e o and overly promotional founder. And a lot of people just get really excited about it. So I’m curious what your thoughts are on that sort of viewpoint and how you might respond to that.

[00:22:54] Brian Feroldi: Oh, I think that’s totally true.

[00:22:56] Brian Feroldi: It could be a very tricky way to invest because companies that are viewed as growth companies with a very exciting future ahead of them often get caught up in the hype cycle. There comes a phase when the company executes very well, the stock price goes up, and then it continues to rise as more investors pile in.

[00:23:20] Brian Feroldi: Eventually, the stock price can get so high that the expectations built into that company are well beyond what the company can deliver, leading to an inevitable fall. We’ve seen exactly that play out over the last three years. In a fast forward phase, given the huge boom we saw in 2020 and 2021, and the ensuing bust that followed throughout 2022.

[00:23:44] Brian Feroldi: So, if you’re the type of investor who follows value investing principles, there’s absolutely nothing wrong with saying, ‘I’m not participating in that at all. I want nothing to do with looking for the next growth stock that will be able to survive that hype cycle and then execute from there.’

[00:24:05] Brian Feroldi: However, if you look back to the 2000s, we saw an enormous bubble in lots of companies, and the ensuing bust wiped out tons of businesses. However, the ones that survived that phase have become household names today. I mean, obviously, Amazon is the poster child for such things, but PayPal was also born in the exact same period.

[00:24:28] Brian Feroldi: So, it can be very challenging to figure out which companies are going to be able to go through that hype cycle, emerge on the other side, and continue to execute. But if you can do that successfully, you can earn life-changing returns on some of those investments.

[00:24:48] Clay Finck: I think a couple of other points that relate to that are: you definitely have to have a really long time horizon. You have to be able to hold out for the long tail to really play out. And then the other important point I think is power laws, where a small, very few number of stocks drive the majority of the returns. Just holding one or two of those out of a huge portfolio really propels the whole portfolio ahead.

[00:25:20] Clay Finck: So, I think power laws are another concept that’s really important to understand if you’re taking that sort of strategy.

[00:25:28] Brian Feroldi: Absolutely. I mean that power law strategy that you’re talking about is the reason that index fund investing works so well. Yes, you’re guaranteed to essentially get every single loser, but you’re also guaranteed to hold every single mega winner.

[00:25:44] Brian Feroldi: And if you look historically over time, it’s only a minority. Of stocks that literally account for the vast majority of the returns of the market over time. So yes, if you’re going to be investing that style, you have to go in knowing that you’re gonna be wrong a whole lot and literally a handful of investments will make or break your portfolio.

[00:26:04] Brian Feroldi: But that is how stock investing works. 

[00:26:08] Clay Finck: Now, some growth stocks are trading below or around where they were in 2019 and 2020, that timeframe. Companies that come to mind are Roku and Square. There’s a long list of names, and interestingly, the sales of many of these companies are much higher than they were during that time period.

[00:26:28] Clay Finck: On the other hand, some other growth companies have done quite well, trading at all-time highs or maybe near all-time highs. I think about Nvidia and Tesla, for example. What are some of the things you look for in a higher growth name to help filter out and distinguish value-accretive growth versus maybe value-destructive growth?

[00:26:50] Brian Feroldi: Yeah, the thing that I key in on is that you can have a hyper growth company with a corporate philosophy of either breaking even and producing a certain amount of free cash flow or profits. Some companies reliably do that. On the other hand, there are hyper growth companies with the mentality of reinvesting all their capital back into growth, even if it means operating at a loss and depending on outside investors for years to come. I think the companies in the latter group, the ones dependent on raising capital from outside investors, have been hit very hard, and rightfully so. For these companies, a falling stock price is a massive problem.

[00:27:35] Brian Feroldi: When your valuation collapses and you need to raise new capital, doing so can be horrifically dilutive to the company itself. However, if you’re in the self-funding phase and have already gone through that process, a falling stock price is a nuisance from a number of perspectives, but not a massive problem for capital raising.

[00:27:57] Brian Feroldi: So, when I think about the companies that have survived that process the best and have bounced back, a common theme that I see is many of them were further along in the business growth cycle and were already producing net income and profits.

[00:28:15] Brian Feroldi: So, how can you tell if a company’s growth leads to shareholder value? The answer is: Are they generating profits?

[00:28:23] Clay Finck: Another piece I think I and many other investors struggle with is thinking about stock-based compensation. Do you have any tips for investors and working through stock-based compensation, whether it be a certain percentage of revenue that might be acceptable, or is it focusing more on the company’s vision and their management and long-term thesis?

[00:28:47] Clay Finck: Or maybe even just simply subtracting out the stock based compensation outta the profits, and then just kind of filtering it out and not thinking about it too much. 

[00:28:57] Brian Feroldi: Yeah, if you ask 10 different investors about their views on stock-based compensation, you’ll get 10 different answers. The same is true for companies themselves.

[00:29:07] Brian Feroldi: Some companies have very generous, almost egregious levels of stock-based compensation built into the DNA of the company. On the other hand, there are companies that, by their very nature, are very stingy with stock-based compensation and only dole it out in small amounts. As a general statement, if a company is rapidly diluting investors, it better be putting up eye-popping revenue growth numbers for investors to be willing to stomach that.

[00:29:36] Brian Feroldi: If a company is reliably growing its revenue by 50% per year for many years, investors may be willing to tolerate 5%, 8%, or even double-digit dilution due to stock-based compensation if they believe the future opportunity is truly huge. However, if that same company’s growth rate falls from 50% per year to 20% per year, and the company is still diluting investors at a high level, it’s likely to face scrutiny from investors during management conference calls.

[00:30:07] Brian Feroldi: My personal rule of thumb, and it’s just a rule of thumb, is that if a company is growing extremely rapidly, more than 25% per year, I’m okay with three to 5% dilution being due to stock-based compensation. More than that, and I start to get perturbed by it. For companies that are growing slower than that, I don’t want anything more than one to 2% dilution annually, and my rule of thumb is a maximum of 1% dilution per year.

[00:30:40] Brian Feroldi: However, Buffett invests in companies that are typically in the capital return phase.

[00:30:45] Brian Feroldi: So he is actually looking for companies that are reducing their share count due to stock buybacks. But if you look back at a company like Salesforce.com, for example, it has been issuing tremendous amounts of stock-based compensation to its employees ever since it was founded. And that stock-based compensation remains high to this day.

[00:31:07] Brian Feroldi: The dilution that investors had to endure over its 20-year period on the public markets has been very high. However, that has not stopped the company from delivering multi-bagger, market-beating returns for its investors. The reason they’ve been able to get away with it is that their growth rate has been so high for so long.

[00:31:29] Brian Feroldi: That’s why the nuance of understanding, looking at, and judging stock-based compensation is so important.

[00:31:35] Clay Finck: Totally agree. Another idea that has had a really profound impact on me, being a host of the show here, is the idea of base rates. When I think about the differences between a growth company and a company that might be a little bit more stable, it’s the base rates between the two.

[00:31:57] Clay Finck: Let’s take a company like Tesla, for example. Tesla in 2012 was a totally different company than the Tesla of 2023. I think it’s pretty difficult to justify a large allocation to a company like that when there’s a very real risk of it going bust. Musk has said that there were times when they were weeks away from not having cash to pay employees or anything else. Having that very real risk justifies a relatively small position in a portfolio, almost thinking of it as a venture-type bet.

[00:32:32] Clay Finck: On the flip side, I look at investors like Charlie Munger and Nick Sleep. When they find something they’re almost certain will continue to grow for 10, 20-plus years, they bet big on it. That’s because they believe the base rate or the odds that they’re right are really high. For example, both of these investors bet early on Costco, and they still hold that investment 20 years later.

[00:33:00] Clay Finck: I’m curious if you agree with this assessment of base rates and how it may apply to this valuation spectrum, if at all.

[00:33:09] Brian Feroldi: Yeah, I think that’s a wonderful point that you brought up. In fact, I think this gets largely into the debate that many investors have about whether their portfolio should be concentrated or diversified. Personally, my view is that if you are a venture capitalist, and you’re out there looking for companies that can grow 5,100 times, it really makes sense to diversify your portfolio and make dozens of very small bets.

[00:33:38] Brian Feroldi: On a percentage basis, because what you’re looking for is that next Google, that next Apple, that next Amazon. And if you can buy into those companies early, even a tiny percentage can literally return the entire value of your portfolio and then some. So if you’re going to invest like a venture capitalist, diversify.

[00:34:00] Brian Feroldi: On the flip side, if you’re going to be a value investor and you’re going after businesses that are big and dependable, like Costco, Target, Walmart, companies that are going to be around for long periods of time, I think it makes much more sense to be a concentrated investor and put lots of capital into high conviction, high probability stocks, and really focus in on those stocks.

[00:34:27] Brian Feroldi: So it, yeah, I think this, the concept of base bait really matters for answering whether I should be diversified or should I be concentrated? Question. 

[00:34:36] Clay Finck: One thing I absolutely love about your YouTube channel is the level of transparency you guys have and all the amazing content you guys are sharing and.

[00:34:45] Clay Finck: Over the past 12 to 18 months, you, along with many other investors, have seen significant volatility in your portfolio. So I’m curious if you could share some of the biggest lessons that you pulled from that experience that was just a much different time period than any other point in your investing career or many other investing careers.

[00:35:06] Brian Feroldi: Yeah, 2022 was a humbling period for a lot of investors, myself included. I really started investing in 2004 and essentially from 2008 all the way up until 2022, interest rates almost didn’t matter because they were so incredibly low for such a long period of time that, that, that warped a lot of markets.

[00:35:28] Brian Feroldi: And I think that’s one reason, not the only reason, but one reason why growth companies did so well over the last 15 years. Is that because the interest rates were so incredibly low? One thing that reversed in 2022 was obviously interest rates came back with a vengeance. The Fed raised interest rates at the fastest rate they’d ever done, and understandably, asset prices and asset values were severely impacted, and those that were hit the hardest were the asset values that have the longest duration.

[00:36:02] Brian Feroldi: So long-duration bonds and high growth companies that are losing money. Those are the longest-duration stock assets that are out there, so rightfully so, we saw valuations absolutely get clobbered from extreme high levels in 2021 to more normalized numbers that we saw in 2022. One thing that I learned is just how impactful interest rates are on affecting the valuation of markets.

[00:36:27] Brian Feroldi: It also taught me during that period the value of having cash in an economic crisis, and for the first time in my investing career, I’m now actively considering putting money into the bond market. I never even considered that a couple of years ago because the yields that you would get on bonds would be so incredibly low compared to the risk that you were taking.

[00:36:54] Brian Feroldi: So it wasn’t even an alternative asset class, you could say. I’m the same thing about holding cash in a bank. When banks are paying zero or 0.2% interest you’re gonna lose money compared to inflation because the rates are so low. Now that rates are more normalized and that bonds are actually a viable attractive alternative when compared to, to, to stocks.

[00:37:17] Brian Feroldi: So 2020 through 2022 taught me a lot of painful lessons. 

[00:37:22] Clay Finck: And I think another one, I think a lot of people sort of learned, is that as the market continued to hit new all-time highs almost every single year, then people would be very hesitant to raise cash. So in 2021, very few investors likely were raising cash.

[00:37:41] Clay Finck: And then in 2022, many people found that to be a big mistake. So in hindsight, I think that’s another really big lesson too.

[00:37:50] Brian Feroldi: Absolutely. Or how about this one? Investing is hard. Investing is hard. Investing the right way is very challenging. Not only do you have to be good with securities selection if you go that route, but the markets put a tremendous amount of pressure on the psychology that you face.

[00:38:10] Brian Feroldi: You can have euphoria when stocks are going up and utter depression when stocks are going down. Analyzing stocks is hard. Dealing with the emotions of investing is hard, so investing is hard, and that’s okay to acknowledge, and it should be.

[00:38:27] Clay Finck: And one of the things that makes investing really hard is coming back whenever you lose money.

[00:38:33] Clay Finck: There’s always gonna be years where your investments don’t do so hot. And Buffett once said that the number one role of investing is not to lose money. And his second role was, don’t forget, enroll number one. So I’m curious how people like the Andres and Horowitz of the world or the venture-like approach, how they work around this.

[00:38:53] Clay Finck: Or work through this approach of protecting for the downside while still exposing themselves to the upside. I’m curious what your thoughts are on how these types of venture type investors can protect against the downside.

[00:39:07] Brian Feroldi: I think this is a great reason that shows why understanding where you are on the valuation mindset spectrum is so important.

[00:39:16] Brian Feroldi: If you are a valuation-focused investor, by your very nature, Buffett’s rule number one, “don’t lose money,” is fantastic advice. It’s the first rule: do no harm, right? Focus on minimizing your downside protection. That’s great advice if you’re a value investor. That’s terrible advice if you are a venture investor because, to a venture investor, the biggest mistake that you can make isn’t striking out nine times in a row.

[00:39:44] Brian Feroldi: The biggest mistake you can make is not putting money into the next Amazon, not putting money into the next Google. So for them, losing money, bleeding capital out a small bit, is perfectly acceptable. That’s a part of the process. That’s not their concern. Protecting the downside is not their biggest concern.

[00:40:06] Brian Feroldi: Their biggest concern is getting the next mega-winner into their portfolio. If that is your mindset, then you should basically ignore Buffett’s advice of rule number one, “Don’t lose money,” because you are going to lose money. That’s part of the game if you’re going to invest like a venture capitalist.

[00:40:26] Clay Finck: That reminds me, I almost wish I could rewind and look at some of these VC funds and see how they weathered through something like a great financial crisis.

[00:40:38] Clay Finck: ‘Cause another Buffett quote comes to mind here, where as investors, you don’t want your investments or businesses to have to rely on the kindness of strangers, as Buffett put it. In order for the business to be successful, it essentially means that you want the business to be self-reliant. You don’t want it to have to rely on other people to survive.

[00:41:03] Clay Finck: And when you think about a business at its core, it can fund its operations in three different ways. It can fund it using internal cash flow, it can issue new shares, or it can take on debt. And when times get really tough, like during the great financial crisis, options two and three might not be viable.

[00:41:26] Clay Finck: So, there’s no choice but for the cash flow-positive companies to weather through quite well, while a lot of other companies may not weather through as well. That’s again why the PE ratio isn’t helpful for many companies that aren’t profitable. So, what do you think about maybe an earlier stage company and how they’re able to weather through and not have to rely on the kindness of strangers?

[00:41:53] Brian Feroldi: I think that the core of the question there, for early-stage companies, really depends heavily on the internal philosophy of the management team. Some management teams, by their very nature, are more conservative when reinvesting in the business. They might be okay with losing a little bit of money, but they want to ensure that those investments are paying off with a high return.

[00:42:19] Brian Feroldi: And they want to minimize the amount of capital that they have to raise from outside investors. Also, they want to make sure that they always have ample cash on hand to survive, let’s say, the next three years. That is a philosophy decision of the management team. They control their internal reinvestment rate.

[00:42:40] Brian Feroldi: They control how much they pour into R&D, into hiring, and all that kind of stuff, which directly impacts what kind of losses they are putting up when they’re in those earlier stages. Some companies really swing for the fences. They say, “We’re completely okay with being dependent on outside markets and outside debt markets to raise capital whenever we need it.”

[00:43:05] Brian Feroldi: That’s a philosophical decision. Other companies are far more conservative, and they want to reach profitability far earlier after the company was founded than others. So one way a company can protect itself is just by being more conservative when they’re raising capital to make sure they have plenty of cash.

[00:43:26] Brian Feroldi: And more conservative with hiring decisions and spending decisions to ensure they never have to rely on outside investors. Bill Gates famously, when he was running Microsoft for decades, always made sure that they had enough cash in the bank to pay off all of their bills for an entire year, assuming they never made another dollar of revenue.

[00:43:46] Brian Feroldi: That’s a philosophical decision to be so conservative financially at that level, and that really paid off. But again, it really depends on the philosophy of the management 

[00:43:54] Brian Feroldi: team of the company. 

[00:43:56] Clay Finck: I totally agree and I think you really need to look for management teams that are able to think long-term and aren’t so focused on the current growth rates and the current metrics they’re hitting.

[00:44:05] Clay Finck: Just like I think of Bezos’s letters where he was just constantly preaching the long-term to long-term. Too long-term. So, I’d like to transition here to some of the analysis you’ve been doing on your YouTube channel. You’ve been doing a ton of updates and analysis on a number of different companies.

[00:44:21] Clay Finck: I love that what you’ve been doing is plugging each company into a reverse DCF, and essentially, that shows you what sort of growth the market is expecting at the current market price, which I think is super helpful for investors in thinking about whether they should trim, add to their positions, or whatever else.

[00:44:43] Clay Finck: So let’s start with Nvidia, a stock that’s catching a ton of people’s attention here. A lot of investors that have been holding that one probably feel that they’ve struck gold, as it’s up over 300% since its October 2022 lows. So, using your reverse DCF model, how much growth is the market expecting from this high flyer?

[00:45:06] Brian Feroldi: Yeah, the run that Nvidia has been on has been nothing short of remarkable. I mean, this is a company that’s currently valued at over $1.1 trillion. And we should, I’m going to really timestamp when I say this because this could change at any moment. Yeah, did I say a billion?

[00:45:27] Brian Feroldi: Yeah, $1 trillion, excuse me. $1.01 trillion. So Nvidia is an incredible business. Fantastic competitive advantage, fantastic margins, fantastic management team. Tons of good things to say about it. Currently, the share price of Nvidia is about $468 per share. So using my reverse discounted cash flow model, I see that over the trailing 12 months, Nvidia has generated about $8.1 billion in free cash flow.

[00:45:53] Brian Feroldi: And if we assume a terminal growth rate for the company after 10 years of about 2% and a discount rate of 10%, so our required rate of return is 10%, you could argue that’s too high, you could argue that’s too low. I’m going to say 10% return is what the investor could expect.

[00:46:15] Brian Feroldi: I see that Nvidia would have to grow its free cash flow over the next 10 years at a 36% compound annual growth rate for today’s price to make sense. Now that might not seem all that high of a number if you think about 36%. But to give you some perspective, that would mean that NVIDIA’s trailing twelve-month free cash flow, which is $8.1 billion today, would have to reach $176 billion dollars.

[00:46:45] Brian Feroldi: In a 10-year time, that’s a 2023x growth in the company’s free cash flow over the next 10 years in order for today’s price to be justified and earn a 10% return. Now, I’m not betting against Nvidia doing that. I would never do that, nor would I short a company based solely on its valuations, but color me skeptical of the company being able to achieve that. And I say that as someone that has a huge admiration and believes that it’s an incredible company.

[00:47:19] Brian Feroldi: I mean, the stock market’s a place where you want to place bets that make a lot of sense. And sometimes there are bets that just don’t heavily stack the odds in your favor, to put it lightly. So, I want to transition to one more company here that you’ve covered on your channel. It’s one we’ve actually been discussing within our TIP Mastermind community where members of our audience have had the opportunity to connect, and the company is Mercado Libre, which I kind of think of as the Amazon of Latin America. It’s a very interesting company that’s doing a lot of really cool things, I think, and I believe you’ve held this company for years, and it’s really been a big winner for you.

[00:48:10] Brian Feroldi: So what’s your updated assessment of Mercado Libre’s progress?

[00:48:13] Brian Feroldi: Yeah, Mercado Libre has been an incredible performer, both from a stock perspective and a business perspective. And it is a fabulously well-run business. To your point, it’s the eBay of Latin America and the Amazon of Latin America and the PayPal of Latin America and the Craigslist of Latin America. It really is all of those businesses wound up into one, and it’s been an incredible performer for me. To your point, I first purchased Mercado Libre in 2010 or 2011, so I’ve held it for more than a decade, and it’s one of my biggest winners ever. This company has just grown at an incredible growth rate over the last 10 years.

[00:48:59] Brian Feroldi: Compounded its revenue at a 44% growth rate, and that number clocked in at over $11 billion last year. Now, what’s interesting about MercadoLibre is that it’s gone back and forth on the business growth cycle as it’s grown as a company. If you know a little bit more about Mercado Libre, they essentially started as the eBay of Latin America, and then over time they started the FinTech business and became the PayPal of Latin America.

[00:49:31] Brian Feroldi: They’ve been using the profits from those businesses to build out their own Amazon-like delivery service so they can actually deliver packages to customers. That’s an incredibly expensive thing to do. Building out that infrastructure is not cheap. Because of that decision, the company’s profitability over the last four or five years has been in and out of favor when you throw in COVID into the mix.

[00:49:58] Brian Feroldi: This company has not consistently generated consistent growth and profitability over the last couple of years. So it has gone back and forth between the phases that it’s been in. More recently, though, the company has achieved profitability on both an earnings basis and a free cash flow basis.

[00:50:17] Brian Feroldi: However, there’s a big difference in this company between its earnings and its free cash flow, and there are a number of reasons for that. One big reason is the company’s provisions for credit loan losses. Because of their provisions, they have been relatively high, which makes a stark difference between this company’s reported earnings and its reported free cash flow.

[00:50:42] Brian Feroldi: So its free cash flow is actually much higher than its stated earnings. However, Mercado Libre is a business with a very strong competitive position, still growing at a very strong rate, has multiple businesses that are growing on its wing, and I think it can continue to grow at a rapid rate for many years to come.

[00:51:05] Brian Feroldi: So its valuation today, depending on how you judge it, looks fair to me, or fair to being on the pricey side. But this is a company that I could easily see myself holding for the next five, 10 years plus.

[00:51:21] Clay Finck: Given the drastic differences between net income, free cash flow, how do you think about which metrics do you think are most valuable for valuing Mercado Libre?

[00:51:31] Brian Feroldi: Yeah, I’m a free cash flow guy. When forced to choose between earnings and free cash flow, I will take free cash flow every time. And Mercado Libre reported free cash flow is much higher than its reported net income. Now, I do respect the fact that this company is provisioning for credit losses, and it’s hard for me to gauge as an outside investor whether those provisions are appropriate, too high, or too low. That adds a whole another level of complexity.

[00:52:05] Brian Feroldi: So one thing you can do is just go in the middle of the company’s reported earnings and its free cash flow and use that as a profitability number for the business. But for me, when I’m looking at Mercado Libre, I’m not necessarily solely focused on the bottom line. I want to know what the growth rates are of the company’s businesses.

[00:52:30] Brian Feroldi: Is the FinTech business continuing to grow rapidly? The answer is clearly yes. They’re attracting new customers, rolling out new features, and shipping more packages than ever. More people in Latin America are still coming online. So as long as the valuation doesn’t get incredibly egregious, I’m personally content to hold as long as the business continues to grow as it has.

[00:52:55] Clay Finck: As I mentioned previous times on our show, you’ve called out why we shouldn’t be using the PE for a lot of companies, and Amazon’s the poster child for this.

[00:53:04] Clay Finck: So I’m curious if you sort of take the free cash flow at face value when valuing MercadoLibre or if there are any adjustments you think are necessary for a business like this. 

[00:53:16] Brian Feroldi: I wouldn’t take the free cash flow at purely face value. When you dig into the sources of that free cash flow and the difference between that and the earnings, I think that you need to make some adjustments.

[00:53:26] Brian Feroldi: So if I’m looking properly, I see that MercadoLibre is trading at about 17 times a price on a free cash flow basis. I don’t think that figure is accurate. I think that is understated, given the dynamics that are happening between net income and free cash flow. It’s priced to an earnings ratio at least on a trillion basis.

[00:53:42] Brian Feroldi: Currently at about 98. So PE ratio is 98. Price to free cash flow of about 17. Obviously there’s a lot of differences between those two numbers. From a valuation perspective, if you kind of take the midpoint I would think it’s priced appropriately given its growth potential. But again, this is a copy that has to continue to execute to justify today’s price.

[00:54:03] Clay Finck: Still relating this company back to Amazon, I think about how so much of Amazon’s market value, in my opinion, is derived from AWS. And it seems like MercadoLibre has sort of turned into a play like this, where you purchase it with the intention of thinking that this company has so much optionality, and you trust the management team and the way they’re able to navigate entering new markets, new regions throughout Latin America and such.

[00:54:34] Clay Finck: So do you still foresee a similar dynamic where it’s almost a bet on the management team and their ability to really just act like a call option on all these different business units? And one of them is almost certainly, in your opinion, able to become not obviously as big as AWS, but something like it.

[00:54:57] Brian Feroldi: Absolutely, when I think back to the best investments that I’ve ever made, many of them, not all of them, but many of them, I bought for one business, and while I’ve owned them, they’ve developed a completely different business that has moved the needle from a revenue perspective. Amazon has done that, MercadoLibre has absolutely done that, and Tesla is really starting to do that.

[00:55:23] Brian Feroldi: So I think the optionality of a business, the ability of a company to launch new products and services that open up needle-moving revenue opportunities, is a very attractive business trait. When I think about MercadoLibre, I absolutely think that it has that in spades.

[00:55:41] Clay Finck: Well, Brian, as I mentioned, we always appreciate you joining us on the show here. Before we close out the show, how can the audience get in touch with you and get a hold of any resources you’d like to share?

[00:55:58] Brian Feroldi: So the easiest place to connect with me is on Twitter. I’m at Brian Feroldi. I do want to call out a free resource that I have created. I have a website that’s valuation.school, the “do” instead of “.com.” It’s school. If you type that into your browser, I created a free seven-day email-based valuation school that goes through many of the valuation multiples that we talked about here. It discusses the valuation mindset spectrum, talks about the business development cycle, as well as has visuals along the way. So if your listeners are interested in learning more about valuation, check out Valuation School. It’s free.

[00:56:40] Clay Finck: Awesome. We’ll be sure to get that linked in the show notes for those interested. Thanks a lot, Brian. 

[00:56:44] Brian Feroldi: Thank you for having me, Clay. Always a pleasure to be here.

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