The Role Of Financial Modeling In Investing With Brian Feroldi - "Why Does The Stock Market Go Up?"

Investing is a minefield. If you're listening to this, you were born to be a horrible investor.

What is the most common mistake you see investors make?

We naturally, naturally want to get into markets after markets have gone up, which is of course the worst possible time to get into the markets. And conversely, when markets have swooned and investors are losing money, we naturally, naturally want to sell stocks, which is of course the best time to actually put money into the market.

Do you build any financial models?

I've learned the hard way to that when it comes to analyzing a business. I put a tremendous amount of emphasis on the quality of the business. Modeling and valuation only comes after the business quality filter.

What's the number one lesson you've learned over your career?

So many things that make us human, that make us who we are, work against us. I've learned best investing style for me is almost. Almost. Bye.

Welcome to Financial Modelers Corner where we discuss the art and science of financial modeling with your host, Paul Barnhurst. Financial Modeler's Corner is sponsored by Financial Modeling Institute. Welcome to Financial Modeler's Corner. I am your host Paul Barnhurst, AKA the FPA Guy. This is a podcast where we talk all about the art and science of financial modeling and finance with distinguished guests from around the globe. The Financial Modelers Corner podcast is brought to you by the Financial Modeling Institute. FMI offers the most respected accreditations in financial modeling and that is why I completed the Advanced Financial Modeler this week. I'm thrilled to welcome our guest onto the show, Brian Feroldi. Brian, welcome to the show.

Paul, thank you for having me. It's an honor to be here.

Yeah, really excited to have you and get to talk a little bit about investing. But before I do that, let me just share with our audience a little bit about your background. So Brian is a financial educator, YouTuber and author. Has been intensely interested in money, personal finance and investing ever since he graduated from college. Brian started investing in 2004. In the beginning, he had no idea what he was doing and got his teeth kicked in. Been there. His returns improved dramatically as his experience and knowledge about the stock market grew. Brian's career mission is to demystify the stock market. He loves to help other people to bet their investments. He has written over 3,000 articles on stocks, investing and personal finance for the Motley Fool. In 2022, his best selling book, why does the Stock Market Go up was published. It was written to explain how the stock market works in plain English. Brian lives in New England with his wife and three Kids. So did I cover it well there, Brian?

Yep. Except for it's now three kids and one puppy.

And the puppy, how old is the puppy?

12 weeks.

12 weeks. Trained yet at all?

No, not even close.

That's what I figured. So you're going through that.

All the rugs in my house are up.

Let's just say that I can have a newborn.

Exactly.

Except for unfortunately this one makes a mess everywhere. The newborn you can put a diaper on.

Exactly. You can't put a diaper on this one.

All right, this is a question we like to talk to about every guest. Obviously we're talking a lot of investing with you. We're also going to talk a little bit about modeling, which a lot of people do for investing. So I'm sure you've seen a few financial models in your career. Do you have a horror story, maybe a terrible model?

So I have seen many models and I was thinking about this and I think that the worst financial model that I've ever seen actually came from Ark Invest, if your listeners are familiar with them, that is the etf, a very popular ETF and fun group that is headed up by Cathy Wood. And they are essentially on trying to be on the bleeding edge of public markets so high growth companies. And, and she puts out these, she thankfully makes her models open so you can actually go in there and see the assumptions that she makes. And she specifically tweaks the models to make it seem like the stocks that she owns are going to like 50x return. So I remember looking at one of her models for Zoom Video Communications and this was post the COVID absolute boom. And according to her model like Zoom Video literally had like 20x upside or something like that. So I clicked into it and this was a company that was, you know, growing in the mid single digits. And her assumption built into the model was that the growth rate was going to accelerate to 66% compound annual growth rate for the next 10 years and therefore it was worth thousands of dollars per share. And when I saw that, I almost laughed out loud at the assumptions that were made into there. And it just goes to show that no matter how good modeling depends on good assumptions. And you can make a model say essentially anything you want as long as you're willing to tweak the numbers 100%.

Agree. I mean assumptions are so huge. That's why I love my professor. My MBA program for finance is, you know, we had to do for every single write up we did, we did Porters five forces and the whole situation of the Company then assumptions. He wasn't looking for a right answer because there isn't a right answer to a model. As George Box once said, all models are wrong, some are useful. Obviously that one wasn't very useful. Right. A 66% growth rate or whatever the number was not, well, more than a few years.

Well, it actually was useful because she got on cnbc, she got to say out loud, this stock is worth blank, you know, a 50 bag of return. So if from a marketing perspective, which was the goal of the model, the goal of the model wasn't to be accurate, it was to get attention. So from that perspective, the model was actually very effective.

Sure, I, I, I get what you're saying. It's all perspective. Right. Funny. With Zoom. I don't know if you remember this, but there was a, another company with the name Zoom that had something to do with engineering or Zoom Info. No, it wasn't Zoom Info. It was another Zoom, similar to Zoom. You know, the video. And at the time a bunch of people bought that stock by mistake, value went up like 300% in a week from like, you know, 15 million. Like is a small little stock on a small exchange. And I just laughed. I mean, like, sometimes it's just better to be lucky than good.

I guess when I see things like that happen, it reminds me of when people say, oh, the market is perfectly efficient, and I just shake my head and laugh.

Yeah, I mean, you can argue it's mostly efficient and I'll buy that anyone who tells me it's perfectly efficient. You have humans involved. Yeah, rational by nature. I know the, you know the book Random Walk Down Wall Street? I had a good friend of his company follow that in investing. Like, I'm not going to beat the market. It's all about tax optimization and asset allocation and you can do fine with that. That's the approach you want to take. So how did you get into investing? Let's start there. You mentioned college, but and getting your teeth kicked in. But how did you get started?

So I graduated from college in 2004. My degree was in business. I was a general business major. And I'm almost ashamed to say that when I graduated from college with a degree in business, I was still financially illiterate. Yes, we covered basic things like accounting and a balance sheet and the basics of business. But it was never explained to me during college how how a company stock price relates to the financial statements of the company or has never explained to me compound interest and how the stock market works. So when I graduated, my dad Gave me a copy of Rich Dad, Poor dad by Robert Kiyosaki. And I read that book cover to cover in like 48 hours. I was just, it was the first time in my life that I'd ever heard really simple concepts like the rich use assets to build wealth. The rich think differently about money. They think about their house differently. They buy or build assets, they keep their expenses low. And you can become rich in one generation if you do your money the right way. Now, looking back, there's plenty of things about that book that I disagree with today. However, it kick started a love affair with money that continues essentially to this day. And it was from there that I started to read other books I about money. So I read every book that I could get my hand on about personal finance, about investing. And over time I discovered that the stock market was the best fit for my investing personality. I thought about gold and commodities, I thought about bonds, I thought about real estate. None of those were a fit for me. The stock market was. And it was just using all of my free time to study the stock market, I just slowly developed an obsession with it.

Got it. Well, no, thank you for sharing that. I'm curious, do you remember the first stock you ever invested in?

Yeah, it was a penny stock that I found on like the Yahoo discussion boards. I lost money on it because again, I didn't know, I didn't know anything about investing other than rich people bought stocks. And my initial experience with it was to try and find low dollar priced stocks and try and sell them as soon as possible for a couple of pennies more than I paid them. I, that's what I thought investing was when I first started. Now looking back, I, I, I lost money often when I was doing that, but that was like the best tuition I could have paid because I quickly learned what not to do. And thankfully I didn't have a lot of money to lose at the time.

Yeah, fortunately they were penny stocks. Right. Oh, I just bought a share of Berkshire Hathaway and it tanked. Not that that's going to tank, but the value of a stock like that.

Yeah. To show you how bad I was, I literally bought shares of US Airways. They were publicly traded after they declared bankruptcy. So this was still a publicly traded stock. It had a queue in it and I was like, look how cheap this is. I've heard of this company and as you can imagine, I did not do well on it. But that is literally how little I knew about the company. The company declared bankruptcy and then I bought shares.

You know, and obviously you didn't have good luck there. But what I just thought of, as you said, that is like, when, you know, you do March Madness and you pick your bracket and the woman comes and picks it all based on the logos that she likes, the colors and the mascots that are pretty, and she wins, you're like, wait a second. What just happened? Yeah. So sometimes just kind of funny how life works. Yeah. US Airways, I was in Arizona, so I remember them well. So I'm curious now. You've obviously had a few years to do this. You've been doing it for 20 years. When you're looking to invest in a company, you get started. How do you go about reading the financials and learning about a company? Maybe walk through a little bit of your process.

So over the last 20 years, through trial and error, through talking to other investors, from studying the investing rates, I've discovered that the best investing process for me is to use and utilize an investing checklist. So I have a highly detailed checklist that I use when I'm going to be evaluating any business. And this checklist has several different sections to it, and it, it ranks the most important factors to me when I'm thinking about making an investment. So if you spouted off like a random ticker to me that I'd never heard of before, what I would do is I'd pull up my checklist and I would go down it top to bottom, and I would answer every single question that I had I about that company. Many of the questions are obvious. Things like, what's the revenue growth rate? What's the gross margin? Is there free cash flow? Is there net income? What are the returns on capital? Some of them are very quantitative and easy to look up. Others are qualitative. And they're things like, does the company have a moat? Is the founder still involved with the business? Do I think the company can raise prices? What happens to revenue during a recession? So there's a mix of numbers that I can look up and qualitative factors. I just ask myself about the business, and then I go to typical typically SEC filings or the company's website to get answers to those questions. And after going through the process and filling out my checklist, I have a much better idea of is this company a fit for my investing style? Now, that doesn't mean that this is like the best company on earth or the safest company on earth or anything like that. It's just, is this company a match for what I'm looking for as an investor. And based on the results of that checklist, I. I will either add it to my watch list, add it to my portfolio, or discard it as an idea.

Got it. And I'm curious, how often do you update the checklist? How often does that change?

Yep. So I've learned the hard way, I get through trial and error that the best investing style for me is almost, almost buy and forget. So I put a lot of emphasis and effort into the investing research process up front. So before I make a buy or sell decision, before. But a part of my investing process is finding companies that can outperform even the most bullish expectations. So when I look back at my biggest winners of all time, they're companies like Amazon, Netflix, Tesla, MercadoLibre. When I first made an investment into those companies, they didn't have business lines that now are major drivers of their profits. So it was almost like the company, through sheer innovation and excellence, was able to grow in excess of my wildest dreams. So I've learned that the best investing style for me is to do a lot of research up front, have very tight filters for what gets into my portfolio, and then once it's in there, let the company do its thing.

So I'm going to state the obvious here and kind of ask a question around that. You said probably 10 times or so, best style for me. Why do you emphasize that so much?

Well, because there's no such thing as a perfect stock for. For. It totally depends on what you're after as an investor. You know, investors, when people think about investing in the stock market, everybody thinks that what they're trying to do is just earn the highest return possible. That is one thing that you could be going after as an investor, but it's not the only thing. Some people look to the stock market and they want to generate the highest income from dividends as possible. That is completely legitimate goal. Other investors look to the market and say, I actually want to invest in stocks but have the lowest volatility possible. So I really want to protect my downside. And what you target as an investor or what stocks that you invest in should align with what goal you're trying to achieve. Now, most people that pick individual stocks, like me, are trying to outperform the market. That's the typical thing that people are going after. However, if your goal is to just generate the most income that you can from the market, you should not be selecting stocks that have the highest growth rate. You should look for the most durable income streams that you can and try and Maximize your yields. So the reason I'm emphasizing that is because my goal with my portfolio, my investment portfolio, is to outperform the market. And by its very nature, that's going to exclude a whole bunch of excellent companies that are big and dominant, but I don't think have huge upside potential.

Sure, yeah. You're looking for high growth companies.

Yep.

Ones with high upside potential versus maybe looking for something that just going to give the fabulous 6% every year, has a good EBITDA margin, strong business, but you know, you're not going to see a 10x return in the next probably ever.

Yep, exactly. So Verizon, Berkshire Hathaway, IBM, all fine companies. I want nothing to do with them in my portfolio.

Yeah, get it. And other people like that. Those are the companies I want. My portfolio. I want nothing to do with Amazon or Tesla or Netflix. So let's go back a little bit of modeling. Now, you mentioned there's both qualitative and quantitative. How do you read the financial statement? If I put a financial statement of a public company in front of you, how are you going to go through it? You got all which statement, main statements. You've got the P and L, the balance sheet and cash flow. Where are you going first? Let's start there.

I always look at the income statement first. I typically want to know what are the company's recent trends, specifically trends with, with revenue. Is the company growing or shrinking? Is revenue cyclical or secular growth? And what happens during a recess. The next thing that I look at is gross profit. I think gross profit is a chronically, chronically underrated financial metric. And I actually value gross profit higher than I do revenue. To me, gross profit is the market's way of rewarding a company's product or service for excellence. And I care more about gross profit growth than I do revenue growth. So revenue gets all the glory. Gross profit is actually what builds wealth, I believe, for businesses. So I go revenue first, gross profit second, and I look at gross margin, of course, and I want to see that it's stable or even better, rising over time. Then I quickly look at operating operating income, pre tax income and net income. Once I'm done with the profit metrics, I then glance at the company's share count and just ask, is shares increasing, stable or decreasing? With just that, that simple analysis, you can get a very easy look at the recent trends of a business, the margin profile of the business, and ask and answer the question, is the company returning capital, shareholders or issuing or issuing equity?

Got it. So you're really kind of focusing on the income statement. What about balance sheet or cash flow? Anything you like to look at there?

Absolutely. I wouldn't, I wouldn't ever invest without looking at all. Yep. So from balance sheet perspective, it's just a matter of is the company's balance sheet asset heavy or liability heavy. So I always look at cash and cash equivalents. I look at long term investments. I take a look at goodwill and compare that to the company's total assets. And that gives me a sense of is the company growing organically or is it growing through acquisitions? I vastly prefer organically. I take a look at the company's debt balance and I compare that to the company's cash balance and into the relationships and then ask, well, why is this the business levered or unlevered? And then I take a look at the equity section and look for specifically retained earnings and then treasury stock. Now I've noticed that a lot of companies kind of hide their treasury stock nowadays. They used to kind of always put it, put it out there for people to easily see. I know that it's a contra equity asset, but I like to know, is the company actively repurchasing stock from the markets?

Yeah. No, I think that's good to know because that impacts stock price and everything else and how they believe in the business. And there's a lot of things that go into that. So I'm curious, as you're analyzing all these, do you build any financial models? Do you have anything you do in Excel as you're analyzing each of these companies?

I've learned the hard way that when it comes to analyzing a business, I put a tremendous amount of emphasis on the quality of the business. And quality of the business comes first and foremost. Modeling and valuation only comes from after the business quality filter. So I don't care how cheap a company is, if it's an awful company or even a mediocre company. I want to invest in excellent companies. And after I determine that the company is excellent, then I would go to some kind of modeling or valuation period. So to me, modeling and valuation comes after business analysis. Sure.

Makes sense. You do your screening and say, is this a good company?

Correct.

Now let me do my numbers to see if it's a good stock.

Correct? Absolutely.

Yeah. Which you could have a great company that's not a good stock.

Absolutely.

Anyway, it may be a good stock next week and it may be a terrible stock next week. I think sometimes people forget that like, well, but it's a great company. I mean, it's going to get you a good return. Everybody else realizes it's a great company.

One of my favorite modern day investors is a guy named Terry Smith. He, he heads up a fund called Funsmith out of England. And he has the best phrase on investing I've ever heard. It's the shortest, most succinct investing policy I've ever heard. It's, it's buy good companies, don't overpay, do nothing. It's like seven words. And it's like, I think that that is an excellent investing philosophy.

Yeah, it's kind of like war. You know, Warren Buffett has said you buy quality and hold forever.

Buy quality at a good price and then effectively hold until it's no longer quality.

Yeah, there's a time when you have to be smart enough to go, all right, time to get out.

Yes, yes.

And hopefully it's before you've lost most that upside.

I, I, I still haven't figured out a way to always consistently sell at the top. So if somebody knows a trick to do that, that would be great information.

Yeah, I was gonna say if I did that I wouldn't be on the show right now.

Exactly.

Before we jump into some other kind of more stock investing question I want to ask, and this is obviously related to investing, but I want to talk a little bit. When I think a strategic mo, often people hear that term. So let's start with what is a moat? And you know, why should we look for one of those?

A moat is one of the most important things to look for when analyzing any, any business. In effect, a moat is a competitive advantage that a company has, a structural competitive advantage that allows it to earn high returns on capital for a longer period of time than it would otherwise. I mean, we live in a brutally competitive world. If a product or service is having success in the marketplace, you can be quite sure that copycats will come along very quickly and try and steal your customers from you. A moat prevents customers from leaving your product or service and allow you to charge prices that allow you to generate good returns on capital. So without of moat you, you could have a great product or a quick growth period, but that will not be a sustainable business for you. And when it comes to investing, you should not care at all about investing in flash in the pans or things that go up quickly and then just drop off a cliff. You should be after durable growth. And nothing makes growth durable like a moat.

So what are some of the different types of moats? Give us some examples.

So generally speaking, there are five broad categories of moat that we can go through. So first would be an intangible asset, some asset that the company has. It is intangible meaning of course, that you cannot touch it. That allows a company to price its products at a premium or get some kind of advantage. So a real simple one would be a strong recognizable brand name that attracts consumers to it. Coca Cola, Apple, Tiffany's, lv, lvmh, Tesla. Names that names that consumers will recognize and actually want to buy and prefer versus competitors simply because of the name. Now this one is easy to screw up because Delta is a name that a lot of people know, for example. But will consumers pay more for a flight on Delta than they will on American Airlines simply because of the brand name Delta? I don't think the answer there is yes. So just having a well known name does not mean that you have a. That brand is an advantage for you. The brand name has to signify in the consumer's mind something that they're willing to pay for or choose just because of the name.

You mean people don't choose Walmart just because of the name. You mean it has something to do with the lower prices?

Yeah. So Walmart is actually a pretty good brand name. But to your point, would you shop at Walmart if all of a sudden they raised prices on you? No. So Walmart is a good name. It's very recognizable.

Yeah.

I don't think that's what gives Walmart its edge.

No, the name is not what gives it a moat. There's other things we could argue with that.

Absolutely.

But I wouldn't say it's the name for sure. I could care less if it's Kmart, Walmart or Target.

Absolutely. I'm right there with you. Just want the good at the lowest price.

All right, so what's some other modes? Give me a few other examples.

Another one is called switching costs. This is when it costs the consumer time, energy, money or some other thing to switch to an alternative service. I'll give you a real quick example. I've been with capital1 for 20 years now. Not because I'm in love with Capital One, the bank, simply because for me to change banks would require me to fill out a whole bunch of paperwork, move all these automatic payments over and go through a relatively painful process. So for me there's time switching costs to going away from my bank and that there are lots of companies out there that have similar dynamics. And it's not, again, it's not always dollars that prevent customers from switching. It's often time. So if you get to know. If you get to know Excel, you got you put a lot of time and effort into studying Excel. Are you going to switch to Google Sheets? Probably not. Even though Google Sheets is free FP.

And a guy here.

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And that's why I said, you know, so many people are like, but my spreadsheet's better. Like, I knew a guy, he launched a spreadsheet. It ran quicker than Excel and had more efficiency than both Excel. Google Sheets had almost all the exact same formulas in Excel. But he could never get traction. It's like, all right, half a second versus a second. Am I really going to switch to something I don't know for a half second of time savings? And the answer was no. He had to pivot the entire company because he could never get traction. Starting with trying to build. But you know, I got all the formulas. It's cloud based and it's faster.

The company that I used to work for, we switched over to salesforce.com was our customer relationship management and literally our entire sales and marketing team and shipping department was built around salesforce.com and when they joined, I was, I remember thinking, God, if Salesforce went down, our company would just grind to a halt. Like, we would have no options. And not only that, we had built so many internal applications and tools and reports around salesforce.com that I just knew that Salesforce had these huge hooks into us and that the odds of us switching away to another provider were effectively zero. So that's a great example of switching costs. And if you can find that in a business, that's a really good sign.

All right, so those are two we've mentioned. Any other moats?

Yep. Another one would be Network Effects. Network Effects is relatively rare. But it can be extremely powerful from a company perspective. So network effects are when new users of a company's product or service create benefits for existing users. A real simple one here would be like the telephone, right? So when the telephone was invented, if there was two telephones in the world, how useful is that? Not really useful at all. You can call essentially one person. However, every time somebody got a new telephone, the number of people that each existing telephone could call magnified. So the network become more powerful. When there were 10 telephones, 100 telephones, a thousand telephones and more. Now you might be thinking that's obviously a really old example. But modern day examples are things like Airbnb, where why do people go to Airbnb? Because it has the biggest network of properties in the world. And why do people list their sites on Airbnb? Because it has the most buyers in the world. So companies like Facebook or cme, a group, these are companies that benefit from network effects. So the more users join the network, the more the network gives benefit to all existing users.

Yeah, no, totally understand social. Social media is the big one like that in the sense that there's a network effect there. Any other mode?

I just grouped the last one together. So it's essentially cost advantage and efficient scale. This is essentially economies of scale. So companies that get really big and have huge buying power or huge distribution power, they can actually price their products and services. They have a lower internal cost inside the company to producing a product or service and bringing it to market. And they can use that to either generate higher profits from selling things at the same price or undercut the competition and the competition just simply can't keep up. So this would be companies like UPS, for example, that just has a massive network and it would be really hard to like start a new, start a new company to compete with UPS or Walmart or Costco or Ikea. Just company with massive buying power that it would be incredibly hard to compete against.

I'm curious, do you look at a proprietary technology, have a patent or anything? You consider that a moat?

Yeah, absolutely. So that would be an intangible asset. A patent is very common in the pharmaceutical industry where they have say a 20 year period where they're the only ones that can produce that, that drug. The only problem with investing in patents is that they expire. So there is a date on a patent where your, your ability to generate high returns disappears. That's not as favorable to moats that don't expire.

Agree drug when they end, we see it all the time. They try to find ways to extend them. And yep, we made a few changes so we can keep our patent longer, whatever it might be. So, yeah, I didn't think of technology under intangible. Totally makes sense. All right, so, you know, most of the audience I have are people who are building financial models, whether it's an fpa, investment banking, private equity, wherever. But let's say they're not necessarily investors. Say someone's listening to the show, you know, they, they know their way around a P L, they understand finance. Where would you recommend they get started? If they wanted to begin investing in the market, what would you advise them?

Step one with investing in anything is always educate yourself. So if you don't know anything about the stock market before you go out and make your first investment, pick a medium that you like to learn from and search for information about that, about that thing. I mean, people today are spoiled. When I first started investing, the only real way to learn about it was through books. Now you can go on YouTube or TikTok or Twitter.

Go on TikTok. By the time this release.

Yeah, that is true. You can go on podcasts, you can go on YouTube. I mean, it's unbelievable how you can get high quality information in essentially an instant that matches your learning style and just start to learn the fundamentals of whatever you're. You're investing in. So if the stock market interests you, look for information about the stock market. Ask questions like, how does it work? Why does the stock market go up? Why is the stock market a thing? What's the history of the stock market? If you can do just a little bit of research, you will give yourself an enormous leg up over effectively everybody else that doesn't do that little bit of work.

Yeah. So kind of leads to my next question. One, obviously educating yourself. Huge. What's the, Is that the most common mistake you see or what is the most common mistake you see investors make?

Investing is a minefield. And if you're listening to this, you were born to be a horrible investor. So many things that make us human, that make us who we are, work against us as an investor. By our very nature, humans want to get along and agree with and go and get their information from the people that are around us. So that means that we naturally, naturally want to get into markets. Aftermarkets have gone up and there's lots of joy and people are making lots of money, which is of course the worst possible time to get into the markets. And conversely, when markets have swooned and investors are losing money, and everybody is filled with fear. We naturally, naturally want to sell stocks, get them out of our portfolio to stop the pain, which is of course the best time to actually put money into the market. So there's so many things about investing well that are completely, completely counter to the human, human nature. So the mistake that would be make we make is just to be unaware of all of the biases that are in all of us that make us bad investors. And it's amazing how just being aware of those biases can go a long way to help combating them.

So you're telling me everybody's biased?

Highly biased. Except for psychopaths, which are obviously horrible people, but sometimes they make great investors.

So I don't know if you've read the book, but there's a book called by Jack McCullough how to survive the psychopath CEO.

Okay.

And it was based on some study where they found they. I don't know how many people say it or how it was done, but like 1 in 6 C level executives are a psychopath.

Okay.

So there you go. You're either Ted Bundy and a serial murderer or you're the next great CEO.

There you go. Yeah, I could see that. I mean the personality that you have to have to found a company and get it to the public markets and or rise in the ranks and take the top job. There are some things going on in your brain that are not, not normal. Like you are an exceptionally high achiever and oftentimes those people have horrible lives outside of working, but that makes them really effective leaders. So I would not want to be that kind of person. But there, there is no doubt that people with those kind of innate abilities are often good CEOs and good investors.

I bet you didn't think we're going to have that conversation and right wasn't on your list when we talked about investing and started this podcast. If one of our listeners wants to build a forward looking model, particularly around valuing stock, any advice you'd offer them kind of, you know, any thoughts or lessons you've learned as you're doing that.

Valuation is hard to do, period. But I think that valuation is nearly impossible to do if you don't understand this really basic and critical concept and that is the concept of the business growth cycle. This is something that oswat the motor and has really popularized and it's essentially a chart that shows the business life cycle, how companies that are startups are really growing fast and they're focused on revenue and then they become a little bit more Mature and they start to focus on operations and then they really start to focus on profits and eventually they start to focus on returning capital shareholders and then they go on to die. One big mistake that so many investors make, myself included and is that when you are analyzing a business it is critical to know which phase of the business growth cycle the company is in because during each phase companies are focused on different objectives and you can't value a startup the same way that you would value a blue chip dividend payer. So it's very common mistake to use like the price to earnings ratio or some simple model or discounted cash flow model on a startup and you come away saying, well, this company's valuation makes no sense, this number looks crazy. The actual thing to do is that you have to do differentiated analysis on a startup than you would on a, on a, on a phase five capital returning company. So that is by far the biggest mistake that I see people making is they use the wrong model on the company at the wrong time.

Let's talk about that for just a minute. What model do you recommend for startup? I think you said differentiated analysis. What do you say you should be using for a startup?

So startups are really, really hard to value as a general statement. But the only model that I think that work are really total addressable market analysis, often very simple multiples. So price to sales analysis or even price to gross profit analysis. And that's basically it. Or you can just do something like really simple market cap analysis. What's the market cap today? What could it be if everything works out and you know, apply some discount rate to that. But modeling and valuing startups is incredibly tricky, I can tell you that. Discounted cash flow models don't work.

So you're telling me there's a reason most venture capital companies don't ever return to the shareholder?

Yes, there are.

Yeah, I talk to a ton of VC companies. All right, so let's talk a company that, you know, not startup, but that hyper growth phase, they're in that first curve where they're just growing, growing, growing revenues, taking off. Maybe they're being smart with their money, maybe they're not. We've seen all those. What, what do you use then? How do you think about valuing?

Yep. So for me, I'm a big fan of simple when it comes to valuation. I'm a big fan of the, I would rather be roughly correct than precisely wrong. So when a company is still in that hyper growth phase, perhaps they're profitable, maybe they're not, maybe they're at break even or something like that. I like to look at the company's P and L statement and start at the top and say, what is this company currently optimized for? Obviously they're optimized for revenue. They are probably optimized for gross profit. But are they optimized for operating income? They're definitely not optimized for earnings, but are they optimized for operating income? So that's where margin analysis is really useful. And I asked myself, what metric, what profit metric on the P L is the company currently optimized for? And that's the valuation metric that I, that I, that I look at and try and value it. So it could be price to sales, it could be price to gross profit, and if the company has made success with profitability, it could be priced to price to EBIT or even price to free cash flow. But I try and first focus on what's the company optimized for and then pick a valuation metric.

Got it. I like that. So this is kind of a fun question we ask every guest, so I'm going to throw it out there. Do you have a favorite shortcut in Excel? Kind of changing subjects a little bit.

I am not an Excel power user, to be completely honest with you. I actually use a whole lot of Google Sheets. So I do not have, I do not have a favorite.

You're goo. Do you prefer Google Sheets over Excel?

I don't prefer it. It's just free and cheap and easily, easily shareable. So to me, I am not like a super detailed power user of spreadsheets. So for me, Google Sheets is perfectly adequate. But I fully recognize it is not nearly as powerful as Excel.

Yeah, no, I get it. And Google Sheets can do a lot of things. Excel. It's a fine spreadsheet. All right, so here's a question for you. Do you think in the future AI will build financial models for us?

Absolutely. I totally think that they can. But just being able to build a model is one thing. Understanding the model is something else. So I can't imagine that model making will really lose its relevance. I think that AI will be a tool that model makers use to make their models a little bit better or do even more scenario analysis. But being able to interpret the model, understand the assumptions that are going into it, is still going to be a critical skill.

Got it. So if you had to pick between using ratios, dcf, reverse dcf, if you had to use one of those for all your investments going forward, which one would you pick?

Well, if I Had to pick one. I would say ratios simply because ratios apply between the startup phase and the, the death phase. But of the three, my favorite there is reverse DCF for sure.

Okay, yeah, I can understand ratios because, yeah, you can apply it anywhere. All right, so get your thoughts on this. Do you think financial models are the number one core corporate decision making tool?

That's a really good question. Models are very, very useful and very, very powerful. But I guess it depends on the type of business that you're, you're, you're in. If you're in a predictable business like say Coca Cola or Proctor and Gamble. Absolutely. Making decisions based on the numbers and the numbers alone makes a whole lot of sense. If you're in the technology space and you're in the inventing products or services that will open up new markets, I would say that no, the CEO's intuition or talking to consumers would actually be the best way to make choices.

As I heard somebody say, no, number one is politics.

If number one is politics, that company is going to be in stage six in the next decade or two.

There's some truth to that. So what is the number one investment tool in your, in your mind that people use? Is the financial models? Is it qualitative? What, what do you think is the number one investment tool?

My favorite investing tool is my checklist that I've built. Again, it's a marriage of qualitative and quantitative. And we are blessed that things like the sec.gov exist that we can go and look up financial statements and financial reports for any publicly traded company in, in an instant. But I think that an investing checklist would be the number one investing tool that I use that you use.

Why do you think it is in general though that people use? I'm doubting that the checklist is number one for a lot of investors. You have a thought?

Absolutely. Plenty of people invest completely differently than I do. I'm a fundamental bottom up investor. So to me, getting into the annual report, SEC filings, earnings report really matters to my investing decision. For other people, it depends on what kind of investor they are. There's plenty of high frequency traders out there that could care less about what the company does that they're, that they're investing in. The same goes for a lot of momentum traders. They don't care what the company does, they just care about the price action. So what tool is the most powerful? Depends on your investment.

What do you think is most used?

You know, a lot of most used? Oh, I would guess probably Excel and Financial modeling for Valuation purposes. But that's a guess.

Yeah, I'm just curious. I get it. To guess. There's no right answer. We're just about to the wrap up point. Just a couple more questions. What's the number one lesson you've learned over your career that you could share with our audience?

When I graduated from high school or graduated from college, I had no idea what I wanted to do for a living. And it's kind of funny how my career has progressed to where it is and effectively the job that I have today, and I have a feeling the job that you have today didn't exist when I graduated college. So I would say the number one skill and the number one advice that I can give is to just be curious and use your free time to see to, to get ahead in the areas that, that interest you. I mean, I especially spent a lot of my time on social media and that's where I make a lot of my income from. I had no idea. But the only reason I'm able to do that is because I've been extremely interested in it for years. So just pure curiosity and a willingness to, to, to seek out information, educate yourself in your free time. I think that's the number one skill.

That anyone can learn. Love it. And so the, the next question I'm going to ask is if you could recommend one book for people, maybe they'll want to learn more about the market, more about investing. Do you have a favorite book you could recommend?

I, I have many, many favorite books. But beyond my, my book is really built for like, very, very beginners, people that are like, starting at the ground floor, like, how do you invest? So for your audience, I'll go with the little book that Builds wealth by, by Pat Dorsey. It's a very fast read and this book is really deep on moats and, and competitive advantage and it talks a lot about them. So an excellent resource.

Thank you. Appreciate that. So if our audience wants to learn more about you, get in touch with you, what's the best way for them to do that?

They should go on their favorite social platform and search my name, which is Brian feroldi. I'm on TikTok and YouTube and Instagram and, and Twitter and LinkedIn and all the places. So whatever platform you're on, search my name and connect with me there.

So you pretty much have them covered?

I have almost all of them covered, yeah.

Is there any platform you won't go on?

Whether I, whether I spend time on there or not is a different thing, but I will pretty much. Set up an account on any platform that has my potential audience on it.

Love it. All right, well, thank you for joining us, Brian. Appreciate your time and you have a great rest of your day.

Thanks for having me. Paul. Awesome, awesome. Fun to be here.

Thanks.

Financial Modelers Corner was brought to you by the Financial Modeling Institute. This year I completed the Advanced Financial Modeler certification and it made me a better financial modeler. What are you waiting for? Visit fmi@www.fminstitute.com podcast and use code podcast to save 15% when you enroll in one of the accreditations today.

Sam.