Investor Lesson: What a Company's Financial Filings Can Tell You

A company's financials are more than just a set of numbers. They can tell a story that helps investors understand the core of a business and where its growth opportunity lies. In this podcast, Motley Fool analyst John Rotonti talks with fellow Motley Fool analyst Auri Hughes about the financials to watch before putting your money into a publicly traded company. They discuss:

• Profit drivers in a company's balance sheet.
• The portions of a 10-K that investors should pay close attention to.
• Metrics that provide insights about a company's growth prospects.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on March 12, 2022.

John Rotonti: You just described it beautifully, this idea that companies reinvest and they grow bigger over time. That's the compounding effect, that's the snowball effect, that's how the math of compounding works.

Chris Hill: I'm Chris Hill, and that was Motley Fool Senior Analyst John Rotonti. The financials of a business are more than just numbers. They tell a story that helps investors understand the core of a business, and where its growth opportunity lies. On this Saturday classroom, John's talking with fellow Motley Fool Senior Analyst Auri Hughes about the profit drivers in a company's balance sheet, the part of a 401(k) they love to read, and a financial metric that can tell you a lot about a company's growth potential.

John Rotonti: Hi Fools. I'm John Rotonti, I'm here again with Auri Hughes, and today we are going to be talking about understanding the core business and the key drivers of value in that business. How you doing Auri?

Auri Hughes: I'm good, how's it going John?

John Rotonti: Things are going well. One of my favorite topics to talk about, so things are going yet even better. Fools, we thought we would maybe start by going through a quick example of how sales flow through a company to become earnings. Let's just take a quick example of looking at Starbucks, because Starbucks is a company that most of us are very familiar with. The sale that Starbucks makes, sales are what happened at the point-of-sale. Point-of-sale meaning the cash register in the store or on app if someone is doing mobile, order, and pay, and so that is the sale. When you go into Starbucks, and you pay four dollars for a cup of coffee or whatever it is, that is the sale. From sales, we subtract something called cost of goods sold or COGS, C-O-G-S, and that is everything that goes into specifically making that cup of coffee. Those are expenses that are involved in making that cup of coffee. The coffee beans, the coffee cups, the plastic lids, the straws, any syrups or whip creams that go into that coffee. The salaries of the baristas that make the coffee for you in the store, any pastries you may buy in the store, napkins, sugar packets. All of that is direct cost of making that product, so that's cost of goods sold. We take the four-dollar sale, we subtract the cost of goods sold, and we get something called gross profit, and that's really the unit economic you're looking at. How much profit is left over after you subtract the input costs that go into making that product? That's your gross profit or your unit economic. From gross profits, we subtract operating expenses, and operating expenses are things like SG&A or sales, general, and advertising, and then R&D expense, things like keeping the lights on, paying your water bill, paying your utility bills, paying the rent on the location. Those are all operating expenses or cost of doing business. From gross profit, we subtract out operating expenses, and we get something called operating income, which is also called, and this is really important, earnings before interest, and taxes or E-B-I-T, EBIT. From EBIT, we subtract interest expense if the company has debt.

So this is a really important point, from EBIT, we subtract interest expense, meaning debt holders are the first to get paid, debt holders or creditors have a primary claim on a company's cash flows. Remember, we had EBIT, E-B-I-T, and we subtract the interest, we subtract the I, and so now we're left with earnings before taxes or E-B-T, and from that, the business pays taxes to the government. So the government is actually the second in line to get paid, and then what is left over is net income or net profit, or net earnings. They all mean the same thing, net income, net profit, or net earnings, and that is the bottom line of the income statement. Remember, the top line of the income statement was the sale that was made at the point of sale, the sale of that cup of coffee, then we subtracted out the cost of goods sold to get gross profit, then we subtracted out operating expenses to get EBIT, then we subtracted out the I, the interest expense on the debt to get EBT. Then we subtracted out the T, the taxes paid to government, and what is left over, if there's anything left over, is what goes to share holders, is what goes to us as the owners of the business. Keep in mind Fools, we are last to get paid, we get the residual, we get what is left over at the bottom of the income statement. That is why it is called bottom line. But for a lot of great companies like Starbucks, for example, like Apple, which we may talk about later, there's a whole lot leftover, there's a whole lot of net income leftover. Auri, maybe over to you, now that we have an idea of how sales flow through an income statement or flow through a profit and loss statement, how do you find out the most important metrics or the most important drivers to focus on when you are analyzing a new business?

Auri Hughes: Wonderful. That was a great description by the way, that was amazing, I felt that much more confident in understanding the income statement.

John Rotonti: Thank you.

Auri Hughes: Basically, I start with the 10-K document. Again, that's probably one of the most important documents in researching a company. After I read the beginning that just describes the business model, I'm going to look for a section called MD&A which stands for management, discussion, and analysis. There's usually commentary from management describing what are the most important things, what are the drivers of the business. They may have some metrics that directly feed into revenue or show what revenue is comprised of. Just to give you an example, they don't do this anymore, but a few years ago, Apple used to breakout how many iPhones they sold. They broke out the iPhones, the tablets, and the max, and you could actually calculate on average, the average price they were selling them at and the number. So if you think about their business, a big portion of it is going to be at its core, the number of devices they sell, and the average price of those devices. You could see that in their MD&A section, and then you could, if you wanted to forecast, and estimate how much they would sell in the future based on guidance or just the environment, you could do that. So that was very critical. So that's a section I usually go back to for most companies to understand, what are the core drivers of this business, what does management want me to know, what are they showing me? They'll usually talk about the trend, has it trended downward year-over-year or upward? They'll probably give some reasoning as to why that trend has changed. Maybe if it's Etsy, they may say, we had a great holiday season or we had more visitors due to this. A lot of times over the past couple of years, i would see things with information related to COVID. If it's a business that's affected by travel or people being out, you may see some pullback due to COVID or things like that, it just provides a lot of insights into the key drivers of revenue of those businesses. So again, I like the MD&A section.

John Rotonti: I agree completely Auri. In that 10-K is where management is going to talk about the metrics that drive value for their business. These metrics are different across industries. If you're looking at a bank, for example, banks take in deposits, and they pay a tiny, tiny bit of interest on those deposits. Then they lend out those deposits, and charge a higher interest rate. So banks, traditional banking, they make their money on that spread, the difference between the small amount of rate they pay on a deposit, and the higher rate they earn when they lend out those deposits, whether it's for a car loan, or whether it's for a mortgage or whatever it is. When you're analyzing a bank, you want to focus on that spread, which is called the net interest margin. There's very few other companies outside of banks where the net interest margin is going to be the key driver of value, but it is for banks. If you are analyzing banks, you have to know that is a key driver of value. If you are analyzing insurance companies, insurance companies look at their own set of metrics. The most popular of which is probably something called the combined ratio, which is a measure of their underwriting profitability, the profitability they earn on their insurance business, on the risk that they take underwriting insurance. If it's a software company, we look at a different set of metrics, we look at sales growth rates, we look at gross margins, we look at gross profit dollar growth, we look at revenue retention rates, we look at how much of revenue is recurring, we look at net revenue retention rates. We look at the rule of 40 for software companies, which is basically revenue growth rate plus the free cash flow margin. There is lots of different metrics, lots of different drivers of value across industries. But Auri, to send it back to you, what metrics would you say at the end of the day, you place the most emphasis on when you're analyzing businesses?

Auri Hughes: That's a great question. I think after working here and just looking at historically the best performing stocks of all time, I would say the first one is revenue growth. It doesn't have to be a huge insane amount of revenue growth, but I like to see sustained revenue growth, ideally organic, preferably. If it's not organic, I want to see a team that has executed on acquisitions over time or that's their specialty, or they know what they're doing. Sustained revenue growth over maybe 15 percent hurdle. Then second, and third, I'll put them on the same bar, is probably free cash flow. I do like money coming in. It makes me a little bit more comfortable in that I know the company won't need to go back to the market. Then net cash on the balance sheet, like a safe business that is less likely to go bankrupt or just doesn't need cash. I think a few of those things have been correlated with high stock returns over time. Those are my go-to metrics.

John Rotonti: Auri, those are so similar to mine, [laughs] and so I love that. For the portfolio that I lead for The Motley Fool, for Showdown, we had to share our investor philosophy statements or IPS's with our members. I wrote out mine and I bullet pointed the things I look for. I said resilient growth businesses, so you said organic revenue growth. I said with superb leadership that are solving important problems, but then I gave the metrics. I said they've already achieved scale. These are companies that they're larger, they're mid cap or large cap. They've already achieved scale. I said immensely strong balance sheets usually with net cash. I then said, are highly profitable with high and/or rising returns on invested capital or ROIC. I said, have strong and growing free cash flow generation. Then I said in parenthesis, in other words, they are self funding which is what you said. They don't have to tap the markets. They don't rely on other people's money for their growth. Then I said, they likely operate in an oligopoly or duopoly with limited competition, wide moats and very high barriers to entry. One of those that I do want to drill down on just because this is a segment on key performance indicators, KPIs, and key metrics that drive value, I do want to talk a little bit and briefly about the power of the return on invested capital calculation. ROIC, or return on invested capital, if you assume we have two companies already, company A and company B that both aim to grow their earnings at a rate of five percent per year, that's the target growth rate that both companies have set for themselves. They want to grow their earnings, which remember, earnings are what belongs to shareholders. That is what's left over at the end of the day.

Both company A and company B want to grow their earnings at five percent per year, but company A has a return on invested capital of 20 percent, and company B has a return on invested capital of only 10 percent. Under these parameters that I've just laid out, company A only has to reinvest 25 percent of its earnings back into the business to achieve its goal of five percent earnings growth, but company B has to reinvest 50 percent of its profits to grow its earnings at the same five percent rate. Company A, which has the higher ROIC, only has to reinvest 25 percent of its earnings to grow at five percent, but company B, which has a lower ROIC, has to reinvest 50 percent of its earnings to grow at the same five percent rate. In other words, company B that has half of the return on invested capital, has to reinvest double to grow at the same rate. Because company A can reinvest less of its earnings back into the business to grow at the same rate, it's reinvesting less back into the business, that means it has more free cash flow left over. It's reinvesting less back into the business, so more free cash flow is left over. Free cash flow, Fools, is ultimately what drives business value. One of the definitions of corporate finance 101 or evaluation 101, is that the intrinsic value of a business, the fundamental fair value of a business, is the present value of all of its future free cash flows that it will generate. Free cash flow is what drives business value. I just went through the math showing you that companies with high ROIC, companies with high return on invested capital are capable of generating far more free cash flow. Any last words Auri?

Auri Hughes: Yeah. Return on invested capital, return on equity are amazing concepts. I think when you truly understand them, the way I think about it is the business produces cash. If you're just entrepreneur, are you going to buy more lemonade? You're going to hire more employees, and then reinvest that into the business, and then next year, the business should produce more cash and then you reinvest that and the business grows over and over, and that's why the relationship, that formula between ROE and growth is so important and they go hand in hand. It's just about your opportunities. Is there an opportunity to keep growing the business? That's one of the core concepts of understanding how businesses get bigger and grow over time. I think your example is great because it touches on the efficiency and how effective of a return that business is generating internally. These are just very important concepts to understand. If you look at a lot of the best-performing stocks over time, the ones that have been profitable have had high ROEs or high return on invested capitals. Copart, Constellation Software, just amazing ROEs over multiple years, and they've gotten substantially bigger. Very important concept.

John Rotonti: You just described it beautifully, this idea that companies reinvest and they grow bigger over time. That's the compounding effect, that's the snowball effect. That's how the math of compounding works. You mentioned the ROE formula. Fools, let me briefly give you that formula. The formula is net income growth. We talked about net income. That's what goes to shareholders. Net income growth is equal to return on equity multiplied by 1 minus the dividend payout rate. To reframe that, net income growth is equal to ROE multiplied by the reinvestment rate. Whatever a company does not pay out as a dividend, it retains or reinvest back into the business. If we do ROE multiplied by 1 minus the dividend payout rate, then we get ROE times retained earnings or ROE times reinvestment, and that gives you growth of net income. I will leave our Fools with one last formula. There's also a formula for growth of operating income, and that is our ROIC times the reinvestment rate. Auri, you bring up such a great point. These return metrics that we're talking about, ROIC and ROE, they're not only measures of profitability and performance, they're also drivers of growth. There you have it Fools. Auri, thank you so much.

Auri Hughes: Thank you, John. This was a lot of fun.

John Rotonti: Fool on!

Chris Hill: That's all for today, but coming up tomorrow, we're going to talk about Russian oligarchs. Yeah, we really are. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what your hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.