All Revenue is Not Created Equal with Brian Feroldi
FEATURING: BRIAN FEROLDI
Revenue that is:
Deserves a MUCH higher P/S ratio than revenue that is:
— Brian Feroldi (@BrianFeroldi) September 21, 2020
Q: You’re constantly stressing the importance of long-term investing in your work for the Motley Fool and your newsletter. What are your tips for investors to keep a long-term view in the face of market uncertainty?
A: Investors need to focus on what drives stock market returns in the long-term: earnings. The problem is we only get feedback on changes in earnings every 90 days, but we get feedback on changes in stock prices every second the market is open. This is why looking at the day-to-day price movements of the stock market can be a huge distraction. My biggest tip for investors is to focus on the business results and do their best to ignore day-to-day market gyrations.
Q: With a long-term investing perspective in mind, how can you analyze a company’s revenue to ensure you’re making a smart investment? How does revenue fit into your scoring system?
A: All revenue is not created equally. As an investor, low-margin, one-off sales are worth much less to me than high-margin, recurring sales. I ask myself questions like: Is revenue recurring? Is it cyclical or recession-proof? Does it grow organically or through acquisition? Is there room to raise prices? What keeps customers loyal?
Revenue growth is the engine that drives profit growth, and profit growth is the engine that drives stock price appreciation. This is why I allocate a large number of points in my ranking system to analyzing the quality of a company’s revenue.
Q: In the chart above, you compared Mastercard’s (MA) revenue to that of Ford (F). Why do you see Mastercard’s revenue as “recession-proof”? Does your view on MA’s revenue lead to high conviction in the stock?
A: There are so many benefits to paying electronically instead of with cash or check. The world has been moving away from cash or checks and toward credit and debit cards for years, and the trend is likely to continue for decades. What’s more, once a consumer has a Mastercard card in their wallet, they use that card again and again to make everyday purchases, even when times are tough. These factors have allowed Mastercard’s revenue to consistently grow over the years, even through recessions. That’s incredibly attractive to me, which is one reason it is such a high-conviction stock for me.
By contrast, companies like Ford sell high-cost, low-margin, infrequently purchased products. Ford needs credit markets to be open to sell cars. Ford also needs the economy to be strong for it to sell even more cars and drive revenue growth. These are unattractive qualities to me as an investor. By looking at long-term revenue charts, I can quickly get a sense of whether or not a business generates what I call “high-quality revenue” (like Mastercard) or “low-quality revenue” (like Ford).
What are the first 5 metrics you look at when evaluating a new stock?
1) 5-yr chart vs. S&P 500
2) Long-term Revenue Growth
3) Profits (Net Income & Free Cash Flow)
4) Market Cap
5) Total Addressable Market
— Brian Feroldi (@BrianFeroldi) September 30, 2020
Q: Your tweet above shows key metrics you look at when evaluating a new stock. How do these metrics inform your long-term investing approach?
A: First, I look at a 5-year comparison chart of the stock vs. the S&P 500. I firmly believe that “winners keep on winning,” so I get excited if I see that a stock has crushed the market. If it has lost badly, the odds are good that something has gone horribly wrong, and I usually pass.
Second, I analyze the long-term revenue growth. I want to see consistent growth over long periods of time and through recessions. If that happens, the odds are good that I’ve found a good business.
Third, I look at net income and free cash flow. I want businesses that consistently generate both, and grow them over time. If they are not generating either right now, that’s okay, but I want to understand why. I also need to believe that the losses are temporary and the company will flip to profitability in the next few years.
Fourth, I look at market cap. In my view, big companies have a harder time doubling or tripling than smaller companies do. For that reason, I try to invest in businesses with market caps under $10 billion.
Finally, I look at the company’s total addressable market opportunity. Ideally, the company has captured less than 1% of its potential. That means that it could grow at a double-digit rate for years.
If I find a company that has beaten the market, consistently grows revenue, generates profits, has a small market cap, and has lots of room to grow, odds are I’ve found a great investment.
Q: YCharts has been part of your analysis process for a while, how has the platform improved your stock research and enabled you to better communicate your insights on social media and in your writing?
A: Charts are amazing tools for telling stories and detecting long-term patterns. I use YCharts daily to see trends in revenue, margin, profits, market cap, and more.
YCharts also makes it incredibly easy to share visuals on social media platforms. You can look at a chart in a few seconds and understand a key point quickly. That makes YCharts an invaluable tool for researching stocks and building a following on social media.