ANDREW BROWN | EBITDAs Dos and Don'ts and Dissecting DCF

I love diving into the jargon to try and understand the metrics that truly matter when making financial decisions. In this episode I chat with Andrew Brown from East72 Holdings to debunk some commonly held beliefs about financial metrics and share insights on how to effectively evaluate a company's value.

First we look at discounted cash flow (DCF) valuations, a metric often authoritatively trumpeted by analysts as a way to value a business. Andrew argues that DCF is useless for valuing most companies: it's based on unfounded assumptions and crystal-balling and can be manipulated to fit any narrative, apart from those with predictable long-term cash flows like motorways or airports. Instead Andrew emphasises the importance of separating a company's operational performance from its financial structure. He uses the analogy of a corner store to illustrate how the same business can appear vastly different when financed with varying levels of debt.

And then there's EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Andrew agrees with the late Charlie Munger's assessment (bullshit!). He explains how EBITDA is an outdated proxy for cash flow, especially in today's accounting landscape. With changes in financial reporting standards, particularly the inclusion of leases on balance sheets. EBITDA no longer provides an accurate picture of a company's financial health.

Brown's preferred metric is free cash flow (FCF), which he believes offers a clearer view of a company's ability to generate cash after accounting for necessary expenses and investments. This metric, he argues, is crucial for understanding a company's potential to finance dividends and future growth.

Don't be fooled by shallow valuations. Whether you're a seasoned investor or just starting, understanding these concepts can help you make more informed decisions and avoid investing mistakes.

TRANSCRIPT FOLLOWS AFTER THIS BRIEF MESSAGE

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EPISODE TRANSCRIPT

Dissecting DCF

Chloe: Shares for Beginners. Phil Muscatello and FinPods are authorised reps of MoneySherpa. The information in this podcast is general in nature and doesn't take into account your personal situation.

Andrew Brown: We make X amount of money from running the business. You know, we sell X amount of stuff, it costs us Y to buy, we have to pay our employees and we pay the rent and that gives us a profit. And then we have to spend a bit of money upgrading our, ah, corner store each year. And so the free cash that comes out of it after that, I want to know what's that cash number at the end of each year?

Phil: G'day and welcome back to Shares for Beginners. I'm Phil Muscatello. You might have realised by now that I love looking at the metrics that experts use to size up listed companies. There's plenty of fancy sounding jargon for the various tape measures that will tell you whether or not a company is worth your hard earned dosh. Today I'm welcoming back Andrew Brown from East72 holdings to talk about his favorite barometers and yardsticks. G'day, Andrew.

Andrew Brown: G'day, Phil. Nice to be here.

Phil: Thank you very much for coming on. Now, I've been toying with the title of this episode and I was thinking about calling it I've never Met a metric I didn't like. Are, uh, there any metrics that you personally disapprove of?

Andrew Brown: There's actually lots, Phil. Probably my favorite metric I really disapprove of is discounted cash flow valuations.

Phil: Hang on, that's one I hear so many people talking about. They love DCF or discounted cash flow.

Andrew Brown: Absolutely. Yeah. They love discounted cash flow because you can fit any story you want to discounted cash flow just for, uh, the benefit of your listeners, Discounted cash flow is where you look out into the future and you project the company's cash flow, its free cash flow. And I'll talk about what that means. But let's just for the time being, just to get the exercise across, let's just say you project the company's profits and the cash that comes from that profits way out into the future. So most people do that. If they do a proper discounted cash flow, they will actually explicitly forecast 10 years of profit. And then from year 10 onwards, they do what's called a terminal value. Okay. And the terminal value is actually quite a simple calculation. It's the sort of things you do at school where you actually take the cash flow, you take an interest rate, you deduct the growth rate from it, you divide the first by the second and you get a number. And the reason discounted cash flow is such utter garbage is first of all that terminal value usually ends up being 70% of the total value. The second reason it's total garbage is you have to project 10 years out into the future. Now let's say you have a building materials company, try and project that 10 years out into the future. Do you know what housing demand is going to be? There's going to be at least one or two upturns and downturns. So they're going to make a lot of money over a couple of years and then maybe not do so well over a couple of years. So the only areas that discounted cash flow really works in are uh, long term assets. So uh, things like motorways, things like airports, with some caveats because obviously airports can move up and down a little bit, obviously if you have Covid and SARS and things like that. But by and large they have really, really predictable cash flows. So you can actually predict what a uh, motorway is going to earn 10 years from now with a reasonable degree of certainty. Whereas obviously, you know, trying to basically understand what a bank's going to earn 10 years from here or just a standard industrial company and certainly a retail company is pretty much impossible. So if people start throwing discounted cash flow or net present value at you and it's just a normal company, not a long term asset. Put the phone down.

Phil: It's interesting because you refer to the difference then between infrastructure companies because you can predict their cash flow because it is based on an actual number that they're going to be getting from tolls or governments or so forth. That's the way that works, isn't it?

Andrew Brown: It is indeed, yeah. I mean the big things with infrastructure companies are, uh, many of them, particularly if it's a toll road. There's usually some kind of inflation proofing for the toll road.

Phil: We've noticed that with every toll that we go through every six months you get that little sign up as you enter the tunnel.

Andrew Brown: Absolutely. To go from Sydney's centre to its west is about $17. Now if you use two toll roads, the Eastern Distributor and WestConnect, so. Or cross City Tunnel. Sorry. So yeah, there's sort of inflation proofing on those things which makes them a little bit easier to use. And also it's pretty predictable. Basically the amount of traffic once they're up and running just really correlates with the population. And now and again you get a Nice little bump because

00:05:00

Andrew Brown: there's a new suburb built that wasn't expected to be built adjacent to the toll road. And so of course that increases the number of people over and above what you would have otherwise predicted. But by and large, for normal companies, as I say, if somebody comes to you saying it's really, ah, cheap on a DCF basis, just wave goodbye to them.

Phil: Yeah, I've never understood that. How they can talk so authoritatively about a number that just seems to lie within so many uncertainties and predictions and, you know, putting your finger into the, into the wind.

Andrew Brown: One of the worst things, Phil, about DCFS and one sense about analysts in general, particularly what's called sell side or stockbroking analysts. What's amazing is most of them have a valuation of the company that's relatively close to the share price. I've been quite happy in at times when I've written about companies. I wrote to some people quite a few years ago about a company called National Hire Group, which is now part of Seven Group Holdings. So, uh, National Hire does basically plant hire and stuff like that. And the shares were trading at $1.20. They're relatively thinly traded. Two guys owned about 80% of the company. That was Kerry Stokes and Dale Elphinston, the richest man at the time in Tasmania. And shares were $1.20 and I thought they were worth $3.60. So imagine writing and you say to people, hey, these shares are worth three times what they're trading at. You know, uh, most people would have, you know, sent the man in white coats to come and, you know, lock me up. You know, because other analysts would have sort of said, oh, we've got a DCF valuation, there's a $50, you know, something like that. So what you find is analysts sort of cluster around the share price in terms of their valuation. Then when the share price goes up, guess what? Their valuation goes up. Why? Have they discovered something new about the company? No, it's just the share price has gone up. So you've got to be really wary, you know, of, uh, people that basically fix their valuation. And I do mean the word fixed, because you can fix the DCF any which way you want. You just change the growth rate of the cash. You change the discount rate at which you're discounting a dollar tomorrow back to today. You know, you Change it from 6% to 5% and instantly your valuation goes up. So those are the kind of things where, you know, if I see stockbroking research that's full of DCFs other than infrastructure and it's ilk, then, um, you know, I'm not interested. So that to me is, you know, just leave that alone.

Phil: When preparing for this episode, you said that you focus a lot on differentiating the business from how it's financed. What does that actually mean?

Andrew Brown: Well, what it means is basically I'm going to use a really simple example of a, uh, corner store. Okay? So basically if you own a corner store, you might have a corner store where you very much bought it outright. There's no debt in the business at all. You might rent the store, and I'm going to come back to that concept in a minute. But you basically run it. There's no debt, and so all the cash flow that comes out of the store basically, uh, belongs to you. On the other hand, you might own a corner store, but you've borrowed a lot of money to do it. And so when we look at the picture, uh, in totality, then what's the coolest store is going to do exactly the same? One assumes, of course, what the bottom line looks like is going to be very, very different. And the reason I differentiate the business from the financing of the business is that of course it is possible to change the financing of the business so that if you found it to be a little bit difficult to run the store because you were paying too much in interest, then what you can do is you can sell a little bit of the store, refinance, pay down the debt, and you still got the store. Maybe not 100% of it, but the business itself is not going to change a lot. And so that's why I try to separate the things out quite distinctly. And it also changes the valuation of the equity if you have a lot of debt, even though the underlying business is exactly the same. Can I give you a really simple example?

Phil: Please do.

Andrew Brown: In terms of just some numbers, let's say you have a business that makes $10 million a year in profit, and that's profit before interest or tax. Now let's assume you have no debt. So that $10 million is going to be $10 million of profit before interest. There's no interest, so it's $10 million of pre tax profit. You pay 30 cents in the dollar tax and so you'll make $7 million after tax. And the stock market might judge that business as being worth a 14 times

00:10:00

Andrew Brown: multiple. So seven times 14 is 98. So your store, the equity of your store because there is no debt, is worth 98. Okay. And so the total value of your store because there's no debt is 98. Now, that's the Muscatello store. Okay? Because Muscatello stores are, uh, very conservative.

Phil: And smart, but lots of olives and Dolmadis.

Andrew Brown: That's right, exactly. And then we have the Brown store, which is not selling Domatis and everything else. It's selling English sausages. So My store makes $10 million a year before interest and tax, but I've got $50 million of debt against it. So my $50 million of debt, I'm lucky enough to have a nice bank who only charges me 5%. So my $50 million cost me $2.5 million a year in interest. So the 10 minus two and a half becomes seven and a half of earnings before tax. The tax on that is two and a quarter. And so the after tax earnings is five and a quarter. So if we multiply by 14 times now, it may not be 14 times. That's about 73 in a bit. Just take my word for it. But the business has got 50 million of debt, so the equity is worth 73 in a bit, but the debt's 50. So altogether, Brown stores are worth much more than Muscatello stores. In total, the total value of the company is about 123 and a half. And yet the businesses are no different. They both make $10 million a year of earnings before interest and tax. And it's simply because we've applied and put some debt into it that makes the total value, that is the equity and debt worth a little bit more. Now, I've simplified it and assumed the after tax earnings are judged at the same price earnings ratio. In practice they wouldn't be. The Brown stores would be a little bit lower, but I can tell you they wouldn't be sufficiently lower to reduce the total value of the business on, um, exactly the same company. So that's why I separate out the financing from the underlying business.

Phil: So between these two stores, the Muscatello store and the Brown store, when you're evaluating a business, you're not valuing the Brown store as highly as the Muscatello business. Is that why, Although other market analysts might be, because of the amount of debt that it's.

Andrew Brown: Is that what I'm hearing at the bottom line? I wouldn't value it as high because it's riskier, okay? Because there's obviously more debt in it. So I wouldn't give it a PE of 14. I might only give it a PE of 12. But under most circumstances, the overall company will turn out to be worth m more in what's called an enterprise value sense. That is the value of its equity plus the value of its debt. And that's why I think it's really, really important that you sort out the financial structures of the company from the company's operating capabilities, the operating profits it makes. And that's why I do that.

Phil: And it's interesting as well. There's a shortcut as well. Can't you. You can look at the difference between the enterprise value and the intrinsic value, can't you?

Andrew Brown: You can indeed, yeah.

Phil: And that quickly tells you how much debt it's carrying, doesn't it?

Andrew Brown: That's correct. Absolutely right. Um, and what's important, Phil, is that when it comes to valuing companies, I often value companies by breaking them apart. They might have two businesses, not just one. And so I value each of the underlying businesses and then I deduct the amount of debt and then that gives me a value for the equity that if you see it written in a research report, it's called a sum of the parts valuation. Because I'm valuing business A, I'm, uh, valuing business B, and if there's a business C, I'm valuing that. I'm adding those values together, but then I'm deducting the debt of the overall, what would be a conglomerate at that stage, and working out a value for the equity. And so the value of that conglomerate is determined mainly by the values that I place on each of those under underlying businesses. Okay. And if I change those valuations, then the debt obviously is the same, but it's determined really by the underlying value of those businesses. I'd love to give you an example.

Phil: I was just going to ask, because I think we both love a beer.

Andrew Brown: We do. We both love a beer. Now this is a really good example for the listeners because this is really rare in Australia. It does not happen very often. I actually don't know another one I'm prepared to be corrected by someone that does. But there are very few companies in Australia that have a lot of debt. And where the banks that they owe that debt to take a haircut,

00:15:00

Andrew Brown: in other words, they agree not to get 100 cents in the dollar back.

Phil: Sorry, am I hearing right? The banks lose Money, the banks lose. And we're talking about, talking about Bogues Brewery here, aren't we?

Andrew Brown: We're going to come and talk about Bogues Brewery. You have to go back to 1996 to find this one, but it's Bogues Brewery. Now, what I should Add is banks don't take haircuts very often because they love administrators, so they appoint administrators. Bogues, back in sort of 1995, found itself in a bit of a tricky situation. It owned quite a few pubs in Tasmania, had 40% of the Tasmanian market, obviously against its mortal enemy, based down in Hobart. Bogues, of course, is in Launceston against its mortal enemy, Cascade, based in Hobart. And in a quirk, funnily enough, Bogues was actually the distributor for Cascade through the rest of Tasmania, which was very funny. So Bogues was actually controlled by a guy called Phil Adkins. Phil had taken a big equity stake in it. When it was mired in DEs, it actually had 200 million million of debt, and it was only turning over about $50 million a year. So you can imagine that wasn't going to work. So sold off some assets that weren't doing very well, and Phil managed to get the debt down to $102 million. But that was still a little bit uncomfortable. So in 1996, and it's the only situation I've seen, and as you imagine from the way I'm speaking to you, when the fund was running at the time, we couldn't buy enough of this stuff. Okay, and I'll, uh, explain why. So Bogues, before it took, got, uh, the banks to take a haircut, had 102 million of debt. The banks took a $50 million haircut, and Bogues raised, uh, $14 million from investors. Now, the share price before the raise was 45 cents. And it said to investors, look, you're getting the benefit of the haircut, so we want you to put Money in at 60. So the funds I running were part of the people who bought as much of this as we possibly could. So the debt came all the way down from 102 million to 38. And the business basically could service $38 million of debt because it was making about $5 million of, um, earnings before interest and tax. So within four years, the debt was still. This debt had been paid down a bit further. The debt got paid down to 8 million by the sale of some hotels, but the equity went up threefold. We got a takeover bid at $1.65 a share. And funnily enough, when you look at Bogues, after it had been recapitalized, the debt was 38 million. The value of the shares was about 36 million. And so the total value of the company was 74 million when it got taken over. The total value of the company when it got taken over was 100 million, of which 92 is attributable to the equity. And there's uh, only 8 million of debt left. And so. And the business didn't actually do that much better. It did a little bit better, but not that much better. So it only went up 25% in total value over the course of four years. But all of that accrued to the equity because the debt got paid down a bit further and the debt had been lowered. And so the business did no better. But because of the financial structure, the winners were the equity holders, and particularly the guys that put Money in at 60 cents and got bought out by San Miguel Eduardo Carranco, the big racehorse owner of the time at $1.65. Now, if you think Mr. M. Coanco overpaid, don't worry too much because seven years later he sold the whole shebang to lion Nathan for 325 million.

Phil: Wow. Not a bad deal. So the lesson is that the way the business is financed, how much debt that it holds, how much interest that it's paying, has a real material effect on the price of the share. What you're calling the equity.

Andrew Brown: Yeah, absolutely. Obviously, if you get a business that's not doing well and it turns round and it has a lot of debt in it, then the value of the equity will skyrocket. Okay. So that's why people often speculate on companies with a large amount of debt that they think will survive because the value of the equity will go up very, very sharply. Uh, the best example I can think of in more recent times was the shares of seven West Media. So that's Channel seven and the West Australian and some other bits and bobs they got down in Covid, I think it was, or just before they got down, they had a lot of debt, they weren't doing very well. The shares fell to 6 cent. But because the company started doing a bit better, the

00:20:00

Andrew Brown: shares went from 6 cents to 40 odd cents inside a year. So six times your money inside a year. Now, you know, they're still struggling, obviously, because the structural impulse on Freeway, uh, media. But there was a period of time where people thought that wasn't going to be quite as bad. The company were doing better because they had a lot of debt then that meant that a small move in the total value of the company all accrued to the equity. And so that's why people punting and speculating it wouldn't go broke, made a lot of money.

Phil: Wow. It's so, uh, counterintuitive thinking about that, that if a Company's not doing well and it's got a lot of debt because you're often told, look at the balance sheet, look how much debt's on the books, look at how much the company is making. That, I don't know, it seems intuitive that it wouldn't be a good stock to buy.

Andrew Brown: It sounds intuitive that it's not. But if it survives, if it's going to survive and just do a little bit better, that's the key. If it doesn't survive, clear, you know, you lose everything obviously, and that's the risk. And so they're the kind of companies, you might read an investment management report, you know, somebody's annual letter or quarterly letter, and they talk about having one or two lottery tickets, inverted commas in their portfolio. And they're the kind of things, it might be a highly indebted business that they think will make it through because of its cash flow characteristics or its positioning in its market. And so they don't have huge positions in the stock, they'll have a few pennies like if you will, a lottery ticket. And uh, so that's the kind of thing they talk about. And that's why again, dissecting the financing of the business from the underlying business is really, really important.

Chloe: Super. Is one of the most important investments you'll ever make. But how do you know if you're in the best fund for your situation? Head to lifesherpa.com to find out more. Lifesherpa, uh, Australia's most affordable online financial advice.

Phil: Okay, there's so much to take in there, but let's move on to ebitda.

Andrew Brown: Yes.

Phil: And why don't you think EBITDA is what it used to be, as in a proxy for cash flow?

Andrew Brown: Absolutely. First of all, and they may be a bleep on, uh, podcast. I want to quote the late great Charlie Munger and he has a one word description for ebitda, which is bullshit.

Phil: We're happy not to bleep that. That's okay.

Andrew Brown: Excellent. That's okay. It's Charlie Munger as well. If it's good enough for Charlie Munger, it's good enough for me.

Phil: Well, strong, strong words from such a taciturn man.

Andrew Brown: Absolutely. Now EBITDA, uh, really came into, uh, prominence in the 1980s. And why did it come to prominence in the 1980s? You remember may remember in the 1980s it was a decade of leveraged buyouts and junk bonds and all kinds of, you know, takeovers of companies to break them up and sell them off and reflux Them at, ah, a massive profit for the underlying person. So of course, you know, it's the 1980s that spawned Gordon Gecko and Blue Sky, Blue Star Airlines and all that kind of stuff. So why did they use ebitda? Uh, because at the time, and with the accounting conventions as they were at the time, EBITDA was a pretty good proxy for pre tax, pre interest cash flow. And if you're going to put a lot of debt into a company and uh, you know, with the intention of either selling it on or breaking it up or whatever, then that's, you know, as I've explained with some of my earlier examples, that's, that's your key thing, you know, it's what kind of cash does it produce before you start paying the banks, before you pay tax and before you have to reinvest in the business, the capital expenditure that you have, uh, even if it's just, you know, to repaint the store or to, you know, do whatever, let alone actually grow the business with new technology or anything like that. And I can assure you none of the entrepreneurs of the 1980s were interested in investing in new technology or anything else that just takes money out of the business. So that's why when you buy a business from those kind of people, you know, that you need to spend a heap of money on it because it's old fashioned, it's falling apart, but it's creating cash. Now why is EBITDA in 1985 not the same as EBITDA, uh, in 2024? It's because of this wonderful body called the International Financial Reporting Standards. And if there's one group of people I rail against its accountants because they've changed the rules to make things really difficult for people like me who will call securities analysts because they've changed two or three parts of the accounting rules which make things really difficult. So let's look at the first bit of that, which is the

00:25:00

Andrew Brown: d bit of EBITDA, uh, so depreciation, the accounting rules changed about four or five years ago. And if you're in Australia, it's called AASB 16 or uh, IFRA 16 if you're overseas. And what does that do? And one of our biggest, best known, in fact two of our biggest, best known companies basically were, you know, their balance sheets changed forever because of this and their coals and Woolworths. The reason why is that the accounting regulations now make you bring leases on balance sheet so that Woolworths had whatever financial debt they had. But obviously Woolworths rent the vast, vast majority of their stores, uh, as do Coles, as do most retailers. But your future commitments to pay rent to Westfield and whoever they uh, now have to be brought on balance sheet. And I can assure you in Europe it's the same thing. But European companies, when they talk about their debt, they include their leases. Now I don't think leases are debt. They're a community.

Phil: No, the corner stores that we're talking about, you'd think that it was just an operating cash flow situation.

Andrew Brown: So what happens now, Phil, is that if you look at EBITDA and you see a company quoting ebitda, uh, because of where it is placed in the cash flow statement, you don't pay any rent. EBITDA excludes rent because the rental payments, they're basically classified as in effect a debt repayment. So you see all these companies quoting EBITDA and there's no rental charge in it. It's nuts. And that's why most retailers, to be fair, you will see in a retailer's presentation, it talks about IFRS 16. Okay. Or before IFRS 16. Because the retailer knows putting out profit numbers without rental charges in a patently stupid.

Phil: God, this makes it really hard for the mug investor to work out exactly what a company is making, you know, compared to even you as a, as an analyst who's doing this day in and day out.

Andrew Brown: Yeah. For mum and dad who may have a little bit of, ah, certainly arithmetic experience, but may not be an accountant. If you go to the cash flow statement and you see operating cash flow, if I say to you my operating cash flow, I'm a retailer, I make X amount of money. The operating cash flow, as I say, does not include the rent. It's really stupid. So EBITDA, uh, certainly in 2024 is not the same as it was in 1985. And the other aspect about EBITDA, uh, and the other aspect about accounting, which is, you know, quite frankly is so out there, is companies are allowed to capitalize expenditure on software at the behest of their auditors. So you take for example, a company like, you know, it's very much in the news at the moment, but not in the news because of its accounts, more of its, how can I put it, the interest of its management of its chair.

Phil: We'll just leave it at that.

Andrew Brown: The company is Wise tech, okay? So every year, what you don't see it is in their cash flow statement. Uh, but Wise Tech every year. And it's a company that basically makes a pre tax profit of about 370 million every year, they exclude payments for intangible assets, which is software. They capitalize that. So when you look at their operating cash flows, that's not in there. So there's all these people I pay to, uh, you know, create these whiz bang programs and everything else. And I acknowledge they have a value for the future, okay, but that should be captured in the stock price, not in the accounts. And so they basically shove 173 million bucks of spend as investing activities. They don't, uh, charge it off in the, in the operating part of the cash flow statement, nor in parts of the P and L. So that's another crazy little thing that goes on now. And so, you know, if you have auditor A, who's a bit strict, an auditor B who just wants the accountant is quite happy to go out for dinner with you, then I can assure you the two bottom line numbers will be very, very different. And so what you're seeing bit by bit is that the ability to not just use the profit and loss accounts for companies because of the change in accounting regulations, but the ability to use the cash flow statements has got more difficult. And if, like me, your key metric at the end of the day is free cash flow from the business before we start refinancing or doing anything with it, but it's free cash flow from

00:30:00

Andrew Brown: the business, then I have to take, and obviously I'm very experienced and it doesn't take me very long at all, but I have to take every cash flow statement and I have to rearrange it. And ironically enough, I have to rearrange it back to what it looked like in 1985. Okay. So that we get a real business that the listeners this podcast would really understand, which is we make X amount of money from running the business. You know, we sell X amount of stuff, it costs us Y to buy, we have to pay our employees and we pay the rent and that gives us a profit. And then we have to spend a bit of money upgrading our corner store each year. We know we're going to have to do that. So we have to put that to one side. And so the free cash that comes out of it is after that. And uh, what I'm looking at as a key metric is what is the free cash that is attributable to the equity holders after paying debt interest and paying for capital expenditure. So keeping the store nice, to put it simply. And perhaps also, you know, putting in some new systems to make it even better, you know, so some type of better point of sale system. I want to know what's that cash number at the end of each year?

Phil: Yeah, it's like me, if I'm making the dolmadis, if I get a machine to make dolmatis that wouldn't be in there. Or if I then was producing virtual dolmadis, that wouldn't. Is this the kind of analogy we can make?

Andrew Brown: Yeah. If you buy a machine because it's got, you're going to be able to sell more damatis because you're going to make them much quicker, as much healthier than you rolling them in your hand anyway. So, um, yeah, that basically that's something insurance going to give you a better income stream going forward. And so one of the key things I always look for is what return a company? What incremental return a company's making when they buy a new DeMarti's Roller? Yeah, when they buy new equipment, property, plant equipment, what's the incremental return? And so what I do, Phil, is I calculate the free cash flow return on equity. So I look at the value of the equity, you know, see If I'm paying $200 for a business, I usually want to see if it's a reasonable business. I like to see somewhere between a 3 to 5, depending on the nature of the growth in the business. I want to see sort of 3, 4, 5% free cash flow return on the business, on the equity. And if I find businesses that are higher than that, I get really interested. Okay. Now sometimes, of course, they're higher than that because the businesses are being run down. You know, there's not much capital expenditure. You're running down your corner store. When the demartis machine breaks down, you're going to roll them by hand again. You don't want to spend any money on it because you're going to try and sell it on to someone else. Okay. Uh, and get as much fruit as you can. So I'm cognizant of what, you know, companies, investors into, new equipment. But that's the key thing to me because that at uh, the end of the day is what you're buying the equity for, because it's that that's going to finance your dividends. You know, it's that free cash flow that finances the future growth of the business, not some other fancy pants thing. So that's what I'm really looking for if I'm going to buy shares in any kind of business.

Phil: Can I just clarify, A few moments ago you talked about a 3 to 5% figure. Is that the amount to be Spent on capital expenditure. Is that what you were.

Andrew Brown: That is the amount of money that comes out of the business after the spend on capital expenditure, if you will. To make it easy, it's net profit after tax minus capital expenditure. But rather than using the profit numbers, I use cash flow numbers. Okay. Because I find them, you know, by rearranging the cash flow statement, I find that a bit more useful because, you know, profits obviously can be adulterated in various ways. You know, the use of provision, accounting and things like that. So I tend to do it on a cash flow basis. And if you think about it, if I'm getting 5% free cash flow return on the price I'm paying for the equity, okay, so not the equity that's in the account. This is the market value of the equity. You know, the number of shares times the share price. If you think about it, what I'm saying is if I can get 5% in the bank and I can get 5% free cash flow return on the price of the equity, that's kind of equivalent. But I'm going to get growth from equity. So if you will, I'm paying a sort of bank interest rate for cash flow, but getting the growth as well. So that's usually a pretty good deal.

Phil: Let's get to talking about Led Zeppelin, which we always like talking about on this podcast.

Andrew Brown: Absolutely.

Phil: Now, have you heard of Rick Rubin, the music producer?

Andrew Brown: I've heard of him, but I don't know too much about

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Andrew Brown: it.

Phil: Oh, he basically, he was one of the founding fathers of hip hop music. He produced the Red Hot Chili Pepper albums, Tom Petty, many. But the last few albums of Johnny Cash, which you might be aware of, he was the one that revived Johnny Cash's career as well. And I was watching an interview with him and he was talking about the way musicians will take music and then turn it into something else. And he gave the example of Jamaica, which is a great Led Zeppelin song, which is Led Zeppelin's version of reggae. And it doesn't sound like reggae, but it's reggae ish, you know. So in terms of putting together your own suite of metrics, I mean, it sounds to me like that you actually have your very own bespoke version. It's like your version of reggae.

Andrew Brown: Absolutely.

Phil: Do you think people and investors need to put together their own version of metrics, or should they be playing cover versions for the rest of their lives?

Andrew Brown: I think what you have to do is, uh. I'm going to sit a little bit in the middle here, Phil, because I think what People have to do is they have to have metrics they're comfortable with. They have to have metrics that, you know, outside of really complex businesses that they can pick up the accounts and they can calculate themselves and they can not just calculate them, but they can understand what that calculation really means and really means, you know, to their investment in that company. It's hard doing metrics on things like infrastructure. You're very much reliant on the fact that infrastructure businesses are, uh, by and large great businesses once they're up and running and mature. And you know, the complexity of the companies underneath it are unbelievable because they put each of the assets in a separate structure and they refinance the structures. And uh, that's a bit of a nightmare for the average retail, uh, investor to do. But you know, if you've got things like some of the companies I don't invest in very often, but when I do usually do, okay, is retail. Now I use all kinds of metrics on retail and the companies by and large give you plenty of metrics to actually work with. Retail is great. I love retail because most people don't realize why they make Money out of retail. It's because it's very, very geared operationally now. You get extra dollars of sales and they fall to the bottom line. And uh, of course if you lose dollars of sales or go discounting, it takes away from the bottom line really quickly because your costs are all fixed. It's rent, it's people, it's insurance and things like that.

Phil: Rinse and repeat.

Andrew Brown: Yeah, absolutely. And so the only thing that changes is your top line margin. Like, uh, can you charge a bit more for selling the same thing or can you buy it a bit cheaper or whatever it is. Once you've earned the top line margin, then what comes out after that is very, very fixed cost. If I can give you good, practically example in the stock market. One of my favorite retail stocks from a few years ago and all my interns that work for me used to get this as an exercise was baby bunting. Mainly because at the time, and it's not the case now, baby bunting had relatively little competition. A lot of competition had gone broke. So it was the, if you. It was the bunnings of baby wear and baby wear and baby gear has particular characteristics about it. Mummy doesn't accept cheap babywear. Let's put it simply like that.

Phil: Don't get me started on car seats. How much the car seats cost and how long you've got to have them these days.

Andrew Brown: That's Right. And what was going on with baby bunting is that they started to make a ton of money because they had the benefit of two or three things. They were opening new stores. Retailers opening new stores usually are pretty damn good because it doesn't cost if it's a good concept. They don't take very long to recoup the capital expenditure on fitting out the new. Your store take about two years to mature. And then all of a sudden it's, it's brilliant, it's money printing. But what you found when you modeled, when you financially modeled baby bunting, I had my boys and girls who came to do this. They all realized very suddenly, number one, it was so reliant on its top line gross margin, which used to be 34%. It briefly went to 40, which is why the shares went from a dollar odd to $4 plus. And of course they tumbled all the way back. And the reason they tumbled all the way back was because their margin got crunched from 40 back down into the 30s again. And they've expanded. There are a few other issues and the accounting by baby bunting is a bit quirky too. And there's a lot more competition now, unfortunately for them. But you know, with retail, I look at things like sales per square meter, sales per store. You can actually work out rent per, per store because none of them own their own stores, they'll rent them. You could work out a whole bunch of things like that. And it starts to tell you really quickly whether uh, the retail is only growing because it's opening new stores, but it's existing networks going nowhere. If it's existing networks doing quite well and it's opening new stores, you have a recipe for, you know, a bit of a firecracker. And it'll usually do well, at least for a picture period of time, you know, until competition comes in or something in the economy happens. So yeah, with retailers, find as many metrics as

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Andrew Brown: you can. And Woolies and Carls are really good. They give you all kinds of stuff, you know, store numbers, they even give you square meterage and things like that. So you can use very specific things like that to get out, you know, so you can analyze various parts of the businesses performance. So when it comes to the bottom line though, I mean my favorite by a long way is what I described to you, which is free cash flow. So basically all the cash that comes out of the business minus the capital expenditure and then divide that into the market value of the company and what kind of yield I get out of that and that's what turns me onto things. I'm cognizant when I do that of what kind of business it is. In the fund I run at the moment, I run quite a few hotel. I actually own quite a few hotel stock now. They're the kind of hotel that I'm very, very much willing for you to pay for me to have a night in, Phil. You know, sort of Peninsula in London. That's about two and a half grand a night. Pounds. Yeah. Hotels are fixed cost businesses and you have to reinvest in the hotel. You know, you've got to paint it up especially if you're charging that kind of money. And so you know, I'm very cognizant of uh, when I invest in a hotel company it's fixed cost. If the occupancy goes down, they start to lose money pretty quickly. But I'm very cognizant. I invest in those on that metric free cash flow return on the market value of the equity. And I've got a couple of others in France where they're high end hotels as well. So they're the kind of things I look at. They're the kind of thing I especially look at when you just get run of the mill, if I can call them that. Businesses that, you know, that make widgets and digits and sell widgets and digits and things like that. So that's my real go to. But I do use a variety of other metrics obviously. But that's the one before I really get interested in um, putting hard earned dollars to work. That's the biggest cost check.

Phil: Well Andrew, thank you for bearing with my tortured musical analogies but I think, I think I'll be starting the Andrew Brown tribute band and do the covers rather than trying to be a completely original band in this instance.

Andrew Brown: That's right. Well you won't have Andrew Brown and that's his voice and drum skills are uh, absolutely appalling.

Phil: Fantastic. Andrew Brown, thank you very much for joining me today.

Andrew Brown: Thanks Phil, really enjoyed it as always.

Chloe: Thanks for listening to Shares for Beginners. You can find more@sharesforbeginners.com if you enjoy learning listening, please take a moment to rate or review in your podcast player or tell a friend who might want to learn more about investing for their future.

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