Understanding Investing Vocabulary

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Understanding Company Financials: A Plain-English Guide to Making Smarter Investment Decisions

Hey everyone! So, if you’re interested in learning more about investing in great businesses, it is crucial you know some vocab.

While financial reports might seem like a maze of numbers and jargon, understanding them is simpler than you think. Let's break down what really matters.

I promise it isn’t as complicated as you may think. Once you understand, it makes researching these companies and subscribing to this publication well worth it!

The Three Key Financial Statements

Think of a company's financial statements like your personal finances:

• The Income Statement is like your paycheck stub (what you earned and spent)

• The Cash Flow Statement is like your bank account activity (money moving in and out)

• The Balance Sheet is like your net worth statement (what you own and owe)

Let's dive into what really matters in each one.

Revenue: The Starting Point

Revenue is simply how much money a company brings in from selling its products or services. But here's something important: not all revenue growth is created equal.

There are two types of growth, and understanding the difference is crucial for long-term investors:

Organic Growth: This is when a company grows by doing more of what it already does well. Think of Adobe. When they grow organically, it means:

• More designers subscribing to Creative Cloud

• Existing customers upgrading to premium features

• New products attracting new customers

• Higher prices as their products become more valuable

This type of growth is usually more sustainable because it comes from the company's core strengths. Adobe doesn't need to make big, risky bets - they just need to keep making their products better and reaching more customers.

Inorganic Growth: This is when a company grows by buying other companies. AT&T provides a perfect example of how this strategy can go wrong. Over just a few years, they made several massive acquisitions:

• Bought DirecTV for $67 billion in 2015

• Acquired Time Warner for $85 billion in 2018

• Took on enormous debt to fund these purchases

While these acquisitions instantly made AT&T bigger, they created massive problems:

• Accumulated over $180 billion in debt (more than the GDP of many countries!)

• Had to cut their cherished dividend for the first time in 30 years

• Struggled to integrate traditional telecom with media businesses

• Failed to adapt to streaming fast enough as cable TV declined

• Faced intense competition in media while core business weakened

The end result? AT&T had to unwind almost everything:

• Spun off DirecTV in 2021 for about $16 billion (a $51 billion loss)

• Spun off WarnerMedia (formerly Time Warner) in 2022, merging it with Discovery

• Their stock price dropped from over $40 in 2016 to around $17 in 2023

Here's why this distinction matters: Research shows that about 70% of major acquisitions fail to deliver expected returns.

Why? Because buying a company is easy - successfully integrating it is hard. Think about it: If you're paying a premium to buy a company, you need everything to go perfectly just to break even.

That's why I prefer companies that primarily grow organically. They might grow slower, but they're:

• Less likely to overpay for acquisitions

• More likely to stick to what they do best

• Usually more financially stable

• Better at creating long-term shareholder value

This doesn't mean all acquisitions are bad. When a large company makes small, strategic purchases (called "tuck-in" acquisitions) to add specific capabilities or technologies, that can work well. I think of Mastercard when it comes to this.

But when companies rely on big acquisitions for growth, it often ends badly for investors.

Understanding Profitability

Let's talk about the three key measures of profitability, from broadest to most specific:

1. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)

Think of this as the "raw" profitability of the business before accounting items. It's like looking at your salary before taxes and other deductions. While it's not perfect (companies still need to pay taxes and interest!), it helps compare companies' core operations.

2. Free Cash Flow

This is my favorite metric - it shows how much cash a company actually has left over after paying for everything it needs to run and grow the business. Think of it as money that's truly "free" to:

• Pay dividends

• Buy back shares

• Invest in new opportunities

• Pay down debt

It's like having money left over after paying all your bills and saving for future expenses.

3. Net Income

This is the "bottom line" - what's left after ALL expenses, including taxes and interest. It's like your take-home pay after every possible deduction.

When you're investing, net income helps you understand earnings per share (EPS) - a crucial metric that shows how much profit is available for each share.

It's simple math: take the net income and divide it by the number of shares.

For example, if a company makes $1 billion in net income and has 1 billion shares, that's $1 per share in earnings.

What makes EPS powerful is watching it grow over time. Companies can increase EPS in two ways:

• Grow net income (make more money)

• Reduce share count (through buybacks)

The best companies, like Apple, do both. They consistently grow profits while buying back shares, creating a double boost to EPS growth.

Margins: Understanding Efficiency

Think of margins like a sandwich shop:

Gross Margin: If you sell a sandwich for $10 and the ingredients cost $4, your gross margin is 60% ($6/$10). This tells you how efficiently a company turns raw materials into products.

Companies like Adobe have gross margins around 90% because once they've created software like Photoshop, it costs almost nothing to sell another copy.

On the flip side, Costco has much lower gross margins (around 11-12%) because they're selling physical products and intentionally keep prices low for members.

So when comparing companies make sure they are in the same industry.

Operating Margin: This includes ALL costs of running the business - staff, rent, marketing, everything except interest and taxes. Going back to our sandwich shop, if you have:

• $10 sandwich price

• $4 ingredients

• $3 in staff, rent, and other costs Your operating margin would be 30% ($3/$10)

Profit Margin: This is what's left after everything - the real money you get to keep.

If taxes and loan payments take another $1 from our sandwich, the profit margin would be 20% ($2/$10).

Cash and Debt: The Safety Net

Remember 2020? Companies with strong balance sheets like Nike sailed through just fine, with over $9 billion in cash and minimal debt. Meanwhile, Boeing, which had taken on massive debt for aircraft development and share buybacks, needed a $30 billion rescue and had to suspend its dividend for the first time in 78 years.

Think of it this way: A company with cash and no debt is like someone with savings and no credit card bills. They can weather almost any storm. A company with lots of debt and no cash is like someone living paycheck to paycheck with maxed-out credit cards - one setback could spell disaster.

Return of Capital: Giving Back to Shareholders

When companies make more money than they need for operations and growth, they can return it to shareholders in two ways:

Dividends: Direct cash payments to shareholders. Like a landlord collecting rent.

Share Buybacks: The company buys its own shares, reducing the number of shares outstanding. This means each remaining share represents a larger piece of the company.

Think of it like this: If you own 10% of a pizza and someone else's slice gets bought by the pizzeria and thrown away, your 10% is now a bigger piece of what's left.

Key Business Expenses to Watch

1. Capital Expenditures (CapEx): Money spent on physical assets like buildings, equipment, or trucks. Amazon spends billions on warehouses and servers - that's CapEx.

2. Research & Development (R&D): Money spent developing new products or improving existing ones. Tech companies often spend heavily here.

3. Sales & Marketing (S&M): Money spent getting customers. Software companies often spend a lot here to grow.

4. General & Administrative (G&A): The overhead - management salaries, office costs, legal fees, etc.

Putting It All Together: What Makes a Great Company?

After looking at hundreds of companies, here's what the best ones tend to have:

1. Strong organic revenue growth (not just from acquisitions)

2. High free cash flow relative to revenue

3. Expanding margins over time

4. More cash than debt on the balance sheet

5. High return on capital (they use money efficiently)

6. Reasonable expenses relative to revenue

Take a company like Visa:

• 70%+ gross margins

• Strong free cash flow

• Minimal CapEx needs

• Clean balance sheet

• Growing organically

This is why great investors often say "it's better to buy a wonderful company at a fair price than a fair company at a wonderful price."

The Bottom Line

You don't need to be an accountant to understand company financials. Focus on:

• How they make money (revenue)

• How much they keep (margins and cash flow)

• How efficiently they operate (returns and expenses)

• How safe they are (cash vs debt)

The best companies score well across all these metrics. They grow organically, generate lots of cash, maintain strong margins, and keep a healthy balance sheet.

Remember: Complex financial statements exist to tell a simple story - how good is this business at making money and using it wisely? Once you understand these basic metrics, you'll be amazed at how clearly you can see the difference between great and mediocre companies.