Value Investing In Your Car Episode 60 – Amazon’s FCF Use And Capital Allocation

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Value Investing In Your Car Episode 60 – Amazon’s FCF Use And Capital Allocation

Value Investing In Your Car Episode 60 – Amazon’s FCF Use And Capital Allocation


so here’s a big question you’re
interested in value investing and valuing and evaluating businesses on a
deep level but you don’t know how even after researching for hours probably
dozens of hours hundreds of dollars on the internet and because nobody else
shows you how to do it this podcast has all those answers and much more about
value investing in finance my name is Jason Rivera
welcome to value investing in your car hey Jason here and today’s episode of
value investing in your car I’m going to recap another call I had with a client
about capital allocation this time talking about Amazon and specifically
Amazon and how it uses its profits to allocate capital well and how this leads
to it’s also paying little taxes for its size before we get to that I need to let
you know this part of this video is available as a podcast in the world
world for free as a podcast on all major podcasting platforms Amazon our
SoundCloud stitcher iTunes anchor and more any major podcasting platform by
investing in your car episodes are available on that for free anywhere in
the world so last week this time last week or the week before I recap the
phone call I had with a client about capital allocation specific capital
occasion decisions based on real-world examples from his business how I would
all it helped them allocate capital we had another talk after that on the phone
about Amazon there’s been this huge news about Amazon and either about how
they’re taking over the world and how they’re making essentially how they’re
taking over the world or how they’re paying little to no taxes
for their size we talked about all that in this in this talk so I want to earn
this call so I want a recap this so first off the client sent me an
article that they found on box which I’m going to share with you if I can find it
where is it okay I cannot find it right now I will
link it below in this article when I do find it yeah I don’t see it anywhere I
thought I had it on my tabs I do not so I apologize for that but I’ll link it
below this video in the podcast so you can get to this article the article is
fantastic there are so many nuances to the whole thing
that it’s kind of amazing and actually just found it as I was looking around
over here and let’s share the screen oops okay
so here we are this article fantastic article again I’ll link it below and
I’ll have my team link it below this but it came out August 21st so as of this
recording about two and a half three weeks ago 2019 and the client found this
I want to talk about it so you see this Amazon’s profits it’s showing almost
zero profits blah-blah-blah-blah-blah two point six
three billion according to this compared to sales of sixty three billion so
Amazon reports poor profits on a pretty much yearly basis which leads most
people to think that they make no money it’s gonna be farther from the truth
so this is where this comes in free cash flow again I’ve talked at length why
don’t like profit or earnings which is net profit and why I prefer free cash
flow operating our income and owners earnings this talk and what I’m gonna
recap for you today is a perfect illustration of that so their profit
down here is 2.63 billion compared to sales of sixty three billion so what’s
that a net profit margin of less than five percent not good right for a
trillion dollar company but their free cash flow to sales ratio is about forty
percent if my mental math is correct that is insane most companies I consider
good to great if they produce five percent free cash flow to sales margins
over a consistent basis Amazon’s lately or as of the last year at least quarter
was that the data looks like it goes to I would assume since the article was
written in August did those two last reporting quarter so free cash flow of
about forty percent margin again insane so how how
how does this affect it and why is this important first let me bring you back
over here to me okay there we are so why is this important first of all it
illustrates why I don’t like net profit that profit you can make it pretty much
anything you want if you have good enough accountants good enough lawyers
and you’re smart enough you can make the number whatever you want and here is why here’s why
Amazon looks like they’re not profitable they put all of their money into capital
expenditures or most of their money into capital expenditures reinvestments in
the business to grow businesses acquire things like Whole Foods Zappos things
like that to continue building their competitive advantages and taking over
the world and that profit doesn’t account for any
of that net profit is all let me get the specific definition here so I don’t
screw it up because I don’t know I don’t follow I don’t follow net profit very much or I
don’t use net profit at all but I know what it means but I don’t know what the
book definition is okay the actual profit after working expenses not
including the calculation of gross profit have been paid so that’s a
terrible definition by Google let’s go to investopedia okay net profit is
revenue minus cost of goods sold – operating and other expenses –
interest – taxes so especially if you have debt and whatever company based
taxes if they’re profitable you can make this number whatever you want which makes it far easier to manipulate
and make it look like whatever you want it to look like so this is these are
some of the many reasons I don’t like net profit or earnings or profit that
all these things mean the same thing so if you want to learn more about that go
to my articles that should be linked below this about why I don’t like the
net net profit because I don’t want to get in that again today but if you want
that information go to those pages so that’s the main reason I don’t like them
profit if you can make it whatever you want here’s a perfect example net profit
is on the bottom of the income statement it’s after subtracting operating
expenses cost of goods sold cost of revenue all these things taxes interest
the things I just mentioned it’s after expensing all of these cost so it’s at
the bottom of the income statement right it’s a cash flow statement you take the
net profit from the bottom of income statement and you move it to the top of
the cash flow statement and you start subtracting and adding things from there
like capital expenditures debt issuances share issuance is payments on interest
stuff like that capital expenditures you put those on the cash flow statement so you add and subtract from the net profit
number to get to your free cash flow number if you have free cash if you have
positive free cash flow that is and you have excess money left over after
investing in businesses so this is the brilliance of Amazon and frankly
berkshire hathaway as well is berkshire hathaway is the same thing they don’t
show as nearly as profitable as they are because they reinvest their profits from
the businesses from their other businesses into either cash or buying
other businesses or reinvesting in those other businesses that they already own
that doesn’t show up in the income statement a capital expenditure
expenditures do not show up on the cash flow statement it’s a big deal right for
most companies so net net profit to go back a little bit is also after taxes
operating profit is before taxes net profit is Africa taxes so free cash flow
is after taxes as well because it comes from the bottom of the income statement
to the top of the cash flow statement so while Amazon does pay profits on its
net profit it doesn’t pay prop or pay taxes on its free cash flow technically
it does at the bottom level but not at the top after adding and subtracting all
these things and this is where Amazon and Berkshire Hathaway gain they’re huge
advantages because they are businesses that they own produce so much cash even
after investing in capital expenditures and buying other assets their businesses
produce so much excess cash flow that doesn’t show up again doesn’t show up on
the net profit statement they produce so much cash flow that they don’t pay taxes
on that portion of their capital expenditures and frankly why should they
if you’re making a capital expenditure you don’t know if it’s going to work out
how I don’t even know how they would tax you making capital expenditures that
would disincentivize companies to make investments in their companies and to
growing their companies I don’t even understand how governments would do that
so without a major major major issues so but this is where Berkshire and Amazon
get their get their excess cash flow from they use the net profit again from
the income statement make capital expenditures buy sell things add to
investments by investments make capital expenditures and their businesses issue
shares issue debt whatever plus or minus all those things and you come up with
the free cash flow number after cut these kind of capital expenditures and
other costs so this is called increase for the other things not capital
expenditure specific there increases and decreases in investing activities is
usually what they’re with their term best for financial financial increased
decrease in financial instruments or something like that so this is how even
though Berkshire and Amazon aren’t as profitable as they look on the first
level this is how they continue to grow and grow and grow and grow exponentially
they use their money efficiently this is only possible or only it’s only done
well over the long term if you invest your capital wealth which is capital
cash the capital allocation will we’ve been talking about for last several
weeks if you invest your excess capital well you’re in this case free cash flow
it compounds exponentially increase the value of your company and gives you more
and more cash flow this is why Amazon is as of this recording either a trillion
dollar company or close to a trillion dollar company this is why Berkshire
Hathaway or this is how Berkshire Hathaway grew from 100
to a million or a hundred thousand dollar initial capital when Buffett
started his partnership to a five hundred thirty billion dollar plus
company because they understand capital allocation they understand free cash
flow you see online people freaking out because Amazon does it pay taxes and you
even see this from presidential candidates that’s not true they pay
taxes on their net profit but they reinvest so much of their money well
well is the keyword they remus so much of their money well
that it produces even more free cash flow but they aren’t taxed on this part
of it until they either sell the entity or it earns them more net profit or
whatever but in terms of that portion of money they’re investing well and they’re
returning capital their investors are there to the shareholders increasing the
value of their shoulders increasing the value of the company they’re growing the
company all great things but you’ll see people and again most people understand
this kind of stuff they just see that Amazon is paying XYZ taxes and the two
trillion dollar company oh they’re not paying taxes that’s not how it works essentially if you were to tax capital
expenditures which is what you would essentially have to do for these kind of
companies you would disincentivize them from growing which of course is a
horrible thing it wouldn’t make much sense so but this is how if you
understand great cap allocation this is why it works so well because you’re
earning money here that you pay taxes on that’s making hopefully a lot more money
over time over here that you’re not paying taxes on and tell it either goes
to income statement or you sell the entity perfect example of this See’s
candy due to accounting rules and regulations worldwide these can be if it
still showed up on Berkshire Hathaway’s annual reports
doesn’t because it’s so small would still show up as only a twenty five
million dollar net or value of the company because that’s what they paid
for you due to accounting rules and regulations and tell you go to sell
something you list it as the value you paid for it so they paid twenty five
million dollars for cease candy in 1972 I sense that time See’s candy has earned
more than two billion dollars in operating profits two billion dollars
plus and operating profits for a business they paid twenty five million
dollars for but it still shows up as only twenty five million dollars due to
accounting rules this is why if you’ve ever heard about that say the true value
of Berkshire Hathaway doesn’t show up in the balance sheet or on the in our
financial statement it’s because this doesn’t show up anywhere on the
financial statements other than I think it might show up as deferred taxes but
even then I’m not quite sure about that it shows up in their financial
statements in terms of free cash flow production and operating profit
production but in terms of an like an asset physical asset on the balance
sheet only shows up as twenty five million dollars then show up according
to current accounting rules and regulations and less they go to sell
sees candy it will always be worth twenty five million dollars even though
again it’s worth well more than twenty five million dollars if it’s earned more
than two billion dollars since 1972 an operating profit this is yeah the client
I was talking with where we were talking about this kind of stuff and he said
this makes complete sense why don’t most people do this or why don’t most people
talk about this because it takes a little bit more time and it’s a little
bit harder to understand then hey this company earned XYZ net profit and this
year they paid XYZ taxes that’s pretty straightforward
again that’s not you can manipulate net profit most people don’t knew that but
that’s pretty that’s a lot more straightforward than what the talk we
just had about cash flow and capital expenditures and issuing shares and
issuing debt and stuff like that that’s more straightforward
another reason is because pretty much every financial website blog magazine
newspaper in the world reports earnings were net profit they don’t report what
operating profit and very rarely we see them talking about free cash flow so why
is that a again it’s as partly to do with what we just talked about it’s
easier to understand these other two concepts be most people in financial
institutions and universities are taught about net profit not about free cash
flow or operating profit most business owners don’t know anything if you talk
to them about free cash flow or operating profit they talk about profit
or earnings which is on the P&L statement if you’re a private company or
on the income statement if you’re a public company again why it’s not taught
right it’s far easier to understand these other cons are to understand that
profit versus these other concepts and frankly most people just don’t know
about this kind of stuff they don’t take the time either to learn it or they
don’t care they just want to take the easy way out one of the two so we were
talking about this and he said this makes so much sense in your
experience dealing with companies and researching companies over the last 12
years and dealing with private companies how much how many people know about this
at all business owners executives whatever very
few I can prove that because very few companies in the world talk about ROI C
and their financial statements and free cash flow they do to a degree because
they have to in terms of free cash flow if they talk about it at all most talked
about just cash in the bank which is different from free cash flow and this
is another topic we so what’s the difference between the core I’ll go back
to the other point what is the difference between free cash flow and
cash on the bank free cash flow or cash in the bank is cash you have on hand
right now that you can use to do whatever you want with free cash flow is
money you’ve earned in from your operations after after subtracting
things like capital expenditures you can use this money to invest in your
internal operations marketing buying other companies whatever but it’s not
cash you have in the bank right now it’s cash more in the business so to get back
to the point I was making earlier free cash flow is talked about to a degree in
financial statements most of the time it’s cash on hand cash in the bank
something like that ROI C is very rarely talked about in financial statements
it’s almost always net profit margin sometimes operating profit margin and sometimes very rarely our return on
equity are we they’re very and this goes all the way
up to public companies most public companies don’t even talk about our ROIC
and which is just absolutely insane to me because our OIC is there have been
studies and I think was Michael Mauboussin
who said the only way to raise the value of your company over the long term in a
healthy manner is to increase ROI see and very few again even public companies
talked about this they talked about growing that profit they gonna talk
about earnings which are the same thing they talk about expanding revenue all of
these things frankly I don’t care about revenue growth great if it’s healthy
what does that mean if you’re growing revenue at 10x for example but you’re
only growing operating profits at 1x you have a major problem
because eventually those will even out and your profits and the value of your
company is based on your profit of profitability in this case it would be
earnings even though I don’t like that in this case will be earned if your
revenue growth is say 10% a year and your profit growth is only 1% a year
you’re not able to control your cost or you’re not controlling your cost you may
be able to but you’re not doing it that again companies are based they should be
based on their the value that value should be based on their profitability
not the revenue this is why I always find companies like Amazon Facebook
Twitter Boober these kind of new tech companies this is why I always find them
under value or massively overvalued because they’re not profitable in a real
world what I consider a real world sense cash in the bank cash on hand with free
cash flow money you can actually use operating profits money you can actually
use to their other business so these are some of the things we
talked about during this hour plus long phone call is we talked about the
importance of free cash flow Amazon taking over the world because of their
knowledge of cash flow and their knowledge of proper capital allocation
the difference between free cash flow and cash from the bank income statement
versus free cash flow statement net profit all these kind of things we
talked about I’m just scrolling here to make sure I’m not missing anything that
I want to talk about because this it was a very very important conversation so
here’s a stat from this article Amazon had a record twenty four billion in
capital spending capital expenditures last year which is nearly as much as
Google parent company alphabet okay I just scanned the rest of the
article I talked about pretty much everything I wanted to talk about but
this again understanding free cash flow in a real-world sense every day since
how to use it well and then allocating that capital well it’s how you turn
berkshire into a five hundred thirty billion dollar company and how you take
amazon from a garage to a trillion dollar company in 25 years again these
are rare cases but if you understand free cash flow in a real-world sense and
proper capital allocation you are incredibly dangerous in terms of what
you can do in the business world in a good way because again most people even
CEOs of gigantic public companies know nothing about this
they just want to grow revenue they want to grow their empires they don’t think
about any of this whatsoever they just keep doing what they’ve always done just
because that’s the what they’ve always done or they don’t want to try anything
different or they’re scared to try something different if you are willing
to learn about free cash flow on a real world sense and proper capital
occasional world sense you are incredibly dangerous in a good way
because you have an advantage over 99 plus percent of people and business
owners CEOs CFOs in the world who just care about short-term and not the long
term this is where Berkshire and Amazon Gaiman get another massive advantage
they don’t care about short-term pain and earnings losses or earnings declines
in the short term they’re always constantly putting more capital into
their businesses when they can in terms of in the terms of Berkshire or taking
that money out and buying other business is completely in Berkshire or investing
constantly in new businesses new opportunities like Amazon Amazon Web
Services is taking over the Internet they run most of the Internet along I think I think what was the
status all a long time ago or a couple months ago I think it was something
along the lines of WordPress Amazon Web Services and Google run somewhere
upwards of 80% of the Internet that’s a pretty that’s an insane stat again I
don’t remember the exact number that might be slightly off but it’s something
along those lines and that’s where Amazon is going to continue gaining its
power as well with its purchase of Whole Foods and Zappos and its distribution
networks and its fulfillment centers and Amazon is going to continue doing what
it’s doing as long as besos and Amazon Amazon board of directors and executive
team members continue wanting to invest and grow they’re going to continue to do
it because they’re doing it well capital allocation it’s not like unless you have
some kind of major incident and you just lose a ton of money like that that
cripples you which again for Berkshire or Amazon would be hundreds of billions
of dollars you’re going to continue growing because the massive snowball
effect of all of this capital turning into more capital if you invest that
well which compounds and turns into more capital which just continues this entire
cycle it’s frankly it’s probably akin to a runaway train there’s not really much
stopping it right now either Berkshire or specific or especially Amazon because
bezels is so much younger than Buffett unless they just do something steep
really stupid another thing this relates to the free cash flow that gives you
options is des Eaux sold I think it was like almost two billion dollars in
Amazon stock not too long ago to fund his space company so he’s using again
Kapaun allocation something he’s passionate about something he believes
in something he wants to do selling his stock capital in this case to raise
money to spend on his other one of his other businesses
people of space and I think was a Tom Mars or no I think he wants to go to the
moon or an asteroid he’s I don’t think he wants to go to Mars like Elon Musk
but this is also another example of how free cash flow and cash flow give you
options as well if your company’s worth of trillion dollars you can take out two
billion dollars and invest it in another pet project company passion whatever you
want to term it and it wouldn’t even cripple come close to crippling him or
Amazon so this this is why and then Berkshire Hathaway and Bill Gates and
other billionaires around the world with the Gates Foundation
when Buffett dies he donating ninety nine percent of his wealth which at this
point will be he’s already donated tens of billions of dollars but at this point
it’s probably gonna be north of sixty is seventy billion dollars that’s gonna go
to the Gates Foundation that Bill Gates is going to allocate to fighting
diseases and educating kids and people around the world so this is another way
to use capital allocation as well is not just to make more more money it’s to
help more and more people as well so I hope this helped I thought this
conversation was super interesting and I hope you found valuing this if you if
you didn’t understand something I’m sorry and let me know in the comments
below I’ll make sure clarify it for you as best I can but this is some super it
makes sense to me and it made sense to this client after I
talked to him about it and it hopefully will make a lot of sense to you as well
after this video in the last video but frankly it’s not how most people in the
finance arena think so it’s incredibly powerful can give you a huge competitive
advantage over other investors other other business people if you know what
this kind of stuff is and how to do it well so I hope you got a lot of value of
this make sure like luck share subscribe and hit the notification bell subscribe
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subscribe like love share all that on the podcast as well thanks for watching
have a great day talk soon bye

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