#5 Finding good companies | Investing convos every millennial should have

Maddy: [00:00:19] Hello and welcome to You're In Good Company's Summer Series. Over the six weeks of summer, we're delving into the investing conversations every millennial should have. We still hear our close friends and family said they don't know how to start honest conversations about money, and it makes them feel like they're not in control of their financial future.

Sophie: [00:00:36] So this is our answer - six conversations on the topics you wanted to hear.

Maddy: [00:00:41] This summer series is brought to you by Superhero. Superhero allows you to buy Aussie and U.S. shares and ETFs with no monthly account fees, and you can now earn Qantas points with Superhero. Eligibility criteria, terms and conditions and fees and charges apply.

Sophie: [00:01:02] So Mads, The age old question is always, 'to buy or not to buy?

 Maddy: [00:01:06] Is this stock a good investment?

Sophie: [00:01:09] Honestly, I think if someone had the golden answer for that, they'd be rich. So rich. Maybe we should make the golden answer. More money to invest with. So I thought we should jump into today like looking at some different ways to value companies. And I think when you start investing, you start to realise that there's lots of different types of companies. You know, you've got your big old, stable companies, you've got your high growth tech companies, and all of them can kind of be measured with different types of metrics and different types of valuation methods.

Maddy: [00:01:41] Yeah. So today we really just wanted to give a couple of examples of some of the really basic metrics that you can use when looking at companies to sort of identify along with all the other information that you're using. Whether or not this company might actually be a good investment.

Sophie: [00:01:55] And just to note, you don't have to be, you know, all about the numbers a lot of people aren't. This is just some of them that you could look at if you wanted to. So last episode, you mentioned that one of the shares that you invest in is Macquarie Group. Can you run us through some of the steps you took to decide on that investment?

Maddy: [00:02:12] Yeah. So Macquarie is an Aussie bank, and I guess one of the things that I would note is that it's a little bit different from like the big four banks - it has a much broader offering. It's also in renewables, it's in asset management, and it operates in 33 markets all across the world.

Sophie: [00:02:26] I often see the share price of Macquarie in the news a little bit, and it's been going up for a long time. So how do you value a company like Macquarie?

Maddy: [00:02:35] Yeah. Well, people often say that Macquarie is expensive and oh, it's too expensive, and yet it keeps going up. So I guess that's one thing to keep in mind is often you hear people say that and it might be true, but it doesn't necessarily mean that it's still not a good investment. So one thing to note with Macquarie is that it's really well recognised for being quite a profitable company, so they actually have 52 years of unbroken profitability. Well, we saw one great metric that you can use to evaluate companies that are making a profit is return on equity or ROE.

Sophie: [00:03:09] That just sounds like a whole bunch of jargon. What is return on equity?

Maddy: [00:03:13] So ROE is a company's net income divided by shareholder equity.

Sophie: [00:03:18] You have just added even more jargon.

Maddy: [00:03:20] All right. So let's break it down. Net income is how much money a company makes after deducting all of its expenses, tax, everything. Shareholder equity is the total amount that the owners of a company, i.e. the shareholders like you and me, have invested in a business. So let's say I have a lemonade store and my mom is an investor. Mom has invested five dollars into my store. How lovely. So on a Saturday afternoon, it's a beautiful, sunny day. My lemonade is super popular. It's delicious and I made $30. My lemons, sugar, soda that all cost me $5. So my net income is my $30 that I made minus my expenses. $25. Okay? I then divide it by my shareholder equity. Five bucks for mum. And times it by 100 to make it a percentage. So my ROI is 500 per cent.

Sophie: [00:04:09] That sounds like a lot. Five hundred percent return.

Maddy: [00:04:13] Look, it's not the most realistic example, because normally the costs associated, I guess in a company would be higher than my $5 of lemon and sugar. But it paints a picture.

Sophie: [00:04:27] So you've set up this simple example, and I can understand where you've gotten your five dollars from and how you've made your profit. So what does that 500 percent actually mean or measure?

Maddy: [00:04:35] Yeah. So I guess our way, if we go back to Macquarie Group, it tells us how efficiently a company is using its investments to generate an income.

Sophie: [00:04:44] So how efficiently you're using your five dollars to generate a lemonade income

Maddy: [00:04:49] In this case very efficiently.

Sophie: [00:05:05] So this is a real life situation. Looking at Macquarie Group. Where am I finding these figures?

Maddy: [00:05:10] Yes, I'd like to jump on Google and go to Yahoo Finance. I look up Macquarie Group and I flick to the tab that says Statistics and then you find ROE currently at time of recording is eighteen point four two per cent. So I guess the next question is how do you know if that's a good ROE or not? And unfortunately, that's not really any right or wrong answer or, you know, target ROE. And I guess whether Macquarie's ROE is considered good or bad depends on what the normal number is in the industry, which in this case is financial services.

Sophie: [00:05:43] So I'm not going to compare it to Coles or Woolworths. I'm going to compare it to something like CommBank.

Maddy: [00:05:47] Exactly. So you can Google the average array of banks or average away of the financial services sector, and you'll find that the industry averages around 14 per cent for this one. So Macquarie's eight percent is looking pretty good.

Sophie: [00:06:00] So within our way, we're looking for a higher percentage than the average.

Maddy: [00:06:04] Yeah, the higher, the better, because it basically just represents, you're getting more bang for your buck. So for every dollar you get in, that's a percentage that you're getting back.

Sophie: [00:06:12] So I'm looking for those high ROEs

Maddy: [00:06:15] Something that you can keep in mind, and this number does change a little bit as time goes on. But generally the long term average growth of the entire stock market, so across all industries is around 14 percent. So 14 percent growth is generally considered to be like an acceptable ratio. And then people sort of say anything less than 10 percent is not so good.

Sophie: [00:06:37] So we've got ROE under our belts. Is there another metric that you look at it all when valuing a company like Macquarie Group?

Maddy: [00:06:44] The other one that I used when looking at Macquarie was price to earnings ratio or PE ratio. And this is one of the most commonly used metrics when valuing companies. And basically what it is is it calculates the company's current share price divided by the earnings per share, and you'll often see it written as P/E on companies, websites and things like that.

Sophie: [00:07:04] So what is this P/E? What does it mean? What does it tell us?

Maddy: [00:07:09] Yeah. So the price is like literally the company's share price at the moment. And then the way is the earnings per share and then you've got earnings per share or often written as EPS is how much of the firm's net income, I guess, is like allotted to each share. So if you think about the big company pie, it's I guess how many pieces the pie needs to be cut into.

Sophie: [00:07:31] So for the pay ratio, do we want it to be high, to be low? What are we talking?

Maddy: [00:07:36] Yes, we mentioned earlier that for ROE, it's the higher the better. But this one is a little bit more complicated. A high pay ratio could mean that the company's stock is overvalued or too expensive, but it also can just mean that investors are expecting high growth rates in the future because at the end of the day, if a company's share price is high, likely because lots of people want to invest in that company.

Sophie: [00:08:00] So bring it back to a real company, Macquarie. I can see that the pay ratio is eighteen point nine six. Is that high or low?

Maddy: [00:08:08] Yes. So again, what's important is that you look at the pay ratio in comparison to its competitors or the other companies in the industry. So the average pay ratio of the financial services sector back in August was around seven point six. So Macquarie's of eighteen point nine six is pretty high in comparison, which would suggest that the stock could be seen as overvalued.

Sophie: [00:08:32] So I guess even though that looks high, it doesn't necessarily mean that the stock is overvalued because there's a bunch of other factors that come into play here, and you can't necessarily look at a metric on its own. And even though some people do say stocks are expensive, it can be for other factors. eg. expectation that that share price is going to grow further.

Maddy: [00:08:49] Yeah, exactly. And people have been saying for years that companies like Microsoft and Apple that the pay ratio is way too high, and yet the share price just continues to go up and up and up.

Sophie: [00:08:59] So I guess what I'm hearing you say is that the pay ratio can be very helpful when you're looking at a profitable company, but you need to take into account all the other factors. It's just one metric in itself, and it doesn't necessarily determine the whole picture.

Maddy: [00:09:12] Yeah, that's exactly right. Now I know that you also had a company in your portfolio that they're going to look at next, and it's a little bit different for Macquarie because this one doesn't turn a profit. But let's hear from our sponsors first. So Soph, if I've explained to you how I would value a profitable company, but I know that in your portfolio you have a lot of sort of more high risk loss making companies. How do you actually value a company that's not even making money yet?

Sophie: [00:09:42] I know it is a bit of a tricky concept to get your head around, but I'm going to talk about a company called Megaport. And sorry, this is a little bit jargony, but it is a cloud solutions company in simple terms. They're taking your data and they're putting it into the cloud for you, and they do this for some of the biggest companies in the world. So there is value there. One thing to note is when you are looking at these tech companies, you actually often hear that they've never turned a profit. And this is mainly because they're using their cash to either reinvest into the company or they're taking loans from banks to build it up. So don't be too put off if you hear it, because it can be common.

Maddy: [00:10:19] Yeah, I read this week that Uber has just turned a profit for the first time, which I would have thought it'd be profitable for years. There you go.

Sophie: [00:10:25] Yeah, first profit. Very well. Well done, guys. After all, my UberEats? Probably.

Maddy: [00:10:30] Yeah, I think we can both safely say they've contributed to that one. So what's your first metric that you would look at for a company like this?

Sophie: [00:10:37] So the first metric that I tend to look at is revenue growth rate and revenue is really just kind of all the sales coming in the door. So if we take your lemonade example, it's that 30 bucks that you've made from your first day of sales. But now I'm expanding and I'm opening two, three, four stores - the Lemonade is really good Mads - I need to spend even more money than what's coming in the door to actually expand. So that's the case of maybe not making a profit, but I'm still got sales coming in, which is your revenue. So what I tend to look at is whether the revenue is growing or not, because this can often signify things like they're growing their customer base or they're expanding into different regions. So if you're seeing a consistent growth, it still means that there's substance there. It's just that they're not making the profit.

Maddy: [00:11:23] So where can I find these numbers?

Sophie: [00:11:26] So with a lot of public companies and even with Megaport, it's super easy to find revenue figures. I mean, they're posted every year in their annual statement, so you can literally type in 2021 revenue. Megaport, it'll come up. Public companies have a lot of public information. So this year, the reported revenue for Megaport was seventy eight point two million dollars, just found from a Google search, which is a 35 percent increase from last year found from another Google search.

Maddy: [00:11:52] So it's thirty five percent pretty good.

Sophie: [00:11:54] It's a bit of a grey area, I think, especially with tech companies, you've got to look at, you know what they're actually providing and what region they're in. This is an Australian company and there isn't always perfect comparables. But with my own risk tolerance, I personally am happy with the fact that they've grown 35 percent this year and they've been growing since their inception.

Maddy: [00:12:12] So earlier, when I gave you the example of the average of the financial services sector, you know, that was a really clear apples and apples comparison, and you could say it's either above or below, but it sounds like in this case, you can't really do that.

Sophie: [00:12:24] I think it's difficult sometimes with tech companies because, you know, a tech company will have their own little niches, they'll be different in different ways. So unfortunately, with this one, it's harder to make that apples to apples comparison. You can definitely look at like broader industries. You could look at the tech industry or companies that are similar. But just note that it's not going to be as clean cut. But what I did do is just have a look back a couple of years and I've had a positive increase with their revenue year on year, and they're picking up big customers like Tesla. So I was happy with that.

Maddy: [00:12:52] Oh, nice.

Sophie: [00:12:54] Another one that you can look at is a debt to equity ratio.

Maddy: [00:12:58] This sounds like one that we should be across because sometimes these companies can have a lot of debt.

Sophie: [00:13:03] So the debt to equity ratio pretty much just measures how a company is funding its operations. So are they going to a bank and getting a loan, which is debt? Or are they raising capital from investors, which is equity? And you're just trying to understand whether or not that they can pay back their short term debts because, say, tomorrow they have they can't pay back any of their debts. That company is going in the bin, they're going bankrupt.

Maddy: [00:13:25] So looking at the debt to equity ratio, how do you know whether they can pay back their short term debts?

Sophie: [00:13:30] So the Megaport debt to equity ratio is four point three times. So I'm going to use that in context of your lemonade store.

Maddy: [00:13:36] Nice. OK. Let me I can understand

Sophie: [00:13:39] Lemonade store is still doing well, and I'm opening four new stores. But for those four stores, I'm taking out a $10 loan from the bank for each of them, of 40 bucks. But you're like, I still really want to help out. I'll give you $10.

Maddy: [00:13:53] Okay, so you've got my $10 investment and then you've got four $10 loans or 40 bucks from the bank.

Sophie: [00:14:00] So pretty much all the ratio is saying is that I'm using four times the amount of debt than I am equity. And when we say equity, it's your shareholder money that you're bringing in rates.

Maddy: [00:14:10] So that sounds like a lot.

Sophie: [00:14:12] It does because you're using a lot more money from the bank, which you have to pay interest on. But I think as we mentioned before, these metrics can't be looked at by themselves and they need to be looked at with other factors in the business.

Maddy: [00:14:23] So how do I know if that much debt is OK? If it's actually really bad.

Sophie: [00:14:28] So as we've mentioned already, you do need to be looking at other factors as well surrounding your investment, and it can't just be that isolated metrics. So in this example with Megaport, and we can translate to lemonade as well. The debt has been reducing. That's the first thing. So, you know, year on year that it's actually been reducing. So I I do have the four bank loans now, but last year at the Lemonade Store, I had five. So it's good. We're going down good direction. The other thing is I also have some cash, so we made $30 profit with the Lemonade Store. Megaport has some cash on their balance sheet, so they still have the ability to pay things back if they need to.

Maddy: [00:15:04] So what I'm hearing is that it's OK for companies to have a reasonable amount of debt. As long as you feel comfortable that you know their business is growing and that they've got sufficient cash in order to be actually able to pay off that debt

Sophie: [00:15:16] 100 percent at the end of the day, we all use debt at some point in our lives just to grow our investments. Buying a house, you go to the bank for a loan, so it's just making sure that you're comfortable with it.

Maddy: [00:15:25] So those are some of the metrics that we look at when trying to decide whether or not a company is a good investment. But we would love to know what you look for when you're investing. Jump into our Facebook group. Why do you say investing podcast discussion group? But before we go? As always, we have some recommendations for you because it is the perfect time of year to be catching up on your reading. Listening, watching

Sophie: [00:15:48] summer's all about making those little habits being like, I'm going to be a big reader this year and then like, gets too much like, Oh,

Maddy: [00:15:55] well, speaking of habits, funny, you say that because my recommendation for you today is a book called Atomic Habits by James Clear, who is an expert on habit formation.

Sophie: [00:16:06] I think I saw this like on my Instagram feed a lot last year, people reading this one.

Maddy: [00:16:11] I read it last year and it is such a good book, so I definitely want to share it with you all today. It just talks about the practical strategies for building good habits, Breaking Bad ones and just mastering like those little behaviours in your life that actually lead to, like, really big results. So I have all these notes on my phone. I listen to the audio book and I would let go for a walk and listen to it, and I just had to keep writing stuff down. So I think I have to remember this. So I put it up before we got on Mac today, and one that I really liked was framing habits as like a feedback loop. So it talks about how your habits shape your identity and then your identity shapes your habits, right?

Sophie: [00:16:52] And so after you read this book, have you formed any new habits?

Maddy: [00:16:56] Well, one that I used to be very good at, and I actually think this book helped a lot with a phase that I went through where I was waking up really early every morning to study before work. What's happened

Sophie: [00:17:08] now?

Maddy: [00:17:09] Well, look, I've fallen off the horse a little bit coming out of lockdown. It's kind of throwing me a bit. I feel like not

Sophie: [00:17:17] summertime,

Maddy: [00:17:18] summertime, but I'm going to try and get back on this one. And the way that the book framed it, which really helped me was it talked about how when your alarm goes off in the morning, you have this moment where it's like a split second decision, whether you get up or whether to snooze. And it's literally just that one moment in your mind, what do you decide to do? And that can change like your whole day. Like if you get up and you walk to work or you get some exercise, you know, you do a bit of study before work that can really set you up for the day versus if you snooze and you stay in bed and you land right and then you don't sleep well because you know you've already woken up and you're going back to sleep. Can you tell I've been going through this a lot recently? Then it can really impact your day. So I love that idea of just like that split second, and I literally think about it when my alarm goes off in the morning. I might go just yet, but it hasn't been happening. It hasn't, but we're going to bring it back. New habit goal for 2020 Terry is bringing back that early morning routine.

Sophie: [00:18:16] We'll check in a couple of months to see how we're going.

Maddy: [00:18:19] What about you? What are you adding to our recommendations today?

Sophie: [00:18:22] I'm also adding a book or a couple of books, Avon or person. You know what? I'm adding a person.

Sophie: [00:18:29] And also I'm adding an author. I'd be remiss of me not to recommend Malcolm Gladwell. So a couple of his books I'm actually a friend of mine, recommended one of his book Talking to Strangers and after writing that I just became obsessed. The actual book I'd recommend first is Outliers.

Maddy: [00:18:45] Such a great book. You've got me on to this one as well.

Sophie: [00:18:47] Yeah, I think it's honestly a book that everyone should read, but it pretty much talks about like the circumstances and the perspectives and the surroundings that make people, I guess, successful in what they're doing. So it kind of talks. Some of the examples range from, you know, hockey players in Canada who make the highest league is because of what's not because of, but like there's parts of it that attributed to their birth date, like being born at the beginning of the year or the end of the year. It talks about Bill Gates and his circumstances that allowed him to flourish in that computer scene. And it even talks about, like some of the biggest companies in the world like, you know, think like JP Morgan, for example. And why they're such big companies today, why no one's kind of taken over that position.

Maddy: [00:19:31] I think that sports story really resonated with me because I was like, always like, I love sports so much at school and I just was like, never quite good enough. And I was like, Now I know why I was born on the wrong date. That's what I'm blaming. You were born in March. Yeah, but I'll see you below. Oh, you're in at school? Yup. So it's all my birthday.

Sophie: [00:19:51] Something so much

Maddy: [00:19:52] now. I would like to just add a little recommendation onto your recommendation here, and that is I listen to the audio book of Outliers and it was amazing. They have this really cool soundtrack that they play throughout, and the music is awesome. So if you're into audio books, maybe listen to it on audiobook. Yeah, if you

Sophie: [00:20:09] haven't picked up any of Malcolm Gladwell stuff, I definitely recommend it this summer. They are books that have really changed my perspective, and I feel like there are lessons in there that can also be applied to making investment decisions.

Maddy: [00:20:20] So that is what we have been writing, but we would love to hear what you are reading over this summer break. So please jump into our Facebook group. YIGC investing podcast discussion group and let us know

Sophie: [00:20:31] Also, take a photo of where you are listening to us today would love to say if you're on a summer vacay or whether you're listening to us on your commute to work, take a photo and tag us on Instagram. YIGC podcast.

Sophie: [00:21:05] For our final episode of our summer series, we will be talking through how we keep track of our portfolio.