Friends,
In the fall of 1941, it seemed like Moscow was doomed to fall to Germany.
Over the previous two years, the Nazis had quickly captured France, Poland, Denmark, and Yugoslavia using Panzer tanks designed for quick movement on paved roads. Their frightening success was undeniable -- the Panzers were the right tool for the job.
But Russia was a different story. Heavy fall rains turned Russian roads into muddy pits. The Panzers got stuck. And then the real trouble began: temperatures dipped to 40 degrees below zero. While the Nazis advanced to just 12 miles outside Moscow, they were ultimately turned away.
The biggest reason: the Panzers -- which had been so successful in other theaters -- were simply the wrong vehicle for a rapid advance on Moscow entering the winter.
We don't want to equate modern investors to the German forces of the 1940s, but we do want to learn from them. To the point: showing up to an obstacle with the right tools is half the battle.
In the world of valuing stocks, too many investors rely on the P/E ratio as a tool for evaluating all companies. But we'd argue that only works for non-cyclical companies that are fully optimized for GAAP net income. That can blind us to excellent opportunities.
Take the case of Duolingo in early August 2024:
- Price-to-Earnings (P/E) ratio = 110. "That's way too expensive," many probably thought.
- Forward P/E ratio = 74. "That's a little better -- it shows there's growth expected. But it's still high."
- Price-to-Free-Cash-Flow (P/FCF) ratio = 31. "That looks a lot better. It might even be acceptable."
- Forward P/FCF ratio = 25. "For a profitable company growing revenue over 40%, that seems pretty reasonable."
Since then, the stock has nearly doubled.
Of course, we're cherry-picking our data. But it underlines an important dynamic: Duolingo isn't focused on maximizing GAAP profitability yet. And because it collects cash before delivering its service, its free cash flow is much stronger than its net income.
Given its growth rates, the forward P/FCF ratio makes much more sense as a tool to value Duolingo than the P/E ratio.
There are -- obviously -- thousands of different scenarios out there. And each scenario warrants different tools to value companies. We can't get into what tool to use in each scenario right now, but we think the visual below could go a long way.
Wishing you investing success,
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Brian Feroldi, Brian Stoffel, & Brian Withers
Long Term Mindset
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