In this podcast, we’ve got an all-star Motley Fool cast on hand to help you understand some common and not-so-common investing terms. It’s lingo-bingo, so prepare to be delighted!
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This video was recorded on January 10, 2024.
David Gardner: Burn rate, asset location, inventory turnover, customer acquisition cost, spiffy pop. Each of these represent intermediate level terms that most serious investors know and most people who are not serious investors do not know. Well, I’m inviting on three serious investors this week, Motley Fool advisors and analysts, all in order to help teach the rest of us some new terms, terms like the ones I just led off with, each of which, by the way, has been covered in the past episodes of this week’s recurring series, some simple, some more advanced, all terms you need to know, drawn from investing and business. Understanding these terms and the concepts behind them will enable you to become smarter about the game of investing smarter, which in my experience leads to happier and richer over time. Or maybe you already know these terms, in which case, well, we’ll have a scoring system you can score yourself this week. It’s Volume 5 of Gotta Know the Lingo, welcoming in Bill Barker, Jim Mueller, and Matt Argersinger to teach you and me this week only on Rule Breaker Investing.
Welcome back to Rule Breaker Investing. Happy New Year. It’s Gotta Know the Lingo Volume 5. The purpose of this series is to look at some of the terms that you might hear about and not always fully understand from business, accounting, investing, sometimes technology as well. Some new terms for many of us to get you thinking at the top of this year about the language of investing, business, and yes, sometimes life to get you smarter about these concepts. We’re about to do Volume 5. All of our terms, each episode are new and different. There are no duplicates, which means if you enjoy this week’s podcast, we got four past Gotta Know the Lingos that will all sound like yesterday and be of a piece with this one. Free education, a veritable potpourri or glossary of some of the most helpful and relevant financial terms to help you round out your education. This week I’m going to be welcoming Matt Argersinger, Jim Mueller, and Bill Barker to share three simple terms and then three advanced terms. Gentlemen, welcome.
Matt Argersinger: Thank you, David.
Bill Barker: Thank you.
Matt Argersinger: Happy New Year.
Jim Mueller: Thanks, David.
David Gardner: Happy New Year to you. Let me start with you, Matt. I’ve asked each of you just to remind us in a sentence or so of what you do around the Fool, and then part B is a choice. You may either answer the question, what’s a New Year’s resolution, might just be small R, that you have for yourself for 2024 or what’s a financial term that you wish you’d known prior to adulthood? Matt, we’ll start with you. What are you doing around the Fool these days?
Matt Argersinger: Well, I am an analyst, still an analyst on our premium services. I bounce around a lot, but spend most of my time on our Dividend Investor and Real Estate Winners services.
David Gardner: Wonderful. What’s been a recent dividend winner?
Matt Argersinger: A recent dividend winner would be Kenvue, which is a recent spin-off of Johnson & Johnson and their consumer health business that Johnson & Johnson spun off. I think it’s got some interesting potential this year.
David Gardner: Excellent. Speaking of this year, Matt, do you have a New Year’s resolution or a financial term you wish you’d known prior to adulthood?
Matt Argersinger: Well, I knew every financial term before I was an adult.
David Gardner: Excellent.
Matt Argersinger: Of course.
David Gardner: I’m glad you’re on this series and also, by the way, on our team.
Matt Argersinger: No. I’ll go with resolution and mine is simple, but I just I want to go and spend more time with people I care about. I read two recent studies this year and they both said mostly the same thing, which is if you want to live a long and happy life, the people that do live long and happy lives tend to spend a lot of time with people they care about and people that care about them. I feel like I do that with my family, of course. But extended family, friends, I’d like to do more of that this year.
David Gardner: Matt, is that why you’re in the studio today with Jim, Bill, and me?
Matt Argersinger: That’s why I drove through this rain that we had to get to the studio.
David Gardner: It has been, in the Greater Washington, DC area, extremely dangerous with just rain and wind. Thank you for making it over and I trust back.
Matt Argersinger: You bet. Oh, yeah.
David Gardner: Is that the Framingham Heart Study or the Harvard University-based long-term study, which was written most recently in a book called The Good Life about how our relationships actually matter more than our cholesterol?
Matt Argersinger: Yes, it’s a snippet from the Harvard study. Then there was another study that, of course, I’m not remembering now, but essentially that was the crux of that of the result.
David Gardner: Last question for you, Matt, before I move on to Jim, this is unfair. Are you going to measure that? Do you have a way of actually knowing at the end of the year that you did spend that time?
Matt Argersinger: That is a great idea, David. I didn’t have one. I hadn’t thought of one. I now am going to think of one.
David Gardner: Although it could be a little alarming. You don’t want to say thank you for the conversation. Check.
Matt Argersinger: Right. Hour and half, that’s 10 points.
David Gardner: Maybe don’t be that guy. But maybe inside, maybe be that guy.
Matt Argersinger: I’ll keep a spreadsheet.
David Gardner: Bill.
Bill Barker: The only idea I think maybe that I’ve had in my life, which I’m truly proud of, was for my 10 anniversary, I went back to 10 restaurants or other places that had been important in the courtship between myself and my wife, and I had friends there unannounced.
David Gardner: That’s great.
Bill Barker: Meeting us, people that we had already lost more contact with than we should have. Now we’re coming up on our 30th anniversary. There are not 30 restaurants I can visit that are important or even 30 restaurants that I’ve been to in the last 20 years probably. But you can just go through your phone and see, oh my goodness, here are people that I need to get with this year. I can put 30 groups together maybe if I keep them small enough, but this is I thought about.
Matt Argersinger: Well, forgive us, David, if we’ve already off-tracked with your podcast, but I read a book this year also called Die with Zero by Bill Perkins. I believe it was his 45th birthday or was his 50th birthday. He decided to get together like 60 people, friends, family at a destination resort because he said, you know what, I’m getting older, I want to see these people. He brought them all together and he reflects on that. It’s like one of the greatest moments of his life. For a week, he had all these friends from high school, college, family, previous marriages. It was all in the details.
David Gardner: Phenomenal.
Matt Argersinger: It was great.
David Gardner: Thank you, Matt. Bill, did you just preview your New Year’s resolution, but let’s move on to Jim Mueller. Jim, what are you doing around the Fool these days?
Jim Mueller: Well, nowadays, I spend a lot of my time on the options service, but still keeping my hand in on the energy service, for example.
David Gardner: That’s great, Jim. How about looking back at 2023. How about an awesome options trade?
Jim Mueller: The ones that I like are the ones where writing puts and the put expires worthless because we’re doing it for just the income to generate cash flow into the portfolio. One that worked out really well was Camping World Holdings, which we wrote puts for several rounds and managed to roll down. As the share price fell, we had to lower the strike on the put and ended up expiring worthless and making some nice money.
David Gardner: I’m glad and glad for our members who listened to you. Jim, I realized I just asked you, you were throwing down some terms. We’re not going to be illustrating all of those.
Jim Mueller: I thought of bringing options into this podcast.
David Gardner: Fair enough.
Jim Mueller: But I think that’d be a whole session by itself.
David Gardner: Probably so and perhaps one day. Jim Mueller, what is a New Year’s resolution you have for this year or a financial term you wish you’d known before adulthood?
Jim Mueller: Well, like Matty, I was well educated and smart from the start.
David Gardner: Of course, that’s what we hire for. We overindexed toward brilliance. [laughs]
Jim Mueller: During the pandemic, during lockdown, when we were working from home, I started solving the New York Times crossword puzzles online and I’ve got a streak going that’s pretty well. Getting up there, but the Sunday puzzle is the largest and takes the most time. Right now, my average is just a hair over 58 minutes for solving that, and I want to get that down below 55 minutes.
David Gardner: Wow, that is impressive. I was going to ask you whether you’re timing yourself, but clearly the answer is yes.
Jim Mueller: They do.
David Gardner: They time it anyway.
Jim Mueller: They time it anyway.
David Gardner: Yeah. Jim, sounds like those three minutes could make all the difference. Good luck this year. Let’s move on to Bill Barker. Bill, what are you doing around the Fool these days?
Bill Barker: Working on Firecrackers, a few other services including Hidden Gems, and a little podcast thing, little Motley Fool Live. Yeah, spreading things around.
David Gardner: Wonderful. It’s great to have you back in Fooldom. Away from that regulated part of our company that we love but can’t talk to because there’s asset management and other important things happening and something we’re proud of at the Fool. We don’t talk too much about that on this podcast. But anyway, Bill, welcome back.
Bill Barker: Thank you. Good to be back.
David Gardner: Bill, did you already share your New Year’s resolution, specifically 30 restaurants that you’ll go back and take your bride back to again, 30 of them throughout the year or something different?
Bill Barker: I don’t have that kind of money, [laughs] 30 restaurants these days. But on a related point, yeah, getting people over and, as part of that, cooking more. Diana is not going to be listening to this, right?
David Gardner: I hope so.
Bill Barker: She’ll hold me to that. Whereas it’s a resolution, which as you know may or may not be realized as the year goes by, and I don’t want to have myself quoted back to me.
David Gardner: That may or may not be an intention. That may or may not be.
Bill Barker: It’s an intent, we’ll see. Let’s all come back in a year.
David Gardner: An intention, not a resolution. We got you. Well, we’re about to get started. Let me introduce our scoring system though. As we introduce each term, the six that we’re going to share with you this week and illustrate it for you at the end. I’m going to ask you, dear listener, quietly to think, did I learn anything from these Fools? If you feel like you didn’t learn anything and your five minutes or so were wasted by that particular term, the score would be zero because you learned zero and we were zeroes, and so zero. If, on the other hand, you thought that was helpful, maybe you did know the term or, “Hey, I knew the term, but they made me laugh,” give yourself a plus one. Finally, if as Matt Argersinger, or Jim Mueller, or Bill Barker present their terms with their illustrations, if you find yourself delighted, not just by the quality of the learning, but maybe you got to smile along with it, if you really enjoyed it, give yourself a plus two. Yeah, you can definitely share your score for this week’s episode on social media or just email us [email protected]. History will show, by the way, gentlemen, that we used to have a different scoring system, one that I invented, that was basically test whether you knew these already before we even shared them. But then my producer sidekick, Rick Engdahl, intervened in a historic moment for this podcast and said, ”Hey, shouldn’t we reward learning? Isn’t it about the learning?” I agreed with you, Rick. So our slightly lame scoring system was born. Term number 1, I’m turning to you, Matt Argersinger. What have you got for us for term number 1 Gotta Know the Lingo?
Matt Argersinger: It is cash from operations, David, and I like to think of cash from operations as the cash register of the business. Bill will appreciate this. Say you’re running a comic bookshop. Once I’ve paid the distributor for my book inventory, I paid my employees, I paid the rent on the shop’s lease, everything I need to run the business either day-to-day, month-to-month, subtract that all from the revenue I make selling comic books, and that’s my cash from operations. If I want to get technical with it, cash from operations, if you look at it, for example, in the cash flow statement, which you can get from any company, well, most companies these days after Enron or WorldCom, I can’t remember, have to provide a cash flow statement. So you’ll find it. It takes net income and it adds back certain non-cash expenses like depreciation, stock-based compensation. It also adds or reduces cash from changes in working capital like when you collect on accounts receivable, when you sell inventory or there are changes in accounts payable and doing all that, you arrive how much cash the company generated from its operations. Now, it doesn’t include things like capital expenditures, acquisitions, increases or decreases in debt, other long-term liabilities. It doesn’t include dividend payments or share repurchases. Those are cash from finances or cash from investments. Those are outside of the operations of running the business. So it’s all about the operations.
David Gardner: Matt, why did you feel inspired to bring cash from operations to this episode?
Matt Argersinger: Well, two reasons. It has to do with the second term that I’m going to bring this.
David Gardner: Spoiler alert.
Matt Argersinger: But also I love looking at cash from operations because, to me, it tells a truer story about a company’s earnings, and I love to use the example of Amazon. I think this is fantastic. If you go back to 2007, so this is more than 15 years ago now, Amazon’s net income in 2007 was right around $500 million, but its cash from operations was 1.4 billion. Go five years forward, 2012, Amazon’s net income was negative. It was a negative 39 million, it lost money, but its cash from operations was $4.2 billion. Let’s go forward another five years, 2017. Now, at this point, Amazon is more mature company, it’s fairly profitable.
David Gardner: Yeah, people have heard of it by 2017.
Matt Argersinger: Of course. By then, its net income is three billion dollars. Pretty impressive. Its cash from operations that year, $18.3 billion. Then let’s go another five years, 2022, its last full calendar year. We don’t have 2023 yet. Net income, it actually lost money in 2022, down 2.7 billion. Cash from operations, 46.7 billion. I’ve been a longtime Amazon shareholder, not nearly as long as David. But I think if you’d followed the company, if you’d followed Amazon for many years, you’d have heard many people say, a lot of analysts say, “They don’t make any money, they’re never going to make any money. It’s so expensive. Even if they did make money, the P/E would be like 1,000. Too expensive, not making money.” If you’d followed the operating cash flow instead, you’d have realized Amazon was in fact a very profitable company and is a very profitable company on a cash basis, and that’s probably more important than earnings.
David Gardner: Excellent, Matt. I’ve asked you and each of our guests this week to provide an illustrative sentence using your term in a helpful sentence for listeners. Are you ready for that?
Matt Argersinger: I am ready.
David Gardner: Go.
Matt Argersinger: I hope they like it. When it comes to earnings, follow the operating cash flow, it’s the best kind of dough.
David Gardner: That works. That works. There was no requirement to rhyme, and yet you did. Thank you, Matt Argersinger. Cash from operations. Let me turn next to Jim Mueller. Jim, term number 2. What do you have for us? The simpler one?
Jim Mueller: I don’t know if it’s simple. Well, I guess it is simpler. It’s macro, at least, inflation target.
David Gardner: Inflation target. I think some of us can at least guess at that one. I know some of us know that down path. By the way, if you do and don’t enjoy what Jim’s about to do, give yourself a zero in our scoring system. But, Jim, talk to us about inflation target.
Jim Mueller: Inflation is a normal part of the economy, the way the economy works, and we know what it is. It’s higher of prices. Things get more expensive over time. But have you ever thought about it or what causes it? We actually do. We’re the ones who are causing it. As we get better at what we do and/or as we move up in our careers, we expect to be paid more. Even if we don’t move up, we still get to expect to be paid more because time and service. As we get paid more, we tend to spend more on goods and services. That increases the demand for those goods and services, which, thanks to the law of supply and demand, when demand goes up, supply goes down and that raises the prices for those goods and services. Our desire to get paid more leads to inflation. Of course, because the companies have to increase the prices to handle the higher labor costs and so on, it’s a nice little circle and when it’s running well, the economy just hums along. It’s when you get too far in one direction or the other that things start to happen and people get worried, and that’s when the Federal Reserve Bank steps in and that’s where the inflation target is and for them, it’s right around 2% per year.
David Gardner: It’s been there for a long time and that’s almost the timelessly good number. I’m not sure the Fed has always purposed that, but at least these times, it feels like we’ve arrived at a place in history where 2% is a desirable inflation target.
Jim Mueller: They’ve had this target since about 2012, after the Great Recession, but that’s what they want to have happen. So too much inflation is bad as we saw last couple of years 7%, 9%. Now it’s back down to 3%. Three percent feels pretty comfortable, especially compared to last year, but too little is just as bad because that means the economy is not going to be growing. There’s too little demand, and so the economy slows down. What’s even worse is deflation.
David Gardner: Yeah, in 2008, ’09, ’10, that was a big danger.
Jim Mueller: When the cost for things goes down and that leads to even a harder slowdown on the economy, because why would you buy a big ticket item like a washer and dryer if you know it’s going to be cheaper three or six months further down the line?
David Gardner: In some ways, it sounds desirable, and for those of us who save money and invest it, inflation really undermines and erodes the saving and investing we’re doing, which is why the Fed has been attacking a 7% inflation rate to help all those of us, many listeners included, get the benefit of their savings, not watch that fritter away. But when it goes the other direction, I guess our savings in stocks are more valuable if we have it. But it doesn’t really create an environment conducive to gains in equities either.
Jim Mueller: That actually turns off people from investing and that also hurts the economy because it’s the invested dollars that companies use to grow their business.
David Gardner: Thank you, Jim. Now about a quarter of our listeners are not US based, so you present a Federal Reserve Bank of the United States viewpoint. But have you ever spent any time looking at inflation targets around the world? Should everybody be kind of working toward 2%?
Jim Mueller: Actually, I don’t know if 2% is the target around the world, but pretty much all the central banks around the world, at least of the larger economies, do have set inflation targets that they’re trying to hold to.
David Gardner: Jim, are you now prepared to reveal the sentence that will help confirm our knowledge of inflation target?
Jim Mueller: Well, something about this target is exactly that, and so my sentence is along those lines. The Federal Reserves inflation target is 2%, but actual inflation will always be either higher or lower than that. Will be rare where we have 2%.
David Gardner: Yes, and that makes a lot of sense. Anywhere in the very low single digits makes me happy and I assume you gentlemen, too, and many people listening to us right now. Thank you, Jim Mueller. Inflation target term number 2. Bill Barker.
Bill Barker: David.
David Gardner: You were with me when we did the last Gotta Know the Lingo. It was May of last year. Really fun, first time to have you on this series. What term have you baked up as your simpler one to kick off the first half of this week’s episode?
Bill Barker: It follows on some of the discussion about inflation, and it is a very simple term and it won’t take long to explain, but it may be worth talking about and that’s the Misery Index. More of a macroeconomic term than an investing term, but it works alongside a lot of investment talk. The Misery Index is very simply in its most basic form just the raw inflation rate plus the unemployment rate. At the time that it first gained currency toward the end of the Jimmy Carter presidency, it had a lot of traction in terms of this being a number that described what was making people miserable, as both the inflation and unemployment rates were quite a bit higher than today. There are more advanced metrics that have added a couple of terms. Sometimes you double the unemployment rate because studies show that unemployment leads to much more misery than inflation.
David Gardner: It makes sense.
Bill Barker: Also a higher lending rate increases misery, and then you can subtract the GDP growth. If you double the unemployment plus inflation plus lending or mortgage rates and then you subtract GDP, because if all those numbers are high but GDP is growing very fast, that’s a trade-off. That’s another way to look at it. Of course, it describes what the Fed’s dual mandate is, employment and inflation being two things they are keeping an eye on and are charged with being aware of in relation of the two. It’s not a number that gets talked about all the time, although the components is always talked about.
David Gardner: Definitely heard the phrase out there.
Bill Barker: It is potentially something that every election revolves around those components, and when they come up with headline numbers, Misery Index is not very high right now.
David Gardner: I mean, 3% inflation, 3% unemployment, 6% or so. Do I have that right?
Bill Barker: Yeah, a little. When you get into the decimal points, unemployment is at 3.6, 3.7.
David Gardner: So maybe seven.
Bill Barker: A little under that on a monthly basis right now and that’s lower than at the beginning of this presidency. Of course, there were very different circumstances going on at the time. There was higher unemployment and no inflation at the time.
David Gardner: I remember even higher unemployment than that a couple of years ago. Americans seem to be staying mainly engaged, but some jobs had to have been lost when we were all sitting there Zooming each other?
Bill Barker: Yeah. Well, the unemployment rate skyrocketed and came down quickly, but it took years to get all the way back to the pre-pandemic.
David Gardner: When you close all the restaurants, all the hotels, the airports and everything, there was a lot of unemployment. It’s actually stark to think how quickly we’ve come back from that.
Bill Barker: Did anybody take economics in college?
Matt Argersinger: I did.
David Gardner: I took a course or two.
Bill Barker: Were you given a number what the full employment rate was?
Matt Argersinger: Five percent.
Bill Barker: It was 6% in the course that I took. In the early ’80s, it was eight. If you run hotter than 6% unemployment, you can’t do it without inflation, and that was just the understanding at the time.
David Gardner: That was the book.
Bill Barker: That was the book.
Matt Argersinger: On the inflation side, I thought the long-term inflation rate was always 3%, 3.5% as well.
Bill Barker: The 100-year inflation rate for the United States ending in 2022 or thereabouts is 3.26%.
Matt Argersinger: What are we complaining about? [laughs] That was another question I had for you, Bill. I did a Motley Fool Money podcast just recently where we talked about the term vibe session. We’re not in an actual recession and we’re not really miserable in terms of the historic Misery Index, but there’s this vibe session. In other words, people just don’t feel good about things and I’m wondering why you think that is.
Bill Barker: Two reasons. I guess one would be there is an effort by, let’s call it, roughly half the electorate to convince people that they are unhappy with their elected representatives right now, and you can always pull some numbers out to tell that story. If you just keep telling it over and over, I don’t know that either party is especially guilty of this more than the other.
David Gardner: It tends to flip and flop over the years. Whoever is in is going to be criticized by whoever is out.
Bill Barker: Yeah. You’re unhappy, and the other reason may be that inflation having been 7-8% for some period of time, it’s down to three, but the prices aren’t going down. If you are used to paying a dollar for coffee or whatever is, if coffee could have ever been acquired for a dollar. [laughs] I can’t remember that back that far. It goes up to $1.20 and now it’s only going up 2-3% a year instead, it’s set at a new level that you’re unhappy about, you’ve been unhappy.
Matt Argersinger: That’s a misconception. People hear in the news, inflation is moderating or going down. They think, “Oh, great, prices are going to go back to 2019.”
David Gardner: They’re just going up less.
Matt Argersinger: That’s right.
David Gardner: It’s like wasn’t Toy Story. Flying is falling with style. [laughs] Jim Mueller.
Jim Mueller: Right. People expecting the prices to go back down to what they were beforehand, it’s not going to happen.
Bill Barker: No. But you can make a political campaign out of it.
Jim Mueller: Exactly.
Bill Barker: If I were around, we would get those prices back down.
Jim Mueller: You’d be creating deflation, which is worse for the economy as we were just discussing.
David Gardner: That is true.
Jim Mueller: It’s going to take a while for us to get used to these new prices.
David Gardner: Fortunately, they’re moderating in terms of their rise, and that’s been very helpful. The stock market saw that last year in anticipation of that more this year. I think it had a great 2023.
Bill Barker: Apparently, despite the fact that the unemployment number is more important to people’s misery or lack thereof, we as a society seem to have gotten used to the idea that unemployment should be at historically low number, just absurdly low number. As I say, I was taught, you can’t maintain unemployment below 6% without ruining the other part of the economy, and we’ve spent the last 20 years.
David Gardner: Well, I was taught that the stock market is just a random walk down Wall Street, and it would only be monkeys throwing darts blindly that could ever beat the market. I disagree with a lot of what we were taught in school. Bill Barker, do you have a sentence to close this one?
Bill Barker: I mean, I don’t have a catchy one. I didn’t work on my rhyming scheme.
David Gardner: Come on, Bill. [laughs]
Bill Barker: Some people here prepared for this. I just say the Misery Index is not a perfect predictor of elections, but it’s pretty useful in knowing what the election is going to sound like.
Matt Argersinger: To close that one out. Thank you, Bill. Do you favor the simplest version of the Misery Index or some of the others where you’re doubling things or adding or subtracting additional stuff? Do you have your gold standard for Misery Index reference?
Bill Barker: I mean, I think the gold standard is the simpler one. It tells you a story which should provoke questions about the things you’re not seeing in the number, but the other number is not as well-known. It doesn’t track you to the extent that people follow it. They follow the Misery Index, the original.
David Gardner: Thank you for that. We’re at the halfway point of this week’s podcast, we’ve just gone through the three simpler terms. A reminder for each of them. Did you learn nothing at all from us because you already knew it and it was a waste of your time? Give that one or all three of them, I hope not, zeroes. If you enjoyed it and learned something, give any of those a plus one. If you were delighted and find yourself smarter, happier, and richer as a consequence of the first half of the show, give that a plus two. Sum those numbers up, and that is your half time score. There are no half time follies. We’re going to continue right in to the second half of this podcast. Gentlemen, each of you is bringing a little bit more advanced term and, Matt, we’re going to turn it back to you. You may have already presaged the term that you’re going to be bringing as term number 4. Could you repeat it now?
Matt Argersinger: Sure. Simpler term was cash from operations. This term, which is very similar, is funds from operations. Now, if you’re analyzing stocks, you’re looking at income statement for a company that’s might be in your portfolio, you’re probably not going to see this line item unless you’re looking at a real estate investment trust.
David Gardner: That’s why I didn’t really recognize it. By the way, people often assume, “Well, David must know everything because he’s the host of this podcast and he’s picked stocks for years.” No, I don’t know some of these. I didn’t take a lot of economics courses. They were boring and very Keynesian at my school. So I avoided some of this, and I rarely have come across funds from operations. But, Matt, that’s because I rarely looked at REITs. By contrast, you have often looked at REITs.
Matt Argersinger: In Real Estate Winners, about 90% of our scorecard in that service are REITs. You need to understand funds from operations for one really big important reason. Real estate gets depreciated over time. In fact, according to the IRS rules, I believe residential real estate is generally depreciated over 27.5 years. Commercial real estate is generally depreciated over 39 years. This is what the IRS assumes is the useful life of any property. Now, I don’t know about you guys.
David Gardner: I thought my house appreciated in value over time, Matt.
Matt Argersinger: Well, there you go, David.
David Gardner: It’s very confusing.
Matt Argersinger: I own a house in DC that’s over 150 years old. It’s still standing. In fact, there are people living in it today. It’s a rental property, and I think, David, you own a house in DC as well that I’m sure is over 30 years old.
David Gardner: It is not actually, Matt. It was built in 1999, although there was a house that pre-existed, the one that we’re living in right on that same property. So yeah.
Matt Argersinger: You’ve had. According to the IRS, you should have depreciated your house for over 25 years. According to the IRS, your house should be worth 90% less than whatever it was paid for in 1999. Now, I don’t think that’s true.
David Gardner: I sure hope not. I will say that of the few houses that I’ve owned, and I’ve loved each one, I don’t really feel like I’ve ever made money on real estate. I think I get excited overpay for the house, but love living there usually for 10 or so years. But then 10 or so years later when I sell the house, it’s like not that much more than I paid for it even though we’re in a big growing urban area. I don’t think I’m a very good real estate investor, Matt, which is why I’m glad you’re my friend.
Matt Argersinger: Well, so real estate. The point being, real estate tends to hold onto its value, even appreciate. So even though by income statement rules, you’re supposed to subtract depreciation from your income statement, it’s something you probably want to account for if you’re looking at a REIT. The funds from operations is essentially the big change that you’re doing is you’re taking net income and adding back depreciation. There are also some other one time expenses that can often be added back, some other non-cash charges, but depreciation is really the big one. What you’ll find is it gives you a much better measure of a REIT’s cash flow.
David Gardner: Matt, looking at the relatively specialized area of real estate investment trust. Again, something available to all individual investors. Many of our listeners are going to have some REITs in their portfolio, but not everybody grows up studying REITs or uses that acronym necessarily that glibly. How important is funds from operations to you? Is there any additional savvy or ratio you want to throw away? Is the point the same as Amazon, making way more money than you think? Bring it home for us.
Matt Argersinger: That’s exactly right, David. If you’re really thinking about, again, the cash register of a business, the cash register of a real estate company, funds from operations is what you want to use. We often get a lot of questions in Real Estate Winners, we’ll recommend a REIT and a member will say, “Well, now this REIT, I don’t understand, Matt. This REIT is trading for 40 times earnings. You said in the recommendation it’s a bargain, but 40 times earnings. I mean, Apple‘s trading for 25 times earnings. Alphabet is 20 times earnings. You’re telling me you want me to pay 40 times earnings for a REIT?” The point being funds from operation gives you a nice way to say, well, actually if you use FFO, funds from operations, per share instead of EPS per share, you can come up with a price to FFO, and maybe the price to FFO is, I’m making this up, 10 or 15 and that’s a relatively good value. It’s a way also of measuring the overall value of a real estate investment trust, and I think it’s pretty useful in that way.
Jim Mueller: Matt, does that concept tie into the fact that a REIT has to pay out most of its earnings to its fund holders and so earnings isn’t as important, but the cash that is paid out comes from the FFO?
Matt Argersinger: Oh, yeah, it’s a great point, Jim. What you often see, because as you rightly point out, REITs have to pay out almost all of their pre-tax earnings out as dividends. Often you’ll see an earnings payout ratio for a REIT that’s well over 100%. Now if you saw that for a normal company, you’d say, well, that’s a problem. That dividend is in trouble. But if you use FFO instead, you’ll often see it might have a 70% FFO payout ratio. So you can say, OK, that dividend is well covered by the REIT’s FFO even though it’s not covered by the taxable net earnings of the REIT.
David Gardner: Matt, I’m going to try to name on you, this is the author, a leading light within this specialized industry. When I say the name Ralph Block, does that mean anything to you?
Matt Argersinger: It absolutely does. Ralph Block probably wrote the primer on investing in REITs. In fact, his book is called Investing in REITs and I know he was a former Fool contributor, at least on our community boards.
David Gardner: That’s why I was thinking about him, Ralph died in 2016. God rest his soul, very good man. He was there in the Motley Fool forums and discussion boards for more than a decade just humbly and expertly answering people’s questions about real estate investment trusts. I really appreciate. I just want to say if anybody connected to Ralph Block is listening, we really appreciate Ralph. We miss him. Matt, I’m not surprised that you knew the name Ralph Block, but I’m guessing most listeners wouldn’t have known that name.
Matt Argersinger: Right. I read Ralph Block’s book twice. It sits near my desk because I’m using it often as a reference tool when we’re writing about REITs or talking about them. I’m so glad he made that great contribution to our community.
David Gardner: Fantastic. Matt, do you have a sentence? I don’t know, is it a poem again?
Matt Argersinger: [laughs] It is, David. I couldn’t help myself. I think this one would go a little bit better maybe than my first one. Just as nerdy though, so right here it goes.
David Gardner: You go.
Matt Argersinger: When it comes to analyzing real estate earnings, don’t be the dunce from Woebegone Station. Make sure to use funds from operations.
David Gardner: Wow, that was pretty elegant. Jim, I feel like you were almost emotionally moved, am I right?
Jim Mueller: No, I’m just ashamed that I didn’t come up with any rhyme.
Matt Argersinger: Oh, he’s ashamed to be sitting next to me, shaking his head. “I can’t believe this guy,” that’s what he’s saying.
Jim Mueller: I had a quote. So the number for the depreciation of household is 27.5 years, is that more or less?
Matt Argersinger: That’s right, 27.5 years. Now that’s residential real estate investment property, so you obviously don’t depreciate your own house.
Jim Mueller: No, but I’m thinking about whether that is an accurate reflection of how quickly my house does depreciate. That is, if I were not cleaning it, charging for the time of cleaning it or paying somebody else to clean it and just not painting it.
Matt Argersinger: Replacing appliances.
Jim Mueller: Replacing appliances a lot faster than 27.5 years, let me tell you.
Bill Barker: Well, yeah, I mean it would be overgrown much faster than that, but at about 3-4% a year of replacement cost for roof, and appliances, and paint, and flooring, and everything else.
Matt Argersinger: It’s a great point, Bill, and I think what you’re getting at rightfully is that even though we love adding back depreciation and saying, oh, we got this great funds from operations cash. The fact is REITs have to also invest in a lot of cutbacks, back into the properties to maintain them, grow them, make them better for existing or new tenants. It is something, it is a good proxy I think for what actual the amount of CapEx it actually has to go in over 27.5 years or 39 years for commercial real estate. I think it’s a rightful deduction even though we adjust for it for cash flow purposes.
Bill Barker: But as a homeowner, I have never not been surprised by something breaking and having to be replaced. It never failed to surprise me. When I bought this house, I was told the roof would be gone in 15 years and it’s been 15 years and you’re telling me it has to be replaced. That makes no sense [laughs] because it’s coming out of my pocket and I get nothing except a roof.
David Gardner: Funds from operations, I’ll be summarizing our terms at the end of this week’s show to make sure you have them all firm in your minds. Remember our scoring system: zero, plus one, plus two. Jim Mueller, you don’t have a zero for us for your advanced term, do you?
Jim Mueller: I hope not.
David Gardner: I hope not, too. What is term number 5 on this week’s Gotta Know the Lingo?
Jim Mueller: Well, zero would actually make it a very odd term. Discount rate is the term and it’s something we’re familiar with, but only in one direction and discount rate is that same thing running backwards, and I’ll explain that. The classical definition of the value of a business is the sum of all the cash the business can produce over its lifetime, discounted, there’s the word, back to the present and an appropriate rate. The question is, why do you have to discount and what is discounting? Well, the point of any business is to generate cash. I mean, if you’re not going to generate more cash than you use to create and market whatever you sell, then why do it? At least if you’re a for-profit business. That excess cash flow is what any company should be after. Suppose a company generates $1,000 extra every year and it pays out to you, its owner, that amount. So you get $1,000 today, and next year you’ll get $1,000 and the year after that you’ll get another $1,000. The question is, is the $1,000 a year from now worth the same as $1,000 to you today?
David Gardner: I’m going to answer no, it’s not because we already talked about inflation.
Jim Mueller: Well, that’s part of it, too, but this comes at it from a different direction, and the answer is no, as you said, but not because of inflation, but it’s because you can invest that $1,000 today.
David Gardner: That’s actually much more important, Jim.
Jim Mueller: Have more money in the future. Say you put it in a savings account that’s paying you 5%, which is not as outrageous as it was just a couple of years ago, but 5% makes the math easy. In a year, it’s going to be worth 1,050. So 1,000 today has a higher value in the future. Going forward in time from now into the future, that’s your return rate, 5%. Discount rate is the inverse, the upside-down version of that. You’re going backward in time from the future back to the present. If you had $1,000 and discounted it back today at 5%, it’s only worth $952. Because you can take that $952, invest it at 5%, and end up with $1,000 in the future. So a thousand today ends up as 1,050, 1,000 in the future coming back to today ends up as 952. Mathematically, going forward, we multiply the amount of money by one plus the interest rate or one plus the return rate. Doing that multiplication once every year. At 5%, 1,000 goes to 1,050, then to 1,102 and change, then 1157 and change after three years and so on.
David Gardner: Compounding.
Jim Mueller: Compounding. So that’s the return rate, but going the other direction from the future back to today. Instead of multiplying, you divide by one plus the discount rate. At 5%, 1,000 a year from now is only worth 952 and change. A thousand two years from now, discounted twice at 5% each year, is worth $907. A thousand three years from now, going three years discounted at 5%, is worth call it $864. The further out in time the company generates that cash flow, the less that cash flow is worth today, which means that the, say, the company lasts 20 years, generating $1,000 each year. It’s not worth $20,000, it’s worth $13,000.
David Gardner: We’ve discounted it using a discount rate.
Jim Mueller: We discounted it back using a discount rate. The question is, what’s the discount rate to use? That’s an entirely different topic, which we’ll get to maybe another episode.
David Gardner: Thank you for that explanation, Jim. We said this was going to be more advanced, you threw some math at us, and no doubt some of our listeners followed the math. But I hope everybody understood the concept because that’s really at the heart of discount rate. The fact is that money generated by our favorite business, either the Motley Fool, the one we all work for, or our favorite stock pick, 10 years from now is not worth as much to us looking backwards to today because we can’t use it, we can’t do anything with it. There is a little bit of nickeling and diming with inflation as well, which leads me to the inevitable question, Jim, would you go ahead and use that phrase in a sentence probably nonrhyming?
Jim Mueller: Sure, definitely not rhyming. Matt set the bar too high. If you expect a certain return rate going forward to grow your money, that is the discount rate to use to find the present value of those future dollars generated by the business in today’s money.
David Gardner: Now Jim, a lot of people, especially so-called value investors, think a lot about this and use this very actively. They’ve got spreadsheets that express it out to an extra decimal or two and it helps them value the stocks. Is that something? Is that a practice that’s part of your arsenal as an investor or not? I think you know about me, I don’t really do that.
Jim Mueller: I know you don’t really do that. I do that depending on the company, I’ll either build a full model, but I like to keep my models fairly simple. But yes, I do certainly do think about the discount rate and the one I use is a hurdle. I want a certain return on my stock investments. I want to beat the S&P 500. The S&P 500 has a long-term return rate of about 10-11%, and then if you put your money in an S&P 500 index, you’ll get about 10% a year for many, many years. If I’m going to go to the trouble of finding out my own investments, I want to get a little bit better than that. So I often use a discount rate of 12%. Remember, discount rate or expected return rate, just as a matter of which direction in time you’re looking, and so it’s the same thing.
David Gardner: Thank you. Jim, perhaps we’ll have you on next time to do discount rate. That would be what the central bank charges commercial banks to loan money to it, which is another version of that same phrase. But thank you for discount rate this way, this time, which I think is a little bit more relevant to investors. For our final term this week, we turn back to Bill Barker. Bill, what do you have for us term number 6?
Bill Barker: My term, and it’s a little more complicated than my first term.
David Gardner: It’s supposed to be.
Bill Barker: Not complicated as Jim’s. It’s the compounded annual growth rate or CAGR. It’s just the mean annual growth rate of an investment over a specific time period of longer than a year. If you are looking at something which as a stock, or as an economy, or as a top-line sales growth rate, whatever it is, it goes up quite a bit in one year, down a little bit the next year, then up a normal amount, up a lot. You take the time period and you take the final time period, divide it by the beginning time period, take it to the one over T power.
David Gardner: We’re doing some math here again. That’s appropriate.
Bill Barker: I want to get this and try to get up as complicated as Jim’s, but I’m never going to come close. It’s really the inverse of the discount rate is, your compounding numbers rather than discounting them, and doing that to a certain power however many years you’re studying. To follow up on Jim’s comment of the 10% or 11% annual returns to the market, in 1994, Jeremy Siegel.
David Gardner: Stocks for the Long Run.
Bill Barker: Stocks for the Long Run published for the first time, there have been a few additional editions, showed in his book in 1994 that the return in real terms for stocks, as measured by the S&P 500, was about 6.5-7% annually and that’s after the real terms, meaning once you’ve subtracted inflation. If you’re talking about the 100-year returns of stocks, they’re a little bit over 10%, but that’s including three-plus percent inflation. Since he published the book, that’s continued to be the compounded annual return of stocks. It’s a little bit higher if you measure from 1994 in January. I think it was published around January. It’s been 30 years.
David Gardner: By the way, the Motley Fool debuted online in 1994. So you’re allowed to have a 1994-centric forward view. You have one, Bill, and it’s been good.
Bill Barker: I mean, Siegel’s great accomplishment was to come up with the research for the time periods prior to his publication and predict more or less this is what one should expect to happen going forward, and out of time period it’s been the same. It’s been a little bit higher if you end the clock right now. But if you’d ended it at the end of a year and a half ago, it would have been a little bit less, about 7.2%.
David Gardner: About the same 30 years later. Good. He had it on. He had gold in there, too. Gold’s compound annual growth rate.
Jim Mueller: He had gold, he had cash, he had bonds.
David Gardner: Gold not so good.
Bill Barker: I can’t remember.
David Gardner: Something close to zero, I think.
Bill Barker: Gold in real terms had compounded at all.
Matt Argersinger: Right. I think it was even negative. I mean, I think it was.
Bill Barker: Yet gold gets about as much commercial time, maybe not quite as much on CNBC, the gold schemes and the people who are like got to get gold now. It’s the only thing.
Matt Argersinger: It seems like when there’s a rash of bad news, you tend to get a lot of gold commercials. I guess they’re almost timed for that kind of moment.
David Gardner: We’re going to continue this term in a sec. But if listeners take nothing else away from this week’s podcast but maybe don’t watch or listen to the gold commercials on CNBC, [laughs] have we done our work? I think, Bill, you may have done your work. Give us a score of two.
Bill Barker: Just go and study Jeremy Siegel’s research on that and see whether it’s maintained its value since 1994 on what gold has done. But cash, gold, bonds, stocks have basically kept their order.
Matt Argersinger: I think it’s just remarkable. He wrote that in ’94 and, of course, we had an epic stock market crash in 2000, 2001, 2002. I mean, Nasdaq.
David Gardner: Sure.
Matt Argersinger: Then six or seven years later had another massive crash in 2008 with the financial crisis, and yet those two really sharp, unbelievable corrections. I don’t like the word correction, but declines in the stock market, yet that long-term rate of return has remained intact.
Bill Barker: He would be called in 2000 when the stock market was at highs and what’s going to happen going forward, and he lowered his number, given the height of the stock market at the times, about 4.5-5.5%, and that turned out to be right for about the next 10-15 years. You have to lower your expectations at times when the market has had exceptional returns from what your future returns can be. That’s just math. But he was still projecting real returns over the long term.
Jim Mueller: That chart where he blaze out the 50, or 60, or 80, or 100 years, I can’t remember the time frame, but it’s decades-long of those returns and how growth of $1,000 of any one of those items would be.
David Gardner: From gold to cash to bonds to stocks.
Jim Mueller: Yeah, the stocks just crushes everything else and it’s counterintuitive to many people because stocks are riskier.
David Gardner: What goes up must come down, right?
Jim Mueller: Yeah. Well, when gravity is in play, sure. But it’s what Warren Buffett talks about is don’t bet against the American economy. When the economy is growing, companies do well. They grow and become more valuable over time while gold just sits there looking yellow.
Bill Barker: Then the important word in this particular term is compound annual growth rate. The annual growth rate of the economy, 2-3% in real terms, throw a little inflation on there, you throw a little bit of dividends, that’s where you get your returns from the market. Margins have improved over time, but each one of those things is just adding 1% or 2%. Altogether that translates into real returns 6-7%. The thing that I guess I would ask, David, you travel in the Rule Breaker world where compounded annual growth rate of 6% probably doesn’t sound all that interesting for many of the companies that you’re looking at in their youth. Of course, the compounded annual growth rate of a successful company when it is small should be much, much higher than that. As a company matures, the annual growth rate almost has to come down. Although large American tech stocks have been.
Matt Argersinger: Unless your name is Apple or something.
Bill Barker: I mean, that’s the amazing thing, not just about Apple, but [Alphabet‘s] Google and Microsoft again and being of a size that previously could not compound it at anything approaching double-digit rates in real terms has been achieved by several companies.
David Gardner: Well, we certainly love companies that have done that. I call a lot of those rule breakers as I think you guys know. Yes, I’ve always been on the hunt for those. I do admire and love though just a good rate of return over a long period of time. Part of what happens with that 6% rate or even if it’s blended higher, 10% or 12%, let’s say, for companies that are at earlier stages with hypergrowth is that you lose a lot, too. Part of that blended rate of return that compounds includes a lot of losses and negatives, and I’ve done a lot of those myself as a stock picker over time. Anybody who follows a Rule Breaker mentality is going to have losers, too. You have to remember those all blend and you have to be willing to accept those losers as part of getting that higher CAGR, that higher compound annual growth rate. Bill Barker, thank you for that term, which just about to close out this week’s episode, except, Bill, you need an illustrative sentence. If you could use all of the phrase compound annual growth rate, I mean, I like acronyms and it’s a little awkward, CAGR.
Matt Argersinger: Like a rhyme.
Bill Barker: See, I was thinking about it and how, what would rhyme. I think rager is about as close [laughs] as I came up with in the middle, but I don’t have a good sentence for CAGR and rager. Give me another few minutes, I might come up with something.
David Gardner: Well, we’re not going to do that, but you do owe our listeners an illustrative sentence. So just use what you had.
Bill Barker: Compound annual growth rate is a term often misapplied as the eighth wonder of the universe to Albert Einstein.
David Gardner: Yes. Einstein didn’t actually say that.
Bill Barker: No, I don’t think he actually said that or wasn’t the first one to say it or any way.
David Gardner: It’s on bumper stickers, it’s in TED Talks.
Bill Barker: It’s an amazing powerful force and I think he said something like it, but he wasn’t the first.
David Gardner: Well, thank you again to our guests this week, Matt Argersinger, Jim Mueller, and Bill Barker. Just for the fun of it, how long has each of you been in and around Fooldom in years? I’m just curious. Matt?
Matt Argersinger: Gosh. Well, if you go back to the discussion board days, gosh, it’s going on 20 years now. But as a Fool, 16.
David Gardner: Sixteen. Jim?
Jim Mueller: As a paid Fool, coming up on 18. As a customer, you can add a couple more years to that.
David Gardner: I’ll just go with the 18, that’s awesome. Bill?
Bill Barker: Twenty-six as an employee and a few years on the message boards. If you date it to my first post of the day, back on the message boards.
David Gardner: Back in the day.
Bill Barker: I won that a couple of times, ’96.
David Gardner: Wow. Well, if I did my math right, that’s 60, six-zero, combined years of Foolishness. One thing that my brother Tom and I take some small pride in as entrepreneurs is that we can find wonderful people like this and they stay with us and we stay together for years and years. I want to thank each of you for your Foolish service, and that includes this week’s podcast where we introduced these six terms. I hope you know them all now. Whether you gave us a zero or one or a two, that’s your own business, dear listener. We would always love to hear your scores if you want to post it, here they are again. Cash from operations, inflation target, Misery Index, funds from operations, discount rate, and compound annual growth rate. Well, we hope your results, listeners, spoke for themselves. Again, whether it was a 0, 1, or 2 for each of our terms. We had a lot of fun bringing that to you this week. Thank you again to Matt, Jim, and Bill. A reminder, next week, I’m going to bring back a few of my most important points made over the years. It’s a Blast From the Past podcast for Rule Breaker Investing, where I bring back important points you may never have heard or maybe you heard and forgot, ones that speak well to the here and now and I hope inspire you. In the meantime, Fool on.