In one sentence: Answering listener Jacob, Phil and Danielle find why two sites show different Netflix free cash flow for 2014 (-$128M vs. -$53M) by going to the 10-K, where an unusual DVD-library line explains the gap, and Danielle sets a 20-companies-in-a-month reading challenge.
Key ideas
- Why value matters at all. Modern portfolio theory treats price as value, so advisers aren't trained to value companies. Rule #1 investors believe price and value diverge, partly because fund managers act on fear. [02:00–07:00]
- The question. Morningstar shows -$128M of 2014 free cash flow for Netflix; MSN Money shows -$53.2M. Free cash flow isn't a GAAP number, which is why it's absent from the "financials" and appears under key ratios or is calculated. [07:00–13:00]
- The formula. Free cash flow = cash from operating activities minus purchase of property and equipment. Netflix: $16.5M operating cash flow, $69.7M of property and equipment, giving -$53.2M. Parentheses mean cash going out. [15:00–28:00]
- Why 128 is closer to right. Netflix has a line "acquisition of DVD content library" ($74.8M) under investing activities, because it treats the library as a productive asset. Adding that gives -$128M. For an owner that cash is spent, so it isn't free cash flow. [30:00–37:00]
- Go to the source. Before putting money in, get the 10-K from the company's investor page (the PDF as filed) or from SEC EDGAR. Check that the period end matches the year you want. [14:00–24:00]
- Reading the statements. Find the table of contents entry for financial statements; cash flow has three sections (operating, investing, financing). Search the PDF for odd line items and read the notes, which explain them. [24:00–39:00]
- Anomalies are the point. The company-specific line is why you only study about 20 companies in a lifetime: you have to dig that deep. [28:00–31:00]
- If it's unclear, it's the too-hard pile. Phil says if a 10-K is intentionally or unavoidably unclear, move on. Danielle replies that beginners can't yet tell "too hard" from "I haven't learned this yet". [38:00–41:00]
- Exercise. Choose 20 companies of interest, perhaps from your three circles, and read the business section of one 10-K a night. Report back in about five episodes. [40:00–42:00]
How it maps to RuleOne
- The stock pages (/stock/TICKER/) show free cash flow, but a derived number is only as good as the classification behind it. Check the cash flow statement for lines like Netflix's.
- The pages link to SEC EDGAR, which is the "source" step. The numbers in the screen come from filings, so any outliers deserve the same footnote check.
Buffett, Munger and Graham links
- Buffett's 1986 letter defines owner earnings (capex needed to maintain the business); a content library purchase that sustains the business fits that spirit.
- Buffett's advice (various letters and meetings) to read annual reports is the model for the nightly 10-K habit.
- "Too hard pile" is Buffett and Munger's term.
Words to know
- GAAP: generally accepted accounting principles, the rules behind the filed statements.
- Cash flow statement sections: operating, investing, financing.
- Footnotes (notes to the financial statements): the explanations of how items were treated.
- EDGAR: the SEC's free filing database.
Try this
Pick a company on /stocks/, open its latest 10-K from EDGAR, and calculate free cash flow yourself (operating cash flow minus purchase of property and equipment). Scan the investing section for unusual lines and read the matching note. Compare your figure with the one on its stock page.
Check yourself
- How do you calculate free cash flow from the statements?
Answer
Cash from operating activities minus purchase of property and equipment. - Why did two sites differ on Netflix?
Answer
Netflix reports DVD library acquisitions on a separate investing line. Some data providers deduct it and others don't. - Where do you look for the explanation of an odd line?
Answer
The notes to the consolidated financial statements, found by searching the 10-K.
Short quotes
"If it is not clear to you what these people are saying, it's not clear for a reason." (Phil, ~39:00, auto-transcribed, paraphrased)