In one sentence: Phil explains why the payback-time method uses free cash flow rather than the earnings per share he used in the book (earnings aren't spendable cash), shows how to get free cash flow from the cash flow statement with a rental-house example, and argues that you should act as if you own the whole company.
Key ideas
- Patient money. Following Buffett works but few professionals can do it, because it requires holding cash longer than clients allow. Pension-fund managers may have only a quarter to half a year to prove themselves, so their incentives differ from their investors'. A private investor has no such pressure. [01:00–05:00]
- Two kinds of fund manager. One believes modern portfolio theory (price equals value, so diversify widely and expect about 5% over a very long time). The other believes you can beat the market but can't wait for it. [03:00–04:30]
- A "real investment". One where you have a high (never 100%) degree of certainty about how it will go, built from the past record plus a price or paradigm for the future. The certainty that matters is that price and value differ. [05:00–06:30]
- Why free cash flow. All four Munger filters (understand, moat, management, price) come down to one number, free cash flow. [07:00–08:30]
- Why the book used earnings. In Payback Time Phil used EPS because it's published everywhere and keeps things simple. But EPS is an accrual-accounting number: it counts revenue promised but not yet received, so companies can show earnings and still go bankrupt without cash. [09:00–12:00]
- Calculating it. Take cash from operations (top third of the cash flow statement) and subtract purchase of property and equipment, a few lines down. Read the footnotes, since they flag unusual items. [12:00–13:00]
- The rental house. $12,000 rent, minus $1,000 tax, $1,000 insurance and about $2,000 of repairs and improvements leaves $8,000 "in my pocket", which is free cash flow. Purchase of property and equipment covers both maintenance and growth spending. [13:00–17:30]
- The investing fiction. Act as if you own the whole company, even though the cash stays inside it. REITs let you do the same with apartments or hospitals. The fiction also makes you ask whether you'd be proud to own all of it, and so ties in your values. [17:00–21:00]
- Vote with your money. Phil says about 85% of stock-market money is ordinary people's, managed by professionals who may not share their values. He gives CEO pay ratios (about 40× then, about 500× now) as an example and notes that some founders take very low salaries. Those are his figures. [21:00–25:00]
- Early-stage and crowdfunded companies. Phil says you can't know how long or how big the cash flow will be, so it's speculation. Danielle pushes back that venture capitalists aren't simply gambling. They settle on a "range of certainty": the Rule #1 range is much narrower than a VC's. [25:00–34:30]
- Earnings vs. free cash flow changes the answer. FCF may be half of earnings (payback twice as long) or 150% (a third shorter). That is why payback time now uses it. [34:30–36:30]
How it maps to RuleOne
- The stock pages show free cash flow (operating cash flow minus capex), the same calculation Phil gives here. Compare it with EPS on /stock/TICKER/ to see how far they differ.
- Where several sites disagree on FCF, check which capex line each uses. Phil raises this in 071.
- The values test is a judgement and can't be automated, so /holdings/ is the place to write down your reason for owning a name.
Buffett, Munger and Graham links
- Buffett's 1986 Berkshire letter defines "owner earnings" (see 050). Phil's quote about discounting free cash flows "until Kingdom come" is a paraphrase of Buffett's valuation principle, and is not a quote to rely on.
- Buffett's "circle of competence" is relevant here: early-stage firms sit outside most people's circles because their cash flows can't be predicted.
Words to know
- Free cash flow: cash from operations minus purchase of property and equipment.
- Accrual accounting: recording revenue and costs when earned or owed, not when cash moves.
- Patient money: capital free to wait in cash until a real opportunity appears.
- Range of certainty: Phil and Danielle's compromise between "investing" and "speculating".
Try this
Pick a company on All stocks and open its page. Write EPS and free cash flow per share side by side, then compute payback time both ways. Which is longer, and what does the cash flow statement say about why?
Check yourself
- Why can a company have earnings and still go bankrupt?
Answer
Accrual accounting counts revenue not yet received, so earnings can exceed the cash in the bank. - How do you get free cash flow from the statements?
Answer
Cash from operations minus purchase of property and equipment (read the footnotes too). - In the rental-house example, what is the free cash flow?
Answer
$12,000 − $1,000 − $1,000 − $2,000 = $8,000. - Why does Phil call early-stage investing speculation?
Answer
You can't judge how long or how large the cash flow will be, so your range of certainty is too wide.
Short quotes
"You can't spend earnings per share. They're not real money." (Phil, ~10:30, auto-transcribed, paraphrased)