The Only Fundamental Analysis Video You Will Ever Need... (Full Course: Beginner to Advanced)

Hey, you're here because you're seeing stocks move up. You're hearing it on Twitter or on TV, or your friends are talking about it, and you want to make money with the right stocks and do your due diligence so you don't lose money. And also be prepared to find bargains when, as you know, the market will inevitably sell off.

Well, the best way to get into stocks is through fundamental analysis, or understanding the financial strengths of a business. Now, I myself have lost thousands and thousands of dollars from using what's called technical analysis, or studying prices. That leads to trading and chasing price trends. Warren Buffett has always said that the best way to make a lot of money in stocks is just to buy a great business at a good price, and the way to do that is with fundamental analysis.

And so, this is everything that I wish I knew before coming from 10 years of Wall Street experience. I was a research analyst at Bank of Montreal, an investment bank in New York, and my clients were funds like JP Morgan and Citadel, and I was helping them pick stocks for their portfolios. So, in this video, I'm packing everything you need to know about fundamental analysis to make a good investment decision. We're talking financial statements, screening companies, valuation, forecasting, identifying opportunities, and even options. And last, but most importantly, the psychology of buying and selling in the market, so that you can identify good versus bad companies, know what price to buy them at, and when to buy and sell them. This will save you from making all the same mistakes that I've made from trading, and instead make good investment decisions with fundamental analysis and become a better investor. Does that sound good?

So, here's a list of everything that you'll learn, and let's jump right in. Okay, so now the psychology of price and earnings. So, fundamental analysis is all about the study of businesses to understand their value. It's about the business and its earnings. So, earnings is just how much money the business makes after paying all its costs. And when we buy a share of a stock, we're buying a share of the business. So, the earnings per share is the value that we get as investors.

So, here I'm pulling up a chart, and this is from Koyfin. It's an online tool that I like to use. I've pulled up the earnings per share and the price per share. Now, if you can, when you're using software like this, is to use the next 12 months earnings per share estimate, or NTM for short, and this is what I have up here. And the reason why is because markets tend to look ahead. So, the earnings estimate will actually give you a clearer sense of how prices are moving with earnings. But if not, historical earnings per share is fine.

So, here we have a chart of Apple. And the black line over here is the, uh, earnings per share, and then the green line over here is the price per share of the business. So, what do you notice? The price follows the earnings per share. So, price follows earnings, as a lot of investors say.

Now, here we have Nvidia. It's a little bit more volatile. You see that the earnings are more cyclical. You've got these peaks and troughs, but overall, it still follows, uh, the earnings.

Now, here we have Tesla. So, it's obviously a lot more volatile. We see these big changes in earnings and much bigger changes in price. So, there's also big divergences between price and earnings per share.

So, fundamental analysis is all about understanding the black line, so the business's earnings, and then using that to value the price per share, so that's the green line over here. When we can do those things effectively, we can figure out what stocks to buy and sell, and at what price, and when to buy them. So, instead of buying a business when it's on decline, we want to buy it when it's improving, so like right, right over here. And instead of buying peak prices over here, we probably want to buy them when they're at better value, maybe over here or around here.

And so, what most people do when they skip fundamental analysis is the following. It's what I like to call the "face and prey" strategy. They, they follow markets really obsessively. They'll start chasing price trends or popular stocks, and then ultimately buy them at peaks. And inevitably, as you know, price comes down, and then they hold it, just praying it will recover, because at the end of the day, they don't really know what they bought.

So, what's actually happening here is that's a momentum strategy. You're just buying prices that go up. And so, what happens if you just keep doing that as a strategy? You get one or two years of gains, and then usually get about two to three years of pain, because those expensive stocks ultimately will revalue. And if you try to hold on, that actually doesn't make it work. Because the strategy, if you actually just keep selling losers and keep rotating to the prices that are going up, this is how the strategy would actually perform. If you were to do what most people do and just pray and, and hold on to the losers, what your portfolio is going to do is just go down like this.

The fundamental strategy kind of flips it on its head. What we our focus on doing is buying good businesses that grow earnings. We're going to value those businesses so that we get it at a good price, and then ultimately, we let the market work for us. You let the price work for you. So, what that looks like is we're first buying shares that are growing earnings, so like at a point like here. We're going to value the shares, so we don't buy it at peaks like over here. And ultimately, as we follow with the business and understand its valuation, we want to get it at a good price, like over here, or like over here.

So, when we do this, the market just works for us. The price goes up as a business makes money and grows in value.

Now, what you don't need, and this is addressing some popular misconceptions. You definitely don't need to be day trading. 90% of trading is algorithmic trading. Computers just do that type of strategy better. You don't need to be an accountant. I myself started with a philosophy degree. You just need to know the essentials. And you don't need insider information. That's highly illegal, especially in the US markets. You will go to jail. And finally, you don't need a lot of money. It really comes down to good thinking. I've seen myself that you don't actually get much advantage at all. It's technically a disadvantage when you have a ton of money to invest.

So, if fundamental analysis is all about the business's earnings, then the foundation is the financial statements. And there are three key things that you must understand with financial statements that make you money as an investor of the business. The first is the growth of its earnings. Second is the margins, so the efficiency of the business. And third is the returns, so the returns on invested capital. You're going to see exactly why all those things work together when we actually build up a financial statement.

Here's a lesson of why this is important. So, back in around 2017, I bought this dumb stock, and I probably lost over $110,000 buying it. It was Rite Aid. And the reason is, I didn't bother reading the financial statements, and I just bought it because a hedge fund was buying. And the stock just obviously went down like this. If I had looked at the financial statements ahead of time, knowing what I know now, and this is Rite Aid's financial statements, I could have seen the warning signs. So, by the end of this as well, you'll be able to see the exact warning signs so that you can avoid mistakes like this.

But first, we've got to understand what those numbers actually mean. And don't worry, this is not going to be a long list of boring metrics. What we're going to do is imagine we're building up a coffee shop together. So, you're going to, we're going to build up the numbers of a coffee shop from the bottom's up, as if we started the business together. And so, then you know exactly what these financial numbers are, how they're linked together, and we're going to analyze them so that you can see exactly what makes you money as an investor.

The first thing when we start a business is we need to raise money. We need to raise capital. So, let's say we each put in $500 to start up the business. Say we each get 10 shares. That works out to about a total of 10 shares at $100 each. We put that in exchange for shares of the business, so that's the stock. And now that's considered equity because it's money invested in the business.

Let's say we also go to the bank, we want to get a loan. We get a $100 loan at a 10% interest rate from a bank. Now, that would be considered debt on our balance sheet. So, that works out to a total of $100 in liabilities, so that's something that the business owes and it's money to be paid back. So, the total capital here is $1,000 in equity plus $100 in liability. So, the total capital invested is $1,100.

Now, with this capital, we want to invest in assets for the business. We want to get a cash register, we want to get a shop store, all the furniture, etc. So, let's put that all together and say we've invested $800 in property and equipment. Now, these are assets. These are stuff that we own, and we expect to make money from it. And we also keep $300 in cash in the bank for the business, just for day-to-day cash needs, whether that's for payroll or for expenses. So, our total assets comes up to $1,100.

Now, you can see that we have a total assets of $1,100, and that has been funded by $100 in liabilities from debt and $1,000 in equity. So, assets from a balance sheet perspective always have to be funded by either liabilities or equity, and they always balance. And that's why it's called a balance sheet.

So, now that we're funded, let's go into business. Now, we want to start to think about the operating metrics for our business. And let's look at this for the first year. Let's say we sell cups. We sold about 150 cups for the year, and we've sold them at a certain price of $5 a cup. So, when we multiply the cups sold times the price per cup, that gets us to $750 in sales.

Now, we've got to pay for the actual coffee. So, we have to pay for the beans, we have to pay for the actual cups. Say that works out to about $3 in cost per cup. Now, we multiply the cups sold by the cost per cup, that gets us to what's called the cost of goods sold, or the COGS for short.

Now, from the perspective of expenses, operating expenses for the business. We have staff and labor costs, works out to about $100 in that first year. Our equipment has worn down a little bit. Let's quantify that as about $80 in depreciation. Works out to about 10% of the asset value. And so, then that total of labor cost plus the depreciation, or the wear and tear of our equipment, gets us to total operating expenses of about $180. And so, this is the basis for our business performance.

Now, we can take that operating metric and start to see it in the income statement, and this will show us how much earnings the business makes. So, we have our total sales that goes into the revenues for the business for the first year, $750. We have our cost of goods sold, or COGS, gets to $450. So, when we take the revenues minus the cost of goods sold, that gets us to our gross profit. So, that's the profit that our business is making before operating expenses. You can think of it as a profit on the product before paying expenses for the business.

Now, from an operating perspective, we have operating expenses. We have depreciation, the wear and tear of our equipment. We also have the labor, of course. Those things sum together gets us to a total operating expense of $180. When we take the gross profit minus the operating cost, that gets us to our earnings before interest and taxes. So, that's EBIT for short, of $120.

Now, of course, we also have our interest expense. Remember, we got a $100 loan, we're paying 10%, so it's $10 in interest. That gets us to our pre-tax income of $110. And then we also pay taxes. Let's say we pay a 20% tax rate on that pre-tax income, works out to about $22 in tax. And then that leaves us with $88 in net income. That's the earnings of the business. And when we take into account the shares of the business, that works out to $8.80 in earnings per share.

Now, this is the most important number, because that earnings belongs to us as shareholders. That's the money the business has made, which will increase its value.

All right, now let's look at it from a cash flow perspective. So, this is a cash flow statement. It can tell us, from a cash perspective, how the money is moving around. Starting off with the cash from operations, we have our earnings. So, we've made $88 in net income. We have our depreciation of $80. So, that's just a non-cash expense, right? Because it's the wear and tear of equipment. So, we add that back, and that gets us to the actual cash produced by the business. The cash from operations is $168 in the first year.

Now, from an investing standpoint, we've invested $800 into our property and equipment when we first started the business. That's year zero. And let's say that we also want to reinvest $80 to offset that wear and tear. So, we fix any equipment that has broken down. Think of it like maintenance. So, when we add those things together, we get our cash that's in from an investing stand.

Now, when we take the cash from our business and minus the investments, we get to what we call free cash flow. Now, that's the cash that the business has produced after investments. And so, that works out to $88. You can see it's $800, a negative $800 because of the investments when we first started it up. And it's called free cash flow, and it's important because this is the cash that our business has that can be used to either pay a dividend to us as shareholders, or maybe to repurchase stock. Effectively, it means that we can pay ourselves as shareholders with free cash flow.

Now, from a financing perspective, we've raised $100 in debt. We've also raised $1,000 in equity from selling our shares. The total is $1,100 from last year, but we haven't done any financing this year, so we don't have anything from year one.

Now, what happens when we put all those things together? We've got our cash from operations, our cash from investing, and our cash from financing. We sum all those things up together, we can see the net change in cash. You can see that's how we ended up with $300 in the, when we first started the business. That's why we have $300 in our bank account. And our business generated $88 in the first year in net cash. And it's the same as earnings, because you can see that our investments are just balanced with the depreciation. It's just there to offset the depreciation. We didn't make any additional investments. So, we take our beginning cash, we take our net cash, and then that ends us with the end cash for the period. So, we started out with $300, and that's how we end up with $388 at the end of year one.

And now we can look at it from a balance sheet perspective. This basically just records where our money goes. So, this is what we started off with when we first started the business. This is our first balance sheet. Remember, we didn't raise any equity capital, so we still have $1,000 in total equity capital. And we've generated $88 in earnings. Let's say we keep that into the business, that would be considered retained earnings, just reinvested into the business. We also have $100 in debt. We didn't pay off any debt, no change to debt. And we also have still $800 in property and equipment. We had that depreciation of $80, but we reinvested $80 in capital expenditures. So, there's no change to our property and equipment. When we add the additional cash of $88, we end with $388 in cash.

So, now we have total assets of $1,188. Liabilities are still $100. And so, then our total equity is $1,088. So, you can see that the assets have gone up by $88, and then the equity has also gone up by $88 because the liabilities have stayed the same. So, equity is sometimes called book value, and that has increased by $88. So, that's the value of the business from an accounting perspective. That's why it's called the book value, and it's sort of like net worth from an accounting perspective. So, it's increased by $88.

So, now let's think about the returns that we made on our investment as investors. We raised $1,000 in equity capital plus the $100 in debt, works out to $1,100 in total capital. Now, the business has made $88 in earnings. So, as a percentage of the equity capital raised, that works out to an 8.8% return on equity. Now, if we want to think about the returns that the business has made for all capital holders, we want to look at the earnings before interest and tax, because interest is paid to the debt holders, or the bank, right? And we still want to pay tax. So, we take the earnings before interest in tax, then deduct the tax, that gets us to $99.60 in earnings before interest in tax after tax on the $1,100 in total capital. Now, that works out to an 8.7% return on total capital.

So, you can also see that because we borrowed some capital, it means we, as equity investors, have used less capital with the same amount of earnings. That's why we have a higher return on our equity.

Now, looking at it from a book value perspective, we started out with a $1,000 book value. Now, with the $88 in earnings, the book value has increased to $1,088. Again, the assets minus liabilities equals the book value of the business from an accounting standpoint. And then the book value per share, we just divide by the number of shares, has increased from $100 to $109. So, that works out to about a 9% increase in the value of the business for us as shareholders, assuming that the business retains its earnings. So, I'd say that's a pretty good return for our investment in the business, just for our first year. 9% is pretty good. If you think about what you get as a bank, it's probably about 3 or 4%. Treasury bonds might get 4 to 5%. But of course, we're not just operating for one year.

The nice thing about a business is that we can start to find more customers and make more money for us as investors. So, let's see how this changes if we grow the business over the next five years. So, starting with our growth assumptions, let's say we grow our cup sales at 10% every year. That works out to 10% every year. And now we can estimate the number of cups that we sold. Let's say that we grow our prices at about 2% a year. That works out to inflation. And then that gets us, of course, to our sales. We take the cups sold times the price per cup, that gets us to our total sales forecast.

Now, from a cost perspective, let's say our cost of goods sold, or COGS, increase also about 2%. So, the same with inflation. So, all of our cups and our beans work out to increase at about that same inflation rate. So, our cost per cup go up by that amount. We can work out the cost of goods sold by the cups sold times the cost per cup, gets us to our estimated cost of goods sold.

Now, we look at it from an operating perspective. Let's say labor costs and wages go up about 5% a year. We use that to estimate the total operating expenses of labor costs going up. Notice also that our labor expenses are growing not as fast as sales. It's growing at 5% versus the 10% in cups and 2% in price. So, we're also getting more efficient in our business, and we're getting more bang for our buck, as they say, like a lever. And that's why it's called operating leverage, when you can grow your sales faster than your operating expenses. If you want to do some quick math, you can see that our operating expenses have increased by about 20%, whereas if you look at our total sales have increased, you know, about 50%. So, you can see that's the leverage that we get. We're getting 50% in sales versus just 20% in operating expenses.

So, now we can put this all together into the new income statement, showing the trends of the business going forward. There's no change to interest. We haven't raised any more debt. No change to depreciation because we maintain the same level of property and equipment. The investments balance with the depreciation. And of course, shares remain the same as well. So, no change in debt, no change in depreciation, no change in shares. And then, so now we have our new revenues, we have our new cost of goods sold, and that gets us to our new gross profit forecast for the future. Remove the labor, so the total operating expenses, and that helps calculate the earnings before interest and taxes. We have our interest, minus that gets us to our pre-tax income. And of course, same tax rate, 20%. Now we have our tax expense, and that gets us to our net income. And of course, our earnings per share for the business.

So, the point is, now you can see that by the end of year five, now we expect to generate $21 in earnings, or about $21 a share by year five. And so, this is how earnings are calculated in a business, and that really is the foundation of financial statements. That, believe it or not, is everything you need to start analyzing a business.

Okay, so now let's switch gears to analyze the financial statements to evaluate the performance of the business as an owner and see what really makes us money. So, we start off by analyzing the trends in the income statement, and we want to be focused on the drivers of earnings. In other words, what makes us money for the business. So, we start off with revenue growth. Just look at the current year as a percentage from the prior year. So, that works out to about 12% a year in growth. You can see that we have 10% growth in cup volume and 2% price. So, 10 plus 2 gets us to our revenue growth, and that tells us that the business is growing.

We can look at gross margins. So, we take the gross profit as a percentage of revenues. That's stable at 40% per year. You can see the reason why is because the price per cup and the cost per cup are both stable. They're both increasing at about 2% a year. So, that tells us that the profits on the product are stable.

We can look at EBIT margin, so earnings before interest and taxes as a percentage of revenues. Now, that has increased from 16% to 23%. Now, what that tells us is that the business is getting more efficient, because the costs are relatively fixed. We know that the revenues are growing faster than expenses. If you remember, labor costs are just growing at about 5% a year. Because revenues are growing faster than expenses, we get operating leverage. What operating leverage does is really it increases the rate of growth of earnings.

So, if we look at EPS growth, the earnings per share growth, current year as a percentage of prior year, we see that earnings per share is growing much faster. It's growing at about 24% per year. So, that tells us that the business is making lots of money.

And then from a balance sheet perspective, again, we're looking at this to see where all the money has gone. Now, we know that there's no additional equity raises, so then that's why this stock level has stayed the same. We know that there's also no additional debt raises, so that's why debt has stayed the same. And earnings, if we assume, have been retained into the business, it's just added up into the balance sheet. Now, this is a cumulative sum. So, earnings are just added up to the prior year sum, so that we can see that the business has generated a total of $729 in earnings for the business.

There hasn't been any additional investments in property and equipment, so property and equipment as a line item has stayed the same. And therefore, all the investments, or all the earnings, excuse me, have grown as cash. And that's why cash has grown by that same amount. So, when we look at the book value, you can see that it's grown from a little over $1,000 to $1,729, which comes from all the earnings that the business has generated. So, the value has increased because of those earnings.

And now we can put that all together to again see the returns that we get on our invested capital. So, if we assume that all the retained earnings are just paid to us as shareholders, we don't have any additional capital investment in either equity, so that stays the same, or debt. So, total capital has stayed the same. We can see that the returns on equity, so just the earnings of the business as a percentage of the equity capital, continues to increase, right? Because we're growing more earnings on the same amount of capital. And that works out to a higher return on equity. And it's the same thing for the return on invested capital, which is the earnings before interest in tax after the tax as a percentage of total capital. You can see that both return on equity and return on total capital have been increasing. So, that tells us the business is making more efficient use of capital. That's why it's getting higher and higher returns.

Now, that's an indicator that the business is really making good money. Now, let's see what all of that does to the value of the business. So, let's start off with the book value. So, the equity, again, it's just the assets minus the liabilities. Think of it as a net worth from an accounting perspective. That has increased from $1,000 to $1,729 book value because the earnings has increased. And so, the book value per share has also increased from $109 to $173 per share. You can see that's all the earnings that have just been added up in the business. And because we're getting higher returns on the capital, that leads to a larger increase in book value. Book value is starting to grow at a faster and faster rate because it's generating more earnings.

And we can also see that from the cash perspective. Our cash per share is now $103 as well. So, if you think about it, we put down $100 per share. If we gave back all the cash to us as investors, we would have made back everything that we've invested, that $100, if we distributed all of our earnings back to shareholders.

Now, from a cash flow perspective, we can look at the trends to see where the investments and where the cash has been generated over time. We know that there has been no equity raises, so there's nothing happening there. No debt raises, so also nothing happening in the financing side of things. The business has been generating an increase in net income, and depreciation is stable because the assets have been kept level, and we have a stable depreciation of assets. So, we can see that cash from operations has been growing as well.

From an investing standpoint, we've reinvested to maintain the property and equipment. So, we've reinvested that same amount of depreciation into capital expenditures. Those are the investments. And it works out to a total of our investing activities. Again, we take the cash from operations from the business minus the capital expenditures, and then that gets us to our free cash flow. And you can see that our free cash flow is growing as well. We're generating $21 in free cash flow by year five, which is the same as the earnings because the investments have been balanced with the depreciation. So, because there haven't been any new investments, depreciation and capital expenditure is balanced, you can see that free cash flow and earnings are growing at the same pace.

Okay, so now let's get back to the most important question: how much money did we make as investors? So, we've put down $1,000 in equity capital as shareholders. And now, over the next five years, let's think about the returns that we get as investors. The business has been generating earnings, and it's generated a total of $729 in earnings. If we pay that all to ourselves, that translates into a 73% total return on our investment.

Now, if we assume that the earnings are just kept in the business, so we retain it, the book value of the business has increased also by $729. So, the book value has increased to $1,729. Now, from a growth in value perspective, that translates into an annual return of about 12% every year. We can also think about it from an earnings perspective. So, the business is now making $211 by year five in earnings, or $21 a share. And relative to that $1,000 that we've invested, that works out to a yield of 21%. You can think of that as like an income.

So, those are the three different types of ways that we made money on our invested capital: one is from growing earnings, second is from the earnings growing business value, and finally, those earnings give us a yield or an income. And so, that's a pretty good business, right? Those are really great return numbers. And so, when you tie that all together, these are the things that make us as investors money. It's really the growth in earnings, so that comes from the sales growth. The margins are the improved efficiency of the business that generates more and more earnings from the sales. And then finally, the returns, or the efficiency of how the business is using capital, will generate more earnings from the same capital invested. If the returns are increasing, and all those three things work together to grow the value of the business and make us money as shareholders.

All right, so now let's apply this analysis and look at the trends in Rite Aid's financial statements. So, if we look at the income statement of the business over here, we can look at the earnings. So, let's look at the net income, and we can see that it's been going down. And if we look at the earnings per share, we can see that it's been going down as well, and it's now zero. So, earnings have been going down. There's a decline in earnings, and there's just no earnings per share. So, that means that the business is not making any money.

Now, if we look at the assets, so over here, we'll look at the balance sheet. So, the assets about $7 billion that goes to $11.6 billion. So, we can see that the assets have nearly doubled. The debt has also increased as well. So, that's gone from $6 billion, oops, I actually marked that, but it's a little over $7 billion. So, looks like they took out more debt. The number of shares have also increased over here, which means they've raised equity. So, they've sold stock. And so, when we put all that together, that means there's an increase in assets, and it's been funded by an increase in debt and an increase in shares. So, they've raised a lot more capital for their investments.

Now, when we look at the cash flow perspective, so all this is the cash to think about where is this money going, what are the returns that they're getting from these investments. If we look at just the cash flow from operations, you can see that that has just been going down pretty dramatically, just $225 million in cash flow. If we want to look at the free cash flow, so we've got the CapEx over here. You can do some quick math, right? So, we have $800 minus about $382, so a little under $500 million in free cash flow. Whereas we look in the latest year, it's about negative $200 million in free cash flow.

So, what that means is that the business is not, is, one, having a decline in cash flow, and also having a decline in free cash flow. So, there's negative free cash flow. So, the business is not making any cash from its investments. And that makes sense with the earnings statement, because the business is not making any earnings. So, with no growth in earnings, we see that decline in efficiency because they're not generating earnings. So, margins are now negative. It's not growing earnings, and returns are now negative. That's why the business value starts to go down, and eventually the business went bankrupt because it ultimately ran out of money because it had no cash flow to pay the interest on its debt. So, when a company can't pay interest on its debt, it gets bankrupt, and the debt holders take over the company.

So, that's a key to reading and analyzing financial statements. Remember, it's just the growth, the margins, and the returns. And we can start to apply this to start to screen good versus bad companies. And that's what we're going to do in the next section.

Now, the key to start screening companies, and there's about 3,000 stocks in the US market, obviously more internationally. You want to start to separate good versus bad companies and to put your money where it's going to grow. And that's where the fundamental research comes in. The key to fundamental research is to figure out what's changing in the business itself and in the industry. And once you figure out which businesses are making money and which businesses are not, and understanding why, that's how you can screen good versus bad companies.

Now, to show you this, let's compare two businesses. We've got Kroger on the left, and they sell grocery stuff, so food, vegetables, meat, food products, so forth. And then Walgreens on the right. They're the pharmacy business. They sell drugs that doctors prescribe. Now, they're similar businesses. They both serve retail, so they have similar customers. And even from a stock perspective, so this is between 2015 and 2019. You can see that they basically performed in line. Kroger is the blue line over here, Walgreens is the purple line, and Kroger is up slightly. It's up 2.5%, and Walgreens is down 2.5% over this time period.

Now, from 2020 onwards, one of them went up more than 140%, and the other one is down 80%. And so, now we're going to look through these two companies, and you're going to see the signs that indicated which would perform better than the other.

So, let's start with the financial statements. Here we've got these two financial statements of these two companies, and we're looking at the past three years from 2017 to 2019, the same period that we're looking in the chart just before. So, what do we notice when we compare the numbers? Remember, we're just looking for growth, overall margin trends, and returns.

If we look at sales, you can see that Kroger is going from $115 to $121. Walgreens, $118 to $120. So, Kroger's is just growing sales slightly better. If we look at gross margin, so 23% to 23%, looks like they're stable. If we look at Walgreens, 25% gross margin goes to 23%. So, Walgreens' gross margin has gone down. That means Walgreens' products are making less profit.

Here we have EBITDA. So, EBITDA is just like we were looking at before, earnings before interest and taxes, but it's also removing the depreciation and amortization. And we do that because those are non-cash charges, and they're related to investments. So, it just makes it easier to compare companies with different levels of investments. If we look at Kroger, we can see there's a slight decline in EBITDA margins, whereas Walgreens is stable. So, that tells us that Walgreens seems to be somehow offsetting that gross margin impact with the EBITDA margin. There's something changing in margins that we should be looking into.

But if we look at earnings overall, you can see that Kroger's earnings are going up pretty nicely, whereas Walgreens is basically flat. It's just gone down a little bit. And from an earnings per share perspective, Walgreens has grown from two to about $3.70 in earnings per share. Walls, Walgreens has gone down from $3.78, or it's gone up, and it's gone up just barely to $4.13. So, Kroger is growing earnings a little bit better. You can see it's grown by almost $1.70, whereas Walgreens has just grown by about 30 cents or so. Because earnings is the most important thing, Kroger's earnings, so that should get us an indicator that something is going on that we should look into.

Now, when we look at the return perspective, now we want to start thinking about what the companies are doing with their investments. We can see that Kroger's returns have been declining a little bit. So, a return on total capital has declined a little bit. And what that probably is, if we look at capital expenditure, we see this big jump in capital expenditure. So, big jump in capital expenditure might explain the reason that they've invested more capital, that's why the returns have gone down. But if we look at free, return on equity, that seems to be going up. So, something to pay attention to. And also, when we look at the cash from operations, that's pretty stable. And from a free cash perspective, it looks like it's going up a lot. So, that's a generally positive sign that they're making cash on their investment.

So, again, something to start to pay attention to. When we look at Walgreens, we see the returns are also stable. Cash flow, however, is declining a little bit. And we see that the capital expenditures has increased a little bit. But when we look at the free cash flow on a per share basis, free cash flow has been going down. And even though they're investing a lot of money, they are not making money from their investments. And so, there's something clearly going on. Walgreens is not growing earnings or even cash flow, while Kroger is growing earnings and cash flow and also making some kind of investment. So, that gives us a big clue of what's going on.

So, then we need to figure out what's happening, what's changing in these businesses, and what's changing in the industry. Because once we understand these trends of who's actually making money and why, we can start to make a good decision of where to invest. Now, this is where fundamental research comes in. What we're doing is searching for the answer to the question of why is Walgreens not growing earnings and why is Kroger growing earnings. And research pretty much looks like this. We can start to look at the 10-K filings, that's the company's annual reports. Want to pay attention to the risk section, the business and industry, and management discussion and analysis, that's MD&A.

We look at company transcripts, so that's earnings calls, conference transcripts, and industry presentations, as well as industry reports.

And so, you do a little reading, and usually it just pops out as long as you have a good question in mind. With some searching, we can start to see why Walgreens' margins have been going down. So, at the bottom over here, we see this is pulled out from their risk section. One of the key risks that they face is reduction in third-party reimbursement levels. So, it turns out that these lower reimbursement levels is a risk. And the reason why that is, if you do a little reading in the 10-K, is that pharmacies in the US are actually reimbursed by these third-party payers. They don't actually make money from selling the drugs. They make money from getting reimbursements when they sell drugs.

The second thing, this is also in the risk section, that they are seeing a pharmacy mix shift to lower margin plans. And this comes from these 90-day subscriptions which have a lower reimbursement rate. And that rate has been going down, which explains why they're seeing pressure on their gross margins because they make less profits on their products. And this is also from a transcript from their earnings call, where the management is saying, "We expect fairly continued pressure from reimbursement on a long-term time horizon." So, management is very clearly saying that they expect pressure and reimbursement. It's a long-term trend in the industry, and that explains why they're having lower margins, which also explains why they're not generating as much earnings. It's declining.

Now, when you search around, you can also start to find industry articles. So, this is a crazy one, that pharmacy fees have increased 91,000%. This is also an indicator that the industry is quite pressured for pharmacies. They're the, those third-party payers are also placing additional fees. So, this pressure is quite well known. This is just from a news article explaining these fees. So, this explains why Walgreens is facing pressure on its earnings, even though its revenues are growing, and it's because of these lower reimbursement rates and higher fees being placed on.

Now, when we contrast it to Kroger, so this is from their investor presentation in 2019, because we're looking at understanding what they're doing with their investments. And it looks like they're doing a lot of different things. This explains why they've been investing a lot. So, they're doing cost savings. They have this alternative profit streams, which turns out to be that they're growing these new marketing and finance businesses. They've also called out this gross margin pressure in retail pharmacy. So, they see it as well. But from a strategic perspective, it looks like they're focusing on fresh, so fresh food. And so, this explains that they're doing a lot of investments. They're strategically changing the business.

And when we look also into transcripts of conferences and earnings calls, just to understand what's going on, we use some keywords. We can see that fresh departments have higher gross margins. We can also see that they have these alternative profit businesses. Just searching around for margin keywords, and also have higher margins. And that fresh offering is an important sales driver. So, what this tells us is that fresh is helping sales. Fresh has higher gross margins, and alternative profits have higher margins overall. So, it's clear that all these investments, to sum it up, is positioning Kroger into higher margin stuff. And that probably explains why they're making more in earnings and cash flow from those investments.

So, when we compare Kroger and Walgreens now with our research, we can see a number of clear trends. One is that Kroger has better sales growth because they are investing in fresh produce, while in contrast, Walgreens has lower reimbursements for pharmacies. And that explains why Kroger is generally growing sales better versus Walgreens. There's also this clear shift to higher to margin products. We've got fresh, alternative profit businesses, versus Walgreens has been shifting to lower margin products, these low reimbursement rate prescriptions. Now, that explains why Kroger has relatively stable gross margins, while Walgreens has declining gross margins. On Wall Street, we would say that there's a mix shift going on. Kroger is shifting to higher margin businesses, Walgreens is shifting to lower margin businesses. And that, at a high level, explains why Walgreens is growing earnings while, uh, uh, sorry, Kroger is growing earnings while Walgreens is not growing their earnings.

So, when we go back to our chart, knowing that, what we know now, is the same time period. Which company do you think is more likely to make money? Meaning, which one should we invest in? Give you a guess. I would probably say let's buy Kroger and maybe sell Walgreens. And let's see what happens in the financials. So, this is for the next four years played out from 2020 to 2023. So, as the financials happen, we can see the trends. We can see that Kroger's revenues have continued to grow, $122 to $148. While as Walgreens has grown as well, but just at a slower rate.

Now, Kroger's gross margins are down slightly, 23% to 22%. So, seeing pressures in gross margins, whereas Walgreens is down almost 2%, so 200 basis points. Basis points is just 1/100th of a percent. So, Walgreens is facing more pressure on its gross margin. You can see that's because of those reimbursement rate pressures that they disclosed before.

Now, Kroger's EBITDA margin is actually improving. It's gone from 4% to 5%. Now, that's probably because they've shifted the business to higher margin businesses as a whole, the fresh, the alternative stuff. Whereas Walgreens has actually their profit been cut in half. That's huge. Their profit margins have gone from 4% to 2%. And that explains why Kroger's EBITDA has expanded nicely, whereas Walgreens has contracted from $4 billion down to $3 billion. And that's why Kroger's earnings are growing as a whole, minus this slight contraction period in 2022. Whereas Walgreens, their earnings have grown slightly, but eventually have started to contract. And if we look into what actually gone.

On happened in 2023. It looks like this big decline was also because Walgreens had to pay a pretty big fine for selling opioid drugs in the US, so that made it worse. Put that together, it seems like this boost in Walgreens' EPS was likely temporary, whereas Kroger seems to have a more sustainable way of growing their earnings.

Another clue from a Walgreens perspective: when we see this increase in EPS but we don't see it in the actual earnings, if it doesn't match up, it means something's going on. It's probably just temporary. Now, I would say, based off these financial trends, it's clear that Kroger's business is probably doing better.

When we look at the returns and free cash flow to see how their investments are doing, you can see that Kroger's returns are now improving as a result of their investments. They're generating more earnings, so returns are improving. Cash flow is stable, and free cash flow is actually trending upward, so that's great.

There's this brief contraction period, looks like over here in 2023. Looks like they also had this big increase in investments. But if they're making these investments and they're actually generating earnings, so it should lead to better returns over time, even with this contraction.

Now, if we contrast this to Walgreens, Walgreens has a very clear decline in the returns on capital. It's basically zero at this point. Cash flow has gone down to have, and even though they've picked up their investments, they're not generating any earnings, and free cash flow is also declining as well. So you can see very clearly that Walgreens is having trouble generating cash. It's having trouble generating earnings, and the investments that they're making just don't seem to be making any returns.

And so, what do you think would happen to the value of these businesses? Well, let's look at from those 2020 onward, matching that per time period of financials. We see that Walgreens has basically just gone down with earnings, and that's why it's dropped 80%. You can see the green line is the stock price, the black line is the earnings per share, and you can see that has just gone downwards. Remember, price follows earnings.

Now, if we look at Kroger, you can see that the price has gone up, and it's gone up about 100%. And with the stock just giving a brief pause at this period when there was this contraction in earnings in 2023. So knowing what we know now, that they're making investments that are generating earnings, and that might just be a temporary contraction, that was actually a good point to start buying the stock. So there is some judgment in making an opinion on whether or not that contraction was temporary. And since it was, you can see that the price recovered, and so did the earnings.

So let's compare the performance together. We put on a pair trade at 2020. We went long or buy Kroger, and we went short Walgreens or sell Walgreens. And Kroger is up almost 150% from that time frame, and Kroger, or sorry, Walgreens is down over 80%. So this would be considered a pair trade once we identified a good versus bad company. And this is what a lot of stock-picking hedge funds do, like Citadel, to make money. And so you can see that's a value when we do this fundamental research. We can see what's changing and quite clearly see what's a good business and what's a bad business.

So the key to screening out good versus bad companies with fundamental analysis is really to just to understand what's changing both in the business and the industry. So you use the financial statements to as a first indicator, then you start to do the research and look for the change, right? You look for the trends and margins and returns. Then it becomes very clear from the research, and that's how you start to look to buy companies with growing returns and growing earnings and sell or short, meaning sell short, the bad companies.

So now that you can pick a company, the question is, how do I know it's the right price? And so that's the next section. We're going to talk all about valuing companies.

Okay, so now that we've analyzed the fundamentals of the company, let's figure out what price do we pay for the stock. And now that's the valuation. And here's why valuation really matters. If you don't pay attention to valuation, you might buy something like this. So this is a company, Lightspeed. And if you had bought at any point, any point in 2020 to 2023, you would lose money, especially of course if you bought it around here. From those peaks, the stock was down 80%, which is what we don't want. And I know because I lost money on this dumb stock because I actually did buy it around here when I was thinking valuations didn't matter. So I'm going to show you how you can avoid those mistakes by learning valuation. And it's going to become very clear why Lightspeed's price didn't work and how you can start to buy a stock at the right price that will actually make you money.

So to explain valuation, let's do a quick rewind and go back to our simple coffee shop to value that. Okay, so these are our coffee shop financials. These are the three-year financials by the end of year five, and they're presented just like you would see any other company in its filings. And so now the question that we should ask ourselves is, what price do we think we can sell the coffee shop at? Now, let's think about this logically. By year five, the cash value is $1,29. So that's probably the lowest price that we can sell it at. It's basically selling it for free for the amount of cash that we have. Or we could look at something like the book value, so the total equity, right? Remember, it's just the assets minus the liabilities. So the book value of the company on the balance sheet, that's about $1,729. So we could just sell it for the value of its assets minus its liabilities.

Or we could do something based off its earnings. We know that it's generating $211 in earnings, or $21.10 per earnings per share, or also the free cash flow is also $211 as well. So maybe some kind of multiple on that, assuming it can make that every year. And we also want to take into account the fact that this business is still growing. You can see that the business is both growing in terms of revenues and margins have actually been increasing. So the business is also getting more efficient. So that should be worth something as well.

And so what we would do in real life if we were selling this company, we'd hire an investment banker. Their job is to sell companies. And the first thing a banker will do is actually look at how similar companies are priced in the market. So the banker would put together a list of similar coffee shops and so that we can look at how they're trading on the stock market to see how their shares are valued.

Here are the companies. We have the list of these comparable companies, and we have the price per share as well as the earnings per share. Now, to get a sense of the price, we can also look at the price as a multiple to the earnings per share. So that would be the price-to-earnings multiple metric, and that's a very common valuation metric. We can also look at the growth estimate for these companies for the next couple of years. And the banker will point out a couple key things. They'll say that the market price for these coffee shops is anywhere between 20 and 23 times earnings. And the multiples are actually higher when growth is higher. And that's very common with a lot of companies. Everyone loves Buffett. Buffett's coffee shop, and that's why Buffett actually trades at a premium relative to its growth.

Now, to normalize for growth, we can look at the PEG ratio. So we can look at the price-to-earnings multiple relative to the growth estimate. And when we calculate the PEG ratio, it becomes a little clearer that they're anywhere between 1.3 to 1.5 PEG. That's the value of these shares. We can then look at the median of the group to get a sense of what is the basically the middle of the line of what investors will pay for the business. And that gives us an indication that investors will probably pay, uh, 23 times earnings for a coffee shop, or about a 1.4 PEG. And that reflects the current market price for coffee companies.

So there's two key things you need to do to value a business for its market valuation. First is to have a good earnings forecast, so understanding the growth for the future. And two is to have comparable multiples, so be able to price those earnings using the right peer multiples. And those two things indicate the price that the market will pay for the business.

So what we'll do is we'll get together our managers to put together our projections for our coffee shop. These are our growth projections or growth assumptions that would underly any financial forecasts. We have our sales. So we expect say 10% of cup sales in growth per year because the market for coffee is expanding. Where our coffee shop is, we expect about 2% a year to grow with inflation. And we also expect our product or unit cost to also grow at about 2% inflation rate as well. Now, we also have our expenses. We expect labor costs to continue to grow 5% every year. Again, it's above inflation, but it's still below our expected revenue growth rate or sales growth rate. We're going to actually need some investments to expand now. And we expect that we'll have to grow investments at probably the same rate of revenues, so about 12%. Remember, we have 10% in sales cups and 2% price, so that would add up to 12%. So that's basically the assumptions of how earnings forecasts are built.

So we can put all that together into a model. These are our growth assumptions. We expect cup sales to grow about 10% every year. That gets us to our expectation for cups sold. We expect price increases of about 2% per year. So that's the price per cup. And then when we multiply, of course, the cups sold times the price per cup, that gets us to our expected sales. From a COGS perspective, or cost of goods sold, we expect the cost per cup to increase about 2% every year. When we multiply the cost per cup times the cups sold, that gets us to our COGS, or cost of goods sold forecast. Our labor expense, we expect a 5% increase per year. That's our wages. And then that gets us to our total operating expense forecast before investments.

From an investing standpoint, we think that we're actually going to need to start to build out the coffee shop in order to get more of these customers. So what we're doing is we're investing. We're adding capital expenditures or CapEx into the business. Those are the investments. We decided we're going to grow investments with revenues. So let's say we keep CapEx as a percentage of revenues at about 7%, so a fixed percentage. And so that allows our CapEx to grow with revenues. So we take our beginning property and equipment, we add our CapEx, and we also need to forecast our wear and tear of equipment. So we expect it also to decrease by about 10% every year. That's just the wear and tear or depreciation. And that gets us to our dollar amount of depreciation that we expect.

Now, to work out our total assets at the end, it's pretty simple. We just take our beginning property and equipment, we add the CapEx, and then we minus the expected depreciation. That gets us to our end forecast of property and equipment, which reflects the growth in our assets from our investments. Now we can then put all these assumptions together into an income statement to start to see the business's expected earnings and growth.

So we have our revenue forecast, and we expect to grow at about 12% every year, just is 10% in cups, 2% in price, pretty simple. We minus the cost of goods sold, that gets us to a gross profit. We minus the depreciation, and notice that depreciation is now going up because we are making additional investments. We reduce it by the labor expense, and then that gets us to our earnings before interest and taxes. We can calculate our margins now. So our EBIT margins, it's just the earnings before interest and taxes as a percentage of revenues. Can also see that it's still expanding because we're still getting more efficient because our labor costs are growing slower. Same debt level, so interest expense rate remains the same. That gets us to our pre-tax income. And we're using the same tax rate of about 20%. So our tax expense increases as we grow pre-tax income. And that gets us to our earnings, net income, or earnings for the business. We don't have any change in equity, we're not raising any more shares, so same share count. And then that's how we can calculate our earnings per share that we expect for the business. So we expect next year to the business to generate $25.30 in earnings per share. And we can also calculate the earnings per share growth. So we expect the business to grow at about 17% in earnings per share for the next five years. So that's our earnings forecast for the business of how much money it will make.

So now let's get back to market prices. Here we have our comparable companies. These are the multiples, or the price of similar coffee shops trading on the stock market. Now, next year, we know we're going to generate $25.30 in earnings per share. We've estimated about 17% growth in earnings per share for the next five years. And so let's use the PEG ratio, or the price-to-earnings multiple relative to the growth estimate. We know that 1.4 is the median PEG for similar coffee shops, so we'll use that. We'll take that 1.4 times 17, that gets us to an expected multiple of about 24 times. We take that 24 times, multiply that by the $25.30 in earnings per share, and then that gets us to our expected value of $595.80 per share. And that's the expected value of our coffee shop based on the earnings per share of $25.30 with a 24 times multiple. So you can see that if we picked the right multiples and did our forecast correctly, we can sell our coffee shop to the market at that price. That's the estimated value of our shares. And you can also notice at that $595, almost $600, is way higher than the $170 or so of book value that our accountants tell us. And this is why bankers get paid a lot more because they can help sell companies at market prices, and usually much better prices.

Now, we also know it's a good price because we know that investors are also getting a good deal. So this is the returns they can expect if they buy the company at $595.80. So they put down $5,958 for 10 shares. We know that the total earnings of the business is going to be $1,782. If all of those earnings are distributed to shareholders, that represents about a 30% total return from the earnings based on how the business is growing its earnings. Now, of course, the second way the investors can also make a return is say they decide to sell the business off at year 10. By year 10, the coffee shop is making about $472 in earnings from our previous forecast. They also sell it at 24 times earnings. They're going to sell it at $11,135. So if they sell it at that future market value, they're getting about 13% in returns based off that growth in market value from the earnings. And same way from a yield perspective, the business is generating $472 by the end of year 10, and so that represents an 8% yield based off the capital put down of $5,958. So that represents the income from the investment.

So if we compare that to other investment options, we can think about treasury yields are about 4.5%, bonds are about five or six, and cash is about 3% at the bank. And so that income, or the earnings yield perspective at 8%, is a pretty good deal. And from a growing value perspective, so capital appreciation, and we're growing at 13% a year, the stock market tends to appreciate at about a 10% rate per year. And so that's actually a good return as well. And ultimately, everything comes down, of course, to earnings. That's where all the value comes from. And so if investors are getting a good deal versus other investment options, that means that the business is most likely going to be sold at that price because it's a good deal. So that's how companies are actually pricing on the stock market and how investors actually figure out if an investment is a good deal or not.

All right, now let's go back to Lightspeed. So that was a company at the beginning of the section. And let's see how this company was valued right at its peak around September 2021. So we're going to use the same process that we did before. We have our comparable companies over here. We got Wex, Corpay, Shift4 Payments. These are all similar-sized payment companies, and they're smaller, so they're not generating a lot of earnings at the time. So what we're going to do was use the FY 2026 earnings forecast, the next five years, to price the companies. FY just means fiscal year, so the company's reporting year. We also have our long-term growth estimate over here. And then the median works out to about a 10 times multiple on the FY 2026 estimates with the 15% growth estimate median, or a 0.7 PEG.

Now, with all that said, just to give you a sense of how extreme Lightspeed's valuation, let's take a look at Lightspeed. So at its peak of $120 a share, that $120 a share represented a 3,000 times multiple on a $0.04 earnings per share for FY 2026 as an estimate, or an 85.7 PEG. So even though the company is growing a lot faster than all these other companies at 35%, it really just was way too expensive. Now, to put it in another way, if you bought it at $120 per share, that $0.4 EPS needs to grow by about 300 times just to get to the same valuation of the group of about 10 times.

So what do you think would happen if you bought it at that $120 price? Well, you lose almost all your money. Lightspeed stock declined over 80%. And yeah, maybe the business slowed down a little bit, but the business is really doing fine. Now, you might notice if you're paying attention that all the valuations came down. Between this time period of 2022, a lot of companies were trading at quite high valuations, and growth slowed down a little bit in 2022, so valuations came down. So you might think, okay, what if I just bought around here, right at the end of 2022? Would I still make money? Let's take a look.

So at the end of 2022, so September, one year later, we'll use the same process with the same comps, except now we're going to use FY 2027 estimates. So for the next five years, the long-term growth hasn't really changed that much. And you can see valuations have come down. They're now at a six times multiple on a five-year estimate on a 15% growth rate, translates into a 0.4 PEG. Now let's look at what Lightspeed looks at. So Lightspeed, even at this $18.60, which is down 80%, Lightspeed is still 35 times. So it's still five times more expensive than the group. And also notice that ShiftWise and or Shift4 and Corpay are trading at a 0.2 to 0.4 PEG. So that's pretty low because a lot of companies, if they're good companies, tend to trade around one. So that's actually a great price, assuming the estimates and the growth are correct.

So what happens if you buy at these prices, both Lightspeed and Corpay and Shift4 Payments? Let's take a look. So what happens if you buy it at that point? Well, at least with Lightspeed, you stop losing money, right? But your stock is still down 4%. So you still don't make money, even though you bought the dip. And this is why you don't just buy dips on stocks without knowing the valuation.

Now let's look at those other two. Let's look at Corpay and Shift4. You can see both of those returns are up more than 100%. So they're both up more than double. And you can start to see the power in doing this, right? By understanding the earnings forecast and how to value these companies, the market will give you real opportunities to multiply your money.

So the keys to valuing a business is one, having a good earnings forecast of what the future earnings of the business looks like. And that's how the market values companies. Second is having a good multiple, so the comparable multiples of how similar companies are priced relative to their future earnings. You get those two things right, and you'll find opportunities to make money.

So how about let's see all this in action? See a real forecast and valuation of a public company, so you can see what it looks like. So we're going to forecast Paylocity. It's this software company. They provide payroll and HR, or human resource platform for small businesses. And I like to use this company as a case study to mentor and teach investors because it's a simple business to understand. So by the end of this, once you understand forecasting and then valuation, you're going to see exactly why this was an expensive price for Paylocity and where you don't want to buy, and why this is actually a cheap price for the stock and where you do want to buy. And I'm going to discourage you now from trading prices. When if you're looking to learn to invest, because if we take a purely price or technical driven view, that discipline would inform you to one, look for the trend, and then you want to sell when the trend breaks. So you would sell over here, and then it would teach you to start looking at support levels and resistance levels, and teach you to start buying around here, selling here, buying here, and selling here.

So what happens if you learn to just value a business correctly? You can figure out these areas like here and here as major price areas that are considered cheap and expensive ahead of time. So it really avoids you having to spend all this time trading back and forth. And that's why I believe that valuing businesses is just much more powerful when you're looking at long-term investing.

Here's the past four-year financial statement from 2020 to 2023 for Paylocity that we use as a base to forecast and value that stock. Most people, when you ask them why they buy a stock, they might say something like, "Well, I like the Starbucks brand and I drink coffee there." When really, you should be thinking, "What is my forecast of the company?" Because if I asked you how much money do you think you can make next year, you'd probably say, "Well, I'm in charge of business development. If my business can hit these sales targets, I can probably get this kind of payout for my contract." Now, that's the exact kind of mentality that you should think about when investing in a company. If you're giving them your money, you should at least think, "What is the business going to do to make me money as an investor?"

Now, the keys to good forecasting is to get three important things reasonably correct. One is sales growth, two is margins, and three is capital investments. Notice these are the exact same things that we use to analyze financial statements because they ultimately help us forecast past the earnings. The key to getting the sales growth rate is getting a base rate. Now, what that is, is you want to be looking for some kind of reference, otherwise you're just making it up or you have to trust someone else's forecast. A base rate can come from a number of places. You can look at the market growth rate, you can look at the growth rate of its peers, you can look at the historical growth rate to get a sense of the trends. You can also look at the company's targets. So what you do is you want to start high-level and then start honing in. And it's really important to get the sales growth number right because everything flows from there. And you'll see when we do the forecast, and it all comes down to guessing from doing good fundamental research.

So let's start by looking at the numbers that we got. First is the growth of the market. So this is a forecast from an industry report on the Human Capital Management market. That's the market that Paylocity is a part of. They forecast this market to grow at a CAGR, or compound annual growth rate, of about 9% for the next few years. So that's the market growth rate. Then we want to zoom in a little bit. So then we want to look at the peers. So these are the comparable companies. These are similar payroll and human resource companies over here. You can see there's obviously a big range of growth rates. So we can start by looking at the median. And so the sales growth rate tends to range between anywhere from 10 to 22%. And Paylocity up over here, we can see 10 to grow at a lot faster rate. So it's a faster growing company than some of its peers. But we can see that it at times can also grow at around the market rate of its peers, like it did in 2021.

Then we want to zoom in again to the company itself. So this is from an investor presentation of Paylocity's own financial targets. We can see that they target around a 20% plus revenue growth rate. This is back in 2023. Here's a forecast model for Paylocity, and here's how it's built. It's just the same way as when we forecasted a coffee shop based on the cups and the number of cups sold and the price per cup. With Paylocity, they sign on businesses, so that's the client count. They charge based off the number of employees. So we have the average employees per client, or the client size. That works out to the total amount of client employees that they're charging. And then there's a price, or a revenue per client employee. And then that gets us to our total revenue forecast.

So then we can work out the three major forecasts that we're going to do, which is the revenue per client employee, the average client size, and the number of clients that they have, which of course gets us to the client employees. Now we're going to work backwards a little bit, starting off with the price forecast. So just put in a 2% revenue per employee, so about the same as inflation. When I look at the average client employee, guys, there was this big jump in 2023. Now it turns out that was actually a one-time thing when they shifted to bigger clients. The prior year, but that shouldn't recur. So we keep that stable, so 0%. So basically, we're just modeling or forecasting based off the growth in the number of clients that they have.

So the peers from a revenue perspective are growing between 10 to 20. So if we take the middle, it's about 15%. And minus the two, and maybe another 1% from other revenue stuff, that gets us to about 12% or so. And so that's how I got to the 12% in the number of clients. And of course, when we multiply that by the average employee size plus the 2% price increase, that's how we get to that 14% revenue growth rate. Now, of course, that's below the 20% target that they have forecasted for themselves. And that's because they make money in some other ways, which I've excluded here just to keep it simple. They make money from interest from withholding payroll for taxes, and that adds generally between 3 to 4%. So the total revenue forecast is about 17 or 18% in revenue growth. And it's slightly under the 20% target, but I'm not trying to get too crazy here, right? I'm trying to just want to make a base forecast.

So when we look at margins, the key is to understand how the business grows its expenses as it expands. And that's where you pay attention to the cost structure of the business, and you get a sense of that by reading the 10K filings as well as the transcripts when the company gives presentations to investors. So here we can look at both the historical margin trends over here as well as their long-term targets. So we can get a sense of how Paylocity margins change as it grows. The first thing that's apparent is that when you have stronger growth, you tend to get higher margins. You can see that when we have this acceleration and revenue growth, you get a big jump in say, EBIT down margins, and same with the gross profit margins. And the reason why that is, is because the business, as it sells more products to the same customers, there's usually not a lot of additional costs to implement their software. Which is why when we look over on the right at their long-term targets, you can see that their long-term targets for both gross profit margins as well as EBIT down margins are a lot higher than the current margin levels, which indicates that's how their long-term targets are incorporating that expected margin expansion because that's how the business will grow.

We can also see over here for modeling purposes, the specific cost items that they expect based on a target of a percentage of revenues. And you can also see basically the trend has already been happening. We get that 68%, 28% gross profit margins, EBIT down margins going up to 69, 32. So it's approaching their targets of 75 to 80% gross margins and 35 to 40% in EBIT down margins. So here's my forecast model for the margin side. Again, the assumptions are in yellow. We have our gross margins over here. And then for the operating margin, I have the individual cost expenses. So I'm just estimating that as a percentage of revenues and then using that to estimate the operating margin. So let's take it one at a time. So the gross margin, just basically forecast it to expand a little bit. So we're going from 68 to about 69, right? It's an assumption that they're getting more profits as they sell new products. Now, on the expense side, you'll notice that it's pretty much basically the general and administrative that is going up to 17.8%. And that's based off the current year's guidance of what they expect. And I expect that to decline a little bit as a percentage of revenues to 17.5%. So that decline means they're getting more efficient at using general and administrative expenses. When we look at the research and development and sales and marketing, basically I'm just keeping them unchanged because they need to use both of these expenses, sales and marketing and research and development, to expand their business. So no change as a percentage of revenues.

So when I put all those operating expenses together, the model that is calculating how much total operating expense that sums up to. When we remove that from the revenues, we get our operating income. And I can calculate the operating margin over here. So a very slight increase in operating margins, that's what the forecast here. And again, this 2024 base year is slightly lower than 2023 because they've already given a forecast or specific guidance of what they expect in 2024. So I used that as the base level.

Now, from a capital use perspective, what we're doing is we just want to figure out the investments that are required to grow the business. And usually, you can find this when we look through the management's plan in places like the investor presentations. So here, as an example, I've pulled out a transcript from one of the earnings calls. "Research and development is a really important investment for Paylocity." And here they've just said that they expect to keep research and development pretty consistent, right, in terms of an investment standpoint. So we expect a pretty steady level of R&D investment. So what they're saying is they want to keep their investments in research and development stable. So that just means as they make new software, they're going to sell it, and they want to grow it with revenues.

Now over here, when they look at what we expense versus capitalize, all they're saying is just some of it's going to be allocated to the income statement when it's an expense versus capitalized, meaning they're put it on the balance sheet. So again, they're just saying that split is roughly consistent and stable. So now here is our model for forecasting the investments. You can see that we have the research and development over here, split up between the capitalized and the expense. So capitalized just means it's an addition as an investment on the balance sheet. So you can see this $52 million over here matches the addition over here. So this is the addition to the software asset. Now to forecast the software asset, you can see we have the asset value over here. We're keeping it at 4% of revenues, represents the additional investment into that software asset. So then that is added to the prior year, and then we just minus the amortization, which we have as an estimate here, which just represents like a wear and tear of software. And then that's how we get to our final estimate for the software asset going forward. So that represents the capitalized portion of research and development.

So the expense portion of the research and development, we already estimated that when we were looking at at the margins. So the expenses of the business. And so finally, when we're looking at property and equipment over here, so this is just like the office stuff that they have. We're also going to keep the additions to property and equipment, which is just like capital expenditures, and we're going to keep it stable at about 2% of revenues going forward. And then we also minus the expected depreciation, so also wear and tear. We're just keeping it stable. So you can see the additions to property and equipment are basically just growing in line with revenues, just like the additions to the investments in software as an asset. So those are all the investments. You can see also that when we add up the total research and development expenses and capitalized portion over here, and we work it out as a percentage of revenue, we can see that as a whole, research and development is stable as a percentage of revenue. So that's how we're modeling the investments growing as the business grows. So we're keeping it very simple here.

So now we can put this all together into a model. And there's going to be a little bit of tinkering. And this is the financial magic of investing that goes behind the scenes. It all comes together into an earnings statement forecast like this. So let's see this built up. We have the recurring and other revenue. That's just our growth forecast for the core business. There's this interest income on funds held for clients. That's the other revenues. So this is just the interest income that they get from withholding cash for payroll taxes for employers. They get interest on that cash. Now, that is going down because interest rates were really high in 2024, and so we expect that to decline. But overall revenues are growing nicely. We've also estimated the cost of goods sold with our gross margin forecast. We can calculate the gross profit, which is just the profit on the software product. We can see that is also growing nicely as well. And then we have our operating expenses. We have our sales and marketing expense, research and development, general administrative. And the operating expenses are just mostly growing with revenues. They're using all of these to expand the business. So the total operating expenses is growing as well. So we take the gross profit minus the operating expenses, and that gets us to our operating income, or the earnings before interest and taxes. And we can see also that the earnings before interest and taxes are also growing nicely as well. Then we got our other income. There's no forecast C there. Minus that to get the income before income taxes, or pre-tax income. And then we minus the tax expense. So estimating here a 21% corporate tax rate, that's standard for the US. And that gets us to the net income, or the earnings of the business. And that's most important. And we have our diluted shares outstanding. Diluted just means it's taking into account when they pay employees with stock options, that increases the number of shares. So you can see that the diluted shares outstanding is also forecasted to increase as well. So then we put that together, we get our earnings per share forecast. And that's the earnings for us as shareholders.

Here's where some tinkering is going on. The adjusted earnings, the adjusted operating income, because stock-based compensation is a non-cash expense, right? You're paying in stock. And so even though it's in the operating expenses, probably here and here, it's a bit like raising equity because the employees are technically buying shares. And if you want to do some quick math, you can see that we have this 4 and 152 over here, that implies about 250 million in stock-based compensation for 2024. And so we're adjusting that to remove the stock-based compensation. And the reason for that is that gives us a cleaner look at the business earnings. And same with the adjusted net income, removing the stock-based compensation. And also the adjusted earnings per share is also removing stock-based compensation. Now, this adjusted earnings per share is the most important for us. These are the earnings that we get as shareholders. That also accounts for the increase in shares. And we don't use this regular EPS over here because it's double-counting the stock-based compensation. It's both in the expenses somewhere in one of these expenses, and it's also going into the shares as well. So it's being double-counted as an expense and in the shares. And that's why we adjust it to the adjusted earnings per share. So we're taking a few reasonable assumptions and turning that into an earnings forecast. That's the output here. We're estimating that Paylocity will generate about $7.50 in earnings per share for fiscal 2026. And we're forecasting 2026 here, is because at this year is when we expect the interest income to start normalizing to a regular growth trend again. We'll use this number to value the company.

All right, do I still got you? I remember when I used to work in a research team, when any of us would get locked into Excel, we'd always come out of the office and just be like in a daze. And you know, we'd always make fun of people, be like, "Ah, you know, she's got the Excel eyes." And so I promise, though, that this will pay off with real money when you invest. Takes a little bit of work. But now that we got our forecast, let's value this company.

So the keys to making a good market valuation, we've covered. We have a good earnings forecast, so we just did that. Now let's get the right comparable multiples. That's how we can value the company and get the right price. So now let's bring up the multiples. So just like with the coffee shop selling the coffee shop, I've brought up the comparable companies. These are all the major public payroll and human resource companies trading on the stock market. On the top here, we have the PE multiples, or price-to-earnings multiples. NTM just means next 12 months, so the multiple, the price is a multiple of the next 12 months earnings. So we have a range of multiples from 2010 to 2023, about 10 years. This gives us an indication of what investors are willing to pay for similar companies in the past. Now, there's already a big range in terms of the low, median, and high. And so what's going on here? If we just look at the multiples, we can see that these payroll companies, we got Paylocity and Paycom, as well as these other companies over here, Ceridian, Paycor, Workday. These are faster growing, smaller companies, so they have less earnings. And because they're faster growing, they have really high multiples. We have our cloud payroll providers here, and these are the enterprise cloud payroll providers here. And then that leaves ADP and Paychex over here. And so you can notice that their valuations are actually a lot more stable because they're bigger, they have stable earnings, and they have more investors. They have a tier valuation range.

Just so we can normalize all of this, let's take a look at the PEG ratio. So that's just the price-to-earnings multiple relative to the growth estimate. In order to normalize the price-to-earnings ratio, we can see that if we look at ADP and Paychex, that tightens up to one to about two. And down here, as a median, it's 0.9 to 1.2. Now, when we look at it from a PEG perspective, we can see that actually ADP and Paychex actually get a premium valuation when we normalize for growth. And again, it's because they're larger, they're more stable, that tends to attract more stable investors, so you get a more premium valuation.

Now, to hone in on the right multiple for Paylocity, I would say let's keep it fairly conservative. Keep it at maybe 25 to 30 times. We don't want to give it a premium when ADP and Paychex have a premium. So about 25 to 30 as a price-to-earnings multiple. And then from a PEG perspective, I would say we can use a group's multiple, 0.9 to 1.2. Again, we don't want to give it a premium, but just give it in line with the group. And we can use those multiples now to price our new Paylocity earnings forecast.

Here's a summary of some valuation calculations. Let's just focus over here on the base. The base case is we forecasted $7.50 in earnings per share for FY 2026. And you can see that's reflecting from an earnings per share perspective of about 13% growth. Now I'm going to use a 25 multiple, so that's at a low end of PE using the ADP, Paychex range. And 1.2, which is about middle of the line from a PEG perspective. When I take the average of those two methodologies of calculating the valuation, so just the multiple times the earnings per share, or the PEG times the growth to get to the expected PE multiple, and then applying that as well to the $7.50 earnings per share, that's how I get these two valuation forecasts. And because they're slightly different, I'm just going to take the average. That works out to about $150 a share as a base case.

Now, the nice thing about using a forecast is now we can start to think of different scenarios. I have a bull case of $8.60 in earnings per share, that represents a higher growth rate of about 18%. And then from a base perspective, $6.90 in earnings per share, which is a lot slower in growth rate of about 8%. So from the bull case perspective, we use a higher multiple, 31 times, so that's the higher end of the range of the ADP, Paychex range, not at their highs, but a high from a median perspective. And I'm going to use the higher group PEG, so about 1.7 times. And you can see actually here the price works out to about similar of about $270 per share.

Now, from a downside case, now we're just looking at low multiples. I'm going to got that 25 times is the lowest multiple that's been recorded for the group. 0.9 is also a low PEG for the group as well. Of course, that's a pretty dramatic decline in price, getting to a seven times multiple. So honestly, that is pretty low. But again, I'm just taking the average of those two. So now I got an estimated bare case or downside case of $110 for the stock. So now the nice thing is we have these valuation scenarios using different earnings forecasts. Now we know that the stock price should have a range of between $110 and $270 as a per share basis.

There's a lot of different numbers going on. So we can actually start to put this together into one value. And to do that, we can use probability. So we use something that's called expected value. Really, what we're doing is just basic mathematical concept of taking the expected gain or loss times the probability to get the expected value. So what's going on is if we just apply an estimated probability to each scenario, we can work out the expected value of these different price scenarios. So we have our price over here of $150. That's the current price at the time. We have our base scenario, which was about $151. So that works out to about a dollar loss, no big deal. But let's say that works out to about a 60% probability. Works out to negative one and expected value. Now for the upside, we expect $269. And so the difference is at about a $17 gain. Let's say that we have a 20% probability of that high growth scenario. That works out to an expected value of 23 from the gain perspective. Now from the downside, we have a $110 price. That works out to a $42 loss. Multiply that by

20% probability gets us to an $8 expected value loss. Now you can see that all adds up to 100% probability. So we've applied the probabilities to each different scenario.

Now another way to look at this, want to think about it from like a gambling perspective, is we can look at it from an odds ratio perspective. So we have our expected gain before probability and our and our loss before the probability estimate. And then that gives us a way to look at the win-loss ratio. So that ratio between 177 and 42 works out to a 2.8 win-loss ratio. That gives us a sense of risk-reward that we can apply our probability estimate towards.

So to add all those things up together, we add up the 23, the one, and the minus 8. You add that to the 150 stock price. That gets us to an expected value of 166 per share, or 9% return. So the value of doing all this is we've forecasted all the different scenarios for earnings as well as valuation. And so now we have a real good sense of the potential price of the stock. And while we can't predict the future, because we've incorporated probability and the different ranges that can occur, this expected value, assuming of course a probability in our forecasts are reasonably correct, if that is a lot higher than the current price, we are just more likely than not to make money.

So when you learn to value stocks correctly, you'll start to understand stock prices a lot better. You can see our scenario range over here. We got 110 and 270 up here. Actually describes Pelotas' stock price really well for the past four years. What that's telling us is that this level over here, this 270, and this 110 levels are expectations for Pelotasy's earnings growth. There was expected a very low growth around 2020 when the stock price was 110, and of course, very high growth expectations in 2021. Now, but because Pelotasy never exceeded that optimistic scenario that we priced in to that 270 mark, which is why the stock price never went beyond that. And likewise, the stock price never even came close to this area over here of 110 because the growth expectations never got even close to our very pessimistic scenario.

And so that 166 price level over here, because it takes into account these different scenarios, the price also doesn't really get below that level because it's the fair price. So when it does trade below, like over here and over over here, because it's considered cheap, the stock price is now trading below what the company is actually performing at. It gets bought up by investors, and that's how valuations work in the market, and that's why valuation is really powerful.

So the best thing about doing good valuation work is that now that we know that a good price at that point in time is 166, but buying at any point below would have been a good chance of making money. And because now we know how to value optimistic scenarios, we know that prices, basically when it gets anywhere close to that 270 level, is probably too expensive. So we, it makes it less likely to make money. And so that's the benefit of buying at good prices. It means you can just sit back and wait. And so as long as a company grows its earnings, you make money, and it truly becomes a passive way to multiply your money. You really don't even need to look at the market price anymore if you've done good valuation work.

So what if we actually wanted to buy at spikes, like here, before this uptrend here, or we want to just buy it before we get another spike over here, and it's likely going to keep going up here? How do we actually identify those opportunities? And we can, if we start to really pay attention to market expectations, and that's when you can actually start to make some serious money. And that's what we're going to cover in the next section.

Have you ever noticed that sometimes a stock just all of a sudden, the stock just starts popping off and the price just takes off, right? And you wish you could just catch that big move over here and ride that rocket ship, which is honestly one of the best feelings in the world. And so that's where we're putting everything in fundamental analysis together, and I'm going to show you how you can catch these moves. And here we're starting to really crack the code of stocks.

Now we've covered the foundation, which is one, the fundamentals. So understanding how to pick companies with growing earnings. Two, its valuation, estimating the price points to buy and sell. The third layer on top of this is expectations. So that's understanding how to identify change in market expectations. And we're going to cover that here because when you put all three things together, they work together so that you can find opportunities to make money, pick stocks. And this is what hedge funds do.

So let's go back to Pelotasy's price and earnings per share chart. It's a reminder, the black is the earnings per share, and the green is the price per share. So now there's this big disconnect over here, right? You see the earnings per share continues to go up, whereas the price has been going downwards. So what's going on here is that market expectations are changing. The market does not see Pelotasy as a strong grower anymore in the future.

So one way you can check market expectations is by looking at analyst estimates. What these are are research analyst estimates of Pelotasy's earnings per share. So you can see we have fiscal 2025, fiscal 2026, and fiscal 2027. These are all forecasts of Pelotasy's earnings per share. So what do you notice? Well, they're all going down. And so something changed in this time period in 2023. And again, it looks like they're all picking up again. So something also changed at the end of 2024. And you can see from the same time period of the stock chart, you can see the stock price actually picked up on this earlier. So right at the end of 2022, or about mid-2022, the stock price started to trend downwards as well. And so then the stock started to move down as estimates came down.

And the high point, of course, was our peak valuation estimate. So that decline in price came primarily from a decline in valuation. This is the price-to-earnings multiple of Pelotasy stock. You can see it's come way down. And part of the reason, of course, why it's come down is because the starting point was very high. This was a 95 times multiple. And see the multiple has now come down to a more reasonable level of about 25 or 28.

And so the question is, why did the valuation come down? So what we're going to do is we're going to put on our fundamental research hat again, one more time, and figure out by looking through the earnings calls and transcripts to figure out what's changing market expectations. So it becomes pretty clear that two things are changing in the payroll and HR space. The first thing is that employment growth has been slowing. Of course, when there's less employees overall, it means that there's less revenues for payroll companies because they get, they charge based on the number of employees. Second is that there's been an end of IRS tax benefits. So there was a lot of COVID-related employer tax benefits. Those were gone after a couple of years. So there's just less filings for payrolls to do for payroll companies to do. So that also means less revenues. So that just translated into into a slower growth in revenues, which of course translates into a lower earnings estimate throughout 2023.

And this, of course, was also confirmed by the company, Pelotasy itself. So this is from an earnings release in August 2024. They provide an outlook for their fiscal 2025 guidance. So the upcoming year. And now they expect revenues to grow at about an 8% rate. Remember, they were used to targeting 20% type growth rate. So it's a much slower growth rate. And so it's reflected in the company's outlook itself. And so that's the reason why analyst estimates came down. You can see back in October 2023, they were expecting about $9 a share in EPS for 2026. That represents about a 30% growth rate year-over-year. And then the new estimates in October 2024, they're expecting a $7 in earnings per share, which reflects about an 8% growth rate. So it's very similar to the new outlook for growth. And the 2025 estimate, of course, was also lowered as well.

So now that you understand what's driving expectations, you can then start to pay attention to the signs that could change these market expectations. So that's the signal. The key to finding opportunities from an expectation perspective is pretty simple. All we're doing is just looking for change that's not priced into the market yet. So one easy way is just to pay attention to what's going on with other companies.

Now, here's Paychex. This is one of the larger companies in the space. You can see starting around August 2024, the stock really started to come up. And there's this big jump over here, which was the earnings release. You can see the stock price jumped and then just kept going up. So what's going on is the market is starting to price something in. The price moving up, that is actually a pretty clear signal.

So what was going on? When we look into the actual earnings release of Paychex, we can see that one, they reported pretty good earnings. They reported $1.60 in EPS, that was better than estimates for $1.14. So they beat by about 2 cents. That just says the business is performing better than expected. Revenue growth also accelerated from 7% from 5% in the prior quarter. So that's an improvement in the growth rate. And guidance is for 6 to 7.5% revenue growth for fiscal 2025, also an acceleration from the prior year of about 5%. So this is a very large company in the space. What they're saying is that there's very clear signs of improving revenue growth. So this may be happening for other companies in the space as well.

Now we can confirm this by looking at other data points. This is the payroll numbers. So this is the number of employees, employment in the US. And we're looking at the year-over-year change. So just looking at growth, you can see it's been slowing all year from 2023 into 2024. But it looks like it's starting to stabilize. So it's not going as steep. The year-over-year trends seem to be stabilizing, which indicates that maybe employment trends are actually getting better, which of course would help payroll companies.

Another way to check is to start just paying attention to what management is saying. So this is a transcript of Pelotasy at a conference back in September of 2024. They're saying that they want to get back to a beat and raise cadence. What that means is they want to be able to beat analyst estimates and also raise their guidance or their outlook. That's what beat and raise means. And they think that if we execute well, allows us to do that based on the guidance that we provided. So they basically are saying that we can probably beat estimates and raise our guidance. They're saying that we can do better than what everyone is expecting.

And finally, just looking at Pelotasy stock price itself. So you can see around this time period as well, Pelotasy stock price has also been trending up into their earnings release as well. So the market is probably picking something up. And again, we know that the market can pick up things pretty fast. So that's why it can be useful as a signal. So we recognize a change that looks like revenue growth is getting better than expected. It might not be priced into the market. So we can probably make money from this. And that's where we get into the setup.

Okay, so the key to a good setup is to figure out what the market is pricing in, and then pricing the new change, and see what the market is missing. We first have to estimate the change ourselves. So here are the signals that we see. One, we see that employment growth is stabilizing. Two, we see the headwinds are passing from the COVID tax benefits. It seems like growth is improving for payroll companies. And three, we see from the company itself saying that there's a potential raise in their guidance or their outlook. Management is hinting at it. So that all points to better revenue growth.

So what we do is we just go back to our model and start to update our earnings forecast. So this is updated for the 2024 actual. So now we're forecasting earnings beyond. And say, if we forecast some improvement instead of that 8%, let's forecast 9% for fiscal 2025. And we forecast a little bit of acceleration for the next couple of years, just showing what can happen if trends start to improve. So now we can forecast that Pelotasy might probably achieve $7.40 in earnings per share by fiscal 2026. And so we have stronger earnings growth. Then we can compare our forecasts to the current estimates to see if the market is pricing it in.

This is the current analyst forecast in October '24, before the earnings release. You can see that they're estimating about an 8% growth for fiscal 2026. Now let's look at our new forecast based on our model. We've estimated that Pelotasy could grow at about 11%. So a slight raise, $7.14 from the $6.95 that the analysts are expecting. So we're expecting improving growth that's not reflected in the estimates. So that's a sign that the market has not yet priced in this change. Now, it might not seem like much, but this is enough to make money because stronger growth is definitely going to change market expectations. It'll bring them up, which means a higher stock price. And of course, we got to value it.

So let's go back to EV valuation perspective. We have Pelotasy's price-to-earnings multiple over here in the blue, as well as some other their other peers. We got Paycom and we got ADP and Paychex over here. So you can see that Pelotasy, as well as Paycom, are both trading below the ADP and Paychex multiple. Pelotasy is 27 versus 28, 29 for ADP and Paychex. So of course, the valuation is reflecting a lower expectation for growth.

So now when you think about it, Pelotasy's valuation is arguably cheap here. It's trading at a discount, number one. And two, if Pelotasy can grow at 8% or even 9% versus the 6 to 7.5% for Paychex, it can probably trade at least at the same multiple as ADP and Paychex, maybe even higher because the growth rate is higher. So there's an opportunity for valuation to start coming up.

So now we can do some back-of-the-envelope math to estimate where the stock can trade after earnings, once we have a change in expectations. So we have our estimate of $7.14 for fiscal 2026, our new forecast with better growth. We have a 28 times multiple, that's the same multiple as Paychex and ADP. So we assume that Pelotasy can trade in line with its peers. $7.14 times 28 multiple equals a $200 stock, which represents a 15% upside from the current stock price of $170 at the time. So that's a 15% upside from the earnings release alone, right?

So this is our investment case going into the earnings release. We have a $200 target, which represents a 15% upside from the current $170 price. And that's based on our fundamental forecast for revenue growth to improve from 8% to 9% for fiscal 2025. So that's a fundamental reason. And because of that acceleration, we think that estimates should go from that $6.95 level to get to that $7.14 level for fiscal 2026 based on our forecast. So the market is not pricing that in from an expectation standpoint.

Now, because of the higher earnings estimates, we believe that Pelotasy's multiple should rise from its 27 level to at least 28 or even higher at 30, which is the same level as ADP and Paychex, or higher, assuming the multiple can expand because its growth expectations are now higher than those two companies. And then when we think about it from a risk perspective, the downside of $6.95, which is the current fiscal 2026 estimate, if we use a low multiple of 24 times, which is what it was trading at a couple weeks before this time, we get to about a $167 target, which is just a slight decline. Which means the stock is already pricing in this low growth scenario already and not pricing in a potential for an upside in growth. And so I think that's a pretty good setup because it's not pricing in this improved outlook. I like it.

So that's the key to a good investment case. You want to get the foundations of the fundamental picture right, and then the valuation, and then you want to think about how expectations will change. And then once you think about all three of those things, you definitely do well because you have a clear plan, you know the numbers, and you know where the stock is going to go.

Now, 15% is pretty good for just an earnings release. So you can get 15% in just one to two weeks. It's not bad. But we can actually juice this up with options. Next section, I'm going to show you how you can get creative to get an even bigger payoff when you find small things like this.

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All right, options. Options give you the right to buy the stock for a fee or a premium. You get the option to buy 100 shares at the strike price at a certain date, and that's the expiry for a premium. And of course, you don't have to put down all the money that you would normally be required to buy all that stock. You really can juice up returns using options.

For example, this is what I did in October 15th, right before the earnings release. I went long, meaning I bought the December 20th expiry 170 strike calls. I bought two of them for 12.82 for premium. So multiply that two means that I've put down $25.64 as a debit. I put that money down, and now each of those options gives me the right to buy 100 shares of Pelotasy stock at 170, that strike price, by December 20th, 2024.

I also sold, so I sold short, meaning short, a November 15th, 2024 expiry, also 170 strike call as well. So I sold that for 9.96. So that works out to a $9.06 credit. So that's basically just to help offset some of that premium cost. So the net cost put down is $1,658. And that's the equivalent of buying 200 shares, which is $34,000 at $170 a share, but I'm only putting down $1,658.

So now I'm only showing you this as one example of a way to make money once you understand how prices work. And I want to give you a warning to protect you that I really don't recommend you try options until you have a very good grasp of the fundamentals of how stocks are priced. And also especially how options are priced. Because if you don't understand things like Black-Scholes, which is an options valuation methodology, I don't think you're ready. And I don't want you to lose money, especially with options. So I will do a video on options in the future if you're interested.

And with that, as a warning, let's see how we can juice up returns with options. Because hey, we all want to make money when we see a good opportunity, right? So the option value can move a lot because of the leverage. Right? We're effectively buying a lot of stock with very little money down. So what happens with this current option setup? If the stock gets to where our $200 target would be, we're making about $13.42. So that's an 81 or about 80% return. So that's great, right? But also, if it gets to 180 or below, we're basically losing anywhere from $6.58 or the total money that we've put down, $1,658. So we lose all of the premium because the options are going to expire worthless. And so I like this structure because the downside is fixed. And I also believe that there's a good chance the stock price would get to $200 and I could keep that option. So this long December 20th calls to keep making money if the stock keeps going beyond 200, like for 210, which should give me an even higher return.

So we've done all the work of forecasting valuation. We figured out a change in expectations. We did all that work. We set up an investment. We did some options. Now all it is is just we wait for the earnings release. We've effectively bought our stock around 170. The stock started to trade up slightly into the earnings release. And now we just wait until what happens with the earnings release.

So now this is the big day, the earnings release. And you're going to see how all of this goes down and how stock prices revalue when it gets new information. So the first thing is that Pelotasy releases its earnings on October 30th, 2024. They released their first quarter 2025 earnings. Now, the first thing that you'll see right away is that the revenue growth for 1Q was 14%. So that's a great revenue growth rate, right? Remember, the guidance was about 8% growth for the year. So that's definitely most likely a beat, meaning they beat the estimate and it's better than what research analysts and the market was expecting.

Now, more importantly, as part of that, they also updated their fiscal 2025 guidance. Now they expect revenues of $1.53 to $1.55 billion, which represents 10% growth in revenue growth. And that's much better than the guidance of 8.3% earlier. So that's the raise, meaning that they now expect the guidance to be higher. That's so they beat estimates and now they raise guidance. And now when you hear beat and raise, that's literally music to an investor's ears because you know that the company's performing better than expected. They've raised their outlook, which definitely almost always means a higher stock price. So you know you're going to make money.

So what does the stock do? So the, the company released its earnings right around here. So the October 30th, 2024 release date. Now, so the next day, the stock opens all the way up 20% right away. So it's up 20% immediately, and it stays there at about 210. Kind of trades down a little bit, but it just stays there over the next few days.

So now, why? So let's break down what's actually going on with the price. First thing is because earnings are better than expected and guidance for fiscal 2025 revenue growth is higher. Now you can see expectations have moved up. These are the earnings estimates, the next 12 months earnings per share estimate for Pelotasy. And you can see that it's moved up from about, you know, $6.40 or so to $6.51. So you can see that increase in analyst estimates for fiscal 2025. And so that's one of the reasons that moves the stock price higher.

Now, second, when we look at a valuation perspective, this is the price-to-earnings multiple of Pelotasy as well as a couple of the other peers. You can see that Pelotasy's multiple has also moved up as well. So right after the earnings release, the stock price jumps up. And so now we get a higher multiple. Pelotasy's multiple has gone up from that 28 to now it's at a 31 times multiple. So it first gets to the Paychex, ADP multiple around the time of the release, and then it moves up to that 31 times multiple and it stays there. The reason why that is because that stronger growth leads to a higher valuation multiple for the stock, just like we anticipated, which is another way of seeing the higher expectations come into the stock price.

So you can see these are all the prior estimates over here on the top, as well as our forecast. So then now let's look at the new estimates for Pelotasy stock right after the earnings release. So a couple days later, now estimates are now $7.14 and it's gone up, and $6.62 for fiscal 2025. So when we look at the change from the prior estimate, so right before the earnings release to the current analyst estimates, you can see that they're all moving up about 3%. So again, it's a small move, but that's a change in market expectations.

So just to put that all together, right? You see this better fundamental outlook. You see the earnings per share outlook going up, and that's reflecting the improving fundamental trends for Pelotasy because of the higher revenue growth. So you get that rise in earnings estimates, you get the rise in valuation, and then that all leads to the stock price hitting that $200 or so stock price, just like how we priced it before the earnings. And of course, it stays a little bit higher, it gets actually up to 210, but kind of bounces between this 200 and 210 mark. And you can see that this is the market revaluing the stock positively. And of course, it works for us because we prepared for it. And the stock will likely keep rising over time as long as Pelotasy grows its earnings.

Okay, so now the fun part. How much money did we actually make with all that preparation? Well, the first thing was we've put down $1,658. Now, the payoff at $200 a share, which is where the stock went up to from a long call perspective. So we have the $200 stock price and we have a $170 strike minus a $12.82 premium. So we have the option to buy it at 170. So we get $30 from the $200 stock price. If we minus the premium, that works out to about $17.18. And we got two of those calls. Multiply that by 100, that gets us to about $3,436 in profit.

Now, the short calls, which we sold to offset the premium, we did $170 strike as well. But because we sold the option to buy, now we're minusing the 200. So now we have to pay up $30. But we're offsetting it a little bit with this $9.06 premium. And so that works out to a 20.94% return based on the money that we put down. And of course, the best thing is, is now we own options to buy 200 shares of Pelotasy at $170 a share. That works out to a $6,000 value of that position, right? Because if the stock is at 200 and we can buy it at 170, that's 30 bucks a position. 30 times 2 is 60 times 100 gets us to $6,000. So that's why it's $6,000 in value. So that value will keep increasing as the stock moves higher. And of course, that's one way to make higher returns because we didn't really put a lot of money down using options creatively.

So the most important thing to take away, you've made it this far, is to make money investing. And that's the whole point of fundamental analysis. You want to pick good companies, companies with strong earnings outlooks, and that are generating good returns from their investments. You want to value them so you can get a good price. And that means putting together a good forecast, getting the right multiple so you can get the right price to buy and ultimately sell those companies. And then you want to look for changing expectations if you want to look for opportunities to time when to buy and sell. Look for what's changing and look for what the market's not pricing in. If you do all three of these things, I guarantee you will make money. And that's everything you need to know about fundamental analysis. And to keep learning investing, I suggest you actually watch this next video. And if you'd like to learn further, I am looking for the next 500 people to help mentor and teach on how to make money with stock investing. And if you love this, I suggest you check out our education program. It's in the description because if you like this, you're going to love the program. I hope you enjoy this and learn something. Spent a lot of hours recording this, so I'm a little tired. And I will see you in the next video.

Coming is coming. Being.

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