How companies make money
This is my understanding, for education. Not personal financial advice.
A stock isn't a ticker. It's a slice of a business. Learn to read the business.
If cash loses (Chapter 3) and the fees and products of conventional finance leak value (Chapter 4), the alternative is simple: own great businesses directly. That only works if you can tell a great business from a good story.
A share is a slice of a business
When you buy one share of a company, you own a tiny piece of its assets and future profits. In the short run, prices swing with news and emotion. Over years, they follow earnings. The investor Benjamin Graham put it this way: in the short run the market is a voting machine, in the long run it's a weighing machine.
The four numbers
You can learn a lot from a company's quarterly report (the 10-Q) or annual report (10-K), free on the SEC's EDGAR site (SEC EDGAR).
| Number | What it tells you | Good sign |
|---|---|---|
| Revenue | How much it sells | Growing year after year |
| Gross margin | What's left after making the product | High and stable (software often 70%+) |
| Operating margin | What's left after running the company | Rising as it grows (scale working) |
| Free cash flow | Real cash left after investments | Positive and growing |
Revenue without margins is a hobby. Margins without growth is a slow decline. You want both.
Where growth comes from
Every growing company grows in one or more of these ways: 1. More customers (new users, new regions). 2. More per customer (price increases, upsells). 3. New products that sell to the same customers. 4. New markets that didn't exist before.
The best growth stories have a huge market that's just getting started. That's why I spend so much time on AI (Chapter 8): the demand for computing power is a market that barely existed at this scale a few years ago.
Moats
High profits attract competitors. A moat is what keeps them out: - Network effects: the product gets better as more people use it (marketplaces, social networks, software ecosystems like Nvidia's CUDA). - Switching costs: it's painful to leave (enterprise software, your bank). - Scale: being big makes you cheaper than anyone else (Costco, Amazon logistics). - Brand and patents: people pay more for the name, or the law blocks copies.
Ask: if a competitor had $10 billion, could they take this business? If the answer is "not easily," that's a moat.
Price vs value
Even great businesses can be overpriced. A simple check is the price-to-earnings ratio (P/E): share price divided by yearly earnings per share. A P/E of 30 means you pay $30 for every $1 of current yearly profit. That's fine if profits are growing fast; it's dangerous if they aren't. Look at the P/E next to the growth rate, not alone.
In 2000, Cisco was one of the best companies in the world. Buyers at the peak waited over 20 years to get back to even. The business didn't fail. The price was just too high.
A one-page checklist
- What does it sell, and to whom?
- Is revenue growing? Why?
- Are margins high, and rising?
- Is free cash flow positive?
- What's the moat?
- Is share count stable or shrinking?
- What would make me wrong?
If you can answer these in plain words, you understand the business better than most people who own it.
Know how the business makes money, why it'll make more, and what stops others from taking it.
Sources
- SEC EDGAR full-text search: https://www.sec.gov/edgar/search/
- Investor.gov, Beginner's guide to financial statements: https://www.investor.gov/introduction-investing/getting-started/researching-investments/beginners-guide-financial-statements
