The market is an exciting and dangerous place. Many people started dabbling in the market during the pandemic, inspired by people doubling and even tripling their money on Stocks That Only Go Up.

The problem is that they don’t Only Go Up. They also Come Back Down. If you bought at the top, you may be sitting with a bewildering situation of having lost half your money on a company that is a household name.

How is that even possible?

Investing is both an art and a science, combining elements of human emotions (both your own emotions and those of the broader market – commonly referred to as “sentiment”) with technical financial concepts like valuation techniques.

In a bull market, it’s difficult to lose money. In a bear market, it’s difficult to make money. Over the long term though, stock picking is a contact sport that can be incredibly rewarding.

The question is: how do you do it? What should you look for? What are the dangers?

Don’t Let The Price Drive Your Narrative

When a stock is flying, it’s easy to believe that this will continue forever. When it is doing badly, the same applies.

The single most important step you can take in your investment journey is to distinguish between the merits of the company and its share price. A great company can be a horrible investment if the price is too high. An otherwise-iffy company can be a terrific punt if the price is attractive.

The only way to do this properly is to first assess the company and then assess the share price. I’m afraid that this requires you to either do the work yourself or subscribe to services that do much of the heavy lifting for you.

For example, doing this work would’ve revealed elements of the Netflix business model that are clearly problematic. I spotted these issues at the start of the pandemic, during a period in which people wanted to throw vegetables at you in the town square if you dared utter a bad word about these growth stocks.

This brings me neatly to the next important concept.

Free Cash Flow

Suddenly, everyone on Twitter is talking about Netflix’s free cash flows instead of its revenue and subscriber growth. If they did that before the capitulation in the share price, they wouldn’t be sitting deep in the red.

The concept of “free cash flow” is the cash left over for shareholders after the company has dealt with everything else it needs to do. This isn’t the same thing as net profit for several reasons:

• Profit often has non-cash income and expense items
• Profit doesn’t take into account changes in working capital (e.g. money tied up in inventory and debtors, or released by taking longer to pay creditors)
• Profit doesn’t consider the need for capital expenditure
• There are often payments to lenders beyond the interest portion (which is the only portion of debt repayments recognised in profit)

In short: you can’t look at the profit of a company and assume that it generates cash flows. A set of financial statements includes a cash flow statement and it is arguably the single most important thing you can look at.

But how does this relate to Netflix?

The streaming giant spends an absolute fortune on content each year and writes it off over several years, so there’s a major build up of a “content asset” over time. Profits look good and free cash flows don’t.

The business model requires constant investment in content, unlike a software-as-a-service operation that develops a product and then just needs to maintain and upgrade it. It’s impossible for Netflix to have the operating margins enjoyed by leading tech companies with subscription models, something that investors recently learnt the hard way.

This doesn’t make Netflix a bad business. It just makes it a lot less valuable than everyone thought. You didn’t need a finance degree to figure this out, by the way. You just needed to think critically about the business model. Unit Economics

We will deal with one more investment concept here: unit economics. Again, you don’t need to be an accountant for this.

The concept of unit economics refers to the value of selling one more unit of whatever it is that you sell e.g. another online subscriber. It’s a grave error to only look at the revenue from this additional unit.

Even the best tech companies are struggling with staff costs in this environment. To bring on new customers, companies are investing heavily in teams of technical and sales experts. The “cost of acquiring a customer” is key here. It doesn’t help your business if that cost is high relative to the “lifetime value” of the customer. In extreme cases, companies barely break-even on an incremental basis i.e. when adding a new customer.

In those businesses, what do you think happens to your investment over time? The faster they grow, the more the financials deteriorate! Yikes.

Common Sense Is A Good Place To Start

Even without a finance degree, you can identify many of the issues that the professionals miss. This is purely because they are so focused on the intricate details that they miss the bigger picture.

The tech industry is full of optimism, which is why it has changed the world in the past few decades. Too much optimism is dangerous for any investment portfolio.

Founders need to be optimistic and investors need to be realistic. If you remember that, you’ll stand a better chance of generating great returns with your tech investments.