OT: Upstart (UPST) - Clarifying Cash Flows

DISCLOSURE: I own a tiny bit of Upstart. However, I no longer actively invest, so call
it a hobby. I’m using money I can afford to lose. A 100% permanent loss here wouldn’t
affect my retirement or other financial goals one bit. In other words, heads I win,
tails I scrape my elbow, but don’t get killed.


Key points:

** Intangible investments are hidden on financial statements.

** Upstart invests heavily in intangibles.

** Rearranging items on the cash flow statement uncovers intangible investments.

** We create a model that tests assumptions about Upstart’s investments.

** The model clarifies Upstart’s cash flows from intangible investments.


Financial statements use accounting rules that were put in place a long time ago.
Back when these rules were developed, most firms were making money by investing in
physical assets like stores, factories, and machines. Even though these companies paid
up front for these investments, the accounting rules allowed them to spread the expense
over multiple years rather than in the year they paid for them. The reasoning behind
this was to match these expenses with the future revenues they generated.

Nowadays you’re more likely to find a business investing in assets you can’t touch or
feel rather than factories or machines. These “intangible assets” are things like AI,
branding, and employee training. Unfortunately, accounting rules haven’t kept up with
this change in investment focus. Firms that invest in intangibles have to expense that
full investment in the current year, and aren’t allowed to spread it over multiple years
like they can with with tangible investments.

This difference leads to a mismatch. The financial statements for companies that invest
heavily in intangibles fail to distinguish between expenditures that support current
revenues and those aimed at generating future revenues. In short, there’s a gap between
what the financial statements say and what we as investors need to know to understand
the business.

Upstart is certainly a business that invests heavily in intangibles. CEO Dave Girouard
said in the most recent earnings call that the cash Upstart generated in 2021 “allowed
us to significantly invest in our future”, effectively doubling their headcount in
engineering and product development. But where do we see these intangible investments on
Upstart’s financial statements? We don’t! They’re hidden.

Fortunately, a number of practitioners have suggested ways to address this issue. I’ll
be using an approach suggested by Michael Mauboussin. Any shortcomings are mine and not
with his method.

Our focus will be on the cash flow statement. We’re going to move some items around from
one section to another. We’re not getting rid of anything, just rearranging. Our aim is
to gain deeper insight into Upstart’s intangible investments, yet at the same time
preserve Upstart’s bottom line cash total that must tie to the balance sheet.

The cash flow statement assigns all cash flows to one of three buckets – operating,
investing, or financing. Operating cash flow shows cash in and out for activities dealing
with the customer. Investing cash flow shows what the company spent to fund future
growth. Financing cash flow tells you how the company funded the gaps between operating
cash flows and investing cash flows. Upstart’s intangible investments don’t show up on
the cash flow from investing section. We want to fix that – we want those intangible
investments to show up where they belong so they are visible and not hidden.

Recall that accounting rules require Upstart to expense all its intangible investments in
the current year, even though some of those expenditures are investments for future years.
These investments are included in the Sales & Marketing (S&M) and Engineering & Product
Development (E&PD) expenses on the income statement, but are not broken out separately.
The expenses are deducted from revenues to get net income which is carried over to the
cash flow statement. The key to Mauboussin’s technique is to extract the intangible
investments hidden in that net income number in the operating section and move them to
the investing section.

Our first challenge with this approach is to determine what portion of those S&M and
E&PD expenditures were investments in future growth and what portion were necessary just
keep the business running. For discussion purposes, let’s pick 50%. We’ll say that 50%
of S&M and 50% of E&PD are linked to current revenues and are necessary just to maintain
current business and the other 50% are investments in future growth. Applying these
assumptions, we arrive at the following estimate for Upstart’s investment in intangibles
for 2021:


Estimate of Upstart's intangible investments in 2021

                                                        Percent
                                              2021     Allocated       Intangible
                                       Expenditure    to Intangible    Investment
                                       -----------    -------------    ----------
Sales & Marketing                          333,453        .50             166,727
Engineering & Product Development          133,999        .50              67,000
                                                                          -------
Total                                                                     233,726

Our second challenge with this method is to figure out how many years these intangible
investments can generate revenues. We’ll use the number we come up with to spread the
investment expense for those same number of years. Again, just for discussion purposes,
let’s pick 3 years for S&M and 5 years for E&PD. From this we create what’s called
an amortization schedule. Using this schedule, we calculate the amount of investment
amortized expense that accumulated as of 2021 was $108,246M.

We now have all the information we need to make our changes to the cash flow statement:

(1) We add to the reported net income of $135,443 the intangible investment for 2021
of $233,726M minus the accumulated amortization of $108,246M. This gives us adjusted net
income of $260,923.

(2) We add back accumulated amortization of $108,246M because it’s a non-cash charge.

(3) We record the investment in intangibles of $233,726M in the Investing Section.

Putting it all together, here’s how the cash flow statement looks before and after our
changes:


Cash Flow Statement

       As Reported by Upstart                                As adjusted by me
                                  2021                                             2021
                                --------                                         --------
OPERATING SECTION
Net Income                       135,443             Net Income                   135,443
                                                     Intangible Investment        233,726
                                                     Accumulated Amortization    -108,246
                                                                                  -------
                                                     Adjusted Net Income          260,923 (1)

                                                     Accumulated Amortization     108,246 (2)

All other operating               32,910             All other operating           32,190
                                 -------                                          -------
Cash from Operations             168,353             Cash from Operations         402,079 <= Increase of 139%

INVESTING SECTION
                                                     Intangible Investment       -233,726 (3)
                                                     Other Investing             -143,877
                                                                                 --------
Cash used in investing          -143,877             Cash used in investing      -377,603 <= Increase of 162%

FINANCING SECTION

Cash provided by financing       855,432             Cash provided by financing   855,432 <= Unchanged

Net change in cash               879,908             Net change in cash           879,908
Beginning Cash                   311,333             Beginning Cash               311,333
Ending Cash                    1,191,241             Ending Cash                1,191,241 <= Same as on Balance Sheet

You may be asking: what’s so special about the inputs you’ve chosen – 50% and 3 years
and 5 years? You could have chosen any numbers!

True, but our goal isn’t to precisely pin down the intangible investment number. Our aim
is broader. First, we want to make sure that intangible investments are visible. And
second, we want a model where we can vary our inputs to see what effect they have on cash
flows. The inputs we pick are based on assumptions about the business. The model helps us
test those assumptions to see how they affect cash in and out.

Think of it this way. The cash flow statement for 2021, using required accounting rules
as reported by Upstart, would have 0% and 0 years as inputs to the model. The reported
numbers are telling us that Upstart’s S&M and E&PD amounts include zero investment in
future growth! That’s not an accurate portrayal of Upstart’s business.

In our example above, where we assume 50% of S&M and E&PD expense was actually
investment in future growth, we see that cash from operations increases 2.4 times and
cash used by investing increases 2.6 times. If we run a few different scenarios with
different inputs, we’ll develop a much better understanding of the effect of Upstart’s
investments on their cash flows.

This model substantially improves the description of Upstart’s business. It’s important
to note that the bottom line cash number has not changed. The payoff of the model is a
more informed interpretation of Upstart’s cash inflows and outflows.

Best to you,
Ears

Note: Below are the Upstart reports used in the discussion above. You should be able to
cut and paste these into worksheets to make your own Excel model.

TABLE 1 - Income Statement as reported by Upstart
TABLE 2 - Amortization Schedule using 50% and 3 years and 5 years
TABLE 3 - Cash Flow Statements as reported by Upstart
TABLE 4 - Cash Flow Statements as adjusted


TABLE 1 - Income Statement as reported by Upstart

                                                          2017         2018         2019         2020         2021
                                                        -------      -------      -------      -------      -------
Revenue from fees, net                                   51,161       88,482      159,847      228,600      801,275
Interest income and fair value adjustments, net           6,128       10,831        4,342        4,816       47,314
Total revenue                                            57,289       99,313      164,189      233,416      848,589

Sales and marketing                                      33,838       63,633       93,175       99,659      333,453
Customer operations                                      10,232       15,416       24,947       37,581      117,579
Engineering and product development                       5,324        8,415       18,777       38,802      133,999
General, administrative, and other                       15,431       19,820       31,865       45,609      122,677
Total operating expenses                                 64,825      107,284      168,764      221,651      707,708

Income (loss) from operations                            -7,536       -7,971       -4,575       11,765      140,881

Other income (expense)                                      330          487        1,036        5,549       -5,174
Expense on warrants and convertible notes, net           -1,649       -3,734       -1,407      -11,364       -1,976
Provision (benefit) for income taxes                          6            0           74          371       -1,712
Net income (loss) attributable to non-controlling        -1,144        1,101       -4,554         -404            0

Net income (loss)                                        -7,717      -12,319         -466        5,983      135,443
Net income (loss) per share diluted                       -0.56        -0.87        -0.03         0.34         1.43
Weighted-average number of shares outstanding dilu       13,874       14,128       14,336       17,514       94,773


TABLE 2 - Amortization Schedule using 50% and 3 years and 5 years

                                                       Cap Rate        Years
Sales and marketing (S&M)                                  0.50            3
Engineering and product development (E&PD)                 0.50            5

                                                          2017         2018         2019         2020         2021
                                                        -------      -------      -------      -------      -------
Capitalized S&M                                          16,919       31,817       46,588       49,830      166,727
Capitalized E&PD                                          2,662        4,208        9,389       19,401       67,000
Total Capitalized                                        19,581       36,024       55,976       69,231      233,726

Amortized S&M                                             5,640        5,640        5,640            0            0
                                                              0       10,606       10,606       10,606            0
                                                              0            0       15,529       15,529       15,529
                                                              0            0            0       16,610       16,610
                                                              0            0            0            0       55,576
                                                              0            0            0            0            0
Total Amortized S&M                                       5,640       16,245       31,774       42,745       87,715

Amortized E&PD                                              532          532          532          532          532
                                                              0          842          842          842          842
                                                              0            0        1,878        1,878        1,878
                                                              0            0            0        3,880        3,880
                                                              0            0            0            0       13,400
                                                              0            0            0            0            0
Total Amortized E&PD                                        532        1,374        3,252        7,132       20,532

Total Amortization                                        6,172       17,619       35,026       49,876      108,246


TABLE 3 - Cash Flow Statements as reported by Upstart

                                                                    2017         2018         2019         2020         2021
                                                                  -------      -------      -------      -------      -------
Net income                                                         -8,861      -11,218       -5,020        5,579      135,443

Change in fair value of financial instruments                      -5,201       42,282       34,716       29,049         -228
Stock-based compensation                                            1,290        2,045        3,806       11,513       73,186
Gain on loan servicing arrangements                                 1,515        2,169          856       -1,530       -6,916
Depreciation and amortization                                          93          314          774        2,278        7,541
Incentive share expense                                                 0            0            0          787            0
Noncash interest expense                                               42           19           74           73        1,983
Gain on repurchased and retired  stock warrants                         0            0       -3,657            0            0
Accrued Interest on convertible notes                                 416          794            0            0            0

Purchase of loans for immediate resale                           -580,438   -1,115,049   -1,779,180   -2,540,948   -8,713,476
Proceeds from immediate resale of loans                           580,438    1,115,049    1,779,180    2,540,948    8,713,476
Purchase of loans held-for-sale                                         0            0            0     -116,127     -219,128
Principal payments received for loans held-for-sale                     0            0            0       18,218        8,659
Net proceeds from sale of loans held-for-sale                           0            0            0       47,604      112,569
Other assets                                                       -4,147       -3,001      -11,957      -13,186      -62,042
Operating lease liability and right-of-use asset                        0            0          871          251        3,126
Accounts payable                                                      946        1,118        3,613        7,033       -7,513
Payable to investors                                               23,525       14,100      -14,875       19,446       62,097
Accrued expenses and other liabilities                                739        1,716       22,381        4,709       59,576

Net cash (used in) provided by operating activities                10,357       50,338       31,582       15,697      168,353

Principal payments received for loans held                         49,556      199,325      158,921       24,018            0
Net proceeds from sale of loans held-for-investment                45,084       45,698      100,678       97,340       51,403
Principal payments received for loans held-for-investment          26,660       38,678       48,124       15,758       24,532
Principal payments received for notes receivable                        0        1,229        8,760       14,665       11,458
Purchase of loans held-for-investment                            -102,541     -169,442     -265,286       -9,655     -159,398
Purchase of non-marketable equity securities                            0            0            0            0      -40,000
Purchase of notes receivable and residual certificates                  0            0         -485           -4            0
Purchase of property and equipment                                      0         -148       -4,004       -1,355       -8,427
Capitalized software costs                                           -773         -896       -1,275       -4,250       -6,688
Acquisition, net of cash acquired                                       0                         0            0      -16,757
Purchase of loans held by consolidated securitizations           -411,407     -251,681            0            0            0
Net cash (used in) provided by investing activities              -393,421     -137,237       45,433      136,517     -143,877

Proceeds from initial public offering                                   0            0            0      159,488            0
Proceeds from secondary offering                                        0            0            0            0      263,931
Proceeds from borrowings                                          118,780      144,048      153,491       92,057      718,422
Payment of debt issuance costs                                                       0            0            0      -15,727
Purchase of capped calls                                                             0            0            0      -58,523
Taxes paid share settlement of equity awards                                         0            0            0         -236
Payments made on securitization notes and certificates            -49,262     -226,775     -176,742      -26,126            0
Repayments of borrowings                                         -111,139      -92,954     -109,939     -148,113      -71,316
Repayments of notes payable                                       -13,634      -21,468      -22,637            0            0
Distributions made to noncontrolling interests                     -2,238      -11,238       -4,960         -622            0
Repurchase of convertible preferred stock warrants                                   0       -1,426            0            0
Repurchase of convertible preferred stock                                            0         -661            0            0
Proceeds from issuance of notes payable                            31,399       42,537       39,863            0            0
Proceeds from issuance of convertible preferred stock               1,112       49,925        1,912            0            0
Proceeds from  convertible preferred stock warrants                                  0        1,631            6            0
Proceeds from employee stock purchase plan                                           0            0            0        4,145
Proceeds from exercise of stock options                               142          323          278        2,362       14,736
Proceeds from the issue of securitization notes                   400,866      242,454            0            0            0
Proceeds from the sale of non controlling interests                16,689        8,914            0            0            0
Proceeds from the issue of convertible notes                       20,000            0            0            0            0
Net cash (used in) provided by financing activities               412,715      135,766     -119,190       79,052      855,432

Net increase in cash and restricted cash                           29,651       48,867      -42,175      231,266      879,908
Cash and restricted cash at beginning of period                    43,724       73,375      122,242       80,067      311,333
Cash and restricted cash at end of period                          73,375      122,242       80,067      311,333    1,191,241


TABLE 4 - Cash Flow Statements as adjusted

                                                                    2017         2018         2019         2020         2021
                                                                  -------      -------      -------      -------      -------
Net income                                                         -8,861      -11,218       -5,020        5,579      135,443
Intangible Investment                                              19,581       36,024       55,976       69,231      233,726
Amortization of Intangible Investment                              -6,172      -17,619      -35,026      -49,876     -108,246
Adjusted Net Income                                                 4,548        7,187       15,930       24,933      260,923

Amortization of Intangible Investment                               6,172       17,619       35,026       49,876      108,246

Change in fair value of financial instruments                      -5,201       42,282       34,716       29,049         -228
Stock-based compensation                                            1,290        2,045        3,806       11,513       73,186
Gain on loan servicing arrangements                                 1,515        2,169          856       -1,530       -6,916
Depreciation and amortization                                          93          314          774        2,278        7,541
Incentive share expense                                                 0            0            0          787            0
Noncash interest expense                                               42           19           74           73        1,983
Gain on repurchased and retired  stock warrants                         0            0       -3,657            0            0
Accrued Interest on convertible notes                                 416          794            0            0            0

Purchase of loans for immediate resale                           -580,438   -1,115,049   -1,779,180   -2,540,948   -8,713,476
Proceeds from immediate resale of loans                           580,438    1,115,049    1,779,180    2,540,948    8,713,476
Purchase of loans held-for-sale                                         0            0            0     -116,127     -219,128
Principal payments received for loans held-for-sale                     0            0            0       18,218        8,659
Net proceeds from sale of loans held-for-sale                           0            0            0       47,604      112,569
Other assets                                                       -4,147       -3,001      -11,957      -13,186      -62,042
Operating lease liability and right-of-use asset                        0            0          871          251        3,126
Accounts payable                                                      946        1,118        3,613        7,033       -7,513
Payable to investors                                               23,525       14,100      -14,875       19,446       62,097
Accrued expenses and other liabilities                                739        1,716       22,381        4,709       59,576

Net cash (used in) provided by operating activities                29,938       86,362       87,558       84,927      402,079

Principal payments received for loans held                         49,556      199,325      158,921       24,018            0
Net proceeds from sale of loans held-for-investment                45,084       45,698      100,678       97,340       51,403
Principal payments received for loans held-for-investment          26,660       38,678       48,124       15,758       24,532
Principal payments received for notes receivable                        0        1,229        8,760       14,665       11,458
Purchase of loans held-for-investment                            -102,541     -169,442     -265,286       -9,655     -159,398
Purchase of non-marketable equity securities                            0            0            0            0      -40,000
Purchase of notes receivable and residual certificates                  0            0         -485           -4            0
Purchase of property and equipment                                      0         -148       -4,004       -1,355       -8,427
Capitalized software costs                                           -773         -896       -1,275       -4,250       -6,688
Acquisition, net of cash acquired                                       0                         0            0      -16,757
Purchase of loans held by consolidated securitizations           -411,407     -251,681            0            0            0
Intangible Investment                                             -19,581      -36,024      -55,976      -69,231     -233,726
Net cash (used in) provided by investing activities              -413,002     -173,261      -10,543       67,287     -377,603

Proceeds from initial public offering                                   0            0            0      159,488            0
Proceeds from secondary offering                                        0            0            0            0      263,931
Proceeds from borrowings                                          118,780      144,048      153,491       92,057      718,422
Payment of debt issuance costs                                          0            0            0            0      -15,727
Purchase of capped calls                                                0            0            0            0      -58,523
Taxes paid share settlement of equity awards                            0            0            0            0         -236
Payments made on securitization notes and certificates            -49,262     -226,775     -176,742      -26,126            0
Repayments of borrowings                                         -111,139      -92,954     -109,939     -148,113      -71,316
Repayments of notes payable                                       -13,634      -21,468      -22,637            0            0
Distributions made to noncontrolling interests                     -2,238      -11,238       -4,960         -622            0
Repurchase of convertible preferred stock warrants                      0            0       -1,426            0            0
Repurchase of convertible preferred stock                               0            0         -661            0            0
Proceeds from issuance of notes payable                            31,399       42,537       39,863            0            0
Proceeds from issuance of convertible preferred stock               1,112       49,925        1,912            0            0
Proceeds from  convertible preferred stock warrants                     0            0        1,631            6            0
Proceeds from employee stock purchase plan                              0            0            0            0        4,145
Proceeds from exercise of stock options                               142          323          278        2,362       14,736
Proceeds from the issue of securitization notes                   400,866      242,454            0            0            0
Proceeds from the sale of non controlling interests                16,689        8,914            0            0            0
Proceeds from the issue of convertible notes                       20,000            0            0            0            0
Net cash (used in) provided by financing activities               412,715      135,766     -119,190       79,052      855,432

Net increase in cash and restricted cash                           29,651       48,867      -42,175      231,266      879,908
Cash and restricted cash at beginning of period                                 73,375      122,242       80,067      311,333
Cash and restricted cash at end of period                          73,375      122,242       80,067      311,333    1,191,241

8 Likes

Hi Ears,

I’ve been looking forward to the kickoff of your “imprecise” breakdown of Upstart, now that the company has reported Q4 and FY 2021 financial results. As you might recall at nevercontent/Neil’s Weekly Analysis Club board, I’m a ROIC-WACC spread follower/believer thanks to Andrew Chan at TMF boards of old and collaborative research and writings by Michael Mauboussin and Dan Callahan, CFA .

In a 10/18/2016 TMF interview, John Rotonti asked Michael Mauboussin: Do you have a preferred measure for the returns a business is generating? Return on assets? Return on equity? Or return on invested capital?
Mauboussin answered: All of these measures have limitations, but return on invested capital is my favorite of that group for a couple of reasons. First, there is a little less room for manipulation when you use ROIC, which is net operating profit after tax, or NOPAT, divided by invested capital. NOPAT is cash earnings before financing costs. You can calculate invested capital from the left or right side of the balance sheet, which can provide insight into the efficiency of asset utilization as well as financing choices.
Second, ROIC is financing neutral. All of those other measures can be manipulated by changes in capital structure. So whether a company has no debt or a lot of debt, its ROIC is the same. That’s a useful feature.

Here’s a more recent Michael Mauboussin/Dan Callahan authored article from my files that jives with your post .
6/9/2020 The Math of Value and Growth - Growth, Return on Capital, and the Discount Rate
By Michael Mauboussin and Dan Callahan, CFA.
https://www.morganstanley.com/im/publication/insights/articl…

Excerpt:
The value of a financial asset is the present value of future cash flows. If you don’t believe that, please put this aside and resume your normal daily activities. If you do believe that, you recognize that you have to grapple with an assessment of the magnitude and timing of cash flows as well as the appropriate rate at which to discount them.

For a company, the relevant definition of cash flow is the money that can be returned to claimholders, including the owners of the bonds and the stock. Cash flow is the profit the business earns after paying taxes minus the investments the company makes. Investments are outlays today with the expectation of profits tomorrow that make the investments worthwhile.

The magnitude of cash flows is a function of opportunity and economics. You can think of opportunity as the total addressable market (TAM), defined as the revenue a company would realize if it had 100 percent share of a market it could serve while creating shareholder value. Many investors use the concept of TAM to gauge a company’s potential size.

The second part of the definition is equally important and attends to the economics. A company’s objective should not be simply to grow; it should be to grow such that it creates value. A company creates value when its investments earn a return higher than the opportunity cost of capital.

You can imagine that there are some very large addressable markets with poor prospects for value creation and some small markets with excellent economic prospects. The holy grail is large markets with attractive economics.

Naturally, opportunities that are big and lucrative attract a lot of attention from current and potential competitors. Barriers to entry are crucial. Bruce Greenwald, a renowned professor at Columbia Business School, goes so far as to say that “competitive advantages are actually barriers to entry.” So investors have to think hard about how leading companies in large markets can sustain their positions.

Understanding the magnitude and return on investments is crucial. Investments have traditionally been in the form of tangible assets that show up on the balance sheet. Examples include increases in working capital or capital expenditures. But in recent decades investments have shifted in form to intangible assets, which are expensed on the income statement and are typically absent on the balance sheet (except for when one company acquires another).

This is important because companies that invest heavily in intangible assets and have high returns on those investments often produce poor profits, or may even lose money. As an investor, you want that kind of company to invest as much as it can. The income statement looks bad, the balance sheet looks better, and the value creation looks great.

Contrast this to generations past when tangible investments were captured on the balance sheet. In those days, the income statement looked good but the balance sheet looked bad.

Saying this differently, two companies can have the same level of investment and return on investment but very different financial statements based on where accountants record investments. Free cash flow, the number we care about, may be the same but the path to get there is different.
——————————

Applying the Mauboussin/Callahan approach in your hands on case study of a specific company Upstart will be most instructive, revealing and greatly appreciated.

Regards,
Ray
Disclosure: UPST investor and not an accountant

5 Likes

The value of a financial asset is the present value of future cash flows. If you don’t believe that, please put this aside and resume your normal daily activities. If you do believe that, you recognize that you have to grapple with an assessment of the magnitude and timing of cash flows as well as the appropriate rate at which to discount them. – article

That is a wonderful… theory. And it makes sense. The problem is knowing those future cash flows and an appropriate discount rate… which is the whole model.

I remember a discussion on the public BRK board. The very best (and SMART!) folks there proved that Amazon was never going to live up to the price that was then in place.

Their “proof” was completely wrong of course because they were not even on the same planet for those future cash flows. Portions of the business grew “too fast” and new business segments were launched that were… of course… unanticipated.

Yeah, I like Amazon for an example but I imagine there are similar examples even today. Resolute advocates of “value of a financial asset is the present value of future cash flows” will say “Can’t win 'em all!”… which is true for everyone. :slight_smile:

Rob
Rule Breaker Home Fool
He is no fool who gives what he cannot keep to gain what he cannot lose.

1 Like

Hi Ray,

Thanks so much for your comments. Much appreciate your perspective on ROIC and link to the article.
P.S., I loved their discussion of the discount rate and especially enjoyed this quote from their
paper: The distinction between value and growth investing is hollow. Warren Buffett…correctly
called it “fuzzy thinking.”

Hewitt Heiserman Jr. back in 2004 got me interested in innovative approaches to the treatment of
intangible investments. He was way ahead of his time. Much of the published work on this topic is
more recent – within the last ten years – and not surprisingly coinciding with the rise of
unprofitable, fast-growing companies.

Last fall Mauboussin and Callahan published their interpretation focused on free cash flow and the
cash flow statement. Their method connecting intangible investments to cash flows resonated with
me. By the way, in that same paper they also discuss novel approaches to the treatment of stock
based compensation and operating leases which might be of interest to you. Here’s the link:

https://www.morganstanley.com/im/publication/insights/articl…

I have one puzzle with Mauboussin. He uses NOPAT in the numerator of his ROIC calculation. But
NOPAT has intangible investment buried in it. For firms investing heavily in intangibles, it will
distort ROIC, depending on your point of view.

Also, I’ve been meaning to ask you…in your WACC calculation, how are you determining cost of
equity. Are you using Damodaran’s estimates or are you brewing your own?

Thanks,
Ears

1 Like

Hi Rob,

Thanks so much for your comments.

That is a wonderful… theory. And it makes sense. The problem is knowing those future cash flows
and an appropriate discount rate… which is the whole model.

Mauboussin would agree with you. Me too. Which is why he advocates looking first at the one thing we
are sure of: the current price. Then he uses DCF scenarios to see what expectations are built into
the price. The last step is to determine if you agree with those expectations. For high growth firms,
he also examines the option value of the cash they generate which can be directed to new ventures.

Best to you,
Ears

2 Likes

Ears: Also, I’ve been meaning to ask you…in your WACC calculation, how are you determining cost of equity. Are you using Damodaran’s estimates or are you brewing your own?
————————-

Replying to your 5/27/2015 post at nevercontent’s board,
https://discussion.fool.com/so-the-question-in-my-mind-is-whethe…

I posted my detailed calculation of WACC for ATRO, the not so fun way.
https://discussion.fool.com/ears-previously-posted-now-that-you-…

BTW, notice back then, I got the heads up about Damodaran from you:
Now that you have a and b you can compare them to the cost of capital for ATRO. You can calculate this yourself but it’s not fun so I cheat and use the industry cost of capital that I get from Damodaran.

In my post I commented:
Ears’ WACC of 8% is between my two calculations. Guess what? All three are “correct” or acceptable! This the reason I have reservations posting my WACC calculations in TMF posts because anyone can nit pick details, variables and methods. Perhaps, I should start using Ears’ useful reference hereafter.

Thereafter, I primarily use the Damodaran’s Cost of Equity and Capital (US), which is “good enough” for me wherever applicable in my due diligence on companies.

Cost of Equity and Capital (US) as of January 2022
https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile…

————————————

Thanks for the Mauboussin/Callahan paper addressing novel approaches for the treatment of SBC and operating leases.

I found interesting Exhibit 1 that shows SBC as a percentage of sales for companies in the Russell 1000 Index based on size. The index is the top thousand companies in the U.S. measured by market capitalization. The ratio of SBC to sales is about 15 percent for the smallest companies and declines steadily to about 1 percent for the largest companies. Further, SBC is strongly correlated with intangible investment.

I could have used this exhibit earlier this week to support why the SBC for a small cap company - SiTime Corporation - that I posted about at Saul’s board has steadily declined from 15% as shown in the following table.

SiTime Corp Stock-Based Compensation

While there is no generally accepted upper limit for SBC/revenue ratio, I prefer 10% or less. Although the SBC/ Revenue ratio has been trending downward, it still demands investor vigilance.


**PERIOD	 SBC   Revenue	SBC/Revenue**
**($ M)	($ M)**	

Q4’ 21  9.361   75.741    12.4%  
Q3 '21  7.951   63.029    12.6%
Q2 '21  7.601   44.496    17.1%
Q1 ’21  7.400   32.667    20.8%  			
Q4 ’20  6.178   40.274    15.3%
Q3 ’20  5.067   32.765    15.5%
Q2 ‘20	3.395	21.473    15.8%
Q1 ‘20	2.974 	21.742	  13.7%
Q4 ‘19	1.379	28.089	   4.9%
	   

FY '21 32.314  218.808    14.7%
FY ’20 17.738  116.156    15.2%    		
FY '19	1.379	84.074	   1.6%
FY '18	0.831	85.214	   1.0%

Here’s my post there - SiTime my high growth diversified holding - that got buried by a huge avalanche of monday.com related posts about reported earnings.
https://discussion.fool.com/sitime-my-high-growth-diversified-ho…

Regards,
Ray

2 Likes

Wow, Ray, you have a great memory.

Funny, when we were all looking at ATRO back then it was at an all time high. Fell off the cliff
shortly after. Neal was right about it being cyclical. It didn’t pass the 5-minute test for me.

Just wanted to comment about Mauboussin’s view on moving SBC to the financing section. It’s a
terrific idea and makes business sense. SBC is primarily a strategic decision made at the Board/
Executive Level (witness the recent decision on Paul Gu at Upstart) and only secondarily a tactical
decision at the operating level. It rightly reduces Cash from Ops (as an expense) and increase cash
from financing. This says nothing about whether SBC is a good idea, just moves it to the place that
makes it most understandable.

Thanks Ray.

Ears

For discussion purposes, let’s pick 50%. We’ll say that 50% of S&M and 50% of E&PD are linked to current revenues and are necessary just to maintain current business and the other 50% are investments in future growth

Ears, We are all grappling with this core challenge in growth investing. From my own personal experience, if you are not able to convert S&M expense within in 4 to 6 quarters ( 6 is really stretching), that expense is wasted. Likewise, I consider some of the marketing like TV advertisements are of very dubious value.

One of the company I am looking at is c3.ai. There SGA is close to 100% of revenue. Their growth is telling me this is not an investment rather the company has $1 B in cash, and they are trying to convince the investment community that they are doing something. For an enterprise software company they are focusing on Small and medium businesses. They are making some breakthrough there but not sure whether they would have gone after that segment, if they didn’t had $1 B cash in the bank.

Personally I like to write off SGA expenses to be conservative.

The very best (and SMART!) folks there proved that Amazon was never going to live up to the price that was then in place.

Bashing Amazon was an hobby, there was never an objective assessment. here are few gems:

  • When comparing AMZN with other retailers excluding debt of retailers in EV calculation
  • Arguing sale and leaseback is a fraud, IRS is not prosecuting Amazon
  • AWS is commodity business that is subsidizing customers with shareholder money
  • Alexa is sold for loss, that money is down the drain
  • You can never make money by delivery, prime cost doesn’t cover delivery expense

It stopped when Berkshire bought $1 B worth of AMZN stock.

When investors blindly believe something, often they are wrong.

2 Likes

Ears,

At what point you think the current excess “operating expenses” and the benefit received from earlier period “investments” becomes a wash? May be not totally a wash, but of only incremental value, i.e., at some point in future then current earnings should benefit from today’s “investment” and they inturn make “investments” for the future, right?

At what point you think the current excess “operating expenses” and the benefit received from
earlier period “investments” becomes a wash?

5-10 years.