Perhaps, instead of getting into this thicket, we can just figure out how much goodwill value this R&D, branding, and other intellectual property has, that is not put on the balance sheet, and add it into goodwill, to help demonstrate why a premium valuation is justified.
Since the above proposal does not generate a real transaction with dollars and cents any addition to Goodwill needs an entry “per contra” (the opposite side of an account or an assessment). You have three options
1- a negative entry in Assets which amount to a footnote – no change in book value
2- an entry in Liabilities which for which you are not liable in cash – no change in book value
3- an entry in Profits which would cause a tax – might be considered padding by management
None of the above make the accounting more understandable.
Denny Schlesinger
What matters to your bank account is what goes into it, not how expensive the source of that money is perceived to be.
I had an argument about this with Tinker on another board. And I am not saying that’s what the particular company you are analyzing is doing.
It matters how you fill up your bank account. I could easily by borrowing on credit cards and letting the debt rack up retain a lot of my earnings in my bank account that I would otherwise spend on rent, food, entertainment, education and vacation. It does matter.
If a company increased their cash flow (e.g ANET did this year by 100MM by letting current liabilities rise more than current assets), then that’s not a source that I necessarily credit the company for (I don’t have a problem if their business is so efficient that instead of costing them operating capital, it is earning them, but that’s not their income, something I owe in less than one year to my creditors). The reason we still look at FCF statements is, to make sure that the business is not running out of cash to fund its growth and will not end up going belly up. That’s not a risk for Saul type companies if they are capital light and sport no debt. I could argue that FCF is almost meaningless for Saul type companies, and pure focus should be on net income and improving operating leverage (in addition to Sales growth of course)
Similarly, and most importantly, when a company pimps out its stock to “save” on expenses, I don’t credit that as “income” when I adjust the net income metric. (It might work out OK in the near term, but could be very costly in longer periods) For e.g ANET spent 75MM on stock based comp. I am not saying its not OK to use your stock to pay your executives, but I am saying that that’s not free money. If the stock is overpriced, that might be a cheaper way to pay a $75 million dollar bill. Whereas if the stock is cheap (underpriced), then it could be an expensive way of paying a $75 million bill. Regardless of whether its cheap or expensive, to offset the dilution, at current level, if its going to cost the company $75 million, then that is certainly not a non-cash expense that I want to credit the company for as “income”.
ANET btw is relatively cheap on P/E basis and if you adjust the Price for the cash on hand, it’s cheaper relative to the growth numbers they have posted. I bought a piece today.
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It matters how you fill up your bank account. I could easily by borrowing on credit cards and letting the debt rack up retain a lot of my earnings in my bank account that I would otherwise spend on rent, food, entertainment, education and vacation. It does matter.
I read Tinker’s comment and it seemed clear to me that the money he was talking about was money earned free and clear. He was talking about net worth using a banking allegory. To take it literally misses the point.
Denny Schlesinger
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Great discussion. I haven’t subscribed to AAII’s Stock Investor Pro in years, but this makes me want to start up there again. It would be super-easy to work this metric up in SIP, apply it to whatever the universe of stocks they cover is (7500?), and export and sort the heck out of it–get, for example, industry-specific averages for the figure.
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In trying to clear out some of my tabs this evening, I noted items on slides 20 and 33 of the below-linked presentation from someone who got Google totally wrong in 2004 that applied to this topic of using EV for valuations (EBITDA rather than FCF on slide 20…but similar reasoning). Slide 33 is more about adjusting for several different factors in looking at valuation, but Google’s net cash position was a big part of that.
http://www.tilsonfunds.com/TilsonGOOG.pdf
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I haven’t looked at this in-depth yet, but it might have some aspects similar to the EV/FCF valuation I have posited. I’ll try to look at this more in the future, but a quick glance at the predicted stock prices versus actual makes it appear that this guy’s framework may have some decent validity.
Here is a link to a Seeking Alpha article discussing it (so it will go behind a paywall in about 10 days):
https://seekingalpha.com/article/4175891-equilibrium-valuati…
Here is a link to the page that has a link to the associated academic-looking paper (might be fully academic, but I didn’t read details yet and can only say it appears to be academic):
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3177338
This may take you directly to a .pdf of the paper:
https://poseidon01.ssrn.com/delivery.php?ID=7320880240870920…
-volfan84
long trying to better understand why stock prices should be at certain levels, thus having advance knowledge of the market’s “weighing machine” prowess to take advantage of the sometimes silly “voting machine” of the short term
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Joel,
Could you also explain your thought process in dividing by FCF versus Revenue/Earnings?
I think I’m trying to get to the same you’ve already done but piecing it together.
Mark
Basically, cash flows are what a company needs to survive and thrive, even moreso than GAAP earnings in some ways. Run out of cash, no way to pay the bills, then possible defaults.
Ideally, a mature company would have great earnings and cash flows and a young, growing company would have a clear path to positive earnings and cash flows (if expanding to “take over the world” like Amazon, needing positive earnings might become less important if the revenue growth rate basically exceeds 30% for a full 20-year period). Only looking at earnings or only looking at cash flows might not give a full story. A company could have much better cash flows than earnings if they have a high amount of stock-based compensation or if they are able to improve their working capital position (accounts receivable and payable).
Consistent and growing earnings and cash flows, with revenue still growing is what you’d ideally like to see with a company. Deferring striving for earnings during expansion mode can make a lot of sense for companies that are still growing their customer base (and thus revenues) at a rapid rate.
In a way perception of TTD is almost skewed negatively by a few folks simply because they’ve already managed to be profitable (GAAP and non-GAAP basis), but they’re also still in essentially “hyper-growth” mode with the past 2 quarters having been at 61% and 54% y-o-y revenue growth if the numbers I’m recalling off the top of my head are correct. The fact that they’ve already shown they can turn a profit is something that myself and DreamerDad alternately view as a positive.
There may be room for some calculus and throwing a derivative into an equation (or group of equations) to incorporate acceleration or deceleration of revenue growth into an improved valuation metric. I have yet to tack that on and “integrate” it into my EV/CF methodology, but perhaps you’ll figure out a decent easy way, since you’re a NASA guy 
-volfan84
I followed up the OP here with a few spreadsheets projecting future hypothetical EV/CF ratios. Here are links to a few of those threads:
PSTG:
http://discussion.fool.com/pstg-future-evfcf-projections-3300352…
NVDA:
http://discussion.fool.com/self-assignment-nvda-evfcf-projection…
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