When we did our original valuation of Disney in late-October / early-November of this year and published it to our members, one of the valuation drivers we struggled with was “Investment Level.” Our valuation framework homes in on three short-term valuation drivers and one related medium-term one.

To create value for its owners in the short-term, a company must:

  1. Find and meet demand for its products or services (Driver 1: Revenue Growth)
  2. Convert revenues to profits (Driver 2: Profitability)
  3. Spend some of those profits on investment projects that help it grow faster in the future (Driver 3: Investment Level)

Depending on how successful the firm is in picking investment opportunities and investing some portion of its profits, its medium-term growth will be good or poor. This is the fourth valuation driver, one we call “Investment Efficacy.”

When we analyzed Disney, we noticed that over the past 10 years, the firm had spent a lot of its Owners’ Cash Profits (OCP) on investments (what we call “Expansionary Cash Flow“) — roughly 40%. These investments included major purchases of Pixar, Marvel, and Lucasfilm, and we wondered if perhaps the last 10 years of investment spending appeared higher because of these “special” investments, or if the company had invested at this level further in the past as well.

Pushing back our analysis to 2001, we noticed that while investment spending had, on average, headed up since Iger hit his stride as CEO (he took over from Eisner in 2005), the company had splurged on a few big purchases before that as well.

Figure 1. Source: Company Statements, Framework Investing Analysis

You’ll note that in 2002, 2006, and 2010, the company spent more on investments than it pulled in in profits. The average investment spending as a percentage of profits over this long time period is roughly 44%. We actually gave the firm the benefit of the doubt and modeled our projection of its investment spending at 35% of profits, simply because of the lumpiness of the firms investing history.

Rumors had started to swirl about Disney buying Fox soon after we published our valuation and this morning, the company announced it was indeed buying Rupert Murdoch’s entertainment business for an enterprise value (i.e., equity plus debt) of $66.1 billion.

When we heard the news, our first question was, what does $66.1 billion mean in terms of the company’s profits and cash flows?

Looking back at the company’s history, we found that Disney had spent more than eight years’ worth of its Owners’ Cash Profits on the Fox acquisition — an enormous bet! (In comparison, consider spending eight years’ worth of your post-tax take-home pay on a single investment). But the acquisition price’s relationship to Free Cash Flow to Owners (FCFO) was even more shocking (FCFO is the amount of cash that could be distributed to shareholders after all expenses are paid and all investments are made).

Our records go back to 2001, and the aggregate of all the years’ FCFO from 2001-2017, the firm has only generated $48.3 billion. In other words, the firm paid nearly 40% more than all the cash flow it had generated for its owners over the last generation to buy the entertainment assets of 21st Century Fox!

While that is a sobering statistic, the next sensible question to ask is whether it is worth it or not.

From our perspective, Disney has been very good at making acquisitions. Lucasfilm is a case in point. George Lucas took forty years to make six Star Wars films, only two of which were — by my estimation — worth going to see at all (sorry Star Wars fans, I calls ’em as I sees ’em). In contrast, Disney will release two Star Wars films in as many years and if critics’ reviews of the Last Jedi are to be believed, both of them are really good films. Disney paid a pretty penny for the Lucasfilm franchise, but arguably, they are able to squeeze a lot more cash flow out of that assets that George Lucas was able to do.

We will take some time to analyze the Disney-Fox transaction and adjust our valuation of Disney to account for the huge boost in revenues and profits that the acquisition will bring. Whether this transaction will benefit owners or not ultimately comes down to the balance between the enormous amount of cash spent on the transaction versus the additional flow of cash to owners that is likely to accrue in the future as Disney manages Fox’s assets.

We will update our readers when our valuation work is done.


This article originally appeared on Forbes.com