A doctor living in Dubai, Dr. Tariq E., just finished our Framework 102 course on Valuation, and sent through several excellent questions about revenues, profits, growth, and “Balance Sheet Effects.” The questions get to the heart of Framework’s valuation methodology, so I thought this was a good opportunity to post them for others to see as well. Here is our exchange.

Questions from Dr. E.,

Hi Erik,

First, I wanted to mention that I thought your analogy [N.B. Which I had written about in an earlier mail] comparing learning valuation to medical education is a very important point.

In fact I learned in my career that if you focus in on a few important things you will diagnose / treat a patient more skillfully however complex his/her situation is. On the contrary, if you gather a lot of information, the noise will conceal the signal and the probability of misdiagnoses is higher. This is the reason that inclined me to your framework as it focuses in few key drivers in similar way to what I do in my daily medical practice.

I just finished the course which exceptional, step by step, logical. I looked at a Guided Tear Sheet to understand how to apply the knowledge acquired in the course in real case. I will try to replicate your work myself (downloading financial statements and looking to the points stressed in you qualitative research).

After finishing the course I have 4 questions :

  1. For Growth do you count the OCP growth or the FCFO growth? Or do you use the more stable one? as I noticed in the video you showed 2 graphs of CAT and Oracle OCP growth but you stated that FCFO growth is what counts.
  2. For Balance Sheet Effects, how should I incorporate a “lottery” or a “snake” on the B/S into valuation? Do you count excess cash/debt per share for example and add it to the module?
  3. Revenue: apart of qualitatively accounting of risk of not realizing revenue in the future (i.e CAT and China case study) what other risks do you look to in general?
  4. Profit: what I understand is
    OCP = CF operation – maintaince CAPEX or:
    OCP = revenue – Costs (COGS+ SG&A + tax + maintenance CAPEX)
    how do I count for the effect of leverage / debt on profits ?

I know your time is limited so please answer at your own convenience; I’m in no hurry.

Thank you
Best regards,

Erik’s Answer

Dear Dr. E,

Thanks so much for your mail and for your kind words about the course! I’m glad you enjoyed the videos! Did you work through the quizzes and case studies as well? How did you find those? Helpful, I hope!

To your point about focus and simplicity, in the 101 course, I talk about decision-making and this is one of the points. Humans feel uncomfortable dealing with what we call the “C-System” processes (rational, stepwise thinking like that used for science, mathematics and medicine), and one of the ways of dealing with this discomfort is by trying to gather all available data about a problem. However, numerous academic studies have clearly shown that, rather than helping decision-making, complexity and large amounts of data actually breed confusion, and contribute more often than not to poor decisions.

Now, let me turn to each of your questions:

OCP vs. FCFO growth rates: You’ve hit on an important point! FCFO is variable over any one year because management has control over what investments they make. I look at Net Expansionary Cash Flow from a long-term capital needs perspective, and expect that my FCFO forecast for any one year will likely be wrong, but over time, the aggregate should (if I’m doing my job well) be right. Because of the variability of FCFO, to assess historical investment efficacy, I usually look more closely at OCP growth. However, as I think about future efficacy, I need to translate that to FCFO growth. This is fairly easy because I’m assuming (and it is usually right, from what I’ve seen) that a company must spend a pretty fixed amount on capital spending over longer time frames. So, I can look at three cases:

  1. The business is in a stable industry and will likely spend an even amount in the future. In this case, OCP growth rate will equal FCFO growth rate.
  2. The business is spending a lot on Net ECF now, but will be able to spend less in the future. In this case, FCFO growth rate will be faster than OCP growth rate, but I can still think about OCP growth rate as a base and add something onto that. (This is most common for small firms that will be getting to scale in a few years’ time)
  3. The business is spending a little on Net ECF now, but will have to spend more in the future. In this case, FCFO growth rate will be slower than OCP growth rate. This is the hardest case to forecast, so sometimes I actually run two models for this and the valuation uncertainty becomes very high.

Balance Sheet Effects: There is a cell on the Framework valuation model that allows you to write in a value for the balance sheet effect. We assume that this has an immediate effect on the value of the firm, even though the actual timing of this effect is hard to know. I am generally cautious about using this cell to change things around unless I have very good information and can quantify the effect. That said, there are several “typical” examples:

  1. Apple: AAPL holds a lot of cash that is “non-operational” but stored in offshore accounts. I added a tax-adjusted amount of its overseas holdings to the B/S Effect cell for the Apple model. You can read about that here and here.
  2. Amazon: AMZN has an unusual situation called “Negative Net Working Capital.” This boils down to the fact that AMZN receives money for its products pretty much immediately (within 30 days, since everyone is using credit cards) but it pays its suppliers only once every 60 or 90 days. As such, money has come in for products that it has already shipped, but for which, it has not had to pay out cash. In this situation, working capital will always serve as a source of short-term credit. I did not want to include this amount in my calculation of OCP (because OCP should be the cash profits of a firm, and the Negative Net WC represents a temporary timing difference that, once corrected, would decrease profitability), so I calculated what this amount would likely be over the next five years, discounted that, and added that as a B/S Effect. This is a very old post, but it talks about that issue.

In cases where things are not so cut and dried, I am just very sensitive to the B/S Effect issue. For instance, I know that a major change to the US tax system has the potential to be a negative B/S Effect for General Electric, so I read any news stories about potential tax changes and try to see if the GE B/S Effect can be quantified. Or, another example is Union Pacific, which has a negative B/S effect associated with the regulatory environment and international trade. Again, I’m very sensitive to those stories and try to quantify the effect on UNP when / if there is material news.

Revenues: I spend a great deal of time thinking about revenues because it is such a very important driver of value. What I try to do is figure out if I am a customer of XYZ company, why would I prefer to buy XYZ’s products or services rather than ABC’s products or services. I try to find out if the customer purchases are subsidized in some way (e.g., Apple’s phone sales are subsidized by the way long-term mobile telephony contracts are structured and Ford pulls its demand forward by loaning customers money so they can buy the cars and trucks), if there are government rules which make or might make the company’s offerings more or less desirable, etc. This is the hardest one to say precisely “Look at this, this, and that.” To me, understanding a company means mainly understanding how it is responding to customer demand. I think this is the reason the Guided Tear Sheets are valuable – if you look at the revenue analysis for Zimmer Biomet, let’s say, that’s completely different from the revenue analysis for Union Pacific. In the case of revenues, I think that practice and bouncing ideas off someone are the two best ways to get comfortable and skillful at this.

Profits and Leverage: You’re right on your first equation. I count OCP as Cash from Operations less an estimate of Maintenance Capex (which is usually related to Depreciation charges). I know that companies can reclassify costs, so am not so focused on COGS versus SG&A, etc. In other words, if a company knows analysts and investors are looking carefully at its gross margin – based on COGS – it can reclassify some costs that were in COGS as SG&A or whatever, to boost gross margin by a few basis points. Nothing changes about the economics of the business, but because the analytical / investor community is focused on gross margin, if the firm reports an unexpected expansion, the company’s stock often gets a pop. When the management needs to reverse this, they call the charge “extraordinary” and offer a Non-GAAP gross margin figure that is essentially pegged to whatever management wants it to be.

Regarding debt and leverage, there are a couple answers to this question. First, if I see widely varying profitability in the past, I start looking for leverage (both operational – such as factories – or financial – debt). If the leverage is integral to the company’s operating profile rather than just temporary (e.g., it takes out debt to buy another firm and is paying that debt down quickly), I know that the spread between the best- and worst-case profitability will be much wider and this will also effect the valuation range of the company. Second, if I see a firm that is both highly indebted and which has low profitability, I start looking at how much interest payments are in relation to OCP and try to assess the thickness and durability of the “cash flow cushion.” OCP is a post-tax, post-interest quantity. I look at how many times the firm has generated negative OCP margins and by how much, then see whether the firm issued new debt to cover the shortfall, new equity, or just what. I also look to see if there is a large chunk of debt that will need to be rolled soon (i.e., a past debt is paid off with new debt issuance). In this case, I know that the valuation is dependent on the firm’s ability to roll this debt, and I know that sometimes (like the 2008-2009 crisis), that decision is not in the hands of company management, but rather in the hands of a potentially skittish market. I am very careful with companies with high amounts of leverage and if I do invest in them, usually (I can’t think of a counterexample) invest using an unlevered strategy.

Thanks again for the mail and the excellent questions! I’ll post our exchange as a mailbag article as I think it will make informative reading for others!

All the best,