An equation is defined as a mathematical statement that equates two expressions. These expressions can be something as simple as 2+2 = 5 err.. 4, to the relativity equation given by Einstein and even the expressions of Nature which includes the symmetry of butterfly, sunflowers and how the yellow and purple stripes of marine angelfish migrate over its body with time . If the abstract can be represented with a mathematical expression (including an unknown variable, as of now), can there be an equation to identify determinants of value in a business?
An Exercise in Lateral Thinking
In other words, are there a set of key variables which when worked on can help increase or decrease the value of a business?
It would be great to explore, understand and stress-test the equation to see if it really stands the value-test across different businesses, industries and business models but first, let’s start with the definition of value.
Value, is often defined by profits that are generated by the business, but probably it is time to ask the fundamental question that how do we define the value of a firm. Viewing profits as a source of value led to lot of accounting cooking as we have seen in the cases of Enron and the likes.
To paraphrase Economist,
Company analysis was anti-deluvian in the 1980s… the worth of a firm was estimated by placing its profits or book value on a multiple, whose value was best decided after a three-Martini lunch.
…Valuation offered new tools… Cashflow, and not easy-to-manipulate accounting profit, mattered. An activity only made sense if capital employed by it made a decent return, judged by its cashflow relative to a hurdle rate (the risk-adjusted return its providers of capital expected).
Though we see the practice of looking at profits is still widespread, for different reasons, it is time we start putting stress on cash flows and re-adjust the definition of value.
Therefore, value for a business, as defined by Aswath Damodaran, is as follows:
Value for a business is the sum total of the cash flows that it generates.
So, now with the definition of value in place, let us see the equation that has been used to determine the cash flows of a business.
FCFF= Revenue * Operating Margin * (1-Tax rate) — (Capex — Depreciation) — (Net change in Working Capital)
where, FCFF = Free Cash Flows to the Firm;
With me so far, Okay good.
Let us look at three greatly run companies which have been in the limelight for different reasons in the times of Covid, as they also belong to different industries and have different business models. Incidentally, all 3 of them are still run by their founders and are industry-leading in their category.
Amazon: Largest online retailer with focus on cloud computing, digital streaming and AI. Estimated to have 156million Amazon prime customers
Facebook: Largest network platform in the world with ~2.5 billion people active daily through Facebook, Instagram or Whatsapp
Tesla: Leading producer of high-performance electric vehicle and other energy products manufacturer with ~350,000 EV sales in 2019
Let us look at ‘The Equation’ to see how much value or cash is generated by each of the firms.
We have the output as Free Cash Flow for all the three companies i.e. $33 billion for Amazon, $12 billion for Facebook and $776 million for Tesla.
So, how does it translate to Value?
The cash flows are the primary means by which a company pays salaries or its suppliers or dividends. In other words, accounting profits do not pay the bills. Actual cash flow do. In still other words, cash is king.
If we are able to estimate the cash flows for future years and discount it back to present year at an appropriate rate of interest (known as cost of capital or hurdle rate), we have the value of the firm.
Impact of Cash Flows on Value of the firm
We see that 3 companies with three different business models and profitability ratios have been put on a pedestal by market as they generate more cash flows.
Amazon being in one of the lowest margin business with profitability of 5% and Tesla which has just hit break-even with an Operating Margin of 0.33% have a free cash flow of $32 billion and $776 million respectively. This is also a tribute to the founders who have been on a mission to further the cause that they augment through their companies.
The huge cash flow of $32 billion gives it the firepower to leave any company… Amazoned. As it trains it guns on logistics, it can buy entire equity of FedEx at $30 billion. Though in the times of cheap liquidity, it can easily raise debt to fund the $30 billion acquisition.
And to see how the market is treating Amazon, Facebook and Tesla, let us look at their market cap along with some of their competitors.
(in $ millions)
Through the comparison on Market cap, we can see how each of these firms are leading the way not only across their respective categories, but also breaking new ground and getting into the trillion figure mark, when it comes to valuation.
So, in a nutshell, if a company needs to increase the value, it has the following value levers:
i. Increase growth rate of revenue
ii. Increase duration of high growth period
iii. Increase profitability
iv. Reduce the risk or cost of capital that is applied to cash flows
While this may seem pretty obvious and simplistic, there are a lot of actions taken by companies which have no impact on the cash flow or value of the company. Some of them are:
i. Stock splits: Reduces the price per share with no impact on financial value of the firm; Increase the number of slices in a pizza without increasing its size
ii. Buy-backs: It inherently signals that the cash in the company should not be used to further the business, but to move the share price. After all, there was a reason they were banned for most of the 20th century
iii. Accounting changes in recognising inventory and depreciation that has no impact on tax calculation and hence, on overall cash flows, etc.
In a nutshell, we see that though Value Optimisation is a priority for companies, at times there are measures taken which do not increase the value of the business but are a cosmetic treatment to increase the share price or to make the company look financially attractive.
The equation, though provides a framework to test and see if the activities and actions are really moving the needle on the value-o-meter.