Financial & Strategic Value Creation 102 for Technologists: Analysis & Valuation

Disclaimer: The views expressed here are personal and meant for information/education purposes only and not representative of his employer directly or indirectly. Any mention of company names are for illustrative examples only.

This article is part of a series on Financial & Strategic Value Creation written for Technologists / techies: "Financial & Strategic Value Creation for Techies 101", "Financial & Strategic Value Creation for Techies 102: Analysis & Valuation", "Financial & Strategic Value Creation for Techies 103: Power of Compounding & Discounting", "Financial Literacy 104: Want Growth?", "Financial Literacy 105: Strategy Meets Execution"

PS: Selected older articles (2016-18): Blockchain/Crypto/Digital Tokens, Cashless Finance: UPI, Blockchain/Agri & Supply Chain Finance, Digital Agri: Commodity Spot / Futures Markets, Digital Agri: Future of Insurance, From Barter to Blockchain: Brief Journey of Payments & Ledgers, Cashless Financial Inclusion...

Janus is the two-faced Roman God of duality depicted in the figure above. Value creation and valuation comes from the balance between the two faces (similar to Janus): Reward and Risk. Greater reward tends to be associated with greater risk; it is the role of managers, entrepreneurs and investors to seek opportunities where the reward (ideally on the long term) is higher than the commensurate risk. When reward realized is greater than risk taken, economic value is added ("EVA"); else it is destroyed. The valuation of a enterprise or enterprise is a measure of the prospective economic value expected to be created by the enterprise.

The measure for reward is is Return on Capital (Employed/Invested) and the measure for risk is the (Weighted Average) Cost of Capital or opportunity costs for capital deployed in the enterprise.

An enterprise is run on three financial principles (Prof. Damodaran) : (a) investment principle (take on projects where reward > risk), (b) financing principle (fund the company with debt & equity to minimize cost of capital), and (c) dividend principle (payout dividends or buybacks to shareholders & retain/reinvest the rest based upon growth goals). You can think of (a) and (c) associated with return (and growth), and (c) associated with risk.

Reward & Return on Capital:

An investor view of the business is depicted in the picture below: a black box which converts capital to (annual) income (similar to how a riskless investment like a fixed deposit converts principal to (annual) interest payments, without risk of loss of principal).

If return (on capital) is greater than risk (measured as cost of capital or opportunity costs), then the business is creating or adding economic value. This will be reflected in a higher market value, than if return is lower than risk. In this latter situation, the business is destroying economic value. The market will tend to price these enterprises lower.

Another way of understanding this is that for a value destroying enterprise, its cash flows (which is a function of returns) will grow slower; and risk and cost of capital (i.e. discount rate applied to future cash flows) is higher. As time progresses, if it is fairly priced now, you would expect its value should come down in the future. Note that the markets may diverge significantly from your estimate of fair value, or there could be a range of uncertainties/outcomes and reflects the current sentiments & liquidity considerations of the marginal investors who are setting the price in the private or public markets.

The ROC investment via of a business can be further expanded via the so-called "Dupont" formula as follows.

Specifically, capital (equity and debt) is deployed into assets. Assets are used to generate sales / revenue / "turnover" and sales growth. More sales require more assets in general. The efficiency of conversion from capital to sales is measured by Asset Turnover Ratio or Capital-to-Sales (or Sales-to-Capital) ratio. Next sales convert into income or cash flows after subtracting costs. The efficiency of converting sales to income is called profitability or margins. Key margins are "operating margins" (pre- or post-tax), net margins, and margins of "EBIT", "EBITDA", "cash flow from operations" (CFOA), "free-cash-flow (FCF)" to firm (FCFF) and equity (FCFE). These are covered in the first article in detail.

In simple terms, return-on-capital can be decomposed into one efficiency part that measures how efficiently sales are generated from capital; and another that measures how efficiently income or cash flows is generated from sales. In an early stage company or startup, you have to focus on how efficiently capital gets converted to sales (if you are trying to get to revenue, i.e. "path-to-revenue" from capital); and once you have then see how efficiently the sales converts to cash flows/profits for a given target rate of growth (i.e. "path-to-profitability" and "path-to-free-cash-flow").

A company that has high sales-to-capital ratio and low margins (eg: Walmart, Amazon) is very different from one that has low sales-to-capital ratio and medium-to-high margin (eg: a capital intensive industry). Facebook has high sales-to-capital ratio and high and sustainable margins as well! A bad business is one that does not do well on both measures, and also has higher risk. When building a business (or valuing / analyzing an existing business), the first thing to understand is what is the capital needed; and capital-efficiency, i.e. how well the business converts capital to sales and subsequently from sales to income or cash flows. This is face 1 of Janus.

Growth & Return on Capital:

It is important, but subtle point, for technologists to understand that returns or capital efficiency is what powers sustainable growth (or give the company the "license" to grow without destroying value). A full cycle of capital is depicted below. A portion of income is paid out as dividends or buy backs (a.k.a "payout") to shareholders; and the rest is reinvested in the business. This is similar to compound interest where the interest (or "price of money") is reinvested to get exponential growth of capital. Growth comes from compounding, and the sustainable growth rate is limited by return on capital and what fraction of is reinvested, i.e. reinvestment rate.

More specifically, the limit on growth rate of cash flows (without external capital raise) is the product of ROC and Reinvestment rate. For example, if ROC is 25% and Reinvestment rate is 80% (and payout ratio, of both dividends and buybacks is 20%), then the max growth rate (without external capital raise) is 20%. If you want the business to grow faster than this, either, the ROC or Reinvestment rate (or both) has to go up; or you need external capital raise. A value destroying enterprise could be growing in sales, but reducing valuation, i.e. will be less valuable with time (i.e. depreciating/declining or liquidating in terms of intrinsic value similar to a depreciating asset like a old car). Note that it is still possible that the market price has been marked down already substantially to more than discount this (also called "cigar butt" investing of yester years). In general you want to avoid such situations, since the appetite for secondary investors to come in and own structurally declining businesses is generally low in the market.

Growth in sales is valuable only it is efficient relative to risks taken (return measured in terms of return-on-capital, i.e .capital-to-sales; and sales-to-cash-flows; and risk measured in terms of cost-of-capital to be covered later). The conversion of capital into sales, margins (i.e. growth-and-earnings cycle) and cash flows (cash-conversion cycle) in more depth is in the following pictures & covered in detail in the prior article.

At the same time, it is interesting to note that growth can enhance ROE (or ROC) with time (other factors being constant) if the starting ROE is lower and growth rate is higher (eg: in figure below ROE goes up from 10% towards 15%). Alternatively, if the initial capital or equity base is lower, initial ROE (assuming accretive earnings) may be much higher than sustainable growth rates, and the ROE will converge to the growth rate (eg: ROE starts almost 100% and then drops towards 15% as pictured below). This observation also illustrates the importance of observing ROE (or ROC) over a period of time to understand the underlying core efficiency of the business in capital allocation. Growth and return on capital can reasonably thought of as driving each other, but often it is better to think of return on capital (and component efficiencies such as operating margins, sales-to-capital ratios as important drivers or pre-requisites to earn growth without needing more capital).

If you are startup, or running a growth business within a larger enterprise, or designing technology to drive growth, please remember these relationships. A growing business has to unpack this step by step. First step is to create revenue eg: via building an audience or pipeline of users (eg: daily average users DAU) and monetization of users / customers via a transaction / subscription / advertisement model elaborated in the last article. The second step is "profitability" or a path to profitability, i.e. to convert sales/revenue into profits (gross profits, operating profits and net profits) and cash flow (cash flow from operations, free cash flow to firm or equity).

Where is Capital Invested? Assets: Tangible vs Intangible; Fixed vs Working

We talked about two steps from capital to revenue and from revenue to cash flows or profits. Actually there is one earlier step. Step zero is asset formation, i.e .to deploy capital (liabilities) into assets as shown in the picture below. Assets in turn drives revenue (asset turnover). On the balance sheet, there are two types of assets shown: long term fixed, and short term (working capital) assets.

More specifically, the "accounting" balance sheet only captures the tangible assets (short / long term) investments, net of depreciation; and the sources of capital (debt / equity) used to fund the assets. Initially if you assume debt is zero (as in early stage companies), then the equity is poured into working capital (WC) and fixed capital assets. It is important to understand the relative magnitude (or %) of WC vs FC in the total asset mix; and how it scales up with the size of the business. Eg: if you would like to grow the business to 10X the current level (of sales or profits), based upon evidence of capital efficiencies/returns & projected forward, how much more WC and FC is necessary? Technologists rarely think of this question. In fact, the whole purpose of technology to transform the composition of fixed/variable costs & its scaling; and its conversion to sales and cash flows. Technology is not an end in itself: having a thesis of its dynamic impact on capital and returns is important in building growth businesses or startups.

A bigger portion of most firms today is intangible assets and the difference between market value of equity and book value of equity as shown below:

Prof Damodaran prefers to call these a management view of the balance sheet - "Assets in Place" (generating today's revenues & cash flows) and "Growth Assets". We will stick to the Tangible vs Intangible and Fixed vs Working view for our discussion.

For example, the marketing assets (i.e. brand value, customer relationships, network effects), intellectual property assets built (eg: through R&D), trusted relationships with value chain participants (suppliers, partners, financiers, etc), employee/management quality & culture, and any sustainable competitive advantage "moats" fall in this category. Therefore it is useful to view the lines in a P&L as incremental working capital investments or incremental human capital investments (either short term before hitting gross profit or longer term): see below.

Note a fine distinction: inventory (or other elements of working capital) can "turn" several times in a year. Therefore there area ratios associated with Inventory Turns (relationship between Inventory line on balance sheet and COGS), Payables Turnover (as a fraction of COGS and admin costs), Receivables & Deferred Revenue (as a % or fraction of revenue).

Note also that the "working capital" (WC) we have depicted on the asset side is technically split between current asset and current liability sides, but WC is defined as current assets minus current liabilities, since this is the incremental capital you need from equity or debt to cover. If this is negative, then you are funding your working capital from your stakeholders (suppliers or customers) and NOT your shareholders; and if this situation can be sustained, then you can grow faster since your equity/debt capital is used for fixed assets and intangible assets only; and working capital is making a net contribution as well. Fixed plus working capital is also referred to as "Capital Employed", and there is a corresponding measure ROC measure (esp in manufacturing companies) called "Return on Capital Employed"; or "Invested Capital (WC - cash)" and an ROC measure called ROIC "Return on Invested Capital".

Working capital also affects cash flows and the cash cycle. Typically post-tax operating income or EBITDA can be adjusted with changes in working capital (note, it is the change in WC not absolute WC level that matters) and some other items to get to "Cash Flow from Operations" (CFOA) or operational cash flow. Once you net out fixed investments from CFOA you get to Free Cash Flow to Firm (FCFF), and if you net out interest to debt you get Free Cash Flow to Equity (FCFE). This is shown in the Cash Conversion Cycle picture, repeated here for convenience.

Now free cash flow to equity (FCFE) is what funds dividends, buybacks (the "dividend decision" to return cash back to shareholders) and reinvestment decision. If FCFE is negative but dividends are positive, watch out for unsustainability! The very existence of dividend means the company is not able to find risk-adjusted projects at target hurdle rate returns; and the dividend payout ratio can give you an idea of how much opportunity the company is able to find or return cash. If the company decides to retain the cash, then it leads to a cash pile as in Apple, Google etc, and the cash is usually netted out for computation of "enterprise value" (EV) and multiples such as EV/Sales and EV/EBITDA; and return metrics like Return on Invested Capital (ROIC, which uses WC - cash, instead of WC alone).

If the intangible asset portion is estimated to be negative, or the market value is less than book value, then the market is saying that there are going to be write downs to assets and equity not reflected in the accounting numbers. Eg: in India, government may seize the cash reserves (eg: as part of retail fuel subsidies) or force mergers of public entities (eg: banks, power sector companies); or there could be higher-than-expected non-performing-assets (NPAs) in the books of banks, or promoter share pledges (or other contingent liabilities) which the market expects will lower the asset and capital base compared to the declared accounting levels. On the flip side a company that has a high Price/Book ratio usually means that the market values its intangible assets to be significantly higher than what is shown on the balance sheet.

The art and science of good valuation and management is to systematically build, estimate and compound intangible assets. As Prof. Damodaran says in his lectures, it is a narrative (or story) which in turn results in expected cash flows estimated quantitatively (i.e. numbers) based upon the evidence presented by the company in the past. Typically we do not try to separately estimate these intangible assets such as brand valuation, but instead project out cash flows or ascribe price multiples to operating metrics (eg: price-to-earnings (P/E), price-to-book (P/B), EV/EBITDA or EV-to-sales multiples) based upon these assumptions.

In summary, it is useful to view intangible assets on the management balance sheet fundamentally as cumulative net investment into "human" and "social" capital associated with customers (via the sales & marketing costs in the P&L or Income statement), intellectual property (via R&D costs), employee culture of constant improvement (eg: Lean, Six Sigma) or innovation, and management quality (via sustained margins / cash conversion / growth compounded and lowered risks). Typically the incremental investment is also referred to as SG&A costs in the P&L / income statement. In other words, the SG&A cost can be viewed an investment into intangible assets. An early stage or growth company's purpose in life is to build up intangible or growth assets which will yield future sales and cash flows/profits. It will therefore have higher SG&A, and therefore possibly negative cash flows and operating profits during its high growth phases. Any net negative free cash flow to equity (i.e. cash burn) has to be funded by existing cash reserves, or through additional capital raise (equity, debt).

Life Cycle of a Company & Implications for Analysis

Companies in different stages of their life cycles behave in different ways. The following picture (from Prof. Damodaran) charts out different stages in a company life cycle and different priorities and valuation outlook needed (or operating focus needed).

An early growth stage company is building up a franchise of customers, revenues, and assets (tangible & intangibles). A small company in an emerging market or an entrepreneur in a poor neighborhood where capital is hard to accumulate may have to grow carefully, i.e. ensure it gets to a viable business model for capital-to-sales and sales-to-profit with good return on capital first and quickly. Once the company gets there, it uses its organic retained earnings to drive reinvestment. Since new capital is unavailable, the maximum reinvestment ratio is 100%. This limits the growth rate to ROIC. In other words, higher ROIC (or more capital efficient enterprise) gives an entrepreneur the license to drive higher potential growth.

However, where venture or growth capital is available externally and the competitive and strategic environment implies that it is a "winner takes all" / "platform-based" market where customer & partner relationships need to be accumulated rapidly, then there may be an imperative to grow faster while finding a pathway from capital invested to revenue, profitability/cash flows and customer lifetime value net of acquisition costs. Indeed, if the company hasn't figured out a "path-to-revenue" or a "path-to-profitability" yet, its business model is not yet fully baked, and earnings, cash flows and ROIC will be negative and revenues may be small or non-existent. If the small company chooses to grow fast to accumulate these assets, revenues (& with the hope of future profits), it is quite possible that its target growth rate (of revenues) is faster than its return on capital. This means it will have to raise "growth capital". But it needs to have a story of path to revenue and profitability so that the negative cash flows will ultimately turn positive; and the magnitude of the positive cash flows in the future should be large so that despite the discounting effect, the company still will have positive valuation and overcome the accumulated negative cash flows of the past.

In case of really early stage (pre-revenue companies), the focus may be on proxies that precede these numbers (eg: customer feedback, audience engagement, daily active users (repeat audience) etc). Another aspect of modern business models is that it takes time and cost to accumulate users; and the user then yields a series of (per-user) revenues and cash flows (or gross cash flows or gross margins) over time over their lifetime (before they churn). This can be measured as the lifetime value of a customer (LTV or CLV). The goal is to optimize the cost of customer acquisition (CAC) relative to lifetime value, and to maximize the lifetime value, minimize churn etc to build a sustainable franchise. Please see prior article for more details. This is also termed "unit economics" or the "value of a user". An excellent coverage of unit economics and the value of a user by Prof. Damodaran is here.

In the context of an traditional, industrial or sales-intensive company, it is important to view customers as "accounts" which give you repeat transactions (i.e. have some equivalence of "loyalty"); and focus the analysis on the cost of acquiring and sustaining new accounts. This is the art of "account management" and cultivating "go-to-market" channel partnerships to lower costs of acquisition. Companies which do not nurture relationships or view customers as individual transactions will not reap the economic benefits of scale with loyal relationships and incur a high cost of sale (i.e. lower gross profit or lower conversion of gross profit to EBITDA) for every transaction. Scalable growth involves paying attention to the growth in cost-of-sales and scaling up customer / partner relationships in relation to your business size.

As a company goes through its growth phases, it becomes more self-funding -- i.e. as the returns on capital grow from negative to positive it will outstrip the growth rate; and the product of ROC & reinvestment rate will be sufficient to both grow the business and throw off positive cash flows. At the early stages of S, the focus is on the investment decision (choosing markets, acquiring customers & maximizing value per customer); and subsequently into financing (debt/equity choices) and subsequently into dividend (payout & buyback, and reinvestment ratio). Metrics such as revenues, growth, cash flows (FCFE), reinvestment and capital needs also vary accordingly by life cycle stage (see below).

This sort of corporate S curve with an ultimate decline exists for each market a company may chose to go into. For example Facebook is jumping from one S curve (social media: facebook, instagram, whatsapp) onto another (payments & crypto, via Libra) and virtual reality (via Oculus). Time will tell whether it will be successful. Google is incubating non-linear plays like Waymo in its Alphabet parent and other plays like Android, Payments, Cloud within the Google enterprise. Amazon has a retail (prime & fulfilment) and cloud (AWS) businesses under one umbrella. Amazon says it is still in Day 1, i.e. still in early stage of several plays. Maybe it is entering Day 2 in the retail e-commerce plays, but it is adding on new dimensions (prime, fulfilment, grocery, off line (Whole Foods), kindle, alexa, amazon go) that keep it in Day 1 mode.

Risk: Financial, Operational and Management/Governance

We have covered returns & growth over the corporate life cycle (which is really an aspect of returns). Now lets turn to "risk". At a high level, risk can be thought of as measuring all the "bad" things that could happen in the future that perturbs the steady rate of "expected return". This is a "downside" view of risk, and can originate from a financial / operational or management/governance source.

There are several aspects of risk important to understanding or managing a business. The first view of risk is a counterbalance to reward (Face 2 of Janus), i.e. use of risk to determine a cost of capital to discount cash flows. In general, you would like to build a high growth, high cash yielding business at low risk. But there may be factors beyond your direct control in achieving this goal.

Financial Risk

More broadly financing risk could be viewed as volatility or variance around a mean, i.e. upside and downside. It could come from "known unknowns", "unknown unknowns" that are company-specific, sector-specific or market-specific. In general, this is a LOT of risk to stack on and take that will really discount the cash flows significantly, if the investor just held this stock. Happily, given the magic of diversification, according to the "capital asset pricing model" (CAPM), the marginal investor who sets the price of a stock in the public market (big institutional holders) is well diversified. A well diversified investor will pick a market portfolio that places a equity risk premium above the risk free rate, scaled up by the slope of the line, called "beta".

The straight line in the picture implies that Cost of equity = Risk free rate + Beta*EquityRiskPremium. The residual or additional risk beyond the risk free rate that is charged to the company as part of (equity) cost of capital is a product of "market risk" and a "beta". Think of this as un-diversifiable component of the company and sector risk (but significantly lower than the overall risk if you just held this company alone). This "beta" component may increase as the company or sector takes on more risks, or through the business cycle, or if the investor raises capital from an undiversified private capital provider.

To summarize, the financial view of cost of capital is that the balance sheet in general has two types of capital liabilities - equity and debt. Both of these start with a risk free rate corresponding to the currency in which the company is being valued; and then a risk premium (either an equity risk premium or a default spread) is attached to the equity or debt components respectively. Debt has a tax benefit attached to it since interest is a pre-tax expense (this also means lower tax rate means lower incentive to take on debt). The weighted average gives a (weighted average) cost of capital, a.k.a. WACC.

The following picture (see Prof. Damodaran paper for more details) gives a investing vs corporate finance view of cost of capital. Investors are focused on opportunity costs (whether they can find alternative investments for comparable risk), and companies view it as a cost of financing; which is the hurdle rate used for investments into component businesses or projects.

Note: When the price of a stock falls, either its expected cash flows in the future have reduced, or the "equity risk premium" scaled up by "beta" or "yield" demanded by investors as gone up. It could also be that the risk premium of alternative investments (eg: bonds, risk free assets) has gone down, which could imply a higher price for the same set of cash flows, equity risk premiums and beta. Similarly if the price of a stock rises, either the prospects for earnings have gone up, and/or the equity risk premium, scaled by beta demanded by investors have gone down. This is also reflected in "expanding" P/E or P/B multiples, also called "re-rating" of stock pricing multiples (or normalized prices) by the market. However, it is better to analyze in terms of how much of the change is explainable to cash flows (numerator) and how much due to the denominator (discount rates, and equity risk premia). When markets are down; and the company continues to deliver excellent ROCs, revenue/cash flow growth, if sustainable, it will sooner or later be recognized by the market.

The implied market equity risk premium (ERP) for a country/market is backed out of the market cash flows, and the current risk free rate. On top of this, a company's operation mix by country/market/industry, and excess volatility (eg: "beta") may add an additional premium.

The "risk" associated with the debt side is captured by the notion of a "default spread" or premium associated with the possibility of default. The default spread can be estimated from a synthetic bond rating measuring the probability of default of the company given its cash flows and level of interest payments to be serviced on a sustained basis. When debt levels are higher, it leads to a non-linear spike in default probabilities and cost of capital. This can be reduced by deleveraging, i.e. reducing debt to equity (D/E) ratio, also referred to as "repairing a weak balance sheet". Conversely, a company that is past its high growth phase and uncertain cash flow phases and has more moderate and predictable growth and levels of cash flows, it can increase the debt portion of its capitalization. The optimal D/E ratio depends upon the stage of corporate life cycle, volatility or relative stability/floor of cash flows, level of tax rates, and the coverage ratio of free cash flows to interest payments.

Beyond the cost of capital (equity and debt), and Debt/Equity ratio there are other aspects of financial risk worth remembering in valuation. A couple of common issues are term-mismatch and currency-mismatch.

Term mismatch refers to a situation where the company may borrow using short term commercial paper and use it to fund long term assets. When the commercial paper comes due, the company has to either repay the principal or roll over the loan. When there is a liquidity crisis in the market or in the specific stock or sector or rating class, it is possible that the cost of roll over may sky rocket, or the capital market may shut down. In the 2008 crisis, commercial paper even for blue chip companies suddenly became very expensive. Warren Buffett used Berkshire Hathaway's liquidity with companies like Goldman Sachs in such a period. A similar challenge is happening in the NBFC (shadow bank) crisis for lower quality NBFCs in India in 2018-19.

Currency mismatch occurs when a company borrows in currency A (eg: dollar) and deploys the funds into assets which pay cash flows in currency B (eg: rupee) without fully hedging the currency risk. In case currency A (the dollar) appreciates significantly against currency B (rupee), then the company's interest coverage ratio may plunge and may default. This is what happened in the Asian financial crisis. In India, these are called "External Commercial Borrowings (ECBs)". Note that if the money is raised in Currency B (rupee) in a foreign exchange (eg: a masala bond) it is a different matter and does not involve currency risk.

On the debt front, you could have covenants on specific debt instruments (that are usually flagged by rating agencies) which could limit operational flexibility of management, and change of control. Also if violated, even without full default of payments, these covenants could trigger a loss of control.

Another aspect is "off balance sheet" debt-like commitments, eg: leases. Consider a company like WeWork that doesnt own property, but leases the property asset for long term (aka an operating lease). These are contracted payments with asset-based covenants that may translate into a critical asset being taken away from the company affecting revenue. This is called "non-recourse" operating leases. In some cases, the covenants may specify "recourse" i.e. the lessor could have a claim on the balance sheet. These kinds of covenants in debt or leases or other contracts (eg: liquidated damages, LDs) are examples of called a "contingent" liability which could suddenly lead to a write down (usually wiping out equity capital in the process). IAS 27 by IFRS requires disclosure of contingent liabilities and contingent assets. For an overview, please see this video.

Also, please note that as of 2019, IFRS and US GAAP regulations have changed requiring long term leases beyond a year to be reported as debt-like liabilities which will effectively increase the debt-to-equity ratio (see this video for an example). Another way to think of this is that an operating lease is an asset funded 100% via debt (i.e. no equity), which increases the D/E ratio and potentially can raise cost of capital if the company is already levered.

On the equity side, recently many silicon valley companies in the last few years have been issuing shares with different classes of voting rights. This retains founder control of key decisions, and weakens governance. In theory this could lead to differential pricing of the shares. Another issue to watch out for is accounting for dilution of shares due to employee stock options. This issue has been better understood in recent years; but during the dot com bubble, companies were issuing shares willy nilly diluting all share holders. Having a larger share count will reduce earnings and free-cash-flow per share. Recently companies like Tesla have been issuing convertible debt despite being a young fast growing company. This is a bit risky strategy given the depressed (and high short interest in) Tesla's shares since if the share price is below the conversion price, the will be a debt rollover or repayment challenge; and if the share price is significantly above the conversion price, it could lead to significant dilution. To prevent dilution, the company may buy out of the money options as a hedge increasing the financing cost.

Operational Risk:

Operational risk occurs when something unexpected happens in operation that leads to a negative impact in earnings, cash flow or asset values / liabilities.

The simplest form of operational uncertainty is volatility in revenue, gross profit, operational cash flows, working capital and investment needs. This is risks in business as usual and managed through prudent planning and proactive operational discipline.

Operational surprises happen when the company has booked revenue / profit but bad stuff happens later. Eg: when a company signs a contract with a customer and gives a warranty for a product or accepts "liquidated damages" (LDs) for delays in a project. When something goes wrong, there will be a cost impact, and charge the company has to to take. Usually companies estimate probabilities and impacts of warranty claims and keep a provisioning reserves; and similarly for aggregate LD exposures. Other issues which may trigger costs include late delivery of projects, cost escalations and customer dissatisfaction due to quality issues.

Another example is when a company A buys another company B and pays more than the current market price of company B, the excess pricing difference is recorded as a plug variable or "goodwill" on the books of company A post merger. Now if expected "synergies" or excess cash flows from company B does not materialize, company A has to write down the value of the goodwill. On the liability side, this will lead to a reduction in shareholder equity (and boost the D/E ratio or leverage).

These are examples of "contingent liabilities", but can be modeled as "known unknowns" with some risk measures. It is possible to have political events beyond contract risk (eg: litigation due to climate change or a foreign government that seizes or freezes assets), which are "unknown unknowns" or true uncertainty that is very hard to plan for except by having a strong diversified balance sheet that can weather such shocks to shareholder equity.

Management / Governance Risks:

There are other risks that happen due to the nature or culture of management in a company or governance issues at the board level. For example in India, it is common for promoters to pledge some of their shares and raise more debt. In essence the company has balance sheet debt; and there may be additional debt taken by the promoter. There could be an implicit guarantee or backstop (a contingent liability) of the company to the promoter. In other cases, even if the company does not have anything to do with the promoter's debt, if he/she defaults, it will lead to a weakening of investor sentiment and steep fall in share prices of the company.

If the board does not exercise due control over auditing or CEO pay / decisions, it could lead to a "rubber stamp" board which does not represent the broader common share holders. Activist investors or leveraged buyout firms could prey on such situations if there is significant erosion of value, drop in share price and opportunity to run the operation more efficiently under new management.

Other subtle aspects include engendering a risk averse or slow moving bureaucratic culture which can limit agility and ability to respond to market challenges.

Price vs Value & Relative Valuation

Price is what you pay. Value is what you get. Valuation is your quantitative estimate of what the median price should be. The ideal approach is to do a discounted cash flow (DCF) valuation based upon the assumptions made about the company, its competitive advantage, addressible market, cash flows, capital efficiency, growth and risk.

More commonly, standardized or normalized price metrics are used as a short hand for valuation, or "relative valuation". An excellent framework for understanding relative valuation and its correspondence to DCF by Prof Damodaran is here. These include P/E (price-to-earnings ratio), P/B (price-to-book), EV/EBITDA ratio, and EV/Sales or Price/Sales Ratios. Prof. Damodaran shows the nature of the distributions of these ratios across companies, and insists on consistency and clarity of definition of these ratios prior to use.

Understanding P/E Ratio:

A stable growth rate (Gordon) dividend discount model is P = DPS0*(1 + g) / (r - g) where DPS0 is dividend in time 0; g is stable growth rate; and r is cost of capital, or a proxy for risk.

Now DPS0 = E*PayoutRatio, where E is earnings (last 12 months).

P/E = PayoutRatio*(1+g) / (r - g).

and PayoutRatio is (1 - ReinvestmentRate); i.e. if a company can efficiently grow at the stable growth rate, with lower reinvestment, and has a high ROE, it can enjoy a high payout ratio in steady state. PayoutRatio (and implicitly ROC), Risk and Stable Growth Rate are therefore key determinents of P/E ratio.

Doesnt this sound familiar? Return, Risk and Growth matter. But PayoutRatio is key. If a company's free-cash-flow to equity (FCFE) is significantly different from accounting earnings, or a company returns cash to shareholders via a combination of dividends and share buybacks, the FCFE can be used instead and the payout ratio applied to it.

PEG ratios divide P/E presumably by stable growth rate g. Often this is divided by a short term (not steady state growth rate). The relationship now does not eliminate g completely - and still has a residual dependency. In any case, it is clear from the analysis above that growth rate relative to risk & cost of capital matters.

Michael Maubossin from Credit Suisse in a famous paper on P/E multiples has the following exhibit. Cost of capital (WACC) is assumed to be 8% in this example and the "steady state" or commodity P/E is 1/8% = 12.5.

For companies who destroy value, i.e. their ROIC < 8%, they have P/E < 12.5. In fact with 4% ROIC and 6% growth or higher, the P/E drops to 3.3 or lower: these companies need a lot of capital to keep growing which they are investing without earning their cost of capital so the market withdraws capital & raises the price of capital (i.e. marks down the price). P/E of 4 implies a yield expectation of 25% (vs a nominal of 8%)! Similarly for a EVA positive company of 16% or 24% they can command a higher P/E. The incremental P/E is a function of the spread of ROIC and Cost of capital, invested capital for the desired level of growth and expected period of such value-accretive growth (also called the competitive advantage period / CAP). For details read the paper!

[Value Investing in Growth Stocks with High ROCE, and High P/E:] Can we model the target P/E given the ROC (v), Cost of Capital (r) and Growth rate (g)? Here is a first approximation for the numbers above. The principle is simple: When you were earning return on capital (v) equal to cost of capital (r), then the P/E is 1/r, and 100% of earnings is retained and compounded at rate r. When v is different from r, then a fraction g/v of earnings is retained and compounded at rate v (retained earnings or retention ratio), and the remaining earnings fraction (1 - g/v) is paid out (dividends or payout ratio) which the shareholders can get a return equal to cost of capital of r.

The weighted average shareholder return is now: w = (1 - g/v)*r + (g/v)*v. If you simplify this, w = (g + r) - (gr/v). What this formula says if the company has ROC (v) > Cost of capital (r) AND it has growth opportunities for the incremental capital of g (ideally equal to v), then it can preferably reinvest the earnings and earn an "excess (economic) return" (v - r) or "economic value added" (EVA) for its shareholders. If the old P/E corresponded to a return of r is 1/r, the new P/E corresponding to weighted average return of w is just the scaled up P/E: (1/r) * (w / r), which simplifies to P/E = {v(g+r) - gr}v.r^2 . Despite the difference in forecast periods, there is a good match in the estimate of New P/E using the above formula (see below). Why is this useful? When you are evaluating a company with apparently high P/E, you can plug in these numbers ROCE (v), earnings or FCFE growth (g) and rough estimate of Cost of Capital (r) to get a first cut estimate of what its P/E should be, and see if you are getting value or not.

Another quick check is to divide P/E by ROCE (even though this is not a "consistent" measure) to see similar to the PEG ratio whether you are overpaying for ROCE. More importantly every market and sector (and based upon level of leverage) has a quick cost of capital you could look up. If ROCE < cost of capital, growth is bad, and the company should stop growing and fix its ROCE. PERIOD. However if ROCE is greater than cost of capital, it has an super-linear effect on P/E based upon how much ROCE - WACC is, and if it can access a high growth rate (g). This myopia about P/E without understanding the drivers is why many investors missed or did not invest in a sustained period in great ROCE + great growth stocks like Google, Amazon etc.

Lesson: Don't miss an Amazon or Google because P/E appeared to be high. If there is secular growth accompanied by excellent capital efficiency, the P/E can be much higher than market and still give excess returns.

Understanding P/B Ratio:

There is a simple correspondence between earnings and book value: Return on Equity (ROE) = E / B. Therefore P / B = P / E * (E / B) = P/E * ROE.

Return on Equity (ROE) is the key companion variable for P/B. Higher ROE and lower risk and higher growth leads to higher P/B.

Especially for banks and financial institutions, the book value has to be updated to be accurate per regulation, and P/B and ROE are better measures than P/E directly.

Observe that if you divide ROE by P/B, you get E / P or an earnings yield. When P/B is greater than 1, the market is assigning greater value to the intangibles of the company, and usually corresponds to the company ROE > cost of capital, i.e. the company is adding economic value. When P/B is less than 1, then the market believes writedowns of shareholder equity are imminent or destruction of value is happening. Many public sector entities in India that trade below P/B of 1 because of perceived uncertain actions by the government (eg: forced mergers, forced participation in social schemes, or subsidy burdens) even if the apparent ROE is high.

Understanding EV/EBITDA Ratio:

Let us unpack EV/EBITDA similar to P/E and P/B.

EV = FCFF / (WACC - g) where FCFF = free cash flow to firm; WACC = weighted average cost of capital; and g is stable growth of FCFF.

FCFF = EBIT (1 - TaxRate) - (Capex - Depreciation) - Change in WC

(i.e. post-tax operating income, subtracting out net capex (i.e. net of depreciation) and change in working capital, i.e. these are the incremental capital requirements - fixed & working - for the period).

FCFF = EBITDA (1 - TaxRate) + Depreciation (TaxRate) - Capex - Change in WC

EV/EBITDA is obtained by dividing both sides above by WACC - g.

This means that EV/EBITDA is influenced by Tax Rate, Reinvestment (i.e. Capex + Change in WC), Growth Rate (g) and Risk (measured by WACC).

If tax rate is low, then EV/EBITDA is higher (eg: Irish firm), or for US and Indian companies after the change in tax rates. Observe that EV/EBITDA is one multiple (unlike P/E, P/B) that is influenced by tax rates !

Higher growth rate of operating earnings, then higher EV/EBITDA. Lower risk of the firm (i.e. lower cost of capital, WACC) then higher the EV/EBITDA. Lowering operational risk is a pathway to higher multiples.

How efficiently is growth being delivered? Lower reinvestment needs (or implicitly higher Return on Capital for same growth rate), the higher the EV/EBITDA. The sensitivities of EV/EBITDA to different variables are pictured below (from Damodaran lectures)

Understanding EV / Sales and Price / Sales Ratio:

A similar analysis for EV / Sales and Price / Sales yields "Net Margin" or "Operating Margin" as the companion variable. The use of P/S or EV/Sales is used in growth companies where the operating profitability is not fully established and is showing high sales growth. The implication of the margins being the companion variable is that as the market sees greater margin expansion, the P/S and EV/Sales ratios can expand non-linearly; and vice versa can shrink non-linearly with reduction in margins. An example sensitivity analysis is below for Coke: observe a super-linear increase in EV/Sales as a function of operating margins (which is an impact of brand value). Brand value (and broadly customer / partner relationships) can therefore drive up margins and valuations non-linearly.

Summary:

In summary, here is a framework for analyzing companies as a investor or operating it as an executive:

• Stage of corporate life cycle: early vs mid vs late. Different expectations and metrics.
• Capital efficiency & Return (on Investment): Start with ROCE (ROCI, ROE) unpack these into Asset turnover and Margins & Cash conversion (Operating, Net, CFOA/FCFE/FCFF etc) to understand asset intensity vs service/distribution intense, Working Capital vs Fixed vs Intangible Capital.
• Growth: Payout / Buyback / Reinvestment Ratio vs sustained Growth rate. ROC * Reinvestment ratio - bound for short term growth rate; FCFE vs Payout/buybacks, addressible market & share / position.
• Risk: (a) Financial: D/E ratio, Implied risk (SD, beta), diluted share count, covenants, share classes (preferred, class A/B etc), borrowing in other currency (ECB), leases (all debt finance) (b) Operational: goodwill, writedowns, acquisitions, contingent liabilities, volatility in revenue/COGS/SG&A/I/T/D, cyclicality, fixed asset / inflexible labor arrangements, land acquisition or cost escalation in complex projects, liquidated damages, political risk beyond contract risks (c) Management / Governance: management quality, governance, pledged promoter shares, culture (mkting vs operational; growth vs steady vs decline), concentrated decision making in a club & no delegation (lack of transparency), strategic positioning/relative power w/ competition/suppliers/customers ...
• Price vs Valuation: P/E, P/B, EV/EBITDA, P/S (or EV/S): choose the right one appropriate to the stage of corporate life cycle and nature of business. Understand the drivers of these measures.

Take-away Message #1: CAPITAL EFFICIENCY and PROFITABILITY and EXCESS RETURNS (ROIC > Cost of Capital (Risk)) are the pathways to value. Compounding value leads to wealth. The three fundamental financial decisions a company makes are below.

Take Away Message #2: Valuation attaches numbers to narratives. It is important to understand what aspect of narrative drives what aspect of valuation, and then appropriately manage (if you are an executive) or evaluate (if you are an investor) those aspects. The journey from narratives to numerical value is outlined below (Prof. Damodaran). There are super-linear impacts of higher sustained margins (eg: in EV/Sales multiples), return on capital (or equity), more efficient reinvestment (or higher payouts), higher stable growth rate and lower risk.

In the end we come back repeatedly to the two faces of Janus: Risk (i.e. cost of capital) and Reward (Return on Capital & Growth/ Compounding/ Reinvestment).

This article is part of a series on Financial & Strategic Value Creation written for Technologists / techies: "Financial & Strategic Value Creation for Techies 101", "Financial & Strategic Value Creation for Techies 102: Analysis & Valuation", "Financial & Strategic Value Creation for Techies 103: Power of Compounding & Discounting", "Financial Literacy 104: Want Growth?", "Financial Literacy 105: Strategy Meets Execution"

PS: Selected older articles (2016-18): Blockchain/Crypto/Digital Tokens, Cashless Finance: UPI, Blockchain/Agri & Supply Chain Finance, Digital Agri: Commodity Spot / Futures Markets, Digital Agri: Future of Insurance, From Barter to Blockchain: Brief Journey of Payments & Ledgers, Cashless Financial Inclusion...

LinkedIn: Shivkumar Kalyanaraman 

Disclaimer: The views expressed here are personal and meant for information education purposes only and not representative of his employer directly or indirectly.

Twitter: @shivkuma_k

If you like this article, please check out these articles: "Financial & Strategic Value Creation for Techies 101", "Financial & Strategic Value Creation for Techies 102: Analysis & Valuation", "Financial & Strategic Value Creation for Techies 103: Power of Compounding & Discounting", "Electric meets Autonomous", "Commercial Electric Vehicles (EV) Fleets: The Stealth Growth", "Towards Affordable, Ubiquitous, Ultra-Fast EV Charging: Part 1: Need & Battery Issues", "EV Taxi Fleets & Ride Sharing: Poised for Huge Growth", "Shared EV Transportation in India", "Understanding the Rs. 3/kWh bids in India in 2017", "Distributed / Rooftop Solar in India: A Gentle Introduction: Part 1","Rooftop Solar in India: Part 2 {Shadowing, Soiling, Diesel Offset}", "Rooftop Solar in India: Part 3: Policy Tools... Net Metering etc..." "Solar Economics 101: Introduction to LCOE and Grid Parity" , "Solar will get cheaper than coal power much faster than you think..", "Understanding Recent Solar Tariffs in India", "How Electric Scooters,... can spur adoption of Distributed Solar in India," "Solar + Ola! = Sola! ... The Coming Energy-Transportation Nexus in India", "UDAY: Quietly Disentangling India's Power Distribution Sector", "Understanding Solar Finance in India: Part 1", "Back to the Future: The Coming Internet of Energy Networks...", "Tesla Model 3: More than Yet-Another-Car: Ushering in the Energy-Transportation Nexus", "Understanding Solar Finance in India: Part 2 (Project Finance)", "Ola! e-Rickshaws: the dawn of electric mobility in India", "Understanding Solar Finance in India: Part 3 (Solar Business Models)" , "Meet Olli: Fusion of Autonomous Electric Transport, Watson IoT and 3D Printing".

All LinkedIn Articles/Posts.