THE SALES-TO-CAPITAL RATIO IN VALUATION

AM | @agumack

"A firm can arrive at a high ROC by using its capital to increase sales" — Aswath Damodaran

In his latest book on valuation, Aswath Damodaran pays less attention to the calculation of discount rates, and much more to the projection of cash flows. It's a bit less fun, but more useful. The key tool here is the sales-to-capital ratio; it allows us to compute reinvestment, a key input in FCFF estimations (*):

                             FCFF = EBIT (1 – t) – [Cap Ex – depreciation + ΔWC]

The second term to the right of the equation captures the reinvestment needed for growth: net investment (Cap Ex minus depreciation) plus additional net investments in working capital. The sales-to-capital ratio or capital turnover ratio is:

                             Sales-to-capital = sales / book value of debt and equity

The next step is to compute the change in sales and the change in capital, that is, reinvestment. Now all the pieces come together. If you have an estimation of the sales-to-capital ratio and a revenue (sales) projection, you can arrive at reinvestment by dividing the change in sales by the sales-to-capital ratio. For example, in the World Domination scenario for Amazon (p. 145) sales are projected at $246.9bn in year 6 and at $278.8bn in year 7, while the sales-to-capital ratio is kept constant at 3.68 times. Therefore reinvestment in year 7 is:

                            ($278.8bn – $246.9bn) / 3.68 = $8.6bn

Now all that remains to do to arrive at FCFF is to subtract that number from the projection of the after-tax EBIT, which Prof. Damodaran puts at $17.3bn. Therefore, in year 7, Free Cash Flow to the Firm is $17.3bn – $8.6bn = $8.7bn.

(*) Aswath Damodaran. Narrative and Numbers. The Value of Stories in Business. New York: Columbia Business School, 2017. See also: "Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges", Stern School of Business, New York University, 2009, especially pp. 26-27
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A SHORT NOTE ON AMAZON

AM | @agumack

"Your margin is my opportunity" — Jeff Bezos

In Cases in Finance BBA321 we analyze Prof. Damodaran's valuation of Amazon [AMZN] with Free Cash Flow to the Firm [1]. As he does in most valuations in his latest book, he projects reinvestment by means of the sales-to-capital ratio [see]. His line on Amazon can be summarized in a couple of sentences: the internet giant is deliberately chasing revenue in order to become dominant in as many areas as possible; at that point, its market power would eventually enable it to drastically improve margins and profits. It doesn't hurt if, along the way, new business opportunities (with higher margins) pop up. This last point is not emphasized enough in Prof. Damodaran's narrative. The reason for that apparent 'neglect' is obvious: it was written in 2014, before the explosion of Amazon Web Services.

* * *

I was reminded of this as I read Richard Waters' informative piece on Amazon and Microsoft's alliance to link their voice-activated digital assistants [2]. Everybody in the AI space wants to be the platform company par excellence. While this happened with PCs and smartphones, Mr. Waters thinks that in the field of AI "it will be difficult for any single platform company to dominate. That explains the alliance between Amazon and Microsoft. They have more to gain from joining forces against mutual enemies Google and Apple. Their decision to connect highlights a shared weakness: their failure to crack the smartphone market". Note that platform companies command significant premia in PE terms: 18x vs. only 13x for large-cap hardware vendors, according to Morgan Stanley. From an Amazon press release:

SEATTLE--(BUSINESS WIRE)--Aug. 30, 2017-- Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ: MSFT) announced today that Alexa will be able to talk to Cortana, and Cortana will be able to talk to Alexa. You will be able to turn to your Echo device and say, "Alexa, open Cortana," or turn to your Windows 10 device and say, "Cortana, open Alexa."Alexa customers will be able to access Cortana's unique features like booking a meeting or accessing work calendars, reminding you to pick up flowers on your way home, or reading your work email – all using just your voice. Similarly, Cortana customers can ask Alexa to control their smart home devices, shop on Amazon.com, interact with many of the more than 20,000 skills built by third-party developers.

 


[1] Aswath Damodaran. Narrative and Numbers. The Value of Stories in Business. New York: Columbia Business School, 2017.

[2] Richard Waters: "Microsoft and Amazon steal AI march as they look past smartphones", Financial Times, 1 September 2017.
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