Earnings and Cash Flows: A Primer on Free Cash Flow

It is never pleasant to be in the midst of a market correction, but a market correction does operate as a cleanser for excesses that enter into even the most disciplined investors' playbooks in the good times. This correction has been no exception, as the threat of losing investment capital has focused the minds of investors, and led many to reexamine practices adopted during the last decade. In particular, there has been more talk of earnings than of revenue or user growth this year, and the notion of cashflows driving value seems to be back in vogue. As someone who believes that intrinsic value comes from expected cash flows, I find that development welcome, but I do find myself doing double takes when I see concoctions of free cash flow that violate first financial principles. While I understand that there is no one overriding definition of cash flow that trumps others, it is essential that we define what we mean when we talk about free cash flows, and get perspective on what companies look like, on these cash flow measures.

Free Cash Flows: The What and The Why!

    Free cash flow is one of the most dangerous terms in finance, and I am astonished by how it can be bent to mean whatever investors or managers want it to, and used to advance their sales pitches. I have seen analysts and managers argue that adding back depreciation to earnings gives you free cash flow, an intermediate stop, at best, if you truly are intent on computing free cash flow. In the last two decades, I have seen free cash flow measures stretched to cover adjusted EBITDA, where stock-based compensation is added back to EBITDA, and with WeWork, to community-adjusted EBITDA, where almost all expenses get added back to get to the adjusted value.  I will use this section to clarify what free cash flows are trying to measure, how they get used in investing and valuation, and the measurement questions that can cause measurement divergences.

What is Free cash flow (FCF)?

    I believe that any measurement of free cash flow has to begin with a definition of to whom those cash flows accrue. Since a business can raise capital from owners (equity) and lenders (debt), the free cash flows that you compute can be to just the equity investors in the business, in which case it is free cash flow to equity, or to all capital providers in the business, as free cash flow to the firm.    

In short, the free cash flow to equity is the cash flow that a business generates after taxes, reinvestment and debt payments (interest and principal). The free cash flow to the firm is a pre-debt cash flow, before interest payments and debt repayments or issuances, but still after taxes and reinvestment. An alternate way of describing free cash flow to the firm is that it measures the cash flows that would have been available for equity investors, if there were no debt in the firm, and it is for this reason that some call it an unlevered cash flow.

To measure free cash flows for equity, you have to define reinvestment and debt cash flows, and we do that below on the left.  Note that we start with net income, earnings that is already after interest expenses and taxes, and that we consider reinvestment in both short term assets (change in non-cash working capital) as well in long term assets (as the difference between capital expenditures and depreciation). To complete the calculation, we incorporate the cash inflows that equity investors receive when they issue new debt and the cash outflows from repaying debt. 

Since FCFF is a pre-debt cashflow, starting with net income which is after interest expenses would be inconsistent. Thus, we start with operating income or earnings before interest and taxes (EBIT) replacing net income. (I know that you can start with net income and add back after-tax interest expenses, but it leaves embedded other items that can create distortions in FCFF). The taxes that are netted out from operating income are not actual taxes paid (accrued or cash) but hypothetical taxes, on the assumption that all of operating income would be taxed, in the absence of interest expenses (since you are working as if you have no debt), but the reinvestment in long term and short term assets is identical to the calculation used for FCFE. 

Estimation of FCFE

    If you have to compute the FCFE for a firm, you can see that every item that you need for the calculation should be accessible in its statement of cash flows, and there seems to be little room for disagreement. However, you will wrestle with what items to include and which ones to exclude, when computing the FCFE for a firm. To illustrate, we have used the statement of cash flows for Microsoft for the 2021 fiscal year (from July 2020- June 2021) as the basis for computing its FCFE in the figure below:

Source: Microsoft Annual Report for FY 2021 (Year ended June 2021)

To estimate the FCFE, I start with net income and add back depreciation & amortization and non-cash gains reported during the year. I do not add back stock-based compensation, and will provide a rationale for why in the next section, but I do subtract out the changes in non-cash working capital (provided in broken down form in the cash flow statement, but consolidated in my FCFE calculation). I net out capital expenditures and cash acquisitions, as reported, to get to FCFE prior to debt of $41,901 million. Since Microsoft did not raise any new debt, while repaying $5,504 million in existing debt, the FCFE after debt cash flows is $36,397 million. Another way of presenting this FCFE is to consolidate the working capital, capital expenditure and depreciation items into a reinvestment number ($19,370 million) and net this reinvestment out of net income to estimate FCFE. Estimating the free cash flow to the firm will require leaving the confines of the statement of cash flows and obtaining two numbers from the income statement - the operating income for the company and its effective tax rate, computed as taxes paid divided by taxable income. For Microsoft, this would yield values of $69,916 million for operating income and an effective tax rate of 13.83% in 2021, resulting in a FCFF of $40,879 million in 2021.

As you can see, the FCFE and FCFF share a common foundation, insofar that they are both after taxes and reinvestment, but FCFE adds a layer of cash flows to and from debt that can sometimes make it higher than FCFF and sometimes lower.

Using Free Cash Flows

   While there are facile reasons that you can give for computing free cash flows, including the usual “we don’t trust accounting earnings” and  “cash is king”, calculating it does involve added computations and there are three contexts where free cash flows get used. The first is that is that computing free cash flows for a past period helps in explaining what happened at a business during that period, in operating, investing and financing terms. The second is that it is that the free cash flows that you compute for a past period can be used as the basis for forecasting expected free cash flows in the future, a key ingredient if you are doing intrinsic valuation. The third is to compute the free cash flow as a base to be used to compare pricing across companies, where the market price is scaled to free cash flow, rather than to earnings. Since each of these missions has a different end game, there can be consequences for how we estimate free cash flows in each one; put simply, the free cash flow you compute, if you just want to explain what a firm did last year, can be different from the free cash flow you compute as the base year number for intrinsic valuation, which, in turn, can be different from the free cash flow that you estimate, if you are computing a pricing multiple.

1. Explain the past

    It is true that when investing in a company, it is what happens in the future that will determine whether you make money, but it is also true that to make these future assessments, a good place to start is by understanding what that company has done in the past. Notwithstanding the mission bloat that has bedeviled accounting in the last few decades, where the notion of fair value has distracted accountants, explaining what a company has done in the past, and where it stands now remains the core mission that should animate financial statements. As a believer in cash flows, I have always gravitated to the statement of cash flows as the accounting disclosure that is least contaminated by accounting overreach and the one that best reflects the true operations of a business. 

Note that the statement of cash flows looks at cash flows through the eyes of equity investors, starting as it does with net income and working its way down through investing and financing cash flows, before concluding with an explanation of the change in the company’s cash balance. As you can see in my earlier computation of FCFE for Microsoft, every item that you need for the calculation is in the FCFE, with your key decisions becoming which items not to count (any cash flows to equity, investments in securities etc.) and which ones to include (cash acquisitions, foreign exchange gains or losses etc.)

An intuitive reading of the FCFE is that it is cash available to be returned to equity investors, either in the form of dividends or as cash buybacks. It is the rare firm that follows a residual cash policy, returning its FCFE every year as dividends and/or buybacks. Some firms hold back and return less than they can, for good reasons (buffer against future bad years, set aside to cover investment opportunities) as well as bad ones (managers/insiders control the cash, over priced acquisitions); when they do hold back, the difference adds to their cash balances. Others choose to return more cash than they should be, and funding the difference from cash balances accumulated in the past and in some cases, fresh equity issuances, again for good reasons (a cyclical or commodity company riding out a down phase of a cycle) and for bad ones (inertia, an unwillingness to cut dividends, me-tooism on dividend policy or buybacks).

Companies with negative FCFE start in a hole, and even if they do not return any cash, they will find themselves with declining cash balances and/or new equity issuances, and if they do choose to pay dividends or buy back stock, they will make the cash deficits bigger. This approach of computing FCFE and comparing it actual cash return can be a device that can explain how some companies end up with huge cash balances and why other companies, especially young and money losing, will be dependent on equity infusions to stay alive. 

One of the limitations of focusing of free cash flows to equity is that you can get tunnel vision, since borrowing money operates as a cash inflow, inflating free cash flow to equity. That can explain why a firm with moderate or even below-average profitability can use debt to fund large dividends and buybacks, and to the extent that the firm is borrowing too much, it can dig a hole for itself. Estimating free cash flows to the firm can alert you to this occurrence, since it is a pre-debt cash flow and new debt issuances or repayments cannot alter it. In fact, the free cash flows to the firm, while less intuitive, are the source of cash flows to all claim holders (lenders as well as equity investors):

Mapping out these cash flows can provide a big picture perspective on where a firm’s cash flows are coming from and going, as well as a better assessment of the operating health of its business. It can also provide advance warning of the company’s exposure to downside risk, since the cash flows to lenders (interest and debt payments) are contractually set.

2. Intrinsic Valuation

    In intrinsic value, the value of an asset, business or equity stake in a business is the present value of the expected cash flows on it. Thus, in intrinsic valuation, the free cash flows (to equity or the firm) that you compute for the most recent year or time period is never part of value, but is useful only because it provides a base for forecasting the future. The question of whether you should be estimating free cash flows to equity or to the firm cannot be answered until you decide whether you are valuing just the equity in a business or the entire operating assets of the business.

• If you are valuing just the equity, you’ll be estimate the free cash flows to equity in future years, and discounting back at the cost of equity, i.e., the rate of return that equity investors can make on other investments in the public market, of equivalent risk.
• If you are valuing all operating assets in a business, you will estimate free flows the entire firm or business, and discount these cash flows back to today at a weighted average of the costs of equity and debt, with the weights reflecting the proportions of each funding type.

The picture below provides the contrasting uses of FCFE and FCFF in valuation:

With either estimate of free cash flow, the end game is estimating the free cash flows in the future, and the way we compute free cash flows  can be different from when we computed free cash flow for explaining the past. Here are a few reasons why:

1. Unusual or Extraordinary items: When explaining last year’s cash flows, you should consider all items, even if they are one-time or extraordinary, since they are cash flows. However, if you are computing cash flows as a base for forecasting the future, you should eliminate any items that you don’t expect to recur in the future. Thus, a cash inflow from a one-time divestiture of a division or a cash outflow due to a loss in a lawsuit, though part of free cash flows last year, will be excluded, if you are computing a base-year free cash flow for estimating future cash flows.
2. Normalized vs Actual numbers: For items that are recurring, but volatile, there is a good case to be made that while you will use the actual values, if computing free cash flows for the most recent year, you should be normalizing them, though the methods you use for normalization can vary across items. With the change in non-cash working capital, a notoriously volatile item on a year-to-year basis, I have found that looking at non-cash working capital as a percent of revenues, and using that statistic to reestimate the change in non-cash working capital in the most recent year provides a better base year foundation. In the Microsoft FCFE calculation, shown in the earlier section, using the historical average of non-cash working as percent of revenues of -10.18% (average from 2012-21), would have yielded a change in non-cash working capital of -$2,552 million in the base year, making it a cash inflow, rather than the outflow of $1,086 million that we attributed to working capital that year. With cash acquisitions, where a company may do only one big acquisition every three or four years, taking a long time series and averaging acquistions over that period will yield a better recurring value.
3. Stock-based Compensation and Acquisitions: The most hotly discussed item in cash flow estimation is stock-based compensation, in the form of restricted stock or options. A simplistic reading is to argue that is non-cash and add it back, just as you depreciation and amortization, but stock-based compensation is not comparable. While depreciation and amortization are truly non-cash, stock-based compensation is more of an in-kind expense, where you give away shares of equity in the company instead of paying cash. If you are estimate free cash flows (to the firm or to equity), with the intent of valuing that firm, adding back stock-based compensation is equivalent to arguing that you can either stop paying employees in the future (and still hold on to them) or that you can keep giving away equity stakes in your company with no consequences for value per share. In short, there is no justification for adding back stock-based compensation to get to cash flows, and none of the numerous variants of adjusted EBITDA that you see populating annual reports or prospectuses holds up to scrutiny. Using the logic that paying for something with shares, instead of cash, still has an effect on free cash flows, we would argue that a company that plans to grow through acquisitions, using its own stock as currency, is reinvesting, and that this reinvestment should reduce expected free cash flows to equity, to existing shareholders. During the 2021 fiscal year, Microsoft bought Nuance Communications for $19.76 billion in all stock transaction, and that amount should be treated as reinvestment for the year, even though it is technically non-cash.
4. Taxes: With free cash flows to equity, you start with net income but that net income can be skewed up if the company had a low effective tax rate that year, either because of write offs or losses carried forward into that year, or down, if it faced an unusually high tax rate that year. With free cash flows to the firm, the effective tax rate plays an even more direct role in determining cash flows, when you use it compute your after-tax operating income. In both cases, it makes sense to leave the effective tax rate at its actual level, when computing free cash flows for the past, but to rethink that when your objective is to forecast future free cash flows. I would suggest looking at an average effective tax rate over a longer period, in computing the base year free cash flow, and then also targeting the marginal tax rate, as you forecast taxes for the future. In the Microsoft FCFF calculation, this would imply replacing the effective tax rate of 13.83% with an average effective tax rate of 22%, using the 2017-2021 time period, which would lower free cash flows to the firm.
5. Accounting Inconsistencies: I have written about the inconsistency in how accountants calculate capital expenditure at firms with significant investments in intangible assets and R&D, and that inconsistency can play out in your FCFE computation. While R&D remains a cash outflow, whether you treat it as an operating or a capital expenditure, moving it from operating to capital expenditures can alter your perception of a company's operations. In the case of Microsoft, for instance, capitalizing the $20,716 million that the company spent on R&D in 2021, will increase the net income for the company, while also raising the reinvestment by an equivalent amount. Put simply, Microsoft is much more profitable than the accounting statements lead you to believe, while reinvesting more than you thought it was, and both of those conclusions will have implications for valuation

In short, in intrinsic valuation, where your objective is get the best estimates that you can for the future, you have a great deal more flexibility and discretion in which items you include (and exclude) in computing free cash flows, and how you estimate values for those items. If you are wondering whether it makes enough of a difference to bother, consider what Microsoft's FCFE look like with all five adjustments made to them below:

The capitalization of R&D adds about $3.7 billion to net income, about $17 billion to depreciation and amortization and about $20.7 billion to cap ex, netting out to no effect on FCFE but with significant changes to profits and reinvestment. Incorporating the stock-based acquisition pushed up total reinvestment substantially, though the question of whether this should be built in as a recurrent component will depend on the story you tell about Microsoft.

Pricing

    The final arena where free cash flows can be used is in pricing, and more specifically, in scaling market price. Again, the question of which variants (FCFE or FCFF) can be used depends on whether you are using an equity pricing multiple (where the market cap or share price is in the numerator) or an enterprise value multiple (where it is the market value of operating assets in the numerator):

• With equity multiples, you can scale the market value of equity (or market capitalization) of a company to its free cash flow to equity, to estimate a Price to FCFE multiple, and offer it as an alternative to the much more widely used PE ratio, where market capitalization is scaled to net income. 
• With enterprise value multiples, you can scale enterprise value to FCFF, instead of using EBITDA or revenues as your scalar. Again, you could argue for the benefits of a more complete measure of cash flow, but as with FCFE, FCFF will be more volatile than revenues or EBITDA, making it difficult to pass pricing judgment. 

The logic that analysts use for the use of free cash flows is simple and seems compelling. If the value of a business is the present value of its expected cash flows, as we argue in intrinsic valuation, it seems reasonable to also argue that the free cash flow that a business generates is a better measure of its value than the accounting earnings. 

In sum, there is nothing inherently better about using free cash flows instead of earnings in a pricing setting, and you can argue that the additional volatility and loss of perspective that comes with free cash flow numbers yields worse pricing. I agree, with one caveat. Even if you choose to stay with PE ratios, as your pricing multiple, knowing how much of earnings gets reinvested back into the firm is a useful input in making your pricing judgments.

Free Cash Flows: Perspective

    With that long lead in on free cash flows, let us talk about why free cash flows vary across companies and across time. To make the connection, I am going to fall back on a structure that I have used before, the corporate life cycle, to look at the evolution of FCFE, as companies age, and use that structure to also examine how these FCFE play out as cash returned to shareholders, over time.

The Life Cycle Effect

    In a corporate life cycle structure, you trace a business from start-up (birth) to the toddler years (very young businesses) through their teenage years into middle and old age. I have found it useful in explaining why the focus of a business changes from finding investment opportunities, when young, to finessing capital structure, as middle age companies, to deciding how best to return cash to investors, in old age, as well as why the challenges you face in valuation are different for young companies than more mature businesses. The corporate life cycle also provides a framework for explaining how free cash flows evolve, as companies move through the life cycle:

Focusing on free cash flows to equity, you should expect to see negative values, early in the life cycle, as businesses struggle to make money and have to reinvest to deliver on their growth potential at the same time, and a resultant dependence on raising fresh equity capital (from VCs and public market investors) to keep going. As their business models take form, and they turn the corner on profitability, you should continue to see negative cash flows because of the need to reinvest to grow; in general, you should expect to see positive cash flows lag positive earnings. At mature businesses, you should expect to see free cash flows to equity to not only stay positive, but also to grow faster than earnings, and in decline, while earnings will follow revenues on their path down, divestitures and asset sales can allow FCFE to be higher than earnings. To see how net income and FCFE evolve, as a company ages, I computed the net income and FCFE for Tesla every year from 2006 to 2021:

Source: Capital IQ

For much of its existence, Tesla has been a money-losing company, reflecting its young, high growth status. It turned the profitability corner in 2020, though FCFE stayed mildly negative that year, and in 2021, the FCFE also turned positive. In corporate life cycle terms, Tesla is growing up, which is good news in terms of profitability and cash flows but bad news, if growth is what rings your bell.

To see if the corporate life cycle has relevance in explaining differences in free cash flows to equity across companies, I looked at US companies, broken down by age, into ten deciles, from youngest to oldest, and computed each component of the FCFE, by decile:

As you can see in the table, among the youngest companies (in the lowest decile), more than 73% are money-losing and more than three quarters of these companies have negative free cash flows to equity. As companies age, the proportion of companies that are money making increasing, as does the percent that has positive FCFE. In relative terms, the companies in the middle of the corporate life cycle, deliver the highest FCFE as a percent of market capitalization

Dividends and Buybacks

    You can critique FCFE as an abstraction, since shareholders cannot lay claim on them, and argue that it is only cash flows that are paid out to equity investors that count. You could focus just on dividends, but by doing so, you are missing a large proportion of cash returned by companies; in 2021, more than two thirds of all cash flows returned to shareholders were in the form of buybacks. Staying with the corporate life cycle construct, we looked at dividends and stock buybacks by companies in each age decile: 

Consistent with what we unearthed in the FCFE table, where younger companies are more likely to be money losing and have negative FCFE, we see that the a much higher percent of older companies pay dividends and buy back stock than younger companies. In the aggregate, this table suggests that it is the presence or absence of FCFE that drives dividend policy, with most firms that have negative FCFE choosing not to return cash and many that have positive FCFE deciding to return cash. 

Pricing

    Earlier, we noted that there are some analysts who use free cash flows, as a basis for pricing, than for intrinsic valuation, with price to FCFE replacing price earnings ratios in equity pricing, and EV to FCFF taking the place of EV to EBITDA multiples, in enterprise valuation. While there are some cash flow purists who prefer cash flow multiples to earnings multiples, they will never be widely used for two reasons. First, the reason that investors like to price companies, using multiples, is because they have frames of reference on these multiples, i.e., a sense of what a typical number should like like in a sector. With PE ratios, their long history of usage has left investors with frames of reference that they can use, rightfully or wrongfully, in pricing stocks, but with Price to FCFE ratios, there is no such reference frame. Second, as you can see from how FCFE is computed, with the netting out of reinvestment and incorporating debt cash flows, it will always be a more volatile number than earnings, with much of the additional volatility telling you little about current earnings power.

   If one problem with using a price to FCFE ratio to judge whether a stock is cheap and expensive is a lack of perspective on what comprises a high, low or typical value, we can counter this problem by estimating the price to FCFE ratio for every publicly traded company globally and compare the distribution of the ratio to distribution for PE ratios.

Source: S&P Capital IQ

The good news is that the distribution for price to FCFE resembles the distribution for PE ratios, but the bad news is that you are replacing a multiple where you lose almost half the firms in your sample, with PE ratios, with an even more flawed multiple in Price to FCFE, which cannot be calculated in more than 63% of publicly traded companies. Put simply, if you start with a peer group of 25 firms, you may end up with a final sample of 10 firms or less, if you are pricing with a price to FCFE multiple. Moreover, price to FCFE ratios show more divergence than PE ratios, as can be seen in the spread between the first and third quartiles of each one.

    I did the same assessment for EV to FCFF, with the contrast drawn to EV to EBITDA, both to see contrasts and get perspective:

Source: S&P Capital IQ

Not surprisingly, the multiple of EBITDA, a pre-tax and pre-reinvestment cash flows, is lower than the multiple of FCFF, which is post-tax and after reinvestment. While you lose about 42% of firms with EV to EBITDA multiples, where EBITDA is negative, you lose close to 55% of global firms, because of negative FCFF. 

    As a cash flow advocate, it pains me to say this, but if your game is pricing stocks, I see little benefit from replacing traditional multiples (like PE and EV to EBITDA) with free cash flow scaled pricing measures. That is because a single year’s free cash flow (to equity or the firm) actually has more noise in it, and is less informative about a company’s operating health, than a single year’s earnings (net income or EBITDA). 

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Regime Change and Value: A Follow up Post on Aramco

In my post from a couple of days ago, I valued Aramco at about $1.65 trillion, but I qualified that valuation by noting that this was the value before adjusting for regime change concerns. That comment seems to have been lost in the reading, and it is perhaps because (a) I made it at the end of the valuation and (b) because the adjustment I made for it seemed completely arbitrary, knocking off about 10% off the value. Since this is a issue that is increasingly relevant in a world, where political disruptions seem to be the order of the day in many parts of the world, I thought that a post dedicated to just regime changes and how they affect value might be in order, and Aramco would offer an exceptionally good lab experiment.

Going Concern and Truncation Risks

Risk is part and parcel of investing. That said, risk came come from many sources and not all risk is created equal, to investors. In fact, modern finance was born from the insight that for a diversified investor, it is only risk that you cannot diversify away, i.e., macroeconomic risk exposure, that affects value. In this section, I want to examine another stratification of risk into going concern and truncation risk that is talked about much less, but could matter even more to value.

DCF Valuation: A Going Concern Judgment

The intrinsic value of a company has always been a function of its expected cash flows, its growth and how risky the cash flows are, but in recent decades a combination of access to data and baby steps in bringing economic models into valuation has resulted in the development of discounted cashflow valuation as a tool to estimate intrinsic value. Put simply, the discounted cash flow value of an asset is:

Extended to a publicly traded company, with a potential life in perpetuity, this value can be written as:

If you are a reader of my posts, it should come as no mystery to you that I not only use DCF models to value companies, but that I believe that people under estimate how adaptable it is, usable in valuing everything from start ups to infrastructure projects.  There is, however, one significant limitation with DCF models that neither its proponents nor its critics seem be aware of, and it needs to be addressed. Specifically, a DCF is an approach for valuing going concerns, and every aspect of it is built around that presumption. Thus, you estimate expected cash flows each year for the firm, as a going concern, and your discount rate reflects the risk that you see in the company as a going concern. In fact, it is this going concern assumption that allows us to assume that cash flows continue for the long term, sometimes forever, and attach a terminal value to these cash flows.

Truncation Risks

If you accept the premise that a DCF is a going concern value, you are probably wondering what other risks there may be in investing that are being missed in a DCF valuation. The risks that I believe are either ignored or incorrectly incorporated into value are truncation risks. The simplest way of illustrating the difference between going concern and truncation risks is by picking a year in your cash flow estimation, say year 3. With going concern risk, you are worried about the actual cash flows in year 3 being different from your expectations, but with truncation risk, you are worried about whether there will be a year 3 for your company. 

So, what types of risk will fall into the truncation risk category? Looking at the corporate life cycle, you will see truncation risk become not just significant, but is perhaps the dominant risk that you worry about, age both ends of the life cycle. With start ups and young companies, it is survival risk that is front and center, given that approximately two thirds of start ups never make it to becoming viable businesses. With declining and aging companies, especially laden with debt, it is distress risk, where the company unable to meet its contractual obligations, shutters its doors and liquidates it assets. Looking at political risk, truncation risk can come in many forms, starting with nationalization risk, where a government takes over your business and pays you nothing in some cases and less than fair value in the rest, but extending to other expropriation risks, where you still are allowed to hold equity, but in a much less valuable concern.

Since truncation risk is more the rule than the exception, and it is the dominant risk in some companies, you would think that investors and analysts valuing these companies will have devised sensible ways of incorporating the risk, but you would be wrong.

• The most common approach to dealing with truncation risk is for analysts to hike up the discount rate, using the alluring argument that if there is more risk, you would demand a higher return. The problem, though, is that this higher discount rate still goes into a DCF where expected cash flows continue in perpetuity, creating an internal contradiction, where you increase the discount rate for truncation risk but you do nothing to the cash flows. In addition, the discount rate that these analysts use are made up, higher just for the sake of being higher, with no rationale for the adjustment. With venture capitalists, this shows up as absurdly high target rates of 40%, 50% or 60%, fiction in a world where these VCs actually deliver returns closer to 15-20%. Discount rates are blunt instruments and are incapable of carrying the burden of truncation risk, and should not be made to do so.
• Some analysts take the more sensible approach of scenario analysis, allowing for good and bad scenarios (including failure or nationalization) but never close the loop by attaching probabilities to the scenarios. Instead, they leave behind ranges for the value that are so wide as to be useless for decision making purposes. 

My suggestion is that you use a decision tree approach, where you not only allow for different scenarios, but you make these scenarios cover all possibilities and then attach a probability to each one. In the case of a start up, then, your two possible outcomes will be that the company will make it as a going concern and that it will not, and you will follow through with a DCF, with a going concern discount rate, yielding the value for the going concern outcome, and a liquidation providing your judgment for what the company will be worth, in the failure scenario:

Since you have probabilities for each outcome, you can compute an expected value. If you do this, you should expect to see discount rates for companies prone to failure (young start ups and declining firms) be drawn from the same distribution as that for healthy companies, but the adjustment for failure will be in the post-DCF adjustments. Put more simply, you should see 12-15% as costs of capital for even the riskiest start-ups, in a DCF, never 40-50%, but your post value adjustments for failure and its consequences will still take their toll.

The Aramco Valuation: Bringing in Truncation Risk 

In my last post, I valued Aramco in a DCF, using three measures of cash flows from dividends to potential dividends to free cash flows to the firm and arrived at values that were surprisingly close to each other, centered around $1.65 trillion, for the equity. Note, though, that these are going concern values, and reflect the expectation that while there may be year to year changes in cash flows, as oil prices changes, management recalibrate and the government tweaks tax and royalty rates, the company will be a going concern and that it will not suffer catastrophic damage to its core asset of low-cost oil reserves. For many investors in Aramco, the prime concern may be less on these fronts and more on whether the House of Saud, as the backer of the promises that Aramco is making its investors, will survive intact for the next few decades.

DCF Valuation: Going Concern Risk

Reviewing my discounted cash flow valuations of Aramco, you will notice that I began with a risk free rate in US dollars, because my currency choice was that currency. I then adjusted for risk, using a beta for Aramco, based upon REITs/royalty trusts for the promised dividend model and integrated oil companies for the potential dividends/free cash flow models, and an equity risk premium for Saudi Arabia of only 6.23%, with a country risk premium of 0.79% estimated for the country added to the mature market premium estimated for the US. The end result is that I had costs of equity ranging from 4.82% for promised dividends to 8.15% for cash flows.

The biggest push back I have had on my valuations is that the cost of equity seems low for a country like Saudi Arabia, and my response is that you are right, if you consider all of the risk in investing in a Saudi equity. However, much of the risk that you are contemplating in Saudi Arabia is political risk, or put more bluntly, the risk of regime change in the country, that could have dramatic effects on value. In fact, if you remove that risk from consideration and look at the remaining risk, Aramco is a remarkably safe investment, with the safety coming from its access to huge oil reserves and mind-boggling profits and cash flows. The DCF values that I have estimated, centered around $1.65 trillion, are therefore values before adjusting for the risk of regime change.

Regime Change Concerns

If you invest in Aramco, you clearly have an interests in who rules and runs the country, since every aspect of your valuation is dependent on that assumption. If the House of Saud continues to rule, I believe that the company will be the cash cow that I project it to be in my DCF and the values that I estimated hold. If the Arab spring comes to Riyadh and there is a regime change, the foundations of my value can either crack or be completely swept away, with cash flows, growth and risk all up for re-estimation. In fact, to complete my valuation, I need to bring both the probability of regime change and the consequences into my final valuation:

Consider the most extreme case. If you believe that regime change in imminent and certain, and that the change will be extreme (with equity being expropriated and Aramco being brought back entirely into the hands of the state), my expected value for equity becomes zero:

If at the other extreme, you either believe that regime change will never happen, or even if it does, the new regime will not want to hurt the goose that lays the golden eggs and leaves existing terms in place, the value effect of considering regime change will be zero. The truth lies between the extremes, though where it lies is open for debate. I believe that there remains a non-trivial chance (perhaps as high as 20%) that there will be a regime change over the long term and that if there is one, there will be changes that reduce, but not extinguish, my claim, as an equity investor, on the cash flows. 

That, in an entirely subjective nutshell, is why I think Aramco's equity value is closer to $1.5 trillion than $1.7 trillion.  As with all my other valuations, I understand that your judgments on Aramco will be different from mine, but I think that the disagreements we have are not so much on the going concern estimates of cash flows and risk but on the likelihood and consequences of regime change. 

Democracies versus Autocracies

I am not a political scientist, but I have always been fascinated by the question of how political structure and economic value are intertwined. Specifically, would you attach more value to a company or project operating in a democracy or in an autocracy? The approach that I have described in this post to deal with going concern and regime change risk allows me one way of trying too answer the question. 

• Democracies are messy institutions, where governments change and policies morph, because voters change their minds. Put simply, a democracy generally cannot offer any business iron clad guarantees about regulations not changing or tax rates remaining stable, because the government that offers those promises first has to get them approved by legislatures, often can be checked by legal institutions and, most critically, can be voted out of office. Consequently, companies operating in democracies will always complain more about the rules constantly changing, and how those changing rules affect cash flows, growth and risk. 
• Autocracies offer more stability, since autocrats don't have to get policies approved by legislators, often are unchecked by legal institutions and don't have to worry about how their decision poll with voters. Companies operating in autocracies can be promise rules that are fixed, regulations that don't change and tax rates that will stay constant. The catch, though, is that autocracies seldom transition smoothly, and when change comes, it is often unexpected and wrenching.

In valuation terms, democracies create more going concern risk and autocracies create more worries about regime change. The former will show up as higher discount rates in a DCF valuation and the latter as post-DCF adjustments. While I prefer democracies to autocracies, there is no way, a priori, that you can argue that democracies are always better than autocracies or vice versa, at least when it comes to value, and here is why:

• The going concern risk that is added by being in a democracy will depend on how the democracy works. If you have a democracy, where the opposing parties tend to agree on basic economic principles and disagree on the margins, the going concern risk added will be small. In the United States, in the second half of the last century, both parties (Republicans and Democrats) agreed on the fundamentals of the economy, though one party may have been more favorable on some issues, for business, and less favorable on other issues. In contrast, if you have a democracy, where governments are unstable and the opposing parties have widely different views on the very fundamentals of how an economy should be structured, the effect on going concern risk will be much higher. 
• The regime change risk in an autocracy will vary in how the autocracy is structured and how transitions happen. Autocracies structured around a person are inherently more unstable than autocracies built around a party or ideology, and transitions are more likely to be violent if the military is involved in regime change, in either direction. In addition, violent regime changes feed on themselves, with memories of past violent meted out to a group driving the violence that it metes out, when its turn comes.

In summary, when you are trying to decide on whether a business is worth more in a democracy than in a dictatorship, you are being asked to trade off more continuous, going concern risk in the former for the more stable environment of the latter, but with more discontinuous risk. I have deliberately stayed away from using specific country examples in this section, because this argument is more emotion than intellect, but you can fill your own contrasts of countries, and make your own judgments. 

Conclusion

I have often described valuation as a craft, where mastery is an elusive goal and the key to getting better is working at doing more valuation. I am glad that I valued Aramco, because it is an unconventional investment, a company where I have to worry more about political risks than economic ones. The techniques I develop on Aramco will serve me well, not only when I value Latin American companies, as that continent seems to be entering one of its phases of disquiet, but when I value developed market companies, as Europe and the US seem to be developing emerging market traits.

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Blog Posts

1. A coming out party for an Oil Colossus: Aramco's IPO

Valuation Links

1. Aramco Valuation(s)

Share Count Confusion: Dilution, Employee Options and Multiple Share Classes!

In my last post, just about four weeks ago, I valued Tesla, and as with all of my Tesla valuations, I got feedback, much of it heated. My valuation of Tesla was $186, in what I termed my base case, and there were many who disputed that value, from both directions. There were some who felt that I was being too pessimistic in my assessments of Tesla's growth potential, but there were many more who argued that I was being too optimistic. In either case, I have no desire to convert you to my point of view, since the essence of valuation is disagreement. In the context of some of these critiques, there was discussion of how my valuation incorporated (or did not incorporate) the expected dilution from future share issuances and what share count to use in computing value per share. Since these are broader issues that recur across companies, I decided to dedicate a post entirely to these questions.

Share Count and Value Per Share

There was a time, not so long ago, when getting from the value of equity for a company to value per share was a trivial exercise, involving dividing the aggregate value by the number of shares outstanding.

Value per share = Aggregate Value of Equity/ Number of Shares outstanding

This computation can become problematic when you have one or more of the following phenomena:

1. Expected Dilution: As young companies and start-ups get listed on public market places, investors are increasingly being called upon to value companies that will need to access capital markets in future years, to cover reinvestment and operating needs. To the extent that some or all of this new capital will come from new share issuances, the share count at these companies can be expected to climb over time. The question for analysts then becomes whether, and if yes, how, to adjust the value per share today for these additional shares.
2. Share based compensation: When employees and managers are compensated with shares or options, there are three issues that affect valuation. The first is whether the expense associated with stock based compensation should be added back to arrive at cash flows, since it is a non-cash expense. The second is how to adjust the value per share today for the restricted shares and options that have already been granted to managers. Third, if a company is expected to continue with its policy of using stock based compensation, you have to decide how to adjust the value per share today for future grants of options or shares.
3. Shares with different rights (voting and dividend): When companies issue shares with different voting rights or dividends, they are in effect creating shares that can have different per-share values. If a company has voting and non-voting shares, and you believe that voting shares have more value than non-voting shares, you cannot divide the aggregate value of equity by the number of shares outstanding to get to value per share.

Note that while none of these developments are new, analysts in public markets dealt with them infrequently a few decades ago, and could, in fact, get away with using short cuts or ignoring them. Today, they have become more pervasive, and the old evasions no longer will stand you in good stead.

Expected Dilution

The Change: An investor or analyst dealing with publicly traded companies in the 1980s generally valued more mature companies, since going public was considered an option only for those companies that had reached a stage in their life cycle, where profits were positive (or close) and continued access to capital markets was not a prerequisite for survival. Young companies and start-ups tended to be funded by venture capitalists, who priced these companies, rather than valued them. In the 1990s, with the dot com boom, we saw the change in the public listing paradigm, with many young companies listing themselves on public markets, based upon promise and potential, rather than profits or established business models. Even though the dot com bubble is a distant memory, that pattern of listing early has continued, and there are far more young companies listed in markets today. An investor who avoids these companies just because they do not fit old metrics or models is likely to find large segments of the market to be out of his or her reach.

The Consequence: If you are valuing a young company with growth potential, you will generally find yourself facing two realities. The first is that many young companies lose money, as they focus their attention on building businesses and acquiring clientele. The second is that growth requires reinvestment, in plant and equipment, if you are a manufacturing company, or in technology and R&D, if you are a technology company. As a consequence, in a discounted cash flow valuation, you can expect to see negative expected cash flows, at least for the first few years of your forecast period. To survive these years and make it to positive earnings and cash flows, the company will have to raise fresh capital, and given its lack of earnings, that capital will generally take the form of new equity, i.e., expected dilution, which, in turn, will affect value per share.

The Right Response: If you are doing a discounted cash flow valuation, the right response to the expected dilution is to do nothing. That may sound too good to be true, but it is true, and here is why. The aggregate value of equity that you compute today includes the present value of expected cash flows, including the negative cash flows in the up front years. The latter will reduce the present value (value of operating assets), and that reduction captures the dilution effect. You can divide the value of equity by the number of share outstanding today, and you will have already incorporated dilution. 

I know that it sounds like a reach, but let me use my base case Tesla valuation to illustrate. In the table below, I have my expected cashflows for the next 10 years, with the terminal value in year 10.

Download Tesla Valuation and Dilution Spreadsheet 

The present value of the expected cash flows across all 10 years is $41,333 million, and netting out debt and adding back cash, yields an equity value of $33,124 million; the value per share is $189.23. However, this value includes the present value of expected cash flows from years 1 through 8, which are negative in my forecast,s and have a present value of $16,157 million. If these cash flows had not been considered, the value of the operating assets would have been $57,490 million and the value of equity would have been $48,282 million, a value per share of $284.41. In effect, we have applied a 33.46% discount to value, for future dilution. 

Implicitly, I am assuming that the firm will fund 88.06% of its capital needs with equity, consistent with the debt ratio that I assumed in the DCF, and that the shares will be issued at the intrinsic value per share (estimated in the valuation), with that value per share increasing over time at the cost of equity. That may strike some as unrealistic, but it is the choice that is most consistent with an intrinsic valuation. If Tesla is able to issue shares at a higher price (than its intrinsic value), we will have under estimated the value per share, and if it has to issue shares at a price lower than its intrinsic value, we will have over estimated value. There is one final reality check. While we have implicitly assumed that Tesla will have access to capital markets and be able to raise capital, there is a chance that capital markets could shut down or become inaccessible to the firm. That risk is not in the discounted cash flow valuation and has to be brought in explicitly in the form of a chance of failure. In my base case valuation, it is one of the reasons that I attached a chance of failure (albeit a small one of 5%) to the company.

A Viable Alternative: There is an alternative approach, where you forecast the number of shares that will be issued in future years to cover the negative cashflows, and count them as shares outstanding today. If you use this approach, you should set the cash flows for the negative  cash flow years to be zero. The peril in this approach is that there is a circularity that can cause your valuations to become unstable, since you will need to forecast a price per share in future years to get an estimate of value per share today. To illustrate this process, assume that you believe that the issuance price for Tesla for the new shares will be $200, with a price appreciation of 9% a year for the next 8 years. The table below computes the new shares that will need to be issued each year, assuming that 88.06% of capital comes from equity, and the dilution that will result as a consequence:

Download dilution spreadsheet

Note that, with the assumptions about the issuance price of $200, Tesla will issue 69.35 million shares over the next eight years. Adding that to the current share count of 169.76 million shares yields total shares outstanding of 236.85 million shares. If you set the cash flows in years 1-8 to zero and compute the value of equity, you arrive at a value of equity of $48,282 million, which can be divided by the 239.11 million shares to arrive at a value per share of $201.92. This is slightly higher than the value that I obtained in the cash flow approach, but it is partly because I have assumed an issuance price that is higher than the intrinsic value.

But Never Do This: Reviewing the two approaches, you can either incorporate the present value of the negative cash flows into the value of operating assets today and use the current share count, in estimating value per share, or you can try to forecast expected future share issuances and divide the present value of only positive cash flows by the enhanced share count to get to value per share. You cannot do both, because you are then reducing value per share twice for the same phenomenon, once by discounting the negative cash flows and including them in value and then again by increasing the share count for the shares issued to cover those negative cash flows.

Share Based Compensation (SBC)

The Cause: Over history, businesses have used equity to compensate employees, either to align incentives or because they lack the cash to pay competitive wages. That said, the use of share based compensation exploded in the 1990s due to two reasons. The first was an ill-conceived attempt by the US Congress to put a cap on management compensation, while not counting options granted as part of that compensation. Not surprisingly, many firms shifted to using options in compensation packages. The second was the dot com boom, where you had hundreds of young companies that had sky high valuations but no earnings or cash flows; these companies used options to attract and keep employees. Aiding and abetting these firm, in this process were the accountants, who chose not to treat these option grants as expensed at the time they were granted, and thus allowed companies to report much higher income than they were truly earning.

The Consequence: As companies shifted to share based compensation, there were two side effects that analysts had to deal with, when valuing them. The first was the drag on per-share value created by past option and share grants to employees, with options, in particular, creating trouble, since they could create dilution, if share prices went up, but could be worthless, if share prices dropped. The second was the question of how to factor in expected option and share grants in the future, since the value of these grants would be affected by expected future share prices. As with the dilution question, analysts faced a circular reasoning problem, where to value a share today, you had to make forecasts of the value per share in future years.

The Right Response: To deal with share based compensation correctly, you have to break it down into two parts:

1. Past option and share grants: If you own shares in a company, the shares and options granted by the firm in prior years to employees represent claims on the equity, that reduces your value per share. The shares issued in the past are simple to deal with, since adding them to the share count will reduce the value per share today. The fact that employees have to vest (which requires staying with the firm for a specified time period) and that the shares have restrictions on trading can make them less valuable than unrestricted shares, but that is a relatively small problem. The options that have been granted in the past are a bigger challenge, since they represent potential dilution, but only if the share price rises above the exercise price. Option pricing models are designed to capture the probabilities of  this happening and can be used to value options, no matter how in or out of the money the options are. In an intrinsic valuation, you should value these options first (using an option pricing model) and net the value out of the estimated value of equity, before dividing by the existing share count :

• SBC Adjusted Value per share = (DCF Value of Equity - Value of Employee Options)/ Share count today including restricted shares

Note that the shares that will be created if the options get exercised should not be included in share count, in this approach, since that would be double counting.

2. Expected future grants: To the extent that a company is expected to continue to compensate its employees with options or restricted shares in future years, the most logical way to deal with these grants is to treat them as expenses in future years, and reduce expected income and cash flows. Rather than grapple with expected future share prices, you should estimate the expenses (associated with SBC) as a percent of revenues, and use that forecast as the basis for expenses in the future. Until accounting came to its senses in 2004 and required companies to expense share based  compensation at the time of grant, this was an onerous exercise for analysts, since it required estimating the value of option and share grants in past years to get historical numbers on the value of SBC grants. With the prevalent accounting rules in both GAAP and IFRS, the earnings that you see for companies should already be adjusted for SBC expenses and reported income should therefore give you a fair basis for forecasting. (The operating and net margins that I report by sector, on my website, are margins after stock based compensation expenses). At first sight, it may seem like double counting to lower future earnings because you expect option and share grants in the future, and then again lower the value of equity that you obtain by the value of options that are already outstanding. It is not, since we are dealing with two separate issues. A company that has had a history of stock based compensation, but has decided to suspend using SBC in the future, will be affected by only the second adjustment, whereas a company that has never used share based compensation in the past but plans to use it in the future, will be affected only by the former. A company that has share based compensation in its past and expects to use it in the future will be affected by both adjustments.

Tesla uses stock based compensation, and its most recent annual and quarterly statements provide a measure of the magnitude.

Tesla 10K for 2017 and Tesla 10Q, First Quarter 2018

The compensation can take the form of restricted stock or options, and the annual filing provides the cumulative effect of this share based activity. At the end of 2017, according to Tesla's 10K, the company had 10.88 million options outstanding, with a weighted average exercise price of $105.56 and a weighted average maturity of 5.30 years and 4.69 million restricted shares. The restricted shares are already included in the share count of 169.76 million shares, but the options need to be accounted for. We value the options, using a modified version of the Black-Scholes model, to arrive at a value of $2,927 million. Netting this value out of the value of equity that we obtained from the cash flows allows us to get to a corrected value per share:

Download Tesla valuation

The value per share, after adjusting for options, is $171.99. There is an elephant in the room in the form of a gigantic grant of 20.26 million shares to Elon Musk, with the issuance contingent on meeting operating milestones (revenues and adjusted EBITDA) and market milestones (market capitalization). The complexity of the vesting schedule on this grant makes it difficult to value using option pricing models, but the effect of this looming grant is to lower value per share today and here is why. If Tesla succeeds in growing revenues and turning to profitability, these option grants will vest, creating large expenses in the year in which that occurs and putting downward pressure on margins. In making my forecasts of future margins for Tesla, I have been more conservative at least in the early years, simply for this reason.

A Sloppy Alternative: There is an alternative approach to deal with options outstanding from past grants. They value options at their exercise value, i.e., the difference between the stock price and strike price today, and ignore out of the money options. This is called the treasury stock approach and the value of equity per share in this approach can be written as follows:

Treasury Stock Value per share = (DCF value of equity + Exercise Price * # Options outstanding) / (Share Count today + Options Outstanding)

By ignoring the time premium on options, this approach will over value shares today and by ignoring out of the money options, you exacerbate the problem. In the case of Tesla, using the exercise stock approach would yield the following value per share:

Treasury Stock Value per share (Tesla) = ($32,124 + $105.56 * 10.88) / (169.76 + 10.88) = $184.19

The analysts who use this approach often justify it by arguing that option pricing models can yield noisy estimates, but even the worst option pricing model will outperform one that assumes that options trade at exercise value.

And Nonsensical Practices: There are two woefully bad practices, when it comes to stock based compensation, that should be avoided. The first is to just adjust the share count for options  outstanding and make no other changes. In this "fully diluted" approach, you are counting in the dilution that will arise from option exercise but ignoring the cash that will come into the firm from the exercise.

• Fully Diluted Value per share =  DCF value of equity / (Share Count today + Options Outstanding)

With Tesla, for instance, this approach would yield the following:

• Fully Diluted Value per share (Tesla) = $32,124/ (169.76 + 10.88) = $177.83

This approach will yield too low a value per share, and especially so if you count out of the money options as well in the denominator. The second and even more indefensible practice is to add back share based compensation to earnings to get to adjusted earnings. The rationale that is offered for doing so is that share based compensation is a non-cash expense, a dangerous bending of logic, since it allows companies to use in-kind payments (shares, services) to evade the cash flow test. Using this logic, Tesla would add back the $141.6 million they had in share-based compensation expenses to their income in the first quarter of 2018 and report lower losses. Carried into future forecasts, this will inflate future earnings and cash flows, pushing up estimated value. Since these two bad practices push value away from fair value in different directions, the only logic for their continued use is that, in combination, the mistakes will magically offset each other. Good luck with that!

Shares with different rights

The Cause: Founders and families who take their companies public have always wanted to have their cake and eat it too, and one way in which they have been able to do so is by creating different share classes, usually built around voting rights. The founder/family hold on to the higher voting right shares and thus maintain control of the company, while selling off large shares of equity to the public, and cashing out. In the United States, shares with different voting rights were rare for much of the last century, primarily because the New York Stock Exchange, which was the preferred listing place for companies, did not allow them. Again, the tech boom of the 1990s changed the game, by making the NASDAQ, which had no restrictions on shares with different voting rights, an alternative destination, especially for large technology companies. The floodgates on shares with different voting rights opened up with the Google listing in 2004, and the Google model, with shares with different voting rights, has become the default model for many of the tech companies that have gone public in the last decade.

The Consequence: When you have different classes of shares, with different voting rights, you have two effects on value. The first is a corporate governance effect, since changing management becomes much more difficult, and that can affect how you value and view badly managed firms. The second is a unit problem, since a voting right share and a non-voting right share represent different equity claims and cannot be treated as having the same value. Thus, you can no longer divide the aggregate value of equity by the total number of shares outstanding.

The Right Response: When valuing firms with different voting rights, you have to deal with it in two steps. When valuing the firm, you have to incorporate the fact that changing management is going to be more difficult to do in your estimates. Thus, if you firm borrows no money (even though it can lower its cost of capital by moving to an optimal or target debt ratio fo 40%), you should leave the debt ratio at zero rather than change it. This will lower the value that you estimate for the operating assets and equity in the firm. Once you have the value of equity, you will have to make a judgment on how much of a premium you would expect the voting shares to trade at, relative to non-voting shares, in one of two ways. In the first, you can look at studies of voting shares in publicly traded companies in the US and Europe, which find a premium of between 5-10% for voting shares, and use that premium as your base number. In the second, you can use an approach that uses intrinsic valuation models to estimate the premium, which I describe in my paper on valuing control. Once you have the estimate, you can use algebra to complete your estimate of value per share. 

Value per non-voting share = Aggregate Value of Equity/ (# Non-Voting Shares + (1+ Voting Share Premium) # Voting Shares)

For example, if the value of equity is $210 million, there are 50 million non-voting shares and 50 million voting shares and the voting share premium is 10%, your value per non-voting share will be:

Value per non-voting share = 210/ (50+ 1.1*50) = $2.00/share

Value per voting share = $2.00 (1.10) = $2.20/share

The Bottom Line

I know that some of you will view this post as nit-picking, but you will be surprised at how much of an effect on value you can have by not being careful about share count. Those of you who use multiples (PE, EV/EBITDA) may be secretly happy that you don't have to deal with the issues of share count, since you don't do discounted cash flow valuations. Unfortunately, that is not true. Dilution, share based compensation and shares with different rights are just as much an issue when you compare multiples across companies, and ignoring them or using short cuts (like full dilution) will only skew your comparisons and lead to mis-pricing stocks. I would suggest four general rules:

1. Aggregate versus Per-share numbers: Given how dilution and options can play havoc with share count, it is better to use aggregate than to use per share numbers, in valuation and in pricing. Thus, to obtain PE, divide the market capitalization of the company by its total net income, rather than price per share by earnings per share.
2. When SBC is rampant, control for differences: If the use of restricted stockand options vary widely across sector, you need to control for those differences when comparing pricing in the sector. If you do not, companies that have large option overhangs will look cheap, relative to those that do not.
3. Don't use SBC adjusted earnings: Adjusting earnings and EBITDA, by adding back stock based compensation, is an abomination, used by desperate companies and analysts to show you that they are making money, when they are not even close. Don't fall for the sleight of hand.
4. With forward multiples, check on and control for dilution: Analysts, when valuing young companies, often divide today’s market capitalization or enterprise value by expected revenues or EBITDA in the future. The dilution that will be needed to get to future EBITDA has to be brought into the equation.

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Spreadsheets

1. Tesla Valuation (June 2018)
2. Tesla Dilution 

Blog Posts on Tesla

1. A Tesla  2017 Update: A Disruptive Force and a Debt Puzzle
2. Twists and Turns in the Tesla Story: A Boring, Boneheaded Update!