Apple ($AAPL) is a profit machine. But is it yesterday's winner or an attractive investment for the future? Read this before you spend even an hour researching the stock.
Thanks for sharing - interesting framework that covers the core pain points of fundamental analysis - capital efficiency, cash generation potential, balance sheet strength and valuation. To my understanding valuation is mainly based on FCF yield and EV cap rate, are these metrics adjusted for growth or financial health to determine if the valuation level is attractive?
I definitely take company quality and growth into account when deciding what level of valuation is interesting. For example if you go back to last week's article on Adobe, I said that a 7.5% free cash flow yield is interesting. That's not because 7.5% is dirt cheap. That's probably average to slightly above average for a company. In Adobe's case it was because it was a combination of excellent economic profits that were growing, excellent free cash flow, high returns on capital, and qualitatively just a strong business that would make this level of valuation interesting to me.
On the other hand if you took a company that has low returns on capital and poor free cash flow characteristics, I wouldn't find a 7.5% free cash flow yield to be interesting at all.
Now I don't have a mathematical mapping between quality and free cash flow yields at this stage. I also don't think that's necessary because remember what we're trying to do is figure out if a company is worth a deep dive and then we can get more precise on valuations. Although even later on I would argue affiliation is definitely an imprecise science.
All we are trying to do here is quickly decide if a company is worth a lot more research before we commit that time. So I do make the adjustment for quality and growth but it's my experience of over a decade of using this framework and this template that helps me do that rather than some strict mathematical relationship.
That is a very solid approach and you are right: a weak business at a cheap price is not attractive but ADBE has a fortress balance sheet and solid cash generation potential trading at attractive multiples. It is hard to adjust multiples deterministically. However, I noticed something interesting: When adjusting multiples and calculating a fair value band over time, we can observe if the band is falling or steepening which can help determine the quality of the business.
Thanks Gary. I find these examples of the PULSE framework very helpful in the learning. Based on your experience, would you have a range for each factor that helps us classify them? For example, at what point, the EP goes from bad to good to excellent. In a previous post, you noted Leverage of +3.5 has a 'watch-out'. Thank you
Thank you for the feedback. Great questions, let me try to address them.
Economic Profit: You would like to *ideally* see it as a) all/mostly positive b) rising over time. Some cyclicality can be fine as long as you understand why. The general idea is that an upward trend means that the company is increasing the value it is creating.
Underlying FCF: You want it mostly positive, mostly rising, and FCF % Net Income to be above 70% (unless there is a specific reason like high growth or organic investments).
Leverage: Of course depends on the business (e.g. more cyclical -> can tolerate lower leverage levels, etc). However, since BBB maps to ~ 3x Debt/EBITDA, much above that would be a yellow/red flag. Few businesses can safely carry 4x+.
Smoothed FCF Yield: Depends on the company quality/growth that it's paired with. However, if we think of the long-term market average as being around 6%-7%, that gives us a reference point. Another reference point is what growth is implied (i.e. a 3% FCF yield needs strong double-digit growth for many years to allow for a 10%+ rate of return for the investor).
EV Cap Rate: I would start with a no-growth business being around 8% in the current rate environment. An average business should probably land around 6% to 7%. A good, growing business can be 4% to 5%. So anything below 4% implies a long duration of high growth.
Great framework, thanks for sharing. Quick question: do you weight any of the five signals more than others? For example if leverage is higher but the EV cap rate is attractive too, how do you think about that tradeoff?
Thanks for sharing - interesting framework that covers the core pain points of fundamental analysis - capital efficiency, cash generation potential, balance sheet strength and valuation. To my understanding valuation is mainly based on FCF yield and EV cap rate, are these metrics adjusted for growth or financial health to determine if the valuation level is attractive?
I definitely take company quality and growth into account when deciding what level of valuation is interesting. For example if you go back to last week's article on Adobe, I said that a 7.5% free cash flow yield is interesting. That's not because 7.5% is dirt cheap. That's probably average to slightly above average for a company. In Adobe's case it was because it was a combination of excellent economic profits that were growing, excellent free cash flow, high returns on capital, and qualitatively just a strong business that would make this level of valuation interesting to me.
On the other hand if you took a company that has low returns on capital and poor free cash flow characteristics, I wouldn't find a 7.5% free cash flow yield to be interesting at all.
Now I don't have a mathematical mapping between quality and free cash flow yields at this stage. I also don't think that's necessary because remember what we're trying to do is figure out if a company is worth a deep dive and then we can get more precise on valuations. Although even later on I would argue affiliation is definitely an imprecise science.
All we are trying to do here is quickly decide if a company is worth a lot more research before we commit that time. So I do make the adjustment for quality and growth but it's my experience of over a decade of using this framework and this template that helps me do that rather than some strict mathematical relationship.
That is a very solid approach and you are right: a weak business at a cheap price is not attractive but ADBE has a fortress balance sheet and solid cash generation potential trading at attractive multiples. It is hard to adjust multiples deterministically. However, I noticed something interesting: When adjusting multiples and calculating a fair value band over time, we can observe if the band is falling or steepening which can help determine the quality of the business.
Thanks Gary. I find these examples of the PULSE framework very helpful in the learning. Based on your experience, would you have a range for each factor that helps us classify them? For example, at what point, the EP goes from bad to good to excellent. In a previous post, you noted Leverage of +3.5 has a 'watch-out'. Thank you
Thank you for the feedback. Great questions, let me try to address them.
Economic Profit: You would like to *ideally* see it as a) all/mostly positive b) rising over time. Some cyclicality can be fine as long as you understand why. The general idea is that an upward trend means that the company is increasing the value it is creating.
Underlying FCF: You want it mostly positive, mostly rising, and FCF % Net Income to be above 70% (unless there is a specific reason like high growth or organic investments).
Leverage: Of course depends on the business (e.g. more cyclical -> can tolerate lower leverage levels, etc). However, since BBB maps to ~ 3x Debt/EBITDA, much above that would be a yellow/red flag. Few businesses can safely carry 4x+.
Smoothed FCF Yield: Depends on the company quality/growth that it's paired with. However, if we think of the long-term market average as being around 6%-7%, that gives us a reference point. Another reference point is what growth is implied (i.e. a 3% FCF yield needs strong double-digit growth for many years to allow for a 10%+ rate of return for the investor).
EV Cap Rate: I would start with a no-growth business being around 8% in the current rate environment. An average business should probably land around 6% to 7%. A good, growing business can be 4% to 5%. So anything below 4% implies a long duration of high growth.
Great framework, thanks for sharing. Quick question: do you weight any of the five signals more than others? For example if leverage is higher but the EV cap rate is attractive too, how do you think about that tradeoff?