Please find below our key excerpts from a brilliant paper written by Michael J. Mauboussin explaining how to adjust financials to get a better understanding of businesses which do heavy intangible investment and stock based compensation. Our summary will help people who want to enter the VC space and for the people who want to analyze tech businesses. (Emphasis Ours)
You can think about a business using some simple ideas. A company spends money on investments that are expected to generate good returns relative to the capital’s opportunity cost. It then sells a good or service to customers that generates revenues and incurs expenses. The difference between revenues and costs is operating income, and after financing costs and taxes a company is left with net income. When income exceeds investments, the company generates cash that it can return to the capital providers. When investments exceed income, the company has to raise capital, usually by issuing debt or equity.
The statement of cash flows appears to match the basic activities of a business. Cash flow from investing activities tells you how much money the company spent to generate future growth. Cash flow from operating activities goes beyond net income to reveal the cash in and out associated with activities based on the customer. And cash flow from financing reveals how the company addresses gaps between the cash flows associated with investments and operations.
A company is in a position to return cash to capital providers when the operations generate more cash than investment needs. When investment needs exceed cash from the operations, the company must raise capital to plug the gap. To be clear, negative free cash flow is not only fine but desirable when the return on investment is attractive.
The point of this report is that today’s accounting creates a huge gap between financial statements and what an investor needs to understand a business.
We use Amazon as our case study. The main takeaway is that Amazon’s cash flow from operating activities and cash flow from investing activities are both substantially higher than what the company reports based on accepted accounting principles.
The definition of free cash flow that investors and companies commonly use is cash from operating activities minus capital expenditures. This is inconsistent with finance theory and can be a very misleading heuristic.
Stock-based compensation. Using equity to pay employees is relatively new.
But there is an essential distinction between incentive compensation, where pay is linked to performance, and equity compensation as a pay delivery mechanism. For a long time SBC did not show up as an expense on the income statement. Not until 2006 was expensing compulsory under U.S. generally accepted accounting principles (GAAP).
But even as the issue of expensing SBC on the income statement has long been resolved, accountants still add back SBC expense in the calculation of cash flow from operations. SBC is a legitimate expense that should not be reversed. Small companies, which generally have fewer financial resources than large ones do, rely heavily on SBC. Employees provide both a source of financing and a service.
You can think of SBC as one number that reflects two transactions. The company first sells shares (financing) and then uses the proceeds to pay employees (compensation for service). Combine these ideas and it makes sense to move SBC from the cash flow from operating activities section to the cash flow from financing activities section. This portrays the cash flow statement more accurately. SBC was most significant for technology companies.
Using stock for compensation can make sense because it provides a source of capital and aligns the interests of employees and shareholders.
Leases. A company that invests in a physical asset can generally buy it or lease it. The problem is that the assets a company purchases show up in cash flow from investing activities, while assets that are leased are reflected in cash flow from financing activities. The adjustment here is to move the property and equipment acquired with leases into the section that captures cash flow from investing activities.
Intangible Investments. The basic structure of financial statements was developed to reflect a world of tangible assets and has not changed much in a century. Intangible assets are not physical and include employee training, brand building, and software code. Tangible assets are physical, such as factories, airplanes, and machines.
Accountants record most intangible investments on the income statement. The essential adjustment is to move intangible investment from cash flow from operating activities, where it is hidden in the calculation of net income, to cash flow from investing activities.
The analytical challenge is to separate selling, general, and administrative (SG&A) expenses into what is an investment and what is necessary to maintain the business. In recent years, academics have developed techniques to do this. The split between discretionary and maintenance SG&A spending is different based on the industry and the company.
We use these techniques to estimate Amazon’s investment in intangible assets. We assume that fulfillment costs, about 45 percent of total SG&A, are linked to current sales and hence have no investment component.
Estimating intangible investment for the remaining SG&A requires two significant assumptions: the percentage of an expense item that is deemed an investment and the appropriate amortization period. We designate three quarters of technology and content expense, one-half of marketing expense, and one-fifth of general and administrative expense as investment in intangible assets. This suggests that 62 percent of eligible SG&A, and 34 percent of total SG&A, are discretionary investments.
We assume a useful life of five years for investments in technology and content and three years for investments in marketing and general and administrative. We create a schedule to capitalize and amortize these estimates through time. The amortization of past intangibles in 2020 equaled $25.4 billion.
The $44.4 billion of intangible investment minus the $25.4 billion in amortization leaves a net investment of $19.0 billion. This is the figure we want to reflect in cash flow from operating activities and cash flow from investing activities.
Cash flow from operating activities increased 15 percent, from $66.1 to $75.8 billion. If the intangible investment adjustment were added to net income, an unrealistic assumption because of taxes, net income would go from $21.3 billion to $40.3 billion, a near doubling.
Cash flow from investing activities goes from an outflow of $59.6 billion to an outflow of $89.3 billion. This is an essential insight for an investor who is trying to get a clear sense of the magnitude of investment in order to make an intelligent forecast about future profits.
Cash flow from financing activities goes from -$1.1 billion to $18.8 billion, suggesting the company raised capital to finance its operations. Note that the sum of the three sections is identical whether you use the as reported or the adjusted figures.
Marketable securities. An analyst who concludes that marketable securities and cash are equivalent can remove the purchases and sales of marketable securities from the cash flows from investing activities. The statement of cash flows would then explain the change during the period to reconcile cash, cash equivalents, and marketable securities.
Exhibit 6 shows this additional adjustment for Amazon. As compared to exhibit 5, adjusted cash flow from operating activities is unchanged at $75.8 billion as is the adjusted cash flow from financing activities of $18.8 billion. But now the revised cash flow from investing activities goes from an adjusted -$89.3 billion to -$67.0 billion. This is the result of reclassifying the $22.2 billion of marketable securities the company purchased in 2020 as a component of the change in cash, cash equivalents, and marketable securities.