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Subject:  Re: Discounted Cash Flow Model - Negative FCF Date:  2/9/2011  1:24 PM
Author:  jackcrow Number:  1642 of 1675


The most important thing you can take away from this sideways discussion is that the journey is more important than the model or its output. Every model I build is founded on that premise. I want to know what makes that company tick and building the model is an excuse to, parse their three sheets, dig through notes, read press clippings and read analysts reports. The goal of all that legwork is to build a model that reflects the company, has inputs and outputs that are meaningful in relation to that company.

Its your choice, if you can understand a model with many moving parts and it helps you understand the important business aspects of the company being studied then build the complicated model. If we are going to study a biotech firm we need to recognize that R&D is the heart of what they do. There are many reasonable ways to treat R&D some more complex than others. If you can gain insight by treating R&D in a simple manner than that is as far as you need to go. If you feel the need to gain better understanding by using a more complex method then that is the direction that is best for you.

If I was to approach a biotech, the science is mostly way out of my wheelhouse, I would use a pretty simple cash flow or EVA approach and build a set of metrics that helped me track R&D's impact to the bottom line(actually EBIT for me). Another way to do that would be to input some portion of that R&D into working capital or invested capital. What we are looking for is, in essence, return on R&D because that is what pure play biotechs do.

R&D is important at Cummings (CMI) but it is not the heart of the company. A diesel engine is a diesel engine. We can squeeze a bit more out of it in fuel efficiency or power but the engineering physics is pretty much understood and the sideboards well known. Capitalizing and/or tracking R&D is pretty much a waste of time. If Cummings can squeeze 4hp more out of their motor Navistar and Cat can too so there is little lasting competitive advantage.

Activision needs to develop new titles only a very few of which will become "franchises". How valuable is their library? Is that library of titles value reflected in their Goodwill or in some other asset category? COGS is really straight forward in any software company so it needs no special treatment or attention, does it look like most of the industry, good, these are not the droids you are looking for. SG&A is something to eyeball because if they have to spend more on sales we have issues in the development pipeline.

The long and short is use the method that makes sense to you and that you can later make sense out of. Often I do not know what I'm going to build into my model until I've done a fair amount of leg work.

Make sense?

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