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Hi everyone,

I think that the article is spot on with the errors and if anyone has built a valuation model from Copeland's Valuation book should be aware of most those issues. Errors 1, 2, & 4 are joined at the hip. I would argue that another egregious error not mentioned but deserves top honors is the error of not normalizing earnings. I think Philip does a good job of making sure the cyclical nature of the business is taken into account. This is also one of Graham's big warnings.

Anyway, I put together a spreadsheet to try and show this with Jim's FORM analysis. I wish the analysis was put on the open boards so everyone could take advantage of it :((Or link to one that is available like the Garmin analysis - but I digress).

So here we go with some data points:
Year                    2006     2007     2008     2009     2010            Terminal     Terminal (ALT)
51,715 69,297 92,859 124,431 166,737 171,739 171,739
FCF 29,705 43,332 57,318 76,806 102,921 106,009 161,926
IC Investment 22,010 25,965 35,541 47,625 63,816 65,730 9,814

Beginning IC 132,487 154,497 180,462 216,003 263,628 327,444 327,444
Ending IC 154,497 180,462 216,003 263,628 327,444 393,174 337,258

ROIC (average beg+end) 36.04% 41.38% 46.84% 51.89% 56.42% 43.68% 50.92%
ROIC (beginning) 39.03% 44.85% 51.46% 57.61% 63.25% 52.45% 52.45%

IC Growth 16.61% 16.81% 19.69% 22.05% 24.21% 20.07% 3.00%
IC Reinvestment 42.56% 37.47% 38.27% 38.27% 38.27% 38.27% 5.71%

Terminal Value 1,247,160 1,905,007

And the calculation of invested capital (my calculation) which is needed to generate the ROIC numbers:
Beginning IC Calculation

Operating Cash @ 5% Rev 11,874
Excess Cash 199,734

Non-Cash Working Capital
Current Assets 80,936
Current Liabilities 60,434
Non-Cash Working Capital 20,502

Net PP&E 81,588
Other Assets net of Liabilities 1,841

Invested Capital
Operating Cash 11,874
Non-Cash Working Capital 20,502
Net PP&E 81,588
Other Assets net of Liabilities 1,841
Invested Capital 115,805

Operating Leases 16682
Invested Capital adj 132,487

Research & Development ???

I provided an alternative Terminal Value to compensate for error 2. However the best way to deal with not generating an error 2 is by extending the forecast enough to stabilize the earnings and returns on capital (error 1). Its hard to rationalize generating a terminal value based on stable earnings off a year when revenues were growing at 30%. You can see the problem by looking at the assume IC growth in the terminal value which is too high.

If you look at the calculated ROIC's, based on my invested capital calculations, they are increasing through the forecasted years and result in a terminal value calculation implying FORM will earn 52% on invested capital forever. This actually could happen if FORM refuses to lower margins to continue growth. That would be the rational behind my terminal value alternative calculation. That example can be found today with many high ROIC companies facing future low growth prospects.

So that's how I would review the potential errors found in the FORM analysis as discussed by Mauboussin. Glad you asked huh? Sheesh. Hey but I gave an alternative TV which would make it less overvalued :)))


While I am at it, there is one paragraph at the end of the error 2 discussion that I disagree with, at least in how I am interpreting Mauboussin.

Maouboussin writes:

Most DCF models fail the economically sound and transparent test because of poor structure: the explicit forecast periods are too short and the continuing value estimates carry too much value. An investor should have a clear handle on the economic assumptions or implications behind whatever continuing value approach they choose.

A single stage DCF is in effect one big terminal value calculation. Therefore technically a calculation isn't "wrong" if its terminal value is larger than the explicit cash flows because we know that a single stage DCF is perfectly fine structure for a mature slow grower. Further to correct error 2 most of the time the terminal value will increase as growth expenditures are reduced which I showed in the alternative terminal value calculation. So its not so much the time horizon itself but the implications in growth expenditures and operating margins built into the terminal value that fail the "economically sound" test.

Geez - what an opinion.

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