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Legendary investor Michael Burry just dropped a new interview with a legendary level of bullshit.

Let’s bury him.

1.⁠ ⁠”It’s the AI consulting thing.”

Burry can’t understand that a consulting business doesn’t have an 80% gross margin at ~50% FCF margin, growing at +60% while maintaining a fixed headcount.

Legendarily embarrassing.

2.⁠ ⁠”Palantir doesn’t produce a product for AI. It was a lucky AI cover.”

Seems Burry spent more time writing tweets on Palantir than actually studying it.

Palantir was doing AI before it was called “AI”. The proof is in the old demos and the fact that it was perfectly positioned as the “AI grid” application for deploying n-models to deliver business value.

If Palantir’s AI wasn’t real:

• its business would have stalled like C3.ai;

• its metrics would not have exploded;

• all the clients presenting at AIPCon are liars;

• ⁠USA Government is deploying a massive scam at scale.

3.⁠ ⁠”SBC wastes all the income.”

SBC is expensed as a cost in the Income Statement, but doesn’t generate a cash outflow from the company.

Palantir GAAP metrics, AFTER the SBC impact:

• 33% Operating Profit Margin;

• 40% Net Income Margin (thanks to Net Interest).

= even if Palantir paid all the SBC in cash, it would still have elite margins.

4.⁠ ⁠”Wall Street takes EPS per share and adds back SBC.”

EBIT Adj is the best metric to assess the strength of the business because it’s a proxy of the operating FCF.

EBIT Adj. = GAAP EBIT + SBC

NB: since the timing of customers’ invoices can vary, EBIT adj. is a smoother and more representative measure of the value generated in the quarter.

5.⁠ ⁠”GAAP understates the real cost of SBC.”

For each employee, SBC expenses from RSUs are recorded at the grant-date price of the shares and remain constant over the vesting period, which is ~4 years.

This means that if Palantir stock rises, the company will continue to record the initial related SBC cost for the vesting period. Still, the shares provided to the employee at the end of the 4 years are actually more valuable than the expenses recorded.

GAAP indeed understates the effective $ amount employees can receive once the shares vest, if the stock rises significantly after the grant date.

That’s the bet employees take. That’s the bet investors take.

SBC negatively affects shareholders as their % ownership of the company is reduced due to the issuance of additional shares, but the accounting value matters relatively little.

What truly matters to shareholders is the change in the number of shares (=dilution), which affects the per-share results and is a serious problem if the company doesn’t grow.

Palantir:

• +60% YoY Revenue;

• +90% YoY EBIT adj;

• +200% YoY EPS;

• +4.6% Diluted Num. of shares.

As long as the business grows much more than the dilution, there is no issue.

I am a happy diluted shareholder.

6.⁠ ⁠”Look how much the company pays in buyback to offset that level dilution.”

Buybacks are stupid only if done at a stupid price.

Since Palantir began its buyback, the stock has risen more than 6x.

NB: in Q3 Palantir bought back $20mn vs $600mn EBIT adj.

7.⁠ ⁠“Billionaires/Revenue ratio bigger than 1 has never been seen.”

Palantir has 5 billionaires owning the stock compared to $4 billion in Revenue generated.

While surely that’s an anomaly, it doesn’t mean anything.

To get to $1 billion, you need to build a business for 20 years, not rolling the portfolio every quarter or selling a newsletter.

Shyam Sankar, Palantir’s CTO, for instance, has helped build the company's value as the #13 employee since 2006.

Meanwhile, Burry called 20 of the past 2 recessions.

That’s unprecedented.

In 5 minutes, Burry dropped 7 bad takes.

That’s unprecedented.

Last week, I was told that Burry has literally coordinated a short attack involving institutional players in the trade.

While I can’t verify the accuracy of this claim, I can verify that Burry looks more desperate than ever to preserve the little reputation left.

Yours,
Arny

Reach me:

• X @arny_trezzi

• LinkedIn: Arnaldo Trezzi

Disclaimer: The views and opinions expressed above are current as of the date of this document and are subject to change without notice. Materials referenced above will be provided for educational purposes only. None of the above will include investment advice, a recommendation or an offer to sell, or a solicitation of an offer to buy, any securities or investment products.

Palantir has one soul, two bodies.

By assessing the individual value of each business, Commercial and Government, we can obtain a fair valuation for the Group by adding them.

In this article, we will perform a Sum of the Parts Valuation Model (“SOPM”), which is widely used by analysts. By wearing “Wall Street glasses”, we could better assess if there could be a potential upside from the relative valuation with Peers despite the strongly adverse market conditions.

Cloud Peers

Palantir Commercial business has the steady recurring structure of the biggest B2B SaaS players while also approaching consumption-based pricing, which provides more growth potential.

Therefore the Cloud peers I chose are:

• Salesforce; ServiceNow = B2B Leaders. Despite different products, Palantir has the same business structure (Seeking the Alpha: PLTR vs NOW);

• Snowflake; Datadog = hypergrowth Cloud leaders. These companies successfully keep growing by more than ~60% per year;

• Alteryx = B2B SaaS under $5bn Market Cap. It is useful for comparison because it has strong growth but a negative FCF margin.

As I shared previously (PLTR Deserves More), valuations in the Cloud sector are mainly driven by the mix of growth rate and FCF margin; the “Efficiency score”.

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Higher growth rates + better FCF margins = higher valuations.

Compared to the selected peers, Palantir Group currently shows:

• ~12% slower growth. This is mainly due to the Government slowdown (Government Slowdown: Not Palantir’s Fault Only);

• ~9% better FCF Margin. This is obtained thanks to the high Contribution Margin, which comes from strong pricing power and faster software deployment (Palantir: This Time It’s Different);

Palantir currently trades at a ~36% discount relative to the 12x average EV/Sales ratio, despite having a similar Efficiency Score.

By focusing on the commercial side, Palantir Commercial Revenues grew 40% in the last twelve months, which is in line with the selected Peer average.

Palantir’s Commercial business deserves at least a multiple of 12x EV/Sales.

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Defence Peers

As comparable companies for the Defence segment, I chose:

• L3 Harris; Lockheed Martin; Raytheon = Prime Defence contractors. Palantir competes directly with L3 Harris and Raytheon on contracts. Lockheed is the benchmark Defence company.

• Leidos; Booz Allen = major providers of National Security IT services. Despite the fact that they also provide solutions for commercial companies, their core business is focused on Defence.

Given the comparison with other Defence Peers, Palantir clearly has superior metrics and deserves a premium, due to:

• Much stronger growth: ~30% Growth vs. ~2% Peers Average.

• Much better margins: ~25% FCF vs. 12% Peers Average.

Despite operating in the Defence sector, Palantir has much stronger financials than Prime Contractors and leading National Security IT companies.

This means Palantir deserves a strong premium compared with Defence Peers.

Despite the slowdown to 21% in the last twelve months, Palantir Government clearly outperformed the almost flat or negative growth of its Peers.

Defence Peers, on average, trade at 0.3x EV/Sales/Growth. Therefore, from an extremely conservative view:

Palantir’s Government business should deserve a 0.4x EV/Sales/Growth at the very least.

Summing the Parts

We first need to select the growth expected for 2022. Conservatively, I chose the following growth rates:

• 40% Growth for Commercial (vs. 46% LTM);

• 20% Growth for Government (vs. 21% LTM).

With these growth rates, we could be conservative in our valuations even if both businesses slowed down in Q3-Q4.

If you would like to perform your own assumptions and help support my research, you could find the link to the Sum of the Parts Model below.

We can finally apply the selected multiples and obtain a valuation of:

• ~$11bn for Commercial @12x EV/Sales;

• ~$9bn for Government @8x EV/Sales or 0.4x EV/Sales/Growth.

By summing the two and the Net Cash expected at Year End, we would get a Valuation of ~$22bn Market Cap for Palantir, which hints that under these conservative assumptions, Palantir can be considered 20% undervalued, at least.

Context is key

For context, the Cloud sector to which Palantir belongs trades at multi-year lows. This is heavily impacted by the high-interest rates (PLTR Fights vs a Tough Competitor), which “hurt” the valuations of the so-called “growth sectors” like the Cloud.

This is a burden on valuations. Until the sector multiples recover, we can’t expect Palantir’s price to change significantly.

In the Sum of Parts valuation that we just performed, we chose 12x and 8x EV/Sales which could be attributed to “Top Quartile” Cloud companies, where Palantir belongs (Seeking the Alpha: PLTR vs NOW).

For Palantir to trade at significantly higher “fair multiples,” two conditions must be met:

• Palantir should grow much more than the current ~26%. Related to the Government business, there are already very good signs the business could accelerate again due to the recent strong contractual activity (PLTR: It’s Raining). On the Commercial Side, the key growth potential is in the US, where Palantir is acquiring significant clients which could move the needle (PLTR US Commercial is Taking the Lead);

• Wall Street should return to an appreciation for the Cloud sector. While many weak Cloud companies will disappear, the best Cloud players that could help companies solve their most important problems could emerge as winners from the current difficult macroeconomic environment and receive premium multiples (Is PLTR Recession Proof?).

Conclusion

By assessing Palantir’s Commercial and Government business separately, we could see that there is some potential upside from a relative valuation framework.

Hints of a brighter future exist, but until those become financial numbers, it is difficult for Wall Street to justify a richer valuation.

Without strong numbers, it is hard for Wall Street to support a growth story.

Yours,
Arny

Join me on:
Twitter: @arny_trezzi
Business Email: arnylaorca@gmail.com

View expresses are my own and do not represent Financial Advice in any way.
I own (many) stocks.

In a previous article, we performed a Reverse DCF (PLTR Reverse DCF: what is the current price implying?) to understand the expectations implied in the current price.

We saw that the market assumes that Palantir could grow 30% for many years and generate over $25bn in Revenues by 2032.

What does Palantir need to get there?

I tried to build a simple Revenue Model to answer the question.

If you would like to perform your own assumptions and help support my research, you could find the link to the Revenue Model below.

Palantir could reach almost $28bn in Revenue and +9.500 clients in 2032 by showing:

• 130% Net Dollar Retention: as shared in the previous article (PLTR’s New Clients are Irrelevant), this is the key driver as more than ~90% of the growth comes from existing clients;

• 30%-65% yearly growth in client count: as the numbers increases;

• $1mn Revenues per new client: this is the avg. Revenue from clients acquired in the Fiscal Year;

• $3.5mn-$8mn on avg. Revenue per existing client.

The real numbers that will be generated could differ significantly from this model. However, this is a starting point to set reasonable expectations in terms of:

• Business growth KPIs (key performance indicators);

• Investment returns at a given price.

In this model, I didn’t separate the Government from the Commercial numbers to keep it simple and set initial broad expectations. In the future, we can update it with more detailed information.

What return should we expect?

Assuming the 30% growth will be achieved, how much return should we get?

As we discussed previously (PLTR Buy Signals: A dive Inside my Playbook):

Investment Return = business growth +/(-) change in multiple.

Therefore, using the model above the key components determining our performance will be:

• Revenue Growth;

• Current Price/Sales multiple;

• 2032 Price/Sales multiple.

As we underlined previously, when talking about DCFs (Why 99% of Palantir DCFs Fail), it is crucial to include the change in the number of shares to incorporate the dilution coming from the Stock-Based Compensation.

This way we obtain a “Diluted Growth” of the sales.

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Palantir could reach $70 per share under the following assumptions:

• 30% growth;

• ~6% dilution;

• 10x Price/Sales multiple in 2032.

This would generate an Internal Rate of Return (“IRR”) of 24% from the initial $8 per share.

This would mean more than 3x the average return of the S&P500, which has an annualized rate of return of ~7%.

Why is $5 “offensive”?

From my previous article (PLTR Buy Signals: A dive Inside my Playbook), you may remember that I underlined how a $5 price for Palantir would be an asymmetrical opportunity.

We could see it also here.

At a price of $5, even if the final multiple would be 5x Price/Sales, Palantir could deliver 22% IRR.

The return would raise to 30% IRR at 10x 2032 Price/Sales and 36% at 15x.

A final P/S of 15x is not absurd if FCF margins stay at 30%. That would mean a P/FCF of 45x which is appropriate for a 30% grower with such high margins.

Durability is key

The numbers we saw could be proven absolutely wrong. They must be considered a starting point on which we can make reflections and have realistic expectations on what could happen.

The model presented relies heavily on the fact that there will be a 30% Revenue growth for 10 years, which is a very strong assumption. By studying the business in depth we can better understand how that growth can be achieved.

In particular, as investors, we need to deeply study the business to better understand the durability of the growth.

Palantir's relative strength of the business, which has better unit economics than and (Seeking the Alpha: PLTR vs NOW) suggests that it could also have a prolonged growth of Revenues above 20%.

Assuming 30% for many years is ambitious, but the opportunity is huge. With the right execution, Palantir could reach ~$28bn Revenue by 2032 and generate superior returns.

I am delighted to share this journey in understanding Palantir’s durability with you.

Yours,
Arny

Join me on:
Twitter: @arny_trezzi
Youtube: @Arny Investing
Business Email: arnylaorca@gmail.com

View expresses are my own. Do not represent Financial Advice.  

I own (many) stocks.

Palantir just returned to a ~$7 per share similar to post Q2 Earnings, a Quarterly call that raised doubts about its operations (PLTR Q2: Really A Disaster?).

Is bad, or is the price starting to imply too much negativity?

To answer this question we can use a Reverse DCF.

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In a regular DCF, we select the assumptions to obtain the “fair value” of the company. Performing an Inverse DCF means doing the opposite.

Starting from the current price we obtain the assumption needed to justify it.

From here:

• any improvement from this case = potential upside.

• worsening numbers = potential downside

This way we don’t seek to answer “what is the company worth?”, but we start from the reality, the current price, in order to test how reasonable the implied assumptions are.

Wrong assumptions implied by the market = overhype or over pessimism.

What does PLTR price imply?

Below is a simple and synthetic PLTR DCF that I’ve created, which expresses potential assumptions implied by the current share price of $7.4 per share.

If you would like to perform your own assumptions and help support my research, you could find the link to the sample DCF below.

The current price implies a conservative scenario:

• 25% Revenue growth for ‘22 but later adjusting to 30% following 30% Guidance;

• 25% FCF Margin for many years, a reduction compared with the 31% in ‘21;

• 10% Dilution in ‘22 and gradually decreasing towards 3%;

• 15% WACC (discount rate) = minimum hurdle rate required by VC funds;

• 3% perpetuity growth rate.

The current price reflects doubts about Palantir’s ability to increase growth above the guidance and already incorporate the adverse effects of SBC (Why 99% PLTR DCFs Fail).

Lots of negativity is already incorporated into the price, leaving more space for the upside.

How can Palantir stock raise?

There are many ways that could support Palantir’s price:

• Better growth sustained both by major wins in Government business (potential wins from NHS, TITAN) and Commercial, especially in the US (PLTR US Commercial is the Key), which is growing by +40%.

• Better margins from existing clients scaling more than the margin pressure from acquiring new clients. I expect the combination of growth and FCF to stay at least ~60%.

• Lower dilution. ‘22 dilution should still be high considering PLTR’s aggressive hiring (PLTR Against the Tide). Any clear sign of steady SBC reduction should be appreciated by the market.

• Lower WACC (weighted average cost of capital), used by analysts. For instance, BofA currently uses 13% discount rate driven from the “high beta” of Palantir sector (PLTR Costs Less than Coca-Cola). If Palantir proves it can successfully navigate a recession (Is PLTR Recession Proof?) analysts could lower the applied discount rate.

• Sector Multiples reevaluation. Currently, SaaS Companies trade almost at the multi-year bottom. Renewed interest in the sector would support higher multiples for Palantir than the current ones (7x EV/Sales).

  

Without the support of these factors, the price would not deserve the current valuation nor would it be subjected to further upside.

Conclusion

It is crucial that Palantir shows better results than those of Q2 (PLTR Q2: Really A Disaster?) and starts translating the clients acquired into Revenue growth.

The assumptions implied by the current price are quite conservative and leave substantial upside if Palantir delivers.

However, a further slowdown would inevitably reduce the assumptions used by banks to evaluate Palantir and create further downside pressure on the stock.

Yours,
Arny

Share Laorca by Arny Trezzi

Join me on:
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Youtube: @Arny Investing
Instagram: @arnylaorca
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View expresses are my own and do not represent Financial Advice in any way.
I own (many) stocks.

The updated article can be found on Seeking Alpha (link)

When to buy? Clues from simplicity

I want this company in my portfolio. Now comes the question “When to buy?”.

Despite there is not a definitive answer to the $1trn question, I believe some clues could help us intuitively see if we are moving odds in our favour.

These clues led my decision to recently double down Palantir at $7 and will drive my decision if its price gets even lower.

This article could be considered my playbook to intuitively assess where Palantir valuation stands, without the need for complicated DCFs, which often fail. 

I believe in the power of simplicity.

The job of a good investor is to spot asymmetries with relatively little downside compared with the upside. By protecting the downside, the investor can benefit from the full potential of the upside. The best investors are those who can play the convexity game “lose little when wrong, gain much when right”. Value investors call the degree of convexity “margin of safety”, but in reality is the intrinsic characteristic of any sound investment in whatever asset class.

The lower the price we pay, the more convexity we get.

According to my experience, 2 dimensions could help to maximise the margin of safety:

• Company vs. value (price of what you pay vs. what you get);

• Company vs. all (relative value vs. peers vs. market). 

The first is by far the most important because it incorporates the essence of investing: we make a good investment only if we pay less than the value we receive.

Otherwise, we are speculating someone pays more for the same asset, but that is not the game I am willing to play.

In this article, I will explore this dimension.

Price is what you pay. Value is what you get

When we buy a company we are buying a financial tool that represents the right on flows generated by the company. The value we get is therefore a combination of cash flows and the expectation of the growth on coming flows.

Comparing the price we pay to the flows generated by the company provides a “multiple”.

• Sustainability and growth? High multiple;

• Instability and no-growth? Low multiple.

Under this framework, the performance we can expect from a stock is derived by:

Performance = Multiple Expansion (or Contraction) + Business Growth

In other words, if we buy Palantir at an $8 price (P/FCF 25x) the performance we receive will be a combination of the expansion of the multiple and the growth in FCF:

• Multiple stays at 25x P/FCF, business grows 30%: stock grows 30%;

• Business grows 30%, Price stays at $8: multiple contracts to 17x P/FCF.

The combination of multiple and growth determines different risk profiles. The combination of low multiple associated with high growth is the dream case for any investor because it offers the best risk/reward outcomes.

More for less: understanding the multiple

Buying lower multiple increases the chances of good performance. This is not only because we “get more for less”, but also because we become more exposed to a potential revaluation of the multiple while being more protected from the downside of multiple contractions.

What multiple should I consider? The choice of the multiple is mainly driven by the stage the company is at. We want a stable metric to intuitively assess where we are in terms of valuation.

EV/Sales multiple is often the only metric we can use for early stage companies because there are no cash flows generated after the Operating Expenses are covered.

EV = Market Cap - Net Cash

The harsh truth is that if we need to value a company on EV/Sales we are in the highly speculative zone where it is very easy to overpay for companies with negative FCF.

As a proxy, I consider 15x EV/Sales the most that I am willing to pay and should be associated with strong growth and potential margins. When I bought Palantir at $10 at DPO, it had 15x EV/Sales combined with a 50% Revenues growth and negative Free Cash Flow.

Focusing on companies already producing FCF with a steady Margin reduces the probability of making mistakes.

What’s the right price for growth and FCF?

As a general principle, the multiple is “cheap” when we buy large growth or strong resilience (or both) for a little multiple.

Dealing with companies with FCF is safer and easier because we could use a simple yet powerful model.

Fortunately, PLTR now produces FCF with pretty stable margins (~30%) and therefore is suitable for it. The recent contraction is probably due to strong client acquisition as highlighted in the previous article.

By comparing the EV/FCF multiple to the growth we adapt the Price-Earnings-to-Growth (PEG). This allows us to judge:

• not appealing: EV/FCF > growth %;

• fair: EV/FCF = growth %;

• appealing: EV/FCF < growth %;

• very appealing: EV/FCF is 1/2 of growth %.

This simple valuation tool is powerful because it incorporates the idea that growth is extremely valuable to investors.

If we can buy “much growth for less” we got a good deal.

Conversely, paying a high multiple for companies not growing much could leave investors exposed to little or no growth and multiple contractions. These lead to catastrophic effects on the performance (ouch!).

Let’s take Palantir as an example. I consider Palantir a 30%-grower, therefore according to the model, I am:

• “not ok” to pay much more than 30x EV/FCF (price > growth)

• “ok” to pay 30x EV/FCF (price = growth);

• “happy” to pay a multiple 25x (price < growth);

• “excited” to pay 15x (price = 1/2 growth).

I use this table to easily assess the multiples at different prices:

These multiples include the effect of SBC in terms of the increased number of shares.

It is all about growth. What growth?

What is cheap for one company is not cheap for another. It is all a matter of growth and its resilience.

“How can I choose the “right growth”? Here is where the understanding of the business comes into play.

With companies at a mature phase, Return on Equity (ROE) and Return on Invested Capital (ROIC) offer clues to sustainable growth. With companies at an early stage like Palantir, we need to do a lot of homework in understanding the business to become confident that the business can grow at a certain rate.

The “right” growth rate depends on the business structure and specific strengths. Understanding what drives the durability of the growth is far more important than understanding the next quarter's growth.

These considerations display that 30% is a reasonable “sustainable growth rate” for Palantir’s foreseeable future:

• ~38% Revenues avg. yearly growth in the last three years;

• +30% yearly Guidance until ‘25;

• ~32% yearly growth of existing clients (132% avg. Net Dollar Retention).

Larger B2B SaaS peers like $NOW (PLTR vs NOW article) and $CRM grew more than 20% for more than a decade. This supports the idea that, with the right execution, Palantir could sustain that 30% growth.

Don’t worry, I’ll pay you back “later”

To understand the importance of growth consider the 2 cases of buying an entire business at 20x EV/FCF:

• no growth: it would take us 20 years to return on our investment;

• 20% growth: it would take us 9 years to return on our investment.

The 20% growth makes us “save” 11 years of investment.

FCF multiple tells us “how many years at 0% growth do I need to fully return on my investment”. A multiple of 20x means that it takes 20 years at fixed FCF rate to fully receive a return on my investment.

Growth accelerates that process. Observing how growth impacts the multiple we pay could be helpful to assess if we risk overpaying for it.

When is the multiple too cheap to ignore?

To address this question, let’s see how a 30% growth affects Palantir's valuation at different purchase prices.

Case 1:

At $8 we purchase Palantir at 25x EV/FCF but if the price stayed at $8 for 3 year the multiple would decrease to 16x due to stronger FCF.

This would be intuitively “too cheap to ignore” for a company growing 30% with 30% FCF Margin.

Case 2

Conversely, if we pay $20, so 71x EV/FCF, it takes many years before the multiple becomes “attractive”.

Note, it takes 6 years of 30% growth to get to the starting point of $8.

Case 3

If we consider the $5 case, underlined by many bears, Palantir would have 14x EV/FCF.

If we invert the 14x multiple, giving 7% return in the first year, this would equal the avg. market return of the S&P500. However, the table below shows that this multiple is more likely associated with a Utility company rather than a potential Alpha company.

A 14x multiple is generally associated with sub-average companies or with little expectations of growth, for instance IBM or GE.

With 30% growth at a fixed 14x FCF Multiple, one could 3x the S&P500.

From here, the convexity would be remarkable:

• Downside case: even if growth slows to 20%, the multiple contraction would have little effect;

• Upside case: if growth accelerates and the multiple expands, returns could be explosive;

With 50% FCF growth and the FCF multiple expanding from 14x to 50x due to investors sentiment, a $5 shareholder could see ~250% return.

The risk of overpaying or misjudging growth could be detrimental

Our duty as investors:

• do not overpay;

• study the business development (products, TAM, competitors);

• understand the structural growth;

• do no get lost in precise DCFs or quarterly data.

Understanding the business at a deep level provides information to better assess the growth trajectory and its durability.

Paying low multiples without paying enough attention to the durability of the growth could bring detrimental results.

This is the mistake I made with BABA last year. I bought at 20x Price/FCF because the business was growing +20%, however I underestimated the government crackdown and the overall slowdown of the Chinese economy. These reduced growth and the multiple accordingly - aka double hit.

BABA needs to reconstruct its Income Statement from 0 each year, therefore it is highly affected by the macro environment. Conversely, Palantir has a business structure with contractual recurring Revenues and client expansion. This means stable Revenues and subsequently stable FCF.

Conclusion: a simple principle

If the growth trajectory is untouched, our performance will become a matter of the price we pay. The lower the price we pay, the more convexity we get.

We can’t predict how our stocks move, but by studying the business deeply we can:

• have a reasonable expectation of the sustainable growth rate;

• pay a low multiple when Mr Market offers us the opportunity.

Key principles:

Underpaying allows for a margin of safety in the case of slower growth. Overpaying can be detrimental for returns.

Yours, 
Arny

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View expresses are my own. Do not represent Financial Advice. 

I own stocks. 

The most common method to assess a company valuation is doing a DCF. However, without assumptions that reflect reality, these models can show you whatever you want.

In particular, I noticed that 99% of the DCFs on the web fail to properly represent the reality on Palantir and deliver outsized “fair prices”.

Our job as investors, is not to dream about unreasonable target prices but to be conscious of the possible downside. Incorporating the following considerations could be valuable to prevent major mistakes when assessing the value of an “unprofitable” company like Palantir.

As discussed in the previous article (“When will Palantir SBC ease?”), Stock-Based-Compensation (“SBC”) could have relevant consequences on the financial returns for shareholders given its dilutive impacts. Therefore it needs to be considered when addressing the value of a company. Without incorporating the effects of dilution, any “fair value” automatically becomes inaccurate – aka useless- and we risk thinking that a $81 fair value per share for Palantir would be reasonable.

Palantir SBC is costly and is here to stay, therefore must be incorporated into a financial valuation.

As a reminder, Palantir is considered by many an “unprofitable trash”. The reality is that Palantir has negative GAAP earnings, but -huge- positive Free Cash Flows from operations. 30% FCF Margin already puts PLTR at an FCF profitability comparable to a “big tech” like Google and Microsoft. If PLTR were truly unprofitable its Cash Balance would have not grown by 50% since the DPO as no new fresh equity has risen.

Discounted Free Cash Flows models focus on a company's ability to generate Cash Flows after all cash expenses are covered. However, SBC is not a cash flow item since it generates no cash in or cash out for the company, but still must generates an impact on shareholder’s value.

How can we incorporate it?

How to deal with with SBC

1) Not considering SBC at all.

This method is the most spread on the web, from Seeking Alpha to Youtube, since it is the simplest to compute. Is it also accurate?

Steps:

1. Calculate the FCF of the company to obtain the Enterprise Value

2. Subtracting the Net Cash obtaining the Equity Value.

3. Divide the Equity Value by the number of shares as of today to obtain a “fair price per share”.

This method is highly inaccurate because it assumes 100% of the future FCF will be given to existing shareholders, which is simply not true when a company incurs high SBC.

As we saw in the past year, ignoring the dilutive effects from SBC inevitably leads to inflated “fair price per share”, like saying PLTR is worth $81 per share (88x EV/Sales ‘22).

2) Consider SBC as a Cash expense.

This method is supported by Aswath Damodaran , the “dean of valuation”, and by many financial professionals and assumes SBC is a monetary expense to be subtracted from FCF.

The resulting FCFs are therefore the original FCF net of SBC expenses.

Steps:

1. Calculate FCF adj as FCF adj. = FCF – SBC

2. Perform a normal DCF using the FCF adj. and the shares outstanding as of today.

Despite it is accurate to assign a negative value to the dilution occurring due to SBC, this method fails to capture the optionality provided by the cash the company does not spend when providing SBC as the company actually holds the cash. This money could have crucial effect in boosting further growth, e.g. could be spent on marketing, which could lead to potential increase in future FCFs.

Let’s think of this with an example.

• Company A: $100mn FCF. $100mn SBC because I pay the employees only in increased % of ownership. $100mn Cash in Bank at the beginning.

• Company B: $0mn FCF, $0mn SBC because the company pays $100mn in salary to employees. $100mn Cash in Bank at the beginning.

According to the method, the two companies would be worth the same. However, in reality, company A should be much more valuable than company B.

After 1y of operations, Company A could use the residual $200mn in their bank account to boost growth, for instance investing in marketing or pursuing M&A operations.

The ability to generate free cash flow provides also the additional optionality to raise Debt at a cheap rate because FCF reduces the risk for potential lenders.

Company B, on the other hand, needs to erode its cash balance, or issue new Debt, in order to pursue growth. New Equity would be detrimental to existing shareholders because it would cause dilution. New Debt would be costly because of the weak ability to generate cash flows.

Therefore, Company A would be much more valuable than Company B over the long term, but the assumption that SBC is a Cash Expense would attribute them the same valuation, which is inaccurate.

Despite the intuition that SBC is a cost that must be accounted for its dilutive properties, considering SBC as a Cash Expense fails to recognize how valuable cash in the bank is for a company with growth potential. Cash generation creates non-linear effects in terms of optionality, which financial models fail to capture. Cash optionality is particularly relevant for companies not requiring much cash to grow, so-called “asset-light companies” like Palantir.

3) Incorporating SBC into the changing number of shares (best!)

This method, which I use, seeks to incorporate the negative effects of dilution as a “tax” on future DCFs.

Steps:

1. Calculate FCF from the company

2. Divide each future FCF by the expected number of shares so that we incorporate the dilutive effects.

3. For simplicity I assume there is no cash inflow from options (conservative).

4. Calculate the terminal value per share and add the Present Value of the estimated FCF per share.

The resulting “Fair Value per Share” is more accurate than the values obtained with previous methods. This method only deals with real cash flows while also incorporating the negative effect coming from the increase in the number of shares.

To show how important this consideration is, I’ll perform a sample DCF model with some gross ‘22-’32 assumptions:

• 30% Revenues Growth

• 30% FCF Margin

• 10% to 6% Dilution - assuming a “normalization process”

• 15% WACC (Weighted-Average-Cost-of-Capital)

• 2% Perpetuity Growth Rate

The following table shows the difference in valuation obtained from incorporating SBC vs Not incorporating. The divergence could be dramatic. This is why including SBC effect is crucial.

The Final Fair Value could change the valuation from $14 per share to $8 as an effect of the “simple” 6% increase in the number of shares by 2030.

In other words, Dilution alone can halve the Intrinsic Value of the shares.

Conclusion

I generally dislike DCFs since they heavily rely on future assumptions. Small variations in assumptions could deliver completely different valuations. Therefore, I prefer to focus on the current business developments rather than assuming future scenarios.

However, if we want to perform a DCF model, it is important that valuations are mentally honest and consider the factors that could have an impact. SBC cannot be ignored.

Be skeptical on DCFs, especially on YouTube finance. Many Youtubers provide an incredibly valuable qualitative assessment of the business. However, models could be easily misleading with fancy calculations that often go against the principle “It is better to be roughly right than precisely wrong”.

Precise estimates become useless if one does not consider the impact of SBC on a company like Palantir, which had SBC accounting for 50% of Revenues in 2021 😳

When a DCF seems too good to be true, it probably is. The incentive for people sharing considerations on companies we love - I include myself in the bucket - is to publish topics that support the bull thesis. Always ask yourself what crucial assumption is moving the valuation or if there is any missing key elements.

Interested in seeing how I value Palantir? Subscribe to be updated on my journey as an investor.

“It is better to be roughly right than precisely wrong” - Keynes

Yours,

Arnaldo

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Join me on Twitter: @arny_trezzi

View expresses are my own. Do not represent Financial Advice. 

I own stocks. 

Sample DCF excel

Download the Sample DCF excel