Lesson 6 of 6
Writing the conditions down
A condition is derived from the reason you hold, not read off the company's history, which is how a level like 39.0 percent gets chosen.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A condition is derived from the reason you hold, not from what the figure has done: pick a level below the history and it will rarely be breached.
- State the reason, work out what has to be true for it to hold, then find the figure that moves when it stops being true.
- Some reasons, like a leverage story, need a date rather than a ratio, and some reasons produce no condition at all.
Every observation in lessons one to five produces one document: the reasons you hold, and the filed conditions that would refute them. A reason with no condition attached is an opinion that cannot be wrong, and one that cannot be wrong never gets revised.
A gross-margin level derived from a reason, not from history
- Current, mix claim intact42.0%
- Reversion half done · condition level39.0%
- Reversion complete36.0%
Condition: reason half gone: 39.0%
The wrong way and the right way
The wrong way looks at what a figure has done and sets a level a little below it, which produces a condition that will not be breached. The right way runs backwards from the reason: state it in words, work out what has to be true for it to hold, find the filed figure that moves when it stops being true, and compute the level at which the reason has failed. The level comes out of the arithmetic; it is not picked.
From reason to level
- State the reason in one sentence, in words a stranger could check.
- Work out what has to keep being true about the business for that sentence to hold.
- Find the filed figure that moves when it stops being true, and compute the level at which the reason is half gone.
A flow reason needs a flow condition
A current ratio is two balances on one day the company chose. If the reason you hold is that the business generates more cash than it consumes, that reason is about a flow, and the condition belongs on free cash flow, not the current ratio. Across Apple's ten filed years, the current ratio sat below Graham's floor of 2.0 throughout while free cash flow ran from 53.5 billion dollars in fiscal 2016 to 98.8 billion in fiscal 2025 without a negative year: two rows describing different things the whole time, a stock and a flow. Fix the definition before the level. Free cash flow here is operating cash flow less capital expenditure. Share-based compensation is expensed under ASC 718, but as a non-cash charge it is added back in operating cash flow under ASC 230, so it lowers earnings without lowering operating cash flow. A level against an unstated definition is not a condition.
Some reasons cannot become a ratio at all
A debt-to-equity condition has no maturity date and a denominator that moves when the company repurchases stock, so it can cross a threshold in a year when nothing about the borrowing changed. What a leverage condition needs is a date: the maturity schedule in the debt note against cash generated from operations in the last twelve months. That condition is checkable only going forward, filing by filing, with no backward test in this data, and a condition you can only check forward is still a condition, one where the answer arrives by waiting.
Write it down, date it, schedule it
Write the level beside the reason, on the same line, so a reader eighteen months later sees why 39.0 percent rather than only the number. Date the writing, not the figures. Then schedule the review against the filing calendar: 60, 75 or 90 days after fiscal year end for the annual filing, 40 or 45 for each quarter. Four known dates a year. The analysis above is a one-off; the review is the process, and it is the only part of this course that happens more than once.
Check yourself
Why is picking a level a little below a figure's own history the wrong way to write a condition?
- It is too conservative
- It will almost never be breached, so it confirms the reason instead of testing it
- It ignores the most recent year
Show the answer
Answer: B.
A condition should come from what has to be true for the reason to hold, then compute the level at which that fails. A level set below the history rarely gets tested at all.Your reason for holding is that the business generates more cash than it consumes. Which figure should carry the condition?
- The current ratio
- Free cash flow
- Debt to equity
Show the answer
Answer: B.
The reason is about a flow, so the condition belongs on a flow. A current ratio is two balances on one day and answers a different question.Why is a plain debt-to-equity threshold a poor leverage condition on its own?
- Debt to equity is not disclosed every year
- It has no maturity date, and its denominator moves when the company repurchases stock
- It is always below 1.0
Show the answer
Answer: B.
The ratio can cross a threshold in a year when borrowing did not change, because equity shrank instead. A leverage condition needs a maturity schedule against cash from operations.Sources
- ASC 718, Compensation, Stock Compensation, and ASC 230, Statement of Cash Flows: share-based pay is expensed under the first and added back as a non-cash charge in operating cash flow under the second.
- Form 10-K, General Instruction A(2), and Form 10-Q, General Instruction A(1): the filing deadlines a review schedule is built on.
What this leaves out
- The levels in the illustrative example come from arithmetic on invented round figures, not from any company's filings, and are not thresholds for use.
- Only the eight figures in lesson one can be checked backward over filed history; a condition on anything else is checkable forward only.
- Nothing here is a view on Apple or on any security, and none of it is a condition anybody should adopt.