John, I'll direct this thought experiment to you since we've been talking about this for a couple of years, but others are welcome to chime in. Mainly, I was getting tired of the options expensing debate, because we've been talking about it for 3 years and most of us agree that it needs to be expensed. Anyway, on to more interesting things, like should we by Cisco now or not?
To answer that question, I always go back to DFCF calculations. In particulate, I've been thinking alot about Free Cash Flows and whether or not a repurchase of o/s shares by a company should be deducted from Free Cash Flows. My conclusion is that it SHOULD NOT be deducted from Free Cash Flows, when using discounted Free Cash Flows to determine enterprise value.
Here's why. The well-known calculation for FCF is Net Income + Depr + Amort - Purchase of PPE - Business Acquisitions.
My thought was that if a company like Cisco throws off free cash of $1.5 billion, like they did this quarter. What they do with it to enhance company value is then up for grabs. If they keep it, then we don't deduct that amount from FCF. If they pay a dividend, we don't deduct it from FCF. Then if they repurchase shares, why would we deduct it from FCF? If you think about it carefully, repurchasing shares, really is a dividend by another name. So my conclusion is that we SHOULD NOT deduct a repurchase of shares from our FCF calculation.
So to verify that I was thinking correctly, I made a trip up to the attick, dusted off my old corporate finance book and looked it up again. Sure enough, Brealey and Myers agree with me. Here's what they have to say:
"Cash not retained and reinvested in the business is often known as free cash flow: Free cash flow = revenue - costs - investment. But cash that is not reinvested in the business is paid out as dividends. So dividends per share are the same as free cash flow per share, and the general DCF formula can be written in terms of per share revenues, costs, and investment...To summarize, we can think of a stock's value as representing either 1) the present value of the stream of expected future dividends, or 2) the present value of free cash flow, or 3) the present value of average future earnings under a no-growth policy plus the present value of growth opportunities."
Exactly, as I thought. So I took it a step further. Based on the last 3 quarters of evidence, it seems that Cisco's CFO has embarked on a policy of using free cash in its entirety to repurchase shares. That's not a bad policy in the short term considering they have a big enough warchest to weather anything. So they really don't need to hoard any more cash. In addition, they clearly aren't finding enough worthwhile investments out there to spend all the free cash they are throwing off. Therefore, I adjusted my discounted free cash flows calculation 1) to conform with Brealey and Myers calculation, 2) to assume 75% of free cash is used to reduce o/s shares for the next 30 years and the other 25% is used for investing in growth opportunities (but since they issues options, I further assumed that of that 75%, 25% goes to offest options issues and 50% goes to actual reduction of o/s shares), and 3) that they will continue to throw off free cash at the rate of 15% of revenues (currently they are throwing off cash at a 21.5% rate). Not surprisingly, Cisco's valuation goes way up. Based on my new analysis, Cisco would be valued at the following share prices at the given discount rates:
* 8% - $18.01
* 9% - $15.64
* 10% - $13.88
BTW, to avoid infinite recursion, I used $13 as my starting point, rather than the calculated amount of the PV of discounted FCF.
So, I think it might be time to become a Cisco long again. Anyway, let the debate begin, John. I'm interested in what you'll come up with to refute my conclusions. |
