Hey John, what you are telling me is that the hypothetical company of yours is worth book value. Yes. This particular company is worth book value BECAUSE it is not generating any wealth for the owners. BECAUSE every dime it generates is going to offset dilution. By construction, BECAUSE I made it this way. Not as a general rule.
You stated: After I buy the company, I'll start cutting back on those stock options issuance and take home some extra money each year. Very interesting statement!
Since it is my example I feel comfortable to tell you that the indispensable employees of this hypothetical company were working for no cash wages. And that while you are free to cut back on stock options, they are free to leave. And they will. Immediately. And exchange their outstanding stock options per their ESOP agreement at the purchase price minus strike. And the subsequent free cash flow will be zero, for ever after. Still think you should value it based on its free cash flow?
We can construct examples going back and forth, enriching each other's fantasy construction to the point of being senseless and still end up tangential to the main point.
You wrote: A company's value is ... the sum of the discounted free cash flows I can expect after I own the company.
Very important point (my bold). Very very true. What the company is earning before you own it is not so important, it's what it earns afterwards that counts. This is the Cisco thread, let's discuss Cisco's business.
Let's pretend you have a spare hundred Billion or so rolling around in your sock drawer and you decide to buy the company. You crack open the books and evaluate their free cash flow. And decide to pay the going rate (forget any customary premium, or the signs that the Market is making at the moment).
Your expectation is that by the time you retire 30 years from now, you'll have been able to suck the free cash flow back out of the company and back into your sock drawer. All 100 billion of it.
Where things go off the rails for you however is when you tell the employees that you contemplated replacing their stock option program with an equivalent sock option program (where they get shares in the contents of your sock drawer). Contemplated it and dismissed it. Because if you allow anyone else to own part of that 100 Billion prize at the end of the rainbow, then you'll get less than 100 Billion out the other end. Having paid 100 Billions for your share, that ends you up in the hole! And you are not stupid.
So you cut the stock option program and forget about the sock option program. The only way to keep the same level of free cash flow is to keep the same level of cash compensation. So no increase in wages either. Quite the salary cut, for some of these people.
By the same token, you have to tell the good folks at the helm of the kibble companies you plan to acquire that they will end up being acquired for free. If you give them shares in your sock drawer, then you won't take home 100% of that 100 Billion you plan to put there. If you plan to pay in cash then you plan to increase capex, which is a plan to operate with reduced free cash flow. Duoh!
Now, I don't know about you, but I doubt I could swing either one of these deals.
So if you are going to pay 100% of free cash flows for the business, you are, in essence, stating that you are buying the business that it isn't! Or that you as a manager could do way better than the current management. Good luck. Alternately, if you had your thinking cap screwed on tight, you would subtract from the purchase price the amount of the goodies you would have to give away in order to run the business.
The bottom line: we could not run Cisco's current business without increasing cash costs and preserve 100% ownership of the free cash flows. So why we would pay 100% of the value for these free cash flows is beyond me. Ideally we should pay only as much as the percentage we expect to retain.
One thing you could do however, is pay the 100 millions and increase everybody's claim on your sock drawer by 5%. Then "motivate" them to work hard and bust their chops and get that Free Cash Flow number goosed up by maybe 5%. Then you might find a wealthy enough fellow non-CPA who is daft enough to value the company based on free cash flows alone. And sell this sucker the company (diluted another 5%) for the 105 M$ free cash flows he thinks it's worth. And you would come out ahead. Rinse, lather, repeat.
Until one day the new new new new owners wake up and howl in outrage at the nasty trick that's been pulled on them when they figure that 2/3 of the "free cash flows" are heading out the door to pay off non-cash promises. Of course, by then, everything in that sock drawer of yours has gone through the laundry. And it wasn't all your fault, you just took 5%.
That is the whole point of expensing things like stock options and acquisitions. Prevents that howl. Also takes away that quick 5% opportunity... but it was only a trick of the light after all.
This is, of course, not Cisco specific. There is an entire industry devoted to a practice that is remarkably similar. An unusually high concentration of which exists here in Silicon Valley. The howl of national outrage coming this way... you can hear it coming, can't you?
Regards,
John |
