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Strategies & Market Trends : Free Cash Flow as Value Criterion
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To: Greg Jung who wrote (58)10/30/1997 7:36:00 PM
From: Pirah Naman  Read Replies (2) of 253
 
Greg:

> I've been trying to figure why IBM is considered a value stock. Free > cash flow is one item used to justify it.

Early in the year they had an excellent price/FCF ratio. Now it is good, but nothing fantastic.

> However that cash is immediately used to buy stock

That's the idea. FCF is cash above and beyond what they need to grow the business. What are the acceptable uses for it? Buy back stock, increase dividend, pay down debt, let it pile up and make some acquisition.

> they also borrow money to do this

Here's the rationale behind this. When you read through this thread you'll note Andrew and I both talk about FCF as an equivalent of a bond coupon. If they can borrow at 7% and buy a share that has a coupon of 9%, then numerically it makes sense. Note, I am not saying that I am in favor of this. Just explaining how they can justify it.

(As for the equity issue, a question to ponder is how IBM at its size can increase its equity. I'm not inclined to believe that physical expansion (building more plants)is appropriate, and they are moving more into software and services - neither of which does much for book value. This is why the debt to equity ratio is perhaps a misleading way to look at debt levels at a software or services company.)

As for the relative merits of IBM as an investment, this is where you must decide whether you approve of managements use of their FCF. For this is a two - pronged concept : one that the company is inexpensive relative to its FCF; and two that the management has a good system for deciding how to employ that FCF.

Pirah
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