That was a pretty long post, therefore I am not going to address all of it at one time.
<I was in no way suggesting that I think IBM is doing a fantastic or efficient job at creating shareholder value. They do however make big investments in R&D and marketing. AND they buy back shares. My feeling is that they just are not investing effectively - you know, the vision thing. So you can't just say "Oh they're buying back shares, so they can't be growing". It doesn't follow. It's incorrect. If they made better (not necessarily more!) R&D and marketing investments, they would be growing AND buying back shares.>
This is the gist of my whole argument. The most valuable companies make the "best" investments with "all" of their available funds. While this is practically impossible, you must find the companies that come as close to this as possible. MSFT is a good example. MSFT spends a lot on investments, with a phenominally high return, therefore creating true value. INTC spends much more on investments, with less of a return but with a significant accumulation of value (you see there are 2 basic parts to the true value equation, spend a lot at an inefficeint rate or spend less at a hihgly efficient rate). IBM is not creating the value that INTC or MSFT is creating due to the reasons quoted from you above.
<My entire position is that after appropriate investments for growth have been made (like R&D and marketing), there is often free cash flow left over. Even Microsoft, with their massive investments that you pointed out, has free cash flow.>
I am not arguing this point. Your posts seem to be based on the assertion that I not a propenent of free cash flow.
<In a growing company, where management has made impressive investments in future growth, yet STILL has cash left over, share buybacks can ACCELERATE the already impressive growth, on a per share basis. And I'm not talking about accounting earnings. I'm talking about value.>
Again, you are talking about value on a per share basis, and not corporate value. When a company can not grow corporate value any further, then there should be a warning signal. Like I said earlier, MSFT had plenty FCF when it developed Windows 95 and NT, INTC (in a capital intensive industry) had plenty of cash on hand when it developed the Pentium and Pentium II with the new socket architecture. Notice that these companies chose to grow the company with thier dollars rather than grow the theoretical value of individual shares (at the expense of company cash, possibly paying more than the cost of capital through the oppurtunity cost of foregone future cash flows from such exciting and fruitful projects).
<You are suggesting that a company has two mutually exclusive choices: invest for growth, or buy back shares.>
This is not true.
<A company with low capital requirements, like software, financial services or franchising often has plenty of cash flow to do both!>
Well then why do so few successful software and financial companies such as MSFT or morgan Stanley do so? The reason is because they have better things to do with thier money. This is a good thing. In theory, there may come a time when they no longer have something better to do with it. When that time comes, investors should be aware.
<Value is derived from true "profit" - free cash flow, which can be returned to the shareholders. Great long term investments are companies that DON'T need to consume all of their cash to grow. They make so much that they have an economic "profit". One mechanism to return this "profit" to the investors is by increasing their stake in the enterprise through share buybacks.>
I fancy myself as being an expert on economic profit. Excess free cash flow is far from economic profit. It is more akin to regular profit. Economic profit is the monies derived from capital investments that are above and beyond the risk charge that is applied to the company (the cost of capital). Free cash flow does not account for any oppurtunity cost of capital or the requisiste risk an investor bears when investing in said coporation. Without an offesetting measure of risk, one cannot truly guage whether one has acutally profited from one's endeavors in said company. The next logical step in your valuations would be to use DCF (discounted cash flow) analysis to guage whether the risk one bears in the company is truly compensated by the profit one is getting out of the company. Of course the discounting rate would be the appropriate risk charge in % terms that one is bearing to invest in the company. LT bond +X% = the WACC (weighted average cost of capital). This is what the majority of the (buys side) street uses to guage corporate value on paper. There is a major problem with this though. It does not account for timing
of the capital expenditures that are needed to create value. This is where the economic profit method comes into to play. For more on true value, see rcmfinancial.com .
I said, "To perform more advanced DCF, you must consider R&D and marketing to be what they actually are, investments."
You said, That's not true. Cash comes in, cash goes out. Some gets left over for the shareholders. One hopes that the cash going out represents investment in future growth. Free cash flow is the same regardless of where these costs show up on the financial statements. It includes them. If you want to not include them because they are "nice" costs, well that's not very realistic. When you make an investment, whether it's real estate, precious metals or common stocks, cash goes out, cash comes in. It would be pretty silly to try to calculate your ROI without including the cost of the investment!
You are in error here. To be honest, it is the a smart error for it is the same error that invalidates basic DCF analysis, and that is the identification and timing of investments. If value is the same (remember that you equated FCF to economic profit which you then equated to economic profit which is knwo a value) is the same no matter how and where you account for R&D, as long as do account for it, then truly R&D intensive companies will be valueless until they have recouped all of thier R&D expenditures above and over the value lost due to teh time value of money. If this is true, then I propose nobody ever invest in Amgen, Merck, or any biotech company that discovers the cure for cancer, a cure for AIDS, or a medicinal vaccination for heart disease until they have already made a significant amount of money (and the share price has been bid through the roof). Sounds silly, huh? Well that is what you are proposing. R&D and marketing are truly investments and not expenses, therefore they must be accounted for as such. If I have Company A that wishes to spend 100 dollars on research and development for a cure for cancer project that is expected to have a horizon of five years. The correct charge for this upfront investment would be a 5 year amortized charge. Therefore I would apply a $20 charge against cash flows for five years, and any return on the investment over and above that $20 dollars would be attributed to profit. Therefore, if the project returned $25 dollars in the first 3 years and $12 dollars in the last two years, then the project was actually successful (this is an oversimplification, and does not take into account the time value of money nor the cost of capital). Using your methodology, the project would be a failure if it does not generate $100 in the year the investment was made. Using this methodology, biotechs and high tech start-ups would NEVER get equity financing.
The problem with standard economic profit scenario is the fact that it still uses accounting data. Although that data is adjusted for use by assimilating the economic book value, it is still book value nontheless. My model takes these and applies them to the actual market values of invested capital, which brings everything full circle to the point of the investor's reality. That is the gist of the INTC model beta that I have posted on my New Media Financial site site under the valuation link. rcmfinancial.com
I may be writing a book on this and other topics soon, if so I do hope you will buy it.
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