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Strategies & Market Trends : Gorilla and King Portfolio Candidates -- Ignore unavailable to you. Want to Upgrade?

To: Uncle Frank who wrote (49286)	11/30/2001 12:30:17 AM
From: Thomas Mercer-Hursh	Read Replies (2) \| Respond to of 54805

So you're saying that if they spend a buck of the retained $7 to buy a new factory, it would reduce the value of the company? It seems to me that this issue is tied in to one's perception of the maturity and growth opportunity of the company. Obviously, if one felt that investing a dollar today was very likely to yield two dollars next year, the one would prefer the company with the lesser FCF, all else being equal. But then, all else is rarely equal. To me, this is why FCF, for all that it has going for it in good solid financial terms, is no more than the tip of the iceberg in terms of valuing companies for LTB&H. After all, a company who was in its sunset years, but had a lock in that would give them say a couple of years of cash cow performance with no capital investment would look super in FCF terms, but you sure wouldn't want to hold it too long, would you? Conversely, a company with a long term patent lock on its market and a really solid market development plan might be investing ever free dollar in R&D and infrastructure development and yet be the best long term bet you can imagine. There is no escaping the need for understanding ... fortunately or unfortunately, depending on one's ability and willingness to understand.

To: Uncle Frank who wrote (49286)	11/30/2001 10:46:40 AM
From: Stock Farmer	Respond to of 54805

So you're saying that if they spend a buck of the retained $7 to buy a new factory, it would reduce the value of the company? No. Folks usually get hung up about why we subtract capital cost from Free Cash Flow. Some even ponder why we add back in non-cash depreciation. As if the two are separate. We are adding one and taking away the other in order to reverse an accounting trick (which subtracted the one and added back in the other). No more, no less. Capital expenditures are an actual drain on the company's profit. At issue is whether we account for this drain in the year that it occurs, or smeared out over future years. For the purposes of quarterly review of a company's affairs, it is useful to smear - it's not "fair" to reflect the cost of capital solely against the results of a single quarter. So GAAP reports something called "earnings", which over-states actual cash profit by the amount of capital spent in the period, and understates profit by a share of capital spent in prior periods. For the purposes of a discounted cash flow analysis, we are incorrect if we do this smearing. Anyone who has ever had a mortgage knows that the sum of a long string of payments is not equal to the present value of one big lump sum. It's a matter of accounting for cash in the year it is spent. No more, no less. John

To: Uncle Frank who wrote (49286)	11/30/2001 11:54:38 AM
From: Pirah Naman	Read Replies (1) \| Respond to of 54805

uf: So you're saying that if they spend a buck of the retained $7 to buy a new factory, it would reduce the value of the company? No. What Ethan is saying is that if they spent a buck on the factory, it is not available for owners. FCF is the money available after the company has bought the new factories it needs to grow the business. It is truly discretionary. They've invested all they could in ventures where they have expectations of a high return, and then they still have money left over. (John Shannon explained the accounting quite succinctly.) Take a look at the Silverbacks. How did they come to have such huge piles of cash? By taking in more cash than they spent, over a prolongued period. Apparently they don't see where they could invest more in ventures that would give them a high return. Now what they do with that FCF is something you can look at in gauging management's rationality. Do they pay a dividend? Reduce debt? Buyback shares? (The latter two will result in increased profits per share.) Or will they invest in a less profitable or less certain venture? Will they get lax on some other costs, e.g. compensation? Thomas' point about the maturity of the company is a good one. If we are looking at "mere" candidates in tornado, we don't expect them to be generating tons of free cash flow. For a young gorilla, we might reasonably expect them to generate some decent free cash flow in the forseeable future. We expect very good free cash flow from a silverback. So this all ties in to what I wrote before about setting expectations. Maybe an investor wants to work with time (company should be modestly free cash flow positive within 5 years) or base it on sales (company must be modestly free cash flow positive at $1B revs), or even just work in terms of TALC. But it makes sense to set some expectations about financial performance. It reflects on their business performance, and it is ultimately what we as owners seek. That is underlying why we look for companies that will become silverbacks - that long stream of FCFs. All of the above only relates to evaluating a company's strength and performance. Not valuation. Valuation is based on the future stream of free cash flows, not the past. A company can be generating huge amounts of free cash flow and still be overpriced; another might be FCF marginal or even negative, but be underpriced, if its future profitabilty is underestimated. - Pirah