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Strategies & Market Trends : Free Cash Flow as Value Criterion -- Ignore unavailable to you. Want to Upgrade?

To: Pirah Naman who wrote (57)	10/30/1997 7:12:00 PM
From: Greg Jung	Read Replies (2) \| Respond to of 253

Thread, I look forward to reading the posts when I have time. I've been trying to figure why IBM is considered a value stock. Free cash flow is one item used to justify it. However that cash is immediately used to buy stock - and they also borrow money to do this, also. Nevertheless again today its been listed under the "value" categories. The integrated performance should reflect in shareholder equity - right? This value remains constant, per share. Total "assets" increase as 7% compounded, per share, during these boom times of technology industry. However (assets - debt)/share is about flat. Why can anyone recommend buying IBM (including IBM, itself)? Here is where I've compiled the data. exchange2000.com They seem to generate cash from the business, but it disappears. Greg

To: Pirah Naman who wrote (57)	10/30/1997 7:46:00 PM
From: Andrew	Read Replies (1) \| Respond to of 253

Pirah, "MOST of it reads to me like things we (you and I) have already establshed agreement on: 1) absolute value 2) exactitute 3) subjective evaluation Am I reading it correctly?" I guess so. I felt that you and you and Joan were more interested in relative value, but I may have misunderstood - I have some questions about some of the math you described that might help clear this up. Also, I thought that you guys mistook my penchant for math as a penchant for exactitude - that's not what I'm looking for, as I think I emphasized better in my last post. "1) Doing the math in this case is almost superfluous, because almost nothing is overvalued today. Seriously! If you calculate the value to you, rather than the intrinsic value, by discounting at your expected rate of return, then you can weed out some companies, but you may have to be "unreasonable" in your expectations. I just don't think the math addds much if any value to the selection process in this case. " Ok, here's the part where the analysis affects the interpretation of the math. Obviously, you can make any company look undervalued by assuming an arbitrarily high growth rate. But you must use your analysis to decide what growth rate you can COUNT on, based on your understanding of the company and it's strengths and weaknesses. And this is part of every investment decision. For example, I am sure that when you decided (if you did) to buy Compaq, you made some implicit assumptions about minimum growth. It might grow 25% a year, but you can probably count on at least 5% or something, on average over several years. Other companies that you don't understand as well might well grow, but you don't have strong enough convictions about them to feel safe investing in their future, even if they have good current financial performance. By this mechanism, it's easy to eliminate as overvalued companies that your not confident will grow enough to make it cheap. I would have no problem assuming Compaq can grow at 10% a year or better for many years, so I may be comfortable buying Compaq if it looks really cheap at 10% using the discounting method. However, I have no such illusions about my ability to predict 10% or better growth at say Kodak, which does indeed look very cheap at 10% assumed growth. So I say there IS a great deal of subjectivity involved in discounting. It's that human value-added that makes a discounting spreadsheet a valuation tool, not a stock picker. The math adds value by quantifying your qualitative analysis into a price that will guarantee success if you're RIGHT. If you're wrong, you'll likely lose money either way. "2) VERY few companies are going to be good for the next 30 years. I can see your subjective argument for MCD being "permanent" but not COHR. If you really intend to HOLD ala Buffett than that eliminates almost all companies. " This is also very subjective, as you said. And based very much on qualitative analysis. You pointed out a weakness I agree with, the perpetuity thing. I am going to fix that. But you can customize your calculation to only extend as far out as you feel confident about. If you're only willing to bet on the next five years, chances are, evrything's too expensive by this method, sure. But I don't see FCF being a dependable-enough influence on stock price over periods shorter than say 5 years. If we have a long bear market, 5 years will prove not long enough for the stock to trend with growth in intrinsic value. So I only use FCF valuation on stocks who I feel have a great long-term future of at LEAST ten years. Remeber Buffett doesn't say "Don't buy tech stocks". Buffett says "I don't buy tech stocks because I don't understand them. You should buy what YOU understand." Personally, I don't buy insurance companies, because I don't understand them. I do understand semiconducters, and lasers. I'm no Ph.D, but I have researched enough to feel confident about the long term future of the largest and best managed laser company in the world. If I turn out to be wrong, I'll sell. But if I'm right, I paid a damn reasonable price. "I don't look at next quarter, but over 3-5 years. In that time period, the shorter range projections offer a better chance of separation." I'm just not confident that a FCF-based valuation of any kind can be counted on to provide a profit in that short a period. I'll venture that it's probably a very good bet, but I'm much more confident about my ability to roughly predict the long term success of a great company that I understand than my ability to predict the lack of a bear market in the next few years. So all of my purchases are predicated on the belief that if I can't feel good about where they'll stand 10-15 years from now, I can't bet on them. I'm not suggesting that's the One True Law. Just that it's my philosophy about investment horizon. I fully appreciate that you have a different (and equally or more valid) one, as you said. "Now you were commenting on absolute value. You will note that Buffett's "quick test" was to see if next year's FCF would exceed the long bond yield. If so a company was an immediate buy on that criterion, since a bond has a fixed coupon and the companies would be expected to rise. This is essentially what I do using the VL numbers." I have not heard of his quick test you describe. It does sound like an absolute valuation. Could you describe the math for me? Thanks. Also, you mentioned earlier that the S&P Buffett program divides the 5-year-out FCF estimate by the long bond rate to get the target price. If I'm not mistaken, that is the present value of an infinite series of equal cash flows. In that light, do you like that method (or were you just describing it for my benefit)? Thanks, Andrew