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

To: Greg Jung who wrote (58)	10/30/1997 7:36:00 PM
From: Pirah Naman	Read Replies (2) \| Respond to 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

To: Greg Jung who wrote (58)	10/31/1997 12:32:00 AM
From: jbe	Read Replies (1) \| Respond to of 253

Greg: Re IBM -- and Compaq and Dell and etc. You write: "I've been trying to figure why IBM is considered a value stock. Free cash flow is one item used to justify it." Well, looking at the admittedly incomplete data I have at hand here, I would say that IBM is not as much of a "value stock" as its major competitors, at least in terms of its free cash flow. Here are some current price/free cash flow ratios: S&P average: 37.86 Computer Hardware industry average: 29.11 IBM: 36.70 Dell: 29.15 Compaq: 12.80 Go, Compaq! (Not that I'm biased, or anything.) Furthermore, IBM's free cash flow seems to be decreasing, while CPQ's and Dell's free cash flow growth rates are increasing. Unfortunately, I don't have the 1997 numbers for IBM, so the numbers aren't strictly comparable. IBM's free cash flow: 1994: 5618. 1995: 5543 (-1.3%) 1996: 4242 (-12.3%) Dell: 1995: 109.9 1996: 197.2 (+79.5%) 1997:451 (+128.7%) CPQ: 1995: 495 1996: 596 (+20.2%) 1997: 890.9 (+49.6%) The free cash flow superiority of Dell and CPQ to IBM becomes even clearer when you look at their debt/equity ratios (in that debt has to be paid off out of free cash flow). IBM's total debt/equity ratio is on the high side: 1.28, as against the S&P average of 0.91, and the computer industry's average of .53. Dell and Compaq, on the other hand, have total debt/equity ratios of 0.00. (Go, Compaq!) The question is -- can IBM reverse what looks like its decreasing free cash flow (I repeat, I don't have the 1997 numbers), and can Compaq and Dell -- especially Dell -- keep on growing free cash flow at the hectic pace of the immediately preceding years? I dare say that Value Line's projected 1988 cash flow numbers, which I do NOT have handy, would help answer that question, but for the longer term, one needs to exercise that "subjective judgment" the folks on this thread have been talking about, based, hopefully, on thorough knowledge of the companies and of the industry they are operating in. None of this is quantifiable, of course. In fairness to IBM, it must be said that by some traditional valuation criteria IBM looks more like a "value stock" than Dell or Compaq. First and foremost, it has a much better price/operating cash flow ratio, which suggests that if it could reduce its capital expenditures and/or pay down its debt it might possibly end up with more FREE cash flow than the other two. IBM's price/CF ratio is only 9.18, as against S&P average of 16.54, and industry average of 17.58. Dell's price/CF ratio is 28.05 (about three times as high as IBM's), and Dell's is a stunning 43.35 (almost five times as high). (Can anyone out there explain this apparent anomaly?) Finally, O'Shaughnessy price/sales ratio freaks would clasp IBM, with its 1.26 price/sales ratio, to their bosoms, but give the back of their hands to Compaq (2.31) and Dell (3.55). And etc., and etc. There are an awful lot of different ways to skin this particular cat.