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

To: Reginald Middleton who wrote (65)	10/31/1997 6:33:00 AM
From: Andrew	Read Replies (1) \| Respond to of 253

"Per share growth does not increase the value of the entity itself, and is therefore quite misleading. That is one of the major tenets favoring DCF over earnings capitalization." I agree with you if you are talking about a private company. But take a widely held company like IBM. Say they have little prospect for growth in FCF, but excellent prospects for maintaining current levels of FCF. When they buy back shares with that FCF, the little guy who owns 100 shares now owns a higher percentage of all future free cash flows. So the value of the entity itself remains about the same, but if those shares were repurchased at a cost below their intrinsic value, the value of each shareholder's stake increases , which is all that matters. So I think DCF capitalization supports this. Do you have some math that suggests that internal growth provides a higher rate of return? "It primarily means that they believe they cannot grow the enterprise (investment in the enterprise consists of much more than aqcuisitions - ex. R&D, upfront marketing, etc.) at a rate that exceeds the markets expectations. That is usually why the stock's price was depressed to begin with. A much more efficient use of said funds would be investment to actually improve the value of the entity itself and not the entity's per share earnings." Again you're just saying that there's no such thing as free cash flow. FCF by definition is the cash left over after expenses and all internal capital investments needed for growth. R&D is an expense. Marketing is an expense. IBM does a lot of both, and it's a very subjective comment to suggest that they don't do enough to grow the business. Isn't it conceivable that they bring in so much cash that they don't need all of it? Sure the managers could find plenty of new internal projects to fund, but who says these could be counted on to deliver a good enough return on investment to accelerate growth of the company? I think a good management makes those kind of calls. What's the point of throwing more money at the PC business if they can't increase their market share anyway? "Just imagine the share price of MSFT if it had spent the bulk of thier FCF dollars on buying back its shares instead of developing Windows 95 (which had a spectular return on investment BTW)." I agree that the development of Win95 was much more beneficial to MSFT shareholders than equivalent spending on share repurchases. But software development and manufacturing is not exactly a heavily capital intensive industry. I don't have their 10K around, but I would venture a guess that the costs of that development were charged as either R&D expense on the income statement or capitalized software development costs on the cash flow statement. Regardless, their high margin software revenues gave them a handsome flow of cash that MORE than covered that cost. Should they have found more and more software projects to work on in order to spend as much cash as possible? No, because there's more than cash required. They need people to work on all those projects. My point is, FCF is defined as the cash left over, which many companies have a lot of - and that in no way implies that they will not have impressive growth ahead of them. Andrew

To: Reginald Middleton who wrote (65)	10/31/1997 8:23:00 AM
From: Andrew	Read Replies (1) \| Respond to of 253

Reginald, I read your first two posts to that thread you started. I agree with your basic premise that accrual earnings are practically meaningless, and that companies who chose to maximize these vs. R&D and marketing investments are doing their shareholders a disservice. To clarify in this light, in my last post, when I said that R&D and Marketing are expenses, I simply meant that presumably appropriate outlays for both were already accounted for in the calculation of free cash flow. I did not mean to suggest in any way that they should be minimized. Here's an example. Where I work, we have a great many projects that we would like to attack, which would definately benefit our shareholders because there is clear market demand for them. However, we cannot tackle all of these projects, so we try to pick the most promising ones. The problem is not lack of money - this company generates a very substantial cash flow - the problem is lack of people. A company with a finite number of employees can only create a finite number of products, and the cost of those finite efforts usually does not require all of the remaining cash flow of the company. As such, many companies have free cash flow, and are still rapidly growing. As I said before, I think that share repurchases are a very rational allocation of this capital. As for external investments, what company does a CEO understand better than his own? It's much easier for management to determine the return on investment offered by buying their own shares than it is to determine that offered by another company's shares. I'm not saying aquisitions are always bad, but they better offer a substantially higher payoff to compensate for the risk and expense of merging two seperate corporations. Also, in your very comprehensive valuation model, why do you include common ratios such as P/S and P/E when you say yourself they're basically useless? Sure, that'll make your model more palatable to the masses, but why weaken the effectiveness of and add unnecessary complication to it? Remember, you suggested that companies should not give sell-side analysts what they want (accrual earnings), they should give true value. But you're falling into the same trap! Have the courage of your convictions! Regards, Andrew