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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 (68)	10/31/1997 12:58:00 PM
From: Pirah Naman	Respond to of 253

Greg: The share buybacks in themselves do nothing to change the value of the enterprise. All they do is change the way the profits of the enterprise are shared. Let's say 10 us own a company and it makes $100 a year profit, $10 each. Two of the guys decide they want out, so we buy them out; now we get $12.50 each. As a percentage of profit nothing changes, as you say, so no obvious advantage there. We had to go get the money to buy the extra shares. But.. what if the $100/year profit is based upon a cost of only $100? That makes it a 100% return on investment in the first year. If we have to borrow money at 10%, I think that to a certain point we would do it, depending upon our confidence level in the ability of our company to keep returning 100%. The profit margin on the items sold is only part of the equation. How fast do we sell the items? If you lend me $100 and I buy 10 widgets and sell them for $11 each, you'd say "big deal, 10%." But what if I sell them the first week, and plough the money right back into more widgets? If I did that every week, how many widgets would I have earned a 10% profit on over the course of the year, if I used ONLY the $100 you lent me and stuck my profits under my mattress? $500! (Hey, so I took a couple weeks off for vacation.) My return on invested capital is 500% before I pay you back. Now what if, instead of lending me $100 for this, you put up the money and I put up the good looks necessary to sell the widgets. For $100 I sell you 80% of the company; therefore you are entitled to 80% of that $500. I'm doing good, I've put in no money and I'm getting 20% of it. But I want more. You've got 80 shares and I've only got 20. Can I buy 10 of yours for $10? No way. Being as you are just got $5/share ($400/80) back on your investment in the first year, you know they are worth more. At what price would you sell them to me? At what price would I be willing to buy? We both have different perspectives on what the business will do. Based upon that we are going to each try to balance our lust for profits with our tolerance for risk. At some price you will feel better having cash from me now then the hope of future profits. At some price I will be willing to buy a few shares out of my profits; at some lower price I might be willing to borrow money from somebody else to buy all your shares. It isn't a matter of growth. DELL, which is growing rapidly, and IBM, which is a slug, are both buying shares back. They may have different rationales for doing so, but the questions they face are the same questions you and I face in the widget business scenario. How they handle it may give us insight into the decision making of their managements. Pirah