You have entered into a circular argument with your previous assertions. I will attempt to clarify my points.
<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.>
If a company has little prospect for growth in FCF, then the assertion that management can not find a capital investment that surpasses the cost of capital is a valid assumption. The only way a company can increase corporate value is to invests in projects that surpass the internally generated hurdle rate, which is the weighted average cost of capital. While I agree that if one cannot find such an investment, than it would be worthwhile to buy back stock at bargain prices, this should alert the investor that management CAN NOT grow the company while simultaneously growing corporate value, therefore must result to reducing the amount of shares outstanding to increase shareholder value. This does not bode well in the face of an industry that is growing like a weed. If IBM cannot increase proportionate market share while simultanesouly corporate value, then it is losing market share on an aggregate basis. Note the dismal market share and return on investment of the Power PC, OS/2 and quite possibly lotus. Notice the threats to the mainframe business from Sun and Wintel. These are all manifestations of an inability to put money in a place where it can effectively grow the business, and therefore create shareholder value at the corporate level. So, instead of creating the new computing paradigm with their excess cash flow like MSFT , INTC, or Compaq, IBM instead decides to repurchase shares. Like I said, this is a red flag to search for a better investment.
<Do you have some math that suggests that internal growth provides a higher rate of return?>
There is a plethora of it. I will supply several links when I get the chance to look them up, or you can search my site. I am sure you will find some info there.
<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. >
This is in error. FCF definitions change with the wind. R&D and marketing are far from expenses. you are confusing reality with the world of accrual accouting. Accrual accounting inefficiencies are the priamry reason that DCF is preferrable to P/E as the optimal method of valuation. To perform more advanced DCF, you must consider R&D and marketing to be what they actually are, investments. They are investments which should be capitalized and amortized over the expected horizon of the project in question. To view them as expenses totally distorts the picture of economic value. To take this a step further, they are not only investments, but they are the new, more efficient tax shields for the digital age. R&D and marketing provide the tax relief that debt does without the stringent requirement of debt service and the requisite cash flow volatility that follows. Remember, you cannot follow accrual accouting rules if you are trying to value a company from a realistic perspective.
<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?>
This is my point exactly. If management is not willing to put money into its own busines due to a lack of an acceptable return, then why should I do it as an investor? There are but so many shares to buy back. Once all available shares are purchased, then what does management do to increase shareholder value?:-) As you alluded to earlier, they cannot not grow the business. Share buy backs are band-aids on a gushing wound. They may make you feel better for the moment, but they are far from solving the problem.
<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?>
Yes. That is why they are putting so much money into new investments. Nearly 3 billion in R&D, which is an investment in cash flow terms, and not an expense (developing IE 4, NT 4.0, NT 5.0 Back office, Office 97, MSNBC, MSN, Sidewalk, etc. the list goes on for a while), nearly 2 billion in marketing (another investment which increass developer, ISV and third party/distribution channel support), nearly a billion in M&A and external investments (Comcast Cable, Progressive Networks, WEbTV, Vermeer Technologies, etc. the list goes on for a while). All of these investments are projected to have a return in excess of MSFT's cost of capital, which is about 11.1%. Whenever the net return on an investment exceeds the weighted average cost of capital, shareholder value is created (and not faked by stock buy backs).
Here is the circular argument:
<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?>
then,
<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.>
You can't have it both ways.
RCM
rcmfinancial.com |
