Reginald, allow me to clarify my position on a couple of things:
1. I totally agree with you that growing companies should maximize their R&D and marketing investments instead of maximizing their present accounting earnings. I think that is a very insightful observation that you made.
2. I like your observations about return on investment above the cost of capital. I will be investigating your website to learn more about this.
3. The only reason I described the above as expenses was to point out that they are already accounted for in the calculation of free cash flow. If these investments were capitalized as you suggest, they would also be accounted for when you calculate FCF. FCF is the cash LEFT OVER. It's the cash an owner could skim off without disrupting the growth trajectory of the current business.
4. I was in no way suggesting that I think IBM is doing a fantastic or efficient job at creating shareholder value. They do however make big investments in R&D and marketing. AND they buy back shares. My feeling is that they just are not investing effectively - you know, the vision thing. So you can't just say "Oh they're buying back shares, so they can't be growing". It doesn't follow. It's incorrect. If they made better (not necessarily more!) R&D and marketing investments, they would be growing AND buying back shares.
5. My entire position is that after appropriate investments for growth have been made (like R&D and marketing), there is often free cash flow left over. Even Microsoft, with their massive investments that you pointed out, has free cash flow. It turns out that they spend a lot of this on share buybacks to cancel out the dilution from stock options. But they also do use it to make aquistions outside their core business, like WebTV and Comcast. If they didn't want to do that (and if the price was right) they could choose to buy back shares. If MSFT's stock was cheap for whatever market psychology reason, and they chose to buy back stock instead of buying part of Comcast, would you accuse them of not having growth ahead of them? Intelligent stock buybacks do not indicate hopelessness. They indicate a business awash in cash, whose managers understand that growth doesn't just happen because you throw cash at projects. I mean it's not like Microsoft has to build expensive fabs or anything.
"<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."
This was only an example to demonstrate why share buybacks increase shareholder value. You were fixating on the fact that they don't increase the value of the entity as a whole. I demonstrated that that's not the point. This however was a special case that highlighted that EVEN in the case of a company that was not growing, smart management can increase the value of your shares. In a growing company, where management has made impressive investments in future growth, yet STILL has cash left over, share buybacks can ACCELERATE the already impressive growth, on a per share basis. And I'm not talking about accounting earnings. I'm talking about value.
"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 is not true! Again, you are suggesting that there is no such thing as free cash flow in growing companies. Coke is growing, has free cash flow, and often buys back shares. Sure they're not growing 30% a year, but so what? You are suggesting that a company has two mutually exclusive choices: invest for growth, or buy back shares. A company with low capital requirements, like software, financial services or franchising often has plenty of cash flow to do both!
"<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."
I'll look it up on your website, thanks....
"FCF definitions change with the wind."
Not in principle. Principles don't change...that's why we call them principles. The only way that an investment in securities can have value to you is if you can expect some future economic benefit from them. You are suggesting that a company MUST consume all of it's cash in order to have investment value. I'm saying that's not true. Value is derived from true "profit" - free cash flow, which can be returned to the shareholders. Great long term investments are companies that DON'T need to consume all of their cash to grow. They make so much that they have an economic "profit". One mechanism to return this "profit" to the investors is by increasing their stake in the enterprise through share buybacks.
"To perform more advanced DCF, you must consider R&D and marketing to be what they actually are, investments."
That's not true. Cash comes in, cash goes out. Some gets left over for the shareholders. One hopes that the cash going out represents investment in future growth. Free cash flow is the same regardless of where these costs show up on the financial statements. It includes them. If you want to not include them because they are "nice" costs, well that's not very realistic. When you make an investment, whether it's real estate, precious metals or common stocks, cash goes out, cash comes in. It would be pretty silly to try to calculate your ROI without including the cost of the investment!
"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?"
Who says they're not putting money back into the business?? What did IBM just shut down all their R&D labs or something? I must have missed the press release!<g>
"There are but so many shares to buy back. Once all available shares are purchased, then what does management do to increase shareholder value?:-) "
I'm pretty sure that the person holding on to that last share has found his investment to be quite satisfactory, to say the least!<g>
"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."
What's the gushing wound over at Coke?
"<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 "
Directly following this post, I'm going to post exerpts from MSFT's recent financial statements (I'll use fixed font so the table works). This will demonstrate that despite their very impressive investments for growth, a significant amount of cash did indeed slip through the cracks into the FCF column.<g> I know that they spent a lot of it on their options program (which is a bit of a drag) and their investments outside the core business (which hopefully will be worthwhile), but if their stock was really cheap, picking up a few million shares instead of Comcast would certainly have been a fine use of their cash.
"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."
This is absurd. You certainly can have it both ways, and there are literally hundreds of examples of fine, growing companies that don't consume all of their cash internally. Microsoft is an excellent example, in fact, as my next post will demonstrate.
Andrew |
