To begin with Andrew, your posts are too long for me to respond to in thier entirety. AS for the references to text book theory, I am probably one fo the most realistic investors I know of. That does not circumvent the fact that securities, inthe '90s are theoretical, ephemeral instruments based upon mathematical concepts. That is what they are, and they will not change because someone disagrees with the basis of thier valuation. That being said, let me tackle some of your post.
<I'll agree with you that the many companies who can't find attractive internal investments large enough to consume all of their cash are likely going to grow slower than identical companies who can. And the fastest growing companies have the fastest growing stock prices.>
Well then this should be the end of the debate, shouldn't it??? (jokingly serious:-)
<What troubles me is that how do you value a company that never "outputs" value. And let's step aside from all that risk-adjusted textbook talk. You claimed that the minute a company stops being able to find investments for *all* of it's cash, it ceases to have value to an investor. So how can it have value before that? It's just not intuitive.>
Ask Bill Gates how we value a company that never outputs value. Somehow, several financial institutions found a way to value him at about 32 billion dollars, without his stock paying a single dividend or coupon. The value is derived from discounted cash flows.
<What true value? In this scenario, they are recycling all of their money. You don't get any of it. What is the value of an ever-expanding cash recycling machine that never outputs cash? Why would you want to pay for one?>
Again, ask Bill Gates. Each share of any growth company is the equivalent of the markets perception of future cash flows discounted to the present value by the appropriately derived cost of capital. If that sounds too convuluted, let us use the most famous derivative in the world, the dollar bill circa 1973. The dollar bill "outputs" nothing to you or I, so why should you want one (or a billion for that matter)? The reason is becasue you are confident that the dollar bill is equivalent to the value of its underlying cash flows, which were pegged directly to the gold standard. If you hold a dollar bill in your had, money doesn't pop out, but it does have value. One should consider the discounted cash flows of a growth company to the underlying gold of a pre-1973 dollar bill.
<You maintain that MSFT recycles almost all of it's cash.>
No I don't.
<Well if so, that's not really "free" cash flow is it? They needed it to fund their growth. We can't have it. I think you want to stamp out FCF!<G>>
We are getting into a new area here. Can the average investor invest the dividend income that MSFT can generate at a higher rate than MSFT itself has historically invested it? If the answer is no, than astute management is absolutely correct in denying dividends, for they are more efficient at investing than thier shareholding constituency. The average market returns for the investor over the last 10 years are somewhere around 10-12% compounded. MSFT has averaged about 25-35% compounded. If you were an independant fiduciary of those monies, where would you put it. In a nutshell, it can be argued that companies that pay dividends beleive that thier shareholders can better invest that money than they can. I don't want to invest in managements with such beliefs. On the other hand, there are a plethora of mitigating circumstances that one must consider (such as market politics) that cause the aforementioned statement to be an oversimplification.
<Why must you insist that giving a bit of cash back to the shareholders indicates that there is exactly zero growth allowed in total corporate value. If you could admit that it's possible for a company to buy back shares and still grow as an entity, well I'd be very happy.>
Okay I admit it. Happy? On a serious note, you are making it sound like it is either or. I never made it out to be that way. I only said it is a red flag when a company tries to grow through accounting tricks rather than through the actual market in which it does business. A company can grow the business and buy back shares at the same time, but it is likely that thier prospects for corporate growth is much less likely than the company that decides it has better things to do with its free cash (or borrowed cash) than buy back stock (with the usual disclaimer concerning compensation plan funding).
<Isn't that the pot at the end of the rainbow? Isn't the whole REASON that you want Microsoft to compound larger is because it just means there'll be more cash to go around at the end? If there is no end, how is there value? Alternatively, if there is no value at the end, how is there value now? Your philosphy is based on an abstraction with discontinuities. It relies on "faith". It's the greater fool theory, just worded in terms of the capital asset pricing model. You have to have faith that in the future, more people will want to pay more money for no cash.>
It does not sound like you should be in the equity markets. All stocks in the US equity markets derive thier value from future cash flows and current assets. Since the future is not here yet, we are talking about assumptions, not actual realities. Once those cash flows become realities they are no longer factored into the stocks price unless they are kept as hard assets. The key word is "derived". If you are looking for cold, hard, guaranteed cash, you should be looking in a bank, and I don't mean bank shares:-)
<C'mon now, get your head out of that textbook! Read what you wrote there! If you made enough money to increase your buying power, you actually profit. Your required rate of return is based soley on how much you want to increase your spending power in a given period of time. If the stock is risky because you don't understand it, don't buy it at all! If you understand it well enough to decide with confidence what the worst case is, and pay a low enough price to profit even in that worse case, where's the risk?
You profit numerically, as in accuonting profit. But do you REALLY profit. Let assume you commit a crime carries an 80% chance of getting caught. The crime pays $20 dollars and the penalty for getting is 50 years in prison. If you commit the crime once and get away with it, you profit $20 (as you said, your spending power is increased by $20). But you see, that is not true economic profit. The reason is that a lot of people do not think that they would be truly compensated for the 50 year risk by a accouting profit of $20. If you commit this crime on a daily basis (like many investors in the market invest on a daily basis), there is a good chance you would be doing 50 years of hard time for less than $100. Now if we were to apply a risk adjusted reward to that crime (what would 50 years of your life be worth?), we could say the breakeven point of committing that crime would be $1,000,000,000. Now, the $20 dollar thief would somehow think he is being waaaaaaay overcompensated, while the economically astute thief feels that he is simply being adequately compensated for the risk that he is taking on a daily basis.
I hope that explains the difference between accounting profit and economic profit. I am from Brooklyn, so it is easy for me to relate in this fashion :-)
<A lot of what I said above will obviously make no sense to you.>
What you say does makes sense to me, but I don't agree with it because it leaves out so much reality, presumably because to include reality would be too complex. I am assuming, but since you took such liberty in assuming what I meant in my posts, I feel I am welcomed.
For instance, I have never seen you include any type of risk in your valuation methods, only rewards. The investment world consists of more than just rewards and free cash flow.
I do hope I am not turning you off by my abrupt and upfront style. If I am, just let me know, and I will stop.
Here is an excerpt form my competitor's site that you may find interesting:
Put most simply, EVA (economci Value Added) is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. As such, EVA is an estimate of true "economic" profit, or the amount by which earnings exceed or fall short of the required minimum rate of return investors could get by investing in other securities of comparable risk.
Profits the way shareholders count them
The capital charge is the most distinctive and important aspect of EVA. Under conventional accounting, most companies appear profitable. However, many actually are destroying shareholder wealth because the "profits" they earn are less than their full cost of capital. EVA corrects this error by explicitly recognizing that when managers employ capital they must pay for it, just as if it were a wage. By taking all capital costs into account, including the cost of equity, EVA shows the dollar amount of wealth a business has created or destroyed in each reporting period. In other words, EVA is profit the way shareholders define it. If the shareholders expect, say, a 10% return on their investment, they "make money" only to the extent that their share of after-tax operating profits exceeds 10% of equity capital. Everything before that is just building up to the minimum acceptable compensation for investing in a risky enterprise.
Aligning decisions with shareholder wealth
Stern Stewart & Co. developed EVA to help managers incorporate two basic principles of finance into their decision making. The first is that the primary financial objective of any company should be to maximize the wealth of its shareholders. The second is that the value of a company depends on the extent to which investors expect future profits to exceed or fall short of the cost of capital. By definition, a sustained increase in EVA will bring an increase in the market value of a company. This approach has proved effective in virtually all types of organizations, from emerging growth companies to turnarounds. This is because the level of EVA isn't what really matters. Current performance already is reflected in share prices. It is the continuous improvement in EVA that brings continuous increases in shareholder wealth.
I will point out the weaknesses in EVA, by using my own proprietary methods on my site sometime this week. I will be sure to let you know when I post it. I will probably use it to walk through a valuation of INTC, since I received requests for more on INTEL.
RCM
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