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Author: yttire Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 46814  
Subject: Listening to free cash flow Date: 4/27/2005 12:11 AM
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So here is my problem:

I am looking at what I feel is an overvalued market. I am doing analysis of companies with PEG, with discounted cash flow from the future, with predictors of future market saturation. But I am wondering: where is the money?

If you are privy to the secret enclaves in which I post I compared PEG with discounted cash flow and decided they are roughly the same thing with a discount rate of 12% and a terminal growth rate of 3% with a 25 year integration.

Buy what exactly is this telling us? It is telling us that a company is making some cash, and then doing something with this cash to make more cash in the future. It is telling me that someone is handling that cash in the company, and I am pretending it is going into my pocket.

It isn't going into my pocket- it is going into the companies pocket. Why am I looking at money going into the companies pocket as if it were going into my own pocket?

I am thinking the reason is because I want to believe it is going into my wallet and not there wallet. Further, I want to believe that this free cash flow is equivalent to dividends. I want to believe that the money they are paying themselves is equivalent to money they are paying me.

They aren't.

For if I was looking at dividends and comparing them to other investments, on a pure dividend level, I would perform the exact same calculation as I do on the discounted cash flow. So why am I performing this calculation on the free cash flow as if it were a dividend? It is not a dividend.

I am pretending that money the company has is my money and it is not- it belongs to someone else.

Does this mean discounted free cash flow is useless? No, but I am thinking that it needs to be brought into alignment with dividend producing stocks, and further dividend producing stocks should be brought into alignment with each other.

What this means in my mind is that an investment needs to be considered as a dividend producing machine- and anything else is just pie in the sky, hoping that some cherry topping will fall on our head.

Since free cash flow is normally going into company growth- I think the correct thing to do would be to say: lets pretend this company begins to offer a dividend in five years- how big will it be, and what will this do to their expansion? This is the question to ask (or else the similar- if they were to be offering a dividend today, how big would it be and what would happen to their expansion?) Then we can compare dividend stocks against potentially dividend producing stocks.

Because face it- unless a company is producing dividends we are merely hoping someone will buy it for more than we bought it for, which is a nice dream, but the reality of an overvalued market may make this dream less than reality.

So why would one of our wonderful companies start producing a dividend when they are not now? One big reason- if the stock market crashed heavily- some companies will start issuing dividends to protect the bottom of the stock price, and because it will be in shareholders best interest. So the theory here is- lets pretend the stock market is going to crash heavily- lets pretend bond yields go up to 8-10 percent over the next 5 years. Now, how do our companies look once they are producing dividends? What has happened to their growth?

If they are kicking off 37% of free cash flow what does the dividend look like? (that would be extremely high, but it would give us an idea) What would be sacrificed here?

In other words- what is the company doing with their cash now which would be sacrificied to produce a dividend?

Anyway those are my thoughts roughly sketched out- I think dividend producing stocks should be compared, as much as possible, to non dividend producing stocks by equating free cash flow and company future prospects on the issuance of dividends.
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Author: WayneOwl Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 38113 of 46814
Subject: Re: Listening to free cash flow Date: 4/27/2005 9:13 AM
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So here is my problem

I have personally struggled for a long time about what companies should do with 'excess' cash and I have formed some conclusions that lead me to believe my trust should be in those who return as much of it to shareholders as is possible and prudent.

1. If it can use it to increase real earnings and book value that is fine with me.

2. Smart 'accretive' acquisitions without excessive 'goodwill' are okay especially if they can eliminate a major competitor and increase their pricing power.

3. Buying back shares is a con game designed to artificially support the share price and increase the value of insider options. It makes me wonder whether shareholders' interests are paramount as they should be.

4. Sitting on cash for no apparent purpose is a sign of hubris and means management thinks they are smarter than I am and that just because they cannot find a suitable investment then neither can I.

Pay me the money ( dividend ) and let me worry about my own tax ramifications. I don't think that is their job.

M2CW
Wayne







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Author: Jacko2 Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 38121 of 46814
Subject: Re: Listening to free cash flow Date: 4/27/2005 9:05 PM
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A lot of your questions in the post are answered (or, at least, discussed) in various investment writings.

John Burr Williams (1938, Theory of Investment Value) started (or, at least, was the first to write about it and have everyone quote him) the DCF calculation method (though not in the way we deal with it today). The main point is what "flavour" of cash is it that you're discounting. His answer was dividends, since that was an investor's "in your pocket" return. Valuing on the basis of dividends will certainly give you a conservative estimate of value. Play around with the Gordon Growth Model to understand that. Hussman has some weekly commentaries (www.hussman.net) applying this sort of analysis to the S&P500 (back in March, I think); on that analysis he came up with fair value at about 700 (maybe 750).

One trouble with that, though, is that many companies don't pay dividends, so how can you value them? Sure, you could guess as to when they're going to start paying dividends. But let's say it's back in 1995 or earlier: would anyone have guessed MSFT would have started paying dividends in 2004? and, as guess #2, the size of that dividend?

So then you have to move away from dividends to other "flavours" of cash: accrual eps; or some variation on "free cash".

The second part of answering your question has to do with the reason why companies retain cash. It was perhaps first written about in the mid or late 1920s (by Irving Fisher, if memory serves; I haven't seen the book) that businesses that retain earnings have the opportunity to compound those earnings.

There are a couple (at least) of points here. Both of them are exemplified by Warren Buffett and his holdings in Berkshire.

First point: By never selling his shares, and by not paying a dividend, Buffett has avoided having to pay personal taxes (on capital gains from the shares and the non-dividends) for (over) 40 years. So holding shares in a growing company that retains its earnings is equivalent to keeping your investments in some kinds of registered investment account. That lack of tax drag is a huge factor in compounding wealth. All investors need to fully "grok" (Robert Heinlein reference, for the non-science fiction readers in the crowd) compounding and its power: that 1 or 2% differences over long periods of time are hugely important. (This is why Bogle has been so intent on lowering management fees in mutual funds, another source of drag / friction.)

Second point: In the really good businesses (the "wonderful" businesses, in Buffett's terminology), the business management will be far better than you (us) at earning high returns on capital retained. Coke is perhaps the prime example. The point here is that it therefore makes economic sense to retain earnings instead of giving them to jacko2.

But then a third part of a response to your questions is the point made by Rob Arnott and someone else, in a paper they wrote a couple of years ago. Mauldin refers to their paper, as well. They compared growth rates of companies that pay dividends with companies that don't pay dividends. (You'll remember maybe three or four years ago that tech companies in particular were reluctant to start paying a dividend, not wanting to be seen as has-been companies. This paper came out in that context.) They found that companies that paid dividends actually performed better than non-dividend payers. They speculated as to why this was so. There were at least two points here:

1) Companies that hold on to money may create an "empire-building" mindset. In plainer language, they end up making investments that don't earn high returns on capital employed.

2) By having to pay a dividend (which has to be paid in real cash and not accounting fiction), management signals confidence in the future of the business.

Lastly, an article in this week's Economist magazine contains a graph showing how holdings of cash has been steadily increasing among large companies, compared to a few years ago. I've seen this written about a few times over the past year or so. Some say that there's hope that further dividend increases will come (and that seems to be what's happening with some of the S&P500 companies, if you can access their weekly "S&P Outlook" commentary). Other's say that it's a bad sign, that worthwhile opportunities aren't plentiful.

Cheers,

jacko2

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Author: WBuffettJr Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 38226 of 46814
Subject: Re: Listening to free cash flow Date: 5/5/2005 2:02 PM
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Hey yttire,

I believe you should view free cashflow largely in the same light as dividends because you are part owner of the company - therefore you have a claim on assets, including the cash. If you own 5% of the company, you are owner of 5% of the cash. It is in effect going to your wallet, it is just that the company is holding it for you. What's the difference? Sure they could pay it to you in a dividend, but then they would have less to grow the company next year, and you would have to pay additional taxes on it. If the company holds it for you, that tax is avoided and they can choose to reinvest it in the company (which you own) to make it bigger.

This is why as long as a company can see their stock price increase more than $1 for every dollar they keep in retained earnings (over years of course), I have no problem with a company keeping my dollar.

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Author: emiller8988 Big red star, 1000 posts Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 38227 of 46814
Subject: Re: Listening to free cash flow Date: 5/5/2005 6:52 PM
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Mr BuffettJR... your dad can keep my cash .... BUT... if you think a dollar in your pocket is worth as much as a dollar you are owed and might get... I've got a brother-in-law who wants to do business with you.

There is an ocean of difference between retained earnings and RETURNED EARNINGS and you need to remember that.

Warren Buffett is a manager of money... not business. For him to retain earnings is really for him to do the job you hired him to do... manage your money.

For Tome Seibel, one of the grossest abusers of ESO's I ever saw, to retain my earnings... for me to trust him to "do the right thing" with me money is lunacy.

free cashflow is a poor proxy for the thing that produces all value in equity... that is money returned to the shareholder. Money returned is the sole reason to own any business, be it a corner dry cleaner right up to MSFT.

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Author: WBuffettJr Big red star, 1000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 38243 of 46814
Subject: Re: Listening to free cash flow Date: 5/6/2005 9:49 AM
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BUT... if you think a dollar in your pocket is worth as much as a dollar you are owed and might get...

I think a dollar in my pocket is worth less than a dollar I keep in a bank account called Berkshire that is managed by Warren Buffett, because he can take advantage of many things afforded to him by his position to invest that dollar better than I can.

I don't see an ocean of difference between retained earnings and returned earnings. The dollar is mine either way. If I think the company can invest that dollar better, I prefer they keep it. If I think they can't, I prefer they return it to me. However, even in that situation that doesn't mean I necessarily want a dividend. The money can also be returned to shareholders with a stock buyback, which would allow me to avoid paying taxes on my dollar.

Warren Buffett is a manager of money... not business. For him to retain earnings is really for him to do the job you hired him to do... manage your money.

I strongly disagree with this. Nothing else should need to be said here.

For Tome Seibel, one of the grossest abusers of ESO's I ever saw, to retain my earnings... for me to trust him to "do the right thing" with me money is lunacy.

I don't find this to be a meaningful example. As I said, if I think the company can invest the dollar better than I can, I prefer they keep it. I don't know why someone would invest in a company with dishonest executives, but if they did, than it makes sense that they demand as much money as possible in the form of dividends because otherwise management will squander it. And if that is the case, then why settle for $0.10 per share? You should demand 100% of free cash flow be returned as dividends.

free cashflow is a poor proxy for the thing that produces all value in equity... that is money returned to the shareholder.

Perhaps I don't understand what is being said here, but free cash flow tells you how much money IS being earned by the shareholder, whether it is returned or temporarily held onto by the company.

Money returned is the sole reason to own any business, be it a corner dry cleaner right up to MSFT.

This is common sense, I'm not disputing that. What I am saying is that it doesn't make any difference whether the money is returned now or later, it has still been earned by you. If you company can invest it better, they should keep it and return it later, if not, it should be returned now.

And finally, I don't see why you would say my "dad" (Warren Buffett) can keep your cash but I cannot. He agrees with everything I have just said and has been saying it himself for 40 years.


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Author: afamiii Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 38271 of 46814
Subject: Re: Listening to free cash flow Date: 5/9/2005 2:04 PM
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I think we may just be talking about risk.

No doubt the only reason to own companies and company stock is for dividends. Dividends paid in this period, or dividends paid in the future.

Both dividends and cash flow have value, but cash flow has a higher degree of risk associated with it (many things can go wrong between the company making and retaining its cash flow and turning it into dividends for you at some point in the future).

Analysing the risk associated with cash flow goes back to basics of investing in companies;

@ Is the management honest and have they been rational in their capital allocation decisions?
@ Have they had (and are they likely to continue to have) high returns on shareholder funds?
@ Does the industry structure - levels of consolidation, barriers to entry, industry growth rate - suggest that competition will not erode margins in the future.
@ Does the company have unique intellectual capital - brand, innovation power, patents, etc. - that can support its ability to compete effectively without lowering marings.

In understanding the risk associated with the company, it becomes possible to decide on a reasonable discount rate for the cash flow, that compensates for the risk that the company is exposed to in holding onto this cash for you.

Afam

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