FCF... deducting total capex or maintenance capex?

[Tim Eriksen]

I would push back on the belief that an ideal company is growing AND throwing off FCF.

 

Option #1:

 

Company creates large amounts of cash flow that it can then reinvest into growth of the existing company or prudently allocate into related/unrelated companies via wholesale purchase or partial purchase on the public markets. In my opinion, this is the best kind of company.

 

Option #2:

 

Company creates large amounts of cash flow that cannot all be reinvested into growth of the existing company or prudently allocated into related/unrelated companies via wholesale purchase or partial purchase on the public markets. Then you have to decide what to do with the cash.

 

Share repurchases are good because there's no tax leakage, but then you have an issue as to how good those repurchases are based on the market prices versus the intrinsic value of a company. Is management good at that? If so, then you're maybe in the same category as Option #1.

 

Alternatively, you can distribute the cash to shareholders, but then the shareholders are forced to pay the dividends tax (unless it qualifies as a return of principal somehow) and you're left in a worse-off position than if you could have reinvested the money at a high reinvestment rate. Highly probable that this is worse than Option #1.

 

I hear this argument all the time but it seems flawed.  Option 2 is riskier than Option 1 because management may screw up the repurchases.  In other words management may not be good at valuing their own business which they know well and comparing it to the market price versus investing in their business.  Yet in option 1 you assume management can properly judge reinvestment into its own business but also acquisitions of businesses they do not know as well as their own.  That does not make sense to me.  How can they be better at valuing what they do not know than what they do know.

 

[merkhet]

I would push back on the belief that an ideal company is growing AND throwing off FCF.

 

Option #1:

 

Company creates large amounts of cash flow that it can then reinvest into growth of the existing company or prudently allocate into related/unrelated companies via wholesale purchase or partial purchase on the public markets. In my opinion, this is the best kind of company.

 

Option #2:

 

Company creates large amounts of cash flow that cannot all be reinvested into growth of the existing company or prudently allocated into related/unrelated companies via wholesale purchase or partial purchase on the public markets. Then you have to decide what to do with the cash.

 

Share repurchases are good because there's no tax leakage, but then you have an issue as to how good those repurchases are based on the market prices versus the intrinsic value of a company. Is management good at that? If so, then you're maybe in the same category as Option #1.

 

Alternatively, you can distribute the cash to shareholders, but then the shareholders are forced to pay the dividends tax (unless it qualifies as a return of principal somehow) and you're left in a worse-off position than if you could have reinvested the money at a high reinvestment rate. Highly probable that this is worse than Option #1.

 

I hear this argument all the time but it seems flawed.  Option 2 is riskier than Option 1 because management may screw up the repurchases.  In other words management may not be good at valuing their own business which they know well and comparing it to the market price versus investing in their business.  Yet in option 1 you assume management can properly judge reinvestment into its own business but also acquisitions of businesses they do not know as well as their own.  That does not make sense to me.  How can they be better at valuing what they do not know than what they do know.

 

 

Huh? Actually, I don't think that's what I said. I think you're conflating some things, so I'll try it again and see if I can make it clearer. Allow me to go backwards.

 

(The Option #2 management cannot be the same as the Option #1 management by definition... it's an either/or statement)

 

The top of the Pantheon is EITHER the ability to soak up all your free cash into reinvestment to the existing business OR the ability to reallocate cash flows not able to be soaked up by reinvestment to the existing business into unrelated companies via wholesale purchase or partial purchase on the public market.

 

There's no requirement that management can properly judge reinvestment into its own business AND also acquisitions of businesses that they do not know as well as their own. Some CEOs can do this and some cannot. The ones that can understand their own business well but do not have reinvestment avenues and do not fare well investing in other unrelated businesses fall out of Option #1 and fall into Option #2.

 

(e.g. I'm not assuming that management is good at reinvestment and purchasing unrelated businesses but terrible at valuing its own company. I AM, however, saying that some managements can be good at reinvestment into their own companies operationally and yet terrible at figuring out when to repurchase their own shares.)

 

As for whether management is good at evaluating the correct price for its own businesses, I offer you the following statement for which I suspect that I could find proof of but have not done so: "Many managements are notoriously terrible at timing their repurchases so that they are accretive to the remaining shareholders." It would seem that Leon Cooperman and Warren Buffet agree...

 

http://www.businessinsider.com/warren-buffett-letter-to-leon-cooperman-2015-7

 

...though I suppose that's not dispositive, since all the people they say are bad at repurchasing their own shares could also be terrible operationally at internal reinvestment. (Though I suspect that's too strong a statement.)

 

Was that clearer or just more confusing?

[Tim Eriksen]

Okay.  I get what you are saying now that you clarified it.  I just don't agree with it. 

[merkhet]

Okay.  I get what you are saying now that you clarified it.  I just don't agree with it.

 

Which part? I'm curious.

[CorpRaider]

I think he's just saying some bidnesses generate cash but have reinvestment opportunities to deploy said cash at attractive returns.  Others dont and management can return it or invest it in other lines of bidness a-la brk.  If most managers are not so great at valuing their own shares/bidness, it makes one positively queasy at the prospect of the empire builder, raining shareholders capital all up in the club with his advisors and their pitch books.  Ceo will probably be treated like a big honking deal though.

 

Good point though merkhet about why fcf isn't generally computed so as to penalize those wonderful bidnesses that actually have reinvestment opportunities.  Of course as we all know the rubber meets the road in determining what is actually sustaining cap ex versus green fields

[Tim Eriksen]

Okay.  I get what you are saying now that you clarified it.  I just don't agree with it.

 

Which part? I'm curious.

 

I disagree with your rankings/distinctions.  Why include acquisitions or partial purchases (security investments)?  Outside of insurance, and Malone controlled entities, it is very rare that allocating funds to partial purchases in the public markets makes sense.  It suffers from double taxation while repurchases has no taxation. 

 

It seems to me Group 1 (more accurate term than Option) can reinvest all FCF back into the business at very high rates of return.  Group 2 cannot and decides what to do with the FCF between various options -  dividends, dept repayment, repurchases, acquisitions. 

[merkhet]

Ah, gotcha. I basically separated between Group #1 and Group #2 based on the fact that Group #1 had reinvestment opportunities and Group #2 did not. (The distinction between (2) & (3) below may be artificial though because some might view repurchase as a reinvestment opportunity whereas I view it as a return of capital opportunity.)

 

A more granular separation would probably be as follows:

 

(1) Internal reinvestment

(2) External reinvestment

(3) Share repurchase at accretive prices

(4) Dividends

 

I think I would still rank external reinvestment over share repurchase because at any given time, there are multiple external reinvestment opportunities and only one "share repurchase opportunity" -- though I see your point.

 

My thought is that there can be a number of external investments that might make sense even accounting for the extra level of taxation when your stock isn't trading at enough of a discount to intrinsic value to merit a repurchase. (i.e. you can get a 20% CAGR on an external investment and repurchasing would only earn you a 10% CAGR) And, of course, waiting around for your stock to trade at a discount would involve opportunity cost, etc.

 

Basically, at any given time, there may or may not be a discount to the intrinsic value of your own company, but most of the time, there is going to be a cheap industry/company out there somewhere that could possible overcome the additional tax hurdle.

[ni-co]

Can we agree that after-tax ROI to shareholders is what counts?

 

I'd simplify your separation, merkhet. In the end, there are really only three options:

 

(1) Internal reinvestment

(2) External reinvestment

(3) Giving capital back to shareholders

 

Good capital allocators choose between those three options and pick the one with the highest ROI.

 

Whether you invest into (1) internal growth opportunities (acquisition of new customers etc.) or (2) external growth opportunities (M&A): management that isn't able to correctly value and choose between those two investment options is bad at allocating capital and should keep its feet still in the M&A space. However, free cash should always be distributed to shareholders when there is no good investment opportunity (meaning the anticipated ROIs of (1) and (2) are below expected market averages).

 

Keep in mind that there is not a huge* difference between, on the one hand, buying back shares at any price and shareholders simultaneously selling an equivalent part of their holdings (in order to re-dilute their stakes), and, on the other hand, paying out dividends. Buy-backs and dividends are two sides of the same coin (= distributing capital to shareholders). Therefore, share buy-backs are probably* always the preferred choice compared to dividends because shareholders are able to decide whether to take the cash (by selling shares) or reinvest it tax free into the company (by not selling shares).

 

There is one case that causes all the confusion about buy-backs: Only in the one case that the share price is so low that investing into the company's own shares promises far higher ROIs than internal or external reinvestment – and only then – the company should prefer buy-backs to investing into options (1) or (2), even if they promise to deliver above market ROIs. This case is very rare and hard to recognize for most management teams. It's mostly true in bear markets or when companies are continuously misunderstood by the market (as e.g. the Liberty family is, in my opinion).

 

 

--

 

* This is of course depend on (i) how capital gains are taxed compared to dividends and (ii) how large your accumulated capital gains are. But as long as dividends and capital gains are treated equally, selling shares will be better or equal from a tax perspective. This is because 100% of your dividend will be taxed in any case while your share sales will only taxed in the amount of your capital gains. Only in the event that you acquired those shares at zero cost, your sales will be taxed at the full 100% of the market price of the shares sold. You can reduce this to: Selling shares is always preferable to receiving a dividend.

[SharperDingaan]

To most folks FCF is either EBITDA – maintenance capex; or cash flow from operations + cash flow from investment – cash flow from financing. The application, dictates which way you go.

 

A rapidly growing company (.com, start-up, serial acquisitor) is relying on ongoing cash flow from financing to cover the cash drain from operations and investment; EBITDA is usually negative as well. You are allocating capital based solely on hype and projection. Hire a good piano player, and you can do very well.

 

An established company has a sizeable EBITDA, at least a 5 year EBITDA track record, and multiple product lines at different stages in their product life-cycle. To get to FCF most folks would simply average the EBITDA & subtract the average maintenance capex. Because it is a 5 year average, it also eliminates much of the change attributable to business cycles. The bigger the average EBITDA, the better it works.

 

The approaches are just opposite sides of the same value coin.

 

SD