Post #2130, with the same name as this post, was pulled by MF because I used part of one of their copyrighted articles. They said it would be okay if I wrote it in my own words. So here it is.
Saul
This is another a nice way to evaluate companies for investment. Using this method, the first step is to look at Cash Flow. You want to make sure the company is self-sustaining, producing positive Free Cash Flow, and not eating away at its Cash Balance. You’d also like to see Free Cash Flow as a percent of Revenue (Free Cash Flow Margin.) grow from year to year
The second step is to see if Revenue is growing year over year, and whether operating expenses grow at a slower rate so that Operating Margins. can increase as revenue expands.
Third is to make sure that the share count is not increasing unreasonably fast.
Our fourth step is to take the market cap (stock price by total number of shares) and divide it by Free Cash Flow to get the Free Cash Flow multiple… It’s actually a P/FCF ratio instead of a P/E ratio, and rational ratios should also be somewhere in the 20’s or so, depending on rate of growth…
Fifth is to check levels of cash and debt.
Sixth the consensus earnings estimates and rate of growth. This could be deceptive as companies often low-ball their estimates, and analysts go along.
Seventh, look at the 10K to evaluate the business, its competitors and its risks.
Finally read the last couple of conference call transcripts to see how management feels about the business now and in the future.
Saul; thank you. this is very useful. I have been doing something similarly in evaluating my investment but not very consistently. After reading #2130, I made a template and added all the measurements listed #2130, and I added a few other measures as well such as insider ownership,
management/glassdoor rating, R&D spending, competitive position, addressable market size. When I study a new investment, I just copy the template and fill the blanks. Of course it has a comment section for me to add whatever I want.
Third is to make sure that the share count is not increasing unreasonably fast.
Saul and everyone,
As I understand it, the share count can be increased through additional stock offerings, presumably to raise additional cash, stock splits, and stock/option grants to employees. Are there other ways?
Also, what are your thoughts on “unreasonably fast”? I recognize that increasing the share count is common, but what is a reasonable rate of increase and why?
As I understand it, the share count can be increased through additional stock offerings, presumably to raise additional cash, stock splits, and stock/option grants to employees. Are there other ways?
Also, what are your thoughts on “unreasonably fast”? I recognize that increasing the share count is common, but what is a reasonable rate of increase and why?
Thank you, Chris
Chris, first of all stock splits don’t count. They don’t dilute your holdings at all. they just divide the pie into smaller pieces but you still own the same percent of the total pie. Stock offerings and stock/option grants, as you suggested are the ways that you get diluted.
I’ll just talk off the top of my head here, but a tech company growing revenue at 50%, may dilute even 8-10% per year, but I certainly wouldn’t like it. A company growing sales at 5% a year shouldn’t be diluting at all.
With a stock offering, at least the company is getting cash, that they can use wisely, you hope, to grow the business. With stock options they are just giving it away, although sometimes it is necessary to attract and hold employees in the fast growing tech world.
How’s that? I’d like to hear other people’s opinions too.
I’ll just talk off the top of my head here, but a tech company growing revenue at 50%, may dilute even 8-10% per year, but I certainly wouldn’t like it. A company growing sales at 5% a year shouldn’t be diluting at all.
With a stock offering, at least the company is getting cash, that they can use wisely, you hope, to grow the business. With stock options they are just giving it away, although sometimes it is necessary to attract and hold employees in the fast growing tech world.
How’s that? I’d like to hear other people’s opinions too.
For fast growing tech companies where employee retention is important, a 3% annual dilution from stock options, or on that order, is reasonable.
I own a bit of Z (100 shares) and like you, wanted to expand my position but it won’t stop going up and it is now in the category of Momentum stock. With the market rather pricey and Z more pricey I intend to watch and wait for a decent pullback and then, depending upon the size of the pullback either double or triple my position, or double and then sell a high premium put to buy more while it has pullbacked.
If the market was not at the heights it is, I’d probably be tempted to nibble, as Saul says, but I think it is high.
Let’s hear from Saul and I reserve the right to be wrong on this but I’m getting nervous that all this nice appreciation may come tumbling down soon and I want to make sure I have some cash to buy. I’ve been lightening at a profit or break even for non-movers, in order to build up a war chest, slowly.
Mykie
PS this is given in the spirit ofas what one guy is doing and not as advice at all.
How’s that? I’d like to hear other people’s opinions too.
I’d also like to hear if “diluted” and “fully diluted” mean the same thing and if not, what is the difference.
It seems to me that diluting is a necessary evil for fast growing companies, (depending upon their stage of development and what they do with the money received) and a hidden expense for mature companies and should be kept under a certain percentage.
Someone else chipping in here would be great. I’m just trying to be responsive.
With stock options they are just giving it away, although sometimes it is necessary to attract and hold employees in the fast growing tech world.
I personally think that compensating employees with stock options is a huge boon for us as investors. It greatly reduces the amount of cash the company needs to burn relative to the talent it can employ, it better aligns employees with shareholders, and it provides a reason for top talent (who are constantly being head-hunted) to stick around so that their options will vest.
Without the use of options, most young companies couldn’t afford top talent. In fact, Ubiquity has spoken to this directly, and now tries to hire engineering talent from other parts of the world so it doesn’t have to compete for it in silicon valley.
For example, numerous studies have been done on the productivity of software engineers, and it’s been confirmed multiple times that a top engineer can be 10 times more productive than a mediocre engineer. That’s a massive difference, especially once you consider all of the other side-benefits of having fewer people for the same level of productivity (less management, less office space, less equipment, less supporting staff, easier communication, better camaraderie, etc). According to U.S. News and World Report, the average salary for a software developer is $93,280 and the lowest paid is $55,190, so that means a top software engineer is worth between $550,000 - $930,000 per year. But instead of paying ten times, companies get away with paying double or triple and granting a lot of stock options. That’s a huge boon for the company.
So assuming management is doing its job and hiring and then utilizing the best people, you should feel good every time you see those options grants knowing that you’re getting a bargain on your employees’ salaries and that their interests have become largely aligned with yours.
I personally think that compensating employees with stock options is a huge boon for us as investors. It greatly reduces the amount of cash the company needs to burn relative to the talent it can employ, it better aligns employees with shareholders, and it provides a reason for top talent (who are constantly being head-hunted) to stick around so that their options will vest.
Hi Neil, I agree with all your points. I was just responding to the following question, and trying to distinguish between the effects of a stock offering and a stock grants.
As I understand it, the share count can be increased through additional stock offerings, presumably to raise additional cash, stock splits, and stock/option grants to employees. Are there other ways?
This was my response. I didn’t respond that differently from you, except that I guess I was a bit harsh in saying they are just giving it away.
First of all, stock splits don’t count. They don’t dilute your holdings at all. They just divide the pie into smaller pieces but you still own the same percent of the total pie. Stock offerings and stock/option grants, as you suggested are the ways that you get diluted….With a stock offering, at least the company is getting cash, that they can use wisely, you hope, to grow the business. With stock options they are just giving it away, although sometimes it is necessary to attract and hold employees in the fast growing tech world.
By the way, some companies do get carried away and give away stock options without caring a wit for the stockholders. Those I don’t appreciate and usually won’t invest in.
Best
Saul
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