With the market at near-record highs and the Fed poised to hike interest rates, many investors are getting nervous about their stock holdings. Many, but not all.
Corporations, for example, continue to plow billions of dollars into stock buybacks. Why just last month, VMware announced plans to repurchaseanother $1 billion worth of its shares. This is on top of the $1 billion repurchase program announced last August.
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VMware made the announcement in conjunction with itsfourth quarterearningsreport. Investors were unimpressed with the muted guidance management provided for the current quarter and fiscal year, sending shares down 7% the day after the release. And this begs the question: Should VMware be buying back shares at all, let alone $1 billion worth?
Today, we'll find out, as we ask two basic questions:
Can VMware pay?No doubt it can. With more than $7 billion on its balance sheet, against only $1.5 billion in debt, VMware is in a good position to buy back shares. For that matter, according to data fromS&P Capital IQ, VMware generated more than $1.8 billion in positive free cash flow last year.
But should it pay?The simple fact that VMware has the money to buy back the shares, however, does not mean it should. If we look at the stock valuation -- even relative to its peers -- there is a good argument to be made that VMware is better off keeping its wallet closed:
Peer comparisons courtesy of Finviz.com.
Simply put, valuations in this sector look ... aggressive. They range from the merely optimistic 18-times trailing earnings for Cisco to the mind-blowing price investors are paying for Splunk. Somewhere in the middle sits VMware.
What this means for investorsBut the truth is that not one of these stocks meets the criteria laid down by master value investor John Neff, who counseled only investing in stocks whose "total return" ratios were significantly cheaper than that of the broader market (currently trading for 1.6). Neff calculated this ratio for each stock by summing its dividend yield and earnings growth rate, and dividing this into its P/E ratio. Generally speaking, results greater than 1.0 end up looking expensive and less than 1.0, cheap.
An investor guided by Neff's reasoning would therefore probably conclude that VMware should not buy back its shares, because its total return ratio of 2.4 is not cheaper than that of the broader market -- but actually about 50% more expensive. There is, however, a caveat to this conclusion.
Remember how I mentioned up above that VMware generated $1.8 billion infree cash flowlast year? Turns out, that is more than twice the "net income" that VMware reported under generally accepted accounting principles -- the "E" that goes into making its "P/E" ratio. What's more, because cash is something tangible, countable, and less subject to accounting quirks than GAAP earnings, I prefer valuing stocks on their free cash flow (P/FCF or EV/FCF) rather than on their P/E. And if you value VMware on free cash flow rather than GAAP earnings, the stock starts to look quite a bit cheaper.
In fact, if you give VMware credit both for its net cash ($5.5 billion)andits ongoing free cash flow ($1.8 billion), the stock'senterprise-value-to-free-cash-flow ratio is only about 15.9. Which when divided by 16.4% projected growth (and a zero dividend) is actually a bit below the 1.0 total return ratio that I target for my own investments.
Meaning, when viewed from one perspective at least, VMware just might be worth buying after all.
The article VMware Announces Yet Another $1 Billion Stock Buyback. Good News? originally appeared on Fool.com.
Fool contributorRich Smithdoes not own, nor is he short, any company named above.You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 302 out of more than 180,000 members.The Motley Fool recommends Cisco Systems, Splunk, and VMware. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.