Archive for Sunday, October 5, 2003

Motley fool

October 5, 2003

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Last week's answer

My roots go back to the early 1900s and the Computing-Tabulating-Recording Co. (C-T-R), which made everything from cheese slicers to census tabulators and punched cards. Today I'm the world's largest information technology company, raking in more than $80 billion in sales and $5 billion in net profits annually. In 2002, Business Week ranked my brand as the world's third most valuable, after Coca-Cola and Microsoft. I employ more than 300,000 people and have more than 600,000 stockholders. I was one of the first companies to offer my employees life insurance and paid vacations. Who am I? (Answer: IBM)

Know the answer to last week's question? Send it to us with Foolish Trivia on the top and you'll be entered into a drawing for a nifty prize! The address is Motley Fool, Box 19529, Alexandria, Va. 22320-0529. Send questions for Ask the Fool, Dumbest (or Smartest) Investments (up to 100 words), and your Trivia entries to Fool@fool.com.

What causes mortgage rates to rise and fall? -- D.B., Anderson, Ind.

Interest rates are affected chiefly by inflation and the market for debt (notes, bills and bonds, among other instruments). With inflation extremely low in recent years, we've enjoyed low interest rates. But when the economy appears to be growing too briskly, which can spur inflation, Alan Greenspan's Federal Reserve may hike short-term interest rates via the "federal funds" rate. That's the rate a bank can charge another bank for use of its excess money. When the economy is sluggish, it might cut rates in order to give American enterprise a boost. Lower rates give companies and people (including home-shoppers) an incentive to borrow money.

The Fed can also change the "discount rate" -- the rate paid by a bank to borrow short-term funds from the Fed. The prime rate and other interest rates (such as mortgage rates) are based primarily on these two interest rates. The money markets themselves (basic supply and demand for money) also exert great influence over interest rates.

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One newsletter we like is Outstanding Investor Digest. It's pricey at $295 per year, but it runs rare transcripts of talks by investing giants such as Warren Buffett who might offer you ideas that pay for the subscription. Read more about it at www.oid.com or call 1-800-869-2420 for more information. We at the Fool have recently launched a few newsletters, too. Check them out at www.FoolMart.com.

Stock buybacks

Companies frequently announce they're buying back some of their shares. Since they typically do so on the open market, they don't buy your shares, unless you happen to be selling them.

A buyback will likely have a small upward effect on the stock price -- because it means there's more demand for the shares out there. Generally, the more shares a company buys and essentially retires, the better off you, the shareholder, are. As a very extreme example, imagine that Meteorite Insurance Inc. (ticker: HEDSUP) has just 100 shares outstanding, and you own 25 of them. That means you own 25 percent of the company. If the company buys back 50 of its own shares, then there will only be 50 shares outstanding. You'll still own your 25 shares, though, so you now own 50 percent of the company.

The more shares that are bought back, the greater your share becomes of a company's earnings. If Meteorite Insurance earned $100 in income, that would be $1 EPS (earnings per share), pre-buyback. After the buyback, though, the firm would still have the same earnings, but those earnings would be spread over just 50 shares -- so the EPS would go up to $2. The price-to-earnings ratio, based partly on EPS, would fall, and each share potentially would be worth more.

If you've ever thought that a company should use available funds to pay shareholders cash dividends instead of buying back shares, think again. Remember that when a company earns income, it pays taxes on that. Then it pays out any dividend to you, the shareholder. And you get taxed on that. So that income is taxed twice -- hardly very efficient. By buying back shares, the company is still rewarding shareholders by making existing shares more valuable, but it's doing so in a way that does not trigger taxable events for shareholders.

Microsoft doubles down

Microsoft (Nasdaq: MSFT) surprised many early this year by announcing its first dividend in history. It has now raised its yearly payout from $0.08 per share to $0.16. That's still modest, with shareholders buying today getting a yield well below 1 percent, but it may well increase significantly in the future.

With 10.8 billion shares outstanding, Microsoft's dividend will cost $1.7 billion annually. That's a small portion of the company's $13 billion in annual free cash flow, not to mention its $49 billion in cash and equivalents, which grows by leaps in interest alone.

If Microsoft has a weakness, it's that it can't find a business that equals or betters its world-dominating software. Any new business venture it takes on (MSN, MSNBC, gaming consoles, keyboard sales, etc.), should it ever grow large enough, would only lower the company's stellar returns on investment. This leaves Microsoft with an enormous, growing pile of cash and few truly exceptional ways to invest it.

The company recently said it would add up to 5,000 jobs (it currently employs about 55,000) in fiscal 2004 and increase spending by $6.9 billion.

Microsoft's shares are among the least expensive in the nation's 20 most widely held stocks. At $28 per share, the company trades at a forward price-to-earnings ratio of 24. There have been much worse times to buy the stock, and there may not have been many better times (in terms of value) since about 1998.

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