Last month, I pointed out what I thought was an amazing statistic: Hewlett-Packard (NYS: HPQ) shares were so cheap that, based on average share buybacks over the last three years, the company would repurchase its entire market cap within the next decade. It didn't need to grow earnings. Ever. Just carry on, slow and steady. At well under 10 times earnings, repurchasing shares was likely a good use of capital that would treat shareholders well.

You know what happened next. The urge to do something dumb.

After offering to buy U.K. software company Autonomy for $10 billion in cash, HP management signaled in a conference call that share repurchase plans would effectively be canned for the near future. Buying Autonomy is a better use of its capital, it reckons.

The problem: HP purchased Autonomy for more than 25 times earnings before interest, taxes, and depreciation (EBITDA). With HP's stock now trading at less than three times EBITDA, the opportunity cost of the cash used to fund that acquisition is massive. Taking a look at the bottom line, management is essentially bypassing purchasing shares of a company trading at about six times earnings (its own) for one trading at 50 times earnings. Value investor Vitaliy Katsenelson elaborated in a recent blog post (emphasis mine):

"There are many ways to illustrate how expensive and meaningless to HP's future this acquisition is: $10 billion is about a fifth of HP's market capitalization, while [Autonomy] will contribute 0.7% to HP's revenues, and 2.7% to its earnings; and HP paid 10x revenues and about 25 times earnings. ...

"Any investment HP makes today should be compared against an opportunity set that includes its own stock, which at 6x times earnings results in about a 16% yield (cost of capital). In fact, if HP used $10 billion to buy its own stock, its earnings per share and dividend would jump by 16%. Autonomy will not be able to match this return, by a long mile."

Technology is a fickle industry. Management feels pressure to do something big. But milking the cash flow of a slow-growing business is preferable to squandering it in the name of change. Other tech companies such as Microsoft (NAS: MSFT) , Cisco (NAS: CSCO) , and even Google (NAS: GOOG) and Apple (NAS: AAPL) , have massive cash hoards they'll eventually be tempted to use. Some execute far better than others, but history makes it clear that when it comes to maximizing shareholder value, dividends are great, buybacks are good, and large acquisitions done at large premiums are regularly horrendous. That goes for all companies, in fact.

Vitaliy concludes: "HP's stock sold off not because the company disappointed Wall Street but because Wall Street grew tired of the overpriced 'must-have' acquisitions."

Fool contributor Morgan Housel owns shares of Microsoft. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Microsoft, Google, and Apple. The Fool owns shares of and has created a bull call spread position on Cisco Systems. Motley Fool newsletter services have recommended buying shares of Cisco Systems, Google, Apple, and Microsoft. Motley Fool newsletter services have recommended creating a bull call spread position in Microsoft. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. 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.

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Gumby

Is Intel preventing AMD from being taken over??

August 29 2011 at 3:38 PM Report abuse rate up rate down Reply
Gumby

HP can and should buy AMD !!! AMD doesnt need as much spending on reserach and development as Intel as AMD will stay small but still capable of matching Intel toe to toe , almost... What a fantastic value in AMD even at $20 billon takeover!! or higher.. AMD IS MONEY MAKER !! AND AMD only need a little more to spend and it will be super!!

August 29 2011 at 3:38 PM Report abuse rate up rate down Reply
Gumby

I am frankly puzzled at why nobody still wants to buy AMD ????? AMD is a mini-Intel.... what more can you ask for? AMD is worth $20 billon or higher despite its earnings... AMD already has extensive fabless capacity that almost match Intel's own... AMD can churn out far more chips especially if and when its Fusion chips finally catch on fire! Why nobody is so excited about its Fusion technology boggles my mind even worse!!! Fusion chips conserve energy while keeping top notch powerful graphics performance inside the chip.. Intel has similiar but far inferior graphics inside its chips... AMD offers value chips that should be flying off the shelves by now! Seems that nobody really understand Radeon 6XXX performance found inside Fusion chips... Intel has equivalent to Radeon 1XXX or so... which is a total rip off to consumers!! You can buy a whole AMD motherboard with top notch Fusion chip for around $300 that you would have to spend double that with discrete graphics cards.. AMD is a bargain or a giveaway... nobody is takiing it... Bizarre1!

August 29 2011 at 3:36 PM Report abuse rate up rate down Reply