Every market participant is looking to make a return. The reason you invest your hard earned cash today, is to get (preferably more) cash from the investment sometime in the future. This is completely normal behavior. In markets, there are a gazillion participants with different motives, timeframes and mindsets. These participants can collectively be referred to as Mr. Market. As we know, this fellow’s opinion on stocks is largely earnings (and crowd) driven. But earnings and cash flow are not the same thing. More specifically, free cash flow.
What is a Company Worth?
Quick answer: The value of any asset (including a stock) is the present value of future cash flows, discounted at an appropriate rate.
Since we don’t own the entire company when we buy a stock, why do we need to think in terms of what the whole business is worth? Because a stock is just a piece ownership of a business. If I buy a pizza for 10€, split it in four slices, each slice is worth 2,5€. Once you figured out what the entire pizza (company) is worth, all you have to do is divide that figure by the number of shares outstanding, and you will get your per-share value of the company.
So if my valuation of a company is correct, how will this show in my returns? If you are correct on the future (and realized) free cash flows the company generates, this will be reflected in the stock price in the long-run. However, in the short-term, wild swings will occur due to shifting investor confidence in the future outlook of the business. These shifts are what creates the opportunities to buy something for less than its worth. The logic is so simple, and yet so few behave in a rational manner and take advantage of these swings.
So what is this discount rate mentioned earlier? And what does “discounted at an appropriate rate” really mean?
The logic is that a dollar (or any currency) is worth less today than tomorrow due to inflation. Having a discount rate in our estimates of future cash flows takes this into account. The question of what’s an appropriate rate is in my opinion made more scientific than what it ought to be. The easiest way to think about a discount rate is in terms of opportunity cost. i.e. What rate of return am I giving up on some other investment instead of the one I have on my mind?
If you believe the opportunity cost is to put your money into a general market index, and you believe the index will compound between 7-10% per year, then you’ll use 7%, 8%, 9% or 10% as your discount rate. You really shouldn’t think too much about the exact discount rate because you should be focusing on those rare opportunities that are “screaming buys” to you.
A Focus on Free Cash Flow Removes Headaches
Price-to-earnings or price-to-book ratios will not on their own tell you if a stock is cheap or expensive. If there are wild swings in earnings-per-share, how are you to make an intelligent conclusion on what the company can earn in the future, and thus determine its intrinsic value? We need an estimate of intrinsic value in order to know if we’re getting a good deal or not.
In order to make an honest assessment of intrinsic value, we need to focus on free cash flow. This is the actual money that is left in the company’s pockets, after accounting for expenses. You’ll get this number from the cash flow statement by subtracting the line item “Property, Plant & Equipment” from “Cash Flow From Operating Activities”.
You’ll be on the safer side in your estimates of future free cash flows when you read plenty of annual reports from a company’s past. The past annual reports build a “story” on why and how a company is where it is today. The “story” should also give insight into management, to see if they have a long-term view and owner-mindset.
Conclusion: Rampant Speculation Forgets Free Cash Flows
During speculative times either in markets or individual companies, the “story” takes the front seat over fundaments. This is what gets people in trouble. There is only so much “story” that will drive a company in the long-run. At some point, the firm will have to produce cash flows to justify its lofty valuation. Even if the story is spectacular, remember, a great business does not mean a great investment! Peter Lynch is very quotable when he stated:
“Buying an overpriced stock in a wonderful company is truly a tragedy. The company did marvelously, but you didn’t make any money.”
I am not telling you to ignore earnings completely. They do play a part. But I have found that some of my biggest mistakes have come from trying to re-invent the wheel with valuation. Yes, an EV/EBIT based valuation may be a great approach, but from my experience, the most reliable estimates of intrinsic value boils down to free cash flows. Interestingly enough, when I’ve made valuations based on free cash flows, I’ve had my biggest successes. I think I know the path that works for me. As Mohnish Pabrai would say, there are “many paths to nirvana”. Whatever you choose as your measure for intrinsic value, by all means continue doing it, so long as it works for you.
“The reality is that Mr. Market knows nothing, being the product of the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals. Emotional investors and speculators inevitably lose money; investors who take advantage of Mr. Market’s periodic irrationality, by contrast, have a good chance of enjoying long-term investment success.” – Seth Klarman
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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