This article is the third in an introductory series on value investing that was first published in 2006 and went on to become the core of our book Value: The Intelligent Investor's Guide to finding hidden gems on the sharemarket.
See also: 1. The essence of value investing; 2. What price a margin of safety?; 4. Value investing, via Don Bradman; 5. The beauty of book value; 6. Putting a price to earnings; 7. The delights of dividends.
When you buy a stock, you’re buying a small part of a business. That means you’re entitled to receive a portion of the profit that business may make at some stage in the future. Establishing the value of a stock depends on working out what that figure might be.
Now, the value of an amount of money depends on when you receive it. This principle is known as the 'time value of money', and we can flesh it out with an example.
Let’s assume that all money earns interest at 8 per cent a year (if only) and costs the same to borrow (perhaps a little high with interest rates so low now, but bear with me). On that basis, if I have $100 now, what will it be worth in 10 years' time?
The answer is: 100 x 1.08^10 = $215.89 (where ^ means 'to the power of').
Now, if someone offered you $215.89 in 10 years' time, how much would you pay them now for it? To answer that, consider this: the money you pay now is either money that won't be earning interest for you at 8 per cent a year for the next 10 years, or it's money that you've borrowed and on which you must pay interest at 8 per cent for the next 10 years.
Either way, paying out money now costs you 8 per cent a year until you get it back. So, to buy a cash flow of $215.89 in 10 years' time, you'd pay up to $100 because, if you'd kept the $100 (or not borrowed it), you'd have turned it into $215.89 over 10 years (or saved yourself that amount).
By answering the question, you’ve performed what is called a 'discounted cash flow' calculation. Apologies for the jargon, but unfortunately there’s no avoiding it. It's the mainstay of what analysts do.
So the $215.89 in 10 years' time has a current value of $100. If you paid more than that you'd make a loss; if you paid less, you'd make a profit; and if you paid a lot less, then you'd make a really good profit. That last bit? Well, that's value investing.
Why 8 per cent, though? Good question. It was nothing more than a stab in the dark really. People will argue until the cows come home about the right figure to use. Essentially, it should represent the 'opportunity cost of capital' which, in plain English, is what you might otherwise plan on doing with the money.
So if you would otherwise have put it into a term deposit paying 3 per cent, you'd use 3 per cent. If you might have put it to work in an exciting business venture on which you expected to make 15 per cent a year, then you might use that as your figure (although anticipating a return of more than 10 per cent is pretty optimistic by most standards, and especially now).
Of course, most stocks generate multiple cash flows, so to get the total value you have to work out the value of each individual cash flow and then sum them all up.
The principle is the same if instead you assume growing cash flows: all cash flows have a value according to when they are going to be received and the 'opportunity cost' (otherwise known as the 'discount rate') you ascribe to them. To get the value of a set of cash flows, you just add up the values of the individual components.
Theory and practice
That’s the theory, at least. But as the late Yogi Berra – catcher for the New York Yankees – said: “In theory there is no difference between theory and practice. In practice there is”.
In fact, Warren Buffett preaches that the value of any business is the sum of its discounted cash flows. However, Charlie Munger, his partner in Berkshire Hathaway, notes that “Warren often talks about these discounted cash flow [calculations], but I’ve never seen him do one. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea.”
In other words, you don’t really need to perform a complicated discounted cash flow calculation if you believe a stock has a big enough margin of safety.
Happily, there are a variety of shortcuts we can use to work out whether this is the case, and we’ll discuss them in upcoming blogs.