At its best, a company is a money machine. Put money in one end and more should come out the other end in profit. The best companies even reinvest their profits and cash flows in ways that compound their returns and shareholder value.
Calculate the present value of future net income streams, adjust for taxes, risks, interest rates (cost of capital) and you should more or less have a value of the company. Divide that value by the number of shares of stock and you should have an approximate value per share.
Worth More than Gold!
A consistently profitable and growing company is worth more than gold! That is because it is an income producing asset. In contrast, gold, silver bitcoin and even most real estate investments do not generate income. They provide no future income stream to pull forward to the present day (present value). Those classes of assets are based on the idea that there will be someone in the future, perhaps a wiser sage or greater fool, open to paying more than you did.
In fact, the S&P 500 index of “income producing assets” has far exceeded the appreciation of gold. Companies like Apple, Amazon, Intel and Microsoft have fueled our economy and created trillions in value since their inception. They are in every sense of the term, ”money machines”.
On the other hand, once great companies like Kodak and Blockbuster have lost billions in value since their peaks. They are examples of “money machines” that became “money pits”. You might say that timing is everything.
A stock is valued on where it is going…not where it has been. And this can be perplexing and counter-intuitive. Past performance can be seen as an indicator of future performance, but trending is only one way to predict future value. For instance, a pharmaceutical company might lose 98% of a drug’s revenue when their patent expires next year. Future sales and profits can fluctuate due to a number of factors including competition, management, innovation and market forces.
Perception versus Reality
A stock price is a perception of the value of a company’s future earnings…not necessarily its true value. It is a magnetic north versus true north. You would need a time machine to know that. And that price is determined by those buying and selling a particular stock on a particular day. By the way, you could do a retrospective analysis of a company for a prior timeframe and see what value was actually created.
Most buyers are betting that a stock price will go up. And most sellers…especially short sellers are betting the stock will go down. But few are focused on the actual value stream the company is creating…probably because that takes time, energy and insight. And therein lies the opportunity.
Over $600 Billion in Shareholder Value!
In 56 years as CEO of Berkshire Hathaway, Warren Buffett has helped to create over $600 billion in shareholder value and delivered an average annual return for investors of 20%. Berkshire shares have significantly outperformed the S&P 500 which has seen a 10.2% gain during that same period.
Value Investing
Value investing is a strategy. And it is mostly the one Warren Buffet employs. . A value investor is someone that searches the market for opportunities that may be undervalued. In other words, where the predicted value of the company is greater than what the company is trading at the moment. Value investing was pioneered by Benjamin Graham who wrote “The Intelligent Investor” and made legendary by his protegee Warren Buffet and partner Charlie Munger.
Here is the strategy in a Nutshell
- Value a company independent of the stock market. Let’s pretend for a moment that there is no market and look at the value a company is creating. How much would you pay for the company…if there was no market price to guide you?
- Figure out if the company is trading at a substantial discount to its predicted price. Graham recommended opportunities trading at 30% below predicted “true” value. He felt that provided plenty of cushion.
- Keep sorting. Finding solid undervalued companies is a bit like looking for a needle in a haystack.
- Buy and hold. Become an owner of the company. Portfolio managers often trade in and out of positions because they believe trading is their job. Buffet and Munger believe finding and owning a part of a solid company is their job. They do a lot of research and comparatively little trading.
- The theory is that market price might be inefficient today but will eventually catch up in the long run. This strategy can work with almost any stock but probably works best with companies that have a stable track record of being in business for a while.
This last step can be difficult, takes genuine conviction and nerves of steel. It will be tempting to trade out of a stock and or put stop losses on the investment.
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