Arguably the world’s greatest investor, Warren Buffett says that you should value a stock as you would value a private business. In the private sector, P/E means nothing. In fact, earnings mean nothing. The only thing that matters in buying a private business is the amount of cash that it can generate-its free cash flow.
When you buy a stock, you are buying the company’s net worth and a right to the cash that the company can generate in the future. Earnings and revenue are numbers reported on the company’s tax return and mean nothing to a business owner or investor. You can’t spend earnings to grow the business-you can only spend the cash that makes it to the bank after all expenses are paid.
If you know the net worth of the company (the Shareholder Equity) and you can reasonably estimate the future cash of the business with a degree of confidence, you can quickly figure out the true value of a business. Once you know the value, you should insist on buying the stock at a discount to its value. (The discount is a Margin Of Safety so that you still earn attractive returns if the company does not produce as much cash as you had expected.)
Only when the stock price is at or below your Margin Of Safety should you consider investing. Interestingly enough, investing in this way produces three unbelievable results:
- It would tell you to buy Johnson & Johnson at $62.33 a share in 2007 – right around the price at which Warren Buffett was buying earlier this year;
- It would have protected you from the Lucent, Enron, and Worldcom scams because free cash flow is hard to fake – even when earnings and other tax return numbers are growing; and,
- It will allow you to invest with confidence and check in on your stocks once a year. Buying businesses as a business investor gives you the confidence and comfort to know that you own wonderful companies at attractive prices and that you do not need to concern yourself with the daily silliness of the stock markets because, over time, as your company’s value grows, its stock price will have to follow.