We can start by following great advice from one of the greatest investors of all time. Warren Buffett says you should value a stock the same way you would value an entire business. There are investors who rely on price over earnings ratios, earnings per share, or BETA, which measures risk. In reality, a business is only as good as the amount of cash it generates. Cash is king.
By calculating the net worth of a company at a certain point in time, you should be able to estimate, with a margin of error, the future cash flows that a business will have. These figures will structure the value of the business at hand. Again, you have to consider that your valuation cannot be certain but only a rough estimate; hence, in the words of Ben Graham, you need a margin of safety.
But why aren’t revenue or earnings alone a key factor?
Cash is the only thing that makes it to the bank after all expenses are paid. Expenses are paid with cash or additional debt. Anything left is what counts.
You will also need an absolute minimum of five years of data to analyze the performance of a company. A compilation of data will give you snapshots of how revenue is made, what expenses are incurred and if management is using all available options at maximum potential.
How can we know if management is using the company’s money at full potential?
You can take a quick look at CROIC (cash return o
n investment capital). This will give you a percentage which can be translated into money. Let’s say you come up with 10%, this means that for every dollar the company has in assets and borrowed money, it makes $0.10.
How is this comparable? Well, just think of your checking account. Unless you are able to accumulate such percentage from an alternative form of investment, then 10% is not all that bad if it is your only choice.
Proper research and valuation techniques will keep you out of trouble:
- You would have avoided major bad investments during the 2008 recession.
- It would have allowed you to profit from companies selling at a huge discount post-recession quarters.
- When you are confident of what a reasonable valuation is, you can invest peacefully and not be affected by market noise or speculation.
Remember, there are no guarantees in investments, and, like mentioned before, you need a margin of safety; this could be a 20-25% discount or more on your total valuation.