Oscar wasn’t even an investor or participant in the stock market. He wasn’t even living the age of stock market. He was a playwright who died in 1900. Nonetheless, his famous quote illustrates the difference between price and value.
All of us are able to distinguish the difference when we behave as consumers. For instance, we wouldn’t pay $10,000 for a vehicle’s CEO with 7 years to go when a new 10-year CEO is going for $12,000. In fact, we’d be downright suspicious of any car salesman trying to pull that one over on us.
As consumers, we want to get the most for our hard-earned money, and we don’t want to overpay for the products we buy. However, we don’t always think the same way when picking stocks.
Then again, valuing a stock is slightly more difficult than looking up a car’s fair value. Maybe that’s why novice investors can turn to false indicators of value – that is the share price on the ticker – and interpret it as value, due to convenience or otherwise.
The thing is, share price alone tells us very little, in fact nothing, about the actual value of a stock. For instance, Singapore Food which trades at $0.86 per share could be a much better value than Capital Land which trades at $7.80 a stub.
To value a stock properly, we need to look at the company’s financial statements – particularly the cash flow statement. If you are either too lazy and do not bother to learn how to interpret the basics of a financial statements, it is highly suggested you do not invest – not even a single cent. Warren Buffett said: “If you bring nothing to the party, you shouldn’t expect to bring any thing home.”
Why the cash flow statement? Cash flow shows us how well the company manages its cash – If its cash is generated through normal operation, loans or otherwise. And cash, after all, is what we eventually want in return from our investments. As Scott Glasser, co-manager of the Legg Mason Partners Appreciation fund, puts it: “Shareholders don’t get earnings. They get cash.”
Moreover, companies with positive earnings could be burning through their cash, which could be a sign of inefficiency. Some businesses could have posted positive earnings over the past 12 months but have not actually produced any free cash flow.
In some other cases, which could be false, the earnings are a fraud – like how Enron did. Before Enron got busted, they were posting earnings of more than a billion. However, they were perpetually negative in free cash flow.
Ideally, you’d like to see a company generating enough free cash flow to either reinvest in the business, repurchase outstanding stocks, or return to shareholders in the form of dividends. Long-term winners such as Procter & Gamble and Johnson & Johnson for instance, have consistently generated enough cash to pay dividends every year since the 19th century.
Once we know how much extra cash a company is generating, we can estimate how much cash it will down the road. Using the discounted cash flow model, we can then decide how much those future cash flows are worth in today’s dollars. If the sum of those values is higher than the stock’s current price, the stock might be undervalued and worth buying.
This is one of the methods that many value investors use to select stocks for their portfolio. And many of them have had a lot of success with it.
Looking at stocks in terms of value and not simply price is a simple way to help improve your returns in the long-term. It’s worked for guys like Buffett, Templeton, Graham, Schloss, Browne and many more. By integrating their framework into your framework, it can work for you too.