How Much Are You Paying for Leadership?

Every single stock is priced based on the market's best current expectation of the underlying company's future cash flows.

After all, a share of stock is nothing more than a fractional ownership stake in a business. That business is worth only the cash that it can generate for its owners over its corporate lifespan, appropriately discounted for the time and risks involved in earning that money.

What do you get for your money?
As an investor, you're buying not only the company's assets and current cash generating capabilities, but its leadership team and its ability to build the business, too. When you look at a stock from that point of view, you can further slice its market price into three parts:

• Proven performance: The price based on future cash flows, at the level that the company has already shown itself capable of generating.
• Natural growth: The price based on the possibility that future cash flow growth will merely keep up with overall real economic growth (plus inflation).
• Strategic leadership: The price based on the company's executives' ability to build the business faster than the overall economy (plus inflation).

One of your primary jobs is to judge whether you'd be paying too little, the right amount, or too much for the company's stock, based on the value that its leadership brings. When you break the stock's price down to those component parts, it becomes much easier to judge what the market thinks of that company's leadership, to help you make your call.

Take a look, for instance, at the companies in this table:

Data from CapitalIQ, as of Feb. 9 and author calculations. Assumes 12% required rate of return, 2% natural growth, and 2% inflation.

For instance, Amazon.com and Wal-Mart are both leaders in the retail business, but the market is making a substantially larger bet on Amazon.com's leaders to grow it faster. The market's belief is so strong that more than 62% of every dollar you invest in Amazon's stock depends on that growth, versus less than 17% for Wal-Mart. Why such a discrepancy? Wal-Mart's current revenue is so much larger than Amazon's that each point of growth is tougher for Wal-Mart to achieve.

A tougher gap to justify is the one between MasterCard and Visa. They're a lot closer in size to each other than Amazon and Wal-Mart are. Additionally, Visa and MasterCard offer such similar services that they're often considered interchangeable by customers. If you're considering one stock vs. the other, why not own the one where the market is pricing in far less growth?

Is it really worth it?
When you compare long-term computer and electronic-gadget archrivals Apple and Microsoft, however, things start to get really interesting from an investing perspective. Apple has been firing on all cylinders, thanks to its iPod, iPad, iPhone -- basically, iEverything. Roughly a quarter of its stock price represents expectations of future rapid growth.

On the flip side, Microsoft's price suggests the market isn't even expecting it to keep up with the economy and inflation over the long haul, as if it were a washed up has-been. While Microsoft doesn't generate quite the buzz that Apple does, Mr. Softy certainly does generate a ton of cold, hard cash. And with that cash flow available at attractive pricing, you'd be getting a huge chunk of any growth that it does generate for free, essentially.

Of course, an apparently cheap price doesn't necessarily mean the company is worth owning. Life Partners may look dirt cheap on the surface, but it's currently being investigated by the SEC for the way it prices its products. At minimum, even if it gets off lightly from the regulators, the increased scrutiny has forced it to change its sales pitch, which will slow its growth. In this case, the market is pricing in a massive case of value destruction by a company's leadership.

Judge for yourself
When you buy a stock, you're buying the underlying company's proven financial performance, its natural growth potential, and its leadership's ability to build the business even faster. Whether you're getting a good deal or a bad deal on your investment depends largely on how well those leaders execute over time, compared with how much you paid for their skills.