One of the surest ways you can fail as an investor is to try to buy stocks. By itself, a stock is a worthless piece of paper. Whatever value that stock has comes from what it really represents -- a fractional ownership stake in a business. As a result, successful investors don't buy stocks. They buy the companies behind those stocks.
It may seem like a subtle and meaningless difference, but it's critically important to remember as an investor. In the end, a business determines the true value of its own stock, based on its financial performance. The wild, day-to-day gyrations in a company's stock price? Noise in the system. If you want to be a top-tier investor, you've got to learn to either ignore that noise or learn to use it to your advantage.
Buy companies cheaply
Yes, you can take advantage of the market's wild fluctuations. You need two key skills:
- The objectivity to see through the noise
- The patience to wait it out
With both of those on your side, you've mastered the keys to learning how to buy low and sell high. Your success as an investor depends on your ability to tell the difference between a company and its stock. The less you pay compared to a company's true worth, the more value you receive for your money. On the flip side, the more you receive when you sell, the more you have available for whatever you'd like -- be it cash to improve your lifestyle or capital to reinvest elsewhere.
This comparison between a company's price and its net worth is key to the market-beating value investing strategy. It's what made Warren Buffett and Charlie Munger legends with picks like Coca-Cola (NYSE: KO ) . It's also the method we follow at Motley Fool Inside Value.
Of course, this raises a key question: What exactly is a good price to pay for a business? The answer depends on the specific company and its ability to generate cold, hard cash. In general, the more cash a business is expected to throw off, the more it will be worth. Yet the amount of cash is only half the story -- when that cash will appear matters, too. To put this in context, would you rather have $100 in your pocket today, or the potential to have $1,000 in your pocket 10 years from now?
To balance those two priorities, value investors have developed something called a discounted cash flow calculation. In essence, you add up a stream of future earnings, while dialing back the ones farther out to compensate you for the time it'll take for those future earnings to arrive. When you add all those dialed-back future earnings together, you wind up with a number that estimates the true worth of a business. It's really not as complicated as it might sound -- so long as you're willing to put forth the time and energy. (At Inside Value, we have an online discounted cash flow calculator that will do the math for you. To check it out, sign up for a 30-day trial.)
The tough part
So -- if the math's so easy, you may be wondering why everyone isn't a successful value investor. To be successful, you've got to be willing to trust the financial data -- and not get caught up in the market's latest wild mania. These days, it doesn't take much effort to claim that XM Satellite Radio (Nasdaq: XMSR ) deserves to be a $12-$16 stock. But last April, when it traded at more than $22 a stub, such a pronouncement was quite radical. Likewise, questioning Google's (Nasdaq: GOOG ) valuation in January 2006 took quite some nerve. Yet since then, despite tremendous profit growth, Google's shares have actually trailed the S&P 500.
Value investors get their edge by identifying market irrationality. Think back to the late 1990s. The Internet was all the rage, and "bricks and mortar" was destined for the dust heap -- or so the pundits would have you believe. By buying then, you could have made a killing owning old-fashioned mall stocks like Simon Property Group (NYSE: SPG ) or Macerich (NYSE: MAC ) .
And think back to March 2003. You could have bought McDonald's (NYSE: MCD ) for less than a third of where it's trading today. Triple your money in less than four years? In the largest fast-food company around? In an efficient market, that'd be unthinkable.
Of course, the past is behind us. We can't crush the market today by buying the values of yesterday. That's why you need to pay attention not to the stocks that have recovered and done well by their owners, but to the businesses behind those stocks. By paying attention to what went wrong in the first place, and how the companies recovered, we set ourselves up to find, buy, and profit from similar situations in the future. The next McDonald's is out there today -- unloved, unappreciated, and poised for a turnaround. That's what we hunt for every day at Inside Value. Our picks are currently beating the market by nearly seven percentage points, and at 4 p.m. ET a brand-new issue, with two new value stocks, releases. You can sample our service free for 30 days, with no obligation to subscribe.