Editor's note: In a previous version of this article, Coca-Cola's free cash flow was incorrectly stated. We regret the error.
Whether you're talking about baseball cards, Beanie Babies, impressionist art, or stocks, every asset class can be valued in one of two simple ways:
1. What it's worth to the owner.
2. What it's worth to someone who wants to own it.
Although those two values will often be close to each other, sometimes they're not. Let's look at the second measure of value first.
Mergers and momentum
If I own a baseball card, and I can sell it to someone else for $10 in cash, then that's the value of the card. Many investors try to figure out what a private equity firm or strategic acquirer will pay for a company, and then they'll buy stock if the shares trade at a discount to that price.
Lately, this strategy has worked well for anyone holding shares in companies such as Archstone Smith, First Data, or Hilton Hotels. Unfortunately, investors might be left holding the bag if deals for companies such as Acxiom (NYSE: ACXM ) or Sallie Mae (NYSE: SLM ) collapse. Thus, investors might want to avoid using acquisition multiples as the sole component of their investment theses.
Momentum investors and technical analysts believe they can predict -- based on volume, patterns, and various other indicators -- the prices other investors will pay for a stock in the next five minutes to five days. Although some investors have certainly enjoyed success with this approach, I have no idea how they do it. While I'm comfortable about a stock's long-term prospects, whether it goes up or down tomorrow or next week is beyond me.
Put another way, I'd much rather bet that Kobe Bryant will average more than 20 points per game over the course of the season than bet that he'll score 20 points in his next game. In the short term, random factors can cause distortions -- Kobe could catch a cold -- so I'd advise a longer-term horizon.
Similarly, in the short term, Citigroup (NYSE: C ) has posted extremely lackluster results because of turmoil in the credit markets. However, some smart investors with long-term horizons, like Sears Holdings (Nasdaq: SHLD ) Chairman Eddie Lampert, have bet that their companies will be worth much more in a couple of years, when the credit markets recover.
Think like an owner
In my Foolish opinion, there's only one real way to value a stock, and that's to pretend that you're buying the whole enchilada. Thus, the obvious approach is to try to figure out what the entire company is worth based on reasonable assumptions, and then buy at a sharp discount to that value, to mitigate any future uncertainty.
So what's a business worth to an owner? It all comes down to cold, hard cash. And you can generate cash either via ongoing business operations or through asset sales. Your job as an investor is to figure out the cash-generating potential of a company and whether management can deliver on that potential.
Let's use an example. Over the past 12 months, Motley Fool Inside Value recommendation Coca-Cola (NYSE: KO ) has earned about $6.78 billion in cash flow from operations, and it's spent about $1.54 billion on capital expenditures. That comes out to around $5.2 billion in free cash flow. Based on the current share price, if you wanted to buy the entire company, you'd have to pay about $140 billion.
As the sole owner of Coca-Cola, you could pay yourself the entire $5.2 billion in free cash flow every year, for a yield of about 3.7% on your investment. Of course, that 3.7% will almost certainly grow, given Coca-Cola's competitive advantages, and you could possibly find other assets that could be sold or would generate additional cash in the future. However, this is a quick and dirty way of deciding whether Coca-Cola's shares are worth further study.
Although there's a lot more to it, learning to think like an owner and valuing a company based on its cash-generating potential can be the most important first step that Fools make in becoming better investors.