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2 Keys to Valuing a Business

There's more than one way to value a company. But in most cases, several crucial clues can tip you off to an investment's true worth.

We can't all be Buffettlike
Master investor Warren Buffett of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) has a knack for making enormously profitable investments that seem obvious in hindsight. In 1973, he sank $10 million into Washington Post (NYSE: WPO  ) , after he noted that its market cap of less than $100 million equaled roughly one-fourth of the value of its assets alone. Today, his stake is worth more than $1 billion.

He enjoyed similar success in 2002 with PetroChina (NYSE: PTR  ) , by noticing that the Chinese oil company enjoyed ample reserves and earned nearly as much profit as players such as ExxonMobil (NYSE: XOM  ) but traded for a fraction of those companies' market value. By the time he sold in 2007, his initial $488 million had become roughly $4 billion.

Buffett makes spotting such discrepancies in the market look easy, but it takes tremendous experience and talent to do what he does. And since none of us is Warren Buffett, we're better off keeping things simple.

My two favorite words: free cash
The more assumptions you have to make in determining a company's fair value, the greater your odds of getting that value wrong. For example, if you're valuing a business based on your belief that its earnings will grow by a certain amount, that the economy will expand, that the price of oil will remain high, or that any number of other factors will occur, you're asking for expensive trouble. Instead, consider valuing businesses based on what really counts: how much cash they make.

Companies become more valuable as they earn more money. Profits are important, but they take a back seat to cash flow, specifically free cash flow. Simply defined, free cash flow is money left over after the business pays it bills for the year:

free cash flow = cash flow from operations - capital expenditures

Find a company that generates healthy doses of free cash flow at a reasonable price, and I'll show you a value-creating investment over time.

The power of greenbacks
Once you find a company that's generating cash, you should also examine how it's using that cash. Chipotle Mexican Grill (NYSE: CMG  ) has been using its cash flow from operations to open more stores, so its capital expenditures depress free cash flow levels. In this case, however, it's using that cash to develop profitable restaurants, which continue to propel the company's growth. Mr. Market has noticed, and so the share price is as juicy and rich as a Chipotle burrito.

Over the long run, a company is ultimately worth the amount of cash it's expected to generate over a period of time. Profits can be massaged to look good, but free cash flow reveals the truth behind them. With cash, able and competent management can easily create long-term value and grow the business prudently without assuming too much debt. Alternatively, management can give the money back to investors through share repurchases or dividends.

Focus on what counts
It doesn't take much for a business to succeed. Like smart investors, businesses that stay focused and stick to a few crucial priorities will find themselves worth a lot more down the road. Value your investments based on the things that really matter -- such as how much cash your companies generate and how wisely they spend it -- and you too, will be worth more down the road.

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