We all have different investing goals. Some investors want the steady income of a quarterly dividend check. Others want a comfortable retirement account for that mythical 59 1/2 milestone. Still others may want a more comfortable financial nest egg for their kids or grandkids, or perhaps want to leave a legacy at a local charity or favorite school. Whatever the goal (and they're all worthy), at the end of the day, we all want invest for the same reason: We want to end up with more money than we started with.
History has shown that investing in the stock market is one of the best ways to reach that goal. But it doesn't matter whether the company that padded your nest egg brings you satellite radio or extracts and manufactures limestone products. The end cash is what matters, and it always spends the same.
Simplify your investments
It's the cash that counts. Once you realize that, figuring out how and where to invest your money becomes much simpler. It really boils down to two straightforward questions:
- How much money do I expect to get back from this company?
- When do I expect to get that money back?
Treat investing the same way that General Electric (NYSE:GE) treats its individual parts. GE knows that a certain amount of cash needs to be invested to maintain and grow each of its businesses, but the company's expectation is that over time, each unit will throw back money above and beyond the cost of starting up and financing its operations. Television stations, aircraft engines, consumer and business financing, or light bulbs -- the exact business doesn't matter as much as the quality of the cash flow. It comes down to the flow of capital: how much goes out as an investment, and how much comes back in as a return.
The value of a dollar
If you're looking to emulate GE's success, you need a clear understanding of how to calculate what that cash is actually worth. It might surprise you that $1 is not always worth 100 pennies. Why? Because time is not on your side. If you invest your money today, you won't get your returns until later. Factor in inflation and the risks associated with being separated from your money for awhile and $1 some time in the future is simply worth less than $1 today.
This is why banks like Washington Mutual (NYSE:WM) or Wachovia (NYSE:WB) charge you interest when you borrow money for mortgages or cars. They'll shell out the cash today, but you don't have to completely pay them back for years. Anything can happen, and some fraction of the loans will go bad. Because of that risk, the interest you are charged includes a premium to assure that, across all borrowers, the banks will get all their money back.
Be your own bank
Whether you're investing in businesses (like GE) or loaning out your money (like Washington Mutual or Wachovia), the money you expect to get back needs to be more than the money you invested in the first place. Or else.
Individual investors would be well served by following that same practice. Calculate exactly how much money you expect to get back from today's hard-earned investment dollars. How, exactly? Well, that's the beauty of the discounted cash flow (DCF) analysis.
In a nutshell, a DCF allows you to put a price on tomorrow's dollar. Over at Motley Fool Inside Value, subscribers have access to our DCF calculator (available here for subscribers), which boils down the valuation process to a few simple inputs.
You can plug in your expectations for a company's future cash production, its riskiness, and the inevitable drain from inflation, and the DCF calculator will generate an approximation of how much those future dollars are worth -- today -- accounting for the risk of investing and the price of inflation. That's a very important number, and it should serve as a jumping-off point for any potential investment.
How it plays out in practice
Remember that cash always spends the same, no matter what company earned it for you. In order for you to come out ahead as an investor, you absolutely must make sure that you don't pay more than your DCF calculation says that all those future dollars are really worth. Internet search pioneer Yahoo! (NASDAQ:YHOO) may still be at the forefront of technology, but its shares today are worth about one-third of what they fetched in early 2000, despite the fact that the company is now earning substantially more money than it was back then. Contrast Yahoo's stock price performance since 2000 with Smucker (NYSE:SJM). As this chart shows, the staid but cash-generating peanut butter and jelly business absolutely walloped the high-tech marvel. A DCF analysis could have warned you that all of Yahoo!'s future growth was already priced in its stock price circa 2000. Smucker, on the other hand, had plenty of room to run.
The Foolish bottom line
At the end of the day, it's not the stock you owned that matters; it's the cold, hard cash you receive from your investments. Keep that in mind, and only invest in companies that legitimately look capable of throwing off enough cash to justify your purchase. In the long run, you'll be glad you did.
Want access to an online DCF calculator that can help you be sure you're paying the right price for your investments? Want two investment selections per month from someone with a track record of beating the market by following this exact strategy? Consider joining us at Inside Value.Click herefor a 30-day free trial and see for yourself whether you've got what it takes.
At the time of publication, Fool contributor and Inside Value team memberChuck Salettaowned shares in General Electric and Smucker. The Fool has adisclosure policy.
