We all like to think we look up, down, left, and right for the best investment opportunities. We screen for sales growth, earnings growth, high returns on equity, and a number of other variables. We read up on the management team. We skim recent 10-Ks.
There can be green lights across the board on all of the favorite investing metrics, but if you pay too much for quality, you'll still find yourself in the investing doghouse a few years down the road. At the end -- or beginning, depending on your point of view -- of every sound investment decision is a valuation estimate. That estimate is why value investing works.
It takes time to evaluate any purchase
I've recently been consumed with buying a new printer. You see, I have a slew of digital photos at home and am now actually hoping to look at them without staring at the monitor. (This is a familiar problem, I'm sure.)
I've considered models from Hewlett-Packard
How things change when making an investment
I'm not sure what part of the human brain controls the need to understand the value of a purchase, but it does seem innate. We will all ask about the price-to-quality and price-to-quantity relationship of nearly everything at the local supermarket, but we'll frequently gloss over such value concerns when it comes to the price of a share.
The same principles and methods of research that I've been using to determine which printer to buy -- or that any of us use to determine whether the 12-pack of Coca-Cola
Let's extend the analogy one step further. With digital photos, the cost-per-ounce equivalent is the total cost of the printer, the paper, and the ink cartridges for 500 photos over a period of three years. That's similar to the idea of "total cost of ownership" when you're thinking about buying a car from Toyota
But when considering an investment in Toyota or Ford (or Hewlett-Packard, Canon, Dell, or Coca-Cola, for that matter), how can you calculate an investing equivalent to the cost-per-ounce? Very simply: a discounted cash flow (DCF) analysis, which will give you the total sum of future free cash flows discounted back to the company's present value.
A DCF analysis requires a few inputs into a spreadsheet or website (subscribers to our Motley Fool Inside Value service can use our easy-to-follow DCF calculator) and takes only a few minutes, but it can turbocharge your returns. Why? Because it gives you the best idea of what a company is worth, given a set of growth assumptions. If you can spend a few hours researching and selecting a printer that costs less than $1,000, it makes sense to take the same tack for stock investments with (most likely) much larger up-front investments.
Foolish final thoughts
It goes without saying that there are differences in valuing a car or a printer or a stock. For starters, the first two are depreciating assets, while the latter is -- hopefully! -- an appreciating asset. Still, the tools and the keys to determining the value of shares in companies as diverse as XM Satellite Radio and Wal-Mart are out there and have been used reliably by value investors for decades. Those same tools are the ones Philip Durell uses each and every month to evaluate companies for his Motley Fool Inside Value newsletter service, which is beating the market over the past year with a 9.7% average return vs. the S&P 500's 4.0% return.
A 12-pack of Coca-Cola is rarely a better deal than a couple of two-liters, by the way. Coca-Cola is, however, a Motley Fool Inside Value selection. You can view the other 20-plus Inside Value stock recommendations with a30-day free trial. A free trial also gives you access to the DCF calculator and to our Foolish community message boards, where thousands of investors are sharing wisdom, ideas, and analysis. Oh, and did we mention it's free for 30 days?Click hereto learn more.
Nathan Parmelee owns shares of Canon, but has no financial position in any of the other companies mentioned. You can view his profile here . Dell is a Motley Fool Stock Advisor recommendation. The Motley Fool has an ironcladdisclosure policy.