Every company has an intrinsic value. It's based on the amount of cash the business will generate, along with the time frames in which those cash flows will occur. To calculate what a company is worth, you simply need to follow a few straightforward steps:
- Figure out how much money a company will make in the future.
- Discount those future earnings to what they're worth today.
- Add up those discounted earnings to come up with the total value.
Of course, that's easier said than done. To know what a company will make this year, next year, or even 10 years from now requires a level of foresight that we mere mortals simply do not possess. In fact, no matter how you go about projecting the future, the odds are that you're probably wrong.
Don't feel bad about that, though. You're in good company. In truth, none of us can predict precisely what will happen to a company. Believe it or not, this is good news. As an individual investor, you can take advantage of this uncertainty in ways that the Wall Street pros simply cannot.
Short-timer's syndrome
The biggest problem facing Wall Street is that its primary job is managing other people's money. When a company looks as though it won't be living up to previous expectations, its shares adjust downward accordingly. (That's Wall Street lingo for "fall off a cliff.") Professional money managers don't particularly like being caught holding such a hot potato. It can ruin their reputations and raise the risk that the investors whose money they're managing will take their remaining cash elsewhere.
As a result, when a company lowers guidance, its shares will often drop much farther than its new reality would justify. This is particularly likely when a company announces that its pain is due to significant investments for its future. It seems to be happening right now, in fact, to technology juggernaut and Motley Fool Inside Value selection Microsoft (NASDAQ:MSFT). In its most recent earnings report, Microsoft guided lower for 2007, largely because of its plans to invest an additional $2 billion to grow and protect its business.
Wall Street saw the announcement, noticed the $2 billion price tag, and immediately knocked Microsoft's shares into the cellar. Its shares traded around $27.25 immediately before the announcement, dropped as low as $24.09 in the next session, and it ultimately fell to $22.73 in the following weeks. All told, more than 16% of the company's market cap evaporated, largely because of that announcement and the company's lowered near-term guidance.
The long-term view
Yet shareholders who cared about the long-term health of the business cheered the news. After all, Google (NASDAQ:GOOG) and its GooglePack present Microsoft with a credible, well-capitalized, motivated, and profitable competitive threat, the likes of which it hasn't seen in quite a long time. Unlike Sun Microsystems (NASDAQ:SUNW), whose forays into free software and platforms distracted it from its own ailing business, Google's core ad-based model has been profitable from the beginning. In addition, Google is fighting from its own position of strength as the dominant global search firm. Until that press release, I was beginning to wonder whether Microsoft's years of dominance had made it soft. This announcement of increased investment let me know that the company still had some fight left in it.
That was important news to hear. After all, we've seen what happened to other former near-monopolies who refused to adapt to the world around them. The original AT&T (NYSE:T), for instance, absolutely buckled under competitive pressures, ultimately finding rescue through an acquisition by its former spinoff, SBC. Xerox (NYSE:XRX), once synonymous with the act of making a photocopy, has stagnated for decades since other firms muscled in on its turf. Even the once-mighty General Motors (NYSE:GM) is a tiny shell of its former self, with junk-rated debt, ever-shrinking market share, and mounting losses.
It's true that $2 billion is a large chunk of money, and it's also true that Microsoft kept mum on its exact plans for that cash. Even so, consider that Microsoft has some $34.8 billion in cash and short-term investments on its balance sheet, and threw off nearly $16 billion in free cash flow over the past year. If there's a company capable of absorbing $2 billion in additional investment, it's Microsoft. If there's a company that needs to make that kind of investment to avoid the fate of so many failing former near-monopolies before it, it's Microsoft as well.
Profit from the conflict
As much as we individual investors would like to think otherwise, Wall Street and its short-term opinion determine a stock's current price. When its opinion turns so solidly negative against a company with such substantial long term potential, you can profit from the situation. Simply by realizing that the long-term future looks brighter than the short-term pain, you can buy and wait out the rough spots. Eventually, the market will forget its jitters and return the stock to a price closer to its true worth. This investing style is precisely what we use at Inside Value, and it's a major reason why our service is handily beating the market, despite investing largely in firms once given up for dead.
Microsoft's $2 billion investment could indeed hamper its earnings over the next fiscal year. Yet if that money is properly deployed, it will help reinvigorate and reenergize the largest, most powerful software firm on the planet. As the company benefits from the longer-term returns on those invested dollars, the investors who bought when things looked their worst on Wall Street will stand to profit the most.
If you're ready to look past short-term weakness and profit from investing in fundamentally strong businesses, join Motley Fool Inside Value today. Or take 30 days to kick our tires, at no cost to you.
At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of Microsoft and General Motors. AT&T and SBC were both former Motley Fool Stock Advisor picks. The Fool has a disclosure policy.
