The stock market creates an amazing amount of wealth. So much, in fact, that one of the best long-run investing strategies out there is simply to buy a market-tracking fund like Vanguard's Total Stock Market Index -- which will give you exposure to all kinds of companies, including Intel (NASDAQ:INTC) and Citigroup (NYSE:C) -- and wait. As the companies that make up that index grow over time, so will the value of the fund and your net worth.
That's all fine in theory. In practice, there's just one small problem: The market doesn't always move up. And that fact is even more pronounced among individual equities. Former high-flying high-tech Cisco Systems (NASDAQ:CSCO) is down more than 75% from its peak.
Over the longer haul, of course, the stocks of successful companies generally move up as their businesses grow over time. Yet if the past six years have taught investors any lessons, the top one would be this: If you pay too much, you'll wait a very long time to see any real benefits.
Enter value
That raises a key question: "How much is too much?" That question gets to the heart of value investing, history's most successful market-beating investing strategy. The answer, while straightforward, is not quite as simple as it seems. To figure out the maximum you'd be willing to pay for a stock, you just have to:
- Project the company's future earnings, year by year.
- Determine how much of an annual return you'd expect in order to justify risking your money in that company.
- Discount those future earnings by your expected return rate.
- Add together each year's discounted future earnings.
The number you arrived at in the last step is what you think the company is really worth. It's called a discounted cash flow analysis. It's such a fundamental part of investing, in fact, that at Motley Fool Inside Value, we have a calculator here that'll do the math for our members. (A free trial is required if you're not already a member.) If you pay more than that value, you've limited your chances of meeting your expected return rate. If you pay less than that value, then you've given yourself an extra edge and the chance to outperform.
It's a straightforward strategy, and it has worked for generations. While the stock market as a whole may still be down from its once lofty peak, companies that were dirt cheap when the overall market peaked are now doing far better. Take, for instance, Enbridge (NYSE:ENB), a leading North American oil pipeline company. While the market was all a-flutter about the next big thing to come from the tech sector, Enbridge simply went about its business moving energy around. How boring -- and how ignored by Wall Street.
Yet there was nothing boring about Enbridge's return since that day in March 2000 where the general market peaked. From a split-adjusted price of then $9.94 to a recent level of $31.19, investors have seen a 213% return -- before accounting for dividends! Not bad during an overall down market.
The catch
Of course, to figure out that value, you have to accurately project the future. Email me if you know exactly, to the penny, how much money industrial titan General Electric (NYSE:GE) will earn in 2009. As one of the largest and most-followed companies out there, GE attracts a significant share of investor scrutiny and analyst projections. Yet even with all that microscopic inspection, not a single person knows with certainty what GE will report this year, next year, or any future year, for that matter.
Without perfect foresight, any projection or valuation attempt we make is an estimate, at best. The good news, though, is that we're all in this together. None of us is a particularly gifted prognosticator. It's because of that uncertain future, in fact, that the market so often gets it wrong. After all, the market is made up of investors, each one with the same lousy ability to predict what will happen.
Your value edge
While you can't perfectly predict the future, you can position yourself to take advantage of that uncertainty. There are two key numbers that matter most in your value estimations:
- How much the company will earn in the future.
- How much a return you demand for those future earnings.
If you aim low on the future earnings, any surprises will likely be in your favor. Likewise, if you aim high on your future return demands, you'll estimate a lower price as the fair value for a company. If you combine both lower projected earnings and a higher return rate and still calculate a fair value that's higher than a stock's market price, then you've found yourself a genuine value. Benjamin Graham, the man who taught investments to Warren Buffett, called searching for such discounts investing with amargin of safety. It's the cornerstone of value investing and the central principle we follow at Inside Value.
What's on sale now?
While the bargains of yesteryear have come and gone, the value principles that discovered them still work today. Looking around for bargains, we can see that amusement-park giant Cedar Fair (NYSE:FUN), which trades at less than nine times trailing earnings and sports a 7.4% dividend, seems like it might fit the bill. Its partnership units have been pummeled recently, thanks in large part to the integration costs associated with the purchase of the Paramount theme parks from CBS (NYSE:CBS). As Cedar Fair integrates its new acquisitions, investors will be watching for indications as to whether it is successfully handling its larger size. If the company manages to wring operating and scale efficiencies out of its new heft, investors who buy low while the future is still uncertain may be richly rewarded for their trouble.
Yet there's something even better than my opinion, and that's the perspective of a proven market-beating investor. Shortly after the market closes today, the newest installment of Inside Value will be released. In it, analyst Philip Durell will reveal two more companies trading below their fair values. If you want to be among the first to see which ones of yesterday's losers have a shot at being tomorrow's champions, click here to get started now.
Want a sneak peak at our newest issue with no commitment attached? A free trial will get you 30 days to kick our tires and test our mettle. In addition to this afternoon's hot-off-the-presses release, you'll have access to all our historical issues, our private value-investing discussion forums, and our online tool during your stay.
At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of General Electric and Intel. Intel is an Inside Value pick. Cedar Fair is an Income Investor pick. The Fool has a disclosure policy.
