It doesn't matter whether a company makes high-speed data routers, toilet paper, toys, or paper airplanes. The only thing that counts is the money the business will generate, starting now and going into the future. Even then, tomorrow's dollars aren't counted at face value; they're scaled back to represent their worth today.
That's what discounted cash flow analysis does -- it takes into account the risks associated with investing, as well as the time you have to wait between investing your money and seeing a return.
Today's $1 is tomorrow's 89 cents
There's more risk in projecting cash flows way into the future, because more time means more chances for something to go wrong. As a result, the farther away from today that you get, the less value any given dollar of income really has. How much less? Well, with a 12% required return rate, an expected dollar a year from now is worth a hair more than $0.89 today.
So either your expected levels of future cash need to be spot-on, or you need to invest with a comfortable margin of safety.
The former point will be nearly impossible, so savvy value investors focus their efforts on the latter.
Diving in
Quite simply, the less you pay compared to an investment's worth, the better your return will be. To illustrate, take a look at the vastly different returns you could have received within the past year, depending on your margin of safety:
|
Co. |
52-Week Low |
52-Week High |
Re-cent Price |
Worst Recent Return |
Best Recent Return |
|---|---|---|---|---|---|
|
Apple Com-puter |
$47.87 |
$86.40 |
$74.08 |
(14.3%) |
54.8% |
|
Archer Daniels Midland |
$23.00 |
$46.71 |
$37.01 |
(20.8%) |
60.9% |
|
Chevron |
$53.76 |
$68.47 |
$62.94 |
(8.1%) |
17.1% |
|
Ford |
$6.06 |
$10.00 |
$8.23 |
(17.7%) |
35.8% |
|
Rent-A-Center |
$14.90 |
$29.95 |
$29.14 |
(2.7%) |
95.6% |
|
Sanofi-Aventis |
$39.23 |
$50.05 |
$44.73 |
(10.6%) |
14.0% |
|
Thorn-burg Mort-gage |
$22.27 |
$29.00 |
$25.85 |
(10.9%) |
16.1% |
It might be sobering to think that the only difference between those returns is the purchase price.
Reality check
OK, OK, you'll rarely buy at the absolute low or sell at the absolute high. The market moves far too unpredictably in the short term for anyone to call the exact bottom or top. In the long term, however, stock prices tend to gravitate toward their true worth -- which is exactly what a discounted cash flow analysis aims to predict.
To win as an investor, you need to identify where companies are trading compared with their "true" worth. Once you know that, buy and sell decisions become much easier. And buying companies trading for far less than their true worth is how value investors like Benjamin Graham, Warren Buffett, and those of us at Inside Value have been able to beat the market for generations. If you want help finding exactly those kinds of companies, click here for free month-long access to Inside Value.
Fool contributor Chuck Saletta does not own shares of any company mentioned in this article. Rent-A-Center is a Motley Fool Inside Value recommendation. The Fool has a disclosure policy.
