"Nowadays, people know the price of everything and the value of nothing."
-- Oscar Wilde, The Picture of Dorian Gray
Wilde wasn't talking about stocks when he penned this famous quote, but it nevertheless illustrates the difference between "price" and "value."
All of us acknowledge the difference as consumers. For instance, we wouldn't pay $10,000 for a car with a Kelley Blue Book of $6,000. In fact, we'd be downright suspicious of any car salesman trying to pull that one over on us.
As consumers, we want to get the most for our hard-earned money, and we don't want to overpay for the products we buy. We don't always think the same way when picking stocks.
Stocks, cars, and stock cars
Then again, valuing a stock is slightly more difficult than looking up a car's fair value. Maybe that's why novice investors can turn to false indicators of value -- namely share price -- to determine value.
The thing is, share price alone tells us very little about the actual value of a stock. For instance, Goldman Sachs (NYSE:GS), which trades at $200 per share, could be a much better value than TiVo (NASDAQ:TIVO), which trades at $6 a stub.
Show me the money
To value a stock properly, we need to look at the company's financial statements -- particularly the cash flow statement.
Why the cash flow statement? Cash flow shows us how well the company manages its cash. And cash, after all, is what we eventually want in return from our investments. As Scott Glasser, co-manager of the Legg Mason Partners Appreciation (SHAPX) fund, puts it: "Shareholders don't get earnings. They get cash."
Moreover, companies with positive earnings could be burning through their cash, which could be a sign of inefficiency. Consider that Ciena (NASDAQ:CIEN), Quiksilver (NYSE:ZQK), and MedImmune (NASDAQ:MEDI) have posted positive earnings over the past 12 months but haven't actually produced any free cash flow.
Ideally, you'd like to see a company generating enough free cash flow to either reinvest in the business or give back to shareholders in the form of dividends. Long-term winners such as Procter & Gamble (NYSE:PG) and Johnson & Johnson (NYSE:JNJ), for instance, have consistently generated enough cash to pay dividends every year since the 19th century.
Pay now, pay later
Once we know how much extra cash a company is generating, we can estimate how much cash it will have down the road. Using the discounted cash flow (DCF) model, we can then decide how much those future cash flows are worth in today's dollars. (Here's a Fool tutorial on discounted cash flow.) If the sum of those values is higher than the stock's current price, the stock might be undervalued and worth buying.
This is one of the methods that Fool value guru Philip Durell uses to select stocks for his Motley Fool Inside Value portfolio. And he's had a lot of success with it, too: Inside Value picks are currently beating the market by more than 5 percentage points on average.
One of Philip's best picks has been Rent-A-Center, which is up 57% since it was first recommended to subscribers back in November 2005. Here was a company that he believed the market had unfairly punished. He saw value in the company's ability to generate cash year after year.
Shrewd consumer, shrewd investor
Looking at stocks in terms of value and not simply price is a simple way to help improve your returns. It's worked for guys named Buffett, Templeton, and Graham, and it can work for you, too.
If you need a little help getting started, consider a free 30-day trial to Inside Value, where you'll have access to all of Philip's past recommendations, receive two new stock ideas each month, and use the discounted cash flow calculator. Click here for more information.
Todd Wenning gives two thumbs up to 1992 movie Class Act starring Kid 'N Play. Johnson & Johnson is a Motley Fool Income Investor pick. TiVo is a Stock Advisor choice. The Fool's disclosure policy misses the high-top fade hairstyle and encourages its comeback.
