Why Are You Buying This Stock?

Every company's stock is worth something. Whether that something is $0 or $1 trillion (or more likely, somewhere in between) depends entirely on the business that underlies those shares.

As my colleague Morgan Housel recently pointed out, great companies' stocks can go nowhere -- or even down -- over long periods of time. If you buy them at too high a price, you won't really get your money's worth. As an investor, if your aim is to make money (and whose isn't?), you need a way to determine what that stock is truly worth to better assure you don't overpay.

Fortunately, there are three little words that can get you a good estimate: discounted cash flow.

What does that mean?
To keep the concept simple, remember that every dollar is worth exactly 100 pennies, assuming the two change hands at exactly the same time.

But what if instead of making you change right away, someone wanted to borrow your dollar and offer you those pennies later? Would it be fair to you to be out your cash and only have that person's promise to pay you back? How much more would you need to make it a fair trade? Would it matter when you could expect to get your money back? And should you worry about the chance that the person on the other side will stiff you altogether?

All that a discounted cash flow calculation does is estimate what would be a fair number of pennies to expect back in the future for your dollar, based on those time and risk factors.

But what about stocks?
When you buy a stock, you hand over your dollars, with the expectation that the company will pay you those pennies over time -- either directly as dividends or indirectly as earnings. At its core, it's the same concept as the one dollar-for-100 pennies exchange, and a fair trade rate can also be estimated with a discounted cash flow calculation.

Since nobody can perfectly predict the future, the calculation can't give you a perfect answer. With reasonable estimates and conservative assumptions for every stock in your portfolio, you can usually get close. Close enough to largely protect yourself against the "help, my stocks went nowhere for a decade" problem.

Running a simplified discounted cash flow calculation on some fairly large and well known businesses today produces results similar to these:

Source: Capital IQ, a division of Standard and Poor's, as of Sept. 19. Calculated Fair Value based on author calculations.

The process that counts
As important as the results themselves, however, are the assumptions that went into them. To arrive at that "calculated fair value" in that table, required the following assumptions:

• The trailing normalized diluted earnings per share provided a decent starting point for future earnings potential.
• The companies would grow from that starting point at their long term consensus rates for five years, half the long term consensus for another five years, and then "at the rate of the economy" (estimated at 2%) beyond that point.
• As an investor in individual stocks, you'd expect a 12% return on a stock of this caliber for it to be worth the risk of investing.

A small change in any one of those assumptions could dramatically change your valuation -- and understanding that is a key part of successful investing. Because you can't predict the future, and because even your best results are only estimates, you need to run a "reasonability check" on anything you put into a model. And it's that reasonability check that really drives the value of your analysis.

After all, if the world bans smoking, Philip Morris International won't have much business left. And with calorie counting coming to a drive-through menu near you, is McDonald's at risk of losing customers? What about the attacks from open-source and web-based tools on Microsoft's Windows and Office franchises? Could that cut down its growth? And just how risky is AT&T these days, now that so much of what it does can be replicated for free over the Internet?

On the flip side, would Carbon Cap and Trade actually be a good thing for United Technologies by spurring demand for higher efficiency Carrier air conditioners? And now that IBM and Oracle have declared some sort of peace with one another, could that lead to better opportunities or faster growth for both of them?

Put it all together
If you understand what a business does, its true financial potential, and what risks and opportunities it faces, you can use a discounted cash flow calculation to get a good feel for what it's worth. And with that information driving your investing decisions, you can help yourself avoid another decade of your investments going nowhere.