Doc's note: There are lots of ways to find out a company's value. You can get into complicated mathematics and bury yourself in financial statements. But the average investor doesn't have the time to do that... And you don't need to.
In today's essay, Extreme Value editor Dan Ferris explains the best way to figure out what a business is really worth.
The first thing to consider when selling your house is, "How much will someone pay?"
That's what you need to ask before anything else because that's what the house is actually worth. It doesn't matter how much you bought it for 10 years ago. It doesn't matter how much the new owners will be able to sell it for 15 years from now.
It's only worth what someone will pay for it right now.
It's the same with every business in the world. It's the same with every stock, bond, and piece of real estate you'll ever own. It has been that way for hundreds of years. And it will be that way for hundreds more.
When investing your hard-earned money, it's important to remember this...
It's dangerous to pretend there's rationality where there isn't. As physicist Richard Feynman once said, "The first principle is that you must not fool yourself, and you are the easiest person to fool."
Don't fool yourself about the stock market. You're always betting the market will eventually get it right... And it frequently gets it wrong for longer than you can ever imagine.
Even the late Benjamin Graham – the ultimate value guru, the father of security analysis, and Warren Buffett's mentor – looked at the stock market as a manic-depressive person named Mr. Market. Graham said we should buy from Mr. Market when he's depressed and sell to him when he's manic. When you buy, you're speculating he won't commit suicide. When you sell, you're speculating it's only a matter of time before he's depressed again.
The only price you'll ever get for any publicly traded equity is the value other investors assign it on the day you sell. So you must have a thoughtful opinion on how they'll behave over the long term... and how you'll behave when they go crazy over the short term (which is usually longer than you want it to be).
It's a shortcoming of human nature that, once we see a particular set of numbers, we anchor on it, assigning it a higher probability of coming true than we should.
But always remember this when assessing a company's value...
Published financial information comes in two varieties: actual past results and projected future results. You can't invest in the past, and you can't know the future.
A business is worth the present value of all future excess cash flows... But as soon as you start trying to predict those flows, you're more likely to fool yourself than to paint an accurate picture of the future.
Like most things in investing, though, it'll have to do. It's all you get, so you'll need to use the numbers in front of you to decide whether you think the investment is worth it.
But just remember to ask yourself, "How much will someone pay?"
P.S. Each month in Extreme Value I look for the safest, cheapest stocks... buying only when the price is right. Click here to learn more.