Monday, December 23, 2013

Investing is about Swaping Cashflows

If we strip down to the bare basics of investing, it is swapping today's money for tomorrow's cashflows (or future cashflows). So, you buy a stock at $100 today. What you actually want is that the stock can generate more than $100 in terms of future cashflows into perpetuity. The goal of value investing is then to determine how much all these future cashflows is worth today, and pay a lower price (at least 30% lower). So in theory, if you can accurately calculate that the value of all the future cashflows is worth $200 today and you buy the stock for $100. Then you have made a lot of money. Of course that's the hardest part - estimating all the future cashflows.

So, how do we calculate all the future cashflow? The simplest methodology is to apply a multiple. If the co. earns $10 today, give it a reasonable multiple, say 15x - there, you have it. The value of all its future cashflow is $150. Now that's crude right? But essentially that's what the whole finance industry does and that's also what the world's greatest investor, Warren Buffett does. Of course Warren Buffett perfected this art, by buying businesses that have predictable cashflow into perpetuity. Well it's still an art, so by default, it is hard to get it right most of the time. I have also discussed this in detail in the 5 Things You Need to Know about Investing.

Buffett also thinks hard about how to discount future cashflows correctly. Discounting is essentially saying that a dollar in the future should be worth less today as a result of compounding. The methodology is discussed in detail in this post: Faces of PE - DCF. But at the crux of it, the ways and means to value a stock is not different. For those readers yearning for a short cut. the easy way out is to determine a long term average earnings per share (EPS) of a company with a solid business (like Colgate or Swatch or Coke) and then multiple it by 12-18x. For a great business, you can pay up to 18x. For a so-so business, better just pay 12x or less.

That's Warren Buffett, world's greatest investor.

Many things affect whether a stock should be 12x or 15x or 18x. You can find some discussion in the Valuation label. Now once you have determined the right valuation, the right EPS and have gotten the intrinsic value of the stock, you compare it with today's stock price. If the stock price is significantly lower than its intrinsic value (like 30% or lower), then you have got a strong case to buy. That's really putting it in very elementary terms and no guarantee for you to make money. To learn more, do read the rest of the 250+ posts on this blog and you can start with this 1,500 word introduction on Value Investing :) Cheers! 

 Ok, next we talk about something more mind-boggling. If we think in terms of swapping cashflows, then we must also realize that this is a totally different ball game vs buying a stock at $100 and hoping that the price goes up and we sell and make a profit at $120 to a Greater Fool. The mind-boggling way to think about this is that there is no stock market and no daily price after you bought the stock. You are buying an asset at $100. The only return you are assured of is how much this asset will generate down the road ie how much cash will this investment eventually churn out over time, into perpetuity. There is no other buyer who will come quote you a price every day. And you cannot hope to sell at a higher price to a Greater Fool who is willing to pay for it at the higher price. 

That is the way we should invest. Warren Buffett ever so often says that the market can shutdown for 10 years, he doesn't really care. Because essentially he is buying future cashflows. And he doesn't give a damn if nobody is willing to buy his business or give him a quote tomorrow, or one year out, or 10 years out. When he paid $100 for the business he wants, he is already sure he would make money. Because the future cashflows from the business is very likely to be more than the $100 he paid today. So essentially, money is already made when we buy, not when we sell.

 I believe that's the way to invest.
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