Monday, February 13, 2012

The fundamental rule of investing: It’s all about the cash

The most reliable way to get rich is to keep investing in assets that generate more cash than you have to put up to buy those assets. That’s why the most important question that you need to ask yourself when valuing an asset is whether the expected future cash flows from the investment is adequate to compensate you for the risk you’re taking and the time you delay spending your money. To answer that question, we will need to apply the discounted cash flow method.

A discounted cash flow is simply today’s value of a future cash flow (a future coupon payment from a bond for instance). You get today’s value of a future cash flow by discounting that future cash flow back to the present at an appropriate discount rate over an appropriate number of periods.

The appropriate discount rate is the rate of return required to compensate you for the risks inherent in the investment. Future cash flows from a company that has a weak balance sheet should be discounted at a higher rate to compensate you for the risk that there will be zero future cash flows if the company goes bankrupt. On the other hand, future cash flows from a company with a strong brand would need to be discounted at a lower rate as the future cash flows are more secure.

The appropriate number of periods to discount a future cash flow is simply the number of periods that you have to wait before receiving that future cash flow. For example: If you want to know the present value of the annual cash flow a company is expected to generate 5 periods from now, then all you have to do is discount that future cash flow over 5 periods (5 years as in this case 1 period = 1 year).

Side note: Contrary to what is written in finance textbooks, the cash flows that should be discounted to get a stock’s value are not the dividends it pays, but the owners’ earnings it generates; even if a company doesn’t pay out all its profits to shareholders, the profits that are not paid out still belong to the shareholders and are being reinvested for their benefit. Owners’ earnings is a term coined by Warren Buffett; owners’ earnings refer to the amount of cash shareholders can take out of the company every year without impairing the company’s future profitability. You can get owners’ earnings by using this formula: Net income + Depreciation and Amortization + or – changes in working capital – capital expenditure necessary to maintain the company’s profitability.

The sum of the present values of the future cash flows as calculated by you will be your estimation of the assets intrinsic value or real value. After calculating the present value of all the future cash flows (the asset’s true value), compare the asset’s true value against the investment you have to make to acquire the asset. If the present value of the future cash flows is higher than the cost of the investment, then it means that you can be expected to be compensated for the risks and earn a return on investment. The greater the present value of the future cash flows over the cost of the investment, the higher the expected return; you would also have a larger margin of safety in case you made an error valuing the asset or a risk event like higher taxes occurs.

Side note: The margin of safety is a concept popularized by Benjamin Graham. The concept states that the higher the discount to intrinsic value at which an investment security can be bought, the safer the investment. This is the case as the intrinsic value of the investment has more room to fall before it’s worth less than what you paid for it. It’s important to note that when I talk about the intrinsic value of the company falling, I’m not referring to the daily movements of the stock price, but to the real value of the company as derived from the company’s profitability. Profits are the driver of a company’s value; a company’s intrinsic value will only go down if its profitability gets impaired. If there’s no impairment to profitability, the day to day movements in share price should be ignored (or taken advantage of by snapping up more shares after they experience large price declines).

Here’s an example of the discounted cash flow method in action:

Awesome Burgers Inc. generates 20 million in owners’ earnings every year. The company is valued at $100 million. Awesome Burgers has a very strong balance sheet, great brand, and operates in a low inflation, politically safe country. It’s safe to say that Awesome Burgers is a very safe company, and since it’s such a safe company, we conclude that a discount rate of only 7 percent should be used. Assuming that we’re long-term investors and that 1 period is 1 year, we conclude that 20 years of expected future owners’ earnings should be discounted back to the present.

After plugging in the numbers, the sum of all the discounted future owners’ earnings of Awesome Burgers is slightly over $211 million. Since the company is only trading at $100 million, it stands to reason that we can make a good return from investing in it. You can use this calculator provided by investopedia.com to help you with the calculations.

A country that’s racking up huge budget deficits and has an unsustainable amount of debt decides to issue 10-year bonds. Each bond will cost $1,000 and has a coupon rate of 10% paid semi-annually (in other words, the bond pay $50 every 6 months). Since the country has a high risk of default, we rationally came to the conclusion that a 20% discount rate should be applied to the bond’s future cash flows.  Here are the numbers we should plug in to get the real or intrinsic value of the bond:                Cash flows = $50   Discount rate = 10% (since coupon payments are semi-annual, discount rate of 20 needs to be divided by 2)   Periods = 20 (coupons paid semi-annually for 10 years). The bond’s principal will also be paid back at maturity, here are the numbers: Principal = $1,000   Periods = 20   Discount rate = 10% (you can use this calculator to calculate the present value of the bond’s future principal repayment). The intrinsic value of the bond is only $574.32, so investing in the bond at $1,000 is a bad idea.

At the end of the day, the fundamental rule in investing is to put money in assets that will generate even more cash for us in the future. While this is a simple rule, and the discounted cash flow method is simple and straightforward to use, there are many things to consider when calculating the intrinsic value of an asset. When valuing a stock, you need to understand the nature of the business to come up with an accurate estimate of the company’s owners’ earnings. You need to understand the risks a company faces to come up with an appropriate rate to discount the company’s future cash flows to the present.

While investing is not easy, it isn’t very hard if you enjoy the investing process. Investing can also be very profitable if you know what you’re doing. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

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