Famous investor Warren Buffett has a lot to teach people when it comes to buying shares. One simple tip of his has helped him get better investment returns – and I reckon it can do the same for me.
What a share is worth
How can one determine what a share is worth? There are different valuation metrics, but a common one is looking at discounted future free cash flow. In other words, one looks at all of the money that a company is likely to generate for the rest of its existence, after it has paid all its debts. Then one discounts it for the impact of inflation and the opportunity cost of tying money up. After all, £10 in a decade probably isn’t worth £10 today, as over the 10 years, the real value of the money will erode.
If the market capitalisation of a company is substantially less than its discounted future free cash flow, it could be a bargain. But if it is more, the shares may not be good value.
While the theory is simple, the application is difficult. After all, no one can be sure what the free cash flow of even a fairly stable company like National Grid or Tesco will be next week, let alone decades into the future.
Evaluating share value
That challenge also applies to Warren Buffett. Like the rest of us, in valuing shares he has to make judgments about what could happen in the future without being sure that it will. But he applies some principles to help him make such choices.
Back in 2009, for example, he explained some principles he and partner Charlie Munger apply when evaluating opportunities. Buffett explained, “Charlie and I avoid businesses whose futures we can’t evaluate, no matter how exciting their products may be”. What does that nugget of advice mean? Buffett gave examples of new technology coming along every couple of decades, which clearly could have massive commercial potential. For example, he mentioned cars in 1910, planes in 1930, and television sets in 1950. He recognised that it was easy to foresee massive growth in such industries. But – and this is the key point – Buffett recognised that such nascent industries had unforeseeable competitive dynamics which could have big implications for any given company’s profitability.
In other words, Buffett explained, “Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy”.
Applying this Warren Buffett tip to my portfolio
That pattern has remained. Whether it is electric vehicles now or the internet in 2000, some new industries clearly have massive potential – but when they first emerge it’s too early for me to pick likely winners in them. I have no idea what sort of profit margins and return on capital Rivian or Tesla can likely produce a decade from now.
By focussing only on shares where I can assess a fairly predictable profit picture in the years ahead, I seek to avoid investing in cash-hungry startups that end up losing out in the competitive scramble. Like Warren Buffett, I hope that can improve my investment returns.
Christopher Ruane has no position in any share mentioned. The Motley Fool UK has recommended Tesco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
This post was originally published on Motley Fool
