Buying Stock at a Discount

Warren Buffett has said that it is always better to buy a wonderful company at a fair price than a fair company at a wonderful price. If you are investing for the long haul, it is more important that you first make sure that you have identified a sustainably profitable business before you try to put a price on it. Only by thoroughly analyzing a company can we truly understand how much its worth.

The most common way to value a business is by using a discounted cash flow model. In a nutshell, this is done by projecting the free cash flows into the future, then discounting those cash flows back to the present at the weighted-average cost of capital (WACC). You then compare this value to the market price to determine whether or not it is trading at a discount to its true value. If it is trading at a significantly lower price, then it would most likely make for a good investment.

This may sound all rosy and simple, but in reality the discounted cash flow model is inherently rife with errors due to estimation and prediction. Projecting cash flows one or two years out is difficult enough; estimating them five or ten years out is impossible. Calculating the WACC is also nearly hopeless as there is no viable way of accurately computing the cost of equity (the CAPM model has been empirically proven wrong).

Tinkering slightly with growth rates and especially discount rates can land your valuations all over the place, so I have found it most useful to look for conservative ratios and yields when determining whether or not a stock is cheap. A simple metric to use is the price to free cash flow ratio, which is simply the market capitalization divided by the free cash flow. If the cash flows have been inconsistent over the past few years, it may be better to take an average rather than using the trailing year's numbers. If the stock in question is trading for less than around 10 times free cash flow, then it is usually a safe bet. The threshold should be adjusted slightly higher if you are confident that the cash flows will continue into the future and grow at a good pace. Remember that the lower the ratio, the higher your margin of safety will be in case of some inevitable error in your analysis or predictions.