last updated February 21, 2015

How much should you pay for a stock? That depends on how much money you want to make! Obviously you want to buy at a low price and sell at a high price, but what’s the right price for a stock?

Throughout our investment guide. we concentrate on the notion of value investing. Our focus is finding stocks trading for less than what the company will earn in the future makes them worth. Clearly we’re most concerned about the earning potential of our stocks. That’s part one.

How do you get from earning potential to a working definition of value? Start by calculating the expected or desired return on your investment.

Calculating the Return on Your Investment

Suppose you buy a doughnut store for $100. (Maybe it’s a little roadside stand in the wilds of Canada, and that’s why it’s such a bargain.) Business is good, but you hate getting up at 4 am to make money, so in a year, you turn around and sell it for $150. You’ve made $50, which is a 50% return in a year.

Suppose you decide you’d rather buy a coffee stand where at least you can sleep in until 5 am to prepare for the commute. You think you can sell it next year for $300. You’d like to make another 50% return on that investment by then. At what price must you buy the stand this year to achieve that? That’s right; $200.

That simple math provides a specific dollar amount at which you can buy and sell this business. If you can achieve that, you have made a very good return on your investment. Your question is now Can I sell this coffee stand for $200 next year? If so, it might be a good investment. In practice, you also must consider what it costs to run the coffee stand, though if it’ll be worth 50% more than what you paid for it, it’s probably a well run business.

What is Free Cash Flow?

With that working definition of investment value, and the understanding of rate of return tied to the prices at which you buy and sell something, we come to the idea of cash flow.

The cash flow of a company is the amount of real money it generates for its ownersits shareholders. This is the money that can be reinvested in the business to help it grow, paid out as dividends. used to buy back stock, or put into play to buy other companies to expand the market, customer base, or types of business.

There are several ways to measure the cash flow of a business, but in short, free cash flow is the amount of cash a business can generate after it pays for its standard upkeep and expansion. In other words, once your business has paid what it needs to pay to stay in business (or build other doughnut carts), what’s left over is free cash.

Free cash flow is one of the best measurements of business success in investing, because it’s tied the fundamental performance of the business and it’s difficult to fudge with accounting tricks. In other words, it’s a really good measure of the value and growth of a business.

What is Discounted Cash Flow?

How does cash flow relate to the current value of an investment? You have to correlate the money you expect a business to generate to the return you want to achieve from owning that investment. Discounted cash flow is the present value of the free cash an investment can generate. That sounds like a mouthful of math, but it’s straightforward. The amount you invested plus the percentage rate of return you want equals the price you have to sell it for. That works great if you know the amount you invested and the return you want to get, but what if you’re trying to figure out the right price to pay ?

This is middle school algebra. If you know two of the three values, you can figure out the other value. If you have the opportunity to buy a cupcake shop (where you can sleep until 10 am and then start making cupcakes for happy hour) now and think you can plausibly sell it next year for $600, and if you want to make another 50% return on your investment in a year, you can figure out how much you want to spend on it right now. In other words, the right price times 1.5 (or plus 50%) equals $600, so $600 divided by 1.5 equals the right price right now. You should spend no more than $400.

What is Present Value?

In all of the examples (doughnut stand, coffee stand, cupcake shop), the underlying business grew in value over time. If that growth rate is reasonably predictable, you can figure out what the business is worth right now if you have a time frame for selling it. This math lets you calculate the present value of an investment, which is the price you should pay for the investment given its expected growth rate.

If you expect your doughnut stand to be worth $200 next year and you want to make 50% in a year, you can pay no more than $100 for it right now. Given a time frame of one year and your expected rate of return, the present value of the business is $100. If it costs you more than that, it’s not a bargain. If it costs you less, it’s very much on sale.

What’s a Reasonable Rate of Return for Discounted Cash Flow Analysis?

In real life, you’re unlikely to see discounts this steep. In the stock market, they sometimes occur. Is a 50% return realistic though?

Over a period of decades, the S&P 500 index fund returns somewhere around 8% a year. That’s the simplest buy-and-hold strategy you can pursue in the stock market, and it’s pretty reliable over time. If you take away only one hot investment tip, it’s this.

If you want to beat the market, you need to earn more than 8% a year. Let’s say 12% for the sake of argument. To find a bargain in the stock market, you’re looking for something with a discounted cash value of about 12%. (We perform our calculations with 15% to give us a further margin of safety. We’re a little bit conservative that way.)

What is Discounted Cash Flow Analysis?

If you take all of these ideas and put them together, you get discounted cash flow analysis. which helps you answer the question What should I pay for a share of a company, given its cash flow situation and the rate of return I want to get?

In this case, the value of a share of stock isn’t exactly what you think you can sell it for in the future. It’s related more closely to the amount of free cash the company will generate for each share of stock. (We do make the assumption that the value of each share of stock will eventually reflect a fair valuation of that free cash flow, but the market can be irrational at times, which lets us find bargains!)

This math does get a little bit more complicated, but you don’t have to understand all of the details if you understand the goal. $100 invested at a 50% rate of return will give you $150 next year. If you know something worth $150 next year and you want to make a 50% return, you can pay no more than $100 for it right now.

Risk and Discounted Free Cash Flow

Because of the volatility of the stock market and the unpredictability of cash flow (see Free Cash Flow Jitter for a measurement of the reliability of a company), you want to add a measure of risk insurance to your calculations. By discounting the final price, you give yourself a margin of error. If there’s a 10% risk that the cupcake shop won’t be worth $600 next year, take 10% off the $400 price and resolve to pay no more than $360 for it.

How To Use Discounted Cash Flow Analysis

Find a good stock you like. Make sure it has reliable cash flow and a good market position. Determine the likelihood that the company will stick around and do good things.

Calculate the cash flow out five or ten years, taking into account the past five or ten years of cash flow or owner earnings.

Choose your discount rate and figure out the present value of the company based on its expected cash flow. Take into account your margin of safety .

You now have a target number. If the stock price is at or below that number, it’s probably on sale. Otherwise, move on. This is the basis of value investing .

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