There Is A Number That The Best Money Managers Care Very Much About
If you placed $10,000 in a savings account and left it there for the next ten years, at today's interest rate level, you'd probably have $10,500 at the end of those ten years . . . so it's hardly worth doing!
But if you gave that same $10,000 to someone like Warren Buffett who has averaged 22.2% per year since 1965 on his investments, the least return you would have after ten years would be about $42,000 more than if you simply left that original $10,000 in the bank.
Now wouldn't it be nice to know exactly how Warren Buffett does what he does? After all, investing should be like everything else in life. Could there actually be a secret to it that makes the entire process a whole lot easier to understand?
Well I'm not suggesting that it's easy to earn big investment returns because that simply is not the case. However, the basic method that Warren Buffett uses to earn great returns is very simple to understand. He is merely using his own variation of a time-tested method of investing. What Buffett does is to focus on one aspect of any business in which he invests: the business's ability to generate free cash flow.
There are several definitions for the term free cash flow, but it all ends up the same thing: Free cash flow is money that comes from doing business. It doesn't come from selling off assets or from selling more shares of its stock. And it's called "free" because it is the cash that is left over after the company reinvests in the business to keep it running. In short, free cash flow is the money that the management is free to do with as it pleases after it has paid all the bills.
The basic method of calculating free cash flow is very easy to do. You take a company's net income, and then you add back certain non-cash charges like depreciation and amortization. Then you subtract how much capital spending the company needs to do to stay in business. And the resulting number is free cash flow.
Value investors like Warren Buffett earn huge returns because they buy companies that trade at discounts to the company's value as a cash generator.
Knowing one year's worth of free cash flow is merely the beginning of the process that value investors go through. In order to do what Warren Buffett does, you'd have to make an estimate of free cash flow for each of the next seven to ten years. Then you would have to account for the fact that a dollar ten years from now isn't worth as much as a dollar two years from now.
The entire process is simple to understand, but doing it can be quite complicated, and is best left to those who thrive on coping with such mathematical complexities!
* * * * *
But if you gave that same $10,000 to someone like Warren Buffett who has averaged 22.2% per year since 1965 on his investments, the least return you would have after ten years would be about $42,000 more than if you simply left that original $10,000 in the bank.
Now wouldn't it be nice to know exactly how Warren Buffett does what he does? After all, investing should be like everything else in life. Could there actually be a secret to it that makes the entire process a whole lot easier to understand?
Well I'm not suggesting that it's easy to earn big investment returns because that simply is not the case. However, the basic method that Warren Buffett uses to earn great returns is very simple to understand. He is merely using his own variation of a time-tested method of investing. What Buffett does is to focus on one aspect of any business in which he invests: the business's ability to generate free cash flow.
There are several definitions for the term free cash flow, but it all ends up the same thing: Free cash flow is money that comes from doing business. It doesn't come from selling off assets or from selling more shares of its stock. And it's called "free" because it is the cash that is left over after the company reinvests in the business to keep it running. In short, free cash flow is the money that the management is free to do with as it pleases after it has paid all the bills.
The basic method of calculating free cash flow is very easy to do. You take a company's net income, and then you add back certain non-cash charges like depreciation and amortization. Then you subtract how much capital spending the company needs to do to stay in business. And the resulting number is free cash flow.
Value investors like Warren Buffett earn huge returns because they buy companies that trade at discounts to the company's value as a cash generator.
Knowing one year's worth of free cash flow is merely the beginning of the process that value investors go through. In order to do what Warren Buffett does, you'd have to make an estimate of free cash flow for each of the next seven to ten years. Then you would have to account for the fact that a dollar ten years from now isn't worth as much as a dollar two years from now.
The entire process is simple to understand, but doing it can be quite complicated, and is best left to those who thrive on coping with such mathematical complexities!
* * * * *
posted by Bob Moser at
10:09 PM
0 Comments:
Post a Comment
<< Home