Picking stocks Buffett's way is straightforward

INVESTING

Undervalued shares not obvious at first

May 14, 2000|By Laura Pavlenko Lutton | Laura Pavlenko Lutton,MORNINGSTAR.COM

Recently in Omaha, Neb., thousands gathered at Berkshire Hathaway's annual meeting to pick the brain of Chairman Warren Buffett. While Buffett did offer new views on a few stocks and industries, much of this legendary investor's strategy hasn't changed in decades.

Before Buffett buys any stocks, he looks at how the company's current share price stacks up against the cash per share that the firm is expected to generate in the future. Determining a stock's present value based on its future free cash flow is somewhat subjective and a bit complicated, but the idea behind it is fairly straightforward.

Simply put, Buffett-like investors determine how much cash the company's operations should generate over time, and then they subtract out the costs associated with maintaining its operations.

Once investors have that figure in hand, they discount the free cash flow because a dollar in a company's coffers today is worth more than the dollar it may earn down the road.

In the end, the discounted cash flows are divided by the total number of outstanding shares at the company, and the investor compares that figure to the company's current share price. If the discounted cash flow per share is higher than the company's current stock price, the investor has found an undervalued stock.

Discounting cash flows can be a little tricky because it requires a financial calculator or a net-present-value table to compute. That's why Morningstar analysts and Wall Street types develop formulaic spreadsheets that automatically discount future cash flows.

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