When it comes to Investment, Warren Buffett stands tall than any of his compatriots. I was reading the book by Robert G. Hagstrom called “The Warren Buffett Way” and I would like to keep a note of important things I have read in this book:
Page-21
When a investor buys stocks he not only owns physical stocks but they also becomes partial owners of the business. Hence it is very important to value stocks before you actually own one of them. Becausing owning stocks is actually going to make you the owner of the business. Value a business then go ahead and buy them.
Warren Buffett says “The value of a business is determined by the net cash flows expected to occur over the life of the business discounted at an appropriate interest rate.”
Net cash flow: If a stock can give healthy cash flow in coming years, then one must go ahead and buy that stock. But the question is how to calculate the future cash inflows? Warren Buffett says that the best way to estimate fure cash flows is to estimate the dividends that will be paid to the share holders.
Discounted future cashflows: Dividends received form companies represent the cash inflow into your pocket. If you have invested $100 and issued dividend is 5% p.a. then at the aend of year you will get $5 on your investment of $100. But after one year $5 will carry the same value as of $5 today. The money gets eroded due to inflation (say 4% p.a.). Hence $5 after one year will be euivalent to $5×0.96=$4.8 of today. Like inflation reduces that value of your return, there is another factor is stock investment that increases the value of your return, it is called “risk premium”. All stock investor demands a risk premium for the risk they are taking by investing is direct equity. Suppose this risk premium of 6% in assumed. It means every year the dividend should grow at a steady rate of 6%. Suppose in year one the dividend is 5%, then in the second year the dividend shall me 5%+6%of5% = 5.3%
Suppose you hold on to this stock worth $100 for 3 years, then it will give you returns as listed below (approximate)
- Year (1) = $100*5% – ($100*5%)*4% = $5 – $0.8 = $4.2
- Year (2) = $100*5.3% – ($100*5.3%)*4% = $5.3 – $0.212 = $5.08
- Year (3) = $100*5.62% – ($100*5.62%)*4% = $5.62 – $0.2248 = $5.4
- Total Returns in 3Years = $14.68
At the end of three years the worth stocks which once costed $100 have gone up to $125, and you decide to sell it then the cash in hand is $125+$14.68 = $139.68. So in tree years time your growth is 39.68%.
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