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Investing Specialists

The Courage to Invest in Tough Markets

A foreign pick illustrates why cash flow is key.

Mentioned:

Ralph Waldo Emerson stated, "Fear defeats more people than any other one thing in the world." There have been many studies that show missing as few as the best 10 days of the stock market since 1900 cuts your returns in half. This is why market-timing is so difficult--you have to be right twice: getting out at the top and getting back in at the bottom.

It is easy to see the fear of wealth destruction as stock prices plummet, but it's difficult to see the reality that stocks are an ownership interest in a company. The real value of a company depends on its cash flows, and it doesn't change day by day like its stock market value does.

When the market is looking so dour, examining a company's cash flow gives us the courage to buy stocks. Ultimately we are buying a piece of a business when we buy a stock, and the long-term value of any business is the present value of its future cash flows. All valuation metrics are trying to estimate that value, and all have limitations. At Morningstar, we use a proprietary discounted cash-flow model to estimate those future cash flows and then discount them back to the present value. This process makes us more confident in our fair value estimates. We have to think about future products from the firm and from competitors, and how they will be received by the market. We think about what will happen to revenues and margins and, ultimately, cash flows. We can also run a scenario analysis to see how changes to our inputs affect the fair value.

Allan C. Nichols does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.