What Makes for a Good Investment?

What does it mean to invest? Investing is the process of providing capital for the receipt of future income, appreciation in the capital, or both. In providing the capital, the investor assumes some risk: the possibility of losing some or all of the invested sum. Typically speaking, when there is higher possibility of loss there also needs to be greater gains in terms of capital appreciation and income in order to offset the risk. The best investors are those that are able to best understand and manage risk, as well as analyze and understand the potential of future income.

Warren Buffett is no doubt one of the best investors of all time. Not only is he an excellent judge of risk and profits, but he has the uncanny ability to properly assess the value of an investment. Even if a company experiences excellent growth and profits, if it is overvalued there is some risk that eventually the valuation of the company may drop to a more reasonable level. Buffett will only invest in a company if he believes it to be fairly valued, or even better undervalued.

So how do you determine the value of a company? There are many methods, but fundamentally speaking I like using discounted cash flows (DCF). With DCF, you discount estimated future earnings by the sum of the risk-free rate (federal government bonds) and a risk premium. The Business Plan Store has a good example here. Robert G. Hagstrom wrote an excellent book called The Warren Buffett Way, in which he provides some insight into how Buffett performs some DCF analysis to value business he has invested in. Later this week, I’ll provide you with an overview of Hagstrom’s calculations along with some examples.

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