Price is what you pay, value is what you get.
The value of a company is tied to the amount of excess cash the business will generate over its lifetime. While it is difficult to predict the future, it is sometimes possible to estimate the current rate of excess cash flow (owner earnings) by calculating:
- capital expenditures required to maintain the company's competitive position and unit volume.
Depreciation, depletion, and amortization are non-cash expenses that accountants are required to deduct before reporting a company's earnings. The third item is the cash expense required to maintain the business. This excludes capital expense for growth. This item is by its nature an estimate and one that is often too difficult to make. It is another reason why the set of companies discussed is limited to the handful of industries we understand.
The stock of a company with a sustainable competitive advantage is deemed to be cheap when it trades at seven times owner earnings or less. That is a yield of more than fifteen percent. Such a price implies an ever-dwindling stream of excess cash. It is a fair price for a mediocre company and a bargain price for a company with sustainable competitive advantages.