The goal of the value investor is to locate a quality business, value it and attempt to buy that business at a significant discount to that value. The process of valuation entails extrapolating future cash flows by examining the past performance of the business. And because the future is uncertain, value investors attempt to invest with a "margin of safety" to protect the analysis from any error, both business specific and at the macro level.
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Learn From Past Mistakes
The trap that many investors fall into, however, is relying far too much on the past as a determinant of those future results. And as 2008 has clearly shown, such over-reliance can lead to some expensive mistakes. It's not that past data is useless, but the fact that investors treat that information equally across the investment spectrum that causes problems.
In other words, I would lend far more weight and creditability on the past results of businesses like Coca-Cola (NYSE:KO) or Wal-Mart (NYSE: WMT) than I would for a business like Whole Foods (Nasdaq:WFMI). And I say this as a big fan of Whole Foods, its CEO John Mackey, and the prudent way in which the company is run. But Coke and Wal-Mart are very entrenched businesses with decades if not centuries of operating data.
The mistake for many investors is treating all past data the same, when in fact, it is not.
The Value of Any Stock
The market price of any given stock is set by millions of market participants that price the stock based on future expectations of profitability of the business. As those expectations improve, the stock price will go up; as they decline, the stock price will drop. Therefore one can conclude that value of any stock comes not from what happened in the past but what will happen in the future. Value investors often view the future over a period of years to account for short-term volatility that has nothing to do with the fundamentals of a business. (For more, see The Value Investor's Handbook)
So while I will often refer to P/E ratios and cash flow metrics in analyzing stocks, I do so knowing full well that these are past figures that may not necessarily be the same. However, when I do this, I am focusing on businesses that have greater future demand characteristics for the products and services they provide.
Prison Stock Example
For example, private prison operator Corrections Corp of America (NYSE:CXW) may not appear cheap based on traditional measures of value with a P/E of 20 and a P/B greater than two. However, investors must consider that Corrections commands over 45% of the private prison market and that market is expected to grow tremendously over the next several years. State budgets are very tight, and having a private (read: more efficient) company like Corrections handle their prisoners makes more and more sense.
Also, the company spent the past couple of years ramping up its number of prison beds. So going forward, capital expenditures should be less than the past few years. Couple that with the likely increase in private prison beds used, and Corrections looks very compelling going forward.
The Bottom Line
Past data is useful, but any future price appreciation in the stock will be the result of what lies ahead. (For more, see Digging Into Book Value.)