For what it's worth

Most people recognise value for money when they see it, whether it's a Sydney-to-Melbourne flight for $49 or mangos for 50c each. But when faced with Telstra at $4, most investors are unsure if they are looking at a bargain or a basket case.

According to Roger Montgomery, of Clime Asset Management, this is because they have no reference point when they try to put a value on shares. While shoppers can check the price of the same item at rival retail outlets, few investors know what Telstra is worth as a going concern.

Part of the problem is that investors get distracted by the daily ebb and flow of share prices, whereas Montgomery argues that price and value are two different things.

For short-term traders the price of the share is often all that matters, because they buy and sell for a quick capital return. So someone who bought Telstra for $4.02 a month ago could have sold for $4.32 two weeks ago and made a quick buck, but whether Telstra was worth $4.32 is anyone's guess.

Yet for long-term investors the quality of the business is paramount, because that is what will underpin the share price and the total return they receive on their investment.

That's not to say price is unimportant. As billionaire investor Warren Buffett points out, the higher the price you pay, the lower your return.

When share prices fall bargain hunters pile in, because the shares look cheap relative to their recent trading history or to similar companies. Many investors use the price-to-earnings ratio (P/E) to determine whether a share is cheap relative to the market or its peers, but this still ignores "intrinsic value" and is often based on estimates of future earnings.

The dangers of predicting future performance were highlighted in a recent survey by Parson Consulting, which found that only four of the top 100 ASX-listed companies met analyst earnings-per-share forecasts last financial year.

As John Price, the developer of the Conscious Investor share analysis software, says, there is no point buying a bargain that stays a bargain. Or worse, buying a bargain that turns out to be another Enron.

In order to tell the difference, investors need to be able to value the business they are investing in to make sure it can deliver the return they require.

Professionals use different methods to value shares. Most brokers use the discount cash flow method, which tries to estimate future cash flow and discount it back to calculate the current value of the shares.

Fund managers develop their own valuation methods, often using a mix of fundamental analysis and sophisticated computer modelling.

Yet few investment professionals are prepared to reveal their complex formulae.

A cynic might say it is in their interests to let investors believe that valuing shares is too tricky for mere mortals.

Price and Montgomery, who both follow Buffett's investment philosophy, sell investment analysis tools, but they insist people who are prepared to invest a little time and thought can go a long way towards valuing companies themselves and making profitable investments.

"I say the only question an investor needs to ask is what return do you need to get. I don't put a value on shares in terms of dollar value but in terms of returns," Price says.

After all, when you finally sell an investment, the important thing is not what price you paid or whether it was overvalued or undervalued at the time, but the total return of all dividends received plus capital gains.

Controversially, neither Price nor Montgomery put much stress on dividends.

"We talk about total returns, dividend plus capital gains. Money is money," Price says.

Buffett doesn't invest in a company unless he is confident he can make at least a 10 per cent return.

Once you know what return you require and what margin of error you can live with, Price says investors need to sit back and look at the business behind the shares. He says you can go a long way by asking a few questions; the answers can be readily found on free websites.

Price says investors should look for growth in earnings and sales, little or no debt and strong and consistent growth in return on equity (ROE) over the past five to 10 years. "If that hasn't been happening, you have to ask why you think it will in the future," Price says.

ROE is a key measure of profitability, showing the profit made on ordinary share capital expressed as a percentage. Buffett looks for a return of at least 12 or 13 per cent, preferably more. Much less and you could invest for lower risk in other asset classes.

While these questions are numerical, others are more subjective.

Buffett prefers businesses he understands. Most Australians come into daily contact with a range of retailers, goods and services, which gives them an insight into how those businesses are going.

Price says to look at what distinguishes a company from other businesses and whether it has an economic moat to protect its cash flow. For an example of an economic moat, investors need look no further than the Sydney Cross City Tunnel, where the operators negotiated a contract closing off alternative routes.

Also look at a company's competition, brand name, and whether it is a market leader or has a monopoly or patents on key technologies or products. Then you should sit back and see if you can imagine the business continuing successfully in future.

Only then is it time to ask what price you should pay for the company's shares. Using the method in the box below, Montgomery says investors can work out how much they should pay to achieve a specific return with a margin for error, or a level of risk, they can live with.

"This approach allows you to relax. When you invest you can be confident about buying and holding because you know [the shares] are worth more," Montgomery says.

Price's valuation method does take P/E ratios into account when deciding what price to pay. He compares current and past P/E levels, information that is available on some websites.

"If it's been 20 but is now 15, this may be a good time to buy. Don't try to buy on dips in price but on a dip in the P/E ratio," he says.

Even so, the better the business, the less important the share price valuation becomes for long-term investors.

"If you paid too much for Westfield 20 years ago, so what? You would still be a multi-millionaire today," Price says.