The Motley Fool

1 simple Warren Buffett tip to improve investment returns

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

Warren Buffett at a Berkshire Hathaway AGM
Image source: The Motley Fool

Famous investor Warren Buffett has a lot to teach people when it comes to buying shares. One simple tip of his has helped him get better investment returns – and I reckon it can do the same for me.

What a share is worth

How can one determine what a share is worth? There are different valuation metrics, but a common one is looking at discounted future free cash flow. In other words, one looks at all of the money that a company is likely to generate for the rest of its existence, after it has paid all its debts. Then one discounts it for the impact of inflation and the opportunity cost of tying money up. After all, £10 in a decade probably isn’t worth £10 today, as over the 10 years, the real value of the money will erode.

5 Stocks For Trying To Build Wealth After 50

Markets around the world are reeling from the coronavirus pandemic… and with so many great companies trading at what look to be ‘discount-bin’ prices, now could be the time for savvy investors to snap up some potential bargains.

But whether you’re a newbie investor or a seasoned pro, deciding which stocks to add to your shopping list can be a daunting prospect during such unprecedented times.

Fortunately, The Motley Fool UK analyst team have short-listed five companies that they believe STILL boast significant long-term growth prospects despite the global upheaval…

We’re sharing the names in a special FREE investing report that you can download today. And if you’re 50 or over, we believe these stocks could be a great fit for any well-diversified portfolio.

Click here to claim your free copy now!

If the market capitalisation of a company is substantially less than its discounted future free cash flow, it could be a bargain. But if it is more, the shares may not be good value.

While the theory is simple, the application is difficult. After all, no one can be sure what the free cash flow of even a fairly stable company like National Grid or Tesco will be next week, let alone decades into the future.

Evaluating share value

That challenge also applies to Warren Buffett. Like the rest of us, in valuing shares he has to make judgments about what could happen in the future without being sure that it will. But he applies some principles to help him make such choices.

Back in 2009, for example, he explained some principles he and partner Charlie Munger apply when evaluating opportunities. Buffett explained, “Charlie and I avoid businesses whose futures we can’t evaluate, no matter how exciting their products may be”. What does that nugget of advice mean? Buffett gave examples of new technology coming along every couple of decades, which clearly could have massive commercial potential. For example, he mentioned cars in 1910, planes in 1930, and television sets in 1950. He recognised that it was easy to foresee massive growth in such industries. But – and this is the key point – Buffett recognised that such nascent industries had unforeseeable competitive dynamics which could have big implications for any given company’s profitability.

In other words, Buffett explained, “Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy”.

Applying this Warren Buffett tip to my portfolio

That pattern has remained. Whether it is electric vehicles now or the internet in 2000, some new industries clearly have massive potential – but when they first emerge it’s too early for me to pick likely winners in them. I have no idea what sort of profit margins and return on capital Rivian or Tesla can likely produce a decade from now.

By focussing only on shares where I can assess a fairly predictable profit picture in the years ahead, I seek to avoid investing in cash-hungry startups that end up losing out in the competitive scramble. Like Warren Buffett, I hope that can improve my investment returns.

“This Stock Could Be Like Buying Amazon in 1997”

I'm sure you'll agree that's quite the statement from Motley Fool Co-Founder Tom Gardner.

But since our US analyst team first recommended shares in this unique tech stock back in 2016, the value has soared.

What's more, we firmly believe there's still plenty of upside in its future. In fact, even throughout the current coronavirus crisis, its performance has been beating Wall St expectations.

And right now, we're giving you a chance to discover exactly what has got our analysts all fired up about this niche industry phenomenon, in our FREE special report, A Top US Share From The Motley Fool.

Click here to claim your copy now — and we’ll tell you the name of this Top US Share… free of charge!

Christopher Ruane has no position in any share mentioned. The Motley Fool UK has recommended Tesco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

Our 6 'Best Buys Now' Shares

Renowned stock-picker Mark Rogers and his analyst team at The Motley Fool UK have named 6 shares that they believe UK investors should consider buying NOW.

So if you’re looking for more stock ideas to try and best position your portfolio today, then it might be a good day for you. Because we're offering a full 33% off your first year of membership to our flagship share-tipping service, backed by our 'no quibbles' 30-day subscription fee refund guarantee.

Simply click below to discover how you can take advantage of this.