I’ve been studying this for 20 years, and believe the following to be the shortest path to understanding and implementing a value approach to investing.

1) Begin with Buffet’s definition of Free Cash Flow, aka ‘Owner Earnings’:  Read the analysis of Appendix A to Buffet’s 1986 Shareholder Letter – Printed below is the formula:

“If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.”

2)  Read Buffet’s early Partnership Letters:  Between 1959 and 1969, Buffet managed money thru several partnerships for friends, family and other investors.  These year’s were Buffet at his very best, achieving a 29.4% annual average return over more than a decade.  Buffet in effect ran a long-only hedge fund, using little diversification.  Each quarter during these years, he wrote a letter to the Partners, summarizing the partnership returns and his thoughts on investing. These letters are short, 1 to 5 pages each, a pleasure to read.  Through the decade you can see Buffet turn from a Ben Graham ‘Net Assets’ type investor into searching for predictable, undervalued firms with good management.  Although he gives little in these letters as far as number-crunching, the insights gained by reading his thoughts are invaluable.  There is no better way to learn than from the Master himself.

3) Read Chapters 8 and 20 of The Intelligent Investor, by Benjamin Graham.  Since it was first published in 1949, Graham’s investment guide has sold over a million copies and has been praised by such luminaries as Warren E. Buffet as “the best book on investing ever written.”  Considered the Bible of investing, Buffett is very particular in giving special mention to Chapters 8 (The Investor and Market Fluctuations) and 20 (Margin of Safety as the Central Concept of Investment). The common theme between them is that they explain how an investor should think, behave and act as would an intelligent businessperson. In Chapter 8, Graham’s gives his famous parable of ‘Mr Market’, the investor’s manic depressive, but very accommodating, business partner:  ‘Every day he [Mr Market] tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.’  If you are a ‘prudent investor or a sensible businessman’, you will not let Mr Market’s daily mutterings influence your view of an investment’s worth. Instead, you’ll simply take advantage of him when he’s getting it wrong. But here’s the hard part—Mr Market might go for a long time without offering you an attractive deal and you will have to wait patiently for opportunities to arise.  Having established that stocks should be valued according to business principles, Graham takes the idea further in Chapter 20, where he explains that they should only be bought when they are priced substantially below their intrinsic value. Indeed he considers this principle to be rather important, as you can tell from the grand opening to Chapter 20:  ‘In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, “This too will pass”. Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.’  The idea is that a sensible businessperson, when making investments, will have a margin of safety available ‘for absorbing the effect of miscalculations or worse than average luck’—and so too should the prudent investor.

4) Read the original Buffetology, by Mary Buffet.  Written by Buffet’s former daughter-in-law, the book is an excellent outline of Buffet’s thinking, his focus on predictable companies, and more importantly, introduces the concept of forecasting future cash flows and discounting them to the present.  Here’s an important caveat: while reading the book – each time you read the word ‘earnings’, think ‘free cash flow’ – as explained in this Gurufocus article.  Buffet would never use Wall-street-type reported earnings when valuing a company.

5) Read all of the blog articles on the F Wall Street website.  After reading Buffet’s early Partnership letters yourself, you’ll be well-prepared to more fully understand value investing with Joe Ponzio as your guide.  Joe takes actual Buffet quotes and shows how they are applied to value investing.  He’s written over a hundred articles on the subject.  You could buy his book, but it doesn’t replace all the wonderful articles.  Read ALL of them.  No cheating yourself, read them all.

6) Study Aswath Damodoran’s website for a more complete definition of how to calculate Free Cash Flow (FCF).  Dr. Damodoran is a professor at NYU Stern School of Business.  He publishes much of his work online.  It is a confusing website to navigate, but worth the trouble, with many pdf docs, presentations and downloadable spreadsheets.  At this point you will develop a deeper understanding of Free Cash Flow.  Supplement this with Warren Buffet’s descriptions of ‘Owner Earnings’ as mentioned in his annual letters, notably his 1987 letter.  Buffet calculates what he calls ‘Owner Earnings’ as his estimate of FCF.

7)  Choose stocks from any of your favorite Value-based screens.

8) Calculate the prior 10-years worth of FCF, ROIC, profit margin, Book Value and other important financial metrics for your stock.  If 10-years of data is not available – move on.   There are thousands of companies out there, we’re looking for ‘Great companies at Good Prices’ – those who have shown the ability to grow FCF over the past 10 years.  We can’t predict the future if we cannot see the past.

9) Using Warren Buffet’s concept of the ‘3 Pillars of Value’, analyze Pillar #3: Management Effectiveness.  This is the more qualitative pillar to judge whether you’re looking at a ‘Great’ company.  Review 10 years of FCF growth, ROIC, proft margins, growth in book value, use of debt, etc. Also visit the company website or other sources to form an educated opinion.  Only move on to the other Pillars of Value if you are dealing with a great company.

10) Pillar #1: Cash on Hand:  Calculate the Cash, Cash Equivalent, and Marketable Securities per Share.  This gives you the current cash balance of the stock.

11) Pillar #2: Discounted Value of future Cash:
a) Project your stock’s FCF out 10 years into the future
b) Discount all future cash flows back to the present at the desired investment return (I use 15% per Buffet 1994).  Include an allowance for the Terminal Value.
c) Divide the Present Value of the future FCF’s by the number of shares outstanding.  ‘
i) double-check your ‘number of shares outstanding’.  Make sure the stock has not recently split – and is not yet accounted for in most recent financial statement.

12) Sum together the per share values of Pillar #1 and Pillar #2.  This is your ‘Intrinsic Value’ of the stock.  We don’t want to buy at this price though.

13)  Before purchasing:
1) check footnoted.com and Citron Research for signs of any really bad behavior by management; and
2) check secform4 for any positive insider buying.

14) If your stock is selling at a reasonable discount to it’s Intrinsic Value (say 25 – 50%), buy it.  The 25-50% discount is your ‘Margin of Safety’

14) Now ignore the stock market.  Hold your stock until the market reaches Intrinsic Value, then sell.

I’ll add more into this as time permits.  I use an Excel spreadsheet I created to download data via the SMF Add-In.  One day I may offer this spreadsheet for sale, but I consider it the most important work I’ve ever done, and want to keep it private for now.