Buffett (or more precisely his mentor Ben Graham) makes a notable distinction between an “investor” and a “speculator”. “Investing” requires that companies be in a situation where a projection of cash flow can be made with a reasonable level of accuracy. “Speculating” is unavoidable if the ability to reasonably project cash flows is highly uncertain. A company might be exciting, popular, undergoing dramatic revenue growth, fundamentally changing the world, etc. But if you can’t make a reasonable multi-year prediction of cash flow, you can only guess at what the company is worth—hence you are speculating, not investing.
New companies almost always are speculative. However, fairly well established and successful companies may fall in this category as well.
Take Google as an example of the latter. It has been around for many years and by any definition has been ridiculously successful. Shareholders have many reasons to be legitimately excited about their future prospects. However, even the cream of the crop financial analyst with world class expertise in the Internet cannot derive a reliable prediction of Google’s cash flow over the coming years. Even if the analyst was given complete access to the proprietary information, and that of all its competitors, the cash flow would be plus or minus a lot. Therefore the intrinsic value of Google is simply unknowable.
At the time of this writing, Google trades for $711 per share and has a market cap of $222 billion dollars and a price to earning ratio of 55. Could you come up with a projection of cash flow to justify this? Yes, but it would involve “tremendous” revenue and cash flow growth. My guess is that you’d have a tough time finding someone who doesn’t believe Google will see “tremendous” revenue and cash flow growth. The problem is the range of disagreement on what “tremendous” means is, well, tremendous.
Google’s nearly certain tremendous growth is just as likely to result in valuation of $350 a share as it is to result in $711 or, for that matter, over $1,000 per share. Any of these can be legitimately justified. The result: if you are buying a share of Google in 2007, you must view yourself as a speculator not an investor.
For Google, this won’t change in 2008. However, it might in 2009 or 2010. And it almost certainly will sometime before 2015. So sometime between 2009 and 2015, Google will be a candidate for Warren Buffet style investing.
Certain areas of telecom, in my opinion, are transitioning to an environment condusive for “investing”. Regulatory environment is stabling. Industry/competitive structure is settling. Technology change is becoming a less dramatic driver of unpredictable change. Demand is easier to predict. All and all, it is reasonable to base valuations on forecasting cash flows, not intuition.
In the next blog entry, I will discuss the implications on “investing” and “speculation” on how management should run their companies.
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