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Warren Buffett: Focus on a Company's Future Earnings Potential

One of the biggest mistakes investors can make when valuing a business is spending too much time on what has happened rather than what could happen.

This is particularly important for value investors. More often than not, I see value investors calculate the intrinsic value of a business based on historical figures. This can be quite misleading. These figures only tell us what has happened, rather than what is going to happen.

Look forward, not backward

More often than not, stocks fall in value because they are suffering from structural or cyclical problems. In either scenario, it is not sensible to rely on historical figures to try and calculate the current intrinsic value of a business. You could end up falling into a value trap if you do, especially with companies suffering from structural decline in their industries.

The newspaper industry is a fantastic example. A few years ago, I stumbled across a couple of publicly traded and newspaper companies, which looked cheap based on historical financials.

However, trying to figure out how much these stocks would be worth in five years was almost impossible. There was just no way of knowing if the companies' cashflows were sustainable and if they could grow. As it turns out, they weren't. Most of these companies have been dead money for the past few years.

The father of value investing, Benjamin Graham, relied on historical financials for his investment analysis. Warren Buffett (Trades, Portfolio) also relied on these figures in the first few years of his career.

However, in the 1960s, Buffett started to move away from deep value investing and spent more time focusing on growth businesses. These businesses cost more to buy but had much brighter long-term prospects.

Growth businesses

A great example was Coca-Cola (NYSE:KO). At the 1995 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual meeting of shareholders, Buffett explained that when he first bought the stock, it was dealing at a high price. However, as earnings expanded over the following decades, the stock grew into its valuation:

"We bought our Coca-Cola, for example, in 1988 and '89, on this stock, at a price of $11 a share. Which -- as low as 9, as high as 13, but it averaged about $11. And it'll earn, we'll say, most estimates are between 230 and 240 this year. So, that's under five times this year's earnings, but it was a pretty good size multiple back when we bought it.

It's the future that counts. It's like what I wrote there, what Wayne Gretzky says, to go where the puck is going to be, not where it is. So, the current multiple interacts with the reinvestment of capital and the rate at which that capital's invested, to determine the attractiveness of something now. And we are affected in that valuation process to a considerable degree by interest rates, but not by whether they're 7.3, or 7.0, or 7.5. But I mean, we'll be thinking much differently if they're -- long-term rates are 11 percent or 5 percent. And -- but we don't have any magic multiples in mind. We're thinking -- we want to be in the business that 10 years from now is earning a whole lot more money than it is now, and that we will still feel good about the prospects of the business at that time. That's the kind of business we're trying to buy all of, and that's the kind of business that we try and buy part of."

So, the next time you value a business, it might be sensible to follow Buffett's advice and evaluate the enterprise on what could happen, rather than what has happened.

Disclosure: The author owns shares in Berkshire Hathaway.

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This article first appeared on GuruFocus.