There are two components you need to understand before making any investment: risk and reward.
You probably don't need me to tell you, but both are in-depth topics requiring a strong skill set and emotional competence.
However, with a little commitment to educating yourself, these seemingly complex topics can be simplified and applied to provide outsized returns on your investments.
To measure the return of a company, I think free cash flow is the best measure of present and future health because it takes into consideration the capital required for maintaining and growing a business.
To measure the risk component, usually I run an array of sensitivities in a valuation model. The 'What-if' analysis is a powerful tool to garner an understanding of where key risks face the business and, in turn, your valuation.
Let's use a quick example of Rio Tinto, which is currently priced around $51 a share.
If I use my estimate of 2014's free cash flow ($6.12 billion) as the basis for my forecasts over the next 10 years, growing at 5% per year, my fair value estimate is $54.
However, if you've kept up to date with the iron ore market, and commodities more generally, you'd know miners like Rio Tinto are under pressure.
Looking out to the full 2015 financial year, Rio Tinto's revenues are likely to fall sharply, and unless its investments in new and existing projects are chopped, it's free cash flow will slump.
I estimate its free cash flow in the year ahead will be around $3.5 billion. Plugging $3.5 billion into my model renders a fair value of $27.80.
If we assume Rio Tinto's average annual free cash flow for the past four years ($4.3 billion), intrinsic value comes in at $35.84.
Risk versus Reward
In the optimistic case, Rio Tinto shares are worth 6% more than their current price. But worst case, they're worth 45% less.
Now, I'm entirely sure none of my three free cash flow projections will prove to be a 100% reliable measure of value because in the share market – as in nature – few things move in straight lines.
However, in my opinion, a quick sensitivity analysis of a valuation of Rio Tinto shares would reveal there is significantly more downside risk in Rio Tinto's current share price than upside potential. At least for iron ore bears like me.
To balance the argument, I should mention Rio Tinto is a well-run business and has many levers it can pull to boost its free cash flow if it needs to pay down debt or return dividends to shareholders.
However, Rio Tinto shares are not a buy in my book because the risks appear too great, and the return too small.
