The dangers of predicting future performance were highlighted in a recent survey by Parson Consulting, which found that only four of the top 100 ASX-listed companies met analyst earnings-per-share forecasts last financial year.

As John Price, the developer of the Conscious Investor share analysis software, says, there is no point buying a bargain that stays a bargain. Or worse, buying a bargain that turns out to be another Enron.

"I say the only question an investor needs to ask is what return do you need to get. I don't put a value on shares in terms of dollar value but in terms of returns," Price says.

After all, when you finally sell an investment, the important thing is not what price you paid or whether it was overvalued or undervalued at the time, but the total return of all dividends received plus capital gains.

Controversially, Price [does not] put much stress on dividends (see below).

"We talk about total returns, dividend plus capital gains. Money is money," Price says.
Buffett doesn't invest in a company unless he is confident he can make at least a 10 per cent return.
Once you know what return you require and what margin of error you can live with, Price says investors need to sit back and look at the business behind the shares. He says you can go a long way by asking a few questions; the answers can be readily found on free websites.

Price says investors should look for growth in earnings and sales, little or no debt and strong and consistent growth in return on equity (ROE) over the past five to 10 years. "If that hasn't been happening, you have to ask why you think it will in the future," Price says.

ROE is a key measure of profitability, showing the profit made on ordinary share capital expressed as a percentage. Buffett looks for a return of at least 12 or 13 per cent, preferably more. Much less and you could invest for lower risk in other asset classes.

While these questions are numerical, others are more subjective.

Buffett prefers businesses he understands. Most Australians come into daily contact with a range of retailers, goods and services, which gives them an insight into how those businesses are going.
Price says to look at what distinguishes a company from other businesses and whether it has an economic moat to protect its cash flow. For an example of an economic moat, investors need look no further than the Sydney Cross City Tunnel, where the operators negotiated a contract closing off alternative routes.

Also look at a company's competition, brand name, and whether it is a market leader or has a monopoly or patents on key technologies or products. Then you should sit back and see if you can imagine the business continuing successfully in future.

Price's valuation method does take P/E ratios into account when deciding what price to pay. He compares current and past P/E levels, information that is available on some websites.

"If it's been 20 but is now 15, this may be a good time to buy. Don't try to buy on dips in price but on a dip in the P/E ratio," he says.

Even so, the better the business, the less important the share price valuation becomes for long-term investors.

"If you paid too much for Westfield 20 years ago, so what? You would still be a multi-millionaire today," Price says.

The drawbacks of dividends

When the sharemarket is volatile or the outlook uncertain, investors flock to companies that pay solid dividends. Yet dividends can hide a multitude of sins.

Price argues that shareholders with a need for short-term cash could sell a few shares and still end up better off in the long run than an investor who buys a mediocre company for regular dividend income.
Warren Buffett's investment company, Berkshire Hathaway, is a good example. It pays no dividends but shareholders have been richly rewarded nonetheless.

Berkshire has produced a steady return on equity of about 25 per cent a year and its shares have grown by an annual average of 22 per cent over the past 40 years.

This is a far better return than most investors could achieve by receiving profits as dividends and investing the money elsewhere.

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