A common mistake by investors is to think that buying quality companies is all that matters and the price paid for the shares is irrelevant.
Paying too high a price for a share is one of the biggest risks that you can take as an investor.
It is just as bad as investing in a poor-quality company in the first place.
The key to successful long-term investing is buying good companies at good prices.
The price of a share is crucial to your long-term investing success.
You will need to learn how to value the shares of companies and set target prices for buying and selling them.
The valuation of shares can become a very complicated exercise.
There are lots of books out there on this subject and many make the process seem difficult to understand.
The good news is that it doesn't have to be this way.
Valuing shares is not a precise science: you only need to be roughly right and err on the side of caution.
The place to start is looking at the fair value of a share.
The fair value of a share
Professional analysts and investors spend lots of time trying to work out how much a share of a company is really worth.
To do this they need to estimate how much free cash flow the company will produce for its shareholders for the rest of its life and put a value on that in today's money, which is known as a present value.
This approach is known as a discounted cash flow (DCF) valuation.
There are three steps to doing a DCF valuation:
1. Estimate free cash flow per share for a period of future years.
Most analysts would probably try to forecast 10 years of future free cash flows.
2. Choose what interest rate you want to receive in order to invest in the shares.
Shares are risky investments - more risky than savings accounts and most bonds - and so people demand to receive a higher interest rate in order to invest in them.
3. Estimate what the value of the shares might be in 10 years' time and give that a value in today's money.
This is the terminal value and it stops you having to estimate free cash flows forever.