Saturday, 1 May 2010

Buffett (2000): Discounted cash flow approach to valuations is the single most important tool in valuing assets of any kind. 'A bird in the hand is worth two in the bush.'

Warren Buffett described his reluctance to invest in tech stocks and the key reasons behind the same (in his 1999 letter to shareholders). Let us move further to the next year and see what the master has to offer in terms of investment wisdom at the turn of the millennium i.e., in his letter from the year 2000.

Buffett's acquisition spree

The year 2000 was the year that could easily go down in Berkshire's history as the ‘year of acquisitions’. Sensing favorable market conditions, the master completed two transactions that were initiated in 1999 and bought another six businesses during 2000, taking the total to eight. This steady stream of acquisitions is perhaps what inspired him to once again bring his theory of valuations out from the closet and present it before his shareholders. However, while the underlying principles of his theory remained the same, it came cloaked in a different analogy.

What Aesop taught Buffett?

This time, the master has turned to Aesop for help and likens the process of performing valuations to his famous saying - 'a bird in the hand is worth two in the bush'. Without getting too much into details, suffice to say that the master reaffirms his faith in the discounted cash flow approach to valuations and believes it to be the single most important tool in valuing assets of any kind, right from stocks to as exotic assets as royalties and lottery tickets.

Let us read the master's own words on his thoughts -

"The formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn't smart enough to know it was 600 B.C.)."

"The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was ‘a bird in the hand is worth two in the bush’. To flesh out this principle, you must answer only three questions. 
  • How certain are you that there are indeed birds in the bush? 
  • When will they emerge and how many will there be? 
  • What is the risk-free interest rate (which we consider to be the yield on long-term US bonds)? 

If you can answer these three questions, you will know the maximum value of the bush 3/4 and the maximum number of the birds you now possess that should be offered for it. And, of course, don't literally think birds. Think dollars."

"Aesop's investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota 3/4 nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe."

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