Sunday, 26 February 2012
WHAT WARREN BUFFETT SAYS ABOUT PREDICTING FUTURE CASH FLOWS
This method of valuation is often referred to as the Discounted Cash Flow (DCF) valuation method, but, as Buffett has said in relation to shares, it is not easy to predict future cash flows and this is why he sticks to investment in companies that are consistent, well managed, and simple to understand.
A company that is hard to understand or that changes frequently does not allow for easy prediction of future earnings and outgoings.
In 1992, Warren Buffett said that:
‘Leaving question of price aside, the best business to own is one that over an extended period can employ large amounts of capital at very high rates of return. The worst company to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.’
It is well worth reading Buffet’s analogy relating DCF to a university education in his 1994 Letter to Shareholders.
So, it would seem that the intrinsic value of a share in a company relates to the DCF that can be expected from the investment.
There are formulas for working out discounted cash flows and they can be complex but they give a result.
The best explanation that we have read of DCF is by Lawrence A Cunningham in his outstanding book How to think like Benjamin Graham and invest like Warren Buffett.
A good online explanation is available here.