Evaluating Quality first, then Price. Fair price is one associated with adequate return at acceptable risk.

1.   The most important task in buying a stock is to determine that the company is a good company in which to own stock for the long term.  (QUALITY)

2.  However, no matter how good the company, if the price of its stock is too high, it is not going to be a good investment.

3.  A stock price must pass two tests to be considered reasonable:
(i)  The hypothetical total return from the investment must be adequate - enough to contribute to a portfolio average of around 15% - sufficient to double its value every 5 years.  (REWARD).
(ii)  The potential gain should be at least 3x the potential loss.  (RISK)

4.  To complete these tasks, you have to have learned how to do the following:
(i)  Estimate future sales and earnings growth.
(ii)  Estimate future earnings.
(iii)  Analyze past PEs (Check the current PE with the average past PEs)
(iv)  Estimate future PEs.
(v)  Forecast the potential high and low prices.
(vi)  Calculate the potential return.
(vii)  Calculate the potential risk.
(viii)  Calculate a fair price.

5.  If you take each of these steps in 4(i) to 4(viii), cautiously and shun excesses, your actual results is likely to be as good or better than the forecast at least four out of the five times.

6.  And you will have a track record to rival any professional.

That's all folks!

When evaluating the price, look at the potential return and the risk you must take to get that return.

When it comes to evaluating the price of a stock, you're really interested in just 2 things:

1.  The potential return, and
2.  The risk you must take to get that return.

If the potential return is worth the risk, the price is right.

If it is not, you can simply wait until it is.

As volatile as the stock market is, most stocks will sell at a favourable price sometime during the year.

To estimate the potential return, you will have to come up with a reasonable forecast of how high the price might go.  Knowing the hypothetical potential high price, you can estimate the potential return.

To evaluate risk, you will need to conservatively estimate the stock's potential lowest price.  If your potential gain is at least three times as much as you risk losing, your stock is probably selling at a fair price.



For example:

Stock TUW

Potential high price = $20
Potential low price = $10
Market price = $12

Potential gain = $20 - $12 = $18
Potential loss = $ $12 - $10 = $2
Therefore, potential gain : potential loss = $8 : $2 = 4 : 1

As the potential gain is at least 3x as much as you risk losing, the stock is probably selling at a fair price.

Prospecting for Good Quality Stocks at the Right Price at any given time.

There are about 16,000 publicly owned companies in the U.S. for you to select from.  There are also about 3 times this number (48,000) of publicly owned companies in the other countries for you to select from too.

With so many companies, of course, some are much better candidates for your consideration than others.

Of these companies, fewer than 2% are likely to make the cut so far as your quality standards are concerned.

And perhaps, only 5% of THOSE might be available at the right price at any given time- and even this could be an overestimate.


Illustration:

1000 stocks

Only 20 are quality stocks (20/1000 = 2%)

Of these 20 quality stocks, only 1 is available at the right price at any given time, if at all. (1/20 = 5%)

Discrepancies between price and value

One cannot be taught how to weigh the future.

The analyst is warned not to trust his projections of the future too far, and especially not to lose sight of the price of the security he is analyzing.

No matter how rosy the prospects, the price may still be too high.

Conversely, the shares of companies with unpromising outlooks may sell so low that they offer excellent opportunities to the shrewd buyer.

Also, the wheel of time brings many changes and reversals.

"Many shall be restored that now are fallen, and many shall fall that now are in honor."

How is market value of common stock determined?

Market value is basically determined by investor expectations of future earnings and dividend payments, although the value of assets is also important.

Prices may also be affected temporarily by large transactions creating bid-offer imbalances, by rumours of various sorts, and by public tender offers.

Price target - this information is helpful for getting a sense of what others are thinking about the stock's price.

Price target is a share price analysts say the stock will achieve at some future date.

Analysts often attach a period to the price, such as a one-year price target of $ 18.

The information is more suggestive than quantifiable.

It is helpful for getting a sense of what others are thinking about the stock's price.

A stock price must past 2 tests to be considered reasonable.

The most important task in buying a stock is to determine that the company is a good company, in which to own stock for the long term. 

However, no matter how good the company, if the price of its stock is too high, it's not going to be a good investment.

A stock price must pass two tests to be considered reasonable:

1.  The hypothetical total return

The hypothetical total return from the investment must be adequate - enough to contribute to a portfolio average of around 15 percent - sufficient to double its value every 5 years.

2.  The potential risk 

The potential gain should be at least 3 times the potential loss.




























To complete these tests, you have to learn how to do the following:

• Estimate future sales and earnings growth
• Estimate future earnings
• Analyse past PEs (check the present PE relative to its usual average PE)
• Estimate future PEs.
• Forecast the potential high and low prices
• Calculate the potential return.
• Calculate the potential risk.
• Calculate a fair price.

Value versus Price - Two Perspectives on Worth

Value versus Price

Two Perspectives on Worth

	VALUATION	PRICING
End	truth -- intrinsic value	illusion -- marginal opinion
Means	method of appraisal *	auction mechanism
Terms	case-by-case	standardized
Institution	private contracts	public exchanges
Approach	rational, logical	arational, emotional
Knowledge	economics	psychology, sociology
Principle	theory of investment	ad hoc, empirical
Result	value range	single price
Precision	highly imprecise	highly precise
Accuracy	within value range	outside value range
Investment	real assets	claims on assets
Units	operating enterprise	common stock issue
Data Source	company reports	market-generated
Measurement	absolute	relative, comparative
Analysis Type	investment	portfolio of stocks
Analysis-Units	one company	compare two stocks
Analysis-Time	one point in time	compare two times
Horizon	long-term (years)	short-term (minutes)
Frequency	sporadic, on demand	continuous supply
Stability	slow, small changes	quick, large changes
Application	individual stock selection	stock trading
* In contrast, the method of anticipation emphasizes earnings growth for the sake of growth rather than the sake of value. Thus, it is not recommended for purposes of estimating value.

Investors will frequently not know why security prices fluctuate. Must look beyond security prices to underlying business value.

Security prices sometimes fluctuate, not based on any apparent changes in reality, but on changes in investor perception.

• The shares of many biotechnology companies doubled and tripled in the first months of 1991, for example despite a lack of change in company or industry fundamentals that could possibly have explained that magnitude of increase. 
• The only explanation for the price rise was that investors were suddenly willing to pay much more than before to buy the same thing.

In the short run supply and demand alone determine market prices. 

• If there are many large sellers and few buyers, prices fall, sometimes beyond reason. 
• Supply-and-demand imbalances can result from year-end tax selling, an institutional stampede out of a stock that just reported disappointing earnings, or an unpleasant rumor. 

Most day-to-day market price fluctuations result from supply- and-demand variations rather than from fundamental developments.


Investors will frequently not know why security prices fluctuate. 

• They may change because of, in the absence of, or in complete indifference to changes in underlying value. 
• In the short run investor perception may be as important as reality itself in determining security prices. 
• It is never clear which future events are anticipated by investors and thus already reflected in today's security prices. 

Because security prices can change for any number of reasons and because it is impossible to know what expectations are reflected in any given price level,  investors must look beyond security prices to underlying business value, always comparing the two as part of the investment process.


Main Point: 
Investors will frequently not know why security prices fluctuate and must look beyond security prices to underlying business value, always comparing the two as part of the investment process

Risk is dependent on both the nature of investments and on their market price

The risk of an investment is described by both the probability and the potential amount of loss.

The risk of an investment - the probability of an adverse outcome - is partly inherent in its very nature.

• A dollar spent on biotechnology is a riskier investment than a dollar used to purchase utility equipment.  
• The former has both a greater probability of loss and a greater percentage of the investment at stake.

In the financial markets, however, the connection between a marketable security and the underlying business is not as clearcut.

• For investors in a marketable security the gain and loss associated with the various outcomes is not totally inherent in the underlying business; 
• it also depends on the price paid, which is established by the marketplace.

Learn to love stockmarket falls

• 13 Aug 07

Most people are net buyers of stocks throughout their lives, which means that market falls should be welcomed rather than feared.

You could be forgiven for thinking that there had been some major ructions in the stockmarket over the past couple of weeks. There’s been talk of crashes, collapses and crunches, with well-known Wall Street pundits shouting and screaming (if only for effect). So far at least, though, we haven’t even seen the 10% drop that people arbitrarily consider is necessary for a ‘correction’ and the All Ordinaries Index is still above where it stood in March.


The truth is that fear and panic get people’s attention and the media is well aware of it. But it’s at times like this that investors need to stand back from the crowd and make a cold assessment of what’s going on. No doubt some companies are affected by recent turmoil in global debt markets, but some have, and/or will generate, all the cash they need for their future investing plans and have little to fear from a recession, which might in fact help them take market share from competitors. Yet these companies have been getting cheaper along with everything else and we’ve been licking our lips.


Only a few stocks have so far drifted into our buying range – Corporate Express, Ten Network and Servcorp (almost) – but we’re hopeful of bigger falls and further opportunities.


It’s a truism to say that, all things being equal, you’ll do better from stocks if you buy them cheaply. But what people forget is that for most of their lives, they’re net buyers, or at least holders, of stocks. And the ideal situation is to reach retirement with enough in your pot that you never have to become a net seller. So for most people, for most of their lives, stockmarket falls are good things.

Price and value


The crucial point to understand is that the price of a stock and its value are two different things. The market sets the former and we spend our days trying to estimate the latter. To make our life easier, we generally avoid poorly managed, debt-laden or cyclical businesses where predictability is poor, and we look for a margin of safety to protect us against an error of judgement – the more uncertain we are about a company’s value, the greater the margin of safety we require.
Most of the time, price is pretty close to value. But sometimes it gets out of whack, and occasionally by enough to give us a decent margin of safety. It’s these situations that present the greatest opportunities for canny investors and the greatest dangers for those who succumb to understandable but irrational mood swings. Preparedness makes all the difference.


Imagine you’re researching a company, Little Acorn Limited, which operates in a predictable industry, has decent management and pays no dividends. It reinvests all its profits, meaning that returns are entirely in the form of capital growth. You’ve done the work, and are as comfortable as you can be that Little Acorn will grow earnings per share (EPS) at 10% per year, from the current level of $1.00, with very little chance of variability.


Deeming Little Acorn to have all the right stuff, you buy the stock for $15 – a price-to-earnings ratio of 15. If your estimate of earnings growth is accurate, then EPS will grow from $1.00 to $2.59 over the next decade. If the market is still happy to pay a PER of 15 at that point, then the stock will trade at around $38.85, and you’ll have achieved an annual return of 10%, in line with the earnings growth.


The future is always uncertain


Of course, the stock might trade lower in a pessimistic market in 2017, giving you a lower annual return (but an underpriced stock that’s likely to do well in future years). Alternatively, it might trade higher, giving you a larger annual return (but an overpriced stock that you might choose to sell).


Which of those possibilities eventuates is of some importance. But what happens in the stockmarket over the next week, month or year doesn’t make a lick of difference as to how the market will view Little Acorn in ten years’ time.

Great oaks from little acorns grow
	Price in 2007	Price in 2017	Annual return
Expected	$15	$38.85	10.0%
outcome	$8	$38.85	17.1%
Lower	$15	$25	5.2%
outcome	$8	$25	12.1%
Higher	$15	$50	12.8%
outcome	$8	$50	20.1%

So let’s say that shortly after purchasing Little Acorn for $15, the market tanks and takes Little Acorn with it – down to $8. The talking heads everywhere go berserk over the ‘blood on the streets’ and you’re staring at a ‘loss’ of almost 50%. The emotional investor gets the chance to do some real and permanent damage here. Avoid this at all cost.


Assuming that Little Acorn is still as likely as ever to grow its EPS at 10% per year and arrive in 2017 with EPS of $2.59 and a stock price of $38.85, your forecast of its future is unchanged, and your expected return from yesterday’s investment is unchanged at 10% per year. You won’t get that return if you sell out now. But if you do nothing but hold, your eventual wealth will be just as great as if the share price followed a straight line from $15 to $38.85 over the course of a decade.


But wait there’s more


If you have some spare cash, though, you can actually improve your position, by going against the crowd and buying more shares in Little Acorn at $8. At that price, your additional investment will compound at 17% per year until the shares trade at $38.85 in 2017, dragging up your average return in the process. So the market tumble has actually provided an opportunity.


Of course, the real world isn’t so neat. Market crashes can hurt the economy, affecting company profits in the short and medium term. And the 2017 value of the stock will swing based on both the mood of the markets then, and the company’s growth in the intervening years. But that’s the case regardless of whether stocks are cheap or expensive today. Which brings us back to the trusim that the less we pay for our stocks, the greater the bargains they’ll prove to be.


So remember that when the market takes a tumble, it’s just changing the price that it’s setting for stocks. The value of those stocks, all things being equal, will remain the same. You don’t have to sell your stocks, but you can choose to buy, if you have the spare cash and can find something suitable. Viewed like this, market crashes won’t do any harm to long-term investors, but actually offer you the chance to compound your money at a greater rate.

http://www.intelligentinvestor.com.au/articles/230/Learn-to-love-stockmarket-falls.cfm

What is the correct company value? Value versus Price

S@R | 15/02/2009

Nobel Prize winner in Economics, Milton Friedman, has said; “the only concept/theory which has gained universal acceptance by economists is that the value of an asset is determined by the expected benefits it will generate”.

Value is not the same as price. Price is what the market is willing to pay. Even if the value is high, most want to pay as little as possible. One basic relationship will be the investor’s demand for return on capital – investor’s expected return rate. There will always be alternative investments, and in a free market, investor will compare the investment alternatives attractiveness against his demand for return on invested capital. If the expected return on invested capital exceeds the investments future capital proceeds, the investment is considered less attractive.

One critical issue is therefore to estimate and fix the correct company value that reflects the real values in the company. In its simplest form this can be achieved through:

Budget a simple cash flow for the forecast period with fixed interest cost throughout the period, and ad the value to the booked balance.

This evaluation will be an indicator, but implies a series of simplifications that can distort the reality considerably. For instance, real balance value differs generally from book value. Proceeds/dividends are paid out according to legislation; also the level of debt will normally vary throughout the prognosis period. These are some factors that suggest that the mentioned premises opens for the possibility of substantial deviation compared to an integral and detailed evaluation of the company’s real values.

A more correct value can be provided through:

• Correcting the opening balance, forecast and budget operations, estimate complete result and balance sheets for the whole forecast period. Incorporate market weighted average cost of capital when discounting.

The last method is considerably more demanding, but will give an evaluation result that can be tested and that also can take into consideration qualitative values that implicitly are part of the forecast.
The result is then used as input in a risk analysis such that the probability distribution for the value of the chosen evaluation method will appear. With this method a more correct picture will appear of what the expected value is given the set of assumption and input.

The better the value is explained, the more likely it is that the price will be “right”.

The chart below illustrates the method.

http://www.strategy-at-risk.com/2009/02/15/what-is-the-correct-company-value/

US Supreme Court Addresses "Fair Price" and "Fair Value" in Appraisal Proceedings

Posted on December 31, 2010 by Francis G.X. Pileggi

Supreme Court Addresses "Fair Price" and "Fair Value" in Appraisal Proceedings; Declines to Adopt Bright Line Rules for Appraisal Proceedings

In affirming the Court of Chancery’s finding of fair value in an appraisal proceeding, the Delaware Supreme Court in Golden Telecom, Inc. v. Global GT LP, declined to adopt two bright line rules urged by the parties on appeal. Slip op. No. 392, 2010 (Del. Supr. Dec. 29, 2010). Read opinion here. Instead, the Supreme Court held that: (1) in an appraisal proceeding pursuant to 8 Del. C. § 262, the Court of Chancery must take into account all relevant factors and need not defer, either conclusively or presumptively, to the merger price as indicative of fair value; and (2) companies subject to an appraisal proceeding are not bound by the data in their proxy materials. The Supreme Court also held that the abuse of discretion standard of review for appraisal cases is a formidable standard wherein the Supreme Court will defer to the Court of Chancery even where the Supreme Court may have independently reached a different decision.

This summary was prepared by Kevin F. Brady and Ryan P. Newell of Connolly Bove Lodge & Hutz LLP.

The Merger and the Petition for Appraisal

In early 2007, Open Joint Stick Company Vimpel-Communications (“Vimpel-Com”) notified Golden Telecom, Inc. (“Golden”) that Vimpel-Com was interested in acquiring Golden. Because the two largest shareholders of Golden were also the two largest shareholders of Vimpel-Com, Golden formed a special committee of independent directors. After nearly three months of negotiations, the special committee ultimately recommended and the Board approved the merger at $105 per share. Golden and Vimpel-Com executed a merger agreement with a cash tender offer and a backend merger. Global GT LP and Global GT Ltd. (collectively “Global”) declined to tender its shares and sought appraisal. The Court of Chancery held that the fair value of Golden as of the date of the merger was $125.49.

Golden and Global Appeal

Golden appealed arguing that, among other things, the Court: (i) should have deferred to the merger price because it was an arms length transaction with an “efficient market price;” (ii) should have given some weight to market evidence; (iii) erred in considering a blended beta; and (iv) erred in accepting Global’s expert and its long term growth rate in its discounted cash flow analysis. Global cross appealed contending that the Court used the incorrect tax rate.

Fair Value Requires Independent Evaluation Not Deference to Merger Price

Relying on the language of § 262, the Supreme Court, stated that “fair value” is to be determined by “all relevant factors” valuing the corporation as a “going concern, as opposed to the firm’s value in the context of an acquisition or other transaction.” The Supreme Court also reasoned that “[s]ection 262(h) unambiguously calls upon the Court of Chancery to perform an independent evaluation of ‘fair value’ at the time of the transaction” and that “[r]equiring the Court of Chancery to defer—conclusively or presumptively—to the merger price, even in the face of a pristine, unchallenged transactional process, would contravene the unambiguous language of the statute and the reasoned holdings of our precedent.”

Court Refuses to Adopt Bright Line Rule

Global contended that in the appraisal proceeding, Golden should not have been permitted to walk away from the tax rate set forth in the fairness opinion. While the Court agreed that the primary purpose of fairness opinions is to convince shareholders that a merger price is fair, it declined to set forth a bright line rule because: (i) the appraisal process is a flexible process with the Court of Chancery having significant discretion in the factors it considers; (ii) section 262 does not require the Court to bind the parties to previously prepared data, but on the contrary requires consideration of “all relevant factors;” and (iii) “public companies distribute data to stockholders to convince them that a tender offer price is fair[;] [i]n the context of a merger, this ‘fair’ price accounts for various transactional factors such as the synergies between the companies.” The Court emphasized the distinction between valuation at the tender offer stage seeking “fair price” under the circumstances of the merger and valuation at the appraisal stage seeking “fair value” of the company as a going concern.

While the Supreme Court held that corporations subject to an appraisal proceeding may deviate from data in their proxy materials, the Court of Chancery “can—and generally should—consider and weigh inconsistencies in data advocated by a company.” In this case, the Court of Chancery had a “rational basis” for accepting the tax rate Golden relied upon in the appraisal proceeding, but not in its proxy.

Court of Chancery Did Not Abuse Its Discretion in the Valuation

The Court described the “abuse of discretion standard of review” as a “formidable standard” predicated on the Court of Chancery’s expertise in appraisal proceedings. Even where the Supreme Court might independently reach a different conclusion, the Court of Chancery’s decision will not be dismissed unless the factual findings are not supported by the record or the valuation is “clearly wrong.” The Supreme Court affirmed the Court of Chancery in this case because it “addressed each of these findings of fact and valuation methods, and [it] followed an orderly and logical deductive process in arriving at [the Court’s] conclusions . . . .”


http://www.delawarelitigation.com/2010/12/articles/delaware-supreme-court-updates/supreme-court-addresses-fair-price-and-fair-value-in-appraisal-proceedings-declines-to-adopt-bright-line-rules-for-appraisal-proceedings/

Warren Buffett's Priceless Investment Advice

It is great when you can find high quality stocks offered at bargain prices.  However, most of the time, you will find that they are selling at fair prices. 

It is only during certain periods in the market when these high quality stocks are again offered at bargain prices.  These bargains are often not large, as those holding these stocks are often smart, long term investors who know the 'intrinsic' value of their shares.

Well, if you have to invest regularly, you can either wait for a 'right' time when stocks are offered at relative bargain prices.  Alternatively, you can actually acquire these stocks 'almost immediately' and 'regularly' as many are trading at their fair prices.

Here is a strategy you may wish to adopt profitably into your investing strategies.  

Click here:  Warren Buffett's Priceless Investment Advice

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

If investing in wonderful companies at fair prices is good enough for Warren Buffett -- arguably the finest investor on the planet -- it should be good enough for the rest of us.

The devil is in the details

Buying great companies at reasonable prices can deliver solid returns for long-term investors. The challenge, of course, is identifying great companies -- and determining what constitutes a reasonable price.

Buffett recommends that investors look for companies that deliver outstanding returns on capital and produce substantial cash profits. He also suggests that you look for companies with a huge economic moat to protect them from competitors. You can identify companies with moats by looking for strong brands that stand alongside consistent or improving profit margins and returns on capital.

How do you determine the right buy price for shares in such companies? Buffett advises that you wait patiently for opportunities to purchase stocks at a significant discount to their intrinsic values -- as calculated by taking the present value of all future cash flows. Ultimately, he believes that "value will in time always be reflected in market price." When the market finally recognizes the true worth of your undervalued shares, you begin to earn solid returns.

Intrinsic Value: The Right Price to Pay

A GREAT COMPANY AT A FAIR PRICE’

Nobody really knows the specific principles that Warren Buffett applies when deciding the price he will pay for a share investment. We do know that he has said on several occasions that it is better to buy a ‘great company at a fair price than a fair company at a great price’.

This tends to agree with the view of Benjamin Graham who often referred to primary and secondary stocks. He believed that, although paying too high a price for any stock was foolish, the risk was higher when the stock was of secondary grade.

PATIENCE

The other thing that Warren Buffett counsels, when deciding on investment purchases, is patience. He has said that he is prepared to wait forever to buy a stock at the right price.

 There is a seeming disparity of views between Graham and Buffett on diversification. Benjamin Graham was a firm believer, even in relation to stock purchases at bargain prices, in spreading the risk over a number of share investments. Warren Buffett, on the other hand, appears to take a different view: concentrate on just a few stocks.

WHAT WARREN BUFFETT SAYS ABOUT DIVERSIFICATION

In 1992, Buffett said that his investment strategy did not rely upon spreading his risk over a large number of stocks; he preferred to have his investments in a limited number of companies.

‘Many pundits would therefore say the [this] strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.’

NO REAL DIFFERENCE BETWEEN BENJAMIN GRAHAM AND WARREN BUFFETT

The differences between Graham and Buffett on stock diversification are perhaps not as wide as they might seem. Graham spoke of diversification primarily in relation to second grade stocks and it is arguable that the Buffett approach to stock selection results in the purchase of quality stocks only.

BERKSHIRE HATHAWAY HOLDINGS

In addition, consideration of Berkshire Hathaway holdings in 2002 suggests that although Buffett may not necessarily believe in diversification in the number of companies that it owns, its investments certainly cross a broad spectrum of industry areas. They include:

• Manufacturing and distribution – underwear, children’s clothing, farm equipment, shoes, razor blades, soft drinks;
• Retail – furniture, kitchenware
• Insurance
• Financial and accounting products and services
• Flight operations
• Gas pipelines
• Real estate brokerage
• Construction related industries
• Media

INTRINSIC VALUE

Both Warren Buffett and Benjamin Graham talk about the intrinsic value of a business, or a share in it.  That is, to buy a business, or a share in it, at a fair price. But, having regard to the possibility of error in calculating intrinsic value, the careful of investor should provide a margin of error by only buying the business, or shares, at a substantial discount to the intrinsic value.

Buffett is said to look for a 25 per cent discount, but who really knows?

DEFINING INTRINSIC VALUE

Buffett’s concept, in looking at intrinsic value, is that it values what can be taken out of the business. He has quoted investment guru John Burr Williams who defined value like this:

‘The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.’ – The Theory of Investment Value.

The difference for Buffett in calculating the value of bonds and shares is that the investor knows the eventual price of the bond when it matures but has to guess the price of the share at some future date.

DISCOUNTED CASH FLOW (DCF)

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.

WHAT WARREN BUFFETT SAYS ABOUT PREDICTING FUTURE CASH FLOWS

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.

EXPLANATIONS OF DCF

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.

HOW WARREN BUFFET DETERMINES A FAIR PRICE

The real secret of Warren Buffett is the methods that he uses, some of which are known from his remarks, and some of which are not, that allow him to predict cash flows with some probability.

Various books about Warren Buffett give their explanations as to how he calculates the price that he is prepared to pay for a share with the desired margin of safety.

Mary Buffett and David Clarke pose a series of tests, based on past growth rates, returns on equity, book value and government bond price averages.

Robert G Hagstrom Jnr in The Warren Buffet Way gives explanatory tables of past Berkshire Hathaway purchases using a DCF model and owner earnings.

Ultimately, the investor must decide upon their own methods of arriving at the intrinsic value of a share and the margin of error that they want for themselves

www.buffettsecrets.com/price-to-pay.htm