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.

INTRINSIC VALUE: THE RIGHT PRICE TO PAY

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.

WHAT WARREN BUFFETT SAYS ABOUT PREDICTING FUTURE CASH FLOWS

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.

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

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.

WHAT WARREN BUFFETT SAYS ABOUT DIVERSIFICATION

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

What Warren Buffett Looks for in Company Management

WHAT WARREN BUFFETT LOOKS FOR IN COMPANY MANAGEMENT

Warren Buffett has identified aspects of management that he looks for in companies in which he invests. They include:

• Buy back of shares where the buy back is in the company’s interests, for example where the company has surplus funds and the shares can be bought back at less than intrinsic value

• Capability in allocation of capital

• Managers who stick to doing what the company does best; ‘the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.’

• Ability and readiness to tackle tough problems as they arise

• The use of retained profits to increase company profitability at beyond market rates

• A conservative approach to debt and liquidity

• Demonstrated ability to consistently grow company earnings and rates of return.

WHAT BUFFETT DOES NOT LIKE IN COMPANY MANAGEMENT

Warren Buffett has, throughout his career of public announcements, identified some things that he does not like in company managers:

• Managers who pursue company acquisitions for reasons other than the good of the company – ego trips, the ‘institutional imperative’ of keeping up with other company acquirers, bad judges (they buy a toad and think that it will turn into a princess when they kiss it); as he famously said in 1981, ‘[M]any managerial [princes] remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee-deep in unresponsive toads’.

• Managers who pursue growth for growth’s sake, irrespective of the value of that growth to the company

• Managers who expend too much of the company’s worth by issuing valuable shares to buy overvalued assets or who use debt to do so.

• Managers who enrich themselves at company expense by with extravagant salaries and the abuse of share option arrangements

GOOD MANAGERS AND BAD BUSINESSES

Buffett does acknowledge that even the best managers will founder if the business is not intrinsically sound. 

His most telling comment on management is: 'When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.’

Sound Management: HOW CAN THE AVERAGE INVESTOR JUDGE MANAGEMENT?

WARREN BUFFETT’S CONTINUING THEME

If there is one theme that continually runs through the public statements of Warren Buffett it is the principle that investor should only consider for investment companies with managers of competence and integrity.

HOW CAN THE AVERAGE INVESTOR JUDGE MANAGEMENT?

The difficulty of course for the average investor is how to determine if a company is soundly managed. Warren Buffett is a rich man and a big investor and, while it is not known if he ever does this, he would be able to question internal company management a lot easier than John Citizen.

The answer for the average investor is to extensively research a company before investing and to ask the kind of questions that it seems Warren Buffett asks before investing in a company.

Earnings Growth: Good Growth and Bad Growth

GROWTH FIGURES FOR ANHEUSER-BUSCH

Take Anheuser-Busch. Ten-year figures to 2002, using the Value Line summaries, show the following:

Year	Earnings per share	Return on equity %	Return on capital %
1993	.89	23.0	14.9
1994	.97	23.4	15.2
1995	.95	22.2	14.3
1996	1.11	27.9	17
1997	1.18	29.2	15.6
1998	1.27	29.3	16.5
1999	1.47	35.8	17.7
2000	1.69	37.6	18.2
2001	1.89	42.0	18.8
2002	2.20	63.4	21.9

GROWTH IN EPS

For Mary Buffett and David Clark, earnings per share growth, and its ability to keep well ahead of inflation, is a key factor in the investment strategies of Warren Buffett. Earnings that are consistently increased are an indication of a quality company, soundly managed, with little or no reliance on commodity type products. This leads to predictability of future earnings and cash flows.

On the other hand, with a company whose earnings fluctuate, future cash flows are less predictable. The reasons may be poor management, poor quality or an over reliance on products that are susceptible to price reductions.

Take an imaginary company with the following earnings per share:

Year	EPS
1	2.00
2	2.25
3	2.98
4	1.47
5	1.88
6	-.65
7	2.75
8	2.20
9	1.98
10	3.01

The only conclusion that follows from these figures is that this company has good years and bad years. Year 11 might be great, it might be dreadful, or it might be average. The only certainty here is the unpredictability.

Of course, a fall in margins for one or two years may be as a result of once only factors and this can provide buying opportunities.

The difficulty is making the judgment as to 

• whether there is something permanently wrong, or 
• whether the problem has been isolated and resolved.

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.
In the case of a low-return business requiring incremental funds, growth hurts the investor.’


http://www.buffettsecrets.com/company-growth.htm

PAST GROWTH AS A PREDICTABILITY FACTOR

Although a consistent record of increases in earnings per share is not of itself an absolute predictor of either further increases, or the rate of any increases,Benjamin Graham believed that it was a factor worthy of consideration.

In addition, it is logical to conclude that a company that has had regular and consistent increases in earnings per share over a protracted period is soundly managed.

COMPOUNDING EFFECT OF GROWTH

Regular growth in earnings per share can have a compound effect if all, or substantially all, of the profits are retained. 

A company, for example, with earnings per share of 40 cents growing regularly 9 % would, in ten years produce earnings per share of 87 cents.

Of course, if the investor can do better with retained earnings than the company can, his or her interests are better served by a full distribution of profits.

WHAT WARREN BUFFETT LOOKS FOR IN COMPANY GROWTH

An investor likes to see a company grow because, if profits grow, so do returns to the investor. The important thing for the investor, however, is that the company increases the returns to shareholders. A company that grows, at the expense of shareholder returns, is not generally a good investment. As Warren Buffett said in 1977:

‘Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5 % increase in earnings per share.’

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.

In the case of a low-return business requiring incremental funds, growth hurts the investor.’

Warren Buffett on Economic Goodwill (Intangible asset)

WARREN BUFFETT ON ECONOMIC GOODWILL

This is what Warren Buffett calls economic good will which he explained in 1983 like this:

‘[B]usinesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.’

Using by analogy, one of the favorite examples of Warren Buffett, take two separate companies. Company A has a net worth of $100,000, $40,000 of which is net tangible assets and $60,000 of which is intangible (brand name, goodwill, patents etc). Company B has the same net worth but $90,000 its assets are tangible. Each company earns $10,000 a year.

• So Company A is earning $10,000 from tangible assets of $40,000 and Company B is earning $10,000 from tangible assets of $90,000.

If both companies wanted to double earnings, they might have to double their investment in tangible assets. 

• For Company A to do this, it would have to spend $40,000 to add $10,000 of earnings. 
• For Company B to do this, it would have to spend another $90,000 to add $10,000 to earnings. 

All other things being equal, Company A would have better future prospects of increase in real earnings than Company B.

THE REAL PROFITABILITY OF A COMPANY

For these reasons, Warren Buffett has said that, in calculating the real profitability of a company, there should be no amortisation of economic goodwill. Does the Gillette brand name actually decrease in value each year? Of course not.

The thoughts of both Graham and Warren Buffett are worth consideration. Book value is another ingredient in the investment equation.

Benjamin Graham and Warren Buffett appear to have differences in importance on tangible and intangible assets.

The assets of a company can be either tangible or intangible and, on this point, Benjamin Graham and Warren Buffett appear to have differences in importance.

WHAT BENJAMIN GRAHAM SAID ABOUT INTANGIBLE ASSETS

‘Earnings based on these intangibles [eg goodwill] may be even less vulnerable to competition than those which require only a cash investment in productive facilities.

'Furthermore, when conditions are favorable, the enterprise with the relatively small capital investment is likely to show a more rapid rate of growth.

Ordinarily it can expand its sales and profits at slight expense and therefore more rapidly and profitably for its stockholders than a business requiring a large plant investment per dollar of sales.’ Emphasis added.

HOW WARREN BUFFETT LOOKS AT INTANGIBLE ASSETS

This last comment of Graham has importance for Warren Buffett, who seems to really like companies with valuable, and sometimes irreplaceable, goodwill. 

To Warren Buffett, it is this intangible good will, an asset that continually produces profits without the need to spend money on maintenance, upgrading or replacement, that adds value to a company. 

Consider what it is that is most important in producing profits for Coca Cola: its name and recipe, or the various factories that produce the drink.

http://www.buffettsecrets.com/book-value.htm

THE BENJAMIN GRAHAM APPROACH TO BOOK VALUE

Graham clearly considered book value an important factor in assessing share investment. He did not include intangibles in his calculations of book value and was attracted towards companies that sold at below their book value. 

This was a big factor in making a judgment about the company as an investment. He said this:

‘It is an almost unbelievable fact that Wall Street never asks, "How much is the business selling for?". Yet this should be the first question in considering a stock purchase.

'If a business man were offered a 5% interest in some concern for $10,000, his first mental process would be to multiply the asked price by 20 and thus establish a proposed value of $200,000 for the entire undertaking. The rest of his calculation would turn about whether the business was a "good buy" at $200,000.’

Graham did however acknowledge that under ‘modern conditions’ intangibles were just as much an asset as tangibles, assuming of course that a proper value could be determined. They could, in some situations, even be superior assets.