Warren Buffett Way

http://www.sfu.ca/~poitras/BUFFET.pdf

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THE WARREN BUFFETT WAY
Investment Strategies of the
World’s Greatest Investor
ROBERT G. HAGSTROM
MAIN IDEA
Warren Buffett is one of the most successful stock market investors of the past 30 years.
His entire approach is to focus on the value of the business and its market price. Once Buffett finds a business he understands
and feels comfortable with, he acts like a business owner rather than a stock market speculator. He studies everything possible
about the business, becomes an expert in that field and works with the management rather than against them. In fact, often his
first act on buying shares in any company is to grant the managers his proxy vote for his shares to assure them that he has no
intention to try and move the company away from its core values.
Buffett champions the value investment strategy, and puts no credence in day to day movements in share prices, the impact of
the economic mood overall or any other external factors. He maintains a long-term perspective at all times, and never loses sight
of the underlying value of a business.
THE BUFFETT APPROACH TO INVESTMENT
1. Never follow the day to day fluctuations of the stock market.
The market only exists to make it easier to buy and sell, not to set values. Keep an eye on the market only for someone who
is willing to sell a stock at a not-to-be-missed price.
2. Don’t try and analyze or worry about the general economy.
If you can’t predict what the stock market will do from day to day, how can you reliably predict the fate of the economy?
3. Buy a business, not its stock.
Treat a stock purchase as if you were buying the entire business, using the following tennets:
Business Tennets
1. Is the business simple and understandable from your perspective as an investor?
2. Does the business have a consistent operating history?
3. Does the business have favourable long-term prospects.
Management Tennets
1. Is management rational?
2. Is management candid with its shareholders?
Financial Tennets
1. Focus on return on equity, not earnings per share.
2. Calculate "Owner Earnings".
3. Search for companies with high profit margins.
4. For every dollar of retained earnings, has the company created at least one dollar’s extra market value?
Management Tennets
1. What is the value of the business?
2. Can the business currently be purchased at a significant discount to its value?
4. Manage a portfolio of businesses.
Intelligent investing means having the priorities of a business owner (focused on long-term value) rather than a stock trader
(focused on short-term gains and losses).
1. WARREN BUFFETT
In the 1993 Forbes list of America’s richest people, Warren
Buffett had an estimated net worth of $8.3 billion. Of all 69 people
listed, Buffett is the only one who obtained his wealth from the
stock market.
Buffett graduated from the University of Nebraska. While there,
he read a book The Intelligent Investor by Benjamin Graham.
This book so impressed Buffett that he went to New York to study
with Ben Graham at the Columbia Graduate Business School.
At the age of 25 in 1956, Buffett started an investment
partnership. He had seven limited partners who contributed
$105,000 and Buffett as general partner put in $100. The limited
partners received 6-percent interest per year and 75-percent of
the profits generated above this level. Buffett was paid the other
25-percent. Over the next 13 years, this partnership
compounded investments at an annual rate of 29.5-percent. In
1965, Buffett closed the partnership and cashed out with a
personal stake of $25 million.
Warren Buffett used his capital to purchase a controlling interest
in Berkshire Cotton Manufacturing, a well established but
struggling textile company. This company merged with
Hathaway Manufacturing, and also bought interests in two
insurance companies in 1967. The combined company was
renamed Berkshire Hathaway.
The insurance companies generated steady cash flow, which
was invested in stocks and bonds to have the funds available for
payment of claims. The company’s stock portfolio in 1967 was
$7.2 million, so Buffett assumed control of this. Within two years,
the stock portfolio had grown to $42 million, and the insurance
company profits far outweighed the return generated by the
textile side of the company.
During the 1970s, Bershire bought three more insurance
companies and started another five. Buffett also closed the
textile side of the company and converted Berkshire Hathaway
into a holding company. Berkshire owns a number of other varied
companies which generate good returns on equity without using
debt. By 1993, the noninsurance side of Berkshire-Hathaway
group had a sales turnover of $2.0 billion and earned $176 million
after tax - about 37-percent of the gorup’s operating earnings.
Warren Buffett and his wife now own around 40-percent of the
stock of Berkshire-Hathaway. He works as Chief Executive of
the company for an annual salary of $100,000 per year. Many
of his employees who manage different parts of the company
earn much more.
Berkshire-Hathway had a corporate net worth of $22 million
when Warren Buffett assumed control. Today, it is worth more
than $10.2 billion. Buffett’s goal is to increase the company’s
worth by a 15-percent compound rate each year.
Berkshire pays no dividends but reinvests all money earnt.
Therefore, shareholders look to a capital gain in the value of their
stock. Since 1964, Berkshire shares have grown from $19 each
to more than $22,000 per share today. Over the past 25-years,
Berkshire has grown at an compound rate of 23.2-percent per
year - well above Buffett’s target of 15-percent per year.
2. TWO MENTORS
Main Idea
Warren Buffet’s investment methodology is a hybrid mix of the
strategies put forward by two 1930s style investment advisers,
Ben Graham and Philip Fisher.
From Graham, Buffett learned the margin of safety approach -
that is, use strict quantative guidelines to buy shares in
companies that are selling for less than their net working capital.
Graham also emphasized that following the short-term
fluctuations of the stock market is pointless, and that stock
positions should be long term.
From Fisher, Buffett added an appreciation for the effect that
management can have on the value of any business, and that
diversification increases rather than reduces risk as it becomes
impossible to closely watch all the eggs in too many different
baskets.
Supporting Ideas
1. Benjamin Graham
Author of Security Analysis and The Intelligent Investor,
Graham is widely considered as the first professional
financial analyst.
Ben Graham grew up in New York and had a science degree
from Columbia University. By the age of 25, he was a partner
in a brokerage firm earning $600,000 per year. He was
financially ruined by the 1929 crash and had to rebuild his
fortune.
Graham’s investment philosophy was that a well-chosen,
diversified portfolio of common stocks, based on reasonable
prices, were the soundest possible long-term investment
anyone could make.
To Graham, the distinction between an investment and a
speculation was: ‘‘An investment operation is one which,
upon thorough analysis, promises safety of principal and a
satisfactory return. Operations not meeting those
requirements are speculative.’’
An investment requires safety of principal and a satisfactory
return. Safety is a relative term, and can never be determined
in an absolute sense. Similarly, the concept of a satisfactory
return (whether dividend income or stock price appreciation)
is also subjective.
Graham described three approaches to investing in common
stocks:
1. The Cross-Section Approach.
The investor buys some shares in companies in every sector
of the market. Then, whatever happens in the economy, at
least one stock will be performing well.
2. The Anticipation Approach.
a. Short-Term Selectivity.
This is the investment in companies which have the most
favourable outlook in the next 6-months to a year. Although
this is volatile and superficial, this is the dominant approach
used by most sharebrokers.
b. Growth Stocks
These are companies whose sales and earnings are
expected to grow at a rate above those of the average
business. The trick is to buy stock in any company whose
products were at an early stage of their life cycle, when profits
and revenues were just about to take off. The difficulty here
is in accurately forecasting rates of growth.
The Warren Buffett Way - Page 2 -
3. Margin of Safety Approach
Invest only in companies which have a large margin between
earnings and fixed costs. In a downturn, that company is
most likely to ride out a recession well. Applying this concept
to a stock, buy shares only in a company for which the share
price is below its intrinsic value as determined by assets,
earnings, dividends and future prospects.
Graham strongly advocated the margin of safety approach
with investment in common stock of growth companies. His
approach to investment was to purchase growth company
shares when the overall market is trading at a low price or
when growth company shares are trading below their
intrinsic value. However, since buying at market lows is
everyone’s objective, there is no competitive advantage in
that approach. Therefore, Graham suggested that identifying
undervalued stocks, regardless of market sentiment, was the
key to stock market investment success.
Intrinsic value is closely linked to a company’s future earning
power and fixed costs. It is hard or real assets plus the future
value of the earnings those assets will produce.
Graham advocated two approaches to buying shares:
1. Buy for less than two-thirds a company’s net asset value.
2. Focus only on low price-to-earnings ratio stocks.
These stocks will generally be out of favour with market
sentiment. The market inefficiency, created by emotions,
generates valuable opportunities for the rational investor.
2. Philip Fisher
Author of Common Stocks And Uncommon Profits, Fisher
was a stockbroker who set up in business just after the 1929
crash.
Fisher focused on companies with an ability to grow sales
and profits over the years at rates greater than the industry
average. He classified these types of companies as:
1. Fortunate and able.
Companies which work aggressively to create larger markets
for their products, and are in a position to benefit from events
outside the company’s control.
2. Fortunate because they were able.
Companies which continually carried out research and
development to produce better products and new markets.
Fisher studied a company’s sales organization in addition to
its research and development capabilities. He also looked at
profit margins and accounting controls. Fisher believed
marginal companies never succeeded over the long run. He
looked for companies which were dedicated to maintaining
their competitive advantage and strengthening their market
position.
He also looked for companies which could grow without
requiring additional equity financing. If a company expanded
on the strength of its products and services rather than by
expanding its capital base, Fisher thought that augered well
for the future.
Above-average management capabilities in companies were
also keenly sought by Fisher. He saw as a good sign any
management who communicated freely with shareholders
when the company was experiencing unexpected hard
times. The management should also have an ability to
develop good working relations throughout the company.
Fisher examined the unique distinguishing characteristics of
each company. He looked for clues by interviewing
customers, vendors, competitors and consultants. He
always tried to garner an accurate picture of relative
strengths and weaknesses by his research.
Fisher suggested it was better to hold stock in a few
outstanding companies than a large number of average
companies. He always invested within his own circle of
competence - that is, with companies he understood and felt
comfortable with.
3. FOUNDATIONS OF THE BUFFETT APPROACH
Main Idea
Warren Buffett lets companies inform him by their operating
results, not by short-term stock market fluctuations. His is a very
patient investment strategy based on the value of the business.
Buffett’s whole approach is to look at a share purchase from the
perspective of a business owner rather than as a stock market
dabbler.
Supporting Ideas
1. There is a large difference between investing in a particular
stock and trying to predict the direction of the general market.
In spite of technology, it is still people that make markets.
Investor sentiment has the largest influence over short-term
market direction and stability. However, the long-term value
of a stock is ultimately determined by the economic progress
of the business, not the day-to-day market fluctuations.
2. The Mr. Market Allegory.
Imagine you are the owner of a small business in partnership
with Mr. Market. Every day, Mr. Market quotes you a price at
which he is willing to buy your half of the business or sell you
his half. While the business is sound and makes good
progress, Mr. Market’s quotes vary widely according to the
mood he is in.
When he is in an upbeat mood, his price is exceptionally high.
Conversely, strike him on a bad day and he is very
pessimistic and quotes an unusually low price.
If you were in business with Mr. Market and you tried to take
advantage of his wisdom, you would be on an emotional
roller coaster ride. Rather, it is Mr. Market’s pocketbook you
should take advantage of, not his wisdom. It is disastrous if
you fall under his influence.
A successful stock market investor should put aside the
emotional whirlwind Mr. Market unleashes on the general
market every day and exercise sound business judgement.
3. Investors must be financially and psychologically prepared
to deal with the everyday market fluctuations. Unless you can
watch the value of your stock holdings decline by 50-percent
or more without becoming panic striken, you will never
succeed.
4. Price declines are a welcome way to add more shares to your
portfolio at a lower price. As long as your are investing in a
soundly run business with good fundamentals, management
and prices, the market will eventually acknowledge success.
5. The ability to say ‘‘no’’ unless all the facts are in your favour
is a significant advantage for any stock market investor.
Rather than constantly buying and selling shares in mediocre
businesses on the strength of a rumour, Buffett buys and
holds shares permanently in just a few outstanding,
well-managed businesses. His approach is always to wait
patiently until a truly great investment opportunity surfaces
and then go to it.
The Warren Buffett Way - Page 3 -
6. Investment success is not the same as infallibility. Instead,
success comes about by doing more things right than wrong.
To do that, reduce the number of things you can get wrong
and focus on the things you expect to get right.
7. The Market Rumour Parable
An oil prospector was met at the gates of heaven by St. Peter
who told him there was no room for him to come in. The
prospector asked if he might say just four words to the oil
prospectors present. He yelled, ‘‘Oil discovered in Hell!’’ With
that, all the oil men marched out of heaven headed for hell.
St. Peter was impressed and invited the man in now there
was plenty of room. ‘‘No thanks,’’ said the newcomer. ‘‘I think
I’ll just go along with the rest of the boys. There just might be
some truth to that rumour after all.’’
Despite all the experience and educational qualifications
found in stock market investors (including institutions), it still
acts irrationally and with a ‘‘follow the mob’’ mentality. Buffett
takes no comfort from having ‘‘important’’ people agree with
him, and does not lose confidence when they disagree.
8. An investor and a businessperson should look at a company
in the same way. The businessperson wants to buy the entire
company while an investor wants a part.
The first question any businessperson will ask is, ‘‘What is
the cash generating potential of this company?’’ Over time,
there will always be a direct correlation between the value of
a company and its cash generating capacity. The investor
would benefit by using the same business purchase crieria
as the businessperson.
Change your thinking from buying and selling shares in a
company to buying and selling a business you want to own
and you’ll have a much improved perspective.
8. Short term price fluctuations are an unwise criteria by which
to judge a company’s success. Instead, look at:
-- Return on beginning shareholder’s equity.
-- Operating margin changes.
-- Debt level changes.
-- The company’s cash generating ability.
That is, use economic criteria rather than price changes.
9. Relationship investing is critically important. With this
approach, investors act like owners of the companies they
own shares in. They provide patient capital allowing
management to pursue long-term growth opportunities.
Stock is held long-term and investors work with management
to improve corporate performance.
10. Warren Buffett usually assigns voting rights for shares he
purchases to the management of the company. That sends
the clear signal that he is not seeking changes. He avoids
companies in need of major overhauls. He also avoids
confronting management to improve shareholder returns.
Buffett simply will not invest in any company which he
considers requires a change in officers before true value can
be realized. He does not look for a company which is
undergoing a turnaround or restructuring exercise, as this
creates a situation in which there are too many variables.
11. Buffett is quite content to hold any security indefinitely, so
long as the prospective returns on equity capital of the
business is satisfactory, management is
shareholder-oriented and competent and the market does
not overvalue the business. Generally speaking, Buffett sells
only when the stock price shows the market is appreciably
overvaluing the business by his reckoning.
Key Thoughts
‘‘The farther one gets from Wall Street, the more skepticism one
will find as to the pretensions of stock-market forecasting or
timing.’’
-- Ben Graham
‘‘I have long felt that the only value of stock forecasters is to make
fortune tellers look good.’’
-- Warren Buffett
‘‘The most common cause of low prices is pessimism -
sometimes pervasive, sometimes specific to a company or
industry. We want to do business in such an environment, not
because we like pessimism but because we like the prices it
produces. It’s optimism that is the enemy of rational buyers.’’
-- Warren Buffett
‘‘An investor should act as though he had a lifetime decision card
with just twenty punches in it. With every investment decision his
card is punched, and he has one fewer for the rest of his life.’’
-- Warren Buffett
‘‘As time goes on, I get more and more convinced that the right
method in investments is to put fairly large sums into enterprises
which one thinks one knows something about and in
management of which one thoroughly believes. It is a mistake
to think that one limits one’s risks by spreading too much
between enterprises about which one knows little and has no
special reason for special confidence. One’s knowledge and
experience is definitely limited and there are seldom more than
two or three enterprises at any given time which I personally feel
myself entitled to put full confidence.’’
-- John Maynard Keynes
‘‘The reasonable man adapts himself to the world. The
unreasonable one persists in trying to adapt the world to himself.
Therefore all progress depends on the unreasonable man.’’
-- George Bernard Shaw
‘‘Can you really explain to a fish what it’s like to walk on land?
One day on land is worth a thousand years of talking about it and
one day running a business has exactly the same kind of value.’’
-- Warren Buffett
‘‘Invest within your circle of competence. It’s not how big the
circle is that counts, it’s how well you define the parameters.’’
-- Warren Buffett
‘‘Rationality is the quality that Buffett thinks distinguishes his
style with which he runs Berkshire - and the quality he often finds
lacking in other corporations.’’
-- Carol Loomis, Fortune Magazine
‘‘Beware of past performance proofs in finance. If history books
were the key to riches, the Forbes 400 would consist of
librarians.’’
-- Warren Buffett
‘‘After we buy a stock, consequently, we would not be distrurbed
if markets closed for a year or two. We don’t need a daily quote
on our 100 percent position in See’s or H.H. Brown to validate
our well being. Why, then, should we need a quote on our 7
percent interest in Coke?’’
-- Warren Buffett
The Warren Buffett Way - Page 4 -
4. THE WARREN BUFFETT WAY
Main Idea
Rational allocation of capital is the key to any investment
success.
The Buffett approach to investment is:
1. Never follow the day to day fluctuations of the stock market.
2. Don’t try and analyze or worry about the general economy.
3. Buy a business, not its stock.
4. Manage a portfolio of businesses you want to own.
Supporting Ideas
1. Never follow the day to day fluctuations of the stock
market.
In essence, a stock market exists simply to facilitate the
buying and selling of shares. Anytime an investor tries to turn
the market into a predictor of future prices, they run into
problems.
The essential question is whether you’ve done your
homework or not. If you know more about a company than
the market does, then why give any attention to what the
market says?
Secondly, if you buy a share because you believe a company
has sound financial prospects and you intend owning it for a
number of years, what happens in the market on a day to day
basis is totally inconsequential.
An investor does not need the market’s validation for any
share purchase they have completed.
The only use for a regular glance at the market is to check
whether anyone is foolish enough to sell a good business at
a great price.
2. Don’t try and analyze or worry about the general
economy.
If it is impossible to predict what the stock market will do from
day to day, how can it be even remotely achieveable to
forecast what the economy as a whole will do in the next few
years?
The problem is some investors begin with an economic
assumption about the direction of the economy and select
only stocks which fit their model. In this way, the predictions
become both self-fulfilling and limiting.
A superior approach is to buy a business which has a realistic
opportunity to progress regardless of whether the overall
economy is expanding or contracting. A business which has
the ability to profit in any economic environment is very
valuable.
3. Buy a business, not its stock.
An investor should only buy shares in a company which he
would be willing to purchase outright if he had sufficient
capital. From this perspective, an investor should look for a
company with business operations that are understood, has
favourable long-term prospects, is operated by honest and
competent people and is available at an attractive price.
The decision to buy a business is based on:
-- Business tennets
-- Management tennets
-- Financial tennets
-- Market tennets
1. Business Tennets
Business Tennet 1.
Is the business simple and understandable from the
perspective of the investor?
Do you understand how the company generates sales,
incurs expenses and produces profits?
That means you need to understand revenues, expenses,
cash flow, labour relations, pricing, flexibility and capital
requirements - an exceptionally high level of knowledge. It
means that investors should buy shares only in companies
within their own circle of financial and intellectual
understanding.
An investor need to be realistic about what they do not know.
Above average results are most often achieved by doing
ordinary things exceptionally well.
Business Tennet 2.
Does the business have a consistent operating history?
In general, the best level of profits over the long-term are
achieved by companies that have been producing the same
product or service for a number of years. One-off windfalls
generated by unusual events are just too hard to reasonably
predict.
An investor should never ignore a current business reality
because of some vision of future success. Look to buy a
business which has shown it can reasonably weather
different economic cycles and competitive forces.
The best time to buy any business is when profitability has
been interrupted for some external short-term reason. This
can create a rare one-time opportunity to purchase a sound
business at an unusually low price.
Business Tenent 3.
Does the business have favourable long-term
prospects?
The economic world is divided into a large group of
commodity companies and a small group of companies that
own the franchise for their product or service.
Commodity companies compete solely on price, with no
differentiation between suppliers. As well as the traditional
oil and gas companies, the commodities group now includes
computers, automobiles and airlines.
By contrast, companies which own the franchise have a
product or service which is needed, has no close substitutes
and for which an unregulated market exists.
Ideally, a business purchaser will want to buy a franchise
type of company. These companies have an appreciable
margin of safety whereby prices can be raised to offset
management mistakes.
The only problem is a strong franchise holder soon attracts
competitors and substitute products, which in turn leads to
the creation of a commodity market around that product or
service. Whenever that happens, the value of the
management becomes even more critical to the economic
performance of the company.
If it is not possible to purchase a franchise company, the next
best option is to buy the lowest cost supplier in a commodity
market. Over the long-term, the lowest cost supplier always
comes to dominate a commodity market.
The Warren Buffett Way - Page 5 -
2. Management Tennets
Management Tennet 1.
Is management rational?
Does the management act and think like an owner of the
company unfailingly? In particular, how is capital allocatted
by the company? Rational managers will invest any excess
cash generated by the company in projects that produce
earnings at rates higher than the cost of capital. Over the
long-term, allocation of capital determines the value of the
company.
All companies move through an economic life cycle. In the
development stage, the company loses money while
establishing markets and improving its products. During the
next stage of rapid growth, the company requires cash to
grow and retains earnings and borrows or issues more
equity. In the third stage (maturity), the company generates
more cash than it needs as sales expand. In the last stage,
excess cash tapers off as sales decline.
The key question is what managers do with the excess cash
in the maturity and decline stages. A rational management
will invest this cash in projects that earn a higher rate of return
than the cost of capital on the open market - otherwise the
funds should be returned to shareholders as dividends or by
buying back the company’s own shares.
By contrast, irrational managers are often overcome by their
own prowess and continue to reinvest in projects with
diminishing returns.
Management Tennet 2.
Is management candid with its shareholders?
The ideal business manager reports financial performance
openly and genuinely, with an ability to admit mistakes and
report the progress of all aspects of the company. The
management should also be able to reaffirm that the
company’s prime objective is to maximize the return on
shareholder’s investment. This concept should colour every
action taken.
The tendency to include every piece of information that
owners would deem valuable when judging the company’s
economic performance is a characteristic of a strong
management team.
Management Tennet 3.
Does management resist the institutional imperative?
The institutional imperative is the tendency of corporate
managers to mimic the actions of other companies, even
when those actions are destructive or irrational. Most
managers are so influenced by what other companies are
doing that they are unwilling to do anything which results in
short-term pain in exchange for long-term profit.
A measure of any company’s management skill is how
effectively they think for themselves rather than settle for
mindless imitation of what everyone else is doing. In
essence, successful companies have managers who refuse
to follow the herd into mediocrity.
3. Financial Tennets
Financial Tennet 1.
Focus on return on equity, not earnings per share.
Companies are continually adding to their capital base by
retained earnings in particular. Therefore, you expect
earnings per share to increase year by year.
A better measure of a company’s performance is return on
equity - the ratio of operating earnings to shareholder equity.
This measures the management’s ability to generate a return
on the operations of the business given the capital employed.
When calculating return on equity, value marketable
securities at cost - not market value (as market value is
beyond management’s control). Exclude all non-recurring
extraordinary items which are unrelated to the business.
A good management team will consistently achieve good
returns on equity while employing little or no debt, or at least
employing a managable debt level for the nature of the
business.
Financial Tennet 2.
Calculate ‘‘Owner Earnings.’’
The ultimate value of any company is its ability to generate
a surplus of cash. However, a company with a high fixed
asset to profit ratio will require a larger share of retained
earnings to stay profitable than a company with a low fixed
assets to profit ratio.
‘‘Owner earnings’’ is calculated by adding depreciation,
depletion and amortization charges to net income and
subtracting the capital expenditure required to maintain
economic position and unit volume.
‘‘Owner earnings’’ reflects the true cash flow position of a
company. Some enterprises (like a real estate development
for example) require heavy expenditure at the start and very
little later on. Others, like manufacturing, require regular
expenditure on plant upgrades or the business slips. ‘‘Owner
earnings’’ is an attempt to provide a cross industry analysis
measure.
Financial Tennet 3.
Search for companies with high profit margins.
Paradoxically, managers of high-cost companies tend to find
ways to continually add to their overheads whereas the
managers of low-cost operations take pride in lowering their
expenses.
Any money spent on unnecessary costs deprives
shareholders of extra profits. The culling of unnecessary
expenses is a consistent theme of effective managers.
Financial Tennet 4.
For every dollar of retained earnings, has the company
created at least one dollar’s worth of extra market value?
Over the longer term, stock market value will accurately
reflect the economic value of the company. The same is true
for increased market value created by retained earnings. A
well managed company will add at least one dollar of market
value for every dollar of retained earnings.
To estimate this factor, subtract all dividends from a
company’s net income over the last ten years. This is the total
retained earnings. Add that figure to the company’s market
value at the beginning of the ten year period to get Total A.
If the company has employed retained earnings effectively,
the market value at the end of the ten year period will exceed
Total A. If it doesn’t, beware.
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4. Market Tennets
Market Tennet 1.
What is the value of the business?
Buffett calculates the value of a business as the net cash
flows expected to occur over the life of the business
discounted at an appropriate interest rate. Net cash flows are
the company’s owner earnings over a long period.
Something like the thirty-year U.S. treasury bond rate can be
used as a measure of the interest rate for this calculation.
By calculating the business value this way, vastly different
business enterprises can realistically be compared. If the
business is growing rapidly but has unpredictable future
revenues, then the company is not classified as simple and
understandable and this formula cannot be applied. The
discounted cash-flow approach described is very
conservative as long as an appropriate discount rate is
applied.
‘‘In our view, what makes sense in business also makes sense
in stocks. An investor should ordinarily hold a small piece of an
outstanding business with the same tenacity that an owner would
exhibit if he owned all the business.’’
-- Warren Buffett
Market Tennet 2.
Can the business currently be purchased at a significant
discount to its value?
Armed with an accurate calculation of the value of the
business, you should now look at the asking price. The rule
for market success is purchase only when the current market
price is at a significant discount to value.
The intention of any investor is to earn above-average
returns. The difference between business value and price is
the investor’s margin of safety. Most investors set their own
margin of safety. Buffet generally aims for a 25-percent
discount as his margin of safety.
Additionally, a well chosen stock will have sound
fundamentals, which over the longer term will lead to an
above average growth in the company’s share price. This, in
effect, becomes an additional reward for the intelligent
investor who purchases at a discount.
4. Manage a portfolio of businesses.
The concept of intelligent investing is that by buying shares
in a company, you should act like the owner of the business,
not the owner of a piece of paper. That means you need to
understand the company’s operating fundamentals.
Diversification is only required when an investor does not
know what they are doing. Very few business owners are
comfortable and experienced enough to operate a number
of companies at the same time. So too, an investor should
act like an owner and buy shares only in companies which
are thoroughly understood.
Key Thoughts
‘‘I would rather be vaguely right than precisely wrong.’’
-- Keynes
‘‘The market, like the Lord, helps those who help themselves.
But unlike the Lord, the market does not forgive those who know
not what they do.’’
-- Warren Buffett
‘‘Investing is most intelligent when it is most businesslike.’’
-- Benjamin Graham
‘‘I put a heavy weight on certainty. If you do that, the whole idea
of a risk factor doesn’t make any sense to me. Risk comes from
not knowing what you’re doing.’’
-- Warren Buffett
‘‘You are neither right nor wrong because the crowd disagrees
with you. You are right because your data and reasoning are
right.’’
-- Benjamin Graham
‘‘It is not good enough to have good intelligence. The principle
thing is to apply it well.’’
-- Descartes
‘‘As far as I am concerned, the stock market doesn’t exist. It is
there only as a reference to see if anybody is offering to do
anything foolish.’’
-- Warren Buffett
‘‘Most managers have very little incentive to make the
intelligent-but-with-some-chance-of-looking-like-an-idiot
decision. Their personal gain/loss ratio is all to obvious; if an
unconventional decision works out well, they get a pat on the
back, and if it works out poorly, they get a pink slip. Failing
conventionally is the route to go; as a group, lemmings may have
a rotten image, but no individual lemming has ever received bad
press.’’
-- Warren Buffett
‘‘It has been helpful to me to have tens of thousands students
turned out of business schools taught that it didn’t do any good
to think. What we do is not beyond anybody else’s competence.
It is just not necessary to do extraordinary things to get
extraordinary results.’’
-- Warren Buffett
The Warren Buffett Way - Page 7 -
SAMPLE CALCULATION
CALCULATING THE VALUE OF A BUSINESS
Assumptions:
1. The company’s cash flow will grow at a compound rate of 15% per year consistently for the next 10 years.
2. A discount rate of 9.0% per year is used to allow for the effect of inflation.
3. Assume in year 11 that the company’s cash flow will again increase by 5%.
4. All dollar amounts are in millions.
PRESENT VALUE OF FUTURE CASH FLOWS
Year 1 2 3 4 5 6 7 8 9 10 TOTAL
Prior Year Cash Flow $275 $316 $363 $417 $480 $552 $635 $730 $840 $966
Growth Rate 15% 15% 15% 15% 15% 15% 15% 15% 15% 15%
Cash Flow $316 $363 $417 $480 $552 $635 $730 $840 $966 $1,111
Discount Factor .9174 .8417 .7722 .7084 .6499 .5963 .5470 .5019 .4604 .4224
Discounted Value Per Annum $290 $306 $322 $340 $359 $379 $399 $422 $445 $469 $3,731
CALCULATION OF RESIDUAL VALUE
Cash Flow in Year 10 $1,111
Growth Rate 5%
Cash Flow in Year 11 $1,167
Capitalization Rate 4%
Value at End of Year 10 $29,175
Discount Factor at End of Year 10 .4224
Present Value of Residual $12,324
BUSINESS VALUE OF A COMPANY
Business Value = Present Value of Future Cash Flows + Present Value of Residual
= $3,731 + $12,324
= $16,055
The Warren Buffett Way - Page 8 -

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