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I was read the book "The Buffett Way".

The book claims that Warren Buffett uses a simple calculation to calculate the intrinsic value of a company.

The regular way is to estimate future earnings and then use a discounting rate to calculate the present value of the free cash flow. The discounting rate is typically one higher than that you receive for fixed income instruments — called a Beta — a premium.

Buffett's formula is to just divide the owner's earnings for the current year by the discounting rate and the discounting rate he uses is the rate on long term US govt bonds.

So on one hand, Buffett uses a low discounting. But on the other hand, he doesn't use future earnings i.e. that may mean that he isn't accounting for any growth in earnings.

I am wondering if these two things (using a low discounting rate but also not assuming any growth) cancel each other out and help him arrive a decent rough estimate? Is there any mathematical justification to this? The cancelling is my assumption — the book doesn't say anything about why he uses a low discounting rate.

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  • Can you show the calculation as dividing by the discount rate in your question is not clear. It could be your understanding of discount rate calculations is incorrect.
    – mmmmmm
    Commented Oct 18, 2018 at 9:41
  • @Mark - If the US long term bond rate is 6%, then Buffett uses (Owners Earnings)/0.06 as valuation of the company.
    – user93353
    Commented Oct 18, 2018 at 12:35
  • Remember that owner earnings are the amount you could pull out of the business after all necessary maintenance capex. It is the amount you can pull out without damaging the business in any way. Since most businesses require repair and replacement, owner earnings is less that the raw earnings per share.
    – zeta-band
    Commented Oct 22, 2018 at 18:59

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It's possible (I haven't read the book to know the context) that the additional risk of the investment is equal to the growth. The formula for the present value of a growing perpetuity is D1/(r-g), where D1 is the income in the next period, r is the discounting rate, and g is the rate of growth of the income.

So just using a risk-free rate in the denominator means that g is 0, or that g is cancelling out the additional risk of a higher r .

However, knowing what I know about Buffett, it's just a quick rule of thumb that involves very few, easy to calculate variables, so that he can do it on thousands of companies at a time, looking for a "value". I doubt there's a lot of science behind it.

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  • What is D1, r & g here?
    – user93353
    Commented Oct 18, 2018 at 13:26
  • @user93353 -- D1 is free cash flow available for dividends at the present time, r is required rate of return (discount rate), g is expected growth rate.
    – Jasper
    Commented Jul 8, 2019 at 21:44
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It is not justified. If the US long term treasury rate reaches 0, as it has been in some countries, the formula would result in division by 0. With the traditional formula, a positive risk premium or negative growth rate can allow you to get a finite price despite 0 (or negative) risk free rate.

Second, consider a power-plant scheduled to be shut-down in 5 years. It would not make sense to discount 5 years of cash flows with the long term rate.

It may be a useful rule of thumb (and therefore useful as a screening tool), but it is not theoretically justified.

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Well, Buffett has already screened out 99.99% of the companies in the market that aren't worth it using his 12 tenets. Already he has a guaranteed return on his portfolio by choosing great businesses (that would remain profitable for 20-25 years).

He expects less return, or less margin-of-safety because he already has achieved almost risk-free returns. By getting it at a modest discount, he can further achieve even more returns to those achieved by the company by operations, growth, etc.

Also, if he were to use a very high return rate, then the price he could pay for (Fair value/no of shares outstanding) would decrease, thus he could indeed miss a great opportunity and a business simply because the market is very near to having realized its value and it isn't trading at a discount to Fair Value, thus having to bear an opportunity cost of not having bought the investment just due to some %age points extra in the denominator of a DCF calculation.

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No, Buffett is not using this formula to arrive at the fair value of the company. He is using it to screen for potentially undervalued companies - those companies that yield the same in earnings that a US bond yields.

That said, your idea of his "trading off" of a risk-free rate for the expectation of earnings growth is correct:

Buffett likes to compare the company earnings yield to the long-term government bond yield. An earnings yield near the government bond yield is considered attractive. The bond interest is cash in hand but it is static, while the earnings of Nike should grow over time and push the stock price up.

https://home.csulb.edu/~pammerma/fin382/screener/buffett4.htm

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