How do you measure value?

[14value]

I am trying to expand my knowledge on valuation metrics and wanted to see what the board felt were the most reliable in finding value?

 

[Liberty]

It always depends on the company and one what you need to feel comfortable (some techniques are inherently more conservative). Basically you need to learn about all the different ways until you have a good grasp of which is appropriate for each situation and why. There's no silver bullet.

 

But for those companies that are valued more with cashflow than assets (ie. not banks or insurance companies), I now like EV/EBITDA. Here's some of the reasoning behind this:

 

http://www.gannonandhoangoninvesting.com/blog/one-ratio-to-rule-them-all-evebitda.html

[WarrenWatsa]

I think you have to tailor your valuation method to the type of company you're looking at, keeping in mind that there are three overarching valuation approaches:

1. Net asset based valuation

2. Free cash flow based valuation

3. Comparables based valuation

 

#1 is the most conservative and #3 is the most aggressive.

 

Technically, a company that has no moat should have a valuation around or not much more than the liquidation value of its net assets. This is because a competing company can begin at anytime at a cost of the replacement value of the net assets of the company with no moat, and take potentially all of the business of the company with no moat accordingly.

 

What I'm saying is, most companies should not be worth much more than #1, even if they're making money. It's similar to asking how many companies out there really and truly do indeed have moats around their businesses.

[mikazo]

I can attest that not all valuation methods work for all types of companies. For example, I tried using a discounted cash flow model of valuation for 5 different railroad stocks, and came up with all 5 being very over-valued. I suspect there is something more than just cash flows and assets that need to be taken into consideration when it comes to railroads, but I haven't figured it out yet.

[Kuhndan]

Free cash flow multiple.

[Guest valueInv]

What does Buffet use?

[twacowfca]

What does Buffet use?

 

Lets rephrase that.  What doesn't Buffett use?  That's the secret.  :)

[Uccmal]

 

Lets rephrase that.  What doesn't Buffett use?  That's the secret.  :)

 

1) market price

2) discounted cash flow models

 

I suspect the secret with railroads is the partial moat, and the assets not on the annual filings such as real estate written down decades ago.  Rail is the cheapest way to transport bulk goods. 

 

 

[Liberty]

Stepping away from the specifics a bit; the best way to value a business is to understand it and it's competitive position very, very well.

[twacowfca]

Stepping away from the specifics a bit; the best way to value a business is to understand it and it's competitive position very, very well.

 

You get a gold star.  :)

[Liberty]

Stepping away from the specifics a bit; the best way to value a business is to understand it and it's competitive position very, very well.

 

You get a gold star.  :)

 

And I wasn't being facetious. :)

 

That's actually what too many people miss about Buffett and other super-investors. They are so good not because they have special tricks to crunch the numbers, they are so good because they make sure to really understand the business not only on a quantitative, but also on a qualitative level, and to stay away as much as possible from things they don't understand.

[Guest valueInv]

Stepping away from the specifics a bit; the best way to value a business is to understand it and it's competitive position very, very well.

 

You get a gold star.  :)

 

And I wasn't being facetious. :)

 

That's actually what too many people miss about Buffett and other super-investors. They are so good not because they have special tricks to crunch the numbers, they are so good because they make sure to really understand the business not only on a quantitative, but also on a qualitative level, and to stay away as much as possible from things they don't understand.

 

How do you derive what to pay for a stock from that?

[Guest valueInv]

 

Lets rephrase that.  What doesn't Buffett use?  That's the secret.  :)

 

1) market price

2) discounted cash flow models

 

I suspect the secret with railroads is the partial moat, and the assets not on the annual filings such as real estate written down decades ago.  Rail is the cheapest way to transport bulk goods.

 

I thought he doesn't use DCF?

[AZ_Value]

 

Lets rephrase that.  What doesn't Buffett use?  That's the secret.  :)

 

1) market price

2) discounted cash flow models

 

I suspect the secret with railroads is the partial moat, and the assets not on the annual filings such as real estate written down decades ago.  Rail is the cheapest way to transport bulk goods.

 

I thought he doesn't use DCF?

 

I think that's what Uccmal is saying. He is answering the question "What doesn't Buffett use?"

 

This is the second time in a span of a couple of weeks that I hear someone argue that WEB doesn't use the discounted value of future cash and I'm starting to think that I've missed something. Where are people getting this from? Can someone enlighten me?

 

See this video that I'm sure many of you have seen and fast forward past the usual advice to college kids (work for people you admire, don't be a jerk etc...) all the way until the 20th minute and listen on through the Aesop anecdote.

 

 

I've always operated under the assumption that WEB's process to compute a company's IV is fairly simple as far as general guidelines:

 

1) Do you understand the business and its economic characteristics? (industry, competitive advantage etc...)

2) If yes for question 1, do you understand it enough to figure out what cash the business will generate for its owners (and discount it to today)?

3) Depending on questions 1 and 2, introduce the concept of Margin of Safety, the less confident you are about 1 and 2 the bigger the margin of safety you should require before you buy the stock.

4) Now introduce the concept of Mr Market and wait for him to offer you the  business at the price you derived in step 3

[augustabound]

 

I think that's what Uccmal is saying. He is answering the question "What doesn't Buffett use?"

 

This is the second time in a span of a couple of weeks that I hear someone argue that WEB doesn't use the discounted value of future cash and I'm starting to think that I've missed something. Where are people getting this from? Can someone enlighten me?

 

 

 

From the 1996 annual meeting;

Munger: I don’t know. We have such a fingers and toes-style around here. Warren often talks about these discounted cash flows, but I’ve never seen him do one.

 

Buffett: Some things you only do in private, Charlie.

 

Munger: Yeah. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea.

 

Buffett: That’s true. It’s sort of automatic. If you have to actually do it with pencil and paper, it’s too close to think about. It ought to just kind of scream at you that you’ve got this huge margin of safety.

[ExpectedValue]

I'm pretty sure Buffett does DCFs, maybe not in the way people think.

 

Unless you're buying a company on an assets-basis Ben Graham style... DCF kind of has to play into it. Owning an equity means owning the present value of the future cash flows thrown off by a business.

 

Sell side guys take this type of modeling to an extreme and focus on year by year prediction for magins, growth rates, etc.

 

My guess is Buffett takes a very simple approach where he analyzes a business's competitive position and makes small assumptions on the overall growth rate and attaches a discount rate.

 

You can arrive at something like this by looking at free cash flow multiples. If two businesses have the same amount of FCF, "X" but are worth different multiples, what does that imply?

 

If you were to a 25-period DCF model, you'd see:

 

10% discount rate, 0% growth rate = 9.1x multiple

10% discount rate, 4% growth rate (about lt avg US growth rate) = 12.6x multiple

10% discount rate, 8% growth rate = 18.4x multiple

 

Using multiples is just a shorthand of doing a really simple DCF. And if you have a good grip on the competitive dynamics of the business and their growth prospects, you can rely on them. It's when things get tricky with distressed businesses where you have to take a more proactive approach I think (or just demand a really really significant discount).

 

 

[Uccmal]

I suspect he uses some very simple version that doesn't require a calculator, also.  I was just trying to answer twa's ?. 

 

I try to normalize earnings.  An example might be BAC (sorry):

 

Numbers are made up:  BAC/ML made 3.00/share in 2001 to 2007.  Take away some for excessive mortage lending (say 0.50) for BAC (absent cwf).  That leaves you 2.50/share x 10Pe = 25.  Book value is 22.  Obviously alot of assumptions.

[ExpectedValue]

I suspect he uses some very simple version that doesn't require a calculator, also.  I was just trying to answer twa's ?. 

 

I try to normalize earnings.  An example might be BAC (sorry):

 

Numbers are made up:  BAC/ML made 3.00/share in 2001 to 2007.  Take away some for excessive mortage lending (say 0.50) for BAC (absent cwf).  That leaves you 2.50/share x 10Pe = 25.  Book value is 22.  Obviously alot of assumptions.

 

Sure, I just want to clarify that using the above method is basically the same thing as a DCF though.

 

In the example:

He's assuming a normalized earnings figure, 2.50 --  by using a 10x PE multiple he's basically saying he's assuming no/little growth, and a 10ish% discount rate to get the 10x P/E input.

 

Multiples is a shorthand DCF.

[twacowfca]

This is the most important thread that has been discussed on the board.

 

Recall that Warren has said that if he ever taught another course on investing there would be only two topics:

 

1) How to value a business.

 

2) How to understand markets.

 

Let's take the first topic.

 

Warren said that Aesop gave the secret to valuing a business more than 2000 years ago.

 

"A bird in the hand is worth two in the bush."

 

This sounds too simple, but this metaphor is profound and worthy of meditation. 

 

How much is the bird in the hand worth to you?  How much to others?  Is it healthy?  Does it lay eggs?  How many?  Over what period of time?  Do you have to feed it?  How much to get an egg?  20 eggs?  Does it have to be tended by a skilled bird keeper?  How much does he cost?  Does he eat some of the eggs in the bird coop in addition to his pay?  Does he  want to build a fancy, bigger coop?  Acquire more birds?  More coops? 

 

What's the price of eggs now?  Over time?  Over a very long time? (this is one of the most important questions Warren asks, unlike most fund managers).  Could your bird and the whole flock be wiped out by a bad case of bird flu?  Is eating eggs a fad?  If not will people continue to eat lots of eggs?  Go vegetarian?  Will the government ban eggs as a health hazard?  Will trial lawyers file a class action lawsuit against egg producers with the government as their ally? 

 

Do you have an edge in raising fowl?  A reliable, low cost source of chicken feed?  Some other reason other chicken producers will be at a disadvantage competing with you?  (The answer to this question is so important that Warren will gererally end the speculation here if the answer is no.)

 

Can you get paid in advance for the eggs you will produce?  (Warren likes businesses like insurance where your customers pay you first). If not, can you still get a nice profit on your sales and return on your investment if customers pay you later?

 

Is there.technological change on the horizon that could destroy the industry?  Perhaps a way for consumers to download chicken DNA from an IPhone and grow a fresh egg in a bread maker at a cheaper price?  Yada, yada yada.

 

And this is only some of the info needed to value the bird in the hand, not to mention the birds in the bush.  How many are in there?  Can you see clearly through the leaves?  When will they come out?  How sure are you that you can catch any of them? 

[Uccmal]

Alot of crow to meditate on.......

 

I also think that WEB operates on an exclusion basis.  He excludes those that dont meet his requirments.  This vastly reduces the research required. 

 

To my recollection he has never invested in an E&p company, a junior miner, startup tech..

[COYS]

Alice Schroeder sheds some light on WEB's valuation process in this video from 2009, where she discusses his 1959 private investment in Mid Continent Tab Company.

 

[Liberty]

How do you derive what to pay for a stock from that?

 

A lot, actually, but it's not the only thing used...

 

For example, there are some businesses with really nice numbers that I won't touch with a ten-foot pole once I learn more about the management or about the industry or whatever.

[twacowfca]

Stepping away from the specifics a bit; the best way to value a business is to understand it and it's competitive position very, very well.

 

You get a gold star.  :)

 

And I wasn't being facetious. :)

 

That's actually what too many people miss about Buffett and other super-investors. They are so good not because they have special tricks to crunch the numbers, they are so good because they make sure to really understand the business not only on a quantitative, but also on a qualitative level, and to stay away as much as possible from things they don't understand.

 

When Warren says that he doesn't understand a business, what he means is that he doesn't understand how that business is almost guaranteed to make good money for many years, even decades, that will be available for the shareholders or wisely reinvested  with high returns on capital  employed.

[returnonmycapital]

Stepping away from the specifics a bit; the best way to value a business is to understand it and it's competitive position very, very well.

 

You get a gold star.  :)

 

And I wasn't being facetious. :)

 

That's actually what too many people miss about Buffett and other super-investors. They are so good not because they have special tricks to crunch the numbers, they are so good because they make sure to really understand the business not only on a quantitative, but also on a qualitative level, and to stay away as much as possible from things they don't understand.

 

When Warren says that he doesn't understand a business, what he means is that he doesn't understand how that business is almost guaranteed to make good money for many years, even decades, that will be available for the shareholders or wisely reinvested  with high returns on capital  employed.

 

Combine this with a price that ensures an attractive return on your own capital and you have value.

[Liberty]

When Warren says that he doesn't understand a business, what he means is that he doesn't understand how that business is almost guaranteed to make good money for many years, even decades, that will be available for the shareholders or wisely reinvested  with high returns on capital  employed.

 

Indeed. Sometimes that's because it's an unpredictable or bad business/industry/management/etc, and sometimes he just doesn't have the specific technical knowledge to really understand the products and competitive dynamics deeply enough to be comfortable.