Warren Buffett’s Advice On How To Value A Business

Warren Buffett’s Advice On How To Value A Business

Warren Buffett has been investing in stocks since his teenage years. Over the past seven decades, he’s bought and sold thousands of stocks across sectors and industries accumulating hundreds of billions of dollars in value for himself and his investors along the way.

During his lengthy career, Buffett has become skilled at calculating intrinsic value, the underlying value of a business based on its fundamentals.

Warren Buffett: Starting with the cash flow statement

The exact process Buffett uses varies from business to business, but it always starts with the cash flow statement.

“If you can tell me what all of the cash in and cash out of a business will be between now and judgment day, I can tell you, assuming I know the proper interest rate, what it is worth,” Buffett told students of Notre Dame in a series of lectures in spring 1991.

The Oracle of Omaha went on to explain that it does not matter whether the business “sells yo-yo’s, hula hoops, or computers,” at the end of the day, cash is cash and “cash spends the same, no matter where it comes from.”

The tricky part is, estimating cash flows “between now and judgment day” and the “proper interest rate” to use in the discount cash flow analysis Buffett described.

This is where experience and the circle of competence comes into play. “My job as an investment analyst, or a business analyst, is to figure out where I may have some knowledge, what that stream of cash will be over a period of time, and also where I don’t know what the stream of cash will be,” Buffett explained to his audience in 1991.

The circle of competence is probably one of the most misunderstood and overlooked concepts in finance. Knowing where yours lies can be critical for investment success.

At the 2010 Berkshire Hathaway annual meeting of shareholders, Buffett declared that the “biggest thing” to understand when valuing businesses is not “how big your circle of competence is, but knowing where the perimeter is.”

Being able to say ‘no’ to companies outside your circle of competence

Being able to say ‘no’ as an investor is a vital skill. You don’t have to understand every single business there is out there on the market to be able to make money. If you concentrate on a few companies that you really know and understand well, just as Buffett has done, it becomes easier to make money as it is easier to spot undervalued opportunities.

As Buffett explained in his answer back in 2010:

“You don’t have to be an expert on 90% of the businesses, or 80%, or 70, or 50. But you do have to know something about the ones that you actually put your money into, and if that’s a very small part of the universe, that still is not a killer.”

The business Buffett knows better than any other is his own, Berkshire Hathaway. And he’s given us plenty of insight over the years about how he would go about placing a value on this $500 billion enterprise.

In an exchange with a shareholder at the 1999 Berkshire annual meeting, Buffet offered some guidance on the sort of template he’d use to value Berkshire — a template that could also be extended to other businesses.

Shareholder Dan Kurs explained that the process he was using to value Berkshire was to take the group’s total look-through earnings and then adjust for normalized earnings at the insurance business.

“Then I’ve assumed that Berkshire’s total look-through earnings will grow at 15% per annum on average for 10 years, 10% per annum for years 11 through 20. And that earnings stop growing after year 20, resulting in a coupon equaling year-20 earnings from the 21st year onward,” Kurs said. He added that he was also using a 10% discount rate.

He asked Buffett if this was the right approach. “I couldn’t state it better myself,” the CEO of Berkshire Hathaway responded, although he didn’t want to comment further on the growth rates Kurs had put forward.

However, Buffett did offer some further advice on his valuation process. He went on to say:

“Now, that doesn’t mean we would pay that figure once we use that discount number. But we would use that to establish comparability across investment alternatives.

So, if we were looking at 50 companies and making the sort of calculation that you just talked about, we would use a — we would probably use the long-term government rate to discount it back.

But we wouldn’t pay that number after we discounted it back. We would look for appropriate discounts from that figure. But it doesn’t really make any difference whether you use a higher figure and then look across them or use our figure and look for the biggest discount.

You’ve got the right approach. And then all you have to do is stick in the right numbers.”

This might all seem a little complicated, especially for beginners. But valuation is a skill like any other, and just like any other skill, the best way to improve is to practice.

Practice makes perfect

This is where it pays to start asking questions to extend your knowledge over time. I’ll let Buffett explain this fundamental principle:

“And I think if you think about what you would pay for a McDonald’s sandwich, you think you would pay for — you know, think about the businesses in your own hometown…Which would you like to buy into? Which do you think you could understand their economics? Which do you think will be around 10 or 20 years from now? Which do you think it would be very tough to compete with?

“Just keep asking yourself questions about businesses. Talk with other people about them. You will extend your knowledge over time. And always remember that margin of safety. And I think you basically have the right attitude because you recognize your limitations, and that’s enormously important in this business. You will find things to do.”

That’s the outline of Buffett’s process for calculating intrinsic value. Unfortunately, this process has no shortcut. Defining intrinsic value for any business is an art. There is no correct value or formula, and every analyst will have their own view of what a company is worth.

The only way to improve your accuracy is practice and experience. Even then there’s no guarantee.

Buffett has been doing this for seven decades, and he’s still making mistakes (Kraft Heinz). All we can do is try to skew the odds of success in our favour.

The author owns shares in Berkshire Hathaway.

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