Some things you only do in private
How does Buffett assess the value of companies? Readers will have a good idea how sell side analysts go about recommending stocks. See recent post here. Readers will also understand the basics of Discounted Cash Flow (DCF) analysis. See this recent post. Warren Buffett has his own way of doing it that is based on the concept of DCF. I suggest readers only continue with this present post if they are comfortable with the concept of DCF analysis.
To begin, let’s look at what Buffett wrote in an essay in 2001 based on a speech he had given in July that year. It was contained in the December 10, 2001 Carol Loomis’ report on the CNNMoney website. http://money.cnn.com/magazines/fortune/fortune_archive/2001/12/10/314691/
Buffett wrote: “A stock, in contrast [to a bond], is a financial instrument that has a claim on future distributions made by a given business, whether they are paid out as dividends or to repurchase stock or to settle up after sale or liquidation. These payments are in effect “coupons.” The set of owners getting them will change as shareholders come and go. But the financial outcome for the business’ owners as a whole will be determined by the size and timing of these coupons. Estimating those particulars is what investment analysis is all about.” [Emphasis added]
The concept of Owner Earnings is Warren Buffett’s invention. In his 1986 Chairman’s letter to the shareholders of Berkshire Hathaway, Buffett writes:
“If we think through these questions, we can gain some insights about what may be called “owner earnings”, These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges… less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume….
Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since(c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”” (Emphasis added)
Rather than deducting what the company happened to spend in one year or even average five years capital spending, Buffett makes an assessment as to the capital spending necessary to maintain the company’s competitive position. This may leave substantially less free cash than typical calculations of Free Cash Flow produce.
Once Buffett has made his ‘vaguely right’ estimate of Owner Earnings, he then asks himself whether the company can make good use of this surplus cash. He says: “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” (Buffett W. E., 1998)p.86.
At this point Buffett has an idea of the Owner Earnings the company can generate over an extended period of time (the cash input for a DCF analysis) and an idea of the ability of the company to employ its incremental or excess capital at “very high rates of return” over an extended period (the growth input).
Readers will know that Buffett views value and growth as joined at the hip. What he means by this is that growth is an intrinsic part of valuing a company. In spreadsheet terms the Owner Earnings figures for future years will be increasing/growing. This is how growth plays out in a DCF analysis. By contrast, in valuing a company using a low price earnings ratio, an investor never turns their mind to future growth.
Use of spreadsheets
In the Value Investing World blog on Thursday, March 29, 2018 it was reported that at the 1996 Berkshire Hathaway Annual Meeting the following exchange took place:
Munger: 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.
The subject continued at the 2007 Berkshire Hathaway AGM, as quoted by the Value Investing World website July 24, 2019, when Warren Buffett commented:
“We don’t formally have discount rates. Every time I start talking about all this stuff, Charlie reminds me that I’ve never prepared a spreadsheet. But, in effect, in my mind I do. We are going to want to get a significantly higher return, obviously — in terms of cash produced relative to the amount we’re outlaying now — for a business than we are from a government bond. That has to be the yardstick at a base. And how much more do we want? Well, if government bond rates were 2 percent, we’re not going to buy a business to earn 3 or 3 1/2 percent expectancy over the years. We just don’t want to commit our money that way. We’d rather sit around and wait a little while. If they’re 4 3/4 percent, you know, what do we hope to get over time? Well, we want to get a fair amount more than that. But I can’t tell you that we sit down every morning and I call Charlie in Los Angeles and say, ‘What’s our hurdle rate today?’ I mean, we’ve never used the term. We want enough so that we feel very comfortable if they closed down on the stock market for a couple of years, if interest rates go up another hundred basis points or 200 basis points, we’re still happy with what we’ve bought. I know it sounds kind of fuzzy, but it is fuzzy.” (Emphasis added)
Hurdle rates and discount rates
Remember the discussion of discount rates in DCF analysis in my recent post see here.
They are comprised of a base, usually the UST 10 year yield, a risk premium for stocks over bonds, a company specific risk premium and then some adjustment or normalization to reflect the manipulation of rates by the Federal Reserve.
As recently as the 1980s, Buffett’s approach was to make a projection of the future stream of cash and apply as a discount rate the rate on long term U.S. government bonds without adding an Equity Risk Premium.
Without the risk premium the low bond rate gives a higher value. Buffett apparently felt a risk premium need not be added because, any companies with predictable and consistent earnings he would be prepared to buy shares in, would be without risk! This at least was the approach he favored at the time of Berkshire’s 1989 Annual Report.
Hagstrom also reports that Warren Buffett uses (or at least at one time used) the risk free ten year U.S. Treasury Bond yield without equity risk adjustment. (Hagstrom, The Warren Buffett Way – Investment Strategies of the World’s Greatest Investor, 1994) p.94. Apparently, as interest rates decline he is more cautious in using the long term rate.
Today I doubt Buffett uses U.S. long bond rates without normalizing them which adds subjective elements. Adding subjective elements is not necessarily bad. It does require business judgement and a recognition that one is not simply letting the data speak.
In a way, Buffett’s approach is akin to comparing sustainable free cash flow yield (free cash flow/price as a percent) with a hurdle rate akin to a discount rate. He might say, this company is producing a growing and sustainable Owner Earnings yield of say 10%, the company can reinvest this excess capital at high rates of return and our yardstick rate for equities is currently 4% based on normalized 10 year UST yields. He may feel he is currently a buyer for such companies producing 8% or more to allow for a Margin of Safety. This company would meet his notional hurdle rate.
These percentages are simply for illustration. In different interest rate environments the base, the risk premium, the yardstick and the hurdle rates may be quite different.
To learn more about identifying the best companies to invest in take a look at Part 6: The Hallmarks of Superb Businesses
And particularly Chapter 31. General approach to choosing common stocks
And Chapter 31.18 Owner earnings.
To learn more about creating a portfolio of stocks take a look at Part 7: Building and managing a portfolio
And specifically to read more on the subjects discussed in this post see:
Chapter 37. Stocks as disguised bonds
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