Q1: How do you think about value?
A1：The formula for value was handed down from 600 BC by a guy named Aesop. A bird in the hand is worth two in the bush. Investing is about laying out a bird now to get two or more out of the bush. The keys are to only look at the bushes you like and identify how long it will take to get them out. When interest rates are 20%, you need to get it out right now. When rates are 1%, you have 10 years. Think about what the asset will produce. Look at the asset, not the beta. I don’t really care about volatility. Stock price is not that important to me, it just gives you the opportunity to buy at a great price. I don’t care if they close the NYSE for 5 years. I care more about the business than I do about events. I care about if there’s price flexibility and whether the company can gain more market share. I care about people drinking more Coke.
I bought a farm from the FDIC 20 years ago for $600 per acre. Now I don’t know anything about farming but my son does. I asked him, how much it cost to buy corn, plow the field, harvest, how much an acre will yield, what price to expect. I haven’t gotten a quote on that farm in 20 years.
If I were running a business school I would only have 2 courses. The first would obviously be an investing class about how to value a business. The second would be how to think about the stock market and how to deal with the volatility. The stock market is funny. You have no compulsion to act and a bunch of silly people setting prices all the time, it is great odds. I want the market to be like a manic depressive drunk.
Q2: How do you calculate intrinsic value?
A2：Intrinsic value is terribly important but very fuzzy. We try to work with businesses where we have fairly high probability of knowing what the future will hold. If you own a gas pipeline, not much is going to go wrong. Maybe a competitor enters forcing you to cut prices, but intrinsic value hasn’t gone down if you already factored this in. We looked at a pipeline recently that we think will come under pressure from other ways of delivering gas [to the area the pipeline serves]. We look at this differently from another pipeline that has the lowest costs [and does not face threats from alternative pipelines]. If you calculate intrinsic value properly, you factor in things like declining prices.
When we buy business, we try to look out and estimate the cash it will generate and compare it to the purchase price. We have to feel pretty good about our projections and then have a purchase price that makes sense. Over time, we’ve had more pleasant surprises than we would have expected.
I’ve never seen an investment banker’s book in which future earnings are projected to go down. But many businesses’ earnings go down. We made this mistake with Dexter shoes — it was earning $40 million pretax and I projected this would continue, and I couldn’t have been more wrong. 20% of Fortune 500 companies will be earning significant less in five years, but I don’t know which 20%. If you can’t come up with reasonable estimates for that, then you move on.
Q3: What do you believe to be the most important tools in determining intrinsic value? What rules or standards do you apply when using these tools?
A3：If we could see in looking at any business what its future cash flows would be for the next 100 years, and discount that back at an appropriate interest rate, that would give us a number for intrinsic value. It would be like looking at a bond that had a bunch of coupons on it that was due in a hundred years … Businesses have coupons too, the only problem is that they’re not printed on the instrument and it’s up to the investor to try to estimate what those coupons are going to be over time. In high-tech businesses, or something like that, we don’t have the faintest idea what the coupons are going to be. In the businesses where we think we can understand them reasonably well, we are trying to print the coupons out. If you attempt to assess intrinsic value, it all relates to cash flow. The only reason to put cash into any kind of investment now is that you expect to take cash out–not by selling it to somebody else, that’s just a game of who beats who–but by the asset itself … If you’re an investor, you’re looking on what the asset is going to do, if you’re a speculator, you’re commonly focusing on what the price of the object is going to do, and that’s not our game. We feel that if we’re right about the business, we’re going to make a lot of money, and if we’re wrong about the business, we don’t have any hopes of making money.
[CM: I would argue that one filter that’s useful in investing is the idea of opportunity costs. If you have one idea that’s available in large quantity that’s better than 98% of the other opportunities, then you can just screen out the other 98% … With this attitude you get a concentrated portfolio, which we don’t mind. That practice of ours which is so simple is not widely copied, I don’t know why. Even at great universities and intellectual institutions. It’s an interesting question: If we’re right, why are so many other places so wrong.]
There are several possible answers to that question! The first question we ask ourselves is, would we rather own this business than more Coca-Cola, than more Gillette …. We will want companies where the certainty gets close to that, or we would figure we’d be better off buying more Coke. If every management, before they bought a business, said is this better than buying in our own stock or even buying Coca-Cola stock, there’d be a lot less deals done. We try to measure against what we regard as close to perfection as we can get.
Q4: Could you comment on the matter of intrinsic value as it applies to some of the Inevitables?
A4：Well, we won’t stick a price on it. They are absolutely wonderful businesses run by sensational people, and they are selling at prices that are higher than they’ve sold at most of the time. But they may well be worth it, either in present terms, or they may be a couple of years ahead of themselves. Gillette doesn’t repurchase their shares … Coke consistently repurchases their shares.
We generally like the policy of companies that have really wonderful businesses repurchasing their shares. The problem with most companies repurchasing their shares is that they are frequently so-so businesses and they are repurchasing shares for purposes other than intensifying the interest of shareholders in a wonderful business.
It’s hard to do things intelligently with money in this world and Coke has been very intelligent about using their capital, particularly to fortify and develop their bottler network around the world, but there’s only so far you can go with that, and to enhance the ownership of shareholders in a company like Coca-Cola [is great].
Q5: When you estimate intrinsic value in capital intensive companies like McDonald’s and Walgreens where a very healthy and growing operating cash flow is largely offset by expenditures for new stores, restaurants, etc how do you estimate future free cash flow? And at what rate do you discount those cash flows?
A5：We use the same discount rate across all securities. We may be more conservative in estimating cash in some situations.
Just because interest rates are at 1.5% doesn’t mean we like an investment that yields 2-3%. We have minimum thresholds in our mind that are a whole lot higher than government rates. When we’re looking at a business, we’re looking at holding it forever, so we don’t assume rates will always be this low.
We don’t formally have discount rates. Every time we start talking about this, Charlie reminds me that I’ve never prepared a spreadsheet, but I do in my mind.
We just try to buy things that we’ll earn more from than a government bond – the question is, how much higher? If government bonds are at 2%, we’re not going to buy a business that will return 4%.
I don’t call Charlie every day and ask him, 「What’s our hurdle rate?」 We’ve never used the term.
Munger: The concept of a hurdle rate makes nothing but sense, but a lot of people using this make terrible errors. I don’t think there’s any substitute for thinking about a whole lot of investment options and thinking about the returns from each.
The trouble isn’t that we don’t have one [a hurdle rate] – we sort of do – but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I’d reject it instantly. It’s like the mail-order-bride firm offering a bride who has AIDS – I don’t need to waste a moment considering it. Everything is a function of opportunity cost.
A6：We perceive risk as items that impair future business. Wants to have mathematical risk on their side over a group of decisions. Not in the business of assuming a lot of risk in business. We look for moats around businesses. We look for castles (businesses) that have a moat surrounding it which is expanding as a primary consideration of a great business.
Q7: What valuation metrics do you use?
The appropriate multiple for a business compared to the S&P 500 depends on its return on equity and return on incremental invested capital. I wouldn’t look at a single valuation metric like relative P/E ratio. I don’t think price-to-earnings, price-to-book or price-to-sales ratios tell you very much. People want a formula, but it’s not that easy. To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. All cash is equal. You just need to evaluate a business’s economic characteristics.
Q8: What do you think of the use of book values in making investment decisions?
Book value is virtually not a consideration in investment decision-making at Berkshire. Their pursuit of high return businesses usually leads to companies with minimal book values. He added that the book value approach could work well with small sums of money, like Graham had managed, and that the approach had worked well for Graham-type practitioners like Buffett’s friend Walter Schloss. The three most important concepts conveyed by Graham in 「The Intelligent Investor」 were the investor’s attitude toward the market, the 「margin of safety」, and the practice of looking at companies as businesses, not stocks.
Munger proffered that 「projections generally do more harm than good, and are usually prepared by persons who have some sort of an interest in the outcome of actions based on the projections. They often have a precision that’s deceptive.」 Buffett added that they’ve never looked at a projection in connection with an equity or business that they’ve acquired. 「It’s a ritual to justify doing what an executive or a board wanted to do in the first place.」
Q9: If you can’t talk with management, and can’t read the annual report, and didn’t know the price, but could only look at the financial statements, what metric would you look at?
A9：WB: Investing is laying out money now to get more money later on. Let’s leave the market price out. If you were buying a farm, you would think about bushels per acre — you are looking to the asset itself. Ask yourself: do I understand enough about the business so that the financials will be able to tell me meaningful things that will help me to foresee the statements in the future? I have bought stocks the way you describe. They were in businesses I understood, and if I could buy at 40% of X, I’d be okay with the margin of safety. If you don’t tell me the nature of the business, financial statements won’t tell me much. We’ve bought many securities, and with most, we’ve never met management. We use our general understanding of business and look to specifics from financial statements.
CM: One metric catches people. We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.
WB: We could value an apartment if we knew where the apartment is, and we know the monthly checks. I have bought a lot of things off the financials. There is a lot I wouldn’t buy even if it had the best management in the world, as it doesn’t make much difference in a bad business.
Q10: How do you think about growth rates when you value businesses?
When the [long-term] growth rate is higher than the discount rate, then [mathematically] the value is infinity. This is the St. Petersburg Paradox, written about by Durand 30 years ago. [Click here for a copy of the original 1957 article. For more on this topic, I recommend Integrating the Outliers: Two Lessons from the St. Petersburg Paradox, by CSFB’s (now Legg Mason’s) Michael Mauboussin.].Some managements think this [that the value of their company is infinite]. It gets very dangerous to assume high growth rates to infinity – that’s where people get into a lot of trouble. The idea of projecting extremely high growth rates for a long period of time has cost investors an awful lot of money. Go look at top companies 50 years ago: how many have grown at 10% for a long time? And [those that have grown] 15% is very rarified. Charlie and I are rarely willing to project high growth rates. Maybe we’re wrong sometimes and that costs us, but we like to be conservative.
[CM: If your growth rate is so high that you conclude the business has an infinite valuation, you have to use more realistic numbers. What else could anyone do?]