Warren Buffett series #7 – How to calculate intrinsic value of a business

People always want a formula. They go to the Intelligent Investor and think somewhere they are going to find a little formula.
It really doesn’t work that way.

“A bird in hand is worth two in the bush” – Aesop

Aesop was onto something but he didn’t finish it. There are a couple of other questions that go along: “When are you going to get the two in the bush?”, “How certain is it to get the two in the bush?”, “What’s the interest rate?”

If you know interest rate and the timetable, you know investing. You would trade a bird in hand.

You lay out cash today to get more cash in the future.

It’s an investing decision. You have to decide how many birds are in the bush, when they are going to get out, and when you are going to acquire them. 

If the interest rate is 5% and you will get the two birds in five years, two birds in the bush is much better than one bird in hand. That’s roughly 15% compounded annually. If the interest rate is 20%, you would decline to take two birds in the bush five years from now. 

With growth, people associate with a lot more birds in the bush. You still have to decide when you are going to get them. You have to measure that against interest rates. You have to measure that against other bushes.

It’s a value decision: what it is worth, how many birds are in that bush, when you are going to get them, and what interest rate is.

Every year you wait to take a bird out of the bush, you have to take out more birds. If a company doesn’t pay you a dividend this year or next year, it has to be able to pay you more in perpetuity the year after.

If you buy a company for $500 billion and purchase 10% of that company and want to get a 10 percent return, $50 billion of cash has to come out of that company year after year. If they delay one year of dividend, $55 billion of cash has to come out. To do that, they have to make $80 billion pretax. There are not many companies that earn $80 billion pretax. So it requires a rather extraordinary change in profitability to give you enough birds out of that particular bush to make it worthwhile to give up the one you have in your hand.

People always want a formula. They go to the Intelligent Investor and think somewhere they are going to find a little formula.

It really doesn’t work that way. What you do is to look at all cash a business will produce between now and judgement day and discount it back at a rate that’s appropriate (intrinsic value), and then buy it a lot cheaper than that (margin of safety). You really want to look for things you can understand and where you can see out for a good many years as to the cash that can be generated from the business. If you can buy it at a cheap enough price compared to that cash, it doesn’t make any difference what the name attached to the cash is.

The intrinsic value calculation should already factor in the fact that certain businesses are going to earn less in the future than now. It’s that their intrinsic value goes down. 

Intrinsic value is very important and very fuzzy. We do our best to work with the kind of businesses where we think we have the highest possibilities where our predictions are of a fairly highly probable nature. That leaves out all kind of companies. It’s something like the natural gas pipeline. The chance of big surprises in a pipeline should be relatively small. It doesn’t mean they are zero but they are relatively small.

Let’s assume that you have a pipeline which either the supply of gas is going to run down or there are competitive pipelines that may be trying to take away your contracts that you wrote 10 years ago and expire in two years and you will have to cut the price. Two years from now when you have to cut the price, the intrinsic value hasn’t gone down from today if you properly calculate it today and build in the fact that profit margins in the future will be lower than today.

You build in the prediction of decline in the future operating years. You don’t want to wait till you get there to anticipate it. That’s part of predicting in business. Lots of businesses’ earning go down. They are going to go down. You have to analyze businesses and some businesses are going to be subjected to enormous competitive pressures that are not extant today.

We made a mistake with Dexter Shoes which was earning $40 million pretax. We assumed the future would look as good as the past. That’s part of the game to figure out what those future cash flows are likely to be. When you can’t come up with reasonable estimates, you move onto the next one.

About me and why this series:
I got a life-changing experience studying Warren Buffett’s annual letters in 2013 after 10 years of speculating, market timing, charting, and forecasting. I started investing in the Vietnamese stock market in 2015 with what I saved from my engineering job. In 2018, I decided to study Warren Buffett’s investing again by going through all of available Berkshire Hathaway’s annual meeting videos. It has been another life-changing experience. Warren Buffett’s teaching is a real germ and yet not many people replicate. Hence, I am committed to share what I learned.

You can subscribe to my blog to follow the series of what Warren Buffett has been teaching in his annual meetings. I attempted to modify but keep as much as possible what he spoke.

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Warren Buffett series #6 – Advice to start investing

You can’t look around for people to agree with you. You can’t look around for people to even know what you are talking about. You have to think for yourself.

Advice to start investing:

Start young.

The big thing about investing is that we started building this little snowball on top of a very long hill. We started at a very early age rolling the snowball down.

The nature of the compound interest is that it behaves like a snowball of sticky snow. The trick is to have a very long hill.

If I am to start out today with $10,000, I would do exactly the same way. I would start going right through companies. I would focus on smaller companies because that would be working with smaller sums and there’s more chance that something is overlooked in that area. 

You have to buy businesses or a little piece of businesses called stocks and buy them at an attractive price. You can’t expect anybody else to do it for you. You’ve got to know what you know and what you don’t know.

Within the arena of what you know, you have to pursue it very vigorously and act on it when you find it. 

You can’t look around for people to agree with you. You can’t look around for people to even know what you are talking about. You have to think for yourself. 

The hard part of the process is the first $100,000. The people who get there quickly are helped if they are passionate about being rational, very eager, and opportunistic, and steadily underspent their income grossly.

About me and why this series:
I got a life-changing experience studying Warren Buffett’s annual letters in 2013 after 10 years of speculating, market timing, charting, and forecasting. I started investing in the Vietnamese stock market in 2015 with what I saved from my engineering job. In 2018, I decided to study Warren Buffett’s investing again by going through all of available Berkshire Hathaway’s annual meeting videos. It has been another life-changing experience. Warren Buffett’s teaching is a real germ and yet not many people replicate. Hence, I am committed to share what I learned.

You can subscribe to my blog to follow the series of what Warren Buffett has been teaching in his annual meetings. I attempted to modify but keep as much as possible what he spoke.

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Warren Buffett series #5 – What to look for when determining if a person is honest or not?

What to look for when determining if a person is honest or not?

We have to have some evidence of behavior in front of us. If we work with someone over a period of a few months or more, we can come up with a pretty high batting average in terms of how they behave. 

People leave track records in life. By the time you at 22 or 23, you will have left quite a track record and the world would be able to figure you out. 

Track records are important. If you start early trying to have a perfect record in some simple thing like honesty, you are well on the way to success in the world.

You can have the reputation you want. If you list all of the things that you admire in other people, you will find out that almost everything you list are qualities you have have if you set out to do that.

The best way to have what you want is to deserve what you want.

About me and why this series:
I got a life-changing experience studying Warren Buffett’s annual letters in 2013 after 10 years of speculating, market timing, charting, and forecasting. I started investing in the Vietnamese stock market in 2015 with what I saved from my engineering job. In 2018, I decided to study Warren Buffett’s investing again by going through all of available Berkshire Hathaway’s annual meeting videos. It has been another life-changing experience. Warren Buffett’s teaching is a real germ and yet not many people replicate. Hence, I am committed to share what I learned.

You can subscribe to my blog to follow the series of what Warren Buffett has been teaching in his annual meetings. I attempted to modify but keep as much as possible what he spoke.

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Warren Buffett Series #4 – The scuttlebutt method – how to use it to analyze a business

You really want to start with a business where you think the economics are good, where they look like a seven-footer, and then you go out with a scuttlebutt approach to possibly reject your original hypothesis. Or maybe you confirm it.

Scuttlebutt method: You can’t do too much of scuttlebutt. The general premise of why you are interested in something should be 80 percent of it. You don’t want to be chasing down every idea using the scuttlebutt method.

So you must have a strong presumption. You should be like a basketball coach who runs into a seven-footer on the street. You are interested to start with. Now you have to find out if you can keep him in school, if he’s coordinated, … That’s the scuttlebutt aspect of it.

As you acquire knowledge about businesses, first do some reading about them, then get out and talk to competitors, customers, suppliers, ex-employees, and current employees, … You will learn a lot. But it should be the last 20 percent or 10 percent.

You really want to start with a business where you think the economics are good, where they look like a seven-footer, and then you go out with a scuttlebutt approach to possibly reject your original hypothesis. Or maybe you confirm it,.

About me and why this series:
I got a life-changing experience studying Warren Buffett’s annual letters in 2013 after 10 years of speculating, market timing, charting, and forecasting. I started investing in the Vietnamese stock market in 2015 with what I saved from my engineering job. In 2018, I decided to study Warren Buffett’s investing again by going through all of available Berkshire Hathaway’s annual meeting videos. It has been another life-changing experience. Warren Buffett’s teaching is a real germ and yet not many people replicate. Hence, I am committed to share what I learned.

You can subscribe to my blog to follow the series of what Warren Buffett has been teaching in his annual meetings. I attempted to modify but keep as much as possible what he spoke.

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Warren Buffett series #3 – What teenagers can do to prepare to become an investor?

If you are interested in investments, you should take the accounting courses. You should do a lot of reading and get as much business experience as possible.

If you are interested in business, you ought to learn all the accounting you can by the time you are in your early 20s.
Accounting is the language of business. It doesn’t mean it’s a perfect language. You have to know the limitations of that language as well as all aspects of it. 

You should work at a number of businesses – in term of part-time employment or anything else. There’s nothing like seeing how business operates to build your judgement in the future about businesses.
When you understand what kind of things are competitive and what kind of things are less competitive and why that works that way, all of that adds to your knowledge.

You should do a lot of reading.

If you are interested in investments, you should take the accounting courses. You should do a lot of reading and get as much business experience as possible.

You should talk business people with people that are in business to find out what they think makes their operation tick or where they have problems and why. 

If you understand business, you understand investment. Investments are simply business decisions in terms of capital allocation.

Any dollar you save before you get out and start having a family is probably worth $10 later on simply because you save it. The time to save is young. You’ll never have a better time to save than really free formation of a family. 

Work for yourself first and put the money aside. I was able to save everything I made in my teens and those dollars got magnified quite a bit. 

About me and why this series:
I got a life-changing experience studying Warren Buffett’s annual letters in 2013 after 10 years of speculating, market timing, charting, and forecasting. I started investing in the Vietnamese stock market in 2015 with what I saved from my engineering job. In 2018, I decided to study Warren Buffett’s investing again by going through all of available Berkshire Hathaway’s annual meeting videos. It has been another life-changing experience. Warren Buffett’s teaching is a real germ and yet not many people replicate. Hence, I am committed to share what I learned.

You can subscribe to my blog to follow the series of what Warren Buffett has been teaching in his annual meetings. I attempted to modify but keep as much as possible what he spoke.

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