I chanced upon this book The Real Warren Buffett: Managing Capital, Leading People by James O’Loughlin at the library today. Found a couple of good quotes from Buffett to capture in this blog.
From Buffett’s 1992 annual report:
“In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.”
From Buffett’s 2000 annual report:
“Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).
The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush ¾ and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.
Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota – nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.”
[Thought: To rank the attractiveness of different uses of capital, Buffett would have to calculate either NPV or IRR. Since he wrote above that he uses the long-term U.S. bonds rate, it seems to imply that he calculates NPV to compare across the different investment opportunities.]
As an aside, basically every value investor in the world uses DCF:
- FocusInvestor.com quoted this from the Clipper Fund: “Our investment approach is very research intensive and includes meeting with management and preparing detailed valuation models for each company followed. The valuation models calculate the intrinsic value which is based on private market transactions and discounted cash flow valuations.”
- It also quoted this from Longleaf Partners: “…determine the company’s ongoing value based on its ability to generate free cash flow after required capital expenditures and working capital needs. We calculate the present value of the projected free cash flows plus a terminal value, using a conservative discount rate.”
- Legg Mason’s Michael Mauboussin likely uses DCF. He has an excellent article on the common errors people make in DCF modeling, here. He has another excellent article on comparing share buybacks vs dividends at here.
- Richard Lawson from Weitz Funds had an interview in the book Wizards of Wall Street where he said: “I ask whether I would like to own a company at its current market price, assuming that I never had a chance to sell it to anybody else. When you think about value from that perspective, all that really matters is the long-term discounted free cash flow. It’s just a function of how much cash you should expect the company to be able to pay out to its shareholders over its life, discounted back to the present.”
[Thought: Lawson’s quote above is interesting on two fronts. First is when you consider that you would not have a chance to sell it to anybody else, it just means that for the terminal value calculation, you will discount future payouts from the company, as opposed to using data from private market transactions or from movements of a multiple. Second, he is clear that what you discount is what the “company pays out to its shareholders”, as opposed to counting free cash flow that is retained.]