Valuation, Value Investing

Quotes from Warren Buffett on DCF and NPV

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:

  • 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.”
  • etc.

[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.]


2 thoughts on “Quotes from Warren Buffett on DCF and NPV

  1. Alice Schroeder on How Buffett Values a Business and Invests…..
    On November 20, 2008, Alice Schrooder, author of “The Snowball: Warren Buffett and the Business of Life”, spoke at the Value Investing Conference at the Darden School of Business. She gave some fascinating insights into how Buffett invests that are not in the book. I hope you find them useful.
    Much of Buffett’s success has come from training himself to practice good habits. His first and most important habit is to work hard. He dug up SEC documents long before they were online. He went to the state insurance commission to dig up facts. He was visiting companies long before he was known and persisting in the face of rejection.
    He was always thinking what more he could do to get an edge on the other guy.
    Schroeder rejects those who argue that working harder will not give you an edge today because so much is available online.
    Buffett is a “learning machine”. This learning has been cumulative over his entire life covering thousands of businesses and many different industries. This storehouse of knowledge allows Buffett to make decisions quickly.
    Schroeder uses a case study on Mid-Continent Tab Card Company in which Buffett invested privately to illustrate how Buffett invests.
    In the 1950′s, IBM was forced to divest itself of the computer tab card business as part of an anti-trust settlement with the Justice Department. The computer tab card business was IBM’s most profitable business with profit margins of 50%.
    Buffett was approached by some friends to invest in Mid-Continent Tab Card Company which was a start-up setup to compete in the tab card business. Buffett declined because of the real risk that the start-up could fail.
    This illustrates a fundamental principle of how Buffett invests: first focus on what you can loose and then, and only then, think about return. Once Buffett concluded he could lose money, he quit thinking and said “no”. This is his first filter.
    Schroder argues that most investors do just the opposite: they first focus on the upside and then give passing thought to risk.
    Later, after the start-up was successfully established and competing, Buffett was again approached to invest capital to grow the business. The company needed money to purchase additional machines to make the tab cards. The business now had 40% profit margins and was making enough that a new machine could pay for itself in a year.
    Schroeder points out that already in 1959, long before Buffett had established himself as an expert stock picker, people were coming to him with special deals, just like they do now with Goldman Sachs and GE. The reason is that having started so young in business he already had both capital and business knowledge/acumen.
    Unlike most investors, Buffett did not create a model of the business. In fact, based on going through pretty much all of Buffett’s files, Schroder never saw that Buffett had created a model of a business.
    Instead, Buffett thought like a horse handicapper. He isolated the one or two factors upon which the success of Mid American hinged. In this case, sales growth and cost advantage.
    He then laid out the quarterly data for these factors for all of Mid Continent’s factories and those of its competitors, as best he could determine it, on sheets of a legal pad and intently studied the data.
    He established his hurdle of a 15% return and asked himself if he could get it based on the company’s 36% profit margins and 70% growth. It was a simple yes or no decision and he determined that he could get the 15% return so he invested.
    According to Schroder, 15% is what Buffett wants from day 1 on an investment and then for it to compound from there.
    This is how Buffett does a discounted cash flow. There are no discounted cash flow models. Buffett simply looks at detailed long-term historical data and determines, based on the price he has to pay, if he can get at least a 15% return. (This is why Charlie Munger has said he has never seen Buffett do a discounted cash flow model.)
    There was a big margin of safety in the numbers of Mid Continent.
    Buffett invested $60,000 of personal money or about 20% of his net worth. It was an easy decision for him. No projections – only historical data.
    He held the investment for 18 years and put another $1 million into the business over time. The investment earned 33% over the 18 years.
    It was a vivid example of a Phil Fisher investment at a Ben Graham price.
    Buffett is very risk averse and follows Firestone’s Law of forecasting: “Chicken Little only has to be right once.” This is why Berkshire Hathaway is not dealing with a lot of the problems other companies are dealing with because he avoids the risk of catastrophe.
    He is very realistic and never tries to talk himself out of a decision if he sees that it has cat risk.
    Buffett said he thought the market was attractive in the fall of 2008 because it was at 70%-80% of GDP. This gave him a margin of safety based on historical data. He is handicapping. He doesn’t care if it goes up or down in the short term. Buying at these levels stacks the odds in his favor over time.
    Buffett has never advocated the concept of dollar cost averaging because it involves buying the market at regular intervals – regardless of how overvalued the market may be. This is something Buffett would never support.
    Here is a link to the video:

    Posted by loong | August 7, 2013, 11:40 am
  2. awesome details. most wanted dint fins this in any research articles either! thank you so much 🙂

    Posted by subodha samarasinghe | February 1, 2016, 5:04 am

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