I am basing what I am typing here off an amazing clip from the 1997 Berkshire Hathaway annual meeting where Warren Buffett and Charlie Munger were asked how they think about intrinsic value and the tools that they use to assess it. The full clip is at the bottom of this post.
As I have said many times before, you are better to spend time watching, listening and spending time reading about Warren Buffett than you are reading my blog posts or listening to my podcasts. The quotes below are taken directly from the video:
“If we could see, looking at any business, what its future cash inflows or outflows from the business to the owners would be over the next 100 years or until the business is extinct and then could discount that back to the appropriate interest rate then that would give us a number for intrinsic value. In other words it would be like looking at a bond that had whole bunch of coupons on it that was due in a 100 years and if you could see what those coupons are you could figure the value of that bond…businesses have coupons that are going to develop in the future too, the only problem is that they are not printed on the instrument and it is up to the investor to try to estimate what those coupons are going to be over time. As we have said in hi-tech businesses or something like that we don’t have the faintest idea what those coupons are going to be. When we get into businesses where we think we can understand them reasonably well we are trying to print the coupons out, we are trying to figure out what businesses are going to be worth in 10 or 20 years”
“If you attempt to assess the intrinsic value it all relates to cash flows, the only reason for putting cash into any type of investment is because you expect to take cash out, not by selling it to somebody else, because that is just a game of who beats who. But in a sense, by what the asset itself produces. That is true if you are buying a farm and it is true if you are buying a business”
“That is what the game of investment is all about. Investment is about putting out money now to get more money back later on from the asset, not by selling it to someone else by what the asset itself will produce. If you are an investor you are looking at what the asset is going to do, in our case businesses. If you are a speculator, you primarily focusing on what the price of the object is going to do independent of the business, that’s not our game. If we are right about the business we will make a lot of money. If we are wrong about the business, we do not expect to make money”.
How do we explain this using an example? I always like to explain this using the analogy of a petrol station that had 10 years left on its lease. You knew that the petrol station was going to produce profits of $1 million per year each year for the next 10 years. What would you pay for that $10 million over the next 10 years? Would you pay $20 million today? Obviously not, why would you pay $20 million today if a business can only produce $10 million over the remainder of its life? You might laugh at that, but it happens all of the time in the stock market. People are prepared to pay far more for businesses than what they can actually produce.
Would you pay $10 million? again, obviously not, why would you pay $10 million today only to get it back eventually in 10 years? You would be better off with the money in the bank, even at today’s yields.
So what would you pay? $5 million? maybe you would, that would depend on the availability of alternatives. If you could get 10% risk-free in the bank then you wouldn’t. Would you pay $1 million? probably. Would you pay $100k? most definitely. Most definitely are the situations to look for in the stock market.
Now the academically correct way of doing this is to do a discounted cash flow where you discount the estimated future cash flows back to present value and an appropriate interest rate, but I always think that if you have to do that sort of thing to the most finite decimal place that you are cutting things too fine. The best way to invest is to wait for the situations where you say you say, “most definitely”. These situations are the ones that will give you the best and lowest risk returns in the stock market after a while.